Is NGDP a sufficient statistic for monetary policy?
George Selgin has some doubts:
Both Market Monetarists and Wicksell himself differ from the Austrians in paying little if any attention to the direct bearing of short-run interest rate changes on real activity, and especially real activity in asset markets. The Market Monetarists consider interest rate movements an unimportant sideshow without significant knock-on effects, and therefore a distraction from what really matters; Wicksell considered them only as a harbinger of changes in spending. Missing in both perspectives is any attention to the way in which interest rate movements redirect demand from certain markets to others. Monetary policy innovations can, in other words, involve both (nominal) “income” and “substitution” effects.
They needn’t do so, of course. “Helicopter” money approximates the case in which monetary innovations boost nominal wealth, and thereby stimulate spending and nominal income, without necessarily involving any particular relative-price changes. The short-run/long-run AS-AD framework tells us all, or almost all, of what we need to know about the potential real consequences of helicopter money drops; and deviations of nominal income from trend supply a reliable indicator of the degree to which monetary policy has been either excessively easy or excessively tight.
But open-market purchases aren’t helicopter drops. Instead (as Wicksell took for granted) they initially involve increases in the relative price of the securities being purchased, and corresponding reductions in market-clearing (but not in underlying “natural”) interest rates. Lower interest rates in turn encourage a re-orientation of spending toward investment, and especially toward those prospective investment projects whose present values increase most in response to a marginal reduction in the cost of funds. This “substitution” effect of easy money–an effect that depends on real interest rate movements rather than on changes in aggregate spending per se–is the key to unsustainable asset price movements, where “unsustainable” indicates a movement than can only go on while interest rates remain unnaturally low. It is possible, at least in principle, to conceive of a monetary policy that gives rise to large substitution effects–that is, to a substantial increase in the perceived present value of particular investments–while having only a modest ultimate effect on the growth rate of nominal final income. The narrower the initial credit channel through which excess liquidity is injected into the economy before spreading out to the rest of the economy–the further removed we are from helicopter drops–the greater the likely importance of relative-price and substitution effects.
The possibility of substitution effects stemming from “unnatural” (monetary-innovation based) interest rate movements supplies reason for taking even modest innovations to NGDP growth, and upward innovations especially, seriously. The possibility suggests that such deviations are likely to be associated with disproportionate deviations of total spending””that is, of spending on both final and intermediate goods””from its own trend. In so far as money supply innovations tend to drive interest rates either below or above their natural levels, increases in the growth rate of NGDP and other nominal income measures may understate the extent to which monetary policy is excessively easy or excessively tight (and are likely to continue to understate the laxness of monetary policy while a boom persists), because the amplitude of short-run deviations of total spending from trend will be greater than that of nominal income, and because velocity and money multiplier declines that typically accompany the bursting of asset bubbles will suppress the acceleration in nominal income growth that might otherwise be observed once substitution effects have worn off.
I look at things a bit differently:
1. I think NGDP tells us pretty much all we need to know about whether money is too easy or too tight.
2. I don’t think that the method by which money is injected is very important, at least during normal times when interest rates are positive. That’s because the injections are so tiny that the direct effect on the market of whatever’s being purchased is small. Consider the Fed’s options in 2003. It could have aimed for a 5% NGDP growth rate over the following three years. It actually produced a growth rate of over 6%. How would interest rates have been different if the policy generated an expected 5% NGDP growth rate? Hard to say. The slightly tighter money would have resulted in slightly higher nominal interest rates. The slightly lower expected NGDP growth would have resulted in slightly lower nominal rates. The net effect? I can’t say, I’m not even sure whether rates would have been higher or lower with slightly slower NGDP growth. They probably would have bought slightly fewer T-securities, but the difference would have been trivial in the vast T-securities market. The effects would have been essentially identical if they had purchased copper or oil with those extra purchases. Just to be clear, I’m not saying a permanent switch from T-bonds to oil would have no impact, I’m saying that if the differential in base demand between 5% NGDP growth and 6.5% NGDP growth had been diverted from T-securities purchases to oil purchases it would have made almost no difference. Money matters because it’s money, the medium of account, not because of what is bought as it’s injected in the economy. Even under the gold standard, when newly injected money purchased gold, short terms rates used to fall after monetary injections. In my view the liquidity effect on short term rates occurs because prices are sticky, not because of what the Fed happens to purchase.
3. We know that 6.5% NGDP growth would not, ceteris paribus, produce a housing bubble. Indeed most other economic expansions saw faster NGDP growth, without a housing bubble. So the argument rests on the proposition that the lower interest rates resulting from easy money produced the housing boom. That’s possible, but the difference in the level of longer term real interest rates between an expected 5% and 6.5% NGDP growth is likely to be very small, regardless of what the Fed buys. So I simply don’t see how it comes close to explaining the housing boom. The current price of homes is closely linked to what people think homes will be worth in 5 or 10 years. And I don’t see how a year or two of easy money right now would have much effect on the expected value of homes 5 or 10 years out, unless it led to expectations of very fast NGDP growth. But it didn’t. Of course the weakness of my argument is that I have no rational explanation for the housing bubble. I’ve discussed bad regulation and tighter zoning and rapid Hispanic immigration to the 4 subprime states, but I don’t really think those explanations are adequate. It’s a mystery to me. Had real housing prices been strongly affected by monetary policy in other periods of US history I’d been very sympathetic to this argument.
I do understand why commenters who are closer to the Austrian tradition don’t find my analysis persuasive. I don’t have an explanation for the bubble and they think they do. That’s an advantage to the other side. But until I’m convinced that it’s a general theory that can explain other money–bubble linkages in other periods of history, I’m not willing to sign on.
(For example, in the 1920s real interest rates were not low and NGDP growth was not high. And yet we still had a big stock “bubble” followed by a severe slump.)
Marcus Nunes also comments on George Selgin.
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2. October 2012 at 17:28
A trouble I have with Austrian explanations of bubbles is that they seem too “mechanical”. There has to be expectations about either increased income or increased capital gain or both for a bubble to get underway. Mere expansion of credit/money surely would not create such expectations about specific assets.
Generally positive expectations about income would encourage spending in general but surely one has to tell a story about specific assets to explain why a bubble occurs there.
2. October 2012 at 17:30
Though I don’t much care for Larry Summers, he had a very simple explanation for the housing and stock bubbles – demographics (boomer surge in peak earning years). One can always argue this should be arbitraged away, but there are limits to arbitrage on that scale which are created by the real economy. Summers argument is not inconsistent with NGDP sufficiency, though it does raise the question about whether a fixed NGDP target is ideal, or whether it could (theoretically) be linked to some crude index of real factors.
2. October 2012 at 17:36
Scott, I think we don’t have to take an either/or approach here. All cycle theories are ideal types, and they will all apply only more or less to the real world. The Austrians have a coherent narrative, but many of them have mistakenly adopted the stance that therefore everything in the cycle is explained by their ideal type. (Steve Horwitz and I critiqued that attitude in a recently published paper.)
Your work has convinced me that NGDP is a major factor in most cycles. But one need not dismiss other cycle theories to hold that to be true: Austrian-type effects can be real without your theory being “wrong” in any sense except if it is held to prove all other cycle theories nonsense.
2. October 2012 at 17:38
@Lorenzo: “A trouble I have with Austrian explanations of bubbles is that they seem too “mechanical”. There has to be expectations about either increased income or increased capital gain or both for a bubble to get underway.”
Roger Garrison and I acknowledged this fact in our 2003 paper on the dot-com boom-and-bust, and specifically called for adding “mania” type explanations to the Austrian theory.
2. October 2012 at 17:51
Scott, did you ever engage Edward Leamer, “Housing IS the business cycle”?
If you have, what’s the URL or reference where I can take a look.
2. October 2012 at 17:51
“I don’t think that the method by which money is injected is very important”
I can assure you that there are banksters with crappy bonds sitting around who think the method of monetary injections is very important.
Why not send out debit cards to the public instead of laundering profits for big banks by biying up old crappy MBS?
oh right…yet you continue to claim that “Bernanke/the fed have nothing but the best of intentions”
I don’t get it
2. October 2012 at 17:57
Gene — The “Austrian narrative” or “Austrian effects” you reference are parodies of Hayek or even Mises monetary economics / cycle theory.
How do we kill this bogus creature which does no reflect that actual science of Hayek
and Mises — but falsely & pathetically pretends to be their science?
2. October 2012 at 18:05
Hi Greg, I realize there are bowlderized views of Mises and Hayek out there, but I meant actual Austrian cycle theory, not cheap versions of it.
2. October 2012 at 18:08
@StatsGuy: “Though I don’t much care for Larry Summers, he had a very simple explanation for the housing and stock bubbles – demographics (boomer surge in peak earning years).”
But why in the world should that create a bubble? These would seem to represent real shifts in the demand curves for these items: why wouldn’t those shifts be self-sustaining until the boomers are all dead?
2. October 2012 at 19:19
Seems to me the broader Austrian picture of capital structure meshes very well with market monetarism. At very least, it gives a partial mechanism by which tight money translates into production within the economy’s PPF. By keeping money tight, thus imposing a ZLB ceiling in the loanable funds market and preventing the interest rate from reaching the Wicksellian equilibrium, the Fed “humps” the Hayekian triangle, depressing long-range speculative investment and keeping consumption low.
Meanwhile, sticky wages act to prevent the labor market from quickly smoothing out the “humped” Hayekian triangle by shifting workers formerly employed in low-demand stages of production to higher-demand stages of production. Intertemporal (as well as intersectoral) labor adjustments occur only slowly in the presence of money illusion. The price level falls, but slowly, as lower demand translates to lower prices. Ultimately, the PPF and the economy’s production move back toward each other.
(The “humped” Hayekian triangle is the opposite of the “broken” Hayekian triangle that occurs when money is excessively loose. There, again, the Austrians provide part of the picture by which loose money results in higher prices.)
Money is the “loose joint” here. When it’s tight, it’s more like a lubricant that seizes up in the cold, preventing the macroeconomy from allocating or reallocating resources. IMO the Austrian story (at least as laid out in Garrison’s book) largely complements market monetarism instead of contradicting it.
2. October 2012 at 19:57
whoa whoa whoa. Did I read this correctly? Did you say that there was a BUBBLE? This is breaking new ground for you. I thought you didn’t believe in bubbles (EMH and all that)?
2. October 2012 at 20:07
adam wrote:
whoa whoa whoa. Did I read this correctly? Did you say that there was a BUBBLE? This is breaking new ground for you. I thought you didn’t believe in bubbles (EMH and all that)?
Heh, adam you are like me the first two years reading this blog. I just stopped taking notes and now I enjoy the ride.
2. October 2012 at 20:48
[…] that light, I was very impressed by Scott Sumner’s recent discussion, in a response to George Selgin, where Scott wrote: We know that 6.5% NGDP growth would not, ceteris […]
2. October 2012 at 21:25
“Lower interest rates in turn encourage a re-orientation of spending toward investment, and especially toward those prospective investment projects whose present values increase most in response to a marginal reduction in the cost of funds. This “substitution” effect of easy money-an effect that depends on real interest rate movements rather than on changes in aggregate spending per se-is the key to unsustainable asset price movements, where “unsustainable” indicates a movement than can only go on while interest rates remain unnaturally low.”
I might just be confused, but I don’t understand what this has to do with MM, as I was under the impression that the Fed wouldn’t need to micromanage interest if using NGDPLT.
2. October 2012 at 22:22
Most every contemporary account of ABC theory certainly is a bowlderizarion of Hayek’s far richer monetary/cycle theory — and often the bowlderizers claim that stuff contained in Hayek is non-Hayekian or something that must be added to Hayek. Eg Hayek’s endogenous money / credit mechanism, his account of the role of shadow money asset price and liquidity rises and crashes, Hayek’s account of changing perceptions of risk and optimism and pessimism, etc., Hayek’s account of the role of sticky wages and long term contracts, Hayek’s account of the post crash secondary depression and his supports of both fiscal and monetary policies to deal with that problem, etc.
“Hi Greg, I realize there are bowlderized views of Mises and Hayek out there, but I meant actual Austrian cycle theory, not cheap versions of it.”
2. October 2012 at 23:45
I’m in complete agreement with Adam, here. You’re saying ‘bubble’? Whoah. I say thee, WHOAH!! So, in that quote, George Selgin gives a nice, concise definition of what he means by ‘unsustainable asset price movements’ which I liked a lot. Do you agree with that concept? If you still believe in the EMH, either strong or weak, could you or someone explain how it permits the existence of bubbles?
3. October 2012 at 00:01
Bonnie:
NGDP targeting, provided it depends on the banking system to lend more when base money increases, necessarily affects interest rates, whether the Fed is intentionally targeting them or not.
Your comment reminds me of a comment Sumner once made, of denying that monetary inflation had anything to with the 1929 stock market bubble and collapse, on the basis that the Fed wasn’t tracking M2 or M3 at the time.
That comment in turn reminds me of omnipotent state theory.
3. October 2012 at 03:29
Scott:
I don’t think that a gold standard involves the central bank making open market operations with gold.
The impact of excess supplies of money on interest rates isn’t just about the impact of central bank pruchases of T-bills, but also the purchases of securities and loans made by the rest of the banking system.
The central bank might purchase copper with freshly printed currency, but in the real world, those selling the copper deposit the money in banks and then spend it. Whether the banks ship the currency about to clear checks, or deposit it in the central bank so that the checks are cleared by accounting balances is irrelevant.
If there is an excess supply of money, the banking system expands its credit–unless they hold 100 percent reserves on the margin.
Under a gold standard, if the quantity of money expanded due to gold deposits in the central bank (the central bank buying gold) then the same thing occurs.
Still, it is true that shifting to a higher growth path of nominal GDP (returning closer to the old trend) results in higher credit demand. If this is expected, it will raise credit demand now. And so, increases in the quantity of money and the suppyl of credit have ambiguous effects on current real interest rates.
But to explain what happened, comparing 5 percent to 6.5% is pointless. Did people expect to return to the trend? Did the expect that the output gap would close and the price level would rise from its current level at a 2% rate? A closing output gap and prices rising 2% from their current level implies more than 5% growth of nominal GDP (if potential is growing 3%.)
Of course, it would be possible for the output gap to close by having the price level drop to a lower growth path, and nominal GDP continue growing at 5 percent (or less.) The Austrians have priors that somehow, only the disinflationary path is consistent with monetary equilibrium.
3. October 2012 at 04:01
[…] Scott Sumner writes, not surprisingly, about NGDP. […]
3. October 2012 at 04:05
“But until I’m convinced that it’s a general theory that can explain other money-bubble linkages in other periods of history, I’m not willing to sign on.”
Scott, but it is a stylized fact that share-price bubbles are typically preceded by low interest rates. So perhaps it’s a necessary but not sufficient condition.
Also, this David Beckworth post may help you make your case: http://macromarketmusings.blogspot.dk/2012/09/is-fed-buying-up-all-treasury-debt.html
Bonnie, I know it’s hard to believe, but MF is actually right this time.
3. October 2012 at 04:07
An Open Market Operation (buying bonds) = a helicopter operation on money + a vacuum cleaner operation on bonds.
If George believes that an OMO increase in the money supply is very different from a helicopter increase in the money supply, then he must believe that a vacuum cleaner operation on bonds (a tax increase used to retire debt) has big effects, equal to that difference.
3. October 2012 at 04:16
Yes, because it changes financing costs, right? The question though is how big the effects are and how long they last. ISLM suggests to me that the LM portfolio rebalancing effect is very brief, nudging the incentive to start spending; after that the general excess-cash balance effect takes over. Then interest rates only stay lower because as income rises in the short run people save more, until prices adjust and the LM shifts back. Or, if the LM shift returns us to long-run equilibrium, then it equates money supply and demand at the rebalanced interest rate which is also the IS-equilibrium rate, so we are at the natural rate and the economy is fine.
3. October 2012 at 04:22
Gene C: Nice clear paper. The treatment of technology seems to be to suffer the same problem as in Garrison’s “Time and Money” in that the uncertainty effects of new technology seem to be somewhat glossed over. A nice discussion is here:
http://www.philadelphiafed.org/research-and-data/publications/business-review/2011/q4/brq411_theory-of-asset-price-booms-and-busts.pdf
Second, you can have bubbles without central banks.
Third, the moral hazard problems in global markets from the IMF, the Fed and other institutions should perhaps be emphasized even more than the paper does.
Fourth, strong expectations of capital gains can pull in credit. Australia has not had a recession (in the sense of two successive quarters of negative GDP growth) for 21 years. So, not much bust in our booms. But we sure have had housing price surges.
Our land rationing (i.e. regulatory constraining of supply of land permitted for housing) has created sustained surges in housing prices such as we now have the most expensive housing in the Anglosphere (apart from Hong Kong). A truly remarkable effort since we have roughly the population of Texas spread over the size of the continental US. (In fact, Texan houses are one half to one third the price of Australian metro housing — using the metric of ratio of median housing to median household income — despite Texas having higher per capita income, faster population growth and more of its population in its top 5 cities.)
In that time, the share of credit in Australia going into housing has gone from about a quarter to about 60% of total credit while business credit has gone from about two-thirds to about a third of total credit. Some of the heat has gone out of our housing markets in recent times, but they are still remarkably expensive. There is very little evidence of over-building; on the contrary, clearly the problem is under-building (as indicated, for example, by high rents and low vacancy rates).
The problem is the price surges that constrained supply creates which then set up expectations of capital gains which pull in credit. We have become a country highly leveraged on regulatory approval. While our public debt is relatively low, our overall levels of debt are comparable to other developed countries.
The Reserve Bank of Australia has managed expectations so expectations about spending have never collapsed, hence the lack of recessions. But the story here is not a credit expansion creating bubbles story; it is constrained supply creating price surges pulling in credit story. The comparison with Texas is telling, because it had the Fed’s monetary policy which your paper fingers but no housing bubble because its housing supply is not constrained.
Just as Germany had no housing bubble because its housing supply is not constrained either. Conversely, the UK and California did, because they both have highly-regulatory-constrained housing (land) supply.
I was left with much the same feeling I often get from “Austrian” analysis: a sense that theory is being used as a template to read the data rather than the data supporting the theory.
3. October 2012 at 04:56
@ Gene
There’s an intertemporal trade problem. Savings represent a demand for future consumption. Ideally, this is matched by investment creating future productivity, or trade with those who want present consumption and are willing to give up some future consumption. Too few people fell into the latter group (e.g. not enough young folks), and so there was an over/mal-investment bubble (in the real sense) which in the financial sense created excess valuation. As the flow of new investment money stopped (simultaneously with a drop in demand due to retirement/reduced boomer consumption), the bubble rapidly deflates.
We can theoretically challenge it, but Summers showed that demographics do a nice job predicting long term stock valuations.
I don’t doubt the sufficiency of NGDP in steady state, but what about when it’s predictably or not predictably shifting from steady state…
This is like asking the following counterfactual:
If the Fed had targeted NGDP for the last 20 years, would the stock bubble or housing bubble have happened (if, indeed, they were bubbles)?
Is there anything else the Fed could have done to prevent them?
If the answers are Yes to both questions, then NGDP is not a sufficient statistic.
3. October 2012 at 04:59
Two general questions for MM:
Where exactly do you think the assumption of Fed independence comes from?
What do you think is meant by allowing the market to clear?
3. October 2012 at 05:04
Greg, I responded at another post a few days ago. If you have an argument, let’s see it. So far you have presented numerous arguments that housing was important, and I’ve shot them all down. I’d love to see a persuasive one–where is it? And please don’t insult my intelligence by telling me that housing downturns preceded recessions.
Adam, I don’t believe in bubbles, I believe in “bubbles.”
Bill, I agree with much of what you say, but central banks most certainly did buy gold under the gold standard.
Saturos, You said;
“Scott, but it is a stylized fact that share-price bubbles are typically preceded by low interest rates. So perhaps it’s a necessary but not sufficient condition.”
I don’t believe that either the 1929 bubble or the 1987 bubble was preceded by low rates. Are you referring to real or nominal rates? And what do you consider low?
And BTW, MF is lying about what I said. The Austrians of the 1920s obviously weren’t defining”easy money” as a rise in M2, as no one was measuring or even talking about M2 at the time.
Nick, Yes, a much easier way to explain things. And the bond repurchases with taxes would be so tiny that it it obviously would have had almost no effect.
3. October 2012 at 05:10
Let me add, Woolsey is asking this question too:
I think that the problem is that the trajectory of nominal wages is too stable. It fails to fluctuate enough to clear labor markets, and so a monetary regime that requires lots of adjustments in nominal wages to clear labor markets is bad relative to one that requires fewer such changes.
3. October 2012 at 06:09
I think both Nick and Scott are too quick to dismiss the interest rate/relative price effects of OMOs, that is, are too quick to dismiss a venerable body of economic reasoning dating back to Cantillon, if not before. In so doing, they only continue an unfortunate tendency that has been common to all stripes of monetarism.
The likelihood of “Cantillon” effects isn’t merely a matter of how large Fed purchases of a particular asset are in comparison to the overall size of the market for that asset. Thinking otherwise is missing the point, which is that OMOs, whatever the nature of the assets involved, are a means for expanding the stock of bank reserves; and that (outside of a recession, and especially in the midst of a boom) such an expansion confronts banks with excess reserves that they will in turn seek to dispose of by pushing out more loans, and hence by reducing lending rates, including but not limited to overnight rates (which is why interest rate “targeting” is possible in normal times, regardless of whether or not such targeting is a good idea).
To suggest as Nick does that OMOs and helicopter money are equivalent is to beg the question concerning how central banks can ever influence interest rates, let alone meet interest rate targets, by means of such operations, or, alternatively, to beg the opposite question concerning how mere “helicopter” money could itself have any influence on interest rates in a world in which the usual long-run neutrality propositions are assumed to hold.
In short, I think there are two noxious extremes each equally worth avoiding. One is the habit of treating monetary policy solely as a matter of moving interest rates (and as being impotent in so far as it cannot influence such rates); the other is that of pretending that the interest rate effects of monetary policy are a mere “sideshow,” diverting attention from things that really count. The MM’s have done a good job combating the first of these noxious tendencies; alas, I fear they are inclined to go too far by embracing the other extreme view. The pendulum, I dare say, could now use some nudging back toward the perpendicular.
3. October 2012 at 06:59
Scott, when you are pointing out to an intelligent man with horse blinders & rose filtered glasses on that he has horse blinders & rose filtered glasses on you aren’t insulting his intelligence, you are makin him aware of contingent limits on his vision and imagination.
3. October 2012 at 07:00
So have you engaged Leamer or not?
3. October 2012 at 08:27
Lorenzo:
A trouble I have with Austrian explanations of bubbles is that they seem too “mechanical”. There has to be expectations about either increased income or increased capital gain or both for a bubble to get underway. Mere expansion of credit/money surely would not create such expectations about specific assets.
Expansion of credit doesn’t just get hoarded. When you intend to pay interest on the principle, you intend to spend the principle. That spending increased the prices of assets. Expectations cannot raise prices unless buyers actually have the money with which they use to purchase that which rises in price.
———————–
ssumner:
And BTW, MF is lying about what I said. The Austrians of the 1920s obviously weren’t defining “easy money” as a rise in M2, as no one was measuring or even talking about M2 at the time.
I wasn’t lying, and that is not what you said. You said:
“In January 1920 the base was $6.909 billion, and in December 1929 it was $6.978 billion. Thus it was basically flat, and this was during a period where the US population and GDP rose dramatically. The broader monetary aggregates rose significantly, but the government didn’t even keep data on M1 and M2 until fairly recently. No one in the 1920s thought the Fed should be targeting aggregates that didn’t even exist.”
and then
“I’ve shown there was no inflation as the term was defined at the time. I’ve shown that there was no alternative non-inflationary policy as understood by policymakers at the time, including those in the 1920s who claimed the Fed was too inflationary. It makes no sense to argue things were inflationary because M2 went up, if M2 didn’t exist. There are no policy implications. M2 was an idea invented much later.”
http://www.themoneyillusion.com/?p=12111
Sumner said aggregate money stocks cannot be responsible for any boom or bust if they aren’t being looked at by the Fed!
This is like saying the black death was not caused by any bacteria or virus, because doctors at the time had no idea what bacteria and viruses were.
Look at me being called a liar. Mistaken, possibly. Misled, possibly. Lying? That is a serious charge that presumes I am intentionally misrepresenting Sumner’s position for nefarious purposes.
3. October 2012 at 08:59
“We know that 6.5% NGDP growth would not, ceteris paribus, produce a housing bubble.”
And yet we had a housing bubble. 6.5% NGDP growth does not crate a bubble, but it permits one to arise.
The bubble begins with rational expectations that the net present value of future cashflows is greater than the cost. As the asset class begins to rise in value, people pile onto the momentum. i.e. the historic returns of this asset are better than my alternatives. Eventually, the greater fool theor dominates pricing — I know it is expensive, but I will be able to sell it to someone at an equally inflated price. This psycological cycle does not depend upon easy money. Easy money does not create a bubble. The bubble creates itself.
Easy money does add gas to the bubble. When the housing bubble was underway, I heard more than one “expert” suggest that if your mortgage rate was 5% and appreciaton was 6% how could you afford to not buy.
3. October 2012 at 09:01
George Selgin:
Excellent comment.
3. October 2012 at 10:22
Doug M:
The bubble begins with rational expectations that the net present value of future cashflows is greater than the cost. As the asset class begins to rise in value, people pile onto the momentum. i.e. the historic returns of this asset are better than my alternatives. Eventually, the greater fool theor dominates pricing “” I know it is expensive, but I will be able to sell it to someone at an equally inflated price. This psycological cycle does not depend upon easy money. Easy money does not create a bubble. The bubble creates itself.
The “pyschological cycle” depends on easy money, because if easy money were absent, then home buyers could not keep reselling to “the greater fool” later on in the cycle. Home prices kept rising because more and more funds become available to bid up house prices. Ask where those funds came from, and we are invariably left with easy money as the cause.
In a free market, if the relative demand for homes should ever rise, then this will be accompanied by a rise in relative profitability in housing and a relative decline in profitability in non-housing goods. This will be accompanied (or anticipated) by relatively more capital being invested in housing and relatively less capital being invested elsewhere (investors chase profits). This would be followed by a relative rise in the production of houses and a relative fall in the production of other things. This will then reduce home prices and increase non-house goods prices, until the relative profitability “restabilizes” (I hate trying to find the right word to describe this phenomena). Further investment in housing beyond this would start to incur losses, so the housing “boom” would in fact be just a readjustment of relative marginal utilities of housing and non-housing goods.
In order to keep the “boom” in housing going, it requires continual low interest rates and continual increase in funds made available for housing. Nobody can say exactly how much of the last housing boom was driven by real demand, and how much was driven by cheap and plentiful money. But the fact that home prices accelerated so quickly, which would otherwise require abstensions from consumption (increase in savings), the fact that there was no reduction in consumption either in the US or in countries that are blamed for generating a “savings glut”, the only explanation is more money and spending (inflation).
NGDP simply cannot communicate this phenomena because we don’t know what US NGDP should have really been in a free market. US NGDP may have fallen in a free market as Americans purchased more and more goods from abroad instead of domestically. If actual NGDP with central banking is stable, or gradually growing, then it could represent incredibly easy money, if US NGDP would have fallen due to market forces.
Imagine the fed printing whatever quantity of money is necessary to make the nominal demand for hoola hoops rise by 5% each year. Suppose market forces would have otherwise made the demand collapse from the 1970s to the 1990s, but because of the Fed, the demand rose at 5% each year the whole time. During this time, the Fed had to create huge quantities of new money to prevent the nominal demand for hoola hoops from falling. According to common sense, one would think that the Fed was extremely loose, easy, inflationary, etc, because the demand for hoola hoops WOULD have fallen in a free market. Yet according to tautological NGDP reasoning, we have to believe the Fed was neither tight nor loose, because “by definition” the Fed succeeded in raising the demand of hoola hoops by 5% each year, market forces be damned.
It is incredibly sloppy, crude, misleading, and fallacy ridden up the wazoo, to claim that stable NGDP necessarily implies no inflationary booms, as if the free market necessarily contains continuous rising spending no matter what market actor’s ctual preferences are and what their actions would actually be.
The same reason it is wrong to believe that the nominal demand for hoola hoops should continually rise at 5% per year forever by using inflation, is the same reason it is wrong to believe that the nominal demand for all goods in a country should continually rise at 5% per year forever by using inflation.
Just like a decline in the relative marginal utilities of hoola hoops and non-hoola hoop products should be accompanied by a relative decline in the nominal demand for hoola hoops, so too should a decline in the relative marginal utilities of US goods and non-US goods be accompanied by a relative decline in the nominal demand for US goods.
There is no good reason why the nominal demand for an arbitrary selection of goods has to rise at a constant rate over time, when market forces would have resulted in something else. Market forces are a good reason to reject NGDP targeting.
3. October 2012 at 10:30
Or, current US NGDP should change if there is a shift in the marginal utilities between present goods and future goods that takes the form of higher or lower cash balances relative to “spending”.
Cash holding is important and should not be held as a signal for the Fed to print more or less. It should be held as a signal to investors.
3. October 2012 at 11:08
MF,
I think you missed my point. Bubbles will always occur regardless of the monitary system.
Economies are Mandelbrotian, chaotic, subject to feedback loops, expiriences vicious and virtuous cycles, faddish behaviors. Whatever you choose to call it, bubbles will happen. All economies will have periods of instability, and no montiary system can change that. Now, you can argue that some systems are worse, less stable, than others, but you will never repeal the business cycle.
3. October 2012 at 11:35
Doug M:
I think you missed my point. Bubbles will always occur regardless of the monitary system.
I got that point, I just don’t think it’s right.
Economies are Mandelbrotian, chaotic, subject to feedback loops, expiriences vicious and virtuous cycles, faddish behaviors. Whatever you choose to call it, bubbles will happen.
You just defined economies as subject to business cycles.
All economies will have periods of instability, and no montiary system can change that. Now, you can argue that some systems are worse, less stable, than others, but you will never repeal the business cycle.
The business cycle arose with the onset of currency debauchery.
I think it is possible to eliminate the credit cycle the same way we have eliminated any electronics business cycle: by letting the market process take full control over production (of money).
It’s one thing to say markets are chaotic, faddish, and so on. It’s another to say this implies the business cycle.
3. October 2012 at 22:03
[…] responses by Marcus Nunes, Bill Woolsey and Scott Sumner to Selgin, questioning whether he used an appropriate benchmark against which to gauge nominal GDP […]
4. October 2012 at 02:00
I am surprised by Scott’s statement that the asset does not matter.
I agree with George Selgin that Cantillon effects matter.
My understanding of the market monetarist prescription was to start purchasing from safest asset (most money like) onward to the riskier and riskier assets.
Govt short term bonds > Govt long term bonds > Commercial Short term bonds > Commercial long term bonds > Dividend paying stocks and so on..
I agree that safest to riskiest is the correct progression.
My concern is that this requires a clear disclosure in advance of the assets which would be purchased, once we have left the area of government securities. If there is such a disclosure, it is possible that this list could be gamed.
4. October 2012 at 05:57
George, I have trouble seeing the connection between money and loans. Even if there is a helicopter drop of $100 bills, at least 90% of the money picked up with be immediately deposited in the banks. Then the banks will immediately buy T-securites (if interest rates are positive.) Then the hot potato effect starts, and every nominal variable gradually rises. That includes nominal prices, nominal wages and nominal bank loans. There might be an impact on real bank loans if there are cyclical effects, but I don’t see more bank loans occuring just because banks are temporarily holding more reserves than they prefer. Unless one defines “bank loans” to include the purchase of securities. But in any case, that extra lending would be equally likely to occur with a helicopter drop.
I still think Nick’s right. If you break up an OMP into two separate actions, neither are likely to signficantly affect interest rates. I’m also puzzled by your suggestion that it’s hard to explain why monetary policy can impact interest rates without “Cantillon effects”. All you need for a liquidity effect is sticky prices, regardless of how the money is injected.
Greg, For the last time, I published an article a few months back criticizing Leamer.
5. October 2012 at 06:48
It seems to me that money can affect short-term interest rates for two reasons. One, because the central bank buys short-term debt and therefore bids up its price directly. And two, because money is a substitute for short-term debt. Bank loans are a substitute for t-bills, so the transmission mechanism does not have to run through t-bills. It seems reasonable that, assuming that the central bank is trying to influence short-term interest rates, it should deal in short-term debt, which is why, pre-crisis, central banks that had reformed their money market operations, like the BoE or the ECB operated mainly in the repo markets.
I don’t believe that low interest rates CAUSED the boom, which I think was triggered by financial innovation (ie rightly or wrongly, CDOs were believed to allocate risk more efficiently and make mortgage finance more available), but monetary policy might have put a spanner in the works, by giving participants pause for thought about how “one-way” asset prices might be. The question that should have been asked was “can we raise interest rates without driving inflation below target”, but such questions are taboo for politicised central bankers in junkie economies like the US and UK. I would put it “the ABSENCE of interest rate increases ALLOWED the bubble to develop”.
5. October 2012 at 10:25
I’d like to read the Leamer paper & need to know where to find it.
4. April 2013 at 18:30
[…] Some commenters (such as Bob Murphy) seem to think I believe that nominal interest rates are a good indicator of the stance of monetary policy. That’s probably because I often quote Friedman saying that ultra-low nominal rates are a sign that money has been tight. I still believe that, but Friedman didn’t think rates were was a reliable indicator of the current stance of monetary policy, and neither do I. Here’s what I wrote last year: […]
5. April 2013 at 05:20
[…] Some commenters (such as Bob Murphy) seem to think I believe that nominal interest rates are a good indicator of the stance of monetary policy. That’s probably because I often quote Friedman saying that ultra-low nominal rates are a sign that money has been tight. I still believe that, but Friedman didn’t think rates were was a reliable indicator of the current stance of monetary policy, and neither do I. Here’s what I wrote last yea… […]