A blog called Canucks Anonymous has a new post up that exemplifies everything wrong with modern macroeconomics. The basic argument is that we market monetarists have fled in terror from Lawrence Ball’s demonstration that NGDP targeting would lead to greater economic instability:
Greg Ip refers us to this excellent paper from Laurence Ball which shows that targeting NGDP is a pretty lousy idea. One can see immediately that Ball must be spot on from that fact that none of the usual suspects, Scott Sumner or Nick Rowe for example, has even acknowledged the existence of the paper even though Nick actually did a post responding to Ip’s article!
I don’t respond to everything I read, as I don’t have time. And I’m especially unlikely to respond if the macroeconomist I most respect (Bennett McCallum) thinks the argument has no validity. But let’s take a stab at it anyway:
Ball writes down the simplest model you can imagine:
y = -b*r(-1) + l*y(-1) + e
pi = pi(-1) + a*y(-1) + n
Here, y is real income, pi is inflation (both as deviations from trend) and e and n are shocks. The notation y(-1) denotes one period lagged income, etc.
I’m already highly irritated. What makes this canuck think that “the simplest model you can imagine” has any bearing on whether NGDP targeting is a wise policy for our highly complex economy? Theoretical macroeconomists love to play with their little toy models, but unfortunately these models don’t actually describe the world we live in. In their models the IS curve slopes downward. Output depends on real interest rates. Inflation depends on output gaps. I don’t know about you, but that’s not the world I inhabit.
Haven’t we seen ultra-low real interest rates for several years? Where is the robust growth? I know, the “error term” takes care of all these pesky little problems. And why is inflation not falling right now? That’s right, the error term explains why. And why did prices rise sharply after March 1933, despite the biggest output gap in US history? Yes, the error term explains why. I prefer models where all the really big phenomena that I’d like to understand don’t have to be explained away by references to error terms.
Balls’ model has monetary policy impact Y with a one period lag and P with a two period lag. In fact, monetary policy affects P with a lead. Or if you consider expectations of future monetary policy to be “policy,” then the effect is contemporaneous–as when rumors of QE2 drove up commodity prices, and hence the headline CPI.
I don’t think the real interest rate measures monetary policy. To the extent that interest rates matter at all, I believe it is the nominal rate minus expected NGDP growth. But I’d rather just leave interest rates out of my “simplest imaginable model,” and stick with NGDP shocks and sticky wages as my explanation of changes in real output. And I’d rather model inflation (or better yet NGDP growth rates) via expected future NGDP, and hence expected future monetary policy. The hot potato effect. I’m not saying the output gap plays no role, but it’s much more complicated than the second equation implies.
Come back to me later when Ball has a model in which output fluctuations are caused by NGDP shocks and sticky wages, not real interest rates.
I also found this amusing:
You can’t cheat this, inflation targeting is simply better.
So inflation is best. Or is Canuck saying that inflation is best in Ball’s model? I can’t quite tell. Canuck doesn’t seem to realize that inflation is something that exists only in the minds of economists, not out there in “reality.” Or perhaps I should say there are as many inflation rates as there are economists. There is the US CPI inflation, which is built on the assumption that using housing prices have risen 7.5% in the past 5 years. Is that the inflation that Canuck wants us to target? Then there is the inflation rate that uses Case-Shiller data, which shows housing prices down 32% in the past 5 years. Given that housing is 1/3 of the CPI, it might be nice to know which of those two inflation rates we should target model. But in my search of Ball’s model I didn’t find any answer to that question. Indeed there are a million inflation rates; are we to believe that all of them are “optimal” policy targets? Is that what Ball’s equations prove?
I don’t work with toy models; I try to stay grounded in the real world. I notice that periods of above 5% NGDP growth (like the 1970s) are viewed as periods where monetary policy was too expansionary. And when NGDP plummets, like in the 1930s, money was too tight. And when NGDP grew at a steady rate of 5%, we achieved the best macro performance in history, the so-called “Great Moderation.” And when we let NGDP collapse in late 2008 and 2009, we had a very severe recession.
I also notice that those who slavishly follow inflation targeting seem to often give the “wrong” advice. And I don’t just mean wrong in the sense that I don’t agree, but also wrong in the sense that almost all sensible economists, even those who don’t believe in NGDP targeting, would beg to differ. Like right now in the UK, when an inflation target would call for much tighter monetary policy. Or indeed even in the US, where the implications of current inflation are ambiguous, but most economists (including I’d guess Ball) think that more demand is obviously desirable.
And that’s not even touching on the political problems associated with inflation targeting. In theory inflation and NGDP are similar targets; whenever either aggregate is too low, the Fed calls for an increase. But as I pointed out in this paper, calling for higher inflation led to a political firestorm in late 2010. In contrast, most Americans would be accepting of a policy aimed at higher NGDP. (An argument I have made many times, and which was recently picked up by Paul Krugman.) But the messy complications of the real world don’t matter to those living in a world of pure mathematics.
I make no apologies for ignoring these little toy models, and having my policy analysis incorporate a complex mixture of politics, macroeconomic history, well-established basic economic principles, and logic.
HT: Bill Woolsey
Update: Josh Hendrickson sent me some comments that might be a more effective rebuttal:
1. In my paper on nominal income and the great moderation, I show that a strong responsiveness to nominal income reduces the variability and the output gap in both a New Keynesian model and McCallum’s P-bar model.
2. It’s hard to assess nominal income targeting when nominal income isn’t defined in the model. Monetary transmission has nothing to do with nominal income in these models so we shouldn’t expect nominal income targeting to be optimal.
3. A long standing reason to support nominal income targeting is because there is uncertainty about how fluctuations in nominal income are divided between output and prices. Ball’s model assumes a specific process for inflation.
4. I continue to go back to the point I made regarding Svensson’s paper. The transmission of monetary policy in the model is through output in the first period and only effects inflation with a one period lag. This is the source of instability and I don’t think its a realistic assumption.