Tuesday, September 29, 2009

Hamilton 3:

Hamilton's second post on the Cato Unbound debate continues to show skepticism regarding index futures convertibility. He states that a divergence between the future expected value of nominal GDP and the fixed target price would result in speculators taking an infinite position on the contract. Then he again expresses concern that changes in the quantity of money will only impact the economy with long and variable lags. He worries that with the lagged effects of a change in the quantity of money being larger, output will be distrupted by the changes in nominal expenditure.

The reason why infinite positions on the futures contract are unlikely is that the market process runs from a divergence between market expectations of the value of future nominal GDP and the target, trading in index futures contracts with the monetary authority at a price reflecting the target, open market operations in bonds by the monetary authority, changes in the quantity of base money, changes in the quantity of money, changes in the future value of nominal GDP, and finally, changes in market expectations of future nominal GDP. An infinite position on the contract would result in an infinite change in the quantity of base money, and a level of base money equal to zero or infinity, a quantity of money equal to zero or infinity, a value of nominal GDP equal to zero or infinity, and supposedly an expectation that nominal GDP will remain above target even though the quantity of money is zero or else below target despite an infinite quantity of money.

This shows that equilibrium in this futures market does require that speculators have at least some slight clue regarding monetary economics. What actually happens to nominal expenditure only plays a role in equilibrating this futures market if the speculators understand that changes in the quantity of money will impact future nominal GDP. For the proposal to be beneficial, speculators must have more than just a clue, and should rather invest in the futures contract based upon their understanding of exactly how today's monetary and financial conditions will impact nominal expenditures in the future.

It should be noted that if speculators are mistaken so that, for example, an infinite level of base money really does result in nominal GDP rising above target (even a little) then the speculators would suffer infinite losses. My view is that even with long and variable lags, an infinite quantity of base money would result in worse than Zimbabwean hyperinflation--infinite inflation. Given the nature of their error and the consequences, infinite losses would be just about what these remarkably ignorant and pigheaded speculators would deserve.

Hamilton also argues that because of the long and variable lags,that most of the impact of an increase in the quantity of money will only impact expenditure in later periods, and so the efforts, perhaps largely futile, to raise nominal expenditure next quarter will result in disruptions to real output in later quarters.

I think the concept of nominal expenditure targeting has yet to sink in with Hamilton and some of his criticisms would apply to price level or inflation targeting. Second, he doesn't seem to recognize that index futures targeting is targeting the future value of nominal expenditures. Some of his criticisms would apply to a scheme that tried to stablize the price level in real time, or absurdly, a feedback rule that effectively tries to stabilize the past value of the price level. (OK, no one thinks that is possible, but a feedback rule is changing the policy instrument in ways that would have been desirable if the changes had occured before the value of the macroeconomic value was realized.)

During the eighties and nineties, I studied and published some papers on the Greenfield-Yeager payments system. They (and I) called it the Black-Fama-Hall payments system. It is a privatized monetary system that would create market forces that stablize the price level in real time though indirect convertibility. The sorts of concerns raised by Hamilton would apply to the Greenfield-Yeager system. With sticky prices, shocks to the price level would plausibly lead to very destructive changes in the quantity of money, nominal expenditures, and real output.

Those of us working in this area, such as Kevin Dowd and including Yeager, moved towards index futures convertibility. More modest changes in the quantity of money and nominal expenditures are needed to budge sticky prices if it is future prices rather than current prices that are targetted. Once the concept of index futures convertibility is adopted, stabilization of any measured macroeconomic magnitude is possible, and for a variety of reasons, I came to view a 3% growth path of nominal expenditure--total final sales--as the least bad option.

While I remain sympathetic to free banking, in the context of the status quo, I think that the Federal Reserve should seek to adjust the quantity of money today to keep expected future nominal expenditure on a stable growth path. While nothing is perfect, stable expected growth of nominal expenditure provides the least bad environment for microeconomic coordination.

Since many of the reasons I came to support targetting expected future nominal expenditure were to specifically avoid the sorts of problems Hamilton describes, problems that would apply to an effort to target the price level in real time, I am left with the impression that he just doesn't get it.

For example, I can imagine index future targeting of a growth path of the CPI involving large flucuations in the quantity of money and nominal expenditure. Unfortunately, fluctuations in real output and employment might be destructive side effects. I am doubtful that the sort of explosive cycles that Hamilton hints at are possible--since they require substantial myopia. However, sticky price problems are irrelevant to nominal expenditure targeting. While there may be large changes in the quantity of money and short term interest rates, there can never be a need to generate large fluctuations in nominal expenditure. Nominal expenditure is what is being stabilized. To the degree that it is fluctuations in nominal expenditure in the face of sticky prices that are causing fluctuations in real output, targetting nominal expenditure avoids that difficulty.

1 comment:

  1. Bill, I'm glad you also noticed that his hypothetical implied a zero money supply. At first I'd wondered if I'd overlooked something basic in the proposal.