A big demand slump isn’t just an economic disaster; it’s also a prediction of an economic disaster. And that means it’s a prediction of policy failure. At least that’s the implication of the Woodfordian view of macro (which I accept.) Changes in current AD are mostly driven by changes in the future path of AD. Changes in near-term NGDP are mostly driven by changes in expected NGDP 1, 2, 5 and 10 years out in the future. Call it the term structure of NGDP. And those are driven by the future expected path of monetary policy.
And of course whenever we have crashes like 1920-21, 1929-30, 1937-38, 2008-09, we also tend to have asset market crashes. Asset markets aren’t perfect (1987) but when there’s a very big economic slump on the way they are pretty good at sniffing it out.
So here’s the problem for macro policy. It’s good at preventing disasters, as we saw with the Great Moderation. But when it fails, it’s really, really hard to fix the problem, because doing so requires policymakers to be more effective than the markets predict. I won’t say that things are hopeless when markets predict disaster, but I wouldn’t put much hope on stabilization policy. In the textbooks, the purpose of stabilization policy is to “fix problems.” In reality it will usually fail at that. Rather it’s good at preventing problems. If you’ve got a problem, you’ve already failed. Like the old joke—”if you are headed there, I wouldn’t start from here.”
I was reminded of all this while reading a Brad DeLong post that discusses a debate between Nick Rowe and Simon Wren-Lewis. DeLong looks at the possibilities offered by monetary and fiscal stimulus when you have a “deficiency in demand.”
Let’s look at this from a different perspective. The problem is not “demand deficiency” it’s expected demand deficiency. Policymakers try to steer the nominal economy, they implicitly or explicitly target NGDP one or two years out in the future. If 12 month forward expected NGDP is right on target, then no policy changes are needed. And if 12 month forward NGDP is below target, then the markets have predicted policy will fail, and their forecast counts for far more than the views of any academic economist or government policymaker. At that point, we really shouldn’t expect much from macro policy. It’s likely to fail. No wonder people are so pessimistic about monetary policy! Markets have observed the behavior of the relevant central bank (Fed, ECB, etc.) and come up with the optimal forecast of the result. If there’s an expected demand shortfall, markets have already given a vote of no confidence to the policymaking apparatus.
From that perspective, DeLong is asking the wrong question. It’s not, “how do we fix this problem?” It’s, “how to we make it so that Brad DeLong and Simon Wren-Lewis never ask, ‘how do we fix this problem.’” I see two ways, and only two ways of doing that. Both methods involve abandoning the Keynesian policy of interest rate targeting. Interest rate targeting doesn’t work at the very moment when good monetary policy is most essential—in a very deep demand slump. Would you buy a car that had a brake that failed just 1% of the time—only on twisty mountain roads with no guardrail? Then why do you (Keynesians) buy interest rate targeting as the appropriate policy instrument?
1. One method would have the central bank peg the price of one year forward NGDP futures, and do OMOs until the market price is right on target. Now you don’t have to worry about what to do if there is an expected demand deficiency, because there never is an expected demand deficiency. At least not one expected by the market. There may be a current demand deficiency, but if it isn’t expected to persist, then stabilization policy is right on target.
2. Let’s say you don’t buy the “market” part of market monetarism. You think markets are irrational. ”Better leave this to the wise mandarins who will control policy in the optimal fashion.” What then? It’s very simple, you do what Lars Svensson suggested, you set the monetary instrument at a position where the central bank’s internal forecast is equal to the policy target. But which instrument? Recall that we have abandoned interest rate targeting. Don’t ask me, I’m the NGDP futures market guy–ask the mandarins. Anything with no zero bound. It might be the monetary base, it might be the trade-weighted exchange rate, it might be the nominal price of zinc. There is an infinity of possible choices. (Now do you see why I’d rather let the markets set policy?)
In his post, DeLong cites Wren-Lewis saying he’s heard the MM arguments, but doesn’t buy them. Then he goes on to conclusively show he has not heard the MM arguments, by using the metaphor of employing both a regular brake and an emergency brake in a car careening down a hill. This metaphor is supposed to provide justification for using fiscal stimulus “just in case” to back up monetary stimulus.
But that won’t work if you have monetary offset.
In any case, monetary policy is a brake that never fails, and if it does fail you don’t end up crashing, you end up with the Bank of England owning the entire world. A level of global domination that makes Victorian-era Britain seem like a 98 pound weakling by comparison. Global GDP is around $100 trillion. So Piketty would say that global wealth must be around $500 trillion. Could the Brits live on 5% of that? I think so. But wait until the Scots secede, those ingrates don’t deserve any of it.
As Dylan said on his greatest album:
. . . there’s no success like failure . . .