Friday, October 21, 2011

Three Objections to NGDP Level Targeting

Not everyone is a fan of nominal GDP level targeting.  Here are three objections to it that I have run across recently followed by responses to them. 

1.  Further monetary stimulus is pointless since banks aren't doing much lending.
The ability of the Fed to influence total current dollar spending does not depend on banks creating more loans.  Rather, it depends on the Fed's ability to change expectations so that the non-bank public rebalances their portfolios appropriately.  Recall that a nominal GDP level target means the Fed makes an unwavering commitment to buy up assets until some pre-crisis nominal GDP trend is hit.  As Nick Rowe notes, just the threat of the Fed doing this would cause the public to expect higher nominal spending growth and higher inflation.  This change in expectations, in turn, would cause investors to rebalance their portfolios away from liquid, lower-yielding assets (e.g. deposits, money market funds, and treasuries) toward higher-yielding assets (e.g. corprate bonds, stocks, and capital).  The shift into higher-yielding assets would directly affect nominal spending through purchases of capital assets and indirectly through the wealth effect and balance sheet channels.  The resulting increase in nominal spending would increase real economic activity, improve the economic outlook, and thus further reinforce the change in expectations.

Bank lending would probably respond to these developments, but it would not be driving them.  It is interesting to note that FDR did something similar to nominal GDP level targeting in 1933 and it sparked a sharp recovery that lasted through 1936.  Bank lending, however, did not recover until 1935.  Bank lending, therefore, was not essential to that recovery.  That may be less true today, but in any event the key point here is that if bank lending does increase it would do so as a consequence of the improved economic conditions brought about by the change in expectations.  

2.  Additional monetary stimulus will only further harm savers and banks' capital position.
The concern here is that additional monetary stimulus would require a further lowering of interest rates, particularly long-term interest rates since short-term interest rates are already at the zero percent bound.   This would harm savers and banks' capital position by lowering net interest margins.  The latter is a big deal given the problems in the banking industry.  But here is the thing.  If a credible nominal GDP level target is implemented there should be real economic gains (as noted above) that would  lead to higher real interest rates.   Savers and banks would benefit.  If we can agree that primary cause of the recession is insufficient aggregate demand, then the fact that the U.S. economy is still sluggish is a sign that monetary policy has failed to do its job.  It has passively allowed the economy to weaken by failing to shore up aggregate demand.  Once it does shore up aggregate demand, as it should under a nominal GPP level target, interest rates will increase and these concerns will disappear.

3.  Nominal GDP targeting has been shown theoretically to increase volatility.
Laurence Ball (1999) demonstrated theoretically in a widely-cited paper that nominal GDP targeting can lead to increased volatility of output and inflation.  Lars Svenson (1999) later reconfirmed Ball's findings. This made some observers questions whether nominal GDP had any future.  Bennett McCallum (1999), however, said not so fast.  He showed that their conclusions were based on special backward-looking IS and Phillip curve relations that are "theoretically unattractive" (because they are backward looking)  and whose results fail to hold up with more general specifications.  Richard Dennis (2001) later confirmed that Ball and Svenson's results were fragile.  Finally, Kaushik Mitra (2003) showed that even with adaptive learning, nominal GDP targeting remains a desirable objective for monetary policy.  Thus, there have been no robust studies that show nominal GDP targeting increases volatility. 

9 comments:

  1. /* If we can agree that primary cause of the recession is insufficient aggregate demand, then the fact that the U.S. economy is still sluggish is a sign that monetary policy has failed to do its job. */

    Phony demand through credit expansion is not real demand. If that went away, then a recession is actually a market force that is trying to correct already misallocated capital.

    Primary cause of the recession is massive malinvestment and misallocation of capital, caused due to the lowering of interest rates after every crisis.

    I don't know if NGDP targeting would work or not, but the primary cause to be 'aggregate demand insufficiency' is a Keynesian myth/fallacy.

    ReplyDelete
  2. with median household income down 6.4% & declining real disposable personal income, even the demand we see today is unsustainable...

    ReplyDelete
  3. Hi, just a point of fact.

    > Bank lending, however, did not recover until 1935.

    In fact, it seems to have been much longer. Banks' loans outstanding were flat from '33 to '40, and by '47 had still not returned to '29 levels. And that's all in nominal dollars.

    http://www.asymptosis.com/banks-who-needs-em.html

    This just redoubles the evidence for your point, that "Bank lending, therefore, was not essential to that recovery."

    ReplyDelete
  4. Nick, Bill W. and yourself have been very helpful explaining these things.

    I have one question.

    "This change in expectations, in turn, would cause investors to rebalance their portfolios away from liquid, lower-yielding assets (e.g. deposits, money market funds, and treasuries) toward higher-yielding assets (e.g. corprate bonds, stocks, and capital). The shift into higher-yielding assets would directly affect nominal spending through purchases of capital assets and indirectly through the wealth effect and balance sheet channels."

    The category of low yielding assets should include not just deposits, money market funds, and treasuries, but also low yielding capital. The category of high yielding assets should include corporate bonds, stocks, and high yielding capital.

    So while the shift into higher-yielding assets would increase nominal spending through purchases of risky capital assets, wouldn't there be a decrease in nominal spending on less-risky capital assets? On net, isn't this a wash?

    Secondly, it seems to me that the prices of risky assets will increase, but non-risky assets will fall. Won't wealth effects cancel out, since some benefit while some don't?

    ReplyDelete
  5. "The category of high yielding assets should include corporate bonds, stocks, and high yielding capital."

    Stocks are high-yield when they are priced low relative to future earnings. That is not the case now, so Fed action that inflates stock prices from the current level will be harmful in the medium- to long-term. Mean reversion happens.

    Thus the objection to price-level targeting: the instrument is blunt and the market is not always efficient.

    Comparison of current conditions to 1933 seem strained to me. The U.S. industrial base had been expanding, but prices were in a deflationary spiral down. Business couldn't make a profit in those conditions; investment was hopeless. Roosevelt didn't use a blunt instrument to raise prices, he used a scalpel by depreciating the dollar via executive fiat. Re-starting productive investment required the reversal of the deflationary spiral. But the soil was otherwise fertile; the country could make more of what it wanted to consume and create middle-class jobs.

    The macro picture in the U.S. today looks different to me: long-term loss of domestic manufacturing base, excess global labor, under-developed merchantilist trade partners, and highly mobile capital seeking higher returns in those under-developed markets where growth potential and interest rates are higher. Our problem today is finding sufficient investment opportunities to increase domestic middle-class employment.

    If the monetarists presented price-level targeting as the best response we can expect for reducing the suffering caused by long-term under-employment in the current macro and political environment - which I can accept - then I'm a cautious supporter of the policy despite the risks. But when this is presented as the optimal response that will enable the efficient market to work its magic, or, more risibly, as the means to "prove Krugman wrong", my suspicion that I'm being sold a bill of goods gets in the way. I may not be the only person who feels this way, so I'm suggesting an improvement in the messaging. But even silencing Sumner for the good of the cause wouldn't help with the hard-money crowd that believes every word on the WSJ editorial page. But an honest assessment of the risks would be appreciated. Or is the implicit message that there are no risks because the EMH is true in the most rigorous sense and asset bubbles and mis-allocation of investment can't happen?

    By the way, if anyone has a wayback machine, I'll wager that if Sumner and most of the other monetarists who praise the Roosevelt devaluation now were sent back to 1933 with future memories, they would denounce FDR on the editorial page of the WSJ for destroying the dollar and usurping the role of the brilliant technocrats at the Fed. Economics is still a social science.

    ReplyDelete
  6. My objection to NGDP targeting is that, while the motives of its advocates may be honest, it is getting air time right now mainly because it provides intellectual cover for raising inflation, and providing the short-term easy but long-term damaging way out of present difficulties (surely it is still the consensus in monetary economics that a predictable value of money is desirable). As inflation targeting is being now, NGDP targeting will be circumvented when its constraints become inconveniently binding, such as the next boom, when there will be pressure to raise the target "to give growth a chance".

    ReplyDelete
  7. RebelEconomist:

    A peevish fixation on inflation, usually coupled with some sort of Old Testament fervor about consequences, is going to be the intellectual death-knell for right-wing economists and maybe this nation.

    Keep you eye on the ball: Economic growth, prosperity, innovation, commercial freedom.

    Oh, we can beat inflation. You can move to Japan and you will never see inflation again. You can also kiss your real estate and equities portfolios good-bye and any growth in per capita GDP.

    ReplyDelete
  8. Benjamin,

    Let's agree to differ on the motivation for hard money, but the fact is that a predictable value for money tends to foster sensible economic decision-making (eg you have to look for real solutions to problems), and has been regarded by many up and coming countries as one reason for, for example, Germany's economic success. Do we have to relearn the lessons of the 1970s?

    But let's be honest. This fad for inflation is not based on objective economics, but on the need for excuses to adopt the age-old quick and easy solution to economic imbalances and overindebtedness. Look at David's desperate search in (3) for research that offsets research that does not favour NGDP targeting.

    ReplyDelete
  9. Rebel Economist:

    David cites two articles against nominal GDP targeting. There are many more that support it. Your claims about a "desperate attempt" indicates you don't know the literature.

    The same is true for your claim that the push for inflation is not based on objective economics. You will be hard pressed to find many studies arguing for a constant rate of inflation, no matter the circumstances. Instead, the rate of inflation should be conditional on the state of the economy. For example, see Bernanke's work on Japan. The only places you find such hard money views being popular is in the popular press.

    ReplyDelete