Cochrane on Woodford -- Too Depressing

John Cochrane commented on Woodford's recent call of nominal GDP level targeting.   While he claims to agree with 99 percent of what Woodford wrote, he rejects nominal GDP level targeting.   My guess is that the "99 percent" he agrees with are the parts that I found wildly implausible, particularly the "Wallace Equivalence" arguments that make all open market operations irrelevant.

But let's get to why Cochrane disagrees with Woodford, and Market Monetarists:

Treasury rates are at 50 year lows. The 10 year Treasury rate is 1.5%. At 2% inflation, they pay you half a percent per year to borrow at that rate. Yes, the economy is in the toilet, but surely too-high Treasury interest rates are not the crucial economic problem right now. 

So the case for "stimulus" must be that some other, unstated lack of "demand" is the problem, and that all "demand" is the same so that monetary "stimulus" will cure that problem. I disagree on that one. 

Mike's enthusiasm for deliberate inflation is even more puzzling to me.  Mike uses the word "stimulus," never differentiating between real and nominal stimulus. Surely, we don't want to cook up some inflation just for its own sake -- we want to cook up some inflation because we think it will goose output. But why? Why especially will increasing expected inflation help? Because that is the aim of all the policies under discussion here -- promising to keep rates low even once inflation rises, adopting "nominal GDP targets," helicopter drops, or similar policies such as raising the inflation target. 

I don't put much faith in Phillips curves to start with  -- the idea that deliberate inflation raises output. I put less faith in the idea floating around Jackson hole that a little inflation will set us permanently back on the trend line, not just be a little sugar rush and then back to sclerosis.
But it's a rare Phillips curve in which raising expected inflation is a good thing.  It just gives you more inflation, with if anything less output and employment. 

So much wrong here.

Now, I don't really want to say that the problem is that Treasury interest rates are too high, and I believe that an appropriate nominal GDP level target would result in higher real and nominal interest rates on Treasuries.   But really, I just don't think the price and yield on Treasuries should be a first order concern.   The right price is the market price.  

I do believe that there is a problem of a lack of demand, and while  I don't think that all demand is the same, I do think that monetary stimulus can fix a problem of too little demand.    The argument is simple.   If the demand for money increases, and the quantity of money fails to increase the same amount, then the demand for something else must fall, and that frequently includes newly produced output.   If that situation arises, then increasing the quantity of money to match the increase in the demand to hold money will result in increased demand for other things, which will frequently include newly produced goods and services.

I fully recognize that an alternative solution to this problems is for the price level (including resource prices like wages) to fall enough so the real quantity of money rises to meet the demand.   This will raise the real demand for other goods, frequently including newly-produced goods.   I consider this a less desirable approach to correcting the imbalance between the quantity of money and the demand to hold it.

So, the alternatives are a higher nominal quantity of money and stable (or recovered) nominal spending on output with prices and wages continuing on their trend trajectories, or else, a nominal quantity of money that fails to meet the additional money demand, and so a lower trend growth path for nominal spending on output,  along with lower growth paths for prices and wages, allowing the real demand for output to recover.   This second alternative is less desirable.   Worse, having the Fed tell everyone that it is trying to keep prices rising 2 percent per year hardly helps coordinate the needed shift to a lower growth path for prices and wages.

Cochrane wants Woodford to distinguish between "nominal stimulus" and "real stimulus."   (Tyler Cowen seems to like this distinction as well.)  I personally live in a nominal world.   I earn money and spend it.   I don't live in a world of barter.   In my world, all stimulus is nominal stimulus.    

Consider the apple market.   When the demand for apples increases, this can be understood as a horizontal shift in the demand curve.  A larger physical quantity of apples is demanded at any given price.   However, by multiplying that given price by the added quantity, that "real" increase in demand is given a nominal value--the desired added dollar spending on apples.

It is also possible to look at the added demand for apples as an upward shift in the demand curve.  For any given quantity of apples, the amount that people are willing to pay increases.   This could be simply a dollar amount (dollars per apple.)   But it is also possible to multiply the given quantity of apples by the added amount people are willing to pay per apple and get the increase in dollar spending on apples.

An increase in the demand for apples is an increase the willingness to spend money on apples--at least in a money economy.    To me, talk about "real stimulus," seems like imagining that the demand curve is perfectly inelastic.   An increase in the "real" demand for apples shifts that vertical demand curve to the right. Nominal demand, on the other hand, doesn't matter.   That is just moving the price up and down the vertical demand curve.   In other words, it makes next to no sense to economists who internalize the law of demand, and certainly would require some account of "supply" to make sense of the changing price in face of a perfectly inelastic demand.

Of course, with an isolated individual who uses labor to grow apples, what counts is the value of leisure, the value of apples, and the productivity of labor.   "Real" stimulus must involve being willing to work more (or harder) to get more apples.  Demanding more apples is supplying more labor (and demanding less leisure.)  If the "real" demand for apples decreases, that is supplying less labor (and demanding more leisure.)

Putting numbers on the hours worked or the apples (wages and prices) would be pointless and irrelevant.   Nominal stimulus would  pointless.   It is only "real stimulus" that counts.   Unfortunately, imagining that a real market economy is more or less the same thing as an isolated individual is just about as absurd as perfectly inelastic demand.

Unfortunately, while I think of economics as an effort to understand a market economy--millions of ordinary people exchanging goods and resources for money, others think of economics as people doing incredibly complicated optimization problems.

Now, what about the Phillips curve?   Cochrane sees the Phillips curve as higher inflation causing higher output.  And he has doubts about it.   According to him, we don't want more inflation for its own sake, but only for it to "goose" output.   And he is skeptical that deliberately causing inflation raises output.  He further argues that higher expected inflation should raise inflation while reducing output and employment.

What a mess.   And sadly, there are probably many economists who suffer from just these confusions.  The positive relationship between prices and output comes from increased spending on output.   Firms respond to the added demand by both raising prices and producing more output.   It is not that the higher prices are causing higher output or that the increased output is causing higher prices.   It is the additional nominal stimulus that is causing both the higher output and the higher prices.

In a growing economy, with growing spending, growing output, and inflation, then more rapid growth in spending on output results in more rapid growth in real output and higher inflation.    A higher inflation rate is associated with more rapid output growth, but the higher inflation rate doesn't cause the higher real output growth, nor does the more rapid real output growth cause higher inflation.   Both are caused by a third thing, the more rapid growth in spending on output.

If, instead, we take spending on output as given, and consider what happens with higher prices, then the result is lower real sales and reduced production.   Similarly, if we consider firms expanding real output, given spending on output, then they must lower their prices to sell the added output.

With a growing economy, with growing spending, growing output, and inflation, if we take the growth of spending as constant, then more rapid inflation results in slower growth in real output.   Firms raise their prices more quickly, real expenditures grow more slowly and firms expand their production more slowly.    And if we assume firms expand their production more quickly, if spending on output is growing at a constant rate, then they can only sell that added output if they raise their prices more slowly.

So, given spending on output, higher inflation causes lower real growth.   And higher real growth causes lower inflation.   Again, it is more rapid growth in spending on output that causes higher inflation and higher real growth.

Now, it is likely that higher expected inflation will cause firms to raise their prices more quickly--cause higher inflation.   And given growth of spending on output, that will result in slower growth in output.

But the actual scenario is more rapid growth in spending on output.

Suppose spending on output is expected to grow 4%, and real output is expected to grow 2%, and inflation is expected to be 2%.     Then due to the new policy of nominal GDP level targeting, spending on output is expected to grow 7%.    And that causes expected inflation to rise to 3%.   Suppose this causes actual inflation to rise to 3% too.   If spending on output actually grows by more than 5%, then while inflation will be higher, so will real output growth.   If spending on output grows 7% as expected, then real output would grow 4%.

Cochrane makes the following claim:

Now, let's be clear what a nominal GDP target is and is and is not. Many people (and a few persistent commenters on this blog!) urge nominal GDP targeting by looking at a graph like this and saying "see, if the Fed had kept nominal GDP on trend, we wouldn't have had such a huge recession. Sure, part of it might have been more inflation, but surely part of a steady nominal GDP would have been less recession." This is NOT what Mike is talking about. 

Mike recognizes, as I do, that the Fed can do nothing more to raise nominal GDP today. Rates are at zero. The Fed has did what it could. The trend line was not achievable.

Well, apparently Cochrane didn't read Woodford's paper.   While Woodford doesn't really speak to whether or not keeping nominal GDP on the trend would have been possible he certainly says that by committing to return nominal GDP to trend in the future, it will raise spending on output today.

Here is the relevant section of Woodford's paper:

Standard New Keynesian models imply that a higher level of expected real incomeor inflation in the future creates incentives for greater real expenditure and larger price increases now; but in the case of a conventional interest-rate reaction function for the central bank, short-term interest rates should increase, and the disincentive that this provides to current expenditure will attenuate (without completely eliminating) the sensitivity of current conditions to expectations. If nominal interest rates instead remain unchanged, the degree to which higher expected real income and inflation later produce higher real income and inflation now is amplified. If the situation is expected to persist for a period of time, the degree of amplification should increase exponentially. Hence it is precisely when the interest-rate lower bound is expected to be a binding constraint for some time to come that expectations about the conduct of policy after the constraint ceases to bind should have a particularly large effect on current economic conditions

Woodford clearly says that expected future levels of inflation and real income effect expenditures on output today.  So, if the central bank can influence expected future inflation and real income, it can impact nominal expenditures now.   That there is a zero-bound today imposes little constraint.    By committing to sufficiently high spending on output in the future, when there is no zero bound, it could raise spending today to any level.

Of course, it may be that the future level of spending on output needed to get current spending up to the trend now would be higher than that trend extended into the future, but we don't know that.    In other words, as many Market Monetarists often point out, a commitment to raise nominal GDP back to the previous trend might require short and safe interest rates  to rise well above zero immediately.

If we consider the reverse situation, where the central bank is committing to cause some massive drop in nominal GDP in a a few years, its is very likely that the result would be nominal interest rates on short and safe assets being pegged at zero, and current spending on output collapsing.   If the proposed massive deflation in a few years was recognized to be insane and dropped, then nominal interest rates as well as current spending on output should at least partially recover.

More to the point, if the Fed had always following a nominal GDP level target, there is good reason to believe that any shortfall from that trend would have been smaller.   And by shifting to that target even now, a stronger recovery in spending on output could be generated.    And while a recovery in spending on output will probably result in somewhat higher inflation (both realized and expected,) it will likely also cause a more rapid recovery in production and employment.

Of course, if Cochrane wants to argue that if increased output and employment were possible just because there was an expansion in spending on output, the prices and wages would already be lower, so that real expenditure would have already increased enough to result in the needed volume of sales of output, then he should stay that.   I would still favor keeping nominal GDP on a slow steady growth path, even if reduced productivity resulted in more rapid inflation of output prices.   And so, if nominal GDP falls below target, I would favor getting it back up to the target growth path-as soon as possible--even if that was associated with higher inflation.

Nominal GDP targeting is a regime.   It isn't just an excuse to cause inflation, "goose output," and reduce real interest rates on Treasuries.