The Goldman Sachs and the Reagan Volcker Alternative--About the Same?

Nominal GDP, the flow of money expenditures on current output, is approximately 14 percent below the growth path of the Great Moderation. The norm of nominal GDP growth path targeting implies that this was an error and it should have been prevented or reversed long ago. However, the Fed has yet to adopt the norm. Given where we are today, what should be done? What is the appropriate growth path for nominal GDP?

The recent proposal from Goldman-Sachs includes a growth path that apparently was generated by starting at the growth path of the Great Moderation at the end of 2007 and then lowing the growth rate from 5.4 percent to 4.5 percent. Presumably this is the sum of a trend inflation rate of 2 percent and estimates of the growth rate of potential output over the last decade of 2.5%. During the Great Moderation, the trend growth rate of potential output was 3 percent, and the growth rate of nominal GDP of 5.4 percent resulting in an inflation rate of 2.4 percent as measured by the GDP deflator.

The Goldman Trend is shown in green below.

The current level of the Goldman-Sachs alternative is $16,905 billion and the current value of nominal GDP, $15,198.6 is 10.1 percent below. The usual Market Monetarist approach is to specify a target one year in the future, so the target for the third quarter of 2012 is $17,679 billion. To reach that level in one year, the growth rate of nominal GDP would need to be 16.3 percent.

The target for two years into the future, for the third quarter of 2013 is $18,488 billion. The annual growth rate of nominal GDP from its current value to that level two years from now would be 10.83 percent. Reaching the new growth path over two years suggests a target for next third quarter of 2012 of $16,824 billion.

While 11 percent nominal GDP is quite high, the annual growth rate of nominal GDP for each quarter from the second quarter of 1983 to the second quarter of 1984 was over 10 percent. If Reagan and Volker could manage it, certainly it is possible.

In a previous post, I had suggested that the Fed copy Reagan/Volcker and target nominal GDP growth for the next two years identical to that of 1983 and 1984. In the last few days, I thought of a slightly different approach. Rather than start now, instead, suppose that the Reagan/Volker growth rates had occurred at the trough of the Great Recession, the second quarter of 2009. Nominal GDP is now 10.7 percent below that growth path. If the new growth rate were 4.5 percent, then the similarity to the proposed Goldman-Sachs alternative is striking.

In the diagram below, nominal GDP is represented in blue. The growth path of the Great Moderation is in red. The Goldman-Sachs alternative is in green. If the growth rate of nominal GDP had matched that from 1983 and 1984 from the second quarter of 2009, the resulting "Reagan/Volcker" growth path is shown in black. The dashed line shows a two year adjustment growth path. The growth rate for those two years would be 10.7 percent.

The difference between the Goldman Sachs and Reagan Volcker alternatives is so small, it hardly makes a difference. It is pretty much the situation that Goldman Sachs proposed a new growth path that approximates what would have happened if Obama and Bernanke had done their job as well as Reagan and Volcker. All I can say is--better late than never.

More on a "Reaganite" Monetary Policy

When Ronald Reagan was President and Paul Volcker was chairman of the Federal Reserve, monetary policy generated nominal GDP growth at a 9 percent annual rate for 1983 and 1984. The growth rates for total spending on output for those eight quarters were:

1983-01 8.19%

1983-04 11.80%

1983-07 11.87%

1983-10 11.11%

1984-01 12.73%

1984-04 10.26%

1984-07 7.07%

1984-10 5.79%

The increase in money expenditures on final goods and services for those two years was nearly 20 percent. By the end of the Reagan administration, the new Chairman of the Federal Reserve, Alan Greenspan, had started the U.S. on the 5.3% growth path of nominal GDP that characterized the Great Moderation.

 

Suppose that President Obama Chairman Bernanke would make a similar commitment for monetary policy, to raise nominal GDP 19 percent over two years, an annual growth rate of 9 percent, and then a 5 percent growth path thereafter. The key element of the policy would be a target for nominal GDP of $17,912 billion for the second quarter of 2013, and then $18,136 billion for the third quarter, and so on, increasing at an annual rate of 5 percent each quarter.

The level of nominal GDP from 1983 to 2011 is shown in blue. The trend growth path of the Great Moderation, from the first quarter of 1983 to the fourth quarter of 2007, is shown in red. The trend growth path of the "recovery" since 2009 is shown in brown. And the proposed "Reaganite" growth path is shown in green.

The trend growth rate of nominal GDP for the recovery has been 4.3 percent. The new growth path increases 19.3 percent, which leaves it 6.4 percent below the trend of the Great Moderation. The new growth path has a 5 percent growth rate, slightly less than the trend growth rate of the Great Moderation, which was 5.4 percent.

What would be the potential benefits? What would be the risks?

The most important potential benefit would be to generate the sort of "V shaped" recovery in real output and employment that was generated in 1983 and 1984 by Reagan and Paul Volcker. The production of goods and services grew at a 6 percent annual rate for those two years, rising more than 12 percent.

1983-01-01 4.9%

1983-04-01 8.9%

1983-07-01 7.8%

1983-10-01 8.2%

1984-01-01 7.7%

1984-04-01 6.8%

1984-07-01 3.9%

1984-10-01 3.2%

The gap between real GDP and potential real GDP (actual production and the estimated productive capacity of the economy,) went from 7 below potential to 1 percent below potential. With the U.S. economy today producing 6.8 percent below potential, a "Reaganite" monetary policy looks to be exactly what is needed.

What is the risk? The risk is inflation.

With nominal GDP targeting, the expected value of the price level is the target for nominal GDP divided by expected potential output. The current value of nominal GDP, $15,013 billion, divided by the CBO estimate for potential output, $14,246 billion, implies a value of the price level (GDP deflator) of 105.4. That is nearly 7 percent below the current price level of 113.

To a large degree, the "inflation" generated by a monetary policy that raises the target for nominal GDP would be an increase in this "equilibrium" price level rather than the actual price level. For the most part, the aim is to generate a rapid recovery without the need for rapid deflation.

Unfortunately, a level of nominal GDP of $17,912 billion in the second quarter of 2013, when divided by the projected value of potential out for that quarter, $14,756 billion, implies a price level of 121.4. That is approximately 7.3 percent higher than the current price level.

The Fed's target for inflation appears to be approximately 2 percent a year, and if the Fed hit that target exactly for the next two years, the price level would be 117. The "Reaganite" monetary policy should result in a price level that is 3.6 percent higher that that growth path. While the current price level is about 1.8 percent below the trend of the Great Moderation, shifting to the "Reaganite" monetary policy would push the price level approximately 1 percent above the trend price level of the Great Moderation.

In the diagram below, the price level, measured by the GDP chain-type index, is shown in blue. The trend for the Great Moderation, from first quarter 1983 to fourth quarter 2007, is shown in red. A 2 percent inflation rate starting from the price level in the second quarter of 2011 is shown in brown. The price level expected from the "Reaganite" monetary policy, found by dividing the target for nominal GDP by the CBO estimate of potential output, is shown in green.

Shifting to the new growth path for the price level over two years would require an inflation rate of 3.6% per year. After the new 5 percent growth path for nominal GDP is reached, however, the inflation rate would return to a more modest 2.5 percent.

While 3.6 percent inflation is substantially higher than the Fed's 2% inflation target or the 2.3 percent inflation trend of the Great Moderation, during the period of "Reaganite" monetary policy, between 1983 and 1984, the inflation rate was also substantially higher than during the Great Moderation as well:

1983-01-01 3.41%

1983-04-01 2.91%

1983-07-01 4.06%

1983-10-01 2.88%

1984-01-01 4.93%

1984-04-01 3.60%

1984-07-01 3.26%

1984-10-01 2.35%

Over the two year period, the price level went up approximately 6 percent, an annual inflation rate of slightly more than 3%. Why would a similar policy have a somewhat more inflationary impact today?

 

Sadly, there has been a substantial productivity slow down during the last few years. During the Great Moderation, the productive capacity of the economy and real output both grew at approximately 3 percent per year. According to the CBO estimates, the growth rate of potential output has been much slower over the last five years

In the diagram below, real GDP is represented in blue. That is the production of goods and services, corrected for inflation. Potential output, the productive capacity of the economy as measured by CBO, is shown in black. The trend growth of both real GDP and potential during the Great Moderation is shown in red.

That the production of goods and services is currently well below the productive capacity of the economy is clear on the diagram, however, it is only slightly more than half of the shortfall of output from trend. According to the CBO, slower growth in productive capacity is also responsible for nearly half. Projecting those trends into the future, by 2020, potential output is forecast to be nearly 10% below the trend of the Great Moderation!

With nominal GDP targeting, if potential output rises less than trend, the growth path for the price level shifts up. If nominal GDP had stayed on the growth path of the Great Moderation, and potential GDP growth had slowed as estimated by the CBO, the price level (found by dividing the trend value of nominal GDP by potential output) would have been much higher.

 

In the diagram below, P* is the price level found by taking the trend growth path of nominal GDP from the Great Moderation and dividing by the CBO estimate of potential output. It is substantially higher than the trend growth path for the price level shown in red or the "Reaganite" alternative shown in green.

In the second quarter of 2011, the trend growth path of nominal GDP from the Great Moderation divided by the CBO estimate of potential output is 122.2. That is more than 8 percent above the current price level and 6 percent above the trend price level of the Great Moderation.

The expected price level from the proposed "Reaganite" policy in the second quarter of 2013 would be 6.4 percent below the price level that would have existed if nominal GDP had remained on the growth path of the Great Moderation. In the diagram below, the trend growth rate of real GDP and potential GDP from the Great Moderation is shown in red. The growth rate of real GDP is shown in blue. And the growth rate of potential GDP according to the CBO is shown in black.

With nominal GDP targeting, the persistently slow growth of potential output results in higher inflation rates. These are shown below. The inflation rate implied by the growth path of nominal GDP from the Great Moderation and the CBO estimate of potential output is show in black.

Notice that in the diagram above, the inflation rates generated by the "Reaganite policy" are not much higher than what would have occurred if nominal GDP had remained on the trend of the Great Moderation. Slow growth in the productive capacity of the economy would have resulted in inflation rates well above 3 percent.

Recently, Chairman Bernanke has said that monetary policy is no panacea. Given the performance of nominal GDP over the past few years, and particularly that it is nearly 14 percent below the trend of the Great Moderation, Bernanke's statement deserves the criticism it has received, particularly from Market Monetarists. Monetary policy can and should fix problems due to inadequate money expenditures on output.

However, monetary policy is no panacea for slow growth in productive capacity. What Bernanke needs to recognize is that slow productivity growth is not a reason to lower the growth path of money expenditures on output. Real output will grow more slowly, and inflation will rise. That a "Reaganite" monetary policy will sadly result in higher inflation when there is a productivity slowdown should be expected.

And that suggests are role for "Reaganite" fiscal and regulatory policy. Tax reform, control of government spending, and sensible deregulation can all help reverse the productivity slowdown. And that can result in both greater growth in real output and lower inflation.

Once the economy has recovered, and productivity growth has improved, it will be time to shift from the 5 percent growth path for nominal GDP to a 3 percent growth path. This would keep the price level stable on average, fulfilling Reagan's legecy and ushering in truly noninflationary prosperity.

It is time for the Republicans in Congress and the Presidential candidates to demand that Obama and Bernanke adopt a "Reaganite" monetary policy now. Step one--nominal GDP at $17.9 trillion for the second quarter of 2013.

A Reaganite Monetary Policy

While reviewing Scott Sumner's rather modest proposal to raise the growth path of nominal GDP to 6%-6%-5%-5%, (something he considers to be as much as is politically possible,) another approach came to mind.

Why not adopt the growth rates of nominal GDP from Reagan's 1983 and 1984 recovery from the recession of 1982?

Looking at monetary policy in the Reagan administration is especially appropriate because it was at the end of Reagan's second term that nominal GDP reached the growth path of what would become the Great Moderation.

Getting to that growth path involved some quite rapid growth in nominal GDP. The average growth rate of nominal GDP for 1983 and 1984 was nearly 10%.

This rapid growth in nominal GDP and the shift of nominal GDP to the growth path of the Great Moderation appeared closely associated with the return of real GDP (the actual production of goods and services) to potential GDP, (the productive capacity of the economy.)

Suppose the Fed was willing to replicate the growth rates of nominal GDP from 1983 and 1984 and then went to a 5% growth rate. What would nominal GDP look like?

The new growth path starts in the third quarter of 2013 with a nominal GDP of $18,609 billion. It then grows at the desired rate.

At the end of the Reagan administration, the U.S. was on the trend growth path of nominal GDP for the Great Moderation. The growth rate was approximately 5.4%. With the productive capacity of the economy growing at 3% over the period, the result has been inflation of slightly more than 2%. While Reagan failed to completely extinguish inflation, the result was much better than the highly inflationary seventies.

Perhaps with this Reaganite monetary policy, the final step towards ending inflation could be taken. Rather than a 5% growth path, a noninflationary growth path of 3% could be instituted. If the productive capacity grows at 3% as it did during the Great Moderation, the result will be a stable price level and zero inflation.

However, this stable price level would be a long run average. A poor harvest or a disruption in oil markets would both reduce production and result in temporary inflation as the price level shifts up to a higher level. On the other hand, unusually rapid productivity growth would lead to a lower price level, and temporary deflation.

Still, a 3% growth path for nominal GDP would not be consistent with persistently high, much less increasing, inflation. Further, this "Reaganite" monetary policy would help avoid disasters like the lesser Depression.

Scott Sumner's Target

Scott Sumner advocates nominal GDP targeting, level targeting. What level does he propose to target now?

I asked, and he said that he favors 6%-6%-5%-5%. In other words, two years of 6 percent growth and then 5% growth afterwards.

The diagram below shows nominal GDP from 1980 until the second quarter of 2011. The trend for the Great Moderation is generated between the first quarter of 1985 and the fourth quarter of 2007. This is a slight change from previous trends that I have used. The reason for the adjustment was the rapid growth in nominal GDP during the recovery from the 1982 recession. Still, this adjustment in the period left the average growth rate at 5.4%.

Examination of the diagram shows that Sumner's proposal is very similar to just a new 5% growth path for nominal GDP at its current level.

While Sumner describes this in terms of growth rates for various periods, a target for a growth

path is a series of levels. This is the series of levels he proposed:

4/1/2011 15012.8

7/1/2011 15237.99

10/1/2011 15466.56

1/1/2012 15698.56

4/1/2012 15934.04

7/1/2012 16173.05

10/1/2012 16415.65

1/1/2013 16661.88

4/1/2013 16911.81

7/1/2013 17123.21

10/1/2013 17337.25

1/1/2014 17553.96

4/1/2014 17773.39

7/1/2014 17995.55

10/1/2014 18220.5

While the target for the fourth quarter of 2012 is $16,415 billion, (Sumner proposes actually targeting nominal GDP one year into the future,) the new growth path really starts in the third quarter of 2013. It is a 5% growth path that starts at $17,123.21 and is made up of a series of quarterly numbers. There is a two year period to shift up to the new path--one percentage point per year.

The trend growth path for the Great Moderation was approximately 5.4%, and its current level is 13.8% below trend. With Sumner's proposed growth path, the gap will shrink to 12.79% of the trend of the Great Moderation by the third quarter of 2013, but then it will start to grow again, because the slightly slower growth rate, returning to its current level by the first quarter of 2016.

While I favor an even greater reduction in the growth rate (from 5.4% to 3%,) I favor shifting up to a much higher growth path. To me, Sumner's proposed target for next year is much too low.