From Robinson Crusoe to NGDP futures targeting
In five easy steps:
Step one: Suppose Robinson Crusoe spends 30% of his time building or expanding his home, and 70% of the time catching fish and collecting fruit. There’s no money in his island economy, but you could say that in terms of hours worked, GDP is 70% consumption and 30% investment. Then Crusoe injures his arm, and his productivity falls by 10%. Call this a “real business cycle”. Economic theory predicts that Crusoe will engage in “consumption smoothing”. Most of the decline in output will show up in less investment, with very little change in consumption. He’ll keep eating, but postpone the expansion of his hut.
Step two: All business cycles predict that investment will be unusually procyclical, much more than consumption. But some models also suggest that investment shocks cause business cycles. Keynesians worry that a drop in animal spirits might depress investment, and this would reduce AD via the multiplier effect. Austrians worry that an excessive burst in investment might lead to malinvestment, and the resulting hangover could lead to a recession.
I believe those theories are misleading. Most modern recessions (except this one) are caused by unstable monetary policy (i.e. unstable NGDP.) Investment is highly procyclical, but that would certainly be true even if investment played no causal role in the recession, as in the deserted island example.
Step three: When people like Keynes and Hayek developed their business cycle theories, however, investment shocks really did cause business cycles. That’s because most developed countries used to be on some form of the gold standard. When the nominal price of gold is stabilized by monetary policy, i.e. when gold is the medium of account, then an increase in demand for gold is deflationary. It also reduces NGDP.
Barsky and Summers showed that falling nominal interest rates increase the demand for gold, which is why nominal interest rates were positively correlated with the price level under the gold standard. A negative investment shock would reduce real interest rates. Because expected inflation was near zero under the gold standard, this led to lower nominal interest rates. Lower nominal rates increased the demand for gold, which is deflationary under a gold standard.
Thus under a gold standard, negative investment shocks really could cause recessions, just as Keynes postulated. But not for the reason he assumed. Just as fish don’t notice that they are wet, Keynes never understood the way his worldview was shaped by the lack of fiat money policy regimes. In the rare cases where fiat money was used (say Germany in the early 1920s), Keynes temporarily became a monetarist.
Step four: Once we shifted to fiat money, investment shocks should no longer have led to business cycles. Monetary policy should be adjusted to offset any change in the equilibrium interest rate resulting from an investment shock, and thus maintain steady NGDP growth. But the Fed tends to be a bit behind the curve when there is a sudden change in the natural rate of interest, so investment shocks still do matter.
In the early 2000s, the Fed did an OK (but not perfect) job responding to the fall in the natural rate of interest after the bursting of a business investment boom. Unemployment peaked at 6.3% in the mild recession that followed the tech boom. That’s much better than the way they responded to the end of the investment boom of 1929!
In contrast, the Fed was far behind the curve in responding to the fall in the natural rate of interest after the bursting of a residential investment boom in 2007-08. This error was partly caused by the Fed freaking out over high headline inflation when oil prices soared in 2007-08.
Step five: So people keep thinking that investment plays a causal role in the business cycle, even though the actual problem is that the investment shocks cause the Fed to inadvertently tighten monetary policy. A successful monetary regime would cause people to no longer see investment shocks as the cause of business cycles. If you favor classical economics, you should root for a successful monetary policy, as this sort of policy regime causes people to see the economy in classical terms.
The best way of persuading people that investment shocks don’t cause business cycles is to adopt NGDP level targeting, and have NGDP futures “guardrails” guiding policy. The ideal monetary policy is one where the market always expects 4%/year NGDP growth over the next year (or two during a pandemic.) If the markets always expect 4% NGDP growth, then people won’t worry about investment shocks causing recessions.
Robinson Crusoe understood that the decline in his housing investment didn’t cause the fall in GDP. Rather his injured arm caused the “recession”, and he decided to smooth consumption during the downturn. A good monetary policy will make us all as smart as Robinson Crusoe. It will make the economy more “classical”. Less investment just means more consumption.
Tags:
17. December 2020 at 17:21
Nicely done, excellent post.
A nation should give fiscal-monetary authorities the tools they need to hit NGDPLT, and in timely fashion.
I like a guard-rails, I like expectations, I like a futures market.
Perhaps, through quantitative easing, the Fed is already effectively engaging in money-financed fiscal programs. Michael Woodford think so.
Stanley Fischer has advocated that the Federal Reserve have its own fiscal facility, but he left the details blurry.
Certainly the Fed would have a lot more respect, that is it would create much more expectations, if it had a fiscal facility, in addition to its monetary policy tool kit. All the better if the Fed could unleash its unlimited fiscal facility on a dime rather than dilly-dallying, dithering and endlessly politicizing, like the US Congress.
The time to stop a recession is like the time to stop an a auto accident—–that is, before it happens.
17. December 2020 at 19:40
Sumner: “Most modern recessions … are caused by unstable monetary policy ” – cite please? And no, quoting Milt Friedman is not a citation. An econometrics study is.
17. December 2020 at 22:30
Less investment spending doesn’t imply or cause more consumption spending so that total spending remains the same as previously.
And fishies may not notice they are wet but probably suffer consequences when they aren’t wet whether they realize that or not. But then I am not a marine biologist like George Costanza so maybe I won’t press that point.
17. December 2020 at 23:33
A grim chuckle here:
“In contrast, the Fed was far behind the curve in responding to the fall in the natural rate of interest after the bursting of a residential investment boom in 2007-08. This error was partly caused by the Fed freaking out over high headline inflation when oil prices soared in 2007-08.”– Dr.Scott Sumner
My take is the above paragraph is true, and on other occasions Dr. Sumner has posited the Fed, roughly speaking, triggered the Great Recession of 2009 through tight money—-a recession called the “Global Financial Crisis,” in other parts of the world.
Here is the grim chuckle: If the above Sumner sentiments are true, then the temporarily incorrect decisions of a lone central bank triggered a global financial crisis, unemploying tens upon tens of millions for a couple of years, and savaging business profits across oceans.
Globally, GDP growth trend-lines never got back to former paths.
This happened to the same “free trade” globalized capital markets upon which conventional economists rhapsodize endlessly—said system collapsed like a house of cards, after the missteps of the Fed.
Is the present system better? Seems sturdier. If this because central banks, at long last, have stopped their peevish fixation on measured inflation?
18. December 2020 at 08:21
Re: “Monetary policy should be adjusted to offset any change in the equilibrium interest rate resulting from an investment shock, and thus maintain steady NGDP growth.”
The “Wicksellian Natural Rate of Interest” is fictional. AD isn’t a function of interest rates. AD = money X’s velocity (not N-gDp as the Keynesian economists claim).
Alan Greenspan’s “Great Moderation” is now widely recognized as fake news.
To repeat what I’ve said for two decades: At the height of the Doc.com stock market bubble, Federal Reserve Chairman Alan Greenspan initiated a “tight” monetary policy (for 31 out of 34 months).
Note: A “tight” money policy is defined as one where the rate-of-change, Δ, in monetary flows, volume Xs velocity, is no greater than 2% above the roc in the real output of goods & services.
Chairman Alan Greenspan didn’t start “easing” on January 3, 2000, when the FFR was first lowered by 1/2, to 6%. Greenspan didn’t change from a “tight” monetary policy, to an “easier” monetary policy, until after 11 reductions in the FFR, — ending just before the reduction on November 6, 2002 @ 1 & 1/4% (coinciding with the bottom in equity prices).
18. December 2020 at 09:43
“The best way of persuading people that investment shocks don’t cause business cycles is to adopt NGDP level targeting, and have NGDP futures “guardrails” guiding policy.”
Probably true, but I don’t think that what people “think” about investment shocks is that important and NGDPLT is pretty darn close to optimum whatever the trigger of a downturn.
Pending NGDP near-nirvana (if the target NGDP growth rate is optimal), I think targeting inflation expectations would be hugely better than anything we’ve seen, at least since 2008. It would have produced somewhat too little inflation in 2020 since we had a negative real shock, but at least we would not have seen the actual decline in expectations that we had in February and neither 5 year nor 10 year TIPS expectations are up to 2% PCE (~2.3 CPI).
[Treasury really ought to run a 1 and 2 year TIPS.]
18. December 2020 at 10:36
The great thing about this economic shock is everyone knows what caused the shock and everyone pretty much agrees the economy from Q2 2014 to February 2020 was a fundamentally sound (Republicans disagree merely on the time frame believing the best economy ever started when Trump was elected). So as divided as we are as a nation this might be the first time during an economic recession when everyone is on the same page!
So with respect to 2008/09 I actually thought too much stimulus could be counterproductive by perpetuating a dysfunctional economy. With this economy I believe it is fundamentally sound but serious problems exist such as with inequities of distribution of wealth. So I actually don’t have a problem with an economy producing billionaires…but I do have a problem with working Americans living paycheck to paycheck and having suboptimal quality of life. The fact the economy is fundamentally sound and the Republican president just spent 4 years throwing money at problems (both preexisting and at ones he created) means both parties agree on the solution to fix this economy’s inequities—throw more money at the problems.
18. December 2020 at 10:41
re: ” the Fed was far behind the curve in responding to the fall in the natural rate of interest after the bursting of a residential investment boom in 2007-08. This error was partly caused by the Fed freaking out over high headline inflation when oil prices soared in 2007-08.”
Damn straight. Bernanke (1) contracted long-term monetary flows, proxy for inflation (affecting those assets most susceptible to a price decline), for 29 contiguous months. This turned otherwise safe-assets into impaired-assets.
Then Bernanke (2) contracted short-term monetary flows, at the sharpest negative rate of change since the Great Depression.
Then (3) Bernanke destroyed the nonbanks by remunerating IBDDs
18. December 2020 at 10:42
And because the FED doesn’t think money matters, the FRED database has the November money stock numbers reported wrong.
18. December 2020 at 12:44
Unrelated to the post:
https://www.businessinsider.com/tax-cuts-rich-trickle-down-income-inequality-study-2020-12
I don’t put a lot of stock in “inequality” arguments as that sounds a lot like jealousy but I do suspect that, when viewed from a consumption basis, that these tax cuts might actually harm the bottom and middle class. Consider that, per the study, the tax cuts result in no additional economic growth; the pie stays the same size. However, the after-tax incomes of the top class increase and thus their proportional share of consumption also increases. If they’re taking a larger slice of the pie and the pie stays the same size, the amount of pie left for everybody else must therefore be smaller…
18. December 2020 at 14:23
Jerry, You said:
“Less investment spending doesn’t imply or cause more consumption spending so that total spending remains the same as previously.”
It does with sound monetary policy.
18. December 2020 at 15:14
Maybe- but what about the fishies and George Costanza?
🙂
18. December 2020 at 18:30
I suspect that fish notice when they aren’t wet, and don’t like it. But I’ll defer to George Costanza on that question.
18. December 2020 at 19:18
An interesting monetary policy question:
If you were starting a nation from scratch, would you have monetary policy implemented through a fractional-reserve banking system?
Or, would you “go direct” and fashion a system in which a central bank injects money into the economy, bypassing the banking system (the existence of a central bank is taken as a given, in this example).
Thus, a central bank would likely effect monetary policy through money-financed fiscal programs, which could (and preferably) manifest through tax cuts, not more government spending.
Bank Indonesia is doing that (in part) this year, so far without much effect on inflation (1.6%) or the exchange rate of the rupiah.
Working through fractional-reserve commercial banks to effect a monetary policy seems rather clunky, even Rube Goldbergian.
Is the present monetary-policy apparatus actually monetary policy as devised by commercial banks?
18. December 2020 at 22:15
Scott,
If I understand your view about the role of monetary policy in low US productivity growth since 2004, you are skeptical because there was relatively high productivity growth during the Great Depression, and the low productivity growth has persisted even after wage adjustment after the Great Recession. Is that correct?
And regarding the wage or ECI to NGDP ratios, when I see a graph like this, I see a ratio falling over time:
https://fred.stlouisfed.org/graph/?g=yUhI
When trying to decide if wages have fully adjusted after a nominal shock, should we just look for a return to the pre-shock ratio, or should we look at the trend path?
19. December 2020 at 06:54
Re: “The best way of persuading people that investment shocks don’t cause business cycles is to adopt NGDP level targeting and have NGDP futures “guardrails” guiding policy.”
Every recession since WWII has been entirely the FED’s fault (except the current one). Every recession is due to the unrecognized distributed lag effects of monetary flows. Paul Volcker was responsible for two back-to-back recessions, in part because he couldn’t discern the economic time lags.
Targeting NGDP requires that the FED’s 400 + PhDs in economics know the differences between money and liquid assets. If the FED’s technical staff understood money, then the FRED database would permit their users to apply the correct money time lags. But the FRED database doesn’t offer that specific capability. So, we know that the FED is clueless.
With the G.6 Debit and Demand Deposit Turnover release, you only needed to apply one lag to calculate NGDP. Using the money stock, you need two separate time lags.
19. December 2020 at 07:12
You’d think, given at least 3 months over the quarterly projection, that the FED would be able to precisely target NGDP.
19. December 2020 at 10:05
Michael, I don’t know of any foolproof method for determining if the labor market has adjusted–it’s a judgement call.
19. December 2020 at 10:53
Do you believe that NGDP targeting could work with a non-fiat currency?
19. December 2020 at 17:04
Carl, It would be very difficult. A very large country might be able to make it work for a decent period of time, but it would probably break down at some point.
21. December 2020 at 10:02
On the one hand you point out that a properly managed fiat currency using NGDPLT can protect against recessions caused by investment shocks. Since recessions often lead to the use of automatic and ad-hoc fiscal stabilizers to mitigate the effects of the recession, fiat currencies could, in theory, lead to less government debt. But history seems to teach that countries with fiat currencies end up with more debt because of the moral hazard issues with a fiat currency.
I’m curious whether you think that:
a) I’ve got my history about the relationship of fiat currencies to debt wrong or
b) I’ve got the relationship right but it will not matter once NGDPLT is adopted because the incentives for fiscal stabilizers will be reduced so greatly or
c) there is just an inevitable trade-off that countries must make between the ravages of investment shocks and government debt or
d) something else
21. December 2020 at 10:34
Carl, Fiat currency may boost debt modestly due to moral hazard, but stable NGDP growth seems to reduce the public debt/GDP ratio.
22. December 2020 at 11:40
So what’s the call now? N-gDp?
The economy is furiously contracting. How’s N-gDp Level targeting work if no one is expecting R-gDp to fall?
When’s the last time a Ph.D. in economics wrote a paper on the distributed lag effect of money?
23. December 2020 at 14:07
Great post, it makes your point clear. I know that your example doesn’t represent the current situation, but I’d like to try:
Robinson Crusoe does his fishing at a lagoon on the far side of the island. He also enjoys swimming there twice a week. However, a shark has recently entered the lagoon and is living there. Should he:
1. Stop fishing and swimming, and increase his time spend building his home, learning better ways to gather fruit, and building a trap for the shark. This might increase his percentage spent on investment from 30% to 50% or
2. Keep fishing and swimming so as not to let the shark “dominate his life”.
24. December 2020 at 09:43
Long-term money flows (proxy for inflation > 100 years) parallel, “abject collinearity”, the CRB Commodity Index better than NSA CPI
https://tradingeconomics.com/commodity/crb
I call it the fixed distributed lag effect, a mathematical constant (the effect is not instantaneous, but the monetary policy effects take time to work through the economy over a definite length of time).
And the “dot plots” in the spread are preponderantly skewed, “lag weights”, in one single month over future time periods.
02/1/2020 ,,,,, 0.04
03/1/2020 ,,,,, 0.19
04/1/2020 ,,,,, 0.47
05/1/2020 ,,,,, 0.54
06/1/2020 ,,,,, 0.61
07/1/2020 ,,,,, 0.65
08/1/2020 ,,,,, 0.68
09/1/2020 ,,,,, 0.68
10/1/2020 ,,,,, 0.76
11/1/2020 ,,,,, 0.87
12/1/2020 ,,,,, 0.91
01/1/2021 ,,,,, 0.95
02/1/2021 ,,,,, 0.92
03/1/2021 ,,,,, 0.87
04/1/2021 ,,,,, 0.90
05/1/2021 ,,,,, 0.87
If the collinearity continues to hold, then inflation will accelerate and remain high in 2021. We will have stagflation.
I used to say these numbers need no “disclaimer”. But the FED has drastically changed how they report all their #s. Like Dr. William Barnett said (a former NSA Rocket Scientist).
“the Fed should establish a “Bureau of Financial Statistics”.