Archive for November 2015


Wage targeting to NGDP targeting

People often ask me for a mathematical model illustrating my views.  I’m not a fan of such models, but I do understand their appeal to others.  In any case, it’s not something I do, but I would encourage younger economists to take a stab at it. Here I’ll suggest one possible path.

We already have models showing that the central bank should target the stickiest prices.  For instance, here’s Mankiw and Reis (2003):

This paper assumes that a central bank commits itself to maintaining an inflation target and then asks what measure of the inflation rate the central bank should use if it wants to maximize economic stability. The paper first formalizes this problem and examines its microeconomic foundations. It then shows how the weight of a sector in the stability price index depends on the sector’s characteristics, including size, cyclical sensitivity, sluggishness of price adjustment, and magnitude of sectoral shocks. When a numerical illustration of the problem is calibrated to U.S. data, one tentative conclusion is that a central bank that wants to achieve maximum stability of economic activity should use a price index that gives substantial weight to the level of nominal wages.

I made this argument in 1995, but without a rigorous model.

So how do we get from wage targeting to NGDP targeting?  One problem with targeting nominal wages is that they respond to monetary policy with a lag, because they are fairly sticky.  I’m not sure if this would be a big problem under level targeting, but just to play it safe it might be wise to make sure the wage target addressed the problem of policy lags.

One approach would be to target expected future wages.  Earl Thompson (an under-appreciated genius, who taught David Glasner) got here first, with a sort of wage futures targeting standardproposed back in 1982.  Unfortunately Thompson passed away a few years ago, but his paper is still on the internet, and still being ignored by the profession.  Maybe in about 50 years they’ll catch up to him.

Until then, how can we overcome the policy lag problem if we don’t have a wage futures market?  One approach would be to target total nominal labor compensation.  Suppose there is a negative demand shock, which will eventually reduce nominal wages, or at least nominal wage growth.  But initially there is little or no impact, because of the stickiness of nominal wages.  In that case, employment would fall before wages, and that’s indeed what we tend to see in the US business cycle.  So by targeting total nominal labor compensation, the Fed could indirectly be targeting nominal hourly wages.  Shifts in employment would be a sort of leading indicator of changes in nominal wages.

What could go wrong?  Let’s suppose employment fell for reasons other than sticky wages, in other words the fall in total nominal labor compensation did not presage a fall in hourly wages.  And let’s suppose that the Fed tried to prevent total compensation for falling.  In that case, the Fed would end up pushing nominal hourly wages slightly higher, as hours worked fell.  But hours worked would decline by less than if nominal wages had been held steady.  The bottom line is that an attempt to maintain stable total compensation, if it were unwise from an hourly wage targeting perspective, would lead to a monetary policy that was slightly more countercyclical that desired.  Surely there are worse things in the world than a slightly too countercyclical monetary policy!

I like to think of potential monetary policy rules from a “robustness” perspective. As in “What’s the worst that could happen?”  With the gold standard, some pretty bad things are easy to envision, after all, the real value of gold has been highly unstable in recent decades.  That’s not to say those really bad things would happen, imposition of a gold standard might substantially reduce the volatility of real gold values, but at least one can envision a really bad outcome.  It’s a possibility.

I’d say the same thing regarding money supply rules.  They might work well, but you can envision a big velocity shock.  As far as price level targeting is concerned, you can envision a supply shock that called for a large reduction in real wages, and price level targeting preventing that from occurring in the short run.  I’m not sure that this would be a particularly significant drawback of price level targeting, but it might be.

But with NGDP targeting, it’s hard for me to envision a plausible outcome that is obviously undesirable.  Many people are confused on this point, mentioning the possibility of 5% inflation 0% growth, or 0% inflation and 5% growth.  Yes, the first of these seems undesirable, but the bad outcome doesn’t have any clear relationship to monetary policy failure.  If we had 5% inflation and 0% growth, it would not be obvious whether money was too easy or too tight, even in retrospect. (Many commenters think a monetary policy failure is “obvious” in this case, but can’t agree whether money is too easy or too tight!!  QED.)

A robust policy is one where it’s hard to envision a major policy failure—and by that criterion NGDP targeting seems like a really robust policy.  But total nominal labor compensation targeting seems even slightly more robust than NGDP targeting, because in commodity dependent economies one could imagine a sudden divergence between NGDP growth and total nominal labor compensation growth. And if they diverged, it seems like targeting total compensation would better stabilize the real economy than stabilizing NGDP.

Economics is all about tradeoffs.  The mathematical model I envision would start from the Mankiw-Reis model, but add in a policy lag problem, to justify targeting total labor compensation. As usual, there would be costs and benefits to this approach, and in a prefect information world we could probably do even better, a target that did not necessarily give equal weights to wage growth and hours worked growth.  I suppose you could add that to the model.  But in the imperfect world we actually live in, it seems like stabilizing growth in total nominal labor compensation is going to be pretty close to optimal.  It’s hard to imagine a scenario where that variable is stabilized at 4%/year growth (gradually adjusted over time to reflect changes in labor force growth), and people say, ex post, “policy was obviously too easy” or “obviously too tight”.  What data could they possibly point to, in order to make that claim?

When is fiscal policy needed?

Over at Econlog I have a new post pointing out that central banks have never actually explored whether the zero rate bound limits monetary policy.  They don’t seem curious. I pointed out that, at a minimum, they’d first have to lower interest on reserves (IOR) so far that excess reserves fell close to zero.

Here I’d like to look at things from a different perspective—when is fiscal policy appropriate?

The place to begin is with the powers of the central bank—let’s use the Fed as an example.  What are their powers?  Who sets them?  Are they vague, or clearly spelled out?

Policy will be more effective if each branch of government clearly understands its role. Unfortunately, we don’t live in that world.  But even so, the Fed can certainly try to spell out its policy options, even if the set of options is rather complex.

As you know, I’d prefer a policy regime where fiscal stimulus was never needed, and instead the Fed bought up whatever was necessary to hit its target, even if it ended up owning the entire world.  Of course we don’t live in that world, so when should fiscal policy click in?

Like everything in economics, it’s all about costs and benefits.  Recall that in 2012 Fed chairman Ben Bernanke talked vaguely about various “costs and risks” of using unconventional monetary policy.  In his memoir, he gives the impression that this was more a concern of the committee, rather than him personally.  But nonetheless the perception of costs and risks is real, and influences policy.  So let’s assume these two costs:

The marginal cost of adding $1 to the Fed balance sheet is an increasing function of the size of the balance sheet.

The cost of a cut in the IOR is negatively related to the level of IOR.  The lower the interest rate, the higher the cost of an additional one basis point cut.

Fiscal policy also has costs and benefits, which increase with the size of the deficit.  In my view, the lowest cost fiscal stimulus, per job created, is a payroll tax cut.  This ignores possible supply-side effects of cuts in capital taxation, which is of course a highly contentious issue.  Or external benefits from more infrastructure, which is also controversial.

In other words, it’s always possible to point to fiscal changes that are desirable even if no fiscal stimulus were needed. (“Now more than ever, blah blah blah . . .) Conservatives want lower MTRs and liberals want more infrastructure or social programs.  But that’s sort of cheating, as those would presumably be done even if there were no need for fiscal stimulus.  And if they are not done, then policymakers clearly don’t agree that they are desirable.  Here I’m trying to approach the subject from a non-political angle, how to generate more AD.  (And yes I know, it’s hopeless—just trying to do thought experiments)

A cut in the payroll tax on employment seems like it would give the most bang for the buck, in terms of job creation.  An increase in the Earned Income Tax Credit is another possible policy aimed directly at more employment.

So let me summarize what I’ve got so far:

In an ideal world, the central bank does whatever it takes; no fiscal stimulus is called for.  The costs of more monetary stimulus are near zero, and certainly lower than the costs of fiscal stimulus.

In the second best world, Congress and Fed clearly describe the powers of the Fed, and the costs of things like a big balance sheet and/or lower IOR.  

In the third best world it’s all a big muddle.  Congress doesn’t even know what the Fed’s powers are, and indeed barely even understands what the term ‘monetary policy’ actually means.  (They probably think it means control of interest rates, not NGDP.) 

In that sort of world the Fed must decide what it thinks it is entitled to do, and the costs of more aggressive monetary stimulus (bigger balance sheet, more strongly negative IOR.)  Then it must weigh those costs against both the cost of high unemployment and also the cost of alternative fiscal stimulus, as well as the probability that this alternative fiscal stimulus will actually occur.

Here’s an example of the third best world (which is obviously the world we live in.)  In late 2012, the Fed saw that Congress was about to sharply reduce the budget deficit (which fell by $500 billion in calendar 2013).  Up until that point in time, the Fed had not done as much monetary stimulus as would normally be appropriate, because (according to Ben Bernanke) the FOMC was worried about the “costs and risks” of a larger balance sheet.  They had done QE up to the point where the perceived marginal cost of an additional dollar of QE was equal to the perceived benefit in terms of lower unemployment.  (I think they misjudged this, but let’s set that aside.)

Now with Congress about to do austerity, the perceived costs and risks changed.  Now the 2012 Fed policy stance would be associated with more unemployment than previously expected.  Still applying cost/benefit analysis, the Fed decided that more QE (and forward guidance) would be appropriate, as the risk in terms of lost employment of not acting was greater than in 2012, due to the fiscal austerity.  So they did act, and indeed overreacted if you buy my model.  That’s because growth actually accelerated, whereas my model predicts a tradeoff, with growth slowing, but not as much as it would have slowed with no action.

This post is rather messy because the real world is messy, so let’s conclude by trying to add some structure:

First, we need to think about what the Fed can and cannot do.  In my view we need clear instructions for the Fed, but I accept that this won’t happen.

Second, if we lack instructions, the Fed must decide on its own what it can and cannot do, and how much it is able to do things like QE and negative IOR.  In my view, it currently has enough power so that fiscal stimulus is not appropriate, if the powers are used wisely.

Third, the Fed doesn’t agree with me that it has enough power so that fiscal stimulus is never appropriate.  However the Fed has never clearly spelled out why it disagrees with my view.  For instance, Bernanke favored Bush’s spring 2008 fiscal stimulus, even though we were not at the zero bound.  But he doesn’t explain why.  What were the “costs and risks” of additional rate cuts, instead of fiscal stimulus?  Or was this about a split within the Fed, where Bernanke couldn’t get enough support for more stimulus, and hence he wanted Congress to do the Fed’s job?  Unfortunately, he doesn’t tell us, which is the weakest aspect of his recent memoir.

And finally, I understand that my view of the risks and costs of monetary stimulus is less important than the Fed’s view.  I do see that if the Fed views unconventional policies (and maybe even conventional?) as involving costs and risks, then they will sometimes fail to take adequate steps to maintain appropriate NGDP growth.  But it’s not really clear what this means.  It would be really easy if the Fed just sort of hit a wall, a legal limit on what they could buy, and then suddenly “ran out of ammo.”  In that sort of case the solution would be clear, let fiscal policy take over at that point, but not when the Fed can still cut rates.  But as we saw in late 2012, we don’t live in that world either; the Fed will do more costly and risky stuff when they see the need as being greater.

So in the end the problem is too complicated for any sort of “scientific” solution.  And thus we should not be surprised that people end up all over the map.  Monetarists like me want more monetary stimulus. Keynesians like Christy Romer want the same, but also employer-side payroll tax cuts.  Paul Krugman worries that employer-side tax cuts would be deflationary, and favors more spending on infrastructure or social programs.  Supply-siders favor cuts in MTRs to boost growth from a supply-side perspective.  The policy “game” being played here is far too complex for even our most advanced game theory models, and hence people will fall back on the solutions that they find the most appealing.

For me, I’m skeptical that Congress can ever do the “NGDP targeting” job adequately. In contrast, I saw signs in 1984 through 2007 that the Fed was reasonably good at the NGDP targeting, and I want to push hard for some additional modifications to overcome the zero bound problem, rather than throw up my hands and hope that Congress solves the problem next time.  I see the Fed’s ability to learn from past mistakes as being far superior to Congress’s ability, at least in the realm of macroeconomic stabilization.  So that’s why I focus like a laser on monetary reforms. It’s not that I don’t understand why others might find fiscal stimulus appealing—in a game this complex I can see how it might be an option.  I just don’t think it’s the best option.

We are about to exit zero rates. Now more than ever we need to fix monetary policy—before the next recession.  If we go into the next recession with the current monetary policy regime then the entire community of macroeconomics will have failed, and failed shamefully, to address the clear need for better options at the zero bound.  The Fed needs to act NOW.  I’m glad to see that the Bank of Canada understands the need for reform, and I hope the Fed also reaches this conclusion.

Most like we won’t solve the problem, and in the next recession a GOP government would do tax cuts and a Democratic government would boost spending.  That’s reality. But I do predict that we will make some progress, and not be as woefully unprepared as in 2008.

Noah Smith on the Great Chinese Data Conspiracy

Noah Smith weighs in on one of my favorite topics, China’s GDP:

It’s very hard to fake economic numbers in the same direction for a very long time — eventually, it becomes obvious to everyone that your economy is either much bigger or much smaller than the cumulative growth rates would have indicated. Something a bit like this happened to China back in 2007, when the Asian Development Bank reported that China’s gross domestic product was much smaller than believed. Chinese inflation had been understated, leading to real (inflation-adjusted) growth numbers that had been too high for too long.

If you follow the link, you get this:

In a little-noticed mid-summer announcement, the Asian Development Bank presented official survey results indicating China’s economy is smaller and poorer than established estimates say. The announcement cited the first authoritative measure of China’s size using purchasing power parity methods. The results tell us that when the World Bank announces its expected PPP data revisions later this year, China’s economy will turn out to be 40 per cent smaller than previously stated.

.  .  .

Well-informed analysts know that PPP calculations are a poor measure of a country’s potential military base, but with the corrected China PPP statistics, the whole question is moot. China is just not that big now and will not get that big any time soon.

I guess the “biggest economy in the world” is “not that big” and “2014” is not “anytime soon”.  Why Noah Smith would link to an outdated 2007 World Bank re-evaluation of China’s PPP GDP, when there is a more recent 2014 re-evaluation by the very same World Bank, that went in exactly the opposite direction—claiming China’s GDP was much larger than previously believed, and indeed is now the largest in the world.

[And please let’s not have any commenters tell me it’s GDP at market exchange rates that matter, unless you also plan to claim that Abe has plunged Japan into one of the greatest depressions in all of world history, reducing GDP in dollar terms by 30%, while miraculously reducing the unemployment rate to 3.4% at the same time.  Is that your argument?  Or is your argument that in the past three years the US GDP has soared by 50% in yen terms, one of the great booms in all of world history?  Or is Chinese GDP measured in Venezuelan bolivars what really matters?]

And then there are the conspiracy theories:

The unreliability of Chinese official economic data has become almost a cliche. A few years before he became China’s premier, Li Keqiang said that the country’s numbers were “man-made” and “for reference only.” If the top economic policy maker of a country says that the numbers aren’t reliable … well, you believe him.

So China’s leader, the most powerful since Mao, is engaged in a vast conspiracy to convince the world that China is growing at 7%, while its number two man, the guy all the China experts say has been completely emasculated by Xi, is publicly trying to expose the conspiracy?  Is that how things work in China?  And wasn’t Li’s criticism aimed at the GDP number for Liaoning province, not China as a whole?  And isn’t it true that the statisticians who compute the national figures completely ignore the provincial estimates, because they don’t believe them?  And isn’t the national growth rate generally lower than the average of provincial growth rates?

The so-called Li Keqiang index focuses on heavy industry (which uses a disproportionate share of the electricity, and rail shipments) and thus is completely inappropriate for an economy rapidly switching from heavy industry to services.

Noah continues:

But I would like to suggest a scenario even more pessimistic than the lowest of the numbers above. After reading reports by Peking University professor Chris Balding on the state of China’s financial sector, I think there’s a possibility that China’s growth is lower even than 3 percent.

Chinese electricity usage is growing at more like 1 percent. Rail freight traffic, though volatile, has suffered some dizzying drops in recent months. These are traditional proxies for heavy industry output. That they are barely growing, if at all, implies that much of Chinese industry has ground to a halt.

I’m confused.  If heavy industry is only growing at about 1%, and EVERYONE seems to agree that heavy industry is doing far worse than the overall Chinese economy, then how is China’s overall GDP growth lower than 3%?

Right now the consensus forecast for Chinese growth is 6.8% this year and 6.5% next year.  When interviewed, these forecasters often say the actual numbers might be only 5% or 6% (which seems plausible to me), but not something like 2%.  I have no idea where Smith is getting these estimates.

In late October there were lots of scary stories like this one:

Alibaba results to dim outlook for China consumer spending

So much for consumer spending, right?  Excepts those stories were about what was expected, the press pretty much ignored the actual figures:

Two of the world’s biggest brands put in an impressive quarter in the Middle Kingdom.

Alibaba’s earnings report yesterday proves, again, that the Chinese consumer is doing just fine in a slowing economy. Thanks to those consumers, hope for something other than an economic crash isn’t misplaced in the world’s second-largest economy.

Alibaba said its quarterly revenue jumped by 32%; annual active buyers on its system rose to 386 million, up 20 million; gross market value, the dollar value of transactions, climbed by 28% to $112 billion; and earnings per share climbed by 30%.

Maybe most importantly for the company, Chinese smartphone users are buying a lot more stuff on their smartphones. Alibaba’s monetization rate, the commission rate that it charges sellers for every transaction, trended upward for the first time in five quarters, according to Jefferies Cynthia Meng in Hong Kong last night, thanks to mobile shoppers buying.

Alibaba could be an aberration. Maybe the low-priced goods popular on Taobao aren’t an indicator of consumer strength. Some corroboration of the trend from rivals JD 3.24% and Tencent Holdings Ltd TCEHY 2.27% , when they report, would certainly be welcome. But recent data show the same positive story for Chinese consumers.

Start with the most widespread luxury consumer brand in China, Apple. New iPhone 6s in mainland China sell for close to $1,000. Yesterday the Cupertino company said China sales increased 99% in its latest quarter, to $12.5 billion, from $6.3 billion. CEO Tim Cook was quoted yesterday saying if he avoided TV and online news and only studied Apple’s numbers, “I wouldn’t know there was any economic issue at all in China.”

Looking only at China’s consumer data, you might say the same thing. China’s third quarter GDP highlighted a thriving services sector, which grew by 8.4% in the third quarter as manufacturing slowed to 6%, and even negative in some provinces heavily reliant on industry. Retail sales in September, meanwhile, grew by 10.9% in nominal terms.

When you are selling $112 billion in a quarter, that’s about $450 billion a year.  That’s huge.  And when that number is rising at 28% year over year then sorry, I just don’t see a recession, or even 2% growth.

I see that Noah Smith relies on Chris Balding’s expertise on China.  He might want to check out this post, before doing so in the future.  Then read the Balding post I link to.  And then think about the fact that Balding wrote the post more than three years ago.  Here’s just a small sample from his post:

The Beijing government admits that 50% of apartments sit empty.  A similar number is found in most major cities in China, not to mention the entire cities that sit empty.  .  .

One recent article noted that the average price per square foot in Beijing was nearly $300 while monthly per capita GDP was only $435.  .  .  .

Living in China I can attest first hand to the fact that China has easily the highest price level of any country I have visited in the past two years.  .  .  .

Beijing isn’t concerned about the 2/3 of the population that still live as subsistence farmers in rural areas.  .  .  .

There is no Chinese economic liberalization story.  .  .  .

However, this year has not been a good year for the party.  Economic data that is now just blatantly made up, at least one coup attempt to begin the year, and a collapsing economy do not make ideal conditions to hand over power.

Outsiders do not realize how tense things are in China right now and bad business is.  In my local mall where police used to stroll by, large battalions of police troops are now regular guests.  Small tanks and rows of paddy wagons line the street under the Starbucks every night.

I was in Beijing when he wrote that blog post, and it doesn’t describe the China I saw, nor are the numbers accurate.  Not even close.

A worthwhile Canadian initiative

Over at WCI, the Bank of Canada has put out a request for monetary policy reform ideas.  This is from a post by Carolyn Wilkins, of the BOC:

During the Great Depression, John Maynard Keynes wrote “It’s astonishing what foolish things one can temporarily believe if one thinks too long alone, particularly in economics.”

Today, this is truer than ever, and it’s a principle the Bank of Canada is keeping top of mind as we tackle some tough policy and research questions. As I explained in a speech last week, we’ve been thinking a lot lately about “innovation, central-bank style.” That means taking on board the lessons from the most recent global financial crisis, questioning old answers to policy questions and changing our corporate culture to remove obstacles to new ideas.

It starts with a clear research agenda. Here are some highlights:

  • While we’re committed to our inflation-targeting framework, we’re taking a hard look at it ahead of the official renewal in 2016. The questions we are asking are: Should we consider targeting a rate of inflation higher than 2 per cent? Should we continue to use CPIX as our operational guide? How do we incorporate financial stability risks into the conduct of monetary policy?
  • We’re analyzing the effectiveness of unconventional monetary policy used by various countries since the crisis. We’ve just published staff discussion papers on quantitative easing, forward guidance and negative interest rates.
  • We’re making a big investment in economic modelling and using new analytical methods like big data and behavioural economics.
  • We’re preparing to confront “alternative futures” such as China’s new role in the international monetary system; new payment methods like Apple Pay and PayPal; disruptive technologies and business models like Bitcoin, peer-to-peer lending and others in the sharing economy.

To get to the right answers to these questions, we need to reach out to people beyond our own four walls. If we don’t, we leave ourselves open to confirmation bias and tunnel vision—and we risk missing out on insights that can ultimately lead to better outcomes for Canadians.

That’s why I’m reaching out to you—those who follow and contribute to Worthwhile Canadian Initiative.

Since they are committed to inflation targeting, I’m not going to recommend NGDPLT. In any case, NGDP targeting may not be optimal for Canada, given the big swings in nominal commodity output.  Instead it might be best to stabilize the path of nominal total labor compensation.  So here I’ll advocate a form of flexible inflation targeting.

Each year, the BOC will estimate the rate of growth in total nominal labor compensation (TNLC) that is consistent, in the long run, with 2% inflation.  Thus suppose they forecast a trend rate of 1.2% labor force growth and 0.9% productivity growth.  In that case, 2% long run inflation is consistent with 4.1% growth in TNLC. Then 4.1% becomes this year’s TNLC target.

Importantly, I am considering a level-targeting regime, although the BOC could adopt a growth rate targeting approach if level targeting made them too queasy. Suppose that one year later, the BOC forecast 1.1% labor force growth, and 0.8% productivity growth. Then this year’s target would have TNLC rise by 8.0% over the level of 2 years ago (4.1% for last year plus 3.9% for this year (ignoring compounding).)  That’s if they choose the level targeting approach.  If they go with a “let bygones be bygones” growth rate approach, then they’d aim for 3.9% compensation growth during this year, from the point where TNLC left off at the end of the previous year.

This regime would assure roughly 2% inflation in the long run, while allowing some year-to-year fluctuation to help stabilize the labor market when the economy is hit by real shocks.  If BOC forecasts were unbiased, then inflation fluctuations should be fairly random. Actual inflation would become somewhat countercyclical, which is the biggest difference between this plan and current central banking policy.  Recall that in most countries inflation fell during the severe 2009 slump.  Under my proposal it would have risen.

PS.  If they insist on staying with simple inflation targeting, I’d raise the target range to 2% to 3%, as in Australia.  Recall that the Aussies easily avoided the liquidity trap in 2009. The zero bound is much more likely to occur in the future than in past recessions.  However under my proposal described above, especially the level targeting approach, no increase in the inflation target is needed.

The Great Depression

My book on the Great Depression is officially being released on December 1st.  At that time I plan to do a few posts discussing the book.  But since some have already received copies, I thought it might help to provide a quick overview for what is a fairly complicated hypothesis.  The book is certainly not “easy reading”, and I’m hoping the following two charts will make it easier to follow the thread of the argument.  (In other words, unlike Garett Jones I didn’t take Bryan Caplan’s advice.)

Here is a flow chart in the first chapter:

Screen Shot 2015-11-19 at 10.25.13 AMThe final chapter (13) includes a more detailed model, intended for serious scholars. In that chapter I also have a more detailed flow chart, which explains how all the pieces fit together:

Screen Shot 2015-11-19 at 10.26.39 AMIf you get confused while reading the book, consult these flow charts.  They explain how each piece of the puzzle fits together.  When I wrote the book (it was done by about 2005) I had no idea that more than 50 people would ever read it, so I wrote it at a level aimed at specialists.  Now it seems that many more people than I expected will read the book. Obviously I’m pleased by the interest, but quite honestly if you only have time to read one economics book this year, make it Garett Jones’s Hive Mind, not my book.