Support for the Thompson/Selgin approach to monetary policy

David Stinson recently sent me an interesting article on monetary economics written by Peter Howitt.  The author reminds me of people like Nick Rowe and David Laidler, as he can be sympathetic to mainstream new Keynesian ideas, but also understands the importance of older monetarist traditions.  The entire paper is worth reading, but this passage on page 22-23 caught my attention:

Moreover, it is not just the policy makers that are learning from monetary theorists. Often the conduct of monetary policy is way ahead of the theory, and we academic economists often have more to learn from practitioners than they have from us.  I came to realize this when I was a participant in monetary-policy debates in Canada in the early 1990s. The Bank of Canada was moving to inflation targeting at the same time as the country was phasing in a new goods and services tax. The new tax was clearly going to create a problem for the Bank by causing an upward blip in the price level. Even if the Bank could prevent this blip from turning into an inertial inflationary spiral, the immediate rise in inflation that would accompany the blip threatened to undermine the credibility of the new inflation-reduction policy.

The bank dealt with this problem by estimating the first-round effect of the new tax on the price level, under the assumption that the path of wages would not be affected, and designing a policy to limit the price blip to that estimated amount.  It announced that this was its intention, and that after the blip it would stabilize inflation and bring it down from about six percent to within one percent band over the coming three years.

At the time I was very skeptical.  Along with many other academic economists I thought it was foolish for the Bank to announce that it was going to control something like inflation, which it can only affect through a long and variable lag, with such a high degree of precision.  To me the idea reeked of fine-tuning, and I thought the Bank was setting itself up for a fall.  But I was wrong.  In the end the Bank pulled it off just as planned.  The price level rose by the amount predicted upon the introduction of the new tax, and then inflation quickly came down to within the target range, where it has been almost continuously ever since.

Two things struck me about this passage.  The first is that economists often overestimate the problem of “long and variable lags,” especially when the goal is to stabilize a nominal aggregate.  If the policy is credible, lags do not prevent the central bank from hitting short term targets, as the short run is strongly influenced by expected longer term outcomes (as Woodford has shown.)

The second thing that struck me is that this incident seems to provide some support for a policy of wage targeting, rather than price level targeting.  In earlier posts I discussed Earl Thompson’s legendary (well it should be legendary) 1982 paper where he proposed a monetary regime with the dollar convertible into contracts linked to the future aggregate wage rate.  George Selgin has recently put his long essay on productivity norms onto the internet, and I plan to do a post on “Less Than Zero” in the next few weeks.  For now I’ll simply point out that one of the two policies Selgin considers, a labor productivity norm, would effectively stabilize nominal wage rates, but allow some fluctuations in the price of goods and services. 

Obviously the Canadian example was an expedient, not the sort of permanent policy regime envisioned by Thompson and Selgin.  But if it really did work as well as as Howitt indicates, why not make it permanent?

I have always thought a wage targeting regime seemed optimal in principle, but ended up advocating NGDP targeting for a variety of reasons.  I was worried that nominal wage targeting would not be politically acceptable, and also worried about measurement issues.  Some jobs are compensated on an hourly basis, some on a yearly basis.

BTW, Howitt cites a 2004 book by Laidler and Robson for his information on Canadian monetary policy.

PS.  This is the 7th post that I did today.  I’ll take a break and come back later with posts on Less Than Zero, and also a promising new way to teach AS/AD.

PPS.  Several times today I have tried and failed to link to PDF files.  Does anyone know what I am doing wrong?



15 Responses to “Support for the Thompson/Selgin approach to monetary policy”

  1. Gravatar of Nick Rowe Nick Rowe
    27. November 2009 at 19:31

    To link to PDF files, put the cursor over the link, right-click, scroll down the list and click on “copy link location”, then paste it where you need to.

  2. Gravatar of Nick Rowe Nick Rowe
    27. November 2009 at 20:57

    By the way, Peter and David were colleagues, and both taught me at Western Ontario in the late 1970′s. I learned a lot from both. That’s the connection.

    I think of their approach as “disequilibrium monetarism”: sort of that narrow intersection of monetarists who take disequilibrium seriously, and Keynesians who take monetary exchange seriously.

  3. Gravatar of marcus nunes marcus nunes
    28. November 2009 at 10:22

    The article is from the book Post Walrasian Economics (Beyond the DSGE Model) edited by David Colander and published in 2006 by Cambridge U. Press. Many of the articles are interesting and useful.

  4. Gravatar of ssumner ssumner
    28. November 2009 at 11:58

    Nick, Thanks, I just added a link to the Selgin piece. I’m glad I wasn’t off base on the similarity among you three.

    marcus, Thanks for the info.

  5. Gravatar of TGGP TGGP
    28. November 2009 at 14:25

    His point about academics being behind Bank officials reminded me of John Wood‘s take on the history of U.S macro policy.

  6. Gravatar of ssumner ssumner
    28. November 2009 at 15:33

    TGGP, Academics have had some impact. But it is really hard to disentagle the effects, as both groups are looking at the same set of facts, both have similar worldviews, and hence it is not surprising that both reach similar policy conclusions at about the same time.

  7. Gravatar of Felix Felix
    29. November 2009 at 03:41

    I don’t understand why you prefer narrative arguments for a labor/ngdp/productivity standard over Woodford’s explicit welfare analysis.

    IMHO, a labor standard is inferior because it is only optimal under the assumption of no stickiness of prices and a ngdp standard is inferior because it produces suboptimal policy in the case of a simultaneous shift of AS and AD to the left or right.

  8. Gravatar of ssumner ssumner
    29. November 2009 at 08:10

    Felix, Those “esplicit welfare analyses” are only as good as the assumptions that go into them. Correct me if I am wrong, but aren’t most new Keynesian models based on price stickiness? I prefer the assumption of wage stickiness. Woodford also assumes that price indices actually measure the price level. They don’t. I believe NGDP shows price level shocks much more accurately than the CPI, which is highly flawed.

    I disagree that labor standards are only superior under no price stickiness. It depends how much price stickiness you have relative to wage stickiness. It is not all or nothing.

    I define AD and NGDP. So your last comment makes no sense to me. How can AD shift under an NGDP standard? By the way, you can certainly find highly technical arguments for NGDP targeting, for instance Bennett McCallumn has written extensively on the issue.

    And finally, I’d be thrilled if the rest of the profession adopted Woodford’s approach to macro. He is one of the few economists who seems to understand the serious errors being made my the Fed. So I’m glad to hear you boosting Woodford. The similarities in his views to mine are far more important the the differences. Level targeting vs rate targeting is far more important that NGDP vs price level targeting.

  9. Gravatar of JTapp JTapp
    29. November 2009 at 19:55

    I just finished reading David Wessel’s In Fed We Trust, chronicling Fed decision making during the crisis. I looked for any policy discussion in it that resembles anything that you’ve been proposing. Bernanke comes across as open-minded in the book, but the fear/loathing by FOMC members of an inflation target and anything “unorthodox” comes out very clearly, as does all the ridiculousness of fearing inflation in 2008.
    The sad reality is that Fed bank presidents, particularly in the “fly-over” states, don’t want to even think about what else they can do with monetary policy.

  10. Gravatar of Doc Merlin Doc Merlin
    29. November 2009 at 21:31

    “as does all the ridiculousness of fearing inflation in 2008.”
    Um, we had really high commodity inflation in the first half of 2008.
    Finished goods and CPI didn’t keep up, so companies had to make cutbacks.
    If you don’t believe me look at this graph.

  11. Gravatar of ssumner ssumner
    30. November 2009 at 05:42

    JTapp, Doc, There was high inflation in the first half of 2008. But here is what is ridiculous:

    1. Stating that the US economy faced a risk on high inflation on September 16th, 2008, when it was obvious that the real risk was low inflation.

    2. Having the Fed call for fiscal stimulus in 2008, rather than implementing a more aggressive monetary stimulus.

    Both actions are indefensible

  12. Gravatar of Doc Merlin Doc Merlin
    30. November 2009 at 07:43

    Yes, I’ll definitely agree with you there, Scott. My views on what happened range from the fed being incompetent to the fed playing political games. Clearly, however they weren’t doing their job properly.

  13. Gravatar of JTapp JTapp
    1. December 2009 at 13:40

    I encourage reading the book just to see the different paradigm the FOMC operates from. The fact that an inflation target is anathema to several on the FOMC was eye-opening (while Bernanke favors it and created the idea of Fed banks publishing long-term inflation forecasts as a way of implicit targeting).
    In other words, they view their jobs much differently than you do.

  14. Gravatar of JTapp JTapp
    1. December 2009 at 13:49

    Just as a follow-up, I mean Mankiw was writing an op-ed in the NY Times about ways to create negative nominal interest rates, Rogoff and others were calling for an inflation target of 6% or more in the Financial Times, others were calling for much different policy but that had NO relevance to the actual Fed if Wessel’s account is at all accurate… that type of creative thinking is not even in their playbook. Creative for them is creating a SIV to buy up bad assets.

  15. Gravatar of Scott Sumner Scott Sumner
    3. December 2009 at 05:50

    JTapp, Everything you say is true. But it is also true that the profession as a whole did not think Fed policy was too tight. Mishkin said the Fed did a good job, despite the fact that his own textbook implies the recession was their fault. And Mankiw only had that one mild suggestion, otherwise he wasn’t critical of the Fed.

    BTW, I operate in a different social milieu. It is much easier for me to be a fierce critic of the Fed.

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