Tuesday, January 22, 2013

Reason on Nominal GDP level Targeting

Reason is the flagship magazine of the libertarian movement, and I have been very disappointed that it has ignored Market Monetarism.   Many, if not most, Market Monetarists are libertarians, typically of the more moderate sort.   At least according to the more radical libertarians, Reason should be right up our alley.   That includes Scott Sumner, who is the leading Market Monetarist writer.   Where is the Reason article on Sumner?

Now, without mentioning Market Monetarism or any Market Monetarist, Reason finally has at least mentioned nominal GDP level targeting.     Of course, the article by managing editor Tom Clougherty, is almost entirely critical.  Only at the end does the mention:

None of this is to deny that NGDP targeting could be an improvement over inflation targeting.

This is the key point made by Market Monetarists.   Nominal GDP level targeting is better than inflation targeting.   But we would add that it is also better than targeting some measure of the price level, some measure of the quantity of money or using gold or some other precious metal to define the unit of account.

What are his concerns?

First, there is  the liquidity trap issue.   The central bank may be able to create money, but supposedly it can't get that money into the broader economy and so impact nominal GDP.  At one time, libertarians took as gospel that increases in the quantity of money would result in higher prices for goods and services.   The Keynesian notion that changes in the quantity of money have little or no impact was ridiculed.   But the liquidity trap is the new wisdom.

Anyway, if the inflation rate is 2% and the central bank insists that the inflation rate is going to stay 2%, then even if the quantity of money rises to a point that would be inconsistent with 2% inflation, then an expectation that inflation will remain 2% as the central bank claims is an expectation that the excessive increase in the quantity of money is temporary and will be reversed as soon as it impacts spending on output and inflation.  In that circumstance, we can expect that new money will not get into the broader economy.

If, instead, the central bank claims that it is targeting a growth path of nominal GDP, and nominal GDP is below that target growth path, then an increase in the quantity of money sufficient to reach the target growth path will not be expected to be reversed.   Further, an increase in the quantity of money beyond what is consistent with the target will be expected to be reversed only partially.   That part necessary to reach and stay on the target will be expected to be permanent.    Still further, an increase in the quantity of money inadequate to reach the target will be expected to be augmented in the future.   Not only will the money created by the central bank get into the broader economy, extra money will seem to "appear" in anticipation of money that the central bank has yet to create!   

In reality, central banks have been able to keep inflation very close to their targets during the Great Recession.    That was what they were trying to do, and they have done it.    Market Monetarists believe that inflation is the wrong target--a growth path for nominal GDP is a better target.

The second issue is the "sectoral problem."   The idea is that the economy is too concentrated on certain sectors and that other areas of the economy need to expand.   For example, the economy is too dependent of financing and building new homes.   The level of new home production (and the financial market activity associated with it) depends on low interest rates.    Efforts by the central bank to get nominal GDP back to a target growth path involve increases in the quantity of money, which (supposedly) involve lower interest rates.   These lower interest rates will encourage new home building and the financial activity associated with it.   But that needs to shrink, not expand.  The central bank is not able to adjust the economy so that the new money reaches the sectors of the economy that need to expand.

The Market Monetarist view is that reallocations between sectors can best occur with nominal GDP remaining on target.    Suppose nominal GPD is on target and housing and the associated financing begins to grow more slowly.   It is so overbuilt, that there are not enough new buyers.   It is true, that ceteris paribus, the slowdown in credit demand should result in lower interest rates.   These lower interest rates will to some degree tend to increase housing demand and keep construction and the associated financial activity growing after all.   However, the lower interest rates will also result in more consumption spending as well as greater investment demand.   Perhaps foreigners will be less interested in helping to finance all of those new houses at lower interest rates and so the exchange rate will fall, making exports more competitive.   Further, the higher prices of imports will make domestic production a bit more profitable as well.    With nominal GDP targeting, the decrease in interest rates is limited such that while spending on housing and the associated financing shrinks a bit lower on net, this is offset by the expansion in spending on domestically produced consumer goods, spending on domestically produced capital goods, and exported consumer and capital goods.   There is a rebalancing with total spending on output remaining on a stable growth path.

If nominal GDP falls below target, then central bank should get it back to target as soon as possible, and then allow market forces to adjust interest rates so that the proper shifts between sectors can occur.    Now, if worries about unemployment have resulted in elevated saving or expectations of poor sales have resulted in less investment, then the interest rate that coordinates saving and investment is lower.    Worrying that interest rates low enough to coordinate saving and investment given current expectations will result in "too much" spending in sectors that should contract, as if expectations in those sectors are not also negatively impacted both those expecations, is logically inconsistent.    

Further, Market Monetarists point out that a central bank committed to returning nominal GDP to a target growth path can generate higher interest rates.    It is not just about lower interest rates motivating more borrowing and so more spending.   It is also about expectations of higher spending in the future generating  less lending and more spending in the present.   When people spend the money they have in the bank or sell off their holdings of short term or long term bonds to fund spending, that is less lending, which tends  to raise interest rates even while spending rises.

Third, there is the issue that depending on what target growth rate is selected and when it begins, the current level of nominal GDP might be either be below or above the target.    This is supposedly a "knowledge problem."     For example, if a 5% growth path for nominal GDP had started in 1965, the current level of nominal GDP is much too high.  

Of course, if a 5% nominal GDP level path had started in 1965, we would have been spared the Great Inflation and the current level of nominal GDP level would be much lower.    During the Great Moderation, nominal GDP remained on a remarkably stable growth path.   The reason for the Great Recession and weak recovery is that nominal GDP is on a much lower growth path today.  

Market Monetarists don't claim 5% or 5.4% or 4.5% starting at some specific date is "ideal" or that some perfect growth path must be discovered.   (Personally, I favor a 3% growth rate.)    Choose a growth path and stick with it.   And if the growth rate must be changed, change the growth rate of the target path starting either now, or better yet, in a few years.   

For example, the growth path of nominal GDP during the Great Moderation was 5.4 percent.   Many would count that as a bit too high.   So, in 2006, it would have been appropriate to say that starting in 2008, it will only grow 5%.    Or, if the slow down in the CBO estimate of potential output suggests 4.5% is better, announce that.    Don't go back 10 years, figure out what nominal GDP would have been with a 5% or 4.5% growth rate, and announce and immediate drop to what the level would have been.  

As for today, my view is that the upper limit on an appropriate growth path is the one from the Great Moderation.   And I certainly don't see any reason to propose shifting to a growth path that requires nominal GDP to fall from current level at any point.  

For some time now, I have been advocating a Reagan-Volcker nominal recovery, about 10% nominal GDP growth for a year, and then a shift to a 3% growth path.   If the CBO is correct and productive capacity only grows at 2.5% for the foreseeable future, then  I think the onus will be on "fiscal policy" (and regulatory policy) to improve the supply-side of the economy enough for productivity to begin growing appropriately.   If the problem is slower population growth or retiring baby-boomers, the answer is to look to immigration policy.    And only after those alternatives are exhausted, should a change in the nominal GDP growth rate be considered.   And if it is implemented, it should start something like 5 years after the decision is announced.

In my opinion, it would have been great to start a 3% growth path for nominal GDP in 1928.   But I hardly think that returning today's nominal GDP to what it would have been under such a regime is sensible.   I think it would be likely disastrous.

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