When Ronald Reagan was President and Paul Volcker was chairman of the Federal Reserve, monetary policy generated nominal GDP growth at a 9 percent annual rate for 1983 and 1984. The growth rates for total spending on output for those eight quarters were:
The increase in money expenditures on final goods and services for those two years was nearly 20 percent. By the end of the Reagan administration, the new Chairman of the Federal Reserve, Alan Greenspan, had started the U.S. on the 5.3% growth path of nominal GDP that characterized the Great Moderation.
Suppose that President Obama Chairman Bernanke would make a similar commitment for monetary policy, to raise nominal GDP 19 percent over two years, an annual growth rate of 9 percent, and then a 5 percent growth path thereafter. The key element of the policy would be a target for nominal GDP of $17,912 billion for the second quarter of 2013, and then $18,136 billion for the third quarter, and so on, increasing at an annual rate of 5 percent each quarter.
The level of nominal GDP from 1983 to 2011 is shown in blue. The trend growth path of the Great Moderation, from the first quarter of 1983 to the fourth quarter of 2007, is shown in red. The trend growth path of the "recovery" since 2009 is shown in brown. And the proposed "Reaganite" growth path is shown in green.
The trend growth rate of nominal GDP for the recovery has been 4.3 percent. The new growth path increases 19.3 percent, which leaves it 6.4 percent below the trend of the Great Moderation. The new growth path has a 5 percent growth rate, slightly less than the trend growth rate of the Great Moderation, which was 5.4 percent.
What would be the potential benefits? What would be the risks?
The most important potential benefit would be to generate the sort of "V shaped" recovery in real output and employment that was generated in 1983 and 1984 by Reagan and Paul Volcker. The production of goods and services grew at a 6 percent annual rate for those two years, rising more than 12 percent.
The gap between real GDP and potential real GDP (actual production and the estimated productive capacity of the economy,) went from 7 below potential to 1 percent below potential. With the U.S. economy today producing 6.8 percent below potential, a "Reaganite" monetary policy looks to be exactly what is needed.
What is the risk? The risk is inflation.
With nominal GDP targeting, the expected value of the price level is the target for nominal GDP divided by expected potential output. The current value of nominal GDP, $15,013 billion, divided by the CBO estimate for potential output, $14,246 billion, implies a value of the price level (GDP deflator) of 105.4. That is nearly 7 percent below the current price level of 113.
To a large degree, the "inflation" generated by a monetary policy that raises the target for nominal GDP would be an increase in this "equilibrium" price level rather than the actual price level. For the most part, the aim is to generate a rapid recovery without the need for rapid deflation.
Unfortunately, a level of nominal GDP of $17,912 billion in the second quarter of 2013, when divided by the projected value of potential out for that quarter, $14,756 billion, implies a price level of 121.4. That is approximately 7.3 percent higher than the current price level.
The Fed's target for inflation appears to be approximately 2 percent a year, and if the Fed hit that target exactly for the next two years, the price level would be 117. The "Reaganite" monetary policy should result in a price level that is 3.6 percent higher that that growth path. While the current price level is about 1.8 percent below the trend of the Great Moderation, shifting to the "Reaganite" monetary policy would push the price level approximately 1 percent above the trend price level of the Great Moderation.
In the diagram below, the price level, measured by the GDP chain-type index, is shown in blue. The trend for the Great Moderation, from first quarter 1983 to fourth quarter 2007, is shown in red. A 2 percent inflation rate starting from the price level in the second quarter of 2011 is shown in brown. The price level expected from the "Reaganite" monetary policy, found by dividing the target for nominal GDP by the CBO estimate of potential output, is shown in green.
Shifting to the new growth path for the price level over two years would require an inflation rate of 3.6% per year. After the new 5 percent growth path for nominal GDP is reached, however, the inflation rate would return to a more modest 2.5 percent.
While 3.6 percent inflation is substantially higher than the Fed's 2% inflation target or the 2.3 percent inflation trend of the Great Moderation, during the period of "Reaganite" monetary policy, between 1983 and 1984, the inflation rate was also substantially higher than during the Great Moderation as well:
Over the two year period, the price level went up approximately 6 percent, an annual inflation rate of slightly more than 3%. Why would a similar policy have a somewhat more inflationary impact today?
Sadly, there has been a substantial productivity slow down during the last few years. During the Great Moderation, the productive capacity of the economy and real output both grew at approximately 3 percent per year. According to the CBO estimates, the growth rate of potential output has been much slower over the last five years
In the diagram below, real GDP is represented in blue. That is the production of goods and services, corrected for inflation. Potential output, the productive capacity of the economy as measured by CBO, is shown in black. The trend growth of both real GDP and potential during the Great Moderation is shown in red.
That the production of goods and services is currently well below the productive capacity of the economy is clear on the diagram, however, it is only slightly more than half of the shortfall of output from trend. According to the CBO, slower growth in productive capacity is also responsible for nearly half. Projecting those trends into the future, by 2020, potential output is forecast to be nearly 10% below the trend of the Great Moderation!
With nominal GDP targeting, if potential output rises less than trend, the growth path for the price level shifts up. If nominal GDP had stayed on the growth path of the Great Moderation, and potential GDP growth had slowed as estimated by the CBO, the price level (found by dividing the trend value of nominal GDP by potential output) would have been much higher.
In the diagram below, P* is the price level found by taking the trend growth path of nominal GDP from the Great Moderation and dividing by the CBO estimate of potential output. It is substantially higher than the trend growth path for the price level shown in red or the "Reaganite" alternative shown in green.
In the second quarter of 2011, the trend growth path of nominal GDP from the Great Moderation divided by the CBO estimate of potential output is 122.2. That is more than 8 percent above the current price level and 6 percent above the trend price level of the Great Moderation.
The expected price level from the proposed "Reaganite" policy in the second quarter of 2013 would be 6.4 percent below the price level that would have existed if nominal GDP had remained on the growth path of the Great Moderation. In the diagram below, the trend growth rate of real GDP and potential GDP from the Great Moderation is shown in red. The growth rate of real GDP is shown in blue. And the growth rate of potential GDP according to the CBO is shown in black.
With nominal GDP targeting, the persistently slow growth of potential output results in higher inflation rates. These are shown below. The inflation rate implied by the growth path of nominal GDP from the Great Moderation and the CBO estimate of potential output is show in black.
Notice that in the diagram above, the inflation rates generated by the "Reaganite policy" are not much higher than what would have occurred if nominal GDP had remained on the trend of the Great Moderation. Slow growth in the productive capacity of the economy would have resulted in inflation rates well above 3 percent.
Recently, Chairman Bernanke has said that monetary policy is no panacea. Given the performance of nominal GDP over the past few years, and particularly that it is nearly 14 percent below the trend of the Great Moderation, Bernanke's statement deserves the criticism it has received, particularly from Market Monetarists. Monetary policy can and should fix problems due to inadequate money expenditures on output.
However, monetary policy is no panacea for slow growth in productive capacity. What Bernanke needs to recognize is that slow productivity growth is not a reason to lower the growth path of money expenditures on output. Real output will grow more slowly, and inflation will rise. That a "Reaganite" monetary policy will sadly result in higher inflation when there is a productivity slowdown should be expected.
And that suggests are role for "Reaganite" fiscal and regulatory policy. Tax reform, control of government spending, and sensible deregulation can all help reverse the productivity slowdown. And that can result in both greater growth in real output and lower inflation.
Once the economy has recovered, and productivity growth has improved, it will be time to shift from the 5 percent growth path for nominal GDP to a 3 percent growth path. This would keep the price level stable on average, fulfilling Reagan's legecy and ushering in truly noninflationary prosperity.
It is time for the Republicans in Congress and the Presidential candidates to demand that Obama and Bernanke adopt a "Reaganite" monetary policy now. Step one--nominal GDP at $17.9 trillion for the second quarter of 2013.