Karl Smith starts off a new post as follows:

I define the simplified version of the Sumner Critique as follows: If the Central Bank is targeting Nominal GDP precisely then all other macroeconomic effects become classical in nature.

That’s a good observation, although I’d put it differently:

I define the simplified version of the Sumner Critique as follows: If the Central Bank is targeting expected Nominal GDP  then all other macroeconomic effects become approximately classical in nature.

It looks similar to Karl’s formulation, but there are three key differences.  First, I prefaced NGDP targeting with “expected.”  This is important for several reasons, but in this context it allows us to remove the term ‘precisely.’  (A term that otherwise allows skeptics to easily dismiss the critique.)   Obviously one cannot precisely target NGDP, but one can precisely peg the price of NGDP futures markets.  If one does that, then the expected fiscal multiplier becomes precisely zero (in nominal terms, supply-side effects are possible.)  But actual NGDP can move around a little bit, and hence the world is only approximately classical in nature.

Even so, I’m so convinced that stabilizing expected NGDP (via level targeting) would also roughly stabilize actual NGDP that I have in the past made grand claims about “the end of macro.”  (Of course I actually meant the end of certain types of macro, just as Francis Fukuyama actually meant the end of certain types of history.)

Macroeconomics is the study of policy failure.  Once an issue goes away the field loses interest.  Liquidity traps were dropped from the curriculum in the 1970s, when 13% inflation and 15% interest rates made the “problem” of being stuck in deflation and zero rates seem absurd.

The reason New Keynesians and real business cycle-types got along so well during the 1990s and early 2000s is that the nominal problem seemed solved.  NGDP growth was stable enough that NKs thought that the Fed could do the job, and that fiscal stabilization wasn’t needed.  And the RBC-types were basically fine with a 2% inflation target, and in any case they were more interested in other issues.  With the fight over NGDP off the table, macroeconomists could focus on other topics, mostly classical in nature.

Of course all that came to an end in late 2008.  The NKs began to see low NGDP as a huge problem.  They also saw that inflation targeting wasn’t enough.  The RBC-types continued to believe inflation targeting was all you needed on the demand-side.

In 1984-2007 we came close to solving the key macro problem, NGDP stabilization.  We were thrown off course by a number of factors, including an inability to use the interest rate instrument at the zero rate bound.  If we can get a better policy instrument (NGDP futures targeting anybody?) then we will go right back to the macro problem being solved.  When that happens, it will no longer be necessary to divide textbooks into micro and macro splits.  The remaining macro areas (such as long run growth) will be special topics, analogous to international trade.

The irony here is that the NKs (and of course us market monetarists) can only succeed by making our models obsolete—thrown into the dustbin of history—and by allowing the RBC-types to take over what little is left of macro.

PS.  Wikipedia year 3012:  “Scott Sumner was an economist who for some odd reason was obsessed with the money supply and NGDP.  Of course as we all know NGDP fluctuates very little, and those small fluctuations are completely uncorrelated with changes in the money supply.  He had his 15 minutes of fame, and then rapidly fell back into obscurity.”

In recent months central banks have resorted to using the phony “credibility” issue.  The claim is that they had to fight hard in the 1970s and early 1980s to get markets to believe they were serious about inflation.

Fortunately, that is simply not true.   Markets have little difficulty figuring out what central banks are up to.  When the central bank wants to reduce inflation (as they did after 1981) markets believe them.  When they didn’t want to, markets didn’t believe they’d lower inflation.  There never was a credibility problem.

In an earlier post I pointed out that this myth was partly due to a misreading of the early Volcker years.  Volcker took over at the Fed in the fall of 1979, but it wasn’t until two years later that inflation started to fall significantly.  But there shouldn’t be any big mystery as to why inflation didn’t fall earlier, money wasn’t tight earlier.  For instance, in the spring of 1980 Volcker cut the fed funds rate from 17.6% to 9.0%, despite the fact that inflation in 1980 was over 13%, the highest in my entire lifetime.

Why would Volcker have done such a stupid thing?  Why slash rates sharply (driving real rates far below zero) when inflation was running 13%?  BECAUSE HE WASN’T FOCUSED ON INFLATION, HE WAS TARGETING REAL GDP.  And we were sliding into recession in the first half of 1980, which threatened to cost Jimmy Carter his job.  (Jimmy Carter appointed Volcker.)

Indeed that was the problem from 1967 to 1981.  In late 1966 the Fed tightened slightly to slow inflation, which was gradually rising.  The yield curve inverted.  Normally we should have had a recession, but instead the Fed quickly switched to a policy of easing in 1967, and we merely had a slightly slowdown.  Then we entered the 15 year period of very high inflation.  If the Fed was trying to control inflation, they would have never once cut interest rates during that 15 year period, as inflation was always too high—usually much too high (although prices controls temporarily held it down in 1972).  The Fed raised and lowered rates again and again during this period, because they weren’t trying to bring inflation down, they were targeting real GDP.  Even worse, to the extent they cared about inflation at all, they were doing growth rate targeting, not level targeting.

After the Fed eased in 1980 by slashing rates, NGDP growth soared to 19.2% in 1980:4 and 1981:1.  This scared Volcker so much that he finally put his foot down in mid-1981, and decided to do something about inflation.   Inflation came down very quickly in late 1981, and ever since then the Fed has never had the slightest difficulty keeping inflation low.  Nor has the ECB or the BOJ.

So the credibility problem is a complete myth.  Where did it come from?  It came from time inconsistency models developed in the early 1980s, which tried to explain why central banks created too much inflation.  Unfortunately, no sooner were those models published than events discredited them, as central banks got inflation under control.  Later Krugman tried the opposite tack–arguing too much credibility could lead to excessively low inflation in countries like Japan.  Indeed that the BOJ might not be able to inflate if it had too much credibility.  That model was also quickly discredited, as the BOJ tightened money twice (2000 and 2006) even as Japan was suffering deflation.  It turns out both the conservative time inconsistency models and the liberal expectations trap models are completely wrong.  Markets see very clearly what central banks are up to.  If they are planning to inflate, the markets figure this out quickly.  If they plan to let NGDP languish at excessively low levels, markets also figure that out, sometimes (as in late 2008) before the central bankers themselves even realize what they will do in the future.

And it’s not just financial markets.  Wage contracts are more closely linked to NGDP growth than inflation, which is why wage growth stayed well behaved in 2008.  As long as the Fed commits to a 5% NGDP trajectory, wage growth will remain quite stable, regardless of what happens to inflation.

This post was triggered by an excellent David Glasner post, which contains this gem:

Now, the ECB, having similarly focused on CPI inflation in Europe for the last two years, is in the process of causing inflation expectations to become unanchored in precisely the other direction.  Why is it that central bankers, like the Bourbons, seem to learn nothing and forget nothing?

I’ve frequently argued that interest rate targeting is like a car with a  steering wheel that locks when you need it most–on twisty mountain roads with no guardrail.  I’ve also argued that although we rarely hit the zero rate bound in past recessions, it may well become the norm in future recessions.  This graph provided by Brad DeLong shows why:

Focus on the red line.  Real yields on 10 year TIPS seem likely to fluctuate between 0% and 2% in the future, with the lower rates occurring in recessions.  If we target inflation at 2%, then nominal yields on 10 year Treasuries will fall to about 2% in future recessions, which means short rates will hit the zero bound.  It’s not just this recession; we’ve seen a secular decline in risk-free real rates going back for decades.

The Fed is committed to a policy that failed in this cycle, and will keep failing until they figure out what they are doing wrong.  Fortunately (as is obvious from my previous two posts), the profession is catching on quickly, so let’s hope this is the last time we see central banks so inept during a major crisis.

PS.  Yes, it’s true that inflation fell a bit faster than markets expected during the 1980s.  But it’s equally true that inflation fell faster than Volcker wanted in the 1980s.

I did a highly critical post of Simon Wren-Lewis a while back (mostly in retaliation to a highly critical post he did on my former adviser, Bob Lucas.)  Today I’m happy to be able to do a positive post.  Here’s Wren-Lewis:

It is of course interesting to speculate why this is. Perhaps it is, as John Kay suggests, an obsession with credibility, involving a misreading of the theoretical literature. Perhaps they suspect, like Chris Dillow, further QE will be ineffective, so there is nothing they can do. (But if it is that, they should say so.) Perhaps it is because policymakers are really serving particular economic interests, as Steve Waldman suggests. Perhaps Rogoff was right, and central bankers really are ‘conservative’, in the sense of caring much less about unemployment than the rest of society. But whatever it is, it is not producing good policy for society as a whole. So we should think about moving to a monetary policy target that better reflects social costs. Maybe, as Britmouse in the UK and many others elsewhere suggest, that is a nominal GDP target, or maybe it is something else, but the status quo is not looking too good right now.

Inflation targeting is being rapidly discredited (see my previous post) and more and more people are attracted to NGDP targeting.  It looks to me like the momentum is almost unstoppable; and as Europe goes downhill NGDPLT will look better each day.

What’s causing this re-evaluation?  Probably lots of things, but I see this as the most important:

1.  Almost everyone thinks the US, UK, EU, and Japan could use at least a bit more AD.

2.  The Fed, BOE, ECB and BOJ say they won’t do more, for fear of inflation.

3.  NGDP proponents point out that NGDP is way below trend.

Ergo NGDP targeting looks better right now.

But that’s not the only reason.  Most macroeconomists recognize the advantages of NGDP when there are supply shocks or VAT changes.  Most understand the beauty of a single target, which addresses the dual mandate.  It’s got lots of support from both liberals and conservatives.  Indeed one could write a long article on all the advantages.  So I don’t believe that interest in NGDPLT will disappear when it no longer seems expedient to favor the policy.

Every economic crisis yields a sea change of attitudes in the field of macroeconomics.  Why would this one be any different?

HT:  Britmouse

BTW, Britmouse pointed out that blogs have more influence than you might expect:

Will Hutton has outed Business Secretary Vince Cable as a supporter of NGDP targeting. The Guardian have Hutton interviewing Cable this weekend. Will Hutton frequently advocates for an NGDP target in his Observer/Guardian columns; it was also known that Cable’s Special Advisor, Giles Wilkes, was a reader of Scott Sumner’s blog and supporter of NGDP targeting. The influence of blogs on policymakers is revealed!

And they laughed when Tyler Cowen said this in my first month of blogging:

Here is the excellent Scott Sumner: an open letter to Paul Krugman.  It’s also the best recovery plan I’ve seen so far, by far.  It’s too good to excerpt, so you’ll have to click through and read the whole thing.  From my point of view, right now the whole world should be beating a path to Scott Sumner’s door.

He has two unpublished book manuscripts and he probably would be free to meet with President Obama as well.

Too bad I never got an opportunity to explain the importance of those empty Fed seats to President Obama.

PS.  The “they” who laughed included me.

Jeffrey Frankel sees which way the wind is blowing:

One candidate to succeed IT as the preferred nominal monetary-policy anchor has lately received some enthusiastic support in the economic blogosphere: nominal GDP targeting. The idea is not new. It had been a candidate to succeed money-supply targeting in the 1980’s, since it did not share the latter’s vulnerability to so-called velocity shocks.

Nominal GDP targeting was not adopted then, but now it is back. Its fans point out that, unlike IT, it would not cause excessive tightening in response to adverse supply shocks. Nominal GDP targeting stabilizes demand – the most that can be asked of monetary policy. An adverse supply shock is automatically divided equally between inflation and real GDP, which is pretty much what a central bank with discretion would do anyway.

A dark-horse candidate is product-price targeting, which would focus on stabilizing an index of producer prices rather than an index of consumer prices. Unlike IT, it would not dictate a perverse response to terms-of-trade shocks.

Supporters of both nominal GDP targeting and product-price targeting claim that IT sometimes gave the public the misleading impression that it would stabilize the cost of living, even in the face of supply shocks or terms-of trade-shocks, over which it had no control.

The GDP deflator is one example of a product-price index.

We aren’t going to win the battle this cycle, but just watch next time the economy goes into recession.  You won’t see the central banks ignoring NGDP like they did in 2008.

HT:  Marcus Nunes, Wadolowski, Jim Glass

Update: I just saw over at Matt Yglesias that the two Fed seats will be filled today.  It’s a disgrace that President Obama left so many Fed seats empty for so long.  I can’t help but think that Larry Summers did not impress upon Obama the importance monetary stimulus (given that he never talks about it in his public remarks.)

There’s nothing more dismaying that seeing progressives revert back to the mistakes of the past.  I’m talking about the renewed interest in super high top marginal tax rates.  Rates even the Nordic countries abandoned years ago.  Even worse, they want to apply the taxes to income, not consumption.  As if higher taxes are going to make Buffett move into a smaller house in Omaha, rather than cut back on his donations to the starving kids in Africa.

Of course the Obama administration is leading the charge, with support from multi-billionaire Warren Buffett (and why not, it won’t affect Buffett’s living standard.)

To see just how serious Obama is about going after the hedge fund managers who financed his 2008 campaign, let’s take a look at who he chooses to subsidize.  After all, welfare economics is all about consumption, not income.

Obama’s export-subsidy chief promised a billion dollars in taxpayer-backed subsidies for corporate jets, according to Bloomberg News.

Fred Hochberg heads the Export-Import Bank, a federal agency that subsidizes U.S. exports by loaning money or guaranteeing loans to foreign buyers of U.S. goods.

Those who have taught economics know that some points that are seemingly obvious can go right over the heads of most students.  For example, subsidies are negative taxes, and hence have the opposite effect of tax increases.  If taxes raise prices, then subsidies cut prices.  (I kid you not, many students think a tax will be passed on to consumers, but a subsidy will be pocketed by corporations.  Why you ask why, they actually think it’s in the corporation’s interest to pass on tax increases, and pocket subsidies.  By which logic a $20 tax combined with a $20 subsidy, i.e. a “nothing,” would cause prices to rise by $20.  Go figure.)

Sorry if I’ve insulted anyone’s intelligence, but on questions of taxes I’ve learned it’s better to be safe than sorry.  Since the rich are the only people who use corporate jets, Obama basically wrote a Treasury check for $1,000,000,000 and handed it over to the very wealthy.

And by the way, who else benefits?  Guess who owns a major corporate jet leasing company:

President Obama, Democrats in Congress, and Obama’s billionaire fundraiser Warren Buffett are talking this week about a tax hike proposal that is mostly about politics, but meanwhile, the IRS just issued guidance on changing tax law in a way that is mostly about increasing profits for corporate-jet owners and Obama’s billionaire fundraiser Warren Buffett, who owns a corporate-jet company.

Berkshire Hathaway, Buffett’s holding company, owns NetJets. NetJets is a company millionaires use in order to arrange fractional ownership of private jets — time shares, of sorts. NetJets lobbied like crazy, as Ryan Grim and Ariel Edwards-Levy at Huffington Post explained last month, to change the treatment under the tax code of flights on fractionally owned jets.

Yup, Buffett owns a corporate jet company.  Now you understand the title of the post, I’m using “rules” as a verb.

PS.  Instead of subsidies, we need a big tax on corporate jets.  If that drives much of the corporate jet industry into bankruptcy, and costs lots of jobs, then GOOD.    What progressives don’t understand is that the only way to make society more equal is to cut jobs in industries making stuff for rich people.  There is literally no other way.

PPS.  Any smears against progressives obviously exclude Matt Yglesias, who understands everything.

Update: Vivian pointed out that the total cost of the subsidy to the US government is considerably less than $1 billion.  On the other hand Joe C. pointed out that corporate jets worsen global warming.