Noah Millman on NGDPLT

Many blogosphere critics of market monetarism are sloppy and obnoxious.  Thus it’s a pleasant surprise to come across a critique as polite and thoughtful as Noah Millman’s recent piece in The American Conservative:

NGDP targeting is usually advocated in the context of advocating a “catchup” plan. Because we went through a period of deflation and contraction, the price level is now under trend, and the Fed should commit to remaining maximally loose until we’ve caught up with the price level.

But, if NGDP really is a new framework, and not just a rationale to keep monetary policy loose, to be discarded when conditions change, then we have to look back at how it would have worked in a period of high nominal growth – and high inflation. Moreover, we’d have to look at how “getting back to trend” would have worked once the back of inflation was broken.

And it seems to me that it would have worked disastrously. From 1965 to 1980, nominal GDP growth never dipped below 6%, and got as high as 12%. To return to “trend” would require keeping nominal GDP well below the economy’s potential for years. You remember “Morning in America?” Well, if we were following a nominal GDP target it would never have happened. The Fed would have raised rates sharply in 1984, as nominal GDP growth spiked up from 6% all the way to 10%.

Of course, nobody would have followed such a policy, even if, in theory, there were some advantage to “undoing” the “Great Inflation.” A policy of “opportunistic disinflation” was much more rational, precisely because much more moderate.

That’s obvious. So why isn’t it obvious that the converse is true?

I have no objection to the actual disinflation during the 1980s; I think Volcker got it about right (after a misstep in 1979-80.)  But Millman raises a very good question; when we introduce a new NGDPLT policy, where do we start the trend-line?  It seems to me that this decision unavoidably involves some degree of discretion.  My basic operating principle is to use a trend line that minimizes disequilibrium in the labor market.  Thus in 2009 I assumed that wages had been negotiated on the basis of the preceding 5% trend line, which had lasted for several decades.  I favored returning to that trend line, as that would bring the labor market back close to equilibrium.  As more time has gone by, I’ve now come to believe that it is no longer wise to return to the original trend line.  Too many wage contracts have been signed on the expectation that we will never return to the old trend line.  Similar discretion would have been appropriate in the early 1980s.

This may seem to conflict with my preference for a fully automatic system with no discretion.  I still favor a rigid rule-based policy, but only after the policy has been implemented.  It is impossible not to use discretion when implementing a new policy.  Choices always must be made.  Consider the reductio ad absurdum of NGDP staying 10% below trend for 100 years.  No one, not even the most fervent “level targeting” proponent, would still consider the pre-2008 trend line to be relevant.

The most interesting implication of NGDP targeting, one that I have come to agree with, is that supply shocks should not drive monetary policy – or should drive it the opposite way than you’d think. A spike in oil prices, which pushes up inflation, should lead to easing, not tightening, because it also causes a hit to real growth, and the second effect dominates, resulting in a lower NGDP.  .  .  .

On the other hand, nominal growth has historically been quite a bit more volatile than the inflation rate, so an NGDP target would require a much more volatile Fed – or one that was much slower on the draw. And NGDP expectations have been more volatile still – and it’s never been clear what metric the Fed would use to measure those expectations.

During the period when the Fed was doing a policy close to 5% NGDP targeting (2% inflation targeting plus what Robert Hetzel calls “leaning against the wind” on real GDP fluctuations), they actually kept NGDP very close to trend (say from 1990 to 2007.)  If they explicitly did NGDPLT I’d expect the result to be at least as good, probably slightly better.  And I have doubts about Millman’s claim that “NGDP expectations have been more volatile still” I am pretty sure the reverse is true.  Indeed under one version of my proposal (futures targeting) there would be no volatility at all in NGDP expectations.  And in the other version (Svensson’s “target the internal Fed forecast”) there is no volatility in the Fed’s internal NGDP forecast.  I don’t see how we can do much better than that.

Then there’s the problem that NGDP targeting implicitly assumes that we know what the long-term real growth potential of the economy is. Scott Sumner, one of the most capable exponents of NGDP targeting, says I have this backwards, but I think he’s confusing the short with the long term. A 2% inflation target is a prudential measure, based on the assumption that we want to get as close to zero (true price stability) as possible without dipping under. I understand the logic of it. Where does a 5% NGDP target come from? Implicitly, it comes from a 3% real growth potential plus 2% inflation. But where does the 3% come from? How do we know that our economy can continue to grow at 3% per year? How do we know that its real potential isn’t lower – or higher? Suppose technological advances push productivity way up. Why should the Fed raise interest rates in response? Suppose a drop in population growth and a slow-down in technological advance pushes the real growth potential of the economy below 2%. Why should the Fed remain persistently looser in response? I understand the logic behind the NGDP-targeting approach to supply shocks. I don’t understand the logic behind the NGDP-targeting approach to changes in productivity and labor-force growth.

Millman’s right about one thing, we should target NGDP per capita, not total NGDP. I’ve always thought the per capita target is best. I often omit that detail, as population growth in the US has been remarkably stable at about 0.9% per year. But he’s wrong on his other points.  There is no good economic argument for price stability.  Zero inflation is just another number.  On the other hand there is something very special about zero wage growth (due to money illusion) and zero interest rates (because of cash, nominal interest rates can’t fall below zero.)  It turns out that what most people regard as the “welfare cost (and benefit) of inflation” is actually better described as the welfare costs and benefits of faster NGDP growth.  The problem with high NGDP growth is that it raises nominal returns on capital, and this increases the tax rate on capital (which should be zero.)  The benefits from higher NGDP growth are that it moves you away from the zero wage boundary, and thus there is less labor market distortion caused by workers refusing to take nominal wage cuts, when market conditions would call for them (and when they would accept real wages cuts via inflation.)  And of course you are less likely to get stuck at the zero interest rate bound.  On the other hand zero inflation is almost a meaningless number.  It doesn’t mean product prices are not rising, it means the prices of computers, cars, TVs, etc, rise at a rate equal to the BLS estimate of quality improvement.  But why would that number matter in a welfare sense?  It doesn’t.

So NGDP growth matters, not inflation.  Thus I didn’t pick 5% because it was 3% plus 2%, rather I picked it for two reasons.

1.  It was the historical trend before 2008.  So it seemed like that was Fed policy.  I argued they should have stuck to their old policy, not changed radically in 2008.  Policy stability leads to macroeconomic stability.

2.  It seemed high enough to keep us away from those two black holes (zero wage boundary and zero nominal interest rates) but not so high as to put a heavy tax burden on capital.  It was a compromise.  I’d be fine with 4% or 6%, as long as it was stable, and level targeting.

Moreover, the whole idea of targeting nominal GDP assumes the Fed is able to command an increase in inflation. Which, I agree, it can do – but it can’t do it without side effects so long as we have a cash economy. In a theoretical world where there was no cash, the Fed could push the Fed Funds rate to negative levels, which it seems reasonable to assume would have similar effects to a cut in rates under normal, positive-rate conditions. In the world we live in, the Fed has to buy up other assets – longer-term government bonds, primarily – in order to further loosen monetary policy. But this isn’t really the same thing as lowering the Fed Funds rate, and it has a variety of distorting effects on both investment decisions and the behavior of the Treasury.

This may or may not be a problem (I don’t think it is) but let’s be clear about one thing; it has nothing to do with NGDPLT.  The amount of debt the Fed must buy depends on the rate of NGDP growth.  The higher the rate of NGDP growth, the higher the nominal interest rate (i.e. Australia) and the lower the ratio of base money to GDP.  So if you want a small Fed balance sheet, there’s only one way to get it—have the NGDP trend growth rate be high enough to keep us above the zero nominal rate bound.  Conversely if you have very low trend NGDP (i.e. Japan) the base to GDP ratio will be very high, and the central bank will have to buy lots of debt.  The base is 4% of GDP in Australia, and 23% of GDP in Japan.

 And some of the main channels by which the Fed affects consumer behavior are blocked right now, preventing monetary policy – even extraordinary policy such as the Fed has been following – from being effective. So long as we have a huge overhang of nonperforming mortgages, refinancing will be difficult. But refinancing is the main mechanism by which the Fed can drive an increase in demand.

In my view refinancing has virtually zero impact on “demand.”  The key is to boost expectations of future NGDP.  That will raise asset prices today, and boost thus demand.

More generally, I agree with economists like Joseph Stiglitz and Jeffrey Sachs that focusing too much on monetary policy is a distraction from the need to address the economy’s structural problems – from the overhang of mortgage debt to wasteful spending on health care to the collapse in manufacturing to a backlog of basic infrastructure needs – which must be addressed for the real economy to improve in a sustainable fashion. These structural problems can be tackled with a view to improving the short-term employment situation, rather than in a way that ignores that situation. But they have to be addressed for the economy to sustainably improve. A monetary-driven expansion in the absence of such an effort will just lead to another crash down the road, and progressive erosion of real wealth.

If the Fed does NGDPLT, there may be recessions down the road, and there may be financial distress down the road. But there certainly won’t be any more “crashes” like 2008.  That requires a crash in NGDP expectations.  And it will be exceedingly hard to do structural reforms if we don’t have faster NGDP growth.

I’m not quite sure what Millman means by “monetary policy is a distraction.”  There is no such thing as “not doing monetary policy.”  Or “not using monetary policy.”  There is only good and bad monetary policy.  Millman’s a reasonable guy, so I’m certain he prefers good monetary policy to bad monetary policy.  But the final paragraph is written in such a way as to suggest that we don’t want to focus too much on monetary policy right now.  I understand how that view might be appealing from a common sense perspective (we do have lots of other structural problems), but on closer inspection I don’t think it makes much sense.  Having a good monetary policy doesn’t require a lot of “effort.”  Congress is not involved at all; it’s up to the Fed.  So I don’t see how it could be viewed as something that distracts Congress from doing sensible reforms in other areas.

Stiglitz has some rather  . . . how shall I put it . . . unconventional views of monetary policy.  I’m pretty sure he would regard Millman’s views on monetary policy as nonsensical, as he doesn’t see the Fed as driving AD, he thinks fiscal policy determines AD.  Stiglitz is the sort of economist who would be likely to say; “now’s not the time to use monetary policy” even though taken literally that statement only has meaning if the speaker is advocating barter.  Obviously people who say that are not advocating barter, which means they don’t actually understand what monetary policy is.  (Stiglitz needs to study Woodford more carefully.)  Millman clearly does understand monetary policy, and his critique of NGDPLT is one of the most thoughtful that I have read.  Thus I was disappointed in the final paragraph of his otherwise fine essay.


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28 Responses to “Noah Millman on NGDPLT”

  1. Gravatar of johnleemk johnleemk
    13. September 2012 at 06:29

    Fantastic post, Scott — the points about the impossibility of “not using monetary policy” in a monetary economy are very important and often forgotten.

    I also find it very odd that Stiglitz and Sachs are flagbearers for a school of thought focusing on “structural problems” in the “real economy”. Sounds like those on the left who are skeptical about monetary easing have their own version of Real Business Cycle theory.

  2. Gravatar of Andy Harless Andy Harless
    13. September 2012 at 06:40

    we should target NGDP per capita

    No! No! No! You and Millman are both wrong! One of the big advantages of NGDP targeting over price targeting is that the target keeps up with the natural interest rate. Inflation targeting gets you into trouble when potential growth slows, because the natural interest rate falls, and during a recession it can easily go below zero in nominal terms unless your inflation target is high. NGDP targeting doesn’t have this problem, because there is an implicit increase in the inflation target to offset the decrease in the potential growth rate, thus making it possible to get the real interest rate down to where it needs to go. You seem to accept this point when the issue is productivity growth, but the exact same point applies to population growth.

  3. Gravatar of ssumner ssumner
    13. September 2012 at 07:00

    Andy, That’s a defensible argument, but . . .

    1. The best target is average hourly nominal wages. NGDP per person is closer to a wage target than total NGDP.

    2. I’d prefer a NGDP target high enough where the zero bound was not an issue.

    Having said that, I am open to persuasion that you are right. If population growth changes very slowly over time, the labor market can adjust, and thus your argument becomes more powerful than mine. And you can make a pretty good argument that population growth does change very slowly over time.

  4. Gravatar of Morgan Warstler Morgan Warstler
    13. September 2012 at 07:12

    Man we came sooo close there, I half expected you’d get into it.

    I think it would be really enlightening if you gamed out:

    4.5% starting today with no make-up.

    Not the firs step, that we are raising rates.

    But if after we have raised rates, and unemployment is 8.5%, and things slow down to run a trend.

    in your view does unemployment STAY at 8.5% for AS LONG AS it has now?

    I’m trying to get you to describe the deeper effects of NGDPLT where nothing changes except what we target.

    I know you think it is preferable, even with no make-up, even at 4.5% – if that’s the only option.

    Why is it so hard to get your explanation as to WHY?

  5. Gravatar of Major_Freedom Major_Freedom
    13. September 2012 at 07:16

    Policy stability leads to macroeconomic stability.

    And that, ladies and gentlemen, is the faith at the core of market monetarism.

    Stable consumer prices requires unstable asset prices.

    Stable aggregate spending requires unstable money supplies.

    Stable X requires unstable Y.

    Why is there never any mention of Goodhart’s Law? We are constantly told that because 1980-2007 saw roughly 5% annual NGDP growth, that this means the Fed can change its policy and target a 5% NGDP growth and achieve the same economic effects. But this is wrong. If the Fed starts to target NGDP, then NGDP will lose the information content that originally qualified it to play that role.

    The same problem happened to price level targeting. If history just so happens to contain “stable” prices and “stable” employment and output growth without central bank price targeting, then it would be wrong to assume that targeting price levels will be accompanied by the same “stable” employment and output.

    —————

    Central bank NGDP targeting is anti-market activity. The market process will constantly antagonize this and thus cannot stabilize. With “stable” NGDP growth targeting, we’ll see this antagonism manifest itself in an unstable money supply, as we saw in Australia 1990s to 2008, after which the acceleration in the growth of the money supply fell from a peak of 23% annualized(!), which was then followed by unemployment increasing. The money supply has since re-accelerated, and unemployment has stopped rising, however NGDP continues to slide, which means expect inflation to keep accelerating again.

  6. Gravatar of Richard A. Richard A.
    13. September 2012 at 07:25

    Immigration has the potential to change the rate of growth of the labor supply. Let’s suppose that Japan suddenly sunk into the ocean and we took on most Japanese as refugees, resulting in a sudden increase of the labor force of one third. The Fed in this case would need to respond by increasing the nominal GDP target by one third.

  7. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    13. September 2012 at 07:48

    I’m old enough to remember the argument put as, ‘Money doesn’t matter.’ Milton Friedman pretty much destroyed it.

    But, I love Millman’s;

    ‘I agree with economists like Joseph Stiglitz and Jeffrey Sachs that focusing too much on monetary policy is a distraction from the need to address the economy’s structural problems – from the overhang of mortgage debt to wasteful spending on health care to the collapse in manufacturing to a backlog of basic infrastructure needs – which must be addressed for the real economy to improve in a sustainable fashion.’

    Let’s go with that. The overhang of mortgage debt was caused by govt. interference in the mortgage market (especially in the early to mid 1990s). Stop it.

    Wasteful spending on healthcare will only be cured by getting away from the third party payer model. I.e. no more insurance companies paying for Sandra Fluke’s birth control pills, insurance only pays for catastrophic care. There goes Medicare and Medicaid, as ‘we know them’, too.

    Government employees need to be forbidden to strike (Hi there, CPS!), and infrastructure should be built and maintained by profit seeking entities. Charter schools, vouchers and tax credits for private schools made available to break the monopolies.

    Eliminate the minimum wage, extended unemployment benefits, occupational licensing. All of which contribute to sticky wages.

    Be careful what you wish for, guy.

  8. Gravatar of dtoh dtoh
    13. September 2012 at 08:33

    Millman says,

    “In a theoretical world where there was no cash, the Fed could push the Fed Funds rate to negative levels, which it seems reasonable to assume would have similar effects to a cut in rates under normal, positive-rate conditions. In the world we live in, the Fed has to buy up other assets – longer-term government bonds, primarily – in order to further loosen monetary policy. But this isn’t really the same thing as lowering the Fed Funds rate, …..”

    1) Last time I checked, even in a positive nominal rate environment the Fed had to buy up assets in order to lower the FF rate.

    2) Millman is another purblind nominalist. I think the real Money Illusion is that it causes otherwise bright economists to blather on about financial asset prices and rates in only nominal terms. Scott, why don’t you hammer these guys to define financial asset prices in real terms. It would eradicate all this ongoing drivel about the ineffectiveness of OMO at the ZLB.

  9. Gravatar of dtoh dtoh
    13. September 2012 at 08:36

    Patrick,
    Totally agree!!

  10. Gravatar of Bill Ellis Bill Ellis
    13. September 2012 at 09:01

    “The Federal Reserve says it will spend $40 billion a month to purchase mortgaged-back securities because the economy is too weak to reduce high unemployment. The Fed says it will keep buying the securities until the job market shows substantial improvement.”

    http://www.cbsnews.com/8301-505123_162-57512296/fed-to-spend-$40b-a-month-on-bond-purchases/

    So the Fed fails to be as effective as they could be.

    Their promise to “keep buying the securities until the job market shows substantial improvement.” is too vague. There is no real target. How can markets be confident with out a target ? How can expectations be effected with out confidence ?

    Why doesn’t Ben Take Ben’s advice ?

    Ben Bernanke’s criticism of the Bank of Japan’s handling of their economy….

    Ben said…”A problem with the current BOJ policy, however, is its vagueness.
    What precisely is meant by the phrase “until deflationary concerns
    subside”? Krugman (1999) and others have suggested that the BOJ
    quantify its objectives by announcing an inflation target, and further
    that it be a fairly high target. I agree that this approach would be
    helpful…”

    How is “… buying the securities until the job market shows substantial improvement.” any less vague than, “until deflationary concerns
    subside” ?

    But it is waaay better than how they were doing it.

    What about the number? Is 40 bil alright ? I have no clue.

  11. Gravatar of Gabe Gabe
    13. September 2012 at 09:14

    70 billion would be better. With escalating injections each month going forward..how are we to have confidence when the real value of the MBS purchases will be declining monthly?

  12. Gravatar of Gabe Gabe
    13. September 2012 at 09:16

    Nominally constant injections are for those who rubes who don’t get it.

  13. Gravatar of Saturos Saturos
    13. September 2012 at 09:18

    Guys: Let’s get all the discussion of the announcement and its consequences on the next post. (It also ties in with the fundamental cause of recessions in the post body, for posterity’s sake,)

  14. Gravatar of Gabe Gabe
    13. September 2012 at 09:24

    want to here comments now…gold has jumped $40….oil up, copper up since the 12:30 announcement….although not by huge amounts. The analysis and commentary from this site will be interesting.

  15. Gravatar of TallDave TallDave
    13. September 2012 at 09:47

    It doesn’t mean product prices are not rising, it means the prices of computers, cars, TVs, etc, rise at a rate equal to the BLS estimate of quality improvement.

    In fact, it means even less than that, because every single product and service has its own unique pricing pressures — zero inflation just means they average to zero. (And hedonic adjustment is little more than a guess anyway.)

  16. Gravatar of NGDP Targeting is no ‘temporary catch up trick’ | Historinhas NGDP Targeting is no ‘temporary catch up trick’ | Historinhas
    13. September 2012 at 10:25

    [...] Scott Sumner refers to this critical of NGDP targeting post by Noah Millman: NGDP targeting is usually advocated in the context of advocating a “catchup” plan. Because we went through a period of deflation and contraction, the price level is now under trend, and the Fed should commit to remaining maximally loose until we’ve caught up with the price level. [...]

  17. Gravatar of Kenneth Duda Kenneth Duda
    13. September 2012 at 21:37

    This is a fantastic post. Thank you Scott!

    The one thing I feel I still do not understand about NGDP targeting is how it actually gets us out of an AD shock. When there’s an AD hit, NGDP growth slows. Assuming an NGDPLT regime, the Fed is committed to maintaining high NGDP growth …. but during a demand shock, there is nothing it can do directly — no expansion of the monetary base can be big enough to actually cause inflation — so how does the Fed actually get NGDP up? What I have read is that the Fed’s policy will create credible expectations of future inflation at some indefinite point in the future. Okay, fine, but how does that cause spending and investment today? What mechanism causes people who are apparently disinclined to spend to start spending? How would a Fed policy of NGDP targeting cause Warren Buffett to buy more yachts or China to start spending dollars on US-made 10-gigabit Ethernet switches (which are the only choices when mainstream consumers are forced to deleverage regardless of their inflation expectations)?

    If anyone could help me understand this, I would be very grateful.

    Kenneth Duda
    kjd@duda.org

  18. Gravatar of Saturos Saturos
    13. September 2012 at 23:45

    Finally got round to reading this one. Scott the explainer scores again.

  19. Gravatar of Saturos Saturos
    14. September 2012 at 00:04

    OK Kenneth, let me try:

    “during a demand shock, there is nothing it can do directly — no expansion of the monetary base can be big enough to actually cause inflation”

    Really? So if the Fed bought every asset in the world, that wouldn’t lead to more spending, pressing up output and prices?
    I’ll quote James Hamilton: “To which I say, PSHAW!”

    But there is no way we’d need to go there. The Fed’s goal is to create an excess supply of money balances in the economy somewhere along the future path of NGDP, or total spending. This will push up NGDP, not only at that point, but also all along the path line – later and before that point. It will even push up NGDP today. We don’t know the price split of that higher NGDP between more inflation and more real output. Obviously we want more of the latter and less of the former. (So we are not trying to create inflation).

    But how will more future NGDP cause more current NGDP? Well, financial asset prices of all kinds (not so much bonds, but rather equities in particular) will rise at that future time, to reflect the news. Unless investors are collectively stupid, this will cause asset prices to rise today, either because the real present value of the assets is greater or because higher inflation leads people to get out of holding money (which is losing value, as it will buy less stuff when prices are higher later) and into those other financial assets, and also to spend on current goods, services.

    Higher current financial asset prices stimulate the production of current assets (Tobin’s Q). And higher asset prices, to the extent they reflect more real income/output later on, will lead people to spend more today as they spread that gain over their consumption path, and firms to invest more to produce that higher future output. So present spending (NGDP) rises too (as current money demand falls and velocity rises).

    Finally, I’ll note that the excess supply will in reality not come so much from the Fed leaving more money out permanently to create that future excess supply, but rather from market participants, knowing that the Fed can make the excess supply happen, to create the excess supply by themselves, by lowering their future demand for money, which will ultimately lower their present demand for money (the “Chuck Norris effect”).

    In short, a fiat money central bank can always “debase the currency” if it wants to (if you doubt that then read this: http://marketmonetarist.com/2011/10/11/gideon-gono-a-time-machine-and-the-liquidity-trap/). And if you still need more clarification then please read this: http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/10/engdp-level-path-targeting-for-the-people-of-the-concrete-steppes-.html

    (Also try to refrain from the fallacy that “deleveraging” detracts from aggregate spending. If spending doesn’t fall when I hand over funds from my income stream to you to spend, then when you hand over the same amount of funds to me to spend later on as repayment, that doesn’t hurt spending either. Sure, I could save by purchasing assets with those funds instead of services – but then so could you have. For every debtor there is a creditor.)

  20. Gravatar of dtoh dtoh
    14. September 2012 at 03:03

    Also try to refrain from the fallacy that “deleveraging” detracts from aggregate spending…….For every debtor there is a creditor.

    If you are looking at the impact on aggregate spending then you need to consider deleveraging of households and non-financial businesses and net out debt (non-money financial assets) held by financials institutions. Looked at this way leverage does have a big impact on aggregate spending.

  21. Gravatar of dtoh dtoh
    14. September 2012 at 03:06

    Saturos,
    Previous comment is a response to yours.

  22. Gravatar of Kenneth Duda Kenneth Duda
    14. September 2012 at 07:50

    Saturos, thank you for the comments!

    Let me see if I can repeat it back.

    If most participants in the economy believe that there will be higher NGDP in the future, then certain asset prices go up today (especially stocks) — which is exactly what happened after Bernanke’s announcement yesterday… this is not a bubble as long as future NGDP really is higher, justifying today’s higher stock values in effect.

    Got it.

    The next step is, “higher current financial asset prices stimulate the production of current assets (Tobin’s Q).” But here you lose me. Tobin’s Q applies to physical assets, not financial assets. The only reason I can see for the price of physical assets to go up is increased demand for them. Perhaps lower interest rates would help, making it easier to buy them, as would an expectation of inflation, making them more desirable to own compared with cash… but I do not see any reliable connection between NGDP expectation and physical asset prices.

    I think from there I am with you the rest of the way. *If* the current price level of physical assets goes up, then that will stimulate their production (thank you Tobin Q) and pull us out of this AD mess. But that still looks to me like a big “if”.

    Can you help me see what I’m missing?

    Thanks,
    -Ken

    Kenneth Duda

  23. Gravatar of Saturos Saturos
    14. September 2012 at 10:49

    Kenneth, Tobin’s Q is just one mechanism, there are others, such as Modigliani or wealth effects, which I also mentioned. In fact that was the mechanism which Bernanke cited in his speech yesterday, although he used the Keynesian language of “people will feel wealthier” which I don’t like as it makes it sound like economic agents are largely irrational in their economic decisions. I think it’s more accurate to say that the higher stock prices reflect an update in the rational market forecast of permanent nominal income. And of course present spending is a function of permanent nominal income as well as interest rates. Another way of putting it is as follows:

    As cash balances are built up, people’s attempts to acquire other assets raise the prices of assets and drive down the interest rate. That will tend to produce an increase in spending. Along standard income and expenditure lines, it will tend to increase business investment. Alternatively, to look at it more broadly, the prices of sources of services will be raised relative to the prices of service flows themselves. This leads to an increase in spending on the service flow, and therefore to an increase in current income. In addition, it leads to an increase in producing sources of services in response to the higher price which can now be obtained for them.

    - Milton Friedman

    At any rate, Tobin’s Q is about the ratio of financial asset prices to real asset prices. Of course people are buying more real assets as they become relatively cheaper (to their financing costs). So your objection is incorrect. But I want you to see the broader picture. I want you to read that Nick Rowe post I linked to. When you’re done also read this one: http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/06/do-the-french-control-the-size-of-the-sun.html. This is also good: http://www.moneyweek.com/news-and-charts/economics/uk/eocnomic-growth-market-monetarism-ngdp-20200

    And in case you’re an economics student/graduate, here is an “ISLM” interpretation:
    Informally – http://www.economist.com/blogs/freeexchange/2012/01/monetary-policy-0
    More formally – http://monetaryfreedom-billwoolsey.blogspot.com.au/2012/05/negative-real-interest-rates.html

    Also, the precise response to your question the way you put it (“Fed’s policy will create credible expectations of future inflation at some indefinite point in the future… how does that cause spending and investment today?”) is given by the Cagan model from intermediate macroeconomics, which Garett Jones just did a post on over at EconLog: http://econlog.econlib.org/archives/2012/09/future_money_an.html

  24. Gravatar of Saturos Saturos
    14. September 2012 at 10:50

    Kenneth, Tobin’s Q is just one mechanism, there are others, such as Modigliani or wealth effects, which I also mentioned. In fact that was the mechanism which Bernanke cited in his speech yesterday, although he used the Keynesian language of “people will feel wealthier” which I don’t like as it makes it sound like economic agents are largely irrational in their economic decisions. I think it’s more accurate to say that the higher stock prices reflect an update in the rational market forecast of permanent nominal income. And of course present spending is a function of permanent nominal income as well as interest rates. Another way of putting it is as follows:

    As cash balances are built up, people’s attempts to acquire other assets raise the prices of assets and drive down the interest rate. That will tend to produce an increase in spending. Along standard income and expenditure lines, it will tend to increase business investment. Alternatively, to look at it more broadly, the prices of sources of services will be raised relative to the prices of service flows themselves. This leads to an increase in spending on the service flow, and therefore to an increase in current income. In addition, it leads to an increase in producing sources of services in response to the higher price which can now be obtained for them.

    - Milton Friedman

    At any rate, Tobin’s Q is about the ratio of financial asset prices to real asset prices. Of course people are buying more real assets as they become relatively cheaper (to their financing costs). So your objection is incorrect. But I want you to see the broader picture. I want you to read that Nick Rowe post I linked to. When you’re done also read this one:

    [links omitted]

    Also, the precise response to your question the way you put it (“Fed’s policy will create credible expectations of future inflation at some indefinite point in the future… how does that cause spending and investment today?”) is given by the Cagan model from intermediate macroeconomics, which Garett Jones just did a post on over at EconLog: http://econlog.econlib.org/archives/2012/09/future_money_an.html

  25. Gravatar of Kenneth Duda Kenneth Duda
    14. September 2012 at 21:05

    Saturos, I really appreciate your efforts to explain to me why expectation of future NGDP growth would lead to spending today. Unfortunately it seems my skull is too thick. For example, I read Garett Jones’ explanation of Cagan’s money demand model. It boils down to the assertion that if people expect higher inflation in the future (which is not NGDP growth), then they will spend:

    > the only way people can reduce their real buying power
    > today is for the price level to rise. Future inflation causes
    > a price increase today.

    Too many assumptions for me. You’ve got to assume that people will conclude that NGDP target means inflation. And then, you’ve got to assume they will try so hard to escape that inflation that they’ll spend on anything, anything to make sure they’re not stuck holding cash. This does not make sense to me. People could easily conclude that NGDP growth will come from productivity growth and population growth (as it easily could in the next few years if we achieve a return to full employment), or, if inflation is inevitable, they could conclude that everything they could do with their cash is even worse than just holding it. So I still cannot see why a prediction of rising NGDP would increase current spending.

    So thanks for trying and I’m sorry for being dense.

    BTW, I am not an economist at all. I’m a software guy at Arista Networks, a data center Ethernet switching company. I started learning about economics a year ago when Congress appeared to seriously consider not raising the debt ceiling. Not raise the debt ceiling? Willfully default on current obligations in your own currency? WTF? What am I missing, I thought. Since then, I have learned a lot about the intersection of economics and politics…

    -Ken

  26. Gravatar of Kenneth Duda Kenneth Duda
    14. September 2012 at 21:05

    Saturos, I really appreciate your efforts to explain to me why expectation of future NGDP growth would lead to spending today. Unfortunately it seems my skull is too thick. For example, I read Garett Jones’ explanation of Cagan’s money demand model. It boils down to the assertion that if people expect higher inflation in the future (which is not NGDP growth), then they will spend:

    > the only way people can reduce their real buying power
    > today is for the price level to rise. Future inflation causes
    > a price increase today.

    Too many assumptions for me. You’ve got to assume that people will conclude that NGDP target means inflation. And then, you’ve got to assume they will try so hard to escape that inflation that they’ll spend on anything, anything to make sure they’re not stuck holding cash. This does not make sense to me. People could easily conclude that NGDP growth will come from productivity growth and population growth (as it easily could in the next few years if we achieve a return to full employment), or, if inflation is inevitable, they could conclude that everything they could do with their cash is even worse than just holding it. So I still cannot see why a prediction of rising NGDP would increase current spending.

    So thanks for trying and I’m sorry for being dense.

    BTW, I am not an economist at all. I’m a software guy at Arista Networks, a data center Ethernet switching company. I started learning about economics a year ago when Congress appeared to seriously consider not raising the debt ceiling. Not raise the debt ceiling? Willfully default on current obligations in your own currency? WTF? What am I missing, I thought. Since then, I have learned a lot about the intersection of economics and politics…

    -Ken

  27. Gravatar of Kenneth Duda Kenneth Duda
    14. September 2012 at 21:06

    It would be really nice if that “submit” button grayed itself out once clicked…
    then people would stop submitting duplicate comments.

  28. Gravatar of Saturos Saturos
    15. September 2012 at 02:18

    Kenneth, you’re right, the Cagan model is a very limited part of the explanation. As I said we’re not really trying to create inflation. But if higher NGDP later did lead to higher prices then, then that would mean inflationary expectations for traders today. This would boost current spending, which would raise both prices and output (hopefully mainly output) today.

    The way that works is that people want to hold less money in the aggregate, as inflation destroys the purchasing power of money and its utility as a store of value. In the aggregate, this means less demand for money. Now there’s a famous equation in economics:

    MV = PY

    which says that the money supply times its rate of turnover equals prices times output. This can be derived from

    M = kPY; k = 1/V

    which says that equilibrium in the supply and demand for holding money throughout the economy determines NGDP, and the velocity of money circulation is simply the inverse of the collective demand for holding on to it. There’s more formal mathematics to show the precise level between expected inflation and present velocity, but the upshot is that people spend more today. (You can also see that nominal bond yields rise when inflation is expected, due to the Fisher effect, and this leads to falling collective demand for holding money, according to standard Keynesian liquidity preference theory.)

    But you’re right, one of the main benefits of targeting NGDP is that it works regardless of whether expected spending leads to higher prices or output. That’s why I wanted you to read this Nick Rowe post (http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/10/engdp-level-path-targeting-for-the-people-of-the-concrete-steppes-.html); he explains it better than me. In fact there are plenty of arguments (just read the rest of this blog, when you have time) to suggest that NGDP level path targeting is always optimal, so that switching to that regime would not, as Krugman says, constitute “promising to be irrespnsible” – but would nonetheless get enough money flowing to cure most unemployment today. (It’s a separate question as to whether the policy just announced consitutes “promising to be irresponsible”…)

    But the point I want you to see is that there is no way that a determined central bank would fail to raise spending by as much as it wanted today. Just think of a medieval king debasing his currency. Interest rates and the financial system ultimately have little to do with it. In fact part of the modern literature is Lars Svensson (best central banker in the world)’s paper on “foolproof escape from a liquidity trap”. The best macroeconomists all agree that the Fed can always boost spending if it really wants to. Indeed, why don’t you take a look at Bernanke’s paper from 1999 (before he got “assimilated by the Fedborg” as Krugman puts it) where he says the same thing?
    http://www.princeton.edu/~pkrugman/bernanke_paralysis.pdf

    Oh, and you are right, economic theory says nothing about why it would be a good idea for the US to have defaulted on it debt. It does however have plenty to say on why politicians might have an incentive to behave that way…

    Kenneth, can I ask you a question? How did you find this blog?

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