I love Reason magazine, but macroeconomics is not their strong suit.  They recently published a critique of NGDPLT by Tom Clougherty:

Moreover, even if one accepts that a central bank is capable of hitting its growth target, that leaves open the question as to what target it should aim for. And it is not possible to know in advance what the “correct” rate of NGDP growth should be. The central bank can base its target on past growth, but even educated guesses can’t ultimately overcome this “knowledge problem.”

As London-based economist Anthony J. Evans has pointed out, if you consider 1997, the year that Bank of England began targeting inflation as your base year, and assume a 5 percent annual NGDP growth target, then you would believe that British monetary policy in the run up to the crash was more-or-less fine: NGDP growth stayed close to 5 percent throughout the “great moderation.” You would also believe that we are now significantly below the “correct” level of NGDP, and should fire up the printing presses to bring things up to scratch. If, on the other hand, you assume a 4.5 percent target since 1997, you would think that monetary policy was too expansionary in the run up to the crash, and that NGDP growth has already returned to trend””hence, time for monetary policy to “normalize”. The point here is not that 5 percent is the wrong target, or that 4.5 percent is the right one. The point is that even a small targeting error can have massive policy implications.

This criticism sounds plausible, but on closer inspection it doesn’t make any sense.  In fact, either 5% or 4.5% NGDP targeting since 1997 would have been fine.  What the author misses is that under either target path the volatility of NGDP would have been much lower, especially after 2007.  Consider the 4.5% path.  It’s true that this path would imply that monetary policy is currently right on target.  What Clougherty misses is that a 4.5% NGDP path after 1997 would have resulted in far smaller gains in NGDP in the lead up to the Great Recession.  About 5% less, to be specific.  And this means that nominal hourly wages in Britain would also have been about 5% lower then they actually were.  And since nominal wages are sticky, wage levels today would also be far lower.  So the same nominal income that produces 7.8% unemployment in Britain today, might lead to only 5% or 6% unemployment if nominal hourly wages were much lower.

The easiest way to think about business cycles is to look at the interaction between changes in NGDP and changes in nominal hourly wages.  When NGDP falls and wages are sticky then there will be less hours worked.  You won’t see that in DSGE models, but that’s what’s actually going on.  Reducing NGDP is like taking a couple chairs away in a game of musical chairs.  Several participants will end up sitting on the floor.  If you want to solve that problem you add chairs to the game.  And if people are unemployed because of the downward stickiness of nominal wages, then you add NGDP to restore full employment.

If people are unemployed because of structural rigidities, then more NGDP probably won’t help (unless that made it more politically feasible to remove structural rigidities like extended UI benefits.)

Evan Soltas allowed me to quote from a recent email he sent out:

I am glad to see NGDPLT getting some play in the libertarian discussion, but there’s quite a bit to criticize about this piece.

(1) I do not understand the argument that macroeconomic stability would prevent sectoral rebalancing. It is a common argument, but I don’t think it withstands serious scrutiny. Macroeconomic instability ought to make sectoral rebalancing more costly.

(2) The author is wrong to suggest that an NGDP target will mean easier credit. Again, a disturbingly common argument.

(3) A “de-facto” NGDP target fails to capture one of the most important benefits — having a clear path for expectations. Many of us have written, more or less angrily, about the Bank of England because of its failure in this respect.

(4) There’s no such thing as the “correct” NGDP target. There might be a welfare maximizing trend rate of NGDP, but within a range of 3 to 6 percent, the welfare costs from missing the optimum will not be significant. I fail to see a knowledge problem. I think the author is butchering Hayek here.

(5) The paragraph recounting Anthony Evans’ argument makes no sense. So what if the extrapolated 10-year trend between 5 and 4.5 percent would capture NGDP? Deciding after the fact that you’re going to drop down onto the previous trend is the source of the problem, not anything about a small targeting error.

Tyler Cowen recently noted that Greece has had surprisingly high inflation for a country mired in a deep depression.  I agree that this is a deep embarrassment for New Keynesian models.  On the other hand NGDP in Greece has fallen sharply, so we market monetarists are not at all surprised by their high unemployment rate.

PS.  Tyler asked the following:

Scott Sumner has a view which I do not understand, and thus do not wish to try to state, but it has something to do with not really believing in the concept of price inflation.

A few remarks:

1.  Economists often discuss whether the CPI measures inflation accurately.  But how can that discussion mean anything when economists have never even explained what the term ‘inflation’ means in an economy where product quality changes rapidly, and where new products are constantly introduced.  Is it the amount of extra income one needs to maintain constant utility?  If so, then we need to define utility.  And suppose happiness surveys show no increase in happiness over 50 years.  Would that mean RGDP did not rise?

2.  There are many types of price indices—it’s not at all clear which one is the “right one.”  I used to do lots of posts talking about how the government claimed housing prices rose 8% after 2006 and Case-Shiller said they fell 35%.  Can they both be right?  Sure, because inflation is a vague and poorly undefined concept, so any measure is fair game.

3.  If you have what looks like a demand-side recession (a deep fall in NGDP) and are puzzled that inflation has not fallen as much as you think it should have, then you should first examine the stickiness of hourly nominal wages.  If they didn’t fall, then sticky wages is your explanation.  If they did fall sharply, then some other factor explains the stickiness of inflation.  This might be higher VAT taxes, higher import prices, or some other sort of adverse “supply shock.”

4.  If you have an adverse supply shock, then inflation should rise.  If inflation falls despite an adverse supply shock, then you have both an adverse supply shock and an adverse demand shock.  Both would be contributing to higher unemployment.

5.  When I was researching neoliberalism back in 2007 I found that Greece had the least market-oriented economy in the entire data set (of 32 countries.)  If the government is running much of the economy, various government policies may introduce a degree of price stickiness. Tim Duy has a post that discusses one example. And Tyler responds. I think Tyler’s right about the unreliability of Phillips Curve models, but I’d make the following observation, FWIW:

Tim’s graph shows inflation falling from about 3% to 4% before the recession to about minus 1% today.  In the Great Depression in America inflation fell slightly more than twice as much, from zero to minus 10%.  Does that difference surprise me?  No, America in the early 1930s was far more market-oriented than Greece.  I’m not surprised that a monetary shock in Greece that was much smaller than in America can produce Great Depression levels of unemployment in Greece.  BTW, interwar price indices were much more weighted toward flexible price goods like food and manufactured goods—not services.

There are many other problems with inflation.  The bottom line is that it’s not a well-defined variable, and there is no reason to expect it to be a good indicator of demand conditions in an economy.  For that you need NGDP.

PPS.  Earlier I posted on the relationship between interest rates and velocity.  Michael Darda sent me a better graph:

Most people are convinced that the housing crash contributed to the recession, even though the facts suggest otherwise.

Now people are convinced that the housing recovery has helped speed up the economic recovery:

The housing market is rebounding faster than anyone thought possible, according to Blackstone Group LP (BX)‘s global head of real estate Jonathan Gray, as the Federal Reserve buys mortgage bonds to keep rates near record lows and investors sop up a diminishing supply of properties for sale.

.  .  .

Arizona‘s capital city is leading the U.S. in price appreciation, surging 22 percent in the 12 months through October, according to an S&P/Case-Shiller index, which had the biggest year-over-year advance since May 2010. Eighteen of the 20 cities in the index showed increases from a year earlier.

.  .  .

Home values climbed by more than $1.3 trillion to $23.7 trillion since the end of 2011, according to Zillow, and prices will rise by 3.3 percent after an estimated 4.5 percent jump last year, based on estimates of 15 economists and housing analysts surveyed by Bloomberg. Sales of existing homes will increase about 7.2 percent in 2013 to 4.98 million, the highest since 2007.

.  .  .

The improving housing market has already helped the broader economy heal after the crash triggered the worst recession since the Great Depression. The unemployment rate has dropped to 7.8 percent, the lowest level since January 2009 and Fed officials in December projected economic growth in a range of 2 percent to 3.2 percent in 2013. Consumer spending, which accounts for about 70 percent of the economy, is also showing signs of improvement. Retail sales rose more than projected last month, according to Commerce Department figures today in Washington.

“For most middle class households, homes are by far their biggest asset,” Weaver said. “So once the housing market starts to recover it helps consumer spending, it helps the whole economy.”  (emphasis added.)

Nice theory, but there is just one problem.  The economy has grown no faster during the 2012 housing recovery, than during the previous few years.  Nor is it expected to grow faster in 2013.  That’s because monetary policy is only allowing for a bit over 4% NGDP growth (for 3 plus years.)  So any faith is the curative powers of a housing recovery are pretty much like the faith that the 2009 stimulus sped up recovery:

1.  It might me true.

2.  It doesn’t show up in the data.

3.  It all depends on how the Fed reacts to the housing recovery.  So far they haven’t reacted well.

All the recent discussion of lead has reminded me of my youth.  In the garage we had large sheets of lead—they must have weighted 50 pounds each, and I presume they were from a demolished building.  When I was about ten I recall taking hammer and screwdriver to chop off lots of pieces of about one inch square.  Just small enough to put in the small pan in my lead melting set.  After it melted, I’d skimmed off all the impurities on top. (Oh my God—I now recall the lead had paint on it–what if it was lead paint!)

The molten lead was quite pretty—sort of like mercury.  Then I’d pour it into a mold to make toy soldiers.  Sometimes the soldier’s rifle would get bent when re-enacting a WWII battle.  No problem—I used my teeth to bend it back straight again.

You might wonder how many IQ points I lost.  Does this explain why I stick to simple-minded MV=PY arguments, and steer clear of more sophisticated NK models?  Does it explain why my posts are often grouchy, and my grammar is often poor?

I don’t think so.  I’m quite convinced that none of the lead got into the “free will” lobe in my brain.  I distinctly recall sitting down one day and deciding to be a grammatically-challenged grouchy monetarist out of my own free will.  You’ll hear no excuses from me.

PS.  Please don’t tell me that lead is nothing to joke about.  That’s true of those seriously injured, but it most certainly is something for me to joke about.  When I was ten years old I heard far worse–dead baby jokes, Polack jokes, etc.  Come to think about it we were pretty appalling back in 1965.  Must’ve been the lead . . .

PPS.  How many are old enough to recall swinging on asbestos pipes in the basement?  Or getting megadoses of second hand smoke all the time?  (Emphysema runs in the family–my grandpa was a non-smoker and died of it.  I have his asthma.  So did my dad–who smoked a lot.) By age 14 I was working on ladders scraping and burning paint off old houses.  I also worked on lots and lots of remodelling projects–sanding down the paint on old window frames, so they could be re-painted.  And people ask me why I’m determined to retire and move to California at 62.  I consider it a miracle that I’m still alive.

PPPS.  FWIW I find the lead—>crime hypothesis plausible, albeit unproven.  Students seem to have improved over time (at my school) and I’ve noticed that young adults today seem less aggressive than when I was young–but maybe that reflects Boston.

There’s a lot of interest in the recent moves by the Abe administration to push for faster growth in Japan.  Paul Krugman’s comments:

As far as I can tell, Posen is going with the notion that unconventional monetary policy, by working both on asset demand and on expectations, can do the job. Maybe, but most of us have taken the limited payoff to quantitative easing as a cautionary tale. There’s a lot to say for the notion of using temporary fiscal stimulus to push the output gap down, ideally even causing some economic overheating, to jump-start the transition to an inflationary regime.

And beyond that, the credibility of a higher inflation target in the face of the deflationary bias of central bankers may well be best established by (a) reducing the central bank’s autonomy and (b) getting the central bank in the business of supporting “” indeed, monetizing “” government deficits, at least for a while.

I don’t have any big problems with the technical framework used by Krugman, but I interpret the situation quite differently.  Let’s start where we agree.  I think neither of us are 100% convinced that Abe plans to carry through with aggressive stimulus.  But suppose he does, what will that tell us?

1.  Krugman see a coordinated fiscal-monetary push, whereas I see markets reacting mostly to the monetary side.  In my view the Japanese have already tried something like what Krugman discusses, and it failed.  They combined aggressive fiscal stimulus, lots of big government construction projects, and aggressive QE.  Been there, done that.

2.  One reason it failed was that the QE was partly temporary.  Krugman’s expectations trap model shows that temporary monetary injections are not effective.  I would add that temporary monetary injections combined with fiscal stimulus are also not effective, or at least they weren’t in Japan.

3.  The huge plunge in the yen began in mid-November, the day Abe announced he’d ask the BOJ to set a 2% inflation target.  I did a post that day, talking about the story.  I’ve followed it very closely ever since.  Lots of Keynesians seem to have jumped on the bandwagon much later, when talk of fiscal stimulus also seemed to impact the stock market.  However it seems to me that the big plunge in the yen has been very closely linked to reports that Abe would push a higher inflation target on the BOJ.  One wouldn’t even expect fiscal stimulus to depreciate the exchange rate at all.  So while we can’t be certain, I think the evidence strongly supports the view that expectations of easier money are depreciating the yen.  And the rise in stocks is very closely correlated with the fall in the yen.  Given that fiscal stimulus didn’t work in the late 1990s and early 2000s, I see little reason to believe that a modest fiscal stimulus would be a game changer today.

Having said that, I don’t dispute that a modest portion of the gain in the stock market, and more importantly the fall in the yen, was linked to a fiscal stimulus announcement, supporting Krugman’s argument that fiscal stimulus might help push the BOJ toward a higher inflation target.  That’s obviously a psychological argument that can never be precisely modelled.

4.  I’ll be focusing more on the BOJ, not fiscal policy.  What sort of target does the BOJ set?  Is it precise or vague?  Do they do level targeting?  When they fall short, how do they respond?  Unlike Krugman, I don’t think expectations traps are a real problem.  I see central banks as being like small children.  Markets can read their moods better than they can read their own mood.  (That’s why despite the fact that they have the technical ability to do “insider trading,” they often lose to people like George Soros.)  So if the BOJ sincerely wants 2% trend inflation, the markets will recognize that fact, and they’ll get 2% trend inflation.  But will they want it?  I’m still a bit dubious, although the odds have obviously improved in recent weeks.

Some commenters ask what sort of outcome would show that I am wrong.  So far it’s been easy to show that no fiat money central bank has ever tried to inflate and failed.  But I could envision it being much harder in the future, which would make my claim more dubious.  What if the BOJ had not raised interest rates in 2000 and 2006?  What if they hadn’t reduced the monetary base sharply in 2006?  What if they had set a symmetrical 2% inflation target in 2000, and consistently failed to hit it?  Yes, I could envision a situation where it’s hard to tell whether they were really trying and failing, or not trying at all.

I suppose I could always point to more things that haven’t been tried.  Why not push the yen to 120/$, and do a Swiss style policy?  If someone responds that the US won’t let them, then I’d respond; “Fine, then it’s not a liquidity trap it’s a US trap. The US is declaring economic war on Japan and forcing them into perma-deflation.”  But like most sweet, innocent, naive Americans, I could never imagine us doing anything so evil.

PS.  Remember, they attacked us in 1941!  We are the good guys. Oh wait, wasn’t there something about an oil embargo . . .

PPS.  Lars Christensen reminds us that Japan did a bit better in the 2000s than the 1990s.  But that wasn’t because of growing AD—NGDP is lower than 20 years ago.  More likely the labor market partially adjusted.  However the Japanese natural rate of unemployment used to be about 2% to 3%, so it’s still quite possible that a bit more AD would help.  (I’m told that Japanese unemployment data is misleading.) That’s not to deny that structural problems are the number one concern in Japan.

HT:  Travis V

Here’s Paul Krugman:

That said, as Neil Irwin points out in the linked article, it’s not clear how much difference it would have made if the Fed had grasped the scale of the danger back in 2007. The big errors came later, after the depth of the crisis was apparent to all, and they came mainly in fiscal and housing policy, not monetary policy.

I think the Fed could have and should have prevented the big fall in AD.  Krugman doesn’t agree.  I’m looking at you Bob and Kevin.

In case it’s still not clear, obviously if the Fed could have and should have prevented the big fall in AD, then not doing so was a very, very, very “big error.”

HT:  Steve.