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.