Ron Paul's Newsletters

I have recently endorsed Ron Paul for President.

Ron Paul was responsible for publishing a variety of newsletters over a long period of time. Between 1989 and 1995, the newsletters included some hateful, racist remarks. There were also ugly remarks regarding gay people.

Ron Paul has said that he didn't write those remarks.

I believe him.

Ron Paul has said that he wasn't aware of the remarks until they were used to attack him in his 1996 campaign for Congress.

I believe him.

Paul served in Congress from 1976 to 1986, failed to get the Republican U.S. Senate nomination in 1986, and then ran for President as the Libertarian Party nominee in 1988. He returned to practicing medicine full time from 1989 to 1996. He returned to Congress again in 1996, and it was during the campaign when he first learned of some of the things that he had supposedly written over the previous several years.

More importantly, Paul disavows the remarks in the newsletters.

Paul's basic political philosophy is libertarian--he believes that all individuals, regardless of ethnic background or sexual preference, have equal individual rights. A racist politics, based upon defending the white race, or focused upon threats to society from African-Americans, Latinos, or Jews, is foreign to his thinking.

Most importantly, Ron Paul is a nice guy who is not comfortable saying or writing rude, ugly, or insulting things.

In my view, his primary political concern has always been inflation, which he believes results from money creation by the Federal Reserve. He believes the result will be economic collapse--a terrible inflationary depression. In his view, the solution is a gold standard. As a practical matter, the emphasis of his politics has been opposing all the activities of the Federal government inconsistent with the very strict limits that follow from his interpretation of the U.S. Constitution. That includes most of U.S. foreign policy today. In his view, the U.S. Constitution solely gives the federal government authority to defend the U.S. There is no constitutional authority for projecting military power to promote the economic interests of U.S. business overseas or even the humanitarian values expressed by voters.

Paul's core views tie together, because the U.S. cannot afford all of this unconstitutional activity, which is what leads the Federal Reserve to print money to finance deficits, which will result in economic disaster in the long run. In Paul's view, the long run is just about here.

So, what about the newsletters?

All of the newsletters were written as if they came from the pen of Ron Paul himself. They didn't. They were ghostwritten. How were these ghostwriters selected? Why didn't Ron Paul review their work?

The best evidence that we have today is that Lew Rockwell was in charge of the newsletters. Who is Rockwell? He was Paul's Congressional Chief of Staff in the seventies. He was a vice-President of Ron Paul Enterprises when the newsletters were written. He was President and then CEO of the Mises Institute.

Rockwell has been accused of penning the offensive passages himself, a charge he denies. I believe him. Rockwell has stated that there were seven or eight ghostwriters for the Ron Paul Newsletters. The most likely scenario is that one, or perhaps several, of these unnamed ghostwriters were directly responsible.

However, I don't believe that there is some rogue ghostwriter that can be singled out. Again, the most likely scenario is that this sort of over-the-top propaganda and nasty invective was exactly what the ghostwriters were asked to provide by Rockwell, and mostly probably, by Murray Rothbard.

During this period, Rockwell was working very closely with Rothbard. Rothbard was a radical libertarian economist and a student of Austrian economist Ludwig Von Mises. Mises hated inflation and strongly supported the gold standard. It is the connection to Mises, along with Rothbard's own uncompromising support for the gold standard, that tied him to Paul.

With the fall of the Berlin Wall in 1989, Rothbard thought that the right wing could be weaned away from foreign intervention. While Rothbard was never much worried about the communist threat and favored deep cuts in defense spending during the sixties and seventies, he hoped that with the dissolution of the Soviet Union in 1991, conservatives could be convinced that a smaller military establishment would be possible.

Second, after the ATF stormed David Koresh's compound in Waco, Texas in 1993, "the militia movement," developed. Conspiracy-minded right wingers were training with assault rifles all over the U.S. Many were concerned that the Clinton administration was going to seize all of their guns. They were devoted to the U.S. Constitution, especially the second amendment.

Third, in Europe, the Progress Party in Norway began to grow by opposing immigration. It received 23% of the vote in 1988 (compared to Paul's .5% for President as a Libertarian.) In 1993, the "libertarian" wing of the party dropped the anti-immigrant focus and political support dropped to 6.3%. The Freedom Party in Austria had been a moderate classical liberal party, like the German Free Democrat party. Under Jorg Haider's leadership, starting in 1989, they began to focus on opposition to immigration. In 1993, they began their anti-immigrant, Austria first, petition drive. They become a major player in Austrian politics. (Haider also created controversy by saying that the Nazi employment policy was better than that of the current government. Haider was regularly accused of having pro-Nazi and anti-semitic views. )

This was the period in which Rothbard and Rockwell developed "paleo-libertarianism." In my view, the newsletters were aimed at appealing to the militia movement, with the goal of turning it into a libertarian movement along the lines of the Progress Party or Freedom Party in Europe, that was strongly anti-foreign intervention, anti-Federal Reserve, and pro-gold.

The rhetorical approach in the newsletters, particularly the ugly invective, was Rothbard's way. Rockwell has a similar rhetorical approach. While Rothbard may have been one of the ghost writers cited by Rockwell, perhaps not. The ghostwriters, presumably other "Rothbardians," (libertarian who continued to follow Rothbard wherever he led,) were writing a message in the newsletters consistent with both the strategy and style of Rothbard and Rockwell.

Most libertarians rejected Rothbard and Rockwell's "paleo-turn." Libertarian economist Steve Horwitz gives his view here. To this day, some of the ugliest invective coming from Rockwell and the remaining paleo-Rothbardians is aimed at the libertarians who refused to follow along.

Ron Paul always stayed above these squabbles, but he let Rothbard and Rockwell use his name. Why?

I think the primary reason is that Rothbard and Rockwell share Paul's strong support for the gold standard and opposition to the Federal Reserve. While many libertarians agree, plenty do not. Further, Ron Paul is extremely pro-life. Rockwell agrees. Most libertarians are pro-choice. While Rothbard, last I knew, took an extreme pro-choice position on abortion, he and the other pro-choice paleo-Rothbardians didn't and don't fight Paul on the matter. Finally, there is the shared opposition to an interventionist foreign policy. While many libertarians agree, plenty do not.

In short, Paul trusted Rockwell and Rothbard to develop a strategy that would help promote individual liberty and limited government. Clearly, he knew the general outlines of their strategy. It was hardly a secret plan. Rothbard and Rockwell both wrote public manifestos in their attempts to bring other libertarians on board.

It came to an end in 1996. What happened?

Todd Seavey suggests that the Oklahoma City Bomber might have had something to do with a softening of tone. Suddenly, appealing to the conspiracy-minded militia movement began too look a bit risky. Seavey also points out that it was the year Rothbard died. A bright and articulate advocate of the approach was no longer there. (On the other hand, who knows what strategic coalition Rothbard would be promoting today.)

But I think it is simple. Ron Paul found out that rude and ugly words were being put into his mouth. "He" was trashing figures whom, on the whole, he admired, like Martin Luther King. Worse, he was supposedly making childish insults of people he had worked with personally, like Barbara Jordan. He put a stop to it.

Some have accused Paul of publishing the newsletters for the money. When challenged by a reporter that he made $1,000,000 in a single year, he seemed surprised. He explained that during that time he was practicing medicine full time to make a living. In other words, he wasn't making so much money as a newsletter publisher that he could retire, and he was busy with his "real job" which might be why he didn't pay much attention to what Rockwell was doing with the newsletter. Rothbard had a position at the University of Nevada at Las Vegas. Rockwell, on the other hand, may have needed to earn an income, and the ghostwriters may well have been writing this stuff "for the money."

Perhaps some of the money ended up endowing the Mises Institute. Still, I think they were writing material that they thought would appeal to rightwingers, trying to turn them away from foreign intervention and towards limited government.

In 1996, when the newsletters were used against him in his campaign for Congress, Paul didn't say that he didn't write the passages nor did he disavow them. Why? He says that his campaign aides argued that his name was on them, and so he was responsible. Trying the explain them would be "too confusing." (His efforts to defend them looked a bit weak to me.)

As far as I know, no one asked him point blank if he really wrote the material and so, he just deflected the questions as best he could. It is also possible that some of those "aides" still thought that those words that were put into his mouth would help with his political career. It could be nothing more than the political contributions they were getting by using the old mailing list, but perhaps they still thought that a U.S. version of the Progress Party was in the cards.

To this day, there are supporters of Ron Paul who will argue that there was nothing wrong with anything in the newsletters. Thankfully, Ron Paul disagrees. Ron Paul is not a racist. He has no use for any kind of racist politics. And, he is a nice guy who doesn't say rude and ugly things about anyone.

Mankiw and Ball on Deficits and National Debt

Here is a very good paper by Mankiw and Ball on budget deficits and the national debt.

The basics are great. Their conclusion is that budget deficits help current taxpayers and future capital owners while hurting future taxpayers and future workers. (For those of us who consider much of current government spending as a waste, and consider cutting that spending an option, the "benefits" to current taxpayers are largely an illusion.)

They also consider the "unlikely" possibility of a fiscal crisis--a sudden loss of confidence in the willingness of the government to pay its debts. This analysis is good as well, though they fail to consider an optimal monetary policy (nominal GDP targeting, of course.) Recent events in Europe are following the script they outlined in 1993 to a remarkable degree.

They express hope that developed country central banks would avoid inflation despite the fiscal crisis. I suppose this is what the European Central Bank is doing. With nominal GDP targeting, a loss of confidence in government debt would be inflationary in two ways. Most importantly, the drop in the exchange rate directly raises import prices, and unlike CPI targeting, import prices play no direct role in nominal GDP. Only as higher import prices (and exports) impact the demand for current output does nominal GDP tend to rise, requiring more restrictive monetary conditions to limit that growth to the target growth path. However, there is a limit to inflation from that source, with the prices of consumer goods rising to a higher level (or growth path) rather than growing at a permanently faster rate.

The other inflationary impact is due to changes in productive capacity. These have two elements, both discussed by Mankiw and Ball. The first is a shift from nontraded goods to traded goods. In other words, an expansion in the production of import-competing goods and exports. In the U.S. today that would be fewer restaurants and yoga lessons and more domestically produced cars and machine tools to be sent to China. Because these shifts take time, production and employment will be depressed. This is a temporary reduction in the productive capacity of the economy which with nominal GDP targeting results in a higher price level.

The second effect is more long run. The capital stock shifts to a lower growth path along with the productive capacity of the economy. This will also raise the price level with nominal GDP targeting.

These two factors imply a shift of the price level to a higher growth path. With a 3 percent growth rate for nominal GDP, the result is temporary inflation, with the inflation rate returning to approximately zero, but at a higher level. With a 5 percent growth rate for nominal GDP, inflation would accelerate for a time, but then return to the 2 percent trend.

Mankiw and Ball also discuss the possibility of a more general financial crisis. The real effects described above could result in bankruptcies for various firms and eventually result in bank failures. While they don't say much about it, they hint at Bernanke's view that it is a disruption of productivity enhancing financial intermediation that results in Depression. While I have my doubts about that, having the banking system closed down, or at least in the process of reorganization, would have some adverse impact on productive capacity too. (Figuring out a way to rapidly reorganize banks, with an emphasis on debt-equity swaps needs to be on the front burner.)

Interestingly, these impacts on the price level and inflation are harmful to foreign creditors. A nominal GDP target, therefore, may limit the ability of a government to borrow in the first place, (and shift more of the impact to capital accumulation.) While that is not necessarily a bad thing, a shift to nominal GDP targeting in the midst of a crisis might exacerbate capital flight.

Of course, the U.S. does not currently have a problem with "capital flight." Still, I wonder to what degree keeping Chinese (and other foreign) creditors happy prevents the Federal Reserve and the rest of the Federal government from implementing nominal GDP targeting.

P.S. Mankiw and Ball are mainstream, new Keynesian, neo-classical economists. What, if anything, do my Austrian friends find wrong with their analysis of deficits and debt?

Rowe on Government Debt

Nick Rowe gives an explanation of why government debt imposes a burden on future generations. He even mentions James Buchanan. Rowe's argument is one of his all apple consumption economies. Still, I think I agree with his argument.

My view, which follows one of Buchanan's simple formulations is that financing government consumption spending by debt allows the current generation to receive the services from public goods at a lower tax price.

While those buying the government debt give up private goods and services (to provide the resources to needed to produce the public goods,) they receive government bonds in exchange and are no worse off. They can receive the principal back in the future, along with interest.

If they had not purchased the government bonds, they could have instead purchased capital goods, either directly or else equity or debt claims. These capital goods would have increased future output, and provided a stream of future income. Further, if the capital goods are not replaced when they wear out, that provides additional consumer goods to pay back the principal.

When they instead purchase the government debt, the stream of income and principle payments come from future taxpayers. Either future taxes are higher than they otherwise would be, and future taxpayers have fewer private goods and services than they otherwise would have, or else, the government pays interest out of given tax revenues and provides fewer public goods in the future than otherwise. Those in the future receive fewer services from public goods than they otherwise would have.

Obviously, this argument is an alternative framing of crowding out of investment and so reduced future production. To me, that only means that one should be careful not to try to make the arguments additive.

Rowe makes the argument without public goods (it is a straight transfer) and without capital goods (it is all consumption loans.) Assuming the interest rate is greater than the rate of growth of the economy, Rowe argues, future taxpayers must give up consumption to pay off the loans, and are worse off. As in the more complicated version I described, the loss to the taxpayers is not offset by the payment bondholders, who are being compensated for the consumer goods they gave up when they purchased the bonds.

Rowe argues that if the interest rate is less than the growth rate of the economy, this no longer holds. Then it is possible to fund government spending by debt without there being any burden on future taxpayers.

In my view, that isn't exactly correct. Interest expense is part of the future budget, and taxes are higher than they otherwise would be, or the provision of public services are less than they would otherwise be. With a growing economy, some of the benefits of future growth are transferred from the future to the present. From my perspective, rather than future generations being able to enjoy lower tax rates because essential government services can be provided with a lower fraction of growing incomes, they must pay interest on past debts.

But Rowe's framing is that the government runs a deficit today to provide public goods (or transfers in his example) and then runs deficits in the future to fund the interest payments on the national debt. If the interest rate on the national debt is less than the growth rate of the economy, the national debt shrinks relative to income. As the centuries pass, the burden of the national debt becomes smaller and smaller. In the year 10,000, perhaps a philanthropist could pay it off with spare change. Of course, that is a burden--just very small. But in that scenario, it never need be paid off.

If this is true, and the interest rate is less than the growth rate of the economy, then why have taxes? Why not provide public goods until their marginal value is zero? Well, presumably private consumer goods and services would still have value, so why not transfers? Apparently, the government should run a deficit and create a national debt high enough that the interest rate is equal to the growth rate of the economy. Outside of Rowe's apple world, this would presumable work at both margins--raising the interest rate and reducing the growth rate of the economy.

What troubles me most about these sorts of thought experiments is that they assume perfect knowledge about the indefinite future. For example, suppose the government can borrow today at a rate that is lower than the growth rate of the economy. We decide to take advantage of the free lunch. What happens if the economy grows more slowly or the interest rate rises? For example, suppose the population begins to decline in the U.S., while great investment opportunities in China pull up interest rates? Maybe those future generations should impose capital controls and outlaw birth control?

Can we really say that there is no burden on future generations?

Ron Paul (and Gary Johnson) for President

Some time ago, I endorsed Gary Johnson for President. Johnson is no longer seeking the Republican nomination for President and is now seeking the Libertarian nomination for President. I hope Johnson is able to win the Libertarian Party nomination.

As for the Republican nomination, I now support my second choice--Ron Paul. My former third choice, Jon Huntsman, now moves to the number 2 position. The South Carolina primary is coming up fast!

While Ron Paul's foreign policy views are more dovish than my own, unlike most of the other Republican candidates this year, he is pointing in the right direction. The U.S. should have withdrawn from Afghanistan (and Iraq) years ago, and war with Iran would be an expensive mistake.

Paul is calling for cuts in the level of federal government spending. I agree that the U.S. government spends way too much. While I don't think $1 trillion cuts in one year are realistic, the rapid increase in government spending and deficits in the Bush and Obama administrations makes these heavy cuts consistent with my usual rule of thumb. Cutting net federal outlays to what they were at the beginning of the Obama administration (2008,) is a $600 billion cut. Ron Paul's $1 trillion returns spending to where it was in 2006, and still leaves a $300 billion deficit (given 2011 receipts.)

For the most part, I agree with Paul's views on personal liberties issues. For example, like Paul, I think Drug Prohibition is a mistake, for much the same reasons that Alcohol Prohibition was a mistake.

Why was Gary Johnson my first choice? I think his political resume as two-term governor is better than Paul's political resume as U.S. Congress back-bencher. On a more personal note, I think Johnson's resume as entrepreneur and mountain climber is great, but in a very different way, so is Paul's background as a medical doctor and family man.

Like Gary Johnson, I describe myself as "pro-choice" on abortion. In truth, I think government should not restrict early term abortions but that it should restrict late term abortions. Paul is strongly pro-life and favors having government outlaw all abortions. Worse, he emphasizes that issue and has sent glossy brochures to my house (and I presume to thousands of other South Carolinians who have voted in past Republican primaries) emphasizing his opposition to all abortions. It is clearly very important to him. Paul, however, does believe that any government suppression of abortion should take place at the state level. So, he opposes having the Federal government outlaw abortions in states that allow the practice.

Like Gary Johnson, I believe that the U.S. should allow more foreigners to come work in the U.S. (I even liked Gringrich's statement in opposition to deporting illegal immigrants who have been in the U.S. for years.) I think Ron Paul agrees. Like Ron Paul, I don't think the U.S. taxpayers should be forced to provide social services to immigrants. I even oppose "birth right citizenship." In 2008, I was a contributor and volunteer for Ron Paul. Like other South Carolina voters, I received glossy brochures on the immigration issue in the weeks leading up to the election. I didn't like what I saw. Ron Paul did get my vote.

What about monetary policy? As far as I can tell, neither Johnson nor Paul (nor any other Republican candidate nor Obama) have much to offer. I support Paul's proposal to audit the Fed. I support Paul's effort to protect the right of citizens to use alternative monies. (This is the core Hayekian monetary reform.) I even support ending the Fed. However, given our current level of economic knowledge, I would favor replacing it with a monetary authority that I suspect Paul would consider no better than the status quo. Still, I think the Federal Reserve, as an institution, just struck out. Strike one--Great Depression. Strike two--Great Inflation. And now, strike three--Great Recession.

Paul has been able to raise lots of money. He nearly won the Iowa straw poll and has a good chance at the Iowa caucuses. He is doing great! While I like Johnson better, most voters apparently disagree. I have met Ron Paul and he is a good guy. I hope that other South Carolinians will join me in voting for him on January 21st.

Bernanke and Woodford on Targeting the Forecast

Ben Bernanke and Michael Woodford wrote “Inflation Forecasts and Monetary Policy” in 1997. The thrust of their paper is a critique of having the central bank “target the forecast.” Most market monetarists have adopted Scott Sumner's insistence that the Fed target the forecast. Sumner credits this view to Svennson.

Bernanke and Woodford describe a scenario where the central bank targets the consensus of private forecasters, which comes right out of Hall and Mankiw’s 1994 paper, “Nominal Income Targeting.” However, they cite Dowd (1994) and Sumner (1995) which propose pegging the price of a CPI futures contract. Interestingly, Bernanke and Woodford have little complaint with Svensson’s (1997) proposal.

They see his proposal as:

“the central bank’s internal forecast is prepared with the use of a structural model, but that the model and data on the current state of the economy are used to determine the policy action, that according to the model, should result in a forecast equal to the target.”

And what of private sector forecasts? They also write:

“a central bank can choose a policy that has the effect of keeping private inflation forecasts equal to the targeting without having the form of a “forecast targeting” rule, and it is desirable that it do so.”

Incredibly, they even believe that the central bank can use the private sector’s forecast of inflation shocks and potential output shocks to plug into their structural model, and so keep the private sector’s expectation of inflation on target (pp. 681-2.) They describe this in the context where the private sector is mistaken so that the central bank is sacrificing that element of inflation stabilization that it could provide by ignoring the private sector’s forecast and just using its own better estimate of inflation and potential output shocks.

They go on to explain (p.682):

“A version of the proposal might reduce the extent to which the central bank is required to stabilize incorrect private forecasts rather than inflation would be to simply require the central bank to give public testimony about the motivation of its policy stance, that might well include discussion of its own inflation forecast. Private sector forecasts that disagree with that of the central bank might well be matters that would require comment on the part of the central bank, but one could accept an explanation on the part of the central bank of how its own forecasts are made as sufficient demonstration of a good faith effort to achieve the inflation target.”

The Federal Reserve doesn’t exactly target inflation, but rather inflation and unemployment. After its most recent meeting, the Fed gave its internal forecasts of both, and explained that both would remain below target for an extended period of time. Perhaps Bernanke should review what he wrote four years ago.

Like most market monetarists, I reject inflation and unemployment targeting and instead favor targeting the growth path of nominal GDP. Replacing inflation with the target for nominal GDP, what Bernanke and Woodford wrote would be appropriate. The Fed should set policy instruments so that its internal forecast is on target. However, it should also be just a little bit less arrogant than Bernanke and Woodford imagine, and be willing to make some adjustments based upon what the “wrong” private forecasts suggest.

Is it really true that if the private forecasters plug in their values for inflation and potential output shocks into a “true” model of inflation and report that, the result is that the eigen value is within the unit circle and the inflation rate is indeterminate? (p.671)? I don’t think so.

The fundamental problem with Bernanke and Woodford’s approach is that they assume that all forecasters have one true model and true information. If so, the central bank should just pay one of the forecasters for this information. Or why not hire one of them in place of their current staff?

The reality is that no one, not the central bank’s internal forecasters or any of the private forecasters knows the true model or has all of the needed information. They disagree. The goal should be to somehow combine both the central bank’s own forecast with those of the private forecasters to generate a market expectation that can be utilized to adjust current market conditions such that the market expectation is that nominal GDP will be on a slow, steady growth path.

Nominal Income Targeting: Hall and Mankiw

In 1994, Robert Hall and Greg Mankiw wrote a paper on "Nominal Income Targeting."

They advocate what Svensson would call a "target rule" for nominal GDP and propose that the Fed look at the consensus private forecast for nominal GDP either four quarters or eight quarters in the future and adjust current monetary conditions to keep the forecast on target. They do not favor an "instrument rule," that would specify a formula relating a policy interest rate or base money to nominal GDP.

They consider a rule for the growth rate of nominal GDP, a growth path of nominal GDP, and a "hybrid rule," that adjusts the target growth rate of nominal GDP according to deviations of real GDP from potential. They run simulations using a simple phillips curve model. They use errors from the actual consensus forecast to estimate the errors that would be generated by the alternative policy. They use the inflation shocks actually observed and assumed those same shocks would apply to the new regime. They simulate the period of the seventies and the eighties. The trend growth rate of nominal GDP is 2.5%.

They find that the growth path policy performs better than the growth rate rule both in avoiding variation in the price level and real output. However, real output is less stable that the actual performance. Since the period is the seventies and the eighties, this is very troubling. The hybrid policy--for example, raising the growth rate of nominal GDP when real GDP is below potential, did better with output stability.

They note that some of the errors in the consensus forecast involved errors in forecasting monetary policy. For example, the consensus forecast didn't predict the Volcker disinflation. If there had never been the Great Inflation of the seventies, there would have never been a Volcker disinflation. They also ran the simulation on the assumption that the forecasts were perfect, and the variance of real output relative to potential was better than actual performance.

Still, part of the reason for the output variance was the response to "supply shocks." The way they describe it, an inflation shock must be reversed within one year. Their simulation shows a deep recession in the early eighties. To the degree that this reflects the Volcker disinflation, it is an illusion. However, their model would generate a deep recession to reverse the inflation caused by the increase in oil prices during the Iranian revolution.

Their model is:

The change in the log of the price level is the trend inflation rate plus a term that shows the persistence of inflation plus a term that shows how the output gap impacts inflation plus the inflation shock term.

So, a supply shock this period just causes inflation this period. This forces nominal GDP above target, and then next period, this extra high inflation will continue to force prices up (the second term,) and based upon the consensus forecast, monetary policy must contract enough to force real GDP below potential enough to force prices down. Given their trend of 2.5 percent nominal GDP, deflation must be generated. Of course, the reduction of real GDP reduces nominal GDP directly and so the recession and deflation must combine to get nominal GDP back to target.

I see two problems with this model. First, there is no recognition that supply shocks combine a decrease in potential output with an increase in the price level. For example, if there is a bad harvest for corn, the supply of corn falls. The price of corn rises and the quantity of corn falls. The decrease in the quantity of corn is simultaneously a decrease in actual and potential output.

This just doesn't show up in the model at all. The increase in the price of corn would show up as inflation in the current period. That the production of corn falls, and that this is a decrease in both real output and potential output is left out. Assuming that the supply shock persists, both potential output and real output remain low and the price level remains high.

In the Hall and Mankiw model, potential output is basically the trend of real GDP. (.98 times its own lagged output plus .02 times current real GDP.) And so, the gap between real output and potential output is basically the deviation of real GDP from trend. That adverse supply shocks also reduce potential output is necessarily ignored, (well 98% ignored,) and overstates the actual deviation of real GDP from potential.

The second problem is the persistence of inflation. If the central bank will accommodate inflation, then it is certainly possible that higher inflation this period will cause people to expect more inflation and raise prices. However, with nominal GDP level targeting, particularly with a 2.5 percent growth path, there should be no persistence to inflation. In their model, inflation this period is partly reversed next period. More generally, if nominal GDP is above target and generates inflation, it will be reversed. A temporary adverse supply shock will be reversed. And a persistent adverse aggregate supply shock will raise the price level and leave it at the new, higher level.

A proper model of nominal GDP targeting will have the expected price level be equal to the target for nominal GDP divided by the expected level of potential output. Any deviation for the price level from that expected level should be expected to be reversed rather than continue to grow. Further shocks to that price level should have a negative covariance with shocks to both output and potential output.

However, Hall and Mankiw claim that only 2% of the volatility they find was due to these price shocks. Apparently, 98 percent was due to forecast errors. With nominal GDP targeting, that would imply a failure to hit the target.

Bernanke and Woodford in 1997 criticized using the consensus forecast for targeting. Under some circumstances such efforts to free ride on the consensus forecast results in indeterminacy. (However, using its own forecast but also considering outside forecasts is feasible.)

Bennett McCallum, also in 1997, proposed an "instrument rule" with feedback between the quantity of base money and nominal GDP. He ran simulations using both levels and growth rates of nominal GDP. His simulation found explosive results when an interest rate instrument was used to target the level of nominal GDP. This was less of a problem with base money targeting, though too large of a change in base money to a deviation of nominal GDP from its target growth path was explosive as well.

Targeting the growth rate of nominal GDP did not have explosive results whether interest rates or base money is used. Perhaps it is this potential for explosive results that has lead McCallum to favor targeting the growth rate rather than the growth path. McCallum also looked at a weighted average of the growth path and growth rate. It avoided explosive results too.

In my view, high frequency oscillations are very unrealistic. Perhaps it is because people don't respond mechanically to controls. Explosive oscillations require that past changes, especially for prices, be projected into the future, when in reality they will be reversed.

Still, even if large fluctuations in short interest rates or base money end up having little effect on nominal expenditure, much less prices or production, there would be little benefit in generating such changes. Targeting the forecast, as suggested by Hall and Mankiw, and allowing market participants to develop expectations that support the regime seems like a better approach that a mechanical feedback rule.

Money Illusion and Real Wages

Suppose money expenditure on output falls. If prices and wages are both sticky, then firms sell less, produce less, and employ fewer workers. Real wages are unchanged. There is a surplus of output, but only in the sense that firms would like to sell more than they are currently producing and selling. There is also a surplus of labor. Households would like to work more than they are.

If money expenditure on output increases, then firms sell more, produce more, and employ more workers. Real wages remain unchanged. The surplus of output and the surplus of labor disappears.

If, on the other hand, money expenditures remain depressed, there is a market solution. The usual response to a surplus is a lower price. The surplus of labor leads to lower wages. As prices and wages fall together, real wages remain the same. However, if money expenditure on output remains the same, the lower prices result in higher real expenditures on output. Firms produce more and hire more labor. The lower money wages were essential to keep real wages from rising and depressing employment.

Note that real wages play no role in either process. Employment fell, and unemployment rose, without real wages changing at all, much less rising above equilibrium. Similarly, an expansion in the money supply increased output and employment without lowering real wages or impacting prices or wages at all. And finally, even if nominal expenditure remained lower, and both prices and wages fell in response to surpluses, employment recovers without any decrease in real wages.

So why is there a tradition of focusing on the real wage? In microeconomics, the demand for labor depends on the real wage. But then, everything in microeconomics is about relative prices, and that includes the relationship between the price of labor and the products of labor.

In macroeconomics, the reason for the focus on real wages is an assumption that wages are sticky and output prices are flexible. If nominal expenditure falls, then as explained above, the demand for output falls. As firms sell less, they lower prices. This raises real wages, and reduces the quantity of labor demanded and raises the quantity of labor supplied. The result, then, is a surplus of labor. Of course, the increase in real wage is also an increase in real costs, and so firms produce less. So, the result of the decrease in nominal expenditure is lower prices, lower output, lower employment, and higher real wages.

If money expenditure increases again, then prices rise, real wages and real costs fall. Firms hire more workers and produce more output. Recovery through an expansion of money expenditures requires a price increase and lower real wages.

The market process that corrects the disequilibrium is lower money wages. This reduces real wages and real costs. The firms hire workers and produce more. To sell the extra output they lower prices. Given nominal expenditure, real expenditure rises. Firms can sell the additional output.

Market oriented economists have sometimes ridiculed the notion that increased nominal expenditure can raise employment. If workers will continue to work (and return to work) in the face of increase nominal expenditure, higher prices, and lower real wages, then why don't firms just cut money wages, reduce prices, and reduce real wages? It must be money illusion.

I don't pretend to have all the answers as to why money wages are sticky. However, the notion that reversing a decrease in nominal expenditure and a temporary decrease in output prices, would cause workers to do anything other than mourn the loss of the remarkable bargains they enjoyed for a time is absurd. That they would demand a nominal wage increase to permanently capture the transitory increase in real wages is possible, but not likely.

Is that money illusion? I don't think so.

"Regime Uncertainty" and Wage Cuts

Free market economists, and especially Robert Higgs, have argued that "regime uncertainty" is reducing business investment. Higgs used the concept to tie the Roosevelt administration's populist rhetoric to low levels of investment during the Great Depression. Higgs has used the same concept to explain the Great Recession.

In my view, if the demand for investment falls, the natural interest rate falls as well. Assuming that the demand for money is less than perfectly interest inelastic, then the quantity of money needs to rise accommodate the increase in the demand to hold money. Nominal expenditure should continue on its previous growth path. The lower natural and market interest rate should dampen the decrease in the demand for capital goods and result in larger than usual increases in the demand for consumer goods. The resulting reallocation of resources may result in structural unemployment and slightly higher prices for a time. Worse, the slower expansion in the capital stock will result in more modest increases in labor productivity, and slower growth in real income. Given the growth path of spending on output, the result could be modest inflation.

If the reason for the decrease in investment demand was empty anti-capitalist rhetoric by politicians, then they should stop. If actual policies are causing the problem, then the economic costs should be weighed against whatever benefits these policies are supposed to generate.

However, some advocates of the free market have argued that an increase in the quantity of money and reduction in market interest rate are inappropriate. For example, Daniel Mitchel is here. Donald Boudreaux is here

In recent weeks, I have discussed the matter in comment threads on Free Banking and Uneasy Money. Comments were made (by the Liquidationist and RobR) suggesting that the "solution" to regime uncertainty was for money wages to fall. (I just found the Liquidationist's blog, here.)

The argument is that firms are accumulating money (and other short and safe financial assets) rather than hiring workers. The demand for labor is lower and the demand for money is higher. The solution is for nominal and real wages to fall enough, and for profits to rise enough, that the higher level of profits compensate firm owners for the higher perceived risk. Given this new distribution of income, firms will again be willing to hire labor, and employment will recover.

One rather obvious problem with the argument is that when the firms spend their accumulated money on hiring workers, wages will rise and profits will decrease, and higher profits no long compensate for the greater risk. However, presumably this sort of process could help explain why employment stops contracting. Lower wages, as well as the higher productivity of labor on the margin as more and more productive workers are let go, combine to make firms willing to bear the greater perceived risk rather than further reduce net revenue per worker by reducing employment further.

The process just doesn't generate recovery. If the nominal quantity of money is held fixed, then lower wages reduce costs, firms reduce prices, and real money balances rise. The conventional analysis is that those holding money balances purchase bonds, and this raises bond prices and reduces bond yields. The market interest rate falls. Real consumption and real investment expand, and as real expenditure rises in total, firms sell more, produce more, and hire more workers.

However, rather than buy bonds with increased real balances, firms might hire workers (and purchase other inputs) and produce output. But this is reducing difference between input and output prices--again reflecting the lower market interest rates.

If saving is perfectly inelastic with respect to the interest rate, then the real interest rate must fall enough so that investment, (including in the working capital firms use to hire workers and purchasing other inputs to produce output,) returns to its initial level. While the distribution of income between bond holders and stockholders might change, with bond holders receiving a lower return and the stockholders receiving higher gross returns and lower risk adjusted returns, real wages would not fall.

But if saving is not perfectly inelastic with respect to the interest rate, then the process results greater consumption. With more consumption and less investment, labor productivity and real wages will grow more slowly, and perhaps might fall.

Taken to the extreme, if saving is perfectly elastic with respect to the interest rate, then any reduction in investment demand, including one caused by "regime uncertainty," has no effect on the natural interest rate, but simply results in less investment and more consumption. Of course, with no decrease in the natural interest rate, there is no increase in money demand and no reduction in spending on output.

Still further, if we assume that the greater "regime uncertainly" applies to wealth accumulated by households, then the supply of saving might fall more than the demand for investment, resulting in a higher natural interest rate along with a shift in the allocation of output away from capital goods and towards consumer goods.

Presumably, firms producing consumer goods would initially be motivated to spend less on labor and other inputs because they insist on a higher interest return. However, the shift in demand from durable capital goods towards consumer goods will result in higher prices. Meanwhile, the firms selling capital goods will see a major contraction in their sales, freeing up "working capital" to use in consumer goods industries.

To sum up, if businessmen respond to "regime uncertainty" by demanding more money rather than purchasing capital goods (or even labor and other inputs for current production,) then this decrease in investment demand results in a lower natural interest rate. Generally, this requires an increase in the quantity of money to maintain nominal expenditure. The allocation of resources shifts from capital goods to consumer goods. If the quantity of money does not rise enough to maintain nominal expenditure, then lower prices and wages will cause real balances to increase and the interest rate to decrease, expanding real consumption and investment expenditure as above. The allocation of resources still shifts to consumer goods from capital goods.

If, on the other hand, businessmen and wealthy households respond to "regime uncertainty" by expanding consumption rather than shifting their asset portfolios to money or other safe assets, then the result is still a shift in the allocation of resources from the production of capital good towards consumer goods. There is no tendency for a decrease in nominal expenditure. There is no need to increase in the quantity of money and perhaps a reason to decrease it. The natural interest rate rises, and real wages will be depressed, or at least grow more slowly.

If "regime uncertainty" leads to an increase in the demand to hold money, then it will tend to depress money expenditures on output. An expansion in the quantity of money and lower market interest rates is exactly the proper response. The result will be the proper change in the allocation of resources. Insisting on "tight money," will simply make a bad situation worse.

While improving "regime certainty" in the sense of creating a better tax and regulatory framework for business would be helpful, it is more important to fix the monetary regime. That involves keeping nominal expenditure growing at a slow steady rate. To the degree greater "regime uncertainty" has been allowed to reduce nominal expenditure, returning it to the trend growth path is desirable and probably necessary for otherwise desirable "supply-side" reforms to be much help.

Rowe, Stiglitz, Caplan

Stiglitz has been arguing that growing productivity in agriculture was responsible for the Great Depression. Similarly, he argues that growing productivity in manufacturing is responsible for the Great Recession. The demand for manufactured goods is inelastic, so those in the manufacturing sector have lower incomes. Supposedly, their lower income reduces demand in the rest of the economy. Aggregate demand falls, firms produce less, so output and employment are depressed.

Nick Rowe takes him to task for failing to see that income equals output. Growing productivity in some sector raises aggregate output and generates the additional income necessary to purchase the output. Rowe recognizes that people may not want to purchase the added output, but that is the source of the problem, not the added productivity. Rowe, then, accepts that an increase in aggregate income or a change in the distribution of income might lead to increased saving. That could reduce spending on output to the degree it results in an increase in the demand to hold money.

(Those defending Stiglitz focus on this argument--he is providing a reason why the natural interest rate might be low. If the natural rate is low enough, conventional monetary policy is ineffective and results in real expenditure less than potential output.)

Caplan has been arguing that Keynesians should be calling for wage cuts. In Caplan's view, lower wages will result in higher employment. He has been challenging the argument that the lower wages will result in lower wage income and reduced spending on output. He argues that if employment grows. while each full-time worker might earn less, there will be more workers to earn income. And further, if the demand for labor is not elastic, and labor income does not rise with greater employment, then profits expand and the expenditures of the owners of the firms generates greater expenditure.

Rowe takes Caplan to task as well. If output is limited by demand--what can be sold--the lower wages will not raise demand for output, and firms won't hire workers to produce more if they cannot sell any more output. Assuming greater employment will not do. And lower wage income and higher profit income, leaving aside quite plausible differences in saving and willingness to accumulate money, just changes who purchases the output.

In my view, Caplan's macroeconomic understanding is sound. He is assuming that wages are sticky and prices are flexible. If nominal expenditure on output falls a given amount and then stays constant, prices of output fall immediately. But wages don't fall. This raises real wages, and the profit maximizing level of output falls. Given that lower level of output, the price level falls enough to sell this reduced level of output, but less than in proportion to the drop in nominal expenditure. With constant money wages and a lower price level, real wages have risen. The firms employ less labor in a way that is perfectly consistent with the lower production. It is basic micro-profit maximization.

Now, when wages fall too, the real wages fall. Costs have fallen and firms produce more and lower their prices. Given nominal expenditure, this is an increase in real expenditure on output. The firms, in aggregate, can sell more. The expansion in production and employment is perfectly consistent with microeconomic principles. If wages fall enough, the new equilibrium is identical to the initial one in real terms. Nominal prices and nominal wages wages are both lower, but real wages, real output, and real income are all at the initial level.

Of course, this argument assumes that lower prices and wages don't cause reduced expenditure on output. In the end, it must be based on given quantity of money and some sort of stable demand to hold real money balances. And the elasticity of the demand for labor and added expenditure out of possibly greater profits are irrelevant.

So, what is up?

Consider a different scenario. All prices and wages are quite flexible, except one problem. There are price floors on all final output. Velocity is constant and the quantity of money is reduced. The equilibrium price level is lower, but prices can't fall. Production falls to match reduced demand for output.

Firms need less labor to produce less output. Employment falls. There are surpluses in labor markets, and so wages fall. Prices are fixed, and so this is a reduction in real wages.

The reduction in wages reduce costs and increases the surpluses in product markets. Firms would like to sell more, but because they cannot reduce prices, their actual sales and production remain at the lower depressed level.

Assuming the supply of labor has the usual positive slope, then once real wages are low enough, the quantity of labor supplied falls enough to match the lower quantity demanded. If the supply of labor is perfectly inelastic or worse, has a positive slope, then real wages would drop to zero. Of course, that is the region where Malthusian effects--starvation--will reduce population enough so that the quantity of labor supplied matches the demand. In other words, real wages turn perfectly elastic at subsistence in the long run.

However, there is another process at work that will tend to clear up the surplus of labor. As real wages fall, it becomes more profitable to utilize more labor intensive production methods. Even assuming output doesn't rise, it will become profitable to use more labor to produce it at lower real wages.

If the supply of labor is assumed to be perfectly inelastic, (workers need jobs,) then real wages fall to a level where the quantity of labor demanded matches quantity supplied. Less capital intensive production methods will be used. Labor productivity falls enough so that full employment of labor results from producing the demand-constrained level of output. (Hopefully, the market clears at wages higher than starvation levels.)

And with the workers having lower real wages, who will be buying this output? Well, if we compare the workers' demand for output at full employment with a lower real wage to what they demanded at less than full employment at a higher real wage, the reduction in total labor income will be less than in proportion to the decrease in the real wage. While the less inelastic labor demand, the smaller the decrease in labor income in aggregate, elastic, or even unit elastic labor demand is implausible. Of course, if labor's share of the fixed income falls, the owners of the firms will be earning more profits, and so they can consume more.

And so, what is the characteristics of the new equilibrium? Real and nominal output and income are at the reduced level. Still, there is full employment, because more labor intensive methods of production are used and because at lower real wages fewer people choose to work. It is very likely that the labor share of income is lower, and workers consume less. The capital share of income is higher, and business owners live in bigger mansions, have bigger yachts, and fancier limousines. And maybe more servants too.

To some degree, the old, more productive capital goods would be abandoned, but it is likely that to some degree they just aren't replaced. In other words, the initial drop in real wages will be greater, and only gradually, as production technologies are shifted to those with lower labor productivity, will the quantity of labor demanded rise. Once the capital stock has readjusted, then there will be no excess capacity. Potential output will have fallen to match the demand-constrained level of output.

I certainly don't accuse Caplan of advocating something like the above. In fact, he advocates raising the quantity of money enough to reverse any decrease in nominal expenditure on output so that there is no need to decrease nominal wages. And, as I explained above, if that doesn't occur, so that we are left with the lower wage "solution," prices fall along with money wages, and either an assumed constant nominal expenditure on output or a real balance effect from a given quantity of money raises real expenditure on output. Still, some of his arguments about why lower real wages generate more employment would apply better to this quite ugly scenario.

FOMC Minutes on Nominal GDP targeting

FOMC on Nominal GDP and Price Level Targeting:

The Committee also considered policy strategies that would involve the use of an intermediate target such as nominal gross domestic product (GDP) or the price level. The staff presented model simulations that suggested that nominal GDP targeting could, in principle, be helpful in promoting a stronger economic recovery in a context of longer-run price stability. Other simulations suggested that the single-minded pursuit of a price-level target would not be very effective in fostering maximum sustainable employment; it was noted, however, that price-level targeting where the central bank maintained flexibility to stabilize economic activity over the short term could generate economic outcomes that would be more consistent with the dual mandate. More broadly, a number of participants expressed concern that switching to a new policy framework could heighten uncertainty about future monetary policy, risk unmooring longer-term inflation expectations, or fail to address risks to financial stability. Several participants observed that the efficacy of nominal GDP targeting depended crucially on some strong assumptions, including the premise that the Committee could make a credible commitment to maintaining such a strategy over a long time horizon and that policymakers would continue adhering to that strategy even in the face of a significant increase in inflation. In addition, some participants noted that such an approach would involve substantial operational hurdles, including the difficulty of specifying an appropriate target level. In light of the significant challenges associated with the adoption of such frameworks, participants agreed that it would not be advisable to make such a change under present circumstances.

Yes, a price level target is a bad idea--big problems with supply shocks.

Yes, picking a growth path of nominal GDP is difficult.

But nominal GDP targeting results in stable inflation in the long run, so there should be no problem with inflation expectations becoming unanchored. That is the danger of inflation targeting. When the rule is to do nothing about inflation surprises, then there must be a constant worry about inflation expectations.

Not yet? Perhaps one day.

Does Nominal GDP Exist?

Taylor claims:

But it introduces another problem: if an inflation shock takes the price level and thus NGDP above the target NGDP path, then the Fed will have to take sharp tightening action which would cause real GDP to fall much more than with inflation targetting and most likely result in abandoning the NGDP target.

Market Monetarists treat nominal GDP as something that really exists--the flow of money expenditures on current output. Critics treat nominal GDP as the product of real output and the price level. "If an inflation shock takes the price level and thus GDP above the NGDP path, then the Fed will have to take sharp tightening action."

Given the growth path of the flow of money expenditures on output, an inflationary shock pushing the price level above its trend growth path will reduce what firms and households will buy and so what firms can sell and produce. While the price level rises to a higher growth path, real output falls to a lower growth path. Nominal GDP remains on target.

If this "inflationary shock" pushed real output below capacity, the resulting surpluses would put downward pressure on prices--automatically reversing the "inflationary shock." Prices would grow more slowly and fall back to their previous growth path and real output would rise again to the growth path of capacity. On the other hand, if the reason for the inflationary shock was a reduction in capacity, then the price level remains on the higher growth path and real output remains on the lower growth path with capacity. Still, nominal expenditures and nominal GDP remain on the target growth path.

On the other hand, suppose nominal GDP is nothing that really exists. It is just the product of the price level and real output. For example, suppose the policy interest rate determines real output in the next period, and then the output gap causes inflation the period after. Of course, we assume some stochastic process that causes inflation shocks during the current period too. Given real output, which was determined by last period's policy rate and its own idiosyncratic shocks, and multiply by the price level, which is already determined by last periods output gap, then multiply and an inflationary shock pushes the product--nominal GDP--above target. How to get the nominal GDP back down? A higher policy rate reduces real output next period, which lowers nominal GDP. And then the period after, the resulting output gap will get the price level back down too. (And will all of this manipulation of the policy rate lead to cycling? Will it be explosive?)

Now, how does this all work? Why does a lower policy rate cause output to change next period? Could it be that it directly causes money expenditures on output to change and firms respond to changes in sales? What happens to the amount that firms can sell next period if the great random number generator in the sky mandates that they charge higher prices? Can they really sell the same amount of output at higher prices? Does the quantity of money rise? Does the demand to hold real money balances fall? Is it that people borrow more? At what interest rate? The last period's interest rate that is supposedly determining output? Or is it the current period's interest rate--the one that will be determining output next period?

If the purpose of a model is to trace out how a given policy rate will impact nominal expenditure, real output, and the inflation rate over time, then perhaps skipping the nominal expenditure step, and going from real output (gaps) in the next period and the inflation rate in the subsequent period will do. But the flow of nominal expenditure on output is the true causal factor in the process. Right? Or are there people who really believe that the policy rate determines output next "period" and output (gaps) determine inflation the following period?

In my view, there is no such thing as an "inflation shock." There are supply shocks where the supply of some particular good or service changes. If the supply of a good decreases, the price rises and the quantity falls. As a matter of arithmetic, the price level rises and real output falls. A price level target requires a monetary contraction to push the price level back down.

An inflation target does nothing to reverse this periods random shock to the price level. But, in the real world, where supply shocks are not produced by stochastic processes but rather reductions in the supply of some particular good, then an inflation target implies a monetary contraction to prevent a developing supply shock from generating inflation. (To pull an example out of thin air, rising oil prices cause worries about inflation expectations becoming unanchored, deterring a decrease in policy rates.)

With a nominal GDP target, the results are more complicated. If the demand for the particular good whose supply decreased is unit elastic, then the increase in the price of the good is inversely proportional to the decrease in the quantity. The arithmetic increase in the price level is inversely proportional to the arithmetic decrease in real output. There is no tendency for nominal GDP to move away from target. Given flow of expenditures in the economy, there is no change in spending in the rest of the economy. There is no need for prices or output to change in other markets.

But if the demand for the good whose supply decreased is inelastic, then the increase in the price of that good is more than proportional to the decrease in quantity. Arithmetically, the price level rises more than in proportion to the decrease in real output. This tends to raise nominal GDP, perhaps pushing it above target. However, if the flow of nominal expenditure on output is already determined, then nominal GDP doesn't rise above target. What happens is that spending rises in the market where supply decreased and falls in the rest of the economy. This decrease in demand tends to depress prices and output in other markets. That is how nominal GDP remains on target despite the sharp increase in the price of the good whose supply decreased.

If demand for the good with the decrease in supply is elastic, then the analysis is reversed. The increase in price is less than in proportion to the decrease in quantity. The arithmetic increase in the price level is less than in proportion to the arithmetic decrease in real output. Nominal GDP tends to fall below target. To the degree that aggregate spending is already determined, then spending on the good whose supply decreased goes down, and spending in the rest of the economy expands. The increase in demand in the rest of the economy tends to raise prices and output for those goods. That is how nominal GDP remains on target despite the sharp decrease in the quantity of the good whose supply has decreased.

In my view, nominal GDP targeting is imperfect. However, the other alternatives are worse. But thinking about random "inflation shocks" in a simple new Keynesian model where the policy rate determines next period's output and this period's output gap determines inflation is highly misleading. It is just as misleading as thinking about random shocks to this periods real output and imagining that inflation must be generated in subsequent periods to return nominal GDP to target.

Negative Interest Rates

Why is there a zero nominal bound on interest rates?

According to Todd Keister, from the New York Fed:

Given the markets’ limited experience with very low interest rates, it is difficult to predict with any degree of certainty how they will react to them. If the types of disruptions described above turn out to be significant, taking steps to lower short-term interest rates could actually make financial conditions tighter rather than looser and thus hinder the economic recovery. To avoid this outcome, policymakers tend to choose policies that keep market interest rates positive.

In other words, the potential for negative interest rates to disrupt financial markets limits the extent to which policymakers can stimulate economic activity by lowering interest rates. This limit is known as the zero lower bound.

In other words, the reason there is a zero nominal bound is that the Federal Reserve chooses to keep interest rates above zero.

Keister had already pointed out how interest rates have been below zero for limited periods of time. He also explains why. It is costly to store currency, especially large quantities. As I have explained in the past, this makes the lower bound on nominal interest rates equal to the cost of storing currency.

Of course, the Federal Reserve is very committed to framing its actions in terms of setting interest rates. From that perspective, the Fed chooses to keep interest rates above zero.

If, for example, the Fed was targeting the quantity of base money, and there were a shortage of T-bills at a nominal interest rate of zero--perhaps because of a flight to safety--then the interest rate would fall until storing currency is cheaper. In other words, paying for safes, guards, and the like.

However, to avoid "money market disruptions," the Fed would seek to prevent this. The most obvious course would be to change its target for base money, reducing the quantity of base money. The resulting excess demand for base money should create a liquidity effect that would at least temporarily raise short term money market yields.

What would be the disruptions that would justify engineering an imbalance between the quantity of money and the demand to hold it? As is usual, there is an air of "only the central bankers know."

Still, Keister provides three possible problems.

Money market funds operate under rules that make it difficult for them to pay negative interest rates to their investors, either directly or by assessing fees. Many of these funds would likely close down if the interest rates they earn on their assets were to fall to zero or below, possibly disrupting the flow of credit to some borrowers.

Since ordinary mutual funds have no difficulty in charging for their services when the underlying portfolio suffers looses, this is a bit of a puzzle. The marketing material for money market funds claims they work very hard to prevent capital loss, and in the Fall of 2008, the "breaking the buck" by Primary Reserve fund, suggests it is possible. Do mutual funds charge for their services as a percent of yield rather than total assets managed like stock mutual funds. Regardless, perhaps it is time for mutual funds to change their rules.

Keister continues:

The auction process for new U.S. Treasury securities does not currently permit participants to submit bids associated with negative interest rates. If market interest rates become negative, new Treasury securities would be issued with a zero interest rate—effectively a below-market price—and bids would be rationed if demand exceeds supply. Such rationing, which has occurred in recent auctions, would generate an incentive for auction participants to bid for more than their true demand, leading to even more rationing. This situation could generate market volatility, as unexpected changes in the amount of rationing in each auction could leave some investors holding either many more or many fewer securities than they desire.

The New York Fed (along with the Office of the Public Debt,) operates the T-bill auctions. The Fed generates monetary disequilibrium to avoid the inconvenience of modifying their procedures in operating the auctions to clear markets? How hard could it be to allow bids of negative yields?

And finally:

A decrease in the IOR rate would also likely affect the federal funds market, where banks and certain other institutions lend funds to each other overnight. A lower IOR rate would give banks less incentive to borrow in this market, which would likely decrease the amount of activity. When less activity takes place, the market interest rate will be influenced more by idiosyncratic factors, making it a less reliable indicator of current conditions. This decoupling of the federal funds rate from financial conditions could complicate communications for the FOMC, which operates monetary policy in part by setting a target for this rate.

So, if market interest rates become negative, then banks would not be motivated to borrow overnight. It is difficult to see why that is true. Certainly, the problem would be the opposite. If the interest rate on reserves is zero, and the federal funds rate is negative, then holding reserves is better than lending them. If the interest rates paid on reserves were negative, along with other short term interest rates, then lending reserves at less negative rate would be desirable. Of course, if the interest rate on overnight loans (or the interest rate on reserves) approaches the cost of holding vault cash, then there would be no motivation to lend.

Frankly, these reasons for keeping interest rates above market clearing levels look to be excuses....bad excuses. Unfortunately, as long as the Fed frames its activity as setting interest rates rather than avoiding imbalances between the quantity of money and the demand to hold it, creating monetary imbalances to manipulate interest rates will seem natural.

HT Mark Thoma

Post Apocalyptic Nominalism

Karl Smith takes issue with my argument that the monetary authority should solely focus on keeping nominal expenditure on target, and should not serve as "lender of last resort" to the government or the banks. Smith believes that the consequence of this approach will be "Post-Apocalyptic Nominalism." Apparently, a few will become vastly wealthy because they will be able to borrow at negative nominal interest rates.

I don't consider this likely. (I hope it is a joke.)

Smith accepts a scenario where a policy aimed at 4 percent nominal GDP growth creates expectations such that all European governments can "self-finance," and the euro-zone economy rapidly recovers.

It seems that the key element of this favorable scenario is that none of the PIGS default. The apocalyptic scenarios both include actual defaults. In one scenario, nominal expenditure is expected to grow on target, but default occurs anyway. The other occurs when nominal expenditure is not expected to grow on target, and default occurs.

Why does government default lead to such a disaster? In my view, the effect is that those governments that lose confidence of creditors default, reduce government spending to current tax revenues, make minimal payments on interest and principal, and presumably reduce the provision of government services. Not exactly pleasant, but hardly apocalyptic.

So why the disaster? Smith assumes the banking system "collapses." Why? Presumably, it is because all the banks in Europe hold the debt of the PIGS. If any of the governments default, then the banks become insolvent. The ECB, then, is supposed to commit to lending to the PIGS so that they will be able to repay banks. And that means that the banks remain solvent. Otherwise, the banks collapse and then it is the apocalypse.

I suppose in Smith's world, when the banks are insolvent they are closed and liquidated, and the depositors receive some partial payment. And then there is a world without banks. Presumably, everyone uses hand-to-hand currency to make all payments. And the ECB creates money solely by purchasing bonds from people they consider solvent. There being so few such people, in order to get them to issue and sell enough bonds, the nominal interest rate is negative.

My view is that permanently closing and liquidating all banks is a very bad idea. If there are many small banks and a few of them are insolvent, closing and liquidating those banks is a reasonable approach. However, when a substantial portion of the banking system is insolvent, reorganizing and reopening those banks is important. If all banks are insolvent, rapid reorganization and reopening is essential.

The simplest approach is that the banks close on Friday, and Monday morning they open again and all of the depositors have substantially lower deposits and shares of stock in the reorganized bank. The banks open and then carry on operations as usual.

If the governments of France or Germany instead want to bail out their banks, then they can purchase the bonds of the governments that default. If, on the other hand, they want to only bail out the depositors in their banks, they can do the same, but reorganize the banks--sell stock to new owners. If they want to solely avoid runs, and bail out all the short term depositors, then they can again do the same, reorganize the banks, and impose haircuts on long term creditors too.

But who exactly is bailed out and how should be the determination of the fiscally sound governments. The ECB should focus on expanding the quantity of money, currency if necessary, enough to meet the demand to hold currency with nominal GDP growing on target. It should not be the responsibility of the monetary authority to lend money to governments so that they can pay off their debts to banks. Nor should it be the responsibility of the monetary authority to lend money to insolvent banks so that they can pay off their depositors.

Taylor on Nominal GDP Targeting

John Taylor still opposes nominal GDP targeting. The Market Monetarist response was rapid. Scott Sumner still hopes that Taylor will get to work developing a "rule" for Nominal GDP rather than inflation. Nick Rowe's post contrasted instrument rules with target rules.

Taylor complains that advocates of nominal GDP targeting have failed to provide a simple formula for a central bank to follow--like the Taylor rule. One version of the Taylor rule is that the target interest rate should be set at 1 + 1.5*(inflation - 2) + .5(output gap.) Taylor favors dropping the output gap term, so that the nominal interest rate should be set at 1 + 1.5*(inflation - 2).

The Taylor rule implicitly makes the target 2 percent inflation. Market Monetarists favor a target for the growth path of nominal GDP. The target is a series of levels of nominal GDP that head off into the future. The goal is to keep (NGDP - NGDP*) equal to zero for each and every future date, where NGDP* is the target level at each future date. NGDP* is growing at a constant rate. The proposed growth rates vary from 5.4% to 2%. However, the key to the proposal is to choose a growth path and stick to it.

How can a central bank actually accomplish this? In my view, if a central bank finds some simple relationship between the short term interest rate in the near future, and nominal GDP in the more distant future, then that would be great. However, it must always be recognized that finding such a regularity is a matter of luck and circumstance. As soon as the regularity breaks down, then adjustments must be made. This is especially true when a short term nominal interest rate is being manipulated.

Taylor claimed that Milton Friedman would have opposed nominal GDP targeting.

For this reason, as Amity Shlaes argues in her recent Bloomberg piece, NGDP targeting is not the kind of policy that Milton Friedman would advocate. In Capitalism and Freedom, he argued that this type of targeting procedure is stated in terms of “objectives that the monetary authorities do not have the clear and direct power to achieve by their own actions.” That is why he preferred instrument rules like keeping constant the growth rate of the money supply. It is also why I have preferred instrument rules, either for the money supply, or for the short term interest rate.

I am not sure what Milton Friedman would do, but Taylor's appeal to rules is confused. Milton Friedman is best known for proposing that the M2 measure of the quantity of money be kept growing at a 3 percent annual rate. But M2 is not directly controlled by the Federal Reserve. From Taylor's perspective, this money supply rule was no rule at all. Where was the actual rule? For example, the policy interest rate is equal to 1 + 1.5*(growth M2 - 3%)?

Of course, during the period when he advocated an M2 money supply rule, Friedman was very critical of the use of short term interest rates as an instrument. He favored looking at the monetary base, which is even more directly controlled by the Fed than interest rates. Did he develop or advocate a rule for the base? Bt = Bt-1 + 1.5*(M2t - M2t*)?

I don't think so. My understanding of "old monetarism," was that the Fed should be given discretion to adjust the monetary base however much is needed to offset any change in the M2 money multiplier so that M2 remains on target. In particular, if bank runs resulted in a decrease in the money multiplier, like in the Great Depression, Friedman insisted that it was the Fed's duty to undertake whatever quantity of open market purchases needed to raise base money enough so that the reduction in the money multiplier is fully offset and the M2 measure of the quantity of money continues on its target path. It has always been my understanding that any errors should be promptly reversed, so that if M2 falls below its trend growth path because of a decrease in the money multiplier, base money should be increased enough to return M2 to the target growth path.

Market monetarists have a view roughly similar to what is outlined above, but taking into account that the observed regularity that M2 velocity was very stable no longer holds. And so, the market monetarist approach is that the least bad replacement target is nominal GDP, and the Fed must adjust the monetary base enough to offset both changes in the money multiplier and velocity.

In my view, the task is inherently more challenging. Statistics of the money supply are reported weekly. While the relationship between depositors, banks, and their borrowers is complicated, the relationship between the demand to hold money and the quantity of money is vastly more complicated. If there is a more or less constant relationship between nominal GDP and some measure of the quantity of money, then adjusting the quantity of base money so that this broader measure of money stays on a constant growth path would be a useful approach to exercising discretion. Similarly, if there is some simple relationship between a short term interest rate and the growth path of nominal GDP, then following a "rule" based on that interest rate would be sensible.

But it must always be understood that there is no reason to expect that any constants will hold in the market system. And when these "instrumental rules" break down, it is the rules that need to change.

While watching some short term interest rate or conglomeration of bank liabilities should not be made into an end in itself, it is essential that the monetary order be based on something other than whatever the central bank likes. "Flexible inflation targeting," means letting the central bank do what it wants.

For many years, I advocated a stable price level. I now believe that this approach is flawed. When the price level is shifted due to changes on the goods side, creating monetary disequilibrium to force it back to a target is disruptive. In my view, keeping total spending on output on a slow, stable growth path is the least bad option. That is the proper rule for the monetary authority. Exactly how best to accomplish that rule where discretion is necessary.

Investment in Equipment and Software

Karl Smith claims that what most people think of as "Investment" is investment in equipment and software, and that it has performed well during the current modest recovery. Real investment in equipment and software has reached its previous peak. The broader measures of investment remain below their previous peaks, but this is due to residential investment and investment in structures. In Smith's view, the problem is construction.

To some degree, Smith is seeking to respond to those "free market" economists, centrally Robert Higgs, who point out that real consumption expenditures has reached its previous peak, so that consumption isn't a problem. Smith has also shown that real retail sales remain below its previous peak, and that the recovery in real consumption expenditures has largely been in implicit rental payments by homeowners, health care paid by Medicare and Medicaid, and the difference between the interest rates banks earn and the very low interest paid on deposits.

My view is that comparing any element of real expenditure to a peak four years ago is really beside the point. As a rule of thumb, each element of real expenditure should by now be about 12 percent higher than its previous peak. (Yes, my rule of thumb doesn't take into account compounding.) More importantly, given that nominal GDP is 14 percent below its growth path of the Great Moderation, my first question is always to compare the nominal value of some type of expenditure to its growth path of the Great Moderation. For example, nominal consumption is nearly 15 percent below its growth path of the Great Moderation. (Real consumption is nearly 12 percent below its growth path of the Great Moderation.)

What about investment in equipment and software? It's current value is $1,137 billion, which has just surpassed its peak of the third quarter of 2007. The trend growth rate of investment in equipment and software during the Great Moderation was 5.92 percent. (From quarter 1 1985 to quarter 4 2007.) This is slightly higher than the trend growth rate of nominal GDP, which was 5.4 percent.

And so what would investment in equipment and software be if it had continued to grow at trend? It's current value would be $1,517 billion. It is currently 24 percent below its trend growth path from the Great Moderation.

Looking at the diagram, perhaps the trend is pushed up by the huge increase right before the 2001 recession. (On the other hand, it is possible that the "problem" was that investment in equipment and software was crowded out by investment in housing.) Interestingly, only a slightly reduced growth rate, to 5.7 percent, puts actual investment very close to this modified trend before the Great Recession.

Even with this slightly slower growth path for investment in equipment and software, it currently remains 17.8 percent below trend. (And if it had been growing with the rest of nominal GDP at 5.4 percent, its current value would be 10% below trend.)

And what about real investment in equipment and software?

Real investment in equipment and software is 28 percent below the trend of the Great Moderation! Like the nominal series, it just passed its previous peak. And while there have been some very high quarterly growth rates during the recovery, (21 percent in the second quarter of 2010,) the collapse was steep during the recession (37 percent in the first quarter of 2009.)

What about the price index for equipment and software? The trend for the Great Moderation was 1.2 percent deflation. And while the price index is currently 5 percent above trend, it has been remarkably stable since 2002 (at 100!) Remarkably, something like the modified nominal series, showing investment 18 percent below trend is likely much more "real" than deflated (that is inflated,) series.

In my view, monetary disequilibrium has depressed nominal expenditure on output across the board. Both consumption and investment in equipment and software have been depressed. That the real value of some element has finally passed its previous peak provides approximately no reason to believe that its current nominal value is appropriate.

Are Nominal Wages Sticky?

Arnold Kling and Bryan Caplan are back to debating aggregate demand and supply. Kling is a skeptic. Caplan supports the "sticky wage" version monetary disequilibrium. Excess demand for money results in reductions in nominal expenditure that should result in lower prices and wages and unchanged output and employment. Prices are flexible and would fall enough to clear markets, but wages only adjust sluggishly. Falling prices and sticky wages imply rising

real wages. Employment and output fall. Easing the monetary disequilibrium would result in higher nominal expenditure, higher prices of final goods, lower real wages, and greater output and employment.

Kling's views are harder to categorize. In my view, they are inconsistent with scarcity. But whether or not his PSST (Patterns of Sustainable Specialization and Trade) makes sense as an explanation for the Great Recession, his most recent argument involved criticism of Caplan's sticky wages approach. ( Sumner also emphasizes sticky wages.) Kling generated the following table:

What Kling sees is that the rate of increase in employment cost slowed more than than the rate of increase in consumer prices. Kling thinks that if employment costs are sticky, then they would have perhaps slowed some (due to growing unemployment) but less than the supposedly flexible consumer prices.

While reasonable enough, what I "see" is that the demand for labor grew faster than the supply of labor resulting in modest growth in real labor compensation (cost to the employers,) during the first period. And then, it would seem, the demand for labor continued to rise, but only slightly more rapidly than the supply of labor during the second period, resulting in even more modest growth in real labor compensation.

But there is some missing information. What happened to employment? My explanation of the above would suggest more rapid growth in employment during the first period and then slower growth in employment in the second period. (The assumption would be that labor supply is growing at a constant rate so that it is the rate of growth of labor demand driving the faster and then slower increases in real compensation.)

Of course, starting in 2007, employment dropped. It is certainly possible that labor supply fell more than demand, and the result was a slight increase in equilibrium real labor compensation. However, a much more plausible explanation is that supply continued to grow and demand fell, and the equilibrium level of real labor compensation fell significantly. But rather than fall with equilibrium real labor compensation, the actual level of real labor compensation grew slightly.

The problem with Kling's reasoning is that during the first period, real labor compensation should have been rising, and in the second period, it should have been falling. It didn't. On the other hand, if product prices are perfectly flexible, then why didn't consumer prices fall? If they are being forced up by growing labor costs, then why didn't they rise by less than labor costs?

Here is a graph of the employment cost index:

It looks like it continued to rise until well after the recession started, and then slowed before rising again at perhaps a slower rate. It looks like it moved to a lower growth path.

What was the growth path of this index during the Great Moderation? What is its current level relative to that growth path? Unfortunately, the series only begins in 2001.

There is a series for wages that exists during all of the Great Moderation--wages of production and nonsupervisory workers. Obviously, this series doesn't include the expense of benefits and it only includes some workers. Still, what has happened to those nominal wages during the Great Moderation?

This measure of nominal wages is 1.39 percent below the trend growth path of the Great Moderation. The price level, as measured by the GDP chain-type price index, is 1.79 percent below its trend growth path. While both prices and wages have risen continuously, this approach and measure suggests that prices are slightly more flexible relative to trend than wages--but not much.

What about compensation? The wage cost index Kling reports only goes back to 2001, but aggregate labor compensation and trend for the Great Moderation are shown below:

Like other nominal measures, the amount firms spend on wages and benefits fell below the trend of the Great Moderation and remains well below trend. However, at 16.47 percent, it has fallen further than nominal GDP, which is "only" 13.87 percent below trend. The other noticeable deviation was in 1999 and 2000, when a positive the gap grew to nearly 5 percent before rapidly disappearing in the 2001 recession.

Employment has fallen during the Great Recession as shown below:

Employment is 9.53 percent below the trend of the Great Moderation. (This is level of employment from the household survey.) There is a very noticeable "boom" in employment right before the 2001 recession. Employment was nearly 3 percent above trend in the second quarter of 2000.

What has happened to compensation per employed person?

Compensation per employed person is currently 7 percent below the trend of the Great Moderation. It did drop significantly during the first quarter of 2009, at a 5% annual rate, but that was fully reversed after two quarters. A better characterization of the period is that compensation per worker quit growing during the recession, but when the economy began to recover in the third quarter of 2009, it began growing again, but remains on a lower growth path. Also note that the "boom" in employment is reflected in a boom in compensation per worker as well right before the 2001 recession.

During this period, there have been substantial changes in the hours worked. Unfortunately, the series going back to 1984 is for production and nonsupervisory workers. Still, the loss in average weekly hours for all private employees was about the same during the Great Recession (About one hour.) Government workers aren't included. (Some government workers were given furlough days. I was.) The following is the average hourly compensation calculated using the average weekly hours of production and nonsupervisory personnel.

When adjusted for the drop in hours worked, the compensation per hour did not drop in the first quarter of 2009. However, its growth certainly slowed with the onset of the Great Recession. It is currently 7.3 percent below the trend of the Great Moderation. It is not that different from the compensation per employed person. (The boom in total compensation, employment, and compensation per worker, also shows up in compensation per hour, though is lagged a bit, hitting 3 percent in the first quarter of 2000.)

These results show no evidence that firms are able (or willing) to significantly cut labor compensation per worker. However, like Kling's simpler analysis, it does suggest that the failure of final goods prices to drop significantly below the trend of the Great Moderation, in the face of a nearly 14 percent decrease in nominal GDP from trend, should not be blamed on labor costs. Nominal labor costs per employee have fallen much further from trend than the GDP chain-type price index.