Sticky Trajectory for Wage Inflation

Simple microeconomics suggests that price falls in response to a surplus.   In labor markets, the price of labor, the wage, should drop in response to a surplus of labor.  

The Market Monetarist explanation of the Great Recession is that nominal GDP fell to a much lower growth path while the price level fell to only a slightly lower growth path.   This resulted in a large down shift in real expenditure on output, to which firms responded by shifting their production to a much lower growth path.   Since this lower growth path of production required less labor, they reduced employment as well.

Market Monetarists don't deny that "supply-side" factors might have reduced potential output a bit, or that workers may have decided they don't want to work quite so much.   But as a matter of fact, we think these were not very significant.   And so, it would seem that on a micro level, the typical market should be in surplus.    

Of course, spending on output began to grow in 2009, as did production and employment.   These factors would tend to reduce the surpluses, but a growing eligible population and rising productivity are tending to increase the surpluses.   In fact, the typical Market Monetarist interpretation is that the growth in production and employment is at best just keeping up with growing capacity.   The underlying surplus remains little changed.

But how is that consistent with basic microeconomics?   If that is true, prices and wages should have both decreased enough so that real expenditure would rise enough to match the productive capacity of the economy.   The surpluses should close through lower prices.  Lower product prices for product markets and lower wages for labor markets.     If nominal GDP is actually kept along the new lower growth path (rather than allowed to drop further,) the decrease in output prices raises real expenditures and so real sales.   The lower wages allow costs to fall enough so that this doesn't generate losses for the firms.     The firms expand production and employment to match the increase in real sales.

Now, let's suppose that firms refuse to actually cut wages.   Wages are sticky, or even rigid, in a downward direction.   Then, the surpluses of labor should result in wages remaining constant.   Prices might fall a bit, but since wages won't fall, firms cut production and employment along with the rising real wages.   Once spending begins to rise, prices should rise along with production and employment.  

Of course, what happened since 2008 is that wages have continued to rise though the rate of increase has decreased.    And while there was one quarter's worth of actual deflation in output prices, generally prices have continued to rise, again, at a slightly lower rate.   Both price and wages are on slightly lower growth paths.  

And so, if the Market Monetarist approach is correct, prices and wages have both continued to increase despite surpluses of output and labor.    Market Monetarists (or most of them) realize that we need to do more than explain that wages won't fall, but rather why the trajectory of wages and prices is sticky.   Why do prices and wages continue to increase in the face of surpluses of output and labor?

In my view, the problem is fundamentally one of "insiders" and "outsiders."    Long run success for a firm depends on having a reputation for being a good employer.   Such a reputation requires that current workers be protected whenever possible.    Managers should be servant leaders, promoting the good of their team.

No existing firm, however, need take responsibility for new entrants into the labor force.  And so, problems develop.

Suppose that population is increasing one percent a year, and the typical career lasts 50 years.   In equilibrium, each year 2 percent of the labor force retires and new hires are 3 percent of the labor force.    Spending on output is growing 5 percent, with employment growing one percent, productivity growing 2 percent, and inflation is 2 percent.      Employers provide compensation plans that provide a cost of living raise and rewards for productivity, so wages increase 4 percent per year.

Spending on output drops to a 15 percent lower growth path.   Employers, seeking to protect their reputations, keep their compensation program unchanged, raising wages 4 percent.   To keep up with rising costs, they continue to raise prices 2 percent.   With productivity rising 2 percent, they can pay 4 percent more and have unit costs rise 2 percent.    

With the significant drop in spending on output and continued price and wage increases, the real volume of sales drop significantly.   The firms don't lay off their employees, since that would hurt their reputation as well.   But they quit hiring new workers.    As workers retire, total employment shrinks by attrition, 2 percent a year.   After 4 years, this would cause employment to fall approximately 8 percent.   The gap between employment and the trend of employment would be approximately 12 percent.

Of course, not all firms can protect all of their employees.    With a severe and rapid drop in sales, some firms may have to restrict or even stop pay increases or layoff employees.   A sharp increase in separations should be expected when spending on output is absolutely dropping.   And perhaps some prices might fall and the rate of increase in prices and wages might slow a bit.   But after biting that bullet, the firms will want to stop laying off employees and return to raising the pay of existing employees according to compensation programs aimed at maintaining their long run reputation as a good employer.

Of course, under normal conditions, many firms fail and lay off employees.   Existing firms that are doing well and new firms expand employment.   For the economy as a whole, if there are few new firms and the relatively successful firms are not doing very well, and so don't expand employment, the drop off in total employment can be very rapid.   Some firms just have a pause in new hiring.   Other firms that would have been successful and hiring, just replace the employees that leave.   And some firms are only replacing some of the employees that leave, and still others are cutting back total employment as fast as possible without actually laying off employees.     With the sort of massive turnover normal in the U.S. economy, rapid decreases in total employment are possible by just limiting new hires.

With the drop off in new hires, there are plenty of workers who would like to have jobs.    Many economists emphasize that it may take some time for these workers to recognize that they cannot find jobs with wages consistent with the previous trend in wages.   Only gradually will they reduce their reservation wages.    But after many years, surely they will accept lower wages.

Of course, labor markets hardly ever involve employees posting offer prices, and then firms choosing to take them.   It is rather that employers offer employment.    And while successful economists may focus on the negotiating process they have experienced, for many new entrants to the labor force, employment is more of a take or leave it "bid" by the employer.     This would surely be true in a buyers' market where total employment is contracting, or at least, growing much more slowly that the number of new entrants into the labor force.

No, what is supposed to happen is that the entrepreneurs in charge of the firms will  change their compensation programs, paying new employees less.   The firms are supposed to recognize that there is a buyers' market and that the unemployed workers have a lower reservation wage.   While this only slightly lowers average wage statistics and average costs, it does reduce marginal costs.   The firms should expand production and employment.

And, sure enough, wages and prices are rising a bit more slowly, and production and employment are growing.    Suppose that spending on output begins growing 5 percent (remaining on a 15 percent lower growth path.)    Firms adjust their compensation packages and start new employees at lower wages, and so inflation is only  1.5 percent.   Real output grows 3.5 percent rather than 3 percent.   How long does it take to recover from a 13 percent shortfall in real GDP?   Decades?

What is wrong?   It is the next step.    Suppose unemployed workers and employees all provided offer prices for their labor, and employers just took it.   The unemployed workers reduce their offer prices, and the employers take them, and some of the existing employees become the unemployed workers unless they also lower their offer prices.    Of course, labor markets work nothing like this.

Now, suppose instead that when employers realize that they can hire new employees at a lower wage, they go to existing employees and explain that they can be replaced at a lower wage.   They also point out to the employees that if they quit, it is difficult to find new jobs, and so they really have no choice but to just take the pay cut.   By taking advantage of their workers, they cut wages and costs rapidly.    Rather than small decreases in marginal costs, there are large decreases in marginal costs.   If firms are competitive, output prices fall.   If nominal GDP is kept on the new (lower) growth path rather than drops further, then real expenditures rise.   Firms expand production and employment.   Both wages and prices fall to the new, much lower growth path that is necessary for real expenditure to rise back to potential output.

So, why don't firms "take advantage" of their existing employees?   Why don't they force pay cuts on them?   There is a surplus of labor.    Their workers have no choice but t0 accept the pay cuts.   Why?  It is because they don't want to have a reputation of taking advantage of their employees.    

Now, if this situation was expected to be permanent, then perhaps the absolute pay cuts would occur.   But even in this scenario, where it is only new hires that take the pay cuts, a firm can maintain its reputation for protecting all existing employees and eventually the economy returns to full employment.   The situation is not permanent.

Even more so, if there is an expectation that spending on output will grow more quickly, generating a recovery more quickly, then any firm that took advantage of existing employees would have a difficult time recruiting good workers, or would have to pay workers more during "normal" times, and suffer a competitive disadvantage.  

More interestingly, if enough firms cut wages and lowered prices, then the other firms could explain to their employees that they have no choice but to do the same.   If all firms cut wages and prices when nominal GDP was low, then no firm suffers a competitive disadvantage during normal times.   (Perhaps all employers would be considered greedy and wicked.)   But if a few firms follow the policy of taking advantage of their employees, they might have fleetingly lower costs and increased profits during the recession, but they would suffer during "normal" times.

For Market Monetarists, the answer is easy.   Don't allow nominal GDP to fall to a lower growth path, and if it does, get it back up to the target growth path as soon as possible.  Allow firms to develop their compensation programs based upon an expectation that spending on output will grow at a slow, steady rate and then fulfill the expectation.

Output and Employment? What Puzzle?

Nominal GDP passed it previous 2008 peak long ago.   It is nearly 8 percent above that peak.   Real GDP has also passed its 2008 peak, having risen nearly 2 percent!   On the other hand, employment has not reached its previous peak.   It is still 2.76 percent below that peak.

The "problem" is that productivity has increased.   The recovery in output has been generated without there being a matching increase in employment.

Right?

During the Great Moderation, real GDP increased by 110 percent and employment only increased 37 percent.      Thank goodness that real GDP rose more than employment, resulting in real GDP per worker rising 53 percent.

Real GDP is 13 percent below trend and employment is 9 percent below trend.   For both to return to trend, real GDP would need to grow more than employment.   In fact, real GDP would need to grow nearly 18 percent and employment about 11 percent.

NGDP and Wages

Nominal GDP divided by the wage rate (multiplied by 2000 to get an annual wage,) is approximately 13 percent below the trend of the Great Moderation.   (Since the GDP deflator and hourly production and nonsupervisory wages are both between 2 and 3 percent below trend, it should be no surprise that this ratio is below trend almost exactly how much real GDP is below trend.)

If nominal wages had remained at $18 as they were when nominal GDP peaked in 2008, the ratio would have increased by 8 percent.   Which is, of course, exactly how much nominal GDP has risen over its previous peak.   The ratio of nominal GDP to wages would still be about 5 percent below its trend growth path.

Market Monetarist Diagrams

The traditional Market Monetarist three:

Nominal GDP:

Real GDP:

Employment:

Keep on telling yourself that this just means that people decided they didn't feel like working as much starting in 2008, so production fell, and so did spending on output.

And what about prices and wages?

and wages:

And now for some new diagrams.   Nominal GDP divided by wages (hourly x 2000)

And since there is this odd notion that a sudden increase in productivity has caused lower employment, here is real GDP per worker:

This last diagram looks more consistent with the view that potential output has fallen a bit  rather than the notion that we are so much more productive that we don't need as many workers.   (Which I think is pretty much inconsistent with fundamental economic principles like scarcity and opportunity cost and instead entirely consistent with naive noneconomists views about the fundamental scarcity of jobs.)

Manufacturing NGDP?

Tyler Cowen argued :

My worry is that some Market Monetarists speak of ngdp as if it is some block of stuff, handed down from on high (of course in the past our central banks have not been targeting ngdp). It’s as if ngdp determines the size of the room, and a carpenter is then asked to build a house within that room. If the room is too small, a large house cannot be built. Or, if you are not given enough clay, you cannot build a very large sculpture. Along these lines, if the growth path of ngdp is not robust enough, the economy cannot do well.
I get nervous at how ngdp lumps together real and nominal in one variable, and I get nervous at how the passive voice is applied to ngdp.

Interesting, but not quite correct.   Market Monetarists recognize that a "bigger house" can be built in the room.  But rather it requires that it have a lower price.   As for the passive voice, the Market Monetarist approach is that people sometimes choose to increase their money holdings beyond the the amount by which the Fed and the private sector choose to increase the quantity of money.  Some of the people can and do increase their money holdings (as David Beckworth is fond of showing with charts showing a large increase in actual holdings of safe assets,) but it had the side effect of reducing spending on output.   Other people, whose incomes are lower because of this (and really, for many, this is relative to what they would have earned, rather than what they were earning while in high school or college four years ago,) are holding less money than they would.

What is passive about that?   People choose to accumulate money holdings and continue to hold high money balances.   And this has consequences for the stream of spending on output.

Cowen continues:

My framing is different. My framing is that the private sector can manufacture its own ngdp. It can do so by trade and it can do so by credit and of course velocity is endogenous to the available gains from trade. Most of the major central banks are, today, not obsessed with snuffing out recovery and increases in real output.
To say “ngdp is low,” or “ngdp is on a low growth path,” or “ngdp is below trend,” and so on — be very careful! Those claims do not necessarily have causal force. Arguably they are simply repeating, in a new and somewhat different language, the point that the private sector has not seen fit to engage in more trade, credit creation, velocity acceleration, and so on. Formally speaking, the claims are not wrong, but I don’t find them useful as an explanation for why economic growth or recovery, at some point in time, is slow. It is one way of repeating or re-expressing the slowness of economic growth, albeit with some transforms applied to the vocabulary of variables.

At first pass, from a Market Monetarist perspective, the way the private sector can increase nominal GDP--spending more on output--is by reducing the demand to hold money.   Hold less money and spend it.    Cowen's argument appears to be that people want to hold money rather than spend it.   Low nominal GDP is just another way of saying that people don't have anything they want to spend money on.     If they had something worth spending their money on, they would do it, and nominal GDP would rise.

From the Market Monetarist perspective, most of those who want to spend are those who are currently unemployed.   They would like to contribute to production, earn income, and then use that income to purchase the products they are going to help produce.    The problem would be that if all of those people did work, earn, and buy products, they would also want to hold more money.   This would increase the demand to hold money beyond the amount that exists.

Note, however, that implicit in this Market Monetarist argument is the notion that the demand to hold money is positively related to real income.    If the unemployed people start working, they will produce more, earn more, and buy more output, but they will hold more money.

The other side of that coin is that when real income falls, the demand to hold money falls as well.    This generates what I call the "Yeager effect."    If we imagine that people just decide to transact less, and so produce less output, then this reduces the demand to hold money.   If the quantity of money doesn't fall, the excess money is spent, raising demand for output back up its initial value.   If people really want to produce less, the result in inflationary.   At the higher price level, the real quantity of money falls, to match the lower demand.

Yeager used this argument to explain why real coordination failures don't result in lower real output and employment.   If we imagine that people really want to work and consume, but somehow, a coordination failure keeps them from doing that, then real output falls, the real demand for money falls, and given the quantity of money, an excess supply of money is generated, which raises the demand for output and labor.  In other words, versions of the "multiplier" where lower income generates lower consumption and so lower income, have no force.

Of course, if the demand to hold money rises or the quantity of money falls, then spending on output falls, and unless prices and wages fall enough so that real expenditures are maintained, then output and employment fall.   In particular, if people don't want to spend, and instead choose to accumulate larger money balances, that is an increase in the demand to hold money.   Unless the quantity of money rises to match that increase in demand, then spending on output falls.

But suppose that the demand for money is not related to real income.   If people choose to transact less, produce less, work less, then they earn less and spend less.   There is less "nominal GDP."     While real output is lower, this does not reduce the real demand to hold money.    There is no excess supply of money, and so no tendency for demand for output to be maintained.   In this particular scenario, this seems quite desirable.   And, if people chose to work more, produce more, and spend more, then spending on output would rise.   The higher real output would not raise the demand to hold money, and so, even without an increase in the quantity of money, spending on output and real output would rise.

However, we don't live in such a world.   All evidence suggests that the demand to hold money is positively related to real income--maybe not quite proportional--but close.

And more importantly, when people choose to hold money rather than spend, even if they have nothing they want to buy, this isn't the same thing as choosing not to produce and sell.    Nominal GDP level targeting works very well to solve the problem of  people choosing to work and not spend.   It solves the problem of an excess demand for money.

Suppose some individual is willing to work, produce and sell, not because they have some product they want to buy now, but rather because some good or service might appear in the future that they will want to buy.  This is called saving.    Usually, this is beneficial to others.   There are people who are willing to pay in order to dissave, as well as people who want to invest--use resources to be able to produce consumer goods in the future.    But if saving supply increases enough, the price that coordinates saving and investment could turn negative.   That means that producing now and waiting to consume in the future is not beneficial to the rest of society.    People might want to save, but they would have to compensate others to use their products now in exchange for being willing to provide consumer goods in the future that the savers just might want to buy.

But with "money" having a zero nominal interest rate, people can always save by accumulating money.   The nominal interest rate can be no lower than the cost of storing currency.     When nominal interest rates are very low, issuing currency is not profitable, and so excess demands for money can develop.   But now, people working, producing, but not spending not only are not creating a benefit for others on the margin, they are causing harm.   Others sell less, produce less, earn less, and so, are willing to hold less money, freeing up money balances for those who want to work and earn now and only maybe consume in the future.

Nominal GDP targeting solves this problem with a monetary regime that creates enough money to accommodate the added demand to hold money so that spending on output continues to grow at a slow steady pace.     (Well, it could also work to reduce the demand to hold money by generating a lower nominal and real yield on money balances.)

Generally, this implies that people who want to continue working and producing and have nothing they want to buy must be matched by firms and households that want to spend on output now.   However, the lower interest rates, perhaps even to negative levels, might convince people who can think of no output they want to buy to choose to work less.

And that is a disadvantage of nominal GDP targeting.   Not that negative real or nominal interest rates might cause people to work less.   It is rather that if people choose to work less, produce less, and spend less for any reason, then nominal GDP targeting causes undesirable disruption.    Like a fixed quantity of money or a gold standard, it results in inflation--both higher nominal incomes for those who continue to work as well as higher prices of products.  

Imagine we lived in a world where most people are self-sufficient.    They produce goods and then consume the goods themselves.    They produce all of their routine consumer goods and services themselves.   But from time to time, they make exchanges of luxuries.   A painting is exchanged for a song.   A short story is exchanged for a sculpture.  

Suppose we use a "song" standard, and calculate the "song" value of these barter exchanges.   Nominal GDP can be calculated as the sum of the "song" values of each barter of artwork.   Why forces these exchanges into a "room?"   Why not just let exchanges happen when people want to make them?   Why not let "nominal GDP" fluctuate according to desired exchanges?

But we don't live in that world.   We live in a market economic system where most people mostly sell goods for money and then use the money to buy the goods and services they need to live--to pay the bills.   Nominal GDP targeting is not perfection.   At least, I don't think of it that way.    It is the least bad monetary regime for the market economic systems that really exist.

Eli Dourado Replies to his Critics

Eli Dourado wrote some more about QE3.

The problem is that even if this story is true, we are probably, again, out of the short run. NGDP is almost 10 percent higher now than it was at the pre-crash peak. The number of people employed, even with population growth, is still below the pre-crash peak. Even assuming that insider nominal wages are totally inflexible, nominal output per worker has grown fast enough that insider real wages have probably adjusted. Furthermore, in five years, a non-trivial fraction of insiders retire or change jobs.

This inspired me to review the numbers again--calculate how far nominal GDP, real GDP, the price level (GDP deflator) and wages (production and nonsupervisory hourly,) are from the trends of the Great Moderation.    I also took a look at the changes from the previous peak.

For example, nominal GDP is $15.6 trillion.    It peaked in the second quarter of 2008 at $14.4 trillion.   Nominal GDP is 8.14 percent above its previous peak.  (I guess that is close to 10 percent, and nominal GDP is 9.19 percent greater than it was in the fourth quarter of 2007, when employment peaked and the recession officially began.)

Of course, most Market Monetarists don't focus much on where nominal GDP is now compared to the peak.   It is currently 15.2 percent below the growth path of the Great Moderation.   It would have to grow approximately 23 percent to get back to that the old trend in one year.

What about the price level?   Using the GDP deflator, the price level is now 115.   When nominal GDP peaked in 2008, it was 108.   The price level has increased 6.5 percent.    The price level has increased less than nominal GDP.  

The price level  is currently 2.4 percent below its trend growth path from the Great Moderation and would need to grow 4.27 percent to return to that trend in one year.

Real GDP is $13,546 billion.   When nominal GDP peaked in 2008, real GDP was $13,300 billion.   Real GDP has increased by 1.76 percent over the last 4 years.  Not much.

Suppose the price level is sticky, even stuck, downward, but had stopped rising when it was 108 back in 2008.  The current nominal GDP would be consistent with real expenditures and real GDP of  $14,400 billion.   If real GDP had increased to that amount, it would have risen approximately 8 percent.   That seems like quite a bit,  but it would still leave it well below trend.

Real GDP is currently 13 percent below the trend of the Great Moderation.   If it had increased 8 percent over the last 4 years, it would still be 7.61 percent below trend.   Absolutely no price increases would have fixed only slightly half of the problem after four years.   For real GDP to return to its trend for the Great Moderation, it would need to grow 17.75 percent.

What about wages?    When nominal GDP peaked in 2008, the hourly production and nonsupervisory wage was $18.   It is now $19.72.   It has increased 9.5 percent--even more than prices.   However, wages are now 2.5 percent below the trend of the Great Moderation, about the same as the GDP price deflator.   For wages to return to the trend over the next year, the increase would need to be a little more than 5 percent.

Employment?  When nominal GDP peaked in 2008, employment was 146 million.   It is now 142 million.   It  is 2.5 percent lower.  

That is pretty bad, of course,   But for most Market Monetarists, the problem isn't that it hasn't reached its previous peak (which was six months before nominal GDP peaked, though not significantly higher,) the problem is the shortfall from trend.  Employment is 9.25 percent below the growth path of the Great Moderation.   It would need to grow more than 11 percent to return to trend in a year.

Most Market Monetarists are struck by these figures--nominal GDP is 15 percent below trend, while prices and wages are about 2.5 percent below trend.   Real GDP is 13 percent below trend and employment is 9.5 percent below trend.

Given these large numbers, is comparing the current level of nominal GDP to its previous peak, and similarly for real GDP and employment, noting that real GDP has passed its previous peak by less than 2 percent while employment is 2.5 percent short--that important?  These are much smaller numbers.  Sure, it is a puzzle, but 2 and 2.5 is nothing close to 15, 13 and 9.

I calculated the ratio of nominal GDP to nominal wages.   I multiplied the hourly wage by 2000 to get an annual full time equivalent.    This ratio is 1.31 percent lower than it was when nominal GDP peaked in 2008.  The ratio is about 13 percent below trend.  

I also looked at the ratio of real GDP to employment.    That measure of productivity has increased by 4.4 percent since nominal GDP peaked in 2008.   Interestingly, it is  4.2 percent below its growth path from the Great Moderation.    To return to trend, it would need to grow 5.8 percent over the next year.

Like other Market Monetarists, I admit that it possible that potential output has fallen to a lower growth path and is now 13 percent below the trend of the Great Moderation.   The 2.5 decrease in prices and wages could have been sufficient to limit the decrease in real expenditures to the reduction in potential output.

It could be.   But I doubt it.

Sumnerian Secession!

Monetary policy in the NGDP Empire is dominated by the Island of Speculativa.   They have decided that the price of gold should grow 2 percent a year.   This results in the index number rising 2 percent per year.   They have an inflation target!

Meanwhile, over in Autarkia, the farmers are generally increasing their productivity.   Corn production is rising.   But when the weather is bad, corn production can grow more slowly or even fall.   Further, the substitution effect is greater than the income effect, so when the weather forecast is bad, the farmers plant less corn.   Employment is lower and so the production of corn is extra low when the forecast is right and weather is bad as was expected.

With the price of gold and so the price index going up 2 percent a year, when employment is low and the production of corn is extra low, nominal GDP grows more slowly and sometimes shrinks.   It almost appears as if slow growth of nominal GDP or decreases in nominal GDP are causing reduced production and employment.

Of course, nominal GDP is just the product of two unrelated things, and so, causes nothing.   Weather and expectations of the weather are causing decreases in employment and real output.

But suppose the Sumneran Party becomes influential in Autarkia and proposes that the quantity of money be expanded so that the price of gold rises more than the magic 2 percent.   The idea is that if index number rises faster, then nominal GDP rises faster.   They have a confused notion that the more rapid increase in nominal GDP will convince the farmers to plant more corn (despite the expectations of bad weather) or even more crazily, assume that it will change the weather.

Well, they can't convince the monetary authority over in Speculativa to create money faster to get gold prices rising faster.   No, they leave the union and become the independent Kingdom of Autarkia.     They issue their own fiat currency.   They no longer worry about the price of gold.  No, they take the quantity of money and divide it by the quantity of corn produced.   They call the quotient, the "price" of corn.   Following the long settled practice in the other island, they calculate an index number based upon the first price calculated.   Then they multiply the quantity of corn by the index, and call it Nominal GDP for Autarkia.   (If you skip the index number step, nominal GDP is just the quantity of money.  And even with the step, it is just an odd way of describing the same thing.)

Well, next time the farmers expect bad weather, the farmers plant less corn and when the weather is really bad, corn production is very low.   The Sumnerans do raise the quantity of money so nominal GDP growth is stabilized.   But the reduction in employment and production is the same as it ever was.

Because, of course, nominal GDP is just the product of real output and a price index.   Right?

P.S.   Maybe in Autarka, but not in the real world where people sell goods for money and buy goods with money.

The Empire of NGDP

The Empire of NGDP  is made up of two islands that have no commercial contact.

The first, called "Autarkia," is made up of self-sufficient corn farmers.   Each farmer grows and eats corn.   Land is plentiful, but weather is variable.   When the weather is good, the labor of the farmers is very productive.   When the weather is poor, not so much corn is produced.    They have quite good weather forecasts.   Expected productivity impacts how much corn is planted and how much the farmers work.

The other island, called "Speculativia" is made up of gold speculators.   There is a fixed stock of gold and a variable quantity of fiat currency.   People buy and sell gold for paper money.   There is, of course, a money price of gold.

Government officials, however, calculate an index number that shows the current price of gold as a percent of its value in a base year.  Just for fun, these same government officials multiply this index number by the annual production of corn on Autarkia, and call it nominal GDP for the NGDP Empire.

Nominal GDP is just a number calculated by multiplying two  "real" things.   Well, the annual production of corn is very much a real thing.   An index number calculated from the money price of gold is a "nominal" thing, but the money price of gold is something that happens in the real world and the index number is just an odd way of describing the money price of gold.

Nominal GDP, on the other hand, is just a product of two unrelated things.   Increase nominal GDP?   What do you want to do?   Get the farmers to plant more corn?   Or get those holding gold to sell less gold, or those holding money to buy more gold, and so increase the money price of gold and so the index number?  

Clearly, it is only things that convince the farmers to plant more corn that result in more employment.  (The farmers spending more time cultivating their corn.)   Increases in the quantity of money might result in a higher money price of gold and a higher index number, and so higher nominal GDP, but what difference could that possibly make to the employment farmers or the production of corn?

That crazy Empire of NGDP.

White on the 5 % "Bubble Path."

The free bankers (Selgin, White, Horwitz and more,) have a strong grasp of the problem of monetary disequilibrium as well as the desirability of some kind of stabilization of spending on output rather than inflation or the price level.    Unfortunately, they remain too fixated on the trend growth rate of spending--insisting that anything more than the most minimal growth in spending on output results in disequilibrium along the lines of an excess supply of money.   Perhaps I misunderstood, but Larry White recently described the 5 percent growth path of the Great Moderation as a bubble path:

To prefer 5% to the current 4% nominal GDP growth going forward, and a fortiori to ask for a burst of money creation to get us back to the previous 5% bubble path, is to ask for chronically higher monetary expansion and inflation that will do more harm than good.

I think it is possible that returning to the 5.4  percent trend of the Great Moderation would "do more harm than good."     I also believe that there were some bubbles during the Great Moderation.  However, I believe that it is a serious mistake to describe the trend growth path of nominal GDP during the Great Moderation as a "bubble path."

While it is true that a more rapid growth path (steeper growth path) requires more rapid growth in nominal money balances, the more rapid growth in nominal GDP results in more rapid growth in the demand to hold nominal money balances.   Alternatively, the more rapid growth in nominal money balances does not result in more rapid growth in real money balances because the higher rate of inflation reduces the growth rate of real money balances to keep them in line with the growth rate of the demand for real money balances.

Perhaps at one time it was reasonable to assume that more rapid growth in spending on output results in ubiquitous shortages of products.   And in response to those shortages, firms raise prices.   More money growth leads to more spending on output and then price hikes in response to the shortages.   But we now know that firms are more than able to adjust to an inflationary environment.   They raise prices all the time--some more and some less.   Shortages do appear, but so do surpluses.  

With a higher growth rate of spending on output, firms develop pricing strategies accordingly.    The increases in prices raise nominal money demand (or reduce real money supply.)    The growing nominal quantity of money matches up with the growing nominal demand for money.   The growing real quantity of money matches up with the growing real demand for money.

What about real world monetary regimes where money is lent into existence?   Central banks purchase bonds, and banks also purchase bonds or make loans.    With the constant increase in the quantity of money, doesn't that imply constant growth in lending and growing debt?

In nominal terms, yes, but not in real terms.   The more rapid growth in the nominal quantity of money will be matched by more rapid growth in nominal lending.   However, the more rapid growth in current and future nominal income will result in more rapid growth in the demand for loans.   This is for two reasons.   With the price level rising, it necessary to borrow more money to purchase the same amount of product.  And further, with future nominal income being higher, those borrowing will have more money to pay off the loans.

So, while the nominal supply of credit is growing more rapidly, the nominal demand for loans is growing more rapidly as well.   This leaves real market interest rates unchanged.   However, because of the Fisher effect, it takes a higher nominal interest rate to generate the same real interest rate, and so if nominal rates were unchanged, borrowing would be more attractive relative to lending, and borrowing would grow more quickly.   This pulls up the nominal rate, bringing the real rate to equilibrium.

But if this is translated into real terms, the real quantity of money is growing with the real demand for money. The real supply of credit is growing with the real quantity of money.   The real demand for credit is growing with real income and output.   The real interest rate is not impacted in any obvious manner.   In other words, a more rapid growth rate of nominal GDP does not require more rapid growth  in the real quantity of money, or the real supply of credit. It does not require lower real interest rates.

Does this process imply more debt?   Other things being equal, more nominal debt would be associated with the process.   The increased lending and borrowing in nominal terms implies that the amount of money borrowers owe lenders will be higher.   But because prices are higher, the real debt is no bigger.   Again, with prices higher than they otherwise would be, borrowers need to borrow more, and with their future money incomes being higher, then can afford to pay more back.   But in real terms, there has been no change.

And what about asset prices?   If more rapid growth in nominal spending on output required lower real interest rates, then the discount rate for the future income generated by some asset would be lower, and so the present value higher.   But more rapid growth in nominal spending on output doesn't require that real interest rates be any lower.  This generates no tendency to force asset prices up.   On the other hand, with a more rapid growth rate in spending, the nominal incomes generated in the future will be higher, and so, this raises the nominal present value of the future income stream.   This raises the current nominal values of assets.   But of course, with prices being higher, this doesn't mean that real asset values are higher.

I think the error comes from assuming that somehow continued excess supplies of money are needed to keep on forcing nominal GDP up.   It would be like it has inertia and "wants" to stay constant.   Only by creating an excess supply of money, forcing real market interest rates down, increasing real debt, and pushing real asset prices up will households and firms be pushed into spending more.   And after they raise spending 5 percent more next year, then they will have to be pushed to raise it 5 percent more.    Every year, we must force it up again.   Another excess supply of money, again and again.

This is about as sensible as assuming that all firms will set prices as they would if spending were constant, and be surprised by shortages year after year.   There is no need to push spending up year after year.   Most of the spending next year will be funded by income earned next year.   The income earned next year will be funded by sales of products next year to those spending next year.   The nominal demand for money will  be higher (other things being equal,) but if the nominal quantity of money  grows with that nominal demand for money, then that won't be a constraint.   Since the nominal demand for credit will be higher with the higher current and future nominal income, there is no need to force down interest rates.   The nominal quantity of credit is growing along with nominal quantity of money.

In my view, if we imagine that firms and households had learned to adapt to a monetary regime where spending on output was constant, or growing with population, so that the price level was falling with productivity, and then, there was a shift to a new regime with spending on output growing 5 percent, then the adjustment path could easily look something like what seems to worry White and the other free bankers.   It would take time to learn the new regime.   Excess supplies of money, market interest  rates below the natural rate, unsustainably high real asset prices might all be problems during the learning period.

But we have never been in a monetary regime like that, and certainly, that isn't what we had before the Great Moderation.   And even if we had, after 25 years, people would have learned the new  regime of spending growth consistent with modest trend inflation.   There would be no need for persistent excess supplies of money, low real market interest rates, high real debt, or high real asset prices.

Concretely, with a 5 percent trend growth path for nominal GDP, a bubble in housing means that spending on other things was less than they would have been.   My perspective on this is that spending on housing was too high, and spending on other things was too low.   Correcting for the bubble would require that spending on housing fall, but spending on other things rise.

The notion that spending could only grow 5 percent due to a bubble (or a series of them) is not only false, it is wrongheaded.   Spending can grow 5 percent without there being any bubbles at all.   If the relative price of housing was too high, that means the relative prices of some other things were too low.    If the production of housing was too high, that means the production of other things were too low.   The answer to the problem is less spending on houses (or really just a lower growth path,) and more spending on other things.

Lower spending on houses, and constant spending on everything else, is a poor signal and incentive to expand the production of other goods--the products that had been crowded out by the excessive production of houses.   Lower spending on houses, and lower spending on everything else, is an even worse way to signal and provide an incentive to expand the production of other things.   Sure, sufficiently low resource prices, like wages, will signal that the opportunity cost of producing other things is now lower.   What a terrible approach.

Anyway, while the notion that a 5 percent growth path of nominal GDP is a "bubble path" is wrong, the current regime promises to close the output gap and keep inflation at 2 percent from here on out.   With the CBO estimate, that is a 5 percent shift up in the growth path, and getting close to Sumner's preferred 1/3 of the way original growth path.   Of course, the Fed's promise is conditional on what the output gap really is.   A 10% Reagan/Volcker nominal recovery and then 5 percent nominal GDP growth going forward, would be about a 5 percent shift up in the growth path.

Still, if we are going to stay on this much lower growth path, the least bad option might be to make that commitment.    If there  really is an output gap, then there will be a motivation to shift prices and wages down to appropriately lower growth path.    The current "Taylor rule" approach is just a disaster.

Eli Dourado on the Short and Long Run

Eli Dourado says he is a fan of Scott Sumner, NGDP level targeting and many of the ideas of market monetarists.  That is good to hear.    Since Market Monetarists don't all agree with one another, I am willing to welcome him to the club.   We could use more Ph.D. students interested in the program.   (OK, it would be nice if they were doing money-macro dissertations.)

Dourado argues that QE3 is unlikely to do much good because the economy has already adjusted to the "long run."   His evidence is that corporate profits are at an all time high and that the mean duration of unemployment has leveled off and remains high.

The high corporate profits are relevant because he supposes that low demand results in lower profits which causes firms to cut production.    While production may be low, this evidence shows that it isn't because low demand has resulted in unusually low profits.

But most other Market Monetarists are arguing is that higher spending on output would cause firms to sell more, and so they would produce more.   We aren't saying that higher spending on output would cause firms to make more profit, and so they would produce more.

What is Dourado arguing?   If spending on output rises back towards (or all the way to) the trend of the Great Moderation, all that would happen is that profits would rise while production would remain on its current low growth path?   For profits to rise with no added growth in output,  firms would need to respond to the added sales solely by raising their prices (more quickly.)   If profits are to rise, their costs can't rise as quickly, which could occur because their debt service costs don't rise.  And, of course, wages might stay on their current growth path too.

That's one scenario.

Consider again the scenario most Market Monetarist suggest instead.   Firms sell more and so they produce more.  To produce more they hire more workers.   Profits don't play a key causal role, though I suppose this scenario  requires that price is above marginal cost for many firms so that if they produced and sold more their profits would be higher.    Well, the current high level of profits are consistent with price being greater than marginal cost for many firms. (Of course, historically high profits only require that prices are greater than usual relative to average costs.   Prices could be equal to marginal costs.)

Dourado also explains that firms have been able to expand production while using fewer workers.  This must be true today since production is above its previous peak while employment is below its previous peak.    However, increased productivity doesn't require reduced employment.    It is perfectly consistent with increased production and constant employment.     In other words, if firms have figured out ways to produce a given level of output with less labor, this just suggests that real demand needs to increase even more.    When employment reaches its growth path from the Great Moderation, production will have surpassed its growth path from the Great Moderation   However, if spending on output only returns to the growth path of the Great Moderation, the added production would require that prices shift down to a lower growth path.

Well, that is another scenario.  By increasing nominal GDP back to the growth path of the Great Moderation and observing whether prices remain below their growth path  from the Great Moderation and real GDP rises above its growth path of the Great Moderation, we will find out how much labor productivity has increased.

Of course, there is also the problem of complementary factors of production.   While more rapid increases in demand could result in the employment of  more workers each producing more output, more of the other factors of production would be needed to produce the added output.   Bottlenecks for these other factors of production could lead to higher costs and higher prices of output.

However, it is hard to imagine that an improvement in labor productivity would cause real output to fall below its existing growth path because of bottlenecks from other factors of production.   It just would not rise as much.   The increase in output would be dampened, at least temporarily.

And, of course, real GDP is about 12 percent below its growth path from the Great Moderation and so speculating about how much it would rise above that path because of added labor productivity versus how much employment would remain below its  growth path of the Great Moderation is very premature.

The typical Market Monetarist perspective is that nominal GDP has shifted to a 14 percent lower growth path.    For real output and employment to remain on its previous growth path, the price level and nominal wages need to also shift to 14 percent lower growth paths.   They haven't.   Instead, they are only about 2 percent lower.

It is possible that raising nominal GDP back to its previous growth path (or even to one 2 percent lower) would have no positive impact on production and employment.   It is possible that if the price level and wages shifted down 12 percent more, the increase in real expenditure would  only result in shortages of output and/or labor.   For this to be true, the productive capacity of the economy must have decreased by about 12 percent.

This is, of course, possible.   Enhanced labor productivity is not something that would tend to have such an effect.

Dourado's version of how shifts in nominal GDP impact real output and employment is based upon an assumption of market clearing.    Prices and wages always adjust so real expenditure is sufficient to purchase everything produced, but when prices and wages shift in unexpected ways, people will work or produce more or less than they would if they understood what was happening to the price level or wages.   These mistaken shifts in supply result in shifts in production, but at each and every point in time, the prices and wages are at levels such that real expenditure is sufficient to purchase all that firms wish to sell or employ all the labor households want to provide.

If there is a surprise decrease in nominal GDP, this will cause the price level and wage level necessary for real expenditure to remain equal to productive capacity to fall.   The falling prices and wages lead to confusion, and firms choose to produce less and households choose to work less.   If the decrease in nominal GDP can be rapidly reversed, then the price level and and wage level rise again and firms will go back to producing the right amount and households will go back to working the right amount.

But it is hard to believe that people are still confused about the lower wages and prices after four years.   They must be producing and working the amount they prefer.   It must be that they prefer producing and working much less.

Most Market Monetarists would say that a decrease in nominal GDP could leave real expenditure unchanged if prices and wages drop in proportion.   If that fails to occur, then real expenditures fall, and firms reduce production and employment to match the lower volume of real sales.   If productive capacity is unchanged, then real output is below productive capacity.      If that is the case, then real output and real income can expand by simply increasing spending on output or lowering prices and wages.  

The puzzle, then, is why haven't firms cut the prices they charge and the wages they pay so that real expenditures recover to the productive capacity of the economy?   They have had four years to make these cuts.    Again, if the problem was a decrease in the productive capacity of  the economy, the lower prices and wages would just lead to shortages of output and/or labor, and do no good.   And so, it would seem that if prices and wages haven't been cut after four years, it must be that the productive capacity of the economy decreased.

If the productive capacity of the economy decreased, then increasing nominal GDP back to the trend of the Great Moderation would solely result in an increase in the growth path of the price level.    Market Monetarists, as advocates of nominal GDP level targeting, believe that if the productive capacity of the economy shifts down to a lower growth path, then the least bad consequences is for nominal income to remain on an unchanged growth path and the price level to shift to a higher growth path.  

Still, even after four years, most of us doubt that there was just a happy coincidence that spending on output fell in near exact proportion to a decrease in productive capacity.   And further, we see substantial evidence that firms would be willing and able to produce more if their sales were to increase.   Few of us ever bought into Dourado's market clearing approach--shifts in supply due to confusion--anyway.   But we see the experience of the last four years as providing evidence that it isn't even a close approximation.  

On the other hand, most of us do believe that firms eventually cut prices and wages in the face of persistent surpluses of output and labor.   Most of us remain puzzled by the slow adjustment.   Personally, I lean to seeing credible inflation targeting as increasing price and wage stickiness as a manifestation of Goodhart's law.   I think credible nominal GDP targeting would worsen wage stickiness for much the same reason, though perhaps lessen price stickiness.   I don't see the sticky wages as much of a problem in that context--rather, it just makes it more important to keep nominal GDP on target.

Mises on Gold and Fractional Reserves

Brad DeLong wrote a long speculative post where he uses "Ludwig Von Mises" as a foil, imagining what Mises must be saying, generally things inconsistent with what Mises wrote.   He was prompted by Krugman's post which wondered what Ron Paul or "Austrians" think about money market mutual funds.

Mises was not opposed to fractional reserve banking.  He did think it caused economic distortions at least sometimes.   Starting from monetary equilibrium, an increase in the quantity of money created by fractional reserve banks would push the market interest rate below the natural interest rate.  (While I don't worry about what Mises really thought, I think this thought experiment assumes a given demand to hold money.)

Mises did think that the creation of money through mining gold leads to economic distortion.   Still, he didn't oppose gold mining and the "free" minting of coins.

The economic distortions created by gold mining and fractional reserve banking were not worrisome to Mises.

The problem that concerned Mises was an effort to hold the market rate below the natural interest rate by money creation.   In his view, this could not happen to any significant degree in a gold standard with banks issuing redeemable notes and deposits.   He didn't say that gold mining and fractional reserve banking would cause no problems.   He just thought the problems would be minimal.

The problem becomes serious, in his view, when government interferes with the contraints.   Central banking, in his view, was about avoiding the constraints of the gold standard so that the market rate could be kept below the natural rate for an extended period of time--well, the implicit goal was permanently, but Mises thought that was impossible.

For Mises, Depressions are always about the market interest rate rising back up to the natural interest rate.   The unemployment associated with them was fundamentally about reallocation from the production of capital goods to consumer goods.   However, much of that shift would really be shifts in the production of different types of capital goods--from capital goods that help produce consumer goods in the distant future to capital goods that help produce consumer goods in the nearer future.

Using monetary policy to "fix" depression, in Mises' view, is pushing the market interest rate back down below the natural interest rate.   In his view, the market rate should just be left at the natural rate, and the reallocation should be allowed to occur.   The production of some capital goods should be allowed to expand while others contract.   Workers who lose jobs in sectors than need to contract should get new jobs in sectors that need to expand.    

As I have explained before, it is Mises' student Rothbard who thought that fractional reserve banking is fraud and should be illegal.  He also argued that gold mining would not cause economic distortions.

Rothbard is best understood as always arguing that the market is all good and government is all bad.  While Mises thought the market was very good and government very bad, for Rothbard, allowing that the market falls short of perfection and government might do some good was unnacceptable.  And so, there were differences between them.   Rothbard defines fractional reserve banking out of the market, and argues that gold mining causes no problem.

Neither Mises nor Rothbard have any sympathy for a cost of production theory of value. They would insist that prices are determined by marginal utility and that opportunity costs are the only costs that matter.  (In my view, they downplay production too much in this context.)

They also understood that money is demanded as a medium of exchange.   In their view, the purchasing power of money depends on the quantity of money and the demand to hold it.   And people mostly hold money because it serves as medium of exchange.   (Pretty orthodox, really.)

Both Rothbard and Mises understood that changes in the purchasing power of money adjust the real quantity of money to the demand to hold it, simultaneously correcting any general glut of goods.

The reason why increases in the nominal quantity of money are a bad idea in their view is that they argue it causes the market rate to fall below the natural rate.   A reduction in prices and wages increases the real quantity of money without having that effect.    (What Mises thought on these matters is somewhat controversial.  Rothbard argued that any increase in the nominal quantity of money not backed 100 percent by gold forces the market rate below the natural rate, and that increases in the purchasing power of money do not result in any distortions.)

As for Hayek, he did argue that the ideal was constant nominal expenditure on output, so the nominal quantity of money should adjust to offset changes in velocity.   He didn't see this as a realistic policy proposal (ever?) and in the early years advocated the international gold standard.   He understood that the gold standard would not generate the "ideal."

Later, as a policy matter, he rejected accepting massive deflation if needed to stay on gold.    Reversing decreases in the quantity of money and increasing the quantity of money to offset decreases in velocity was the least bad option, in his view.

And finally, in his later life, he favored full privatization of money, and expected it to generate something like a stable price level.   The quantities of monies would likely adjust to offset both changes in velocity and changes in productivity to leave the price level stable.   While he said he expected that this would result in some market distortions, he didn't think they would be significant.   As with Mises and fractional reserve banking in the context of gold redeemabiliy,  Hayek thought that price level stability would limit and constrain any tendency of banks to push the market rate below the natural rate.

Ron Paul sees Mises as the font of all economic wisdom, but he is also influenced by Rothbard.  Since both Mises and Rothbard are dead, Paul is influenced somewhat by followers of Rothbard.    I don't know where Paul comes down on what distortions, if any, are created by mining gold under a gold standard, but I know that he is open to arguments that fractional reserve banking is fraud.

However, Paul's core political support combines elements of the libertarian movement and elements of the patriot movement.    The economic views of Mises, and Rothbard especially, are very influential in the libertarian movement.   (The views of the "Austrian" free bankers, and even monetarists, like Milton Friedman, are influential too.   In fact, most Market Monetarists, at the very least, lean libertarian.)

The patriot movement, however, has some views on monetary theory and policy that are very inconsistent with Mises and Rothbard.   One view is that central banking is about a conspiracy of international bankers to  earn unjustified profit from the issue of currency.   The element of truth to this is that early central banks, like the Bank of England and the Bank of the United States, were private.   They issued currency that paid no interest to fund loans to government and the private sector that did pay interest.   The private owners earned profits from borrowing at zero interest.   The government was using tax dollars to pay interest to the private owners of the central bank.

Why are the bankers earning interest on "our" money?   Today, the typical central bank is nationalized and whatever income they generate goes to the government.  The confused structure of the Fed, where the member banks do receive dividends, makes the Patriot theory at least a tad true, but only a tad.   Most of the income generated by the Fed goes to the Treasury.

Another Patriot theory is that credit money systems result in situations where there is not enough money in existence to pay interest on loans.   The quantity of money is equal to the principal of the loans.   The amount that must be repaid is the principal plus interest.   There is not enough money to pay back all of the loans used to create the money along with interest to the bankers.   Depressions occur when this problem manifests itself.   Debtors can't pay their loans because the monetary system doesn't create enough money to pay interest.   Generally, the lenders, trying to obtain more interest from borrowers than there is money available to pay, are villains.

Put this together, and the secret international bankers that own the Fed are profiting from issuing "our money," and their efforts to collect the interest leads to situations where there is not enough money to pay the interest and so people are forced into bankruptcy--losing their homes, farms, and businesses.   Often, the "patriot" approach harks back to "greenbackism," and insists that paper money should be issued by the Treasury to fund government expenditures and not lent into existence by the "private" Federal Reserve.  (Libertarians of all stripes dislike this approach.)

Anyway, there are self-described Austrian economic pundits, who are fans of Ron Paul, who spout confused combinations of Mises, Rothbard, and these patriot monetary theories.   I suppose that requiring 100 percent gold backing for currency prevents the secret bankers from profiting from earning interest and maybe even avoids this "not enough money to pay the interest" problem.

(I was a Rothbardian years ago.    I supported Ron Paul for President in 1988, 2008, and 2012.   I think "the fractional reserve banking is fraud," "the secret international bankers profit from issuing currency," and the "there is not enough money to pay all the interest" theories are absurd.    I don't think Depressions are about reallocating resources.   While I don't think excess supplies of money are desirable, I doubt whether they cause significant malinvestments.   I am certain that a monetary regime creating slow steady growth in spending on output would not create significant malinvestments, regardless of the changes in the quantity of money necessary to maintain the regime. )

Selgin and Measures of Spending

George Selgin is worried that QE3 will lead to an unsustainable boom.   He is concerned that the Fed is repeating the mistake it made in 2002.   Sumner responded with skepticism that monetary policy was too expansionary during that period.   Sumner's view is "maybe a little."

Sumner wrote:

1. NGDP grew at a slower rate during the 2001-07 expansion than during any other expansion during my lifetime.
2. NGDP growth modestly exceeded 5% during the peak of the housing boom.

Selgin came back suggesting that NGDP is the wrong measure of  spending on output.   He suggests that Final Sales to Domestic Purchasers is better measure of spending on output.   He correctly points out that Niskanen favored that measure.   Further, Market Monetarists are well aware that our "fellow travelers" among the "free bankers," have favored that measure.

Selgin reproduces a diagram from Niskanen showing the deviation of final demand from trend. 


While the diagram uses Final Sales to Domestic Purchasers, much the same diagram can be shown using nominal GDP.   This diagram shows the deviation of spending on output from trend.   This is a diagram that is based upon a level target.    There was a large positive deviation during the Dot.Com boom.   From the point of view of a growth path target for nominal GDP, monetary policy was too expansionary during the Dot.Com boom.

However, the question at hand is not the Dot.Com boom, but rather the housing boom.    Niskanen's diagram ends with a closing gap from trend.   What happened?   Was the run up in housing prices and increase in housing construction due to an excessively expansionary monetary policy?   Was spending on output above trend during in 2002 to 2005?

Selgin provides charts showing the growth rates of nominal GDP and Final Sales to Domestic Purchasers.





While Final Sales to Domestic Purchasers was growing more quickly than nominal GPD  from 2004 to 2007, that is hardly unusual.   Both show spending on output growing more quickly than the long term trend of 5.5 percent.

The problem with Selgin's analysis of the chart is that it assumes growth rate targeting.   From 2001 to 2003 both measures of spending grew below trend.   The result was that both fell below the trend growth path.   To return to that growth path, both needed to grow faster than trend.    Pretty much all of the more than 5 percent growth in both measures of spending between 2004 and 2007 was a return of spending to the trend growth path.

Here are the levels of the two series:



Final Sales to Domestic Purchasers is greater than Nominal GDP and gap looks to be increasing after 1998. How do they compare to trend?   Here is nominal GDP.




And here is Final Sales to Domestic Purchasers:



Both show the Dot.Com boom and that spending fell below trend in the 2001 recession.  It is true that Final Sales to Domestic Purchasers shows the a slight upward deviation starting in 2005, but it is pretty insignificant.

What is the difference between nominal GDP and Final Sales to Domestic Purchasers?    The major difference is the trade deficit.   Nominal GDP for the U.S. measures total spending on goods and services produced in the U.S.    Consumer goods and services, capital goods and government goods and services produced in the U.S. and sold to people in the U.S. are included, as are consumer goods and services and capital goods sold to foreigners.    Imports aren't included.    Spending on foreign goods and services aren't included.

Final Sales to Domestic Purchasers includes imports.  It includes spending by U.S. residents (firms and households and government) on foreign goods and services.    It does not include exports, spending by foreigners on goods and services produced in the U.S.

The gap between the two is the trade deficit.   The growing gap is the growing trade deficit.   The difference between their growth rates is the growth rate of the trade deficit.

Selgin approvingly cites Niskanen, who argued that spending by Americans is more closely related to an excess supply of money for Americans than is spending on American products.    And so, he argued, Final Sales to Domestic Purchasers is the more appropriate target for monetary policy.

While Niskanen is probably correct that an excess supply of money by Americans impacts spending by Americans,  a monetary authority that creates money that is held by both foreigners as well as its "own" citizens would need to be concerned about a possible excess supply of money in the hands of foreigners.   U.S. exports are a natural way for foreigners to spend excess U.S. dollars.

Further, not only is it unlikely that only imports would be impacted by an excess supply of money, there is a rather direct connection between "excess" imports and spending on domestic output.    Those foreigners selling the products now have the "excess dollars" which they would naturally sell for their own currency.   The resulting depreciation in the exchange rate makes exports cheaper for foreigners and imported goods more expensive.   That makes import competing goods look like bargains.   And so, through the depreciation of the exchange rate, an excess supply of money spent on imported goods rapidly translates into demand for domestic product--exports and import competing goods.   The ability of speculators to buy foreign currency can speed up the process.

More importantly, while a growing trade deficit could be the consequence of an excess supply of money, there are many other possible reasons for a growing trade deficit.   In particular, growing foreign investment will result in a growing trade deficit and so a growing gap between nominal GDP and Final Sales to Domestic Purchasers.   German auto companies buying German machinery for their new plants in South Carolina, for example.

But then, German car companies and their employees could take the money they earned from exports to the U.S. and put it in their German banks, and the German banks could purchase U.S. asset backed commercial paper, that is backed by mortgage backed securities, and the mortgages could be used to pay for over-priced houses in Las Vegas.   Final Sales to Domestic Purchasers would expand relative to nominal GDP.   And problems just might develop.   But it would not be because of an excess supply of money.

Suppose Chinese toy manufacturers retain earnings and hold them in Chinese state banks.   The Chinese state banks accumulate funds in the Bank of China, which in turn accumulates U.S. T-bills.   This occurs at such a rate that T-bill yields become very low.   Investors in U.S. money markets look for a better yield and buy asset backed commercial paper.   The assets backing the commercial paper are mortgage backed securities.   They are used to fund mortgages to pay for over priced houses in Las Vegas.   Again, Final Sales to Domestic Purchasers expand relative to Nominal GDP.   Problems might develop.   But it isn't because of an excess supply of money.

The other difference between nominal GDP and Final Sales to Domestic Purchasers is inventory investment. Final Sales does not include the accumulation of inventories.  Final Sales of Domestic Product is nominal GDP without the inventories--it includes exports and not imports.  

There is a sound intuition for leaving off inventories.   If spending on output grows "too fast" or "too slow" relative to productive capacity, then inventories will be depleted or accumulate.   In principles of economics this is called "unplanned inventory investment."    Avoiding "unplanned inventory investment" seems like a good idea, and so stabilizing final sales seems like a good idea.

However, the only way that any of these statistics account for "intermediate goods," is through changes in inventories.   Rather than focusing on inventories of cars, think about inventories of car parts, either in the hands of the part manufacturers or the auto companies.   Consider various "raw commodities," like copper or wheat.   These aren't final products but are intermediate goods.   They are only directly counted as inventories in the production process.

For example, if an excess supply of money leads to higher copper prices, then copper inventories will be worth more.   This raises nominal GDP, but it doesn't raise any of the Final Sales measures.

Finally, avoiding unplanned inventory investment is a good thing, but readjusting inventories at any time, including after there has been unplanned inventory investment, is a type of expenditure that requires resources.    A nominal GDP target takes that demand into account.

Nominal GDP is not perfect, but it is better than Final Sales to Domestic Purchasers or Final Sales of Domestic Product.   In my opinion, as much as we honor Bill Niskanen as a pioneer, Market Monetarists have made some progress on these issues.

Even so, I share Selgin's concerns about promising to hold short term interest rates at a near zero rate for an extended period of time.   Similarly, I don't at all like it when the Fed purchases various longer term to maturity assets explaining that their goal is to lower long term interest rates.    Further, that the Fed generally kept nominal GDP close to a trend growth path in the Great Moderation, doesn't necessarily mean that the performance of interest rates or the quantity of money were the same as they would have been if the Fed had clearly articulated that goal.     Leaving aside the desirability of keeping nominal GDP on trend during the Dot-com boom, after nominal GDP fell below that trend, a clear commitment to return nominal GDP to trend could not only have resulted in a more rapid recovery in spending and output, but also resulted in a decrease in short term interest rates that was smaller and of shorter duration.  In other words, inflation targeting using an interest rate instrutment is a really bad idea.

 

Where has Michael Woodford Been?

Michael Woodford was asked if he had been influenced by Scott Sumner, and he said no.

I believe him.

On the other hand, where has Woodford been for the last four years?

I think the answer is obvious--way, way up there in his ivory tower.

Apparently, in his own mind, Woodford is a long time advocate of gap-adjusted price level targeting.   Nominal GDP targeting, according to Woodford, is a similar, though less than optimal, simplistic alternative.

Who knew?

Woodford explained that he has never advocated that the Fed keep interest rates at zero for either a vague "extended period of time," or else for a specified number of years.   No, his view has been that the Fed should keep interest rates at (or near) zero until the appropriate level target--ideally the gap adjusted price level--is reached.

Who knew?

Woodford is no Krugman.   If Krugman had been damning the Fed for the last four years for promising to keep interest rates low rather than promising to keep them low until the gap adjusted price level had returned to 125 (or something,) then we would know.    No, we had Krugman saying that monetary policy was out of ammunition (with fine print and occasional clarification that this means "conventional" monetary policy.)   We had Krugman saying that the only answer was for the Fed to commit to being irresponsibly inflationary.   (How is that for rhetorical sabotage?)  No, Krugman was insisting we need more government spending to create jobs.

Another way to say it is that Woodford is no Milton Friedman.   During the Great Inflation, Milton Friedman clearly said that the Fed was making a terrible mistake and the solution was a strict rule limiting the growth rate of the quantity of money.  Friedman, of course, was a leading monetary economist like Woodford.  Krugman's fame as an economists is from international trade theory.   But like Krugman, Friedman was a well known economic pundit.

Hey, not everyone can be a Milton Friedman.   Still, it is bit troubling that Christina Romer, Krugman, DeLong, and BERNANKE haven't been discussing gap-adjusted price level targeting for the last four years!    

It is no news to Market Monetarists that some of Woodford's ideas were very consistent with ours.   Sumner frequently has mentioned Woodford--almost to the point of making arguments from authority.   Expectations of future monetary conditions is the most important determinant of spending on output now.    Sure, Sumner came up with it from reading old newspapers from the Great Depression.   Stock prices were immediately impacted by news about gold--monetary policy at the time.   It was nothing like first the quantity of money or interest rates changed, and spending on output changed.  Woodford was thinking about how rules for an overnight interest rate impact spending.    How could one night's of interest impact anything directly?  It is all about expectations.

Anyway, I think Ryan Avent of the Economist has it right.   Sumner to Cowen to DeLong to Krugman to Goldman Sachs to Christina Romer.   And way up there in the ivory tower, it began to look like maybe, just maybe, a nominal GDP level targeting was a bit more realistic than a gap-adjusted price level.

Unfortunately, the Fed hasn't adopted nominal GDP level targeting.   All we got was open ended open market purchases, a long time market monetarist goal, which is something that Woodford argued would not be effective!

Scott Sumner Day!

Ryan Avent, of the Economist, wrote a great post about the contributions of Scott Sumner and Market Monetarism in moving the Fed away from its disastrous monetary policy.  HT Marcus Nunes.

QE3--One Step in the Right Direction

Finally, the FOMC has adopted QE3.    From the Market Monetarist perspective, the new policy is an improvement, but it could be better.

The key element of Market Monetarism included in the new Fed policy is a program of open ended open market operations until a macroeconomic goal reaches a desired level.    Market Monetarists favor open-ended open market operations until nominal GDP reaches a specific target growth path.    What the Fed proposes is purchases of  $40 billion of mortgage-backed securities each month until labor markets improve.

Until labor markets improve?   That is extremely vague.    We could imagine an appropriate labor-oriented nominal variable--a growth path of nominal wage income.   But that isn't what the Fed has proposed.   Unemployment, employment, or maybe the employment-population ratio seem to be the focus. And what is the proposed level? Whatever the Fed decides is appropriate at some future time.   Still, employment is something that is traditionally given a level-type goal.   (Of course, the Fed might use growth in employment which would be a growth rate target.)

Targeting real variables is a potential disaster.    Expansionary monetary policy seeking an unfeasible  target for unemployment was the key error that generated the Great Inflation of the Seventies.   Employment or the employment/population ratio could have the same disastrous result.

Given  the potential for inflationary catastrophe, that the Fed stated that this improvement in the labor market must be done in the context of price stability is better than nothing.   The Fed mentioned its 2 percent target for inflation.

However, an inflation target remains the wrong nominal target.    It is a growth rate rather than a level target. I saw nothing in the Fed's statement that suggested any room for allowing the price level to catch up to its previous growth path, which would imply more than 2 percent inflation (though not much for very long.)

On the other hand, in response to questions at the press conference, Bernanke said that because both employment and inflation are part of its mandate, if recovery in employment was associated with a temporary increase in inflation, that would  be acceptable, as long as inflation returns to its target in the long run.

This is exactly what would happen with a target growth path for the price level.   For example, if the price level were on a 2 percent growth path, and a recession caused the inflation rate to slow, perhaps even to the point of deflation, then returning to the previous growth path would temporarily require more than 2 percent inflation.   Once the price level recovered to its previous growth path, then the "target" for inflation would return to 2 percent.  

Unfortunately, Bernanke is actually saying that slightly higher inflation will be tolerated for a time if it would result in improved labor conditions.    Perhaps it is best to simply understand this in the context of the Taylor rule.   If the weighted negative output gap is greater than weighted excess inflation, then monetary accommodation is appropriate.

Now, if the Fed were seeking to return nominal GDP to a target growth path, then the more rapid growth in nominal GDP could result in higher inflation as well as more rapid growth in real output, and so, employment.   A willingness to tolerate higher inflation along with improvement in employment appears consistent with an upward shift in the current, excessively low, growth path for nominal GDP.  

The way Market Monetarists would put it is that the Fed should commit to return nominal GDP to a higher growth path (closer to the trend of the Great Moderation if not that very trend.)    The Fed should make it clear that it will follow this policy whatever happens to inflation or employment.   While it is true that lower inflation and more employment would be better, what will happen, will happen.  The Fed's should see its task as keeping nominal GDP on a stable growth path, which includes reversing any deviations of spending on output from that path.   How spending splits between inflation and production is not the Fed's responsibility.

The other "problem" with the Fed's policy is that it has specified that it will be purchasing mortgage backed securities.   Since these are all "agency debt," that means they are already guaranteed by the U.S. taxpayer for credit risk.

Generally, Market Monetarists (like Traditional Monetarists) do not worry much about what particular assets the Fed purchases.   It is the impact on the Fed's liabilities--the quantity of base money--that is important.     However, this policy certainly has an odor of credit allocation--the Fed is trying to encourage people to obtain home mortgages and buy houses.    Bernanke reinforced this view at the press conference by explaining how the policy is supposed to work.   It is supposed to lower interest rates on home mortgages and so more mortgage lending and more spending on housing.

Market Monetarists believe that the way monetary policy works, and the way it should work, is primarily by expectations of spending on output in the future, and the last thing we would like to see is the central bank direct credit to preferred sectors.   The key for this process to work is that people now must believe that the Fed will expand base money enough in the future to get nominal GDP to the target level at some future time.  This process has nothing to do with getting people to borrow more now or in the future.

Now, if people already believe that (which we insist would be better done by an explicit nominal GDP target rather than a commitment to  improve labor market conditions and a willingness to tolerate temporary above target inflation,) then many Market Monetarists would agree that increasing base money now by purchasing assets with a zero nominal interest rate would not do anything more to immediately raise spending on output. And so, the Fed would need to purchase some financial asset that has a positive yield.   Mortgage backed securities do have a positive yield, and so they should work.

Still, Market Monetarists generally favor a more systematic approach of purchasing assets with progressively more duration and risk.   While we see no real harm in purchasing extra amounts of short and safe assets, it seems plausible that using open market operations, of perhaps heroic magnitude, to generate a prompt recovery of spending on output, would require purchasing assets with a positive yields.   Agency securities are usually included on our lists--right after the thirty year government bonds.

More importantly, Market Monetarists reject the notion that an expansionary monetary policy will necessarily lower nominal or real interest rates.   In particular, the key pathway through which an expansion in the quantity money works--changes in expected future spending on output, will tend to raise both real and nominal interest rates.

Still further, Market Monetarists insist that an expansionary monetary policy does not require that people choose to borrow more to fund spending on output.   It is entirely possible that such a policy could work entirely by households and firms choosing to lend less.   Households and firms can sell off current holdings of bonds and use the money raised to purchase consumer and capital goods.   This is not more borrowing.  It is less lending.   If households and firms sell more bonds than the Fed buys, then this can occur with higher nominal interest rates.

In fact, many Market Monetarists would insist that the best scenario today is that firms, currently holding huge portfolios of short term to maturity securities, will sell off some of those securities and buy capital goods.  Again, if firms sell more bonds than the Fed buys, then short term nominal interest rates can rise while spending on current output and employment rises.   The motivation for purchasing the capital goods now would be higher expected sales of products in the future.

So, rather than promising to lower interest rates, the Fed needs to be committed to raising spending on output now and in the future.   How much?   They need a specific target growth path for spending on output.

Open ended purchases of mortgage backed securities to lower interest rates to encourage people to borrow and buy housing until labor markets improve though only if inflation doesn't rise too high for too long...

Well, open ended purchases of something is a move in the right direction.   But the Fed has a long way to go.