Tuesday, May 1, 2012

More on Andofatto's Challenge

There have been several efforts by market monetarists to answer David Andolfatto's question.   While I thought the answers quite good, they mostly were explanations as to why a regime of nominal GDP targeting is superior to inflation or price level targeting.  

Nick Rowe gave three reasons for nominal GDP targeting, all of which were very good.   1) Stable nominal GDP is a better baseline for contracts than a stable price level or inflation because it shares the risk of unexpected productivity shocks between borrower and lender.  (David Eagle has done much work on this topic.   2)  Nominal GDP targeting performs as well as inflation or price level targeting for aggregate demand shocks and depending on the exact nature of the shock, sometimes much better than price level targeting for aggregate supply shocks.  3) Nominal GDP level targeting does as well as price level targeting in self correcting aggregate demand shocks, and better than inflation targeting.    All key points, but the framework is comparative institutional--what regime is best?     Inflation targeting is weak on self-correction.   Price level targeting is disastrous for some supply shocks.   Nominal GDP targeting looks like the least bad option, and by the way, it is probably the better base line for contracting.   If someone really wants to be shielded from economy-wide real risk, then a special inflation-indexed contract would be appropriate, assuming there are lenders willing to make that commitment.

David Glasner added another regime-oriented plus related to nominal and real interest rates.   To the degree that the natural interest rate depends on expected future real output, then the negative relationship between real output growth and inflation with nominal GDP targeting tends to stabilize the nominal interest rate.   For example, expected slow real output growth will lower the natural interest rate, and while this will tend to lower the nominal interest rate, the expected slow real output growth will raise expected inflation, tending to raise the nominal interest rate.   I suspect Glasner puts no more weight on stable nominal interest rates than I do as a general proposition.   However, he is very concerned with avoiding situations where the equilibrium nominal interest rate is negative.   Nominal GDP targeting makes that less likely.       

Scott Sumner responded as well, with a grab bag of 9 arguments for "more" nominal GDP and two opposed to inflation targeting.   Those last two arguments are clearly based on "comparative institutions," as were many of the 9 arguments in favor of nominal GDP.     I agreed with all of Sumner's arguments.   

But what about Andolfatto's question?   He wasn't asking whether or not we should have a regime of targeting a growth path of nominal GDP rather than a growth path for the price level or inflation rate.   He was asking whether higher nominal GDP is desirable for the economy in 2012.

Sumner argues that the price level should return at least part way to its 1984-2008 trend because the shift from debtor to creditor is undesirable in the midst of a global debt crisis.   He adds that financial markets appear to think that higher inflation is desirable at this time (citing Glasner.)   He argues that a drop in real wages would desirable in at least some labor markets--people that "should" be getting nominal wage cuts will get appropriate real wage cuts.   He argues that the Europeans might respond to growth in U.S. nominal GDP by expanding their own nominal GDP.   And finally, he argues that a monetary policy that raises nominal GDP will "crowd out" inefficient public policies, like debt-financed government spending, that are justified by the supposed need to raise aggregate demand.  

Sumner gave first place to an argument that is a call for a regime shift:
One reason I favor more NGDP now is that even a belated shift toward level targeting would help to restore Fed credibility in future recessions, which is especially important if they again run up again the zero bound (as Woodford has emphasized.) It’s easier to prevent NGDP from plunging in the short run if markets expect it to return to trend in the not-too-distant future. The second advantage is that it makes policymakers more accountable. They can’t keep sweeping past errors under the rug (as the BOJ does.)
Face it, market monetarists are all about rules.   Andolfatto's question, "why is increasing nominal GDP a good idea right now" is difficult to answer.   
From 1985 to 2008, nominal GDP remained very close to a 5.3%  growth path.  Market monetarist "theory" has come to emphasize the benefits of expectations generated by clear communication of a goal for future levels of nominal GDP.    While there are some hints that Greenspan actually cared about nominal GDP, there was no clear communication of a nominal GDP growth path.  The actual "rule" was something like "mumble, mumble" something about price stability, and no long run trade off between inflation and unemployment.   

The dual mandate requires price level stability in the long run and high employment.   Somehow, a stable price level was transformed into persistent 2% inflation, and high employment to slowly closing any output gap between real GDP and potential.    The Taylor rule suggests a formula relating the policy intereset rate to deviations of inflation from 2% and the output gap.     Mainstream macroeconomists, anyway, assume that everyone in the real world takes that formula very seriously.
Market monetarists like to give the actual stable growth path for nominal GDP credit for the relatively mild fluctuations in real output and employment and the low and stable inflation rate during the Great Moderation.    The disaster of 2008 and 2009, and the current low level of output compared to its previous trend and low employment relative to its previous peak are blamed on the empirical reality that nominal GDP fell well below the growth path of the Great Moderation and remains far below it today.

The other empirical reality is that the price level fell to only a slightly lower growth path and the shift in the growth path of wages was smaller still.   The theory is that with nominal spending on output falling to a growth path 12% below the previous trend, and prices and wages falling only about 2% below trend, real expenditure fell to about 10% below trend.   Firms responded to the shrinking sales by cutting production and employment.  

After the trough, nominal GDP began to rise again, but prices and wages continued to grow and on an only slightly lower growth path.   Real sales have expanded, and firms have responded by expanding production but at a slow rate.   Real sales, and so, real output and employment, remain far below the trend growth path of the Great Moderation.

 The prediction is that if nominal GDP grew more quickly, promptly returning to the growth path of the Great Moderation, prices and wages would perhaps rise a bit, also returning to their growth paths of the Great Moderation.   However, real sales would grow quickly, and firms would respond to the growing real sales by expanding production and employment rapidly.    Production and employment would then recover to something close to their growth paths of the Great Moderation.

Market monetarists are aware that there is an alternative explanation.   On that view, in 2008, the productive capacity of the economy fell, and shifted to a lower growth path.   Happily, nominal spending on output fell along with the productive capacity of the economy, so that only modest adjustments in the growth paths of prices and wages were needed.   Apparently about a 2% reduction in the growth path of prices was necessary and slightly less for wages.  

What is the evidence for this?   It is pure theory--market clearing.   If nominal expenditure had fallen to a growth path that was more than 2 percent below the growth path of the productive capacity of the economy, then theory "proves" taht prices and wages would have fallen by more.   In theory terms, the theory is that if  real expenditure is below the productive capacity of the economy, then there are gains from trade by lowering prices and wages.    Optimizing agents will not sacrifice the greater utility they could receive by utilizing any idle productive capacity to produce more consumer goods in the present and future.  

I find this theory plausible enough.     It is strengthened by the empirical reality that firms are raising prices and wages rather than simply leaving them unchanged.   If there is plenty of excess capacity--idle land, labor, and capital--then the current low levels of nominal expenditure growth would generate larger gains from trade in the form of more real output and employment if prices and wages were left unchanged.    Perhaps cutting prices and wages is a challenge, but why increase them in the face of what are supposedly wide ranging surpluses?   (That's not to say that firms are continuing to build up unsold inventories of goods, but rather that they supposedly have the capacity and willingness to expand production if they could sell more at current prices.   Why raise prices and wages unless there would be shortages at unchanged prices?)

Andolfatto doesn't discuss this, perhaps because it is all supposed to be obvious.   In his second post on his challenge, he does link to an earlier post where he critiques "sticky prices."    To me, it seemed like a criticism of periodic price adjustments due to menu costs.  

I think it is fair to say that market monetarists don't have some unique explanation as to why changes in nominal expenditure, even given unchanged productive capacity, don't result in rapid adjustments in prices and wages, but instead result in changes in real sales, and firms adjusting production and employment to those real sales.   I am more than willing to replace periodic price adjustments due to menu costs (Calvo pricing) with some alternative.    Search theory and game theory might provide better explanations.   I am doubtful, however, that prices and wages do smoothly adjust to keep real expenditure equal to productivity capacity, and that "general gluts" are just an illusion after all.    (Game theory considerations seem to be a likely candidate for explanations as to why the trajectories of prices and wages have such inertia.    Could a central bank's commitment to 2% inflation generate a Schelling point of everyone raising prices and productivity-adjusted wages by 2% from their current levels?)

Andolfatto continues to return to the issue of debt.   I was a bit puzzled by his notion that market monetarists believe that debt overhang is restricting aggregate demand, and that inflation is desirable to reduce this debt overhang and so allow additional real expenditures.     If more real expenditures are needed, presumably because prices and wages have failed to fall enough and left real expenditures below potential output, then expanding nominal expenditure would increase real income and also reduce the debt overhang.   Sumner, anyway, often points out that it is the increased nominal GDP that directly fixes the debt overhang--to what degree it involves higher prices or higher real output doesn't much matter on that particular count.  

Andolfatto focuses on the small shift in the growth path of the price level (about 2 percent,) when it is the large shift in the growth path of nominal GDP that is important (more like 12%) for preexisting debt contracts.   Of course, if prices and wages are all sufficiently flexible so that this reflects a very large decrease in productive capacity, then raising nominal GDP back to its previous trend would result in substantially higher inflation for a time.   While this would count as a benefit of a nominal GDP targeting regime, creditors didn't make their contracts under such a regime.   Most of the contracts were made under the Greenspan mumble regime or the unspoken 2 percent inflation regime.   We had a regime where the government (the Fed) promised creditors that they would be shielded from any loss due to "supply shocks."   All the losses would be suffered by equity investors and workers.

Of course, with a "flexible" inflation target, you really do get "mumble, mumble."   Flexibility means that inflation will be on target unless the Fed decides that it is best for it not to be on target.   Not much of a rule.   So, mumble, mumble, flexible, low inflation...what should be expected?
My own view is that the Fed should immediately implement rapid growth in nominal GDP approximating the Volcker-Reagan recovery of 1982-1984.   And then, we should start a new regime--a 3% growth path for nominal GDP.    Given that regime, if we have some failure by the Fed to hit the target, I certainly will favor prompt and rapid action to return to target.


  1. Very good post Bill.

    One question: deep down, at root, is there any difference between: David Glasner's valid point about the relation between the equilibrium interest rate and NGDP growth; and the self-correcting mechanism of NGDP level path targeting?

    I have a feeling these two points are related.

    "Face it, market monetarists are all about rules. Andolfatto's question, "why is increasing nominal GDP a good idea right now" is difficult to answer."

    Yep. Good point.

  2. I will grant that the stable nominal interest rates and the self correcting characteristics are related.

    Glasner responded to my comment on his blog by pointing out that he had that effect in mind and not solely the sort of scenario I described.