Thursday, September 27, 2012

White on the 5 % "Bubble Path."

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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