Archive for December 2010


Reply to Thoma on NGDP targeting

Mark Thoma recently asked the following question:

So, for those of you who are advocates of nominal GDP targeting and have studied nominal GDP targeting in depth, (a) what important results concerning nominal GDP targeting have I left out or gotten wrong? (b) Why should I prefer one rule over the other? In particular, for proponents of nominal GDP targeting, what are the main arguments for this approach? Why is targeting nominal GDP better than a Taylor rule?

The entire post is rather long, and Thoma raises issues that I don’t feel qualified to discuss, such as learnability.  My intuition says that’s not a big problem, but no one should take my intuition seriously.  What people should take seriously is Bennett McCallum’s intuition (in my view the best in the business), and he also thinks it’s an overrated problem.  I think the main advantage of NGDP targeting over the Taylor rule is simplicity, which makes it more politically appealing.  I’m not sure Congress would go along with a complicated formula for monetary policy that looks like it was dreamed up by academics (i.e. the Taylor Rule.)  In practice, the two targets would be close, as Thoma suggested elsewhere in the post.

Instead I’d like to focus on a passage that Thoma links to, which was written by Bernanke and Mishkin in 1997:

Nominal GDP targeting is a reasonable alternative to inflation targeting, and one that is generally consistent with the overall strategy for monetary policy discussed in this article. However, we have three reasons for mildly preferring inflation targets to nominal GDP targets. First, information on prices is more timely and frequently received than data on nominal GDP (and could be made even more so), a practical consideration which offsets some of the theoretical appeal of the nominal GDP target. Although 20 collection of data on nominal GDP could also be improved, measurement of nominal GDP involves data on current quantities as well as current prices and thus is probably intrinsically more difficult to accomplish in a timely fashion. Second, given the various escape clauses and provisions for short-run flexibility built into the inflation-targeting approach, we doubt that there is much practical difference in the degree to which inflation targeting and nominal GDP targeting would allow accommodation of short-run stabilization objectives. Finally, and perhaps most important, it seems likely that the concept of inflation is better understood by the public than the concept of nominal GDP, which could easily be confused with real GDP. If this is so, the objectives of communication and transparency would be better served by the use of an inflation target. As a matter of revealed preference, all central banks which have thus far adopted this general framework have chosen to target inflation rather than nominal GDP.

1.  I believe the federal government could estimate monthly nominal GDP numbers that are accurate enough to be useful for policy purposes.  However, even if they could not I’d still favor NGDP targeting, because like Lars Svensson I believe the Fed should be targeting the forecast, that is, setting policy in such a way that the Fed’s forecast of future NGDP is equal to their policy target.  I also favor level targeting (recently recommended by Woodford), and I think this would reduce the overshooting problem associated with futures targeting.

2.  It seem to me their second point (which isn’t really a criticism at all) was actually disproved during the recent crisis.  Between mid-2008 and mid-2009 NGDP fell over 8% below trend (or about 3% in absolute terms.)  On the other hand core CPI inflation fell only slightly below trend.  Because the Fed is an (implicit) inflation targeter, the slight slowdown in CPI inflation did not present an unambiguous signal (in their view, not mine) for aggressive stimulus.  Hence they waited until November 2010 to undertake QE2.  If they had been targeting NGDP along a 5% growth trajectory, it would have been immediately obvious that NGDP was coming in well below target, and would remain below target for many years.  In my view the QE2 program would then have been adopted much sooner and in larger amounts, and I think it retrospect it is clear that additional stimulus would have been welcome in late 2008 and 2009.

3.  The third point is where I most strongly disagree with Bernanke and Mishkin.  In the current crisis we’ve seen just how difficult it is to communicate the need for higher inflation.  The public interprets that as the Fed trying to raise their cost of living.  I’m not surprised the plan is unpopular.  I’d guess that in 1997 Bernanke and Mishkin were thinking about the central bank communicating the need for lower inflation, not higher inflation.  In contrast, NGDP is essentially nominal income.  The Fed can tell the public they are trying to raise nominal growth to 5%, because a healthy economy requires the incomes of Americans to grow by about 5% per year.  That’s much less negative sounding that trying to raise the cost of living.  Of course the opposite could be argued on the upside, but the Fed has shown a much greater ability to hold inflation down that increase it, as the zero rate bound has left them spinning their wheels when inflation has fallen below target.  I think it would be easy to explain to the public that an excessively rapid growth in nominal incomes could be inflationary, and raise rates when needed.  Especially given that they were widely criticized for not raising rates enough during the housing bubble.

4.  Regarding revealed preference, NGDP targeting is more desirable the larger and more diversified the economy.  If an economy is dependent on just a few industries, then a major price shock in one export industry might force a dramatic contraction in other industries under NGDP targeting.  Price level targeting might provide for a better macroeconomic outcome in that case.  Thus I wouldn’t expect small countries to be the first to adopt NGDP targeting.  And would I be out of line in noting that the BOJ and ECB haven’t become famous for creativity and boldness?

Update:  I just noticed that Bill Woolsey has a long and very informative reply to my discussion of NGDP futures, and also a response to some of the points made by Brad DeLong.  Bill knows my plan better than I do, so I usually defer to his judgment.  He’s correct that I cut some corners in selling the idea to the National Review’s readers, and that the actual plan is more complicated than I suggested.  Indeed, I believe he was the first to use the phrase “index futures convertibility.”

Misleading moralistic macro

Continuing in the theme of cognitive illusions, I’d like to discuss how moralistic reasoning distorts our view of macroeconomics.  Consider the following from

During the recent fight over extending unemployment benefits, conservatives trotted out the shibboleth that says the program fosters sloth. Sen. Judd Gregg, for instance, said added unemployment benefits mean people are “encouraged not to go look for work.” Columnist Pat Buchanan said expanding these benefits means “more people will hold off going back looking for a job.” And Fox News’ Charles Payne applauded the effort to deny future unemployment checks because he said it would compel layabouts “to get off the sofa.”

The thesis undergirding all the rhetoric was summed up by conservative commentator Ben Stein, who insisted that “the people who have been laid off and cannot find work are generally people with poor work habits and poor personalities.”

Both liberals and conservatives are engaging in moralistic thinking, and both are wrong.  They’re fighting the age-old battle over whether the unemployed are the “deserving poor” vs. the “undeserving layabouts.”  To utilitarians like me, there are no “just deserts,” just more or less utility as a result of various public policy options.

I don’t see any evidence that the unemployment problem is caused by laziness.  Or perhaps I should say that I doubt the work ethic of the recently unemployed is much different from the employed.  There are definitely people who would rather not work if they didn’t have to (like me), especially those with dangerous, dirty, or unpleasant jobs.  Or lots of exams to grade.  But people also like money, and I’d guess the vast majority of unemployed people would rather be back at work.

But the liberals are also wrong; 99 week unemployment insurance probably does modestly raise the unemployment rate.  It’s only natural that a person who loses a fairly good job would like to return to a fairly good job.  A laid off accountant would be foolish to accept a job as a maid, janitor or coal miner.

But the main point of my post is that it’s a big mistake to form opinions about the impact of macro policies on the basis of personal observation, or intuition about human nature.  And that’s because of the fallacy of composition.  If an accountant losses his UI and becomes desperate for work, that doesn’t increase his chances of getting his old accounting job back.  But if every unemployed worker loses his or her UI and becomes desperate for work, it does increase the chances of the accountant getting his job back.  The reasons are complex.

Let’s start by assuming that UI doesn’t affect NGDP, rather the path of NGDP is determined by the Fed.  Of course Krugman and Eggertsson would not agree, they’d argue that less UI would reduce NGDP.  But recent actions by the Fed indicate that they won’t let inflation fall below about 1%, and that also puts a floor on NGDP.  Every time the economy weakens, the Fed does more QE, or at least more talk about future expansionary actions.

If we hold NGDP constant, then how does eliminating UI raise RGDP?  It does so by sharply boosting the supply of labor, which depresses the equilibrium nominal (and real) wage rate.  Workers who are desperate for work now throw themselves onto the job market.  Suppose each worker becomes willing to accept a job paying 40% less than his former job.  This lowers wages at all levels, and for any given NGDP that increases employment.  It is equivalent to a rise in AD.  The accountant who suddenly becomes willing to be a bank teller, paradoxically is more likely to get his old job back, because the general expansion of the economy that results from lower wages leads to a greater need for accountants.  Of course this process wouldn’t work perfectly, but there would be some tendency for employment to increase.

So the liberals are right that the unemployed aren’t lazy, but the conservatives are right that less UI would reduce the unemployment rate.

By now you might have assumed that I am advocating cutting UI.  If so, you are again engaged in moralistic thinking, assuming that someone making a technical argument is actually making a normative argument.  I don’t have strong views on exactly where the UI cut-off should be.  In the long run I’d like to see the system reformed to include more self-insurance, but for right now you can make a respectable argument for keeping UI in place, despite the modest increase in unemployment.  It does reduce suffering in the short term, suffering caused by needlessly contractionary policies instituted by policymakers who may not even know a single unemployed person.  (Oops, now I’m being moralistic.)

One other quick example of the problems with moralistic thinking.  Liberals say cutting the estate tax favors people like Paris Hilton.  Conservatives counter with stories of family businesses that must be sold off to pay the estate tax.  If these were actually the two arguments, I’d go with the liberal view.  I’m a utilitarian who thinks a dollar is worth much more to a poor person that a rich person.  But I want to abolish the inheritance tax precisely because it’s not a tax on the rich; it’s a tax on capital, whereas we should be taxing consumption.  We need a progressive consumption tax.

Part 2:  Always avoid annoying alliteration

I just noticed that my last three posts have been entitled Disinflation denial, Avoid asymmetries, and “Misleading moralistic macro.  I apologize.

Avoid asymmetries

In a recent post I pointed to a weird asymmetry.  Even though bubble theory proponents think that prices are more likely to fall after a large run-up, those who correctly predict that prices will go even higher seem less famous (at least in America) than those who correctly predict the bubble will burst (which is allegedly the easier market call.)  I suggested this is just a part of the general problem of cognitive bias, which leads people to see patterns where there is actually nothing more than randomness.

In the comment section of a recent Tyler Cowen post, Rajiv Sethi made the following observation:

Let me repeat that I admire Scott Sumner, the coherence of his vision, and his general approach to blogging (as laid out in his amazing birthday post). But I think that his faith in market efficiency is misplaced and his glib dismissal of those who take bubbles and crashes seriously (we suffer cognitive illusions) baffling.

On a certain level I agree with Sethi (who is a very smart guy.)  There’s nothing people like less than for someone to respond to their argument by calling them irrational, or suggesting they have bad motives.  But this also raises an interesting problem for the bubble theorists.  Unless I’m mistaken, most anti-bubble theories assume some sort of irrationality among market traders, or dare I say, cognitive illusions.  (Which is supposedly “proven” by economic experiments which in fact do nothing of the sort.)  I’m not sure Sethi was actually complaining about my cognitive illusions comment, although I got that impression.  But if so, is it really any different from what the bubble theorists assume about asset market participants?

I need to constantly repeat a very important point; I’m not arguing the EMH is true.  I’m arguing the EMH is useful and that anti-EMH models are not useful.  The reason I don’t think the EMH is true is because I believe market participants do have cognitive illusions.  And the reason I don’t think the anti-EMH theory is useful is because I think academics and policymakers are equally susceptible to cognitive illusions.

Paul Einzig made the same basic argument back in 1937:

“On June 9, 1937, this veteran monetary expert [Cassel] published a blood-curdling article in the Daily Mail painting in the darkest colours the situation caused by the superabundance of gold and suggesting a cut in the price of gold to half-way between its present price and its old price as the only possible remedy.  He took President Roosevelt sharply to task for having failed to foresee in January 1934 that the devaluation of the dollar by 41 per cent would lead to such a superabundance of gold.  If, however, we look at Professor Cassel’s earlier writings, we find that he himself failed to foresee such developments, even at much later dates.  We read in the July 1936 issue of the Quarterly Review of the Skandinaviska Kreditaktiebolaget the following remarks by Professor Cassel:  ‘There seems to be a general idea that the recent rise in the output of gold has been on such a scale that we are now on the way towards a period of immense abundance of gold. This view can scarcely be correct.’ . . . Thus the learned Professor expected a mere politician to foresee something in January 1934 which he himself was incapable of foreseeing two and a half years later.  In fact, it is doubtful whether he would have been capable of foreseeing it at all but for the advent of the gold scare, which, rightly or wrongly, made him see things he had not seen before.  It was not the discovery of any new facts, nor even the weight of new scientific argument that converted him and his fellow-economists.  It was the subconscious influence of the panic among gold hoarders, speculators, and other sub-men that suddenly opened the eyes of these supermen. This fact must have contributed in no slight degree towards lowering the prestige of economists and of economic science in the eyes of the lay public.” (1937, pp. 26-27.)

Sub-men and supermen.  Hmmm . . . I wonder into which group Paul Krugman would place himself?

Now let’s see if we can draw a broader set of conclusions from this pattern, these asymmetries.  We’ve seen bubble predictors are treated differently from bubble deniers, and in the previous post we saw that conservatives were gung ho about focusing on commodity prices, except when commodity prices showed a desperate need for much easier money.  Can we find a third example?

How often have you heard people remark that high gasoline prices are caused by the machinations of oil market speculators?  But we know that the net demand for oil by speculators averages out to roughly zero in the long run.  This means that for every period where speculators are raising prices, there is another period where they are reducing prices.  But how often in general conversation do you hear people say:

Hmmm, gas is really cheap right now, I wonder if speculators are depressing the price?

Because I’m a mind reader, I can answer the question for you.  Zero times.  And it’s not just because people prefer to talk about bad news, they don’t even think speculators depress oil prices.

The world is full of this sort of asymmetrical thinking.  And it’s almost always a sign of sloppy thinking, of cognitive illusions.  And it often leads to bad public policy.

PS.  This isn’t an exact analogy, but notice that narcotics and sex transactions are usually considered bad if money is involved.  But in most societies the selling of sex and drugs is considered far worse than the buying of sex and drugs, even though each participant has an equal role in the transaction.  A sign of bad public policy?

PPS:  Five minutes after posting this I came across another example. We think that people who make lots of money are evil villians, whereas people who lose lots of money are innocent victims.  Consider the following:

Earlier that year, Picard claimed in court filings that Picower was a key beneficiary of Madoff’s scheme. The trustee said Picower had withdrawn $7.8 billion from Madoff’s firm since the 1970s, even though he only deposited $619 million. Picower “knew or should have known that [he] was profiting from fraud, because of the highly implausible high rates of return” on his accounts, the trustee said.

Right after the Madoff scandal broke all the brain-dead critics of laissez-faire said “see, this shows that unregulated capitalism doesn’t work.”  Eventually people pointed out that we don’t have unregulated capitalism, the SEC is supposed to prevent these sorts of abuses.  Even worse, someone told the SEC about the Madoff fraud, and even pointed to absurdly high and persistent rates of return that anyone with half a brain knew were impossible.  Or anyone who believes in the EMH knew were impossible.  But apparently the SEC is one of those groups that doesn’t find the EMH to be “useful.”  So they ignored the whistle-blower.  Now when we find someone who actually made off with lots of money from Madoff (pun intended) we react in horror.  Surely that rich bastard knew he couldn’t be earning that money legitimately!

That’s right, the supposedly expert SEC is given a pass in not responding to these high returns, as people keep insisting this shows we need still more regulation.  But the person that benefited, who like all humans would just love to think his success was well earned, that it resulted from his investment acumen, is somehow obviously guilty.

I give up.

Disinflation denial

During the past several years I’ve repeatedly insisted that the huge increase in the monetary base of 2008 would not produce high inflation.  I suppose I was naive in thinking that when it became clear that excessively low inflation was the real problem, the inflation hawks would admit they were wrong and re-evaluate their models.  I don’t see much evidence of that happening.

One recent theme has been the supposedly unreliability of the core inflation rate, which is now below 1%.  Critics (and cartoon bunnies) point to the fact that food and energy are an important part of the average American’s budget.  When it’s noted that even headline inflation is barely over 1%, the attention turns to other prices.  For instance, Congressman Ryan has recently argued that the Fed should focus on commodity prices.  My initial reaction is to say “Yes!  Let’s focus on commodity prices!  Commodity prices are the best way to tell if money is too easy or too tight.”  Think I’m being sarcastic?  Then you are in for a surprise.

Before continuing, I’d like to remind readers that in late 2008 you could count on one hand the number of economists (in the entire world) claiming monetary policy was very tight.  So let’s take a look at the change in commodity prices in late 2008:

That’s right, commodity price indices fell by more than 50%.  That’s Great Depression-style deflation.  And where was Congressman Ryan when the Fed was engineering one of the greatest deflations in world history?  I don’t recall him or any of the other inflation hawks calling for easier money.  But maybe I missed something.  If so, I hope my readers will dig up all the stories of conservatives demanding easier money in the fall of 2008.  In any case, it’s good to know that whereas back in late 2008 I was almost all alone in viewing money as being extremely tight, I now have the vast right wing conspiracy on my side.  Money really was tight in late 2008.  And if commodity prices are now the preferred metric of the right, then I’m half way to convincing the economics establishment that I was right all along.  Now I just have to convince the left that money was way too tight in 2008.  About those near-zero interest rates . . .

BTW, I don’t mean to bash Congressman Ryan, who is from my home state and is  one of the best of a bad lot.  If all 435 Congressmen and women were like him we’d probably end up with a much more economically sensible tax and spending regime.   But I have to say that the conservative movement has recently been grasping for straws on monetary policy.  All their predictions are coming in false, and they aren’t drawing the appropriate conclusions.

Update 12/19/10:  This post wasn’t well written.  I have always felt that commodity prices were one of many useful indicators of whether money is too tight or too easy.  But I left the impression that I completely supported a monetary policy that single-mindedly focused on commodity prices.  In fact, I’d prefer the Fed look at a wide range of indicators when estimating market NGDP growth expectations, including stock prices, bond prices, TIPS spreads, forex rates, commodity prices, real estate prices, etc.  Many commenters correctly pointed out that commodity prices can be an unreliable indicator, and I entirely agree.  I got overly enthused trying to show that if it was the right indicator, then money was ultra-tight in late 2008.

Kling on NGDP targeting

Here’s Arnold Kling’s response to my recent advocacy of NGDP targeting:

Because of a cold, I will be missing an invitation-only event featuring Scott Sumner. In the spirit of sharing my ideas without my germs, let me offer some thoughts on nominal GDP targeting.

That’s no excuse, I also had a cold.   🙂

Kling continues:

1. For the Fed, a target represents a justification for taking action. Some people may be upset with what your action does to the exchange rate or the interest rate. Having a target allows you to justify your action.*

2. I would like to see the Fed use a target to justify its actions.

3. If the Fed were to use a target, then future nominal GDP would be an excellent choice.

4. In the current environment, a target for future nominal GDP could be used to justify expansionary actions.

5. There are plenty of expansionary actions available. The Fed could charge a penalty for holding excess reserves. The Fed could be buy foreign bonds (this might require a change in current law). There still are plenty of long-term Treasuries out there for the Fed to buy.

6. In the best case, the Fed would hit a target for future nominal GDP, unemployment would fall fairly quickly, and we would live happily ever after.

7. In the worst case, we would begin to shift to a regime of high and variable inflation. The Fed would have to undertake strong contractionary measures in order to keep nominal GDP on target, while unemployment remains high.

I believe we would all live happily ever after, and that inflation would not become high and volatile.  In order for inflation to be high (on average), RGDP growth would have to average much less than 3%. Let me repeat; much less, not slightly less.  A trend rate of 1% or 2% RGDP growth will not get you high inflation on average, unless you think inflation was still high after Volcker brought it down to low levels.

Much more importantly, I don’t think high or variable inflation is a problem as long as NGDP growth is on target.  All of the problems that are widely believed by economists to flow from high and variable inflation; actually result from high and variable NGDP growth:

1.  Excessive taxation of capital in a non-indexed tax system results from high nominal rates of return, associated with high NGDP growth.

2.  Unfair borrower/lender redistributions actually result from volatile NGDP, not volatile inflation.

3.  Distortions to the labor market (when nominal wages are sticky) are caused by NGDP shocks.

4.  Even the “shoe leather” cost of inflation may be better described by NGDP growth, assuming real interest rates and real GDP growth rates are strongly correlated.

George Selgin has much more to say about the advantages of using NGDP.

In the end Kling argues the NGDP targeting is worth a shot, and he also has some interesting things to say about the possible reasons why the Fed hasn’t yet taken this step:

(a) They do not want to be embarrassed if they are unable to hit a target
(b) This is what Tyler Cowen would call a Straussian situation, in which the insiders must never reveal their true agenda, or horrible demons will be let loose, leading to social breakdown and bloodshed.
(c) They fear that announcing a target would create “lock-in” and cost flexibility.
(d) A target would make many of the departmental functions and rituals (such as FOMC meetings) long cherished at the Fed seem pointless.
(e) The Fed is institutionally more concerned with the stability and profitability of the banking system than with macroeconomic variables.

I would add that most private macroeconomists also prefer inflation targeting to NGDP targeting.  Or they favor flexible inflation targets, but don’t plump for NGDP targeting because it seems too crude.  I believe that is because inflation and RGDP play an important role in their macro models.  Unfortunately, the ‘inflation’ in their models bears little resemblance to real-world inflation indices.