Woolsey’s index futures convertibility: two paths converging

This post was inspired by Bill Woolsey’s recent post on a monetary constitution based on index convertibility.  I’d like to follow a similar procedure, but emphasize slightly different issues.  The goal is to show that we can get to the same place from several different directions, but also that Woolsey’s approach offers some conceptual advantages over the approach that I have been emphasizing.

Woolsey starts by discussing various approaches to monetary rules, some of which ended up as dead ends.  These include Friedman’s 4% rule for money growth, as well as more flexible feedback rules such as Simon’s plan to adjust the money supply in such a way to achieve price stability.  Woolsey ends this part of his analysis with an imaginary (but very plausible) account of how hard it would be for the Fed to explain a recession that occurred because its feedback rule was faulty:

Sadly, the actual testimony would likely skip all of the accountability and go straight to the fundamental excuses–the price level deviated from target because of financial innovation, or the collapse of an asset price bubble or whatever it is that in hindsight was not properly accounted for in the monetary authority’s model.

Then Woolsey skips over to monetary regimes based on convertibility, starting with the gold standard.  I’ll get there eventually, but first let’s do a bit of “post-monetarism.”

I see new Keynesianism as one line of post-monetarist thought.  They accepted the need for a nominal target.  They accepted the natural rate assumption that the long run Phillips Curve was vertical.  They accepted the view that nominal interest rates can be highly misleading due to the Fisher effect.  They accepted the need for policy rules at some level.  And they accepted the view that monetary policy can be effective in a liquidity trap, as long as money supply increases are expected to be permanent.  In other words, there’s a lot of monetarism in new Keynesianism.

But there is also some discretion, and a preference for interest rates as a policy “instrument,” (although as Michael Belongia emphasizes they are actually short run targets.)  Some new Keynesians preferred tactical discretion with the strategic goal of a stable inflation rate of roughly 2%.  Others favored a Taylor Rule regime.  For any discretionary regime, the big stumbling block is policy lags.  And that’s where Lars Svensson comes in.

Svensson argues that if we are going to use discretion to try to stabilize inflation, why not set the instrument at a level that is expected to produce on target inflation.  In other words, why not try to succeed?  By then why rely on merely the central bank’s discretion, why not use market expectations?  Both Garrison and White, and Bernanke and Woodford, pointed out there was a circularity problem in trying to target market expectations when setting policy, if the markets knew policymakers would react to and try to offset any changes in inflation expectations.

OK, then try to get a market forecast of what instrument setting is most likely to produce on target growth.  And that’s where I have focused much of this blog.  I won’t bore you with all the details, this post summarizes my views.

Now let’s return to Woolsey’s narrative and see if we can get to the exact same place, from an entirely different path.  I promise it will be worth the effort, as I believe it will lead you to think of futures targeting in a new way.  Bill started with the gold standard, the convertibility system with which we are most familiar.  He also briefly discussed alternatives, such as Buchanan’s proposal for a brick standard.  All of these “mono-metallic” standards have a basic flaw, the relative price of the medium of account can change, causing price level (and NGDP) instability.

OK, how about bi-metallism?  I’m no expert in this area, but the system is actually more workable than many of us were taught.  Indeed it might well be better than a gold standard.  There might be an occasional “flip” from one metal to the other, but those would actually tend to make the price level more stable, despite the inconvenience of changing metals.  An even better approach is “symmetallism,” meaning the medium of account is not gold or silver, but a certain weight of gold plus a certain weight of silver.  This system does not flip flop between metals.  Both are always part of the medium of account.

And if one is going to use symmetalism, why stop at two?  Why not add copper and iron and cement, and cotton and bushels of wheat and gallons of 89 octane gasoline?  It would still “work,” but even a broad basket of commodities might not stabilize the overall price level, as commodity indices tend to be volatile in real terms.  So why not include all the goods in the CPI?  Here is where we run into problems.  Many goods are non-homogenous.  What is a “house?”  Or a “haircut?”  And many are non-storable, and are not traded in auction-style markets.  So do we have to stay with commodities?  No, we can make a CPI futures contract the medium of account.  Make currency convertible into CPI futures contracts.

Now let’s pick up Woolsey’s narrative.  He points out that if NGDP stability is the best way to achieve macro stability, why not make NGDP futures contracts your medium of account.  Make currency convertible into NGDP futures contracts instead of gold.  So we have followed a very different narrative.  Instead of the new Keynesian narrative culminating in the work of Lars Svensson, we have followed in the tradition of what was once called the New Monetary Economics.  This was pioneered by people like Black, Fama, Hall and Thompson.  Then further work was done by Greenfield, Yeager, Glasner, Woolsey and Dowd, among others.

But I don’t think many people understand this connection.  Bernanke and Woodford criticized Dowd’s 1994 Economic Journal proposal as if it was in the Svensson tradition.  As if it was merely an attempt by the Fed to target some price index out there in the economy.  But Dowd’s plan was not subject to the circularity problem (nor was my 1989 paper that they ignored) as it relied on index convertibility.

You might say that in the end it doesn’t matter which path we take, as long as we end up in the same place.  Technically this is true, but I think Woolsey’s approach offers some insights into the policy that are obscured when one arrives there from the new Keynesian direction.  I will conclude with two such possible advantages:

1.  Woolsey argues that the plan should not be fully automatic, that central banks should be free to take a position in NGDP futures, to trade on their own account, and not just passively balance out the long and short positions of the public.  Then he makes this argument:

Sumner’s version of index futures targeting aims at avoiding all discretion by the monetary authority. The general idea is that ordinary open market operations in bonds are tied by some mechanical rule to trading in index futures contract. The simplest one is dollar-for-dollar parallel trades. Every time a bear speculator sells an index futures contract, and so, the monetary authority buys one, the monetary authority also makes an conventional open market purchase of government bonds. The expectation by speculators that nominal expenditure will be below target results in an increase in base money. Similarly, if a bull speculator buys an index futures contract, and so, the monetary authority sells one, the monetary authority also makes an open market sale of government bonds. The expectation by speculators than nominal expenditure will be above target results in a decrease in base money.

I am skeptical of mechanical rules. It is not realistic that a monetary constitution can end all discretion by the monetary authority. What it needed is a framework that provides incentives to promote macroeconomic stability. Index futures convertibility shows promise as useful limit on the discretion of a monetary authority.

The more I think about it, the more open-minded I am on this issue.  Some commenters challenged me with the observation that very few speculators might choose to trade NGDP futures.  At first I thought this was undesirable, but the more I think about it, the more I realize that it really isn’t a problem at all.  If no one traded we’d be back to a fully discretionary regime, as we now have.  Then you might ask; “wouldn’t that be bad?”  Not really, because the Fed never would have been able to get away with NGDP expectations falling so sharply last year.  So my answer is yes, maybe no one would trade, but only if they thought the Fed was doing a good job.

As an analogy, under a gold standard or a fixed exchange rate regime the central bank has some flexibility; but only within limits.  It cannot allow the price of foreign exchange to move outside a narrow band.  The same would apply to NGDP future convertibility.  The Fed could use its best judgment, and the market would only “nudge” policy if the Fed got so far off course that speculators overwhelmed the Fed’s own position in the futures market.  As a practical matter I believe this would keep NGDP growth expectations in the 4% to 6% range (assuming a 5% target) although I have no proof.  Then Woolsey discusses how the Fed’s profits or losses would provide feedback as to whether their discretion was helpful.  This is a much more evolutionary approach toward monetary reform, and hence more politically acceptable than just turning policy over to a futures targeting system.

2.  Several commenters have also raised the issue of “efficient markets.”  How can we trust speculators to set monetary policy?  What if they are wrong?  What if NGDP and inflation turns out to be higher than expected?  If you look at that issue from the new Keynesian direction it might seem quite worrisome, but from the index convertibility perspective it seems less so.  Here’s why:

Under index convertibility we are trying to stabilize NGDP expectations.  Is actual NGDP the ultimate goal?  This question is harder to answer than one might think.  Here’s my take:  I think the key macro problem is wage stickiness.  Periods of falling wages are associated with rising unemployment, and vice versa.  At first glance it would seem that falling wages should help reduce unemployment.  But suppose some wages are sticky and others are readjusted each period.  Then if overall wages are falling, the sticky wages will be above equilibrium—thus causing unemployment.  So a stable monetary policy should lead to fairly stable wage negotiations.  And that requires stable expected NGDP growth, as NGDP expectations are a key determinant of wages.  Stable NGDP expectations lead to stable aggregate wages, which leads to stable core inflation and stable unemployment.

So if we look at things from Bill’s index convertibility perspective, we no longer use the “shooting an arrow at a target” metaphor.  Monetary policy is no longer trying to beat the policy lags problem.  We return to older metaphors about money being convertible into something of value.  About fixing a price.  Gold was an improvement over previous systems, but it wasn’t good enough.  With NGDP targeting we have the dollar’s value stabilized in terms of NGDP expectations, and NGDP expectations are the “gold standard” of macro stability.  It was the collapse of NGDP expectations in 2008:H2 that triggered all the more obvious problems that we saw last year.  That can’t happen under index convertibility, and I emphasize “can’t.”  Actual NGDP can bounce around a little bit, but not NGDP expectations.

And then we can all start teaching Say’s Law, and junk all those multiplier chapters; as the expected multiplier (going forward) will always be exactly zero.


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38 Responses to “Woolsey’s index futures convertibility: two paths converging”

  1. Gravatar of Doc Merlin Doc Merlin
    19. October 2009 at 19:05

    1) Woot, I was wanting a post on free-ish banking.

    2) This is brilliant. Actually its what I have been thinking about the past few weeks. Its good to see that I’m not the only one. The best part of these sort of systems is they remove money creation from the hands of the Fed and banks and moves it to whoever is making goods/services/etc.
    That makes these sort of systems as effectively the same as having a free banking system, /except/ with a single currency instead of multiple currencies. That is the best part. So we have some of the macro benefits of free banking, without the annoyance of confusing currencies.
    This is only so long as anyone has access to the NGDP futures, not just certain financial institutions.

    3) Also, making the currency be a futures’ contract on NGDP growth means that monetary expansion happens uniformly through society instead of being concentrated in banks. Its a brilliant, excellent idea.

    4) A, is that it is still manipulatable by changing how the NGDP is counted.

    5) The expansion for the targeting needs to happen regularly enough that there isn’t as strong a desire to hold onto the futures right before they are expanded, as this could create artificial temporary deflation.

    6) As per point (2), if only certain small number of institutions can convert the NGDP futures, they have incentive to create deflation. The best way to do this is to set up an exchange, that anyone can access, much like a normal futures exchange. Or to trade the futures on a large commercial exchange.

    7) Another option is to make the money itself a future, instead of just convertible into one. Cue Dramatic Music

    8) I completely agree about stability, it seems to me that what is dangerous is not inflation or deflation per-se, but differences between inflation/deflation expectations and reality.

    – Jorge Landivar

  2. Gravatar of Jon Jon
    19. October 2009 at 20:43

    It was the collapse of NGDP expectations in 2008:H2 that triggered all the more obvious problems that we saw last year. That can’t happen under index convertibility, and I emphasize “can’t.” Actual NGDP can bounce around a little bit, but not NGDP expectations.

    So is this a quantification of ‘animal spirits’? Ill-feelings (collapse of NGDP expectations) creates reality? We also just need a little nominal nudge? At some-level this comports with basic impressions. My experience was that the ‘ill-feelings’ on the news led to cutting costs before revenue declined–and declined it did (later). Certainly that comports with your phrasing.

    But what does this say about the neutrality of money? i.e., if I suddenly conclude that real-value being traded is less than I thought at a given price, don’t I perceive that as a shift in the supply curve and doesn’t the QD decline.

    i.e., aren’t people reacting to their expectations of the real-value volume of the future market. Isn’t that what we always learned about rationality?

    Or compare the ‘conventional’ narrative. The real-shock in oil prices subsides once the market realizes that there is substantial supply elasticity at $70 (yr2000 dollars). Prices decline rapidly causing a resetting of inflation expectations. The Fed burned by helping to elevate inflation expectations in the prior year is slow to react. Policy becomes tight despite the tepid easing. A nominal-shock ensues.

    In the conventional narrative, the Fed should have supported the price-level to sustain inflation expectations. Notably absent from this story is any claim that the Fed should have supplanted short-falls in RGDP growth with further inflation. Suppose the shock persists for a while. Don’t inflation expectations reset to the full 5%? And once they do, doesn’t policy again become neutral? Once this happens, any real-growth that follows should be met with reduced inflation. Don’t we still believe that if inflation goes down below expectations, policy is tight? Would we then get stuck a new zero-growth equilibrium? Perhaps the Fed should pick a steeper NGDP growth path then, and steeper, and steeper.

  3. Gravatar of rob rob
    19. October 2009 at 20:47

    1) Sounds cool but what is the over/under for how many decades away we are from selling this politically? In what country?

    2) Could you explain the “circularity problem”?

  4. Gravatar of Doc Merlin Doc Merlin
    19. October 2009 at 21:14

    Hrm, forgot to mention though that this has the same main problem that the gold standard has, which is government can at will leave it, to allow themselves to inflate to borrow as much as they want.

    Only way I see a permanent fix is a separation of economics and state. Not sure of the details on how to make this workable however.

  5. Gravatar of Doc Merlin Doc Merlin
    19. October 2009 at 21:16

    @rob

    The circularity problem is, in my understanding, with using exchanges to predict what the fed should do, means that people can manipulate the exchanges to change fed policy in ways that benefit them.

  6. Gravatar of Greg Ramsom Greg Ramsom
    19. October 2009 at 21:23

    Hayek has a very good essay on this proposal:

    “And if one is going to use symmetalism, why stop at two?  Why not add copper and iron and cement, and cotton and bushels of wheat and gallons of 89 octane gasoline?”

  7. Gravatar of Greg Ramsom Greg Ramsom
    19. October 2009 at 21:36

    Evidence suggests that industrial wages and industrial unemployment rose under Hoover because of Hoover’s wage and cartelisation policies — before there were significant deflation or bank panics.

    So monetary policy does not insure a solution to high wage and unemployment problems.

  8. Gravatar of Doc Merlin Doc Merlin
    19. October 2009 at 22:26

    I have to agree with you, Greg. Even the best monetary policy won’t ensure that there is good regulatory policy.

  9. Gravatar of ssumner ssumner
    20. October 2009 at 03:48

    Doc merlin, You raise some interesting points:

    1. Bill has also discussed how index convertibility can lead to free banking.

    2. It is true that NGDP could be redefined. But when the government makes major changes they track the data both ways for a period of time. The existing contracts could be paid off under the old system, and new futures contracts could be entered into with full knowledge of the new system.

    3. I agree that the final step is making money itself into NGDP futures, but that will have to wait for a fully electronic money system. (Because their are technical difficulties of paying positive or negative interest on cash and coins.) I used to think that was a long way away, but I think we can begin to see how it might happen within decades, not centuries.

    Jon, You said;

    “So is this a quantification of ‘animal spirits’? Ill-feelings (collapse of NGDP expectations) creates reality? We also just need a little nominal nudge? At some-level this comports with basic impressions. My experience was that the ‘ill-feelings’ on the news led to cutting costs before revenue declined-and declined it did (later). Certainly that comports with your phrasing.

    But what does this say about the neutrality of money? i.e., if I suddenly conclude that real-value being traded is less than I thought at a given price, don’t I perceive that as a shift in the supply curve and doesn’t the QD decline.”

    Now when I read keynes I constantly notice his frequent references to “confidence.” From the context it seems clear he is talking about future expected changes in nominal expenditure, or AD. But these aren’t created by the public out of thin air, there must be something real behind them. And we now know there was, the Fed has not intention to bring us back to the old 5% growth trajectory, instead we will start on a new 5% growth trajectory that is 8% to 10% below the old one. Thus the markets were right to become bearish about Fed policy, the Fed has confirmed their worst fears. And that was also true in 1920,1929,1937, 1981. The Fed didn’t return us to the previous NGDP trajectory (and in the 1980s that was a good thing.

    [Note to grad students; there might be a paper in comparing Keynes idea of confidence in the GT, to Woodford’s view that future expected AD drives current AD (in his Interest and Prices book.]

    The question of expectations is complex. It is true that fully expected nominal changes are neutral, that is changes expected before wage and loan contracts are signed. But a sudden “unexpected” change in near-term expectations is not neutral, as we saw late last year. That occurred too quickly to have been incorporated into existing contracts.

    I’m not sure I fully understand your last two paragraphs, but I’ll make a few comments.

    1. The fact that the current price of oil is $80, and we are in a deeply depressed world economy, should make people a bit less skeptical of my earlier argument that high oil prices in mid-2008 (when the world economy was strong) were rational. Just imagine how high oil would be now if we weren’t in recession. But I agree with your point that the Fed’s tepid response to the commodity price fall was a mistake.

    On the last paragraph. It makes me nervous when people start talking about inflation under supply shocks. I think NGDP is the right variable, so I don’t care at all if supply side problems cause real growth to fall to 0% and inflation to rise to 5%. As long as NGDP is well behaved, I think wages and core inflation will also be well-behaved.

    I don’t quite follow your last two sentences, as monetary policy can’t effect long term trend growth.

    rob, If the Fed targets a private CPI futures market at 2%, and reacts to any deviations, then futures prices won’t budge from 2%, because they know that any breakout to say 3% would be offset immediately by tighter Fed policy. But if the futures market never budges from 2%, then it can’t send the signals necessary to let the Fed know when to take offseting actions when their are velocity shocks.

    Doc#2, Alas, that will never happen.

    Greg, Those are both good points. But it would be more correct to say that Hoover’s policies prevented wages from falling, there was no significant rise in nominal terms. This is important, because although his policy of opposing wage cuts raised unemployment in the Depression, it would not have had much effect had NGDP growth stayed at the 3% trend of the 1920s. The strong union push came under Roosevelt, and I agree that no monetary policy can offset that, nor can monetary policy offset minimum wage laws, which also came under FDR. So we are basically on the same page.

  10. Gravatar of Current Current
    20. October 2009 at 03:49

    Interesting, didn’t Fisher support something similar.

    How do we avoid governments manipulating the NGDP or CPI figures used?

  11. Gravatar of Bill Woolsey Bill Woolsey
    20. October 2009 at 07:27

    Current:

    The early and general expositions of the compensated dollar is pretty much what Scott described above. It is also what Greenfield and Yeager proposed in their BFH payments system, though combined with free banking. The more precise schemes Fisher described amount of a feed back rule from the CPI, though it does use the price of gold as mechanism. The official price of gold would be changed, and money would be convertible into gold at that price. The price changes using a feedback rule from the CPI. (This sort of stuff was/is the bread and butter of the New Monetary Economics.)

  12. Gravatar of Doc Merlin Doc Merlin
    20. October 2009 at 07:46

    Speaking of Oil:
    The price of oil strikes me as very odd. There are huge stockpiles and the extraction costs are well below $80.
    The alternatives to Oil are also priced below $80 a barrel to produce.
    E85 is cheaper than Gasoline right now. (roughly close to the same price in terms of energy content)
    Coal-to-oil oil costs significantly less than $80 a barrel to produce.
    Natural gas is insanely cheap right now.

    This makes me think that we are seeing maybe a bubble in oil?… Or the value of the dollar is much less to oil exporters than to other countries? I have no idea, but the current prices will probably continue to rise again then fall once-more.

    Anyway, slight digression, on what is a very interesting topic.

  13. Gravatar of Current Current
    20. October 2009 at 09:40

    Bill,

    OK, I’ve read about a little of that.

    I think that it could work with free-banking. That is, it could work if the issuers of the money decide themselves on index to use themselves. Customers could reject ones they see as unreasonable.

    However, I’m not sure it could work in a state run system. Once the NGDP or CPI become policy determining variables the political gain in manipulating them will be increased significantly. Mises made this point about the compensated dollar plan.

    In the UK there is a 2.5% price inflation target. The Bank of England use the CPI index to calculate it. The UK CPI is known to be highly favourable to indicating low inflation. The acceptability of this index is shown by the fact that index-linked treasury bonds are still linked to the older RPI index.

    It would be possible for governments to game the NGDP without even corrupting the statistic agencies. As far as I can see all they need do is find a way to raise government expenditure G. They need to find a way to do so that comes just outside the rules for what constitutes a transfer payment.

  14. Gravatar of StatsGuy StatsGuy
    20. October 2009 at 10:37

    ssumner:

    “I think the key macro problem is wage stickiness.”

    Without challenging anything else – since your/Bill’s proposals really fix many problems simultaneously – let me just ask why you think this?

    In the current crisis (leaving aside how we got here), the key problems didn’t seem to be wage stickiness (a lot of people are willing to take low paying jobs right now, and for the first time since the Great Depression we had mass wage cuts). Rather, it seemed to be accumulated debt. (And some true structural problems.) In other words, one of the chief things suppressing spending power is not just lack of jobs, but the high (real) cost of carrying debt – which drives expectations of lower AD that cyclically drive deflation extectations etc. One particular nasty example was “housing stickiness” – people who are underwater on their mortgage but cannot escape because if they walk away they can’t get a loan for a cheaper house (which would let them take a lower paying job). (Thus the logic of _personal_ credit ratings, which are based on history, as compared to _corporate_ credit ratings, which are based on expected ability to repay.) Others have argued real changes in risk perceptions, distributional shifts and non-linear utility functions, “recalculation”, etc. I would personally argue that there are a number of reasons why the savings/investment equillibrium is broken – including the carry trades (and currency misalignments). I sure one could construct a model that _real_ uncertainty about the future combined with any level of risk aversion creates an _individual_ disincentive for long term investment even though in _aggregate_ the reward function is more certain – in other words that we chronically under-invest in our future. Can all of these be reframed as a labor market clearing problem?

    I think the solutions fix many problems (including enhancing legitimacy by removing perceived discretion), and Woolsey’s semi-discretionary approach has the advantage that we know afterwards what the answer was (an essential metric for political agency oversight). So why focus on labor markets clearing?

  15. Gravatar of Greg Ramsom Greg Ramsom
    20. October 2009 at 10:44

    Re 29-30, should have said relative wages rose — productivity increased so real income was rising, and non-industrial wages were falling.

  16. Gravatar of ssumner ssumner
    20. October 2009 at 16:23

    Current; You asked;

    “Interesting, didn’t Fisher support something similar.

    How do we avoid governments manipulating the NGDP or CPI figures used?”

    Fisher’s plan was more of a feedback rule–using the price of gold to stablize the price level. Similar, but not identical.

    The contracts would be paid off using NGDP constructed in the same way as when the contracts were issued, so the government would gain nothing from redefining NGDP.

    Bill, I should have read your reply first.

    Doc Merlin, I think the current behavior of the oil market strongly supports my view of the mid-2008 price. There is no theoretical mechanism for a permanent bubble. I think prices are equally like to rise or fall going forward (does anyone know what the oil futures look like?)

    Current, You said;

    “The acceptability of this index is shown by the fact that index-linked treasury bonds are still linked to the older RPI index.”

    This strongly supports my earlier answer—market participants demand a fair system if they are going to invest in the asset.

    Statsguy, You said;

    “In the current crisis (leaving aside how we got here), the key problems didn’t seem to be wage stickiness (a lot of people are willing to take low paying jobs right now, and for the first time since the Great Depression we had mass wage cuts). Rather, it seemed to be accumulated debt. (And some true structural problems.) In other words, one of the chief things suppressing spending power is not just lack of jobs, but the high (real) cost of carrying debt – which drives expectations of lower AD that cyclically drive deflation extectations etc.”

    A couple points. If the problem is aggregate wage stickiness, individuals cannot save their jobs with nominal wage cuts, and the sectoral impact of recessions is very uneven. Some keep their jobs with no wage cuts, others would lose their job despite a willingness to accept 10% wage cuts.

    You also seem to be mixing up two very separate issues; what determines nominal spending, and how do declines in nominal spending get transmitted into changes in real GDP and employment. Recall that classical theory predicts a decline in NGDP should have no impact on RGDP, just prices. So when you argue that debt burdens may have reduced nominal spending, I don’t necessarily disagree, but that is a very different issue from how changes in nominal spending end up impacting employment.

    As to why I believe wages are important, in 1989 Steve Silver and I published a paper in the JPE showing that wages were much more countercyclical in recessions caused by demand shocks than recessions caused by supply shocks. Also my research on the Depression led me to focus on wages, as they seemed to be the best way of understanding the transmission mechanism. For instance, greater wage flexibility helps explain why the 1920-21 depression was much shorter. But I would never argue wage stickiness is the only transmission mechanism, just the most important.

    I do agree with your fianl point. I think we can come up with solutions for stabilizing the macroeconomy without agreeing on whether wages are key. That’s because the policy implications of various transmission mechanisms are often quite similar.

    Greg, You may be right about the relative wages. But my point was that I am pretty sure Hoover only tried to prop up industrial wages because we were in a depression. Of course it was a big mistake, but my point was that if we had had no depression, Hoover might not have intervened. So I basically agree, except that I think NGDP targeting could have reduced the harming meddling by the government that so often follows business downturns.

  17. Gravatar of rob rob
    20. October 2009 at 18:02

    I keep thinking this is an example of the problem with our idea of the separation between economics and political science. Scott, you’ve called yourself a pragmatist, but if something isn’t politically pragmatic, it doesn’t matter how economically pragmatic it is — it isn’t pragmatic. I turned on CNBC for 30 minutes today and read the headlines in the Economist online. Everyone was worried about the status of the dollar as a long-term safe-haven currency.

    If the dollar were suddenly backed by NGDP futures — a concept which most people would never understand — the uncertainty alone might do it in. Can you imagine members of congress even being able to grasp the concept? It isn’t politically feasible.

    On the other hand, imagine if someone were to start a U.S. NGDP futures market in, say, Ireland. Would the Fed be able to ignore it?

  18. Gravatar of rob rob
    20. October 2009 at 18:59

    This is immediately off-topic, yet relevant if we were to make a radical shift in our currency. Looking forward, does it make more or less sense to try to unify more currencies? Soros’ agenda back in the 80’s was the problem he saw with national currencies crashing into each other “like tectonic plates”. A situation which he managed to make an enormous amount of money from, yet decried. (A liberal never takes his own side in an argument. -AB) His proposal then was a universal currency backed by oil. (CO2 emissions apparently weren’t such a hot-button.)

    You’ve posted that the US should be more like the EU. With the imagination tilted against the next century: do you picture further consolidation of currencies? Would this be good, bad, or neutral?

    Which is worse: many, many currencies all over the globe, or one good one (if you assumed the one were backed by global, um, NGGP?

    Who are your favorite guitarists? TC willingly answered this question… (Please don’t leave out Zappa.)

  19. Gravatar of rob rob
    20. October 2009 at 19:09

    Another off-topic question: should someone who is about to turn 40, who has a background in math with a good paying job that they are bored silly with consider getting an advanced degree in economics–just for the fun of it? Would it be irrational?

  20. Gravatar of Jon Jon
    20. October 2009 at 20:00

    Scott writes:

    On the last paragraph. It makes me nervous when people start talking about inflation under supply shocks. I think NGDP is the right variable, so I don’t care at all if supply side problems cause real growth to fall to 0% and inflation to rise to 5%. As long as NGDP is well behaved, I think wages and core inflation will also be well-behaved.

    See now, I usually have stagflation in mind when I hear about miracle nominal policies. In some sense this feels like deja vu: a nominal policy (once Keynesianism, now NGDP targeting) claims to also stabilize real variables (unemployment).

    I don’t quite follow your last two sentences, as monetary policy can’t effect long term trend growth.

    I think the claim under consideration is that it will surprise us into stable employment. Not whether it alters long-run growth per-se.

    My other line of inquiry was whether the Fed could keep surprising us for a long while and suppress real-growth. i.e., if the Fed induces a 5% inflation expectation and keeps holding pursing a 5% NGDP target won’t they keep ‘surprising’ us with below expectation inflation, and won’t that keep knocking real-growth down. Sure the ratex claim would be that we learn the policy and aren’t ‘surprised’, but how long does this take? In the meantime, why do we want a policy rule that keeps inducing a surprise disinflation every time real-growth picks up a little bit.

  21. Gravatar of Jon Jon
    20. October 2009 at 20:10

    Scott:
    BTW, I came across the following graph from the Cleveland Fed regarding ‘inflation expectations’. This particularly relates to your claim that Fed policy seemed irrational because inflation was below target. I suggested in that thread that perhaps the Fed has a different index in mind.

    Apparently the public does as well:
    http://www.clevelandfed.org/research/data/updates/2009/1009/cs.gif

  22. Gravatar of Current Current
    21. October 2009 at 01:51

    I’ll reply to folks soon before then an interesting article…

    http://www.guardian.co.uk/commentisfree/2009/oct/20/afghanistan-election-karzai-liberal-arrogance

  23. Gravatar of StatsGuy StatsGuy
    21. October 2009 at 05:27

    “You also seem to be mixing up two very separate issues; what determines nominal spending, and how do declines in nominal spending get transmitted into changes in real GDP and employment.”

    Yes, I am… but permit me to press a bit here.

    http://www.bls.gov/news.release/pdf/realer.pdf

    Since Dec 08, real wages have declined 1.9% according to BLS (which means even higher nominal wage declines, since we’ve had YoY disinflation). Wage declines seem to have lagged GDP declines by only about 3 months (that’s based on eyeballing only). YoY GDP decline was on the order of 3-4% over those 12 months. Obviously there’s a gap, supporting the stickiness story, but it does appear that real wages were remarkably flexible (historically speaking) over the past 12 months. Strikingly (this time around) the relationship between unemployment and GDP decline is a little more exaggerated than usual (on the tails of Okun’s Law).

    http://www.calculatedriskblog.com/2009/07/unemployment-and-gdp.html

    I understand the point about unevenness of wage declines, but it does seem that a greater portion than usual of the nominal-to-real transmission is due to non-wage-stickiness in this particular case. Maybe a little more “real” frictional adjustment costs than usual. Maybe other transmission mechanisms (debt payments get vacuumed into reserves, but don’t result in investments that really would be valuable, meaning that accumulated specialized human capital which _is_ potentially productive sits idle waiting for GDP to pick back up… does the classical model account for specialized human capital?).

    I’m not arguing that wage stickiness is not a big factor (clearly there is a big gap in real GDP decline/real wage declines). But focusing on the wage story tends to imply that the problem to fix is wage rigidity (i.e. those pesky unions).

    Alternatively? Under_investment_ and idle specialized resources (including human capital), that are waiting to be set back to work (or, to conclusively learn that their human capital is wasted). This is one of the reasons that I think it’s important to differentiate between government spending that is simply “stimulative” (while incurring fiscal deficits), and government spending that is actual investment.

  24. Gravatar of ssumner ssumner
    21. October 2009 at 16:07

    rob, You said;

    “Everyone was worried about the status of the dollar as a long-term safe-haven currency.”

    The weakness of the dollar is one reason stocks are up 60% since March, and one reason why housing seems to have bottomed out. When you say “everyone” is worried, are you including those equity investors who are growing increasing optimistic about the health of the economy. (BTW, even real stock prices are up sharply, as the price level changes slowly.)
    Don’t get me wrong, I think there is a grain of truth in those that worry about the dollar. let’s consider three possibilities:

    1. The dollar is weak because inflation is roaring ahead.
    2. The dollar is weak because of a monetary policy aimed at ending deflation (such as 1933’s devaluation)
    3. The dollar is weak because the supply side of the economy has all sorts of problems caused by stupid bankers and stupid politicians.

    I would argue that one doesn’t apply right now, two does a little bit, and three also applies. But the central bank has no control over the long run real exchange rate, that reflects the supply-side of the economy. And point two is appropriate.

    rob#2 You asked;

    “You’ve posted that the US should be more like the EU. With the imagination tilted against the next century: do you picture further consolidation of currencies? Would this be good, bad, or neutral?

    Which is worse: many, many currencies all over the globe, or one good one (if you assumed the one were backed by global, um, NGGP?

    Who are your favorite guitarists? TC willingly answered this question… (Please don’t leave out Zappa.)”

    I don’t have strong views on this, but I think there will be some further consolidation of currencies. How good it is depends on how well the currencies are managed, and how much the economies are in synch.

    I don’t think a single global currency is practical in the near future. The goals of each major economic block are too different, and their busienss cycles are not completely in synch.

    Improvements in technology (such as electronic money replacing cash), might make even the euro less desirable.

    Unlike TC I have somewhat narrow taste in music. There are some bands I liked a lot (mostly blues rock bands from the late 1960s and 1970s) but I am not qualified to judge the guitarists. All the famous guitarists (Clapton/Page/Hendrix/ etc) sounded really good to me, and I focused more on other aspects of the music. Sorry to disappoint you. I do have a few Zappa albums however, so I hope that counts for something (the only name I recall is “Hot Rocks”.) My strength is the visual arts–that’s just how my brain is wired. For what it’s worth my favorite album is the Dylan bootleg from Royal Albert Hall (actually Manchester) in 1966. But I don’t suppose that would appeal to someone focused on great guitar music.

    rob#3, I don’t really know for sure. All I can say is that if you plan to do this at age 40, go to a fun department like George Mason, not some department full of math geeks.

    Jon, The problem is that I don’t know eactly what you mean by “stagflation.” Many people think of the 1970s, when NGDP was growing 10% a year, but that is not likely. You said:

    “My other line of inquiry was whether the Fed could keep surprising us for a long while and suppress real-growth. i.e., if the Fed induces a 5% inflation expectation and keeps holding pursing a 5% NGDP target won’t they keep ‘surprising’ us with below expectation inflation, and won’t that keep knocking real-growth down.”

    Sure it’s possible, but I don’t see much chance of this happening. I see no evidence that labor sees high inflation, as wage growth is very slow. So I think if the Fed aimed for 5% NGDP growth and 2% inflation, the public would probably believe them.

    Jon#2, I don’t pay much attention to those surveys, and i doubt the Fed does either. As you can see, the public grossly overestimates inflation, indeed it is not clear that they are even thinking of the same concept. They probably are thinking about how much more “cars” cost, not that a 6 cylinder Honda Accord today is better than a $22,000 Acura was in 1986. If you asked the average person they’d say cars are much more expensive than in 1986. And the average car bought does cost more. But the quality adjusted inflation in cars is extremely low.

    More to come . . .

  25. Gravatar of ssumner ssumner
    21. October 2009 at 16:40

    Current, Why is the article “interesting?” There is a lot there, but not the only thing I would have found interesting–his plan for dealing with the Taliban.

    Statsguy, I am confused by your assertion that real wages have fallen by 1.9%. The table shows nominal wages up 2.5% over the past 12 months. The CPI has fallen during that period. So real wages have increased significantly. But even if you are right, I would add several points:

    1. In earlier posts I’ve argued that the CPI is almost useless during business cycles. Housing prices rose about 2% between mid-2008 and mid-2009 according to the CPI. And yet everyone knows they fell by more than 10%. So let’s say construction worker wages were flat over that period. It would have looked like real construction worker wages fell 2%, whereas they actually rose sharply in terms of what they produce.

    Furthermore “hourly wages” may be skewed to the more cyclical parts of the economy, such as manufacturing. (Although I have no proof.)

    But here’s my basic argument: If nominal spending falls 8% below trend over 12 months, then hourly wages must also fall 8% below trend, or else unemplyment will rise. And if it is true that nominal hourly wages have risen 2.5% over the past 12 months, then they obviously haven’t fallen 8% below trend (which I assume to be roughly 4%.)

    You said;

    “I’m not arguing that wage stickiness is not a big factor (clearly there is a big gap in real GDP decline/real wage declines). But focusing on the wage story tends to imply that the problem to fix is wage rigidity (i.e. those pesky unions).”

    I don’t think unions have much to do with nominal wage rigidity. It is possible they make some real wages more rigid, but I think nominal wage rigidity is pretty common in both union and non-union sectors. Even when real wages are pretty flexible and unions are weak (such as 1921) unemployment can rise sharply with a nominal shock.
    Going after unions to solve the business cycle would be a huge mistake. I know that that is not what you are advocating, I just want to make it clear that I also would disavow that sort of solution.

    There is no way my data could in anyway disprove your view that real factors are more important this time. So you might be right. Keep in mind, however, that if “real factors” include banking problems, then it is quite possible that the nominal shocks made those real factors even worse in 2008. So the two types of shocks are “entangled.”

    But let’s say the problem is more real this time. I don’t see how government investment helps the reallocation problem that Arnold Kling talks about, unless it is stuff we should be doing anyway, and will be doing after the recession is over. But I think most unemployed workers from the private sector will eventually find new jobs in the private sector. Let’s speed up that adjustment process with a positive nominal shock. Government projects are fine if they are things we ought to be doing anyway, but I don’t think there is enough of that to make a big difference, indeed if you look at the data I think it would support my claim. I don’t think the stimulus package has led to much more government employment in investment projects. So even if I bought that policy in theory, I don’t think it is a practical solution to rapidly reemploying million of unemployed workers.

  26. Gravatar of Doc Merlin Doc Merlin
    21. October 2009 at 21:01

    @Scott

    The future’s price for light crude for august of next year is in the mid 80’s right now. From my limited experience with future’s contracts, it seems in general they are really bad for predicting the spot price of something on an exchange with any degree of accuracy over the long term.

    I am not an expert on the future’s market (as I tend to trade ETFs instead of futures for commodity trades, but for oil, the futures’ seem to be usually priced at current spot plus some small amount.

  27. Gravatar of StatsGuy StatsGuy
    22. October 2009 at 04:23

    The 1.9% real decline is since December 08. So the point is that after a 3 month lag, wage prices responded fairly sharply (more so than is historically visible). Much has been made of the fact that we’re seeing the true pay cuts on a scale not seen since the 30s.

    http://www.nytimes.com/2009/10/14/business/economy/14income.html

    Also, as noted earlier, regardless of the mechanism – wages or something else – a positive nominal shock fixes many things. So the reco is the same in that regards, and I have defended that here and elsewhere till I’m blue in the face.

    The only little thing, I think, is that a slightly greater focus on a different mechanism (in this recession) may yield somewhat different results in terms of the federal role. You are right about the “things we should be doing anyway”. The problem is that when present consumption declines we _should_ see investment going up, BUT instead we see investment declining. To the extent an investment is worthwhile, if the private sector is failing to redeploy savings into investment, then focusing on a non-wage mechanism (e.g. a market failure in moving funds from savings to investments) justifies more aggressive fiscal intervention in _investment_. This is the piece of Krugman’s argument I agree with (though he didn’t say it quite like that – he made an argument about G and money multipliers which fails to differentiate government investment and government consumption).

    The current administration (e.g. Larry Summers) sort of makes this argument in the notion that banks are not extending enough credit, but his view is inconsistent with the data (e.g. the reason for banks not making loans is lack of demand for credit from worthy borrowers, not the “credit blob” tale – the point of a previous post). If the problem is demand for credit, then the market failure is in the process that generates demand – which is in, I think, future expectations about the returns on investment. Largely, this is a coordination/uncertainty stabilization problem, which your/Woolsey’s nominal targeting regimes mostly fix. (different mechanism, same solution)

    But, this view does leave a larger role open for a temporary increase in government _investment_. Or, as Krugman put it once, when interest rates are really low that is a market signal the government should be making _more_ long term investments, not fewer. (assuming we can differentiate between government investment and government consumption)

    And the reason the sticky-wage view doesn’t lead us to the same conclusion is because of the reality that labor is not very fungible (because it is coupled with specialized human capital). That’s not Kling’s “frictional” switching cost or recalculation. That’s a story about subpar capacity utilization due a market failure in the savings/investment link, specific labor/capital assets that should _not_ be reallocated to different tasks, and the need to coordinate expectations/stabilize risk for returns on long term investment.

  28. Gravatar of ssumner ssumner
    22. October 2009 at 04:48

    Thanks Doc Martin, Yes, I suppose intertemporal arbitrage keeps them close. But I still think that as bad as they are, they are our best forecasting method.

    Statsguy, OK, but if my 12 month numbers are correct, there must have been a huge real wage increase late last year, which hase been only partically unwound. So real wages are still well above equilibrium. And again, I think the CPI is a horrible way to look at real wages. In my empirical work I deflated manufacturing hourly wages by the WPI (now the PPI). The PPI falls much faster than the CPI in most recessions (excluding supply shocks.)

    I look at things differently than people like Ohanian, who tend to be reassured by wage cuts. If things are so bad that we are seeing nomuinal wage cuts at bigger levels than since the Great Depression, then that just further convinces me that we have seen a huge nominal shock, and that the shock explains much of the unemployment problem. I may be wrong about the transmission mechaism–for instance price rigidity may play a bigger role than I assumed–by there has almost certainly been a big nominal shock.

    Furthermore, although I favor a NGDP target for pragmatic reasons, on theoretical grounds I actually prefer Thompson’s wage target. In the system the benchmark of macroeconomic equilibrium is stable nominal wage growth.

    I think I do understand your broader argument. There are two assumptions in my view that would make your argument convincing:

    1. Government spending stimulus has a shorter lag than monetary policy.

    or

    2. Monetary policy would not offset the stimulative effect of fiscal policy.

    I think point one is unlikely. Point two seems overwhelmingly plausible, so that should be a point in your favor. But I have doubts, which were expressed on my post on the multiplier debate. Basically I think that if Congress hadn’t done the $800 billion dollar stimulus, the Fed would have gone into crisis mode and come up with a much more aggressive and effective monetary stimulus. But I certainly can understand why people don’t buy this argument, it seems very counterintutive at first glance, particular since many assume the Fed already did all it could.

    It is possible you are making a separate argument that I missed. An argument that monetary and fiscal stimulus are qualitatively different, and that fiscal stimulus can boost output more effectively (for any given increase in nominal spending.) I find that implausible, if that is your argument. But I couldn’t quite tell, as the Keynesian language always seems a bit fuzzy to me (but maybe that’s just my problem.)

  29. Gravatar of StatsGuy StatsGuy
    22. October 2009 at 06:16

    The argument is slightly different – it’s about marginal returns to different types of interventions. Overall, monetary action plays the larger role, and should account for more of the response. But the mechanism suggested preserves _some_ role for compensatory increases in government investment (“stimulus” is a lousy term; it implies “keeping busy” but not necessarily doing anything valuable; keeping people busy is the Keynesian argument).

    Consider Point 1 (lag time). There’s actually a tradeoff curve with lag time in one dimension and marginal federal investment on the other. The higher the federal investment, the longer the lag time (holding other things constant).

    For some amount of federal investment, the lag time is quite rapid – for exactly the same reasons you argue that monetary lag time is rapid (anticipatory response). Budgeting cycles for local government occur 1+ years ahead of actual expenditures. Over the summer, municipal govts have built in budget cuts and delays to long term infrastructure expenditures for next year because of anticipated cuts in federal/state matching funds. A credible commitment to keep those matching funds in place or even increase them modestly would change budgeting behavior pretty fast, and that changes management/investment decisions at all levels.

    But further along the curve, lag times are much longer… This suggests there is an equillibrium between different types of interventions (with the greater portion of the response being monetary). I would also add that at least some portion of the govt. investment increase should be funded by monetary action, which partially makes the fiscal action an agent of the monetary authority (with explicit prejudice in how to inject money).

    Sorry for occupying your time responding to this.

  30. Gravatar of van van
    22. October 2009 at 16:11

    scott, i dont quite understand the mechanism of covertibility under such a plan. the convertibility analog under gold was that $1 in paper money by law was due a fixed quantity of gold, correct? so under an index regime, $1 paper would be converted into…perhaps i missing something more fundamental about NGDP futures

  31. Gravatar of ssumner ssumner
    24. October 2009 at 04:41

    statsguy, Those are all good points. The best arguments are for propping up State&Local spending, and also payroll tax cuts to encourage employment. The one negative on aid to states is that it encourages wasteful spending in the long run. Any business cycle policy is not a one shot deal, but something expected to occur in each recession. The more the federal government gives to state governments (and it’s already a lot) the more wasteful state and local spending that we get. I seem to recall reading that this problem explains the enormous waste in government spending in Brazil, for instance.

    That doesn’t mean that the gains can’t outweight the costs in a cyclical sense, but I’d feel better if we offset these subsidies to states with less aid during good times, so that the overall average didn’t change.

    Van, Under a gold standard dollars are always convertible into a fixed amount of gold. Under the simplist version of this plan the dollar would be convertible into a fixed amount of NGDP futures with the same par value. It might be a claim to buy 1/15 trillionth of the NGDP 12 months from today. That would make the future expected NGDP always equal to $15 trillion, assuming that the Fed bought and sold unlimited amounts of contracts at $1 each.

    Under the plan which targets a slowly growing NGDP, it would be like a gold standard that is a crawling peg, where the dollar is convertible into 1/35 oz of gold one day, and 1/35.001 the next day, and 1/35.002 the next, etc.

  32. Gravatar of Doc Merlin Doc Merlin
    24. October 2009 at 23:42

    Basically, Van, its a way to inflate the currency in a way that is market driven as opposed to model (socialist calculation) based pricing.

  33. Gravatar of van van
    26. October 2009 at 16:31

    OK, so the citizenry would, when faced with uncertainty, convert their uncertain dollars into NGDP futures? I dont mean to sound flip, but the first thing that comes to mind is how i would explain the new monetary system to my wife…its one thing to say, ok, we can go to the bank and convert this dollar for a certain amount of [insert commodity]. but this is more abstract. does this make sense?

    also, what aspects of a commodity system are we improving with the NGDP futures contracts. I can name several improvements from the current system, starting with the market based pricing, as doc merlin points out

  34. Gravatar of ssumner ssumner
    27. October 2009 at 16:09

    van, Merlin was pointing out that my plan was market based. There is no need for you to explain anythiong to your wife. Under the gold standard very few people exchanged dollars for gold with the Treasury. Speculators would do most of the transactions. The point isn’t to make a warm and fuzzy system, it is to create macroeconomic stability.

  35. Gravatar of Van Van
    28. October 2009 at 04:49

    sccott, that makes more sense to me now – and my wife thanks u ahead of time.

    i have seen you speak about the superiority of such a model to a commodity system. in fact, i have seen things by thompson and bob hall to that effect. hall points out that under the “classic” gold system, the dollar still lost ~40% in purchasing power cumulatively over 30years. thompson’s claim had to do with the stickiness in wages if i remember correctly? does this sound reasonable? is this also your contention? what else am i missing?

  36. Gravatar of ssumner ssumner
    28. October 2009 at 17:57

    Van, Yes, in an earlier post I cite Hall and Thompson as two pioneers of this approach.

  37. Gravatar of Van Van
    29. October 2009 at 08:06

    last question, does your work along with thompson and hall then imply that the key problem confronted during economic downturns is that wages are sticky, and falling expectations makes them rise in real terms–> leads to unemployment, falling income, fall in aggregate demand?

  38. Gravatar of Scott Sumner Scott Sumner
    30. October 2009 at 11:30

    van, I think in normal recessions the problem is 70% sticky wages and 30% sticky prices. I can’t speak for the others, but I know that Thompson also focuses on wages. I think in this recession there has been an additional problem, unexpected deflation has worsened the banking crisis (which was originally concentrated in the subprime area.)

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