About That Goldman Sachs Endorsement of NGDP Targeting

Here it is and it is really good.  One might think they were reading a market monetarist policy paper.   Matthew Yglesias provides further comments on the piece as does Ryan Avent.   Here is my initial response to the piece. 

An IS-LM Model That Almost Has It All

There is an ongoing debate in the blogosphere on the usefulness of the IS-LM model taught in undergraduate economics.  Brad DeLong nicely summarizes the problems with this model:

We really need a model with five moving pieces:

1. Money demand equilibrium M = L(i, PY) as a function of the level of spending and the short-term safe nominal interest rate.

2. Flow-of-funds S = I + (G-T) as a function of the level of spending and the long-term risky real interest rate.

3. Expected inflation to get you from the nominal to the real interest rate.

4. A term premium as a function of expectations to get you from the short-term to the long-term real interest rate.

5. Risk spreads to get you from the safe to the risky real interest rate.

Well Brad, there actually is such an undergraduate IS-LM model that fufills most of these criteria.  It is developed by Charles L. Weise and Robert J. Barbera in this paper here.  It incorporates the short-term policy rate, the natural interest rate, the long-term risky real interest rate, the term premium, the risk premium, and the term structure of interest rates.  The model has an IS curve, an AS curve, and a TS or term structure curve.  The model can also be easily drawn in (r, Y) space. The big drawback is that money and its importance for recessions--money is the one asset one every market and thus the one asset that can disrupt every market--is ignored.  Still, the Weise-Barbera IS-LM model is still a vast improvement over the standard undergraduate IS-LM.  Do take a look.

Since When is the Fed Doing its Job Considered Going Nuclear?

Joe Weisenthal is reporting that Goldman Sachs has come out in favor of the Fed adopting a nominal GDP level target that would put it back on its long-run, pre-crisis trend.  This endorsement speaks to the growing interest and recognition of nominal GDP level targeting by the public. Even some Fed officials are speaking in favor of it.  Great news.

What is remarkable to me is that many observers in this debate describe the adoption of nominal GDP level targeting as the Fed going nuclear.  For example, Weisenthal's article above is titled "Goldman Advises The Fed To Go Nuclear, And Set A Target For Nominal GDP" and not too long ago David Wessel had an article titled "The Fed's (Gulp) Nuclear Options" where one of the options was nominal GDP targeting.  I did not realize that the Fed doing its job was considered going nuclear.  All along the Fed should have either prevented or corrected the steep fall in nominal spending that took place in late 2008 and early 2009.  The central bank of Sweden was able to do so, but not the Fed.  The best it could do was throw some ad-hoc monetary stimulus programs (i.e. QE2, Operation Twist) against the wall and hope that they would stick.  How much easier life would have been for the Fed--both operationally and politically--had it stated up front in 2008 that it was committed to maintaining trend nominal spending at any cost.  This would have better anchored nominal spending and inflation expectations that in turn would served to stabilize aggregate demand.  Instead, we have had three years of effectively tight monetary policy where it has become seen as normal so that for the Fed to do the job it should have done all along is considered going nuclear.  It should never have come to this point.

Market Monetarist or Austrian? You Decide.

Via Lars Christensen we learn of this new paper by Steven Horwitz and William Luther, two Austrian economist who take seriously monetary disequilibrium.  You might be shocked to learn that they call for nominal GDP targeting rule for the Fed.  Take a look.

The Great Recession and its Aftermath from a Monetary Equilibrium Theory Perspective

Abstract: Modern macroeconomists in the Austrian tradition can be divided into two groups: Rothbardians and monetary equilibrium (ME) theorists. It is from this latter perspective that we consider the events of the last few years. We argue that the primary source of business fluctuation is monetary disequilibrium. Additionally, we claim that unnecessary intervention in the banking sector distorted incentives, nearly resulting in the collapse of the financial system, and that policies enacted to remedy the recession and financial instability have likely made things worse. Finally, we offer our own prescription to reduce the likelihood that such a scenario occurs again by better ensuring monetary equilibrium and eliminating moral hazard.

Update: paper link fixed.

Mohamed El-Erian vs. Bruce Bartlett on the Fed

 

Bruce Bartlett  in a recent CNBC interview made the case that the Fed should be doing more.  He criticized the Fed for "sitting on its hands"  and argued it could spur aggregate demand if it adopted a nominal GDP level target.  Mohammed El-Erian was shocked to hear this claim.  He replied that most people, including himself, believe the Fed cannot do anything constructive at this point and that it probably has gone too far.  He wanted to know why Bartlett would argue otherwise.   (You can see the exchange above at about the 6:50 mark.)

I am shocked that El-Erian was shocked.  The man who seems to own a column space at the FT and a studio chair at CNBC is convinced that the Fed now is in incapable of making a meaningful dent in aggregate demand and that most observers agree with him. Apparently, he has not been reading Mike Woodford, Greg Mankiw, Ken Rogoff, Paul Krugman, Charles Evans, Scott Sumner, and others who claim the Fed could be doing more. Even Fed Chairman Bernanke has said the Fed could do more.  For example, here is Bernanke in September:

 In addition to refining our forward guidance, the Federal Reserve has a range of tools that could be used to provide additional monetary stimulus.

Now the key to the successful aggregate demand management comes from the Fed properly managing expectations.  So far the Fed has not done very well on this front and, as a result, the economy is suffering.  But it doesn't have to be this way.  FDR was able to properly shape monetary policy expectations and turn things around from 1933 to 1936 and Sweden has done  the same more recently.  So El-Erian can take comfort in knowing that this view is more than academic pipe dream.  In case El-Erian is curious, here is a short primer on nominal GDP targeting, here is how it could make a big dent in nominal spending, and here is why the Fed should adopt it.

Hat Tip: Edward Harrison

FOMC: We Got a Money Demand Problem

The FOMC minutes for the September, 2011 meeting were released today and the first things that stand out are the clear hawk-dove divide, the smorgasbord of additional ad-hoc monetary stimulus policy options that were discussed, and the increased economic pessimism of the members.  Something else, though, really caught my attention in the minutes.  It was this acknowledgement by the Fed staff:

 M2 surged in July and August, as investors and asset managers sought the relative safety and liquidity of bank deposits and other assets that make up the M2 aggregate. Notably, institutional investors, concerned about exposures of money funds to European financial institutions, shifted from prime money funds to bank deposits, and money fund managers accumulated sizable bank deposits in anticipation of potentially large redemptions by investors. In addition, retail investors evidently placed redemptions from equity and bond mutual funds into bank deposits and retail money market funds.

In other words, we have rapid growth in M2 coming from a surge in money demand.  This is a big deal, because money is the one asset on every market and an increased demand for it will thus affect every other market.  The more money demand there is, the less nominal spending there will be on goods, services, and other assets.  This development means the economic slump is being prolonged. 

It is great to see the Fed acknowledge this problem, but the fact is this problem has been going on for the past three years and the Fed has failed to address it in a forceful and systematic manner.  All the Fed's interventions over the past three years, including Operation Twist from this meeting, have not arrested this problem.  

How do we know this?  Well, start with the figure below.  It shows that the share of household's liquid assets (cash, checking account, time and saving deposits, money market accounts, and treasury securities) as a percent of all household's assets is closely tied to the swings in M2 velocity.  

 

Note that household's share of liquid assets never has returned to its pre-crisis level.  Due to the ongoing economic uncertainty, households still have an elevated demand for these assets and consequently money spending has fallen.  Consequently, velocity too has yet to return to its pre-crisis level.  

This next figure shows the actual dollar amounts.   From the peak of household asset values in 2007:Q2 to the latest data for 2011:Q2, households have lost around $8.8 trillion worth of non-liquid assets. Despite these large losses and the subsequent slump in personal-income growth, households have somehow increased their holdings of money and money-like assets by a staggering $1.6 trillion:

The composition of the increase in liquid assets is also interesting as seen in the next figure. Most of the increase has come in the form of time and saving deposits, though treasuries have been important too.  Money assets alone (cash, checking account, time and saving deposits, and money market accounts) have remained elevated and close to their peak value in late 2008.

Now these graphs only take us through 2011:Q2.  To get a sense of what has happened since then we can look at the weekly M2 data which shows the spike mentioned in the FOMC minutes.  A closer look at the M2 data, however, shows that main growth is in saving deposits. The next figure vividly illustrates this growth:

The growth of saving deposits is even more stark if viewed as percent of personal income:

This last figures shows us that the growth in savings is clearly not an increase in money demand from income growth.  It is all about holding precautionary money balances.  And this is why nominal spending continues to slump.

So what can be done?  My own view is that the money demand problem could be fixed by properly shaping expectations about future spending and inflation via something like a nominal GDP level target.  Unfortunately, the latest FOMC minutes indicate that is not an option.  So for now we lumber on, hoping that in absence of forceful and systematic Fed actions the market will be able to heal itself in a timely fashion.

Update:  This figure from a previous post shows that share of liquid assets has been systematically related money velocity over the past 60 years or so.  

My Journey Into Market Monetarism

When I started blogging in 2007 my writing focused on the Federal Reserve's failure to properly handle the productivity boom of 2001-2004 and how this failure contributed to the global housing boom.  This productivity boom--spawned by the opening up of Asia and the ongoing technological gains--increased economic capacity, put downward pressure on inflation, and implied a higher natural interest rate.  The Fed, however, responded to the fist two developments as if they were signalling falling aggregate demand rather than rapid increases in aggregate supply.  The Fed did this by failing to raise the federal funds rate when the natural interest rate rose and then kept it well below the natural rate level for several years.  Given the Fed's monetary superpower status, this sustained easing created a global liquidity boom  that was a key force behind the "global saving glut".  This view was what initially drove most of my blogging. 

By late 2008 my focus began to change.  I had been critical of the Fed for allowing too rapid growth in nominal spending during the first half of the decade, but by this time it seemed the Fed was erring in the opposite direction.  Nominal spending was falling fast and the Fed's seemed more focused on saving the financial system than in directly preventing the collapse of aggregate demand.  The Fed's introduction of interest payments on excess reserves in October, 2008 only served to confirm my fear that the Fed was too narrowly focused on financial stability.   This fear combined with what I was reading from Nick Rowe and Bill Woolsey (in the comments section initially) about the excess money demand problem and early posts from Scott Sumner about the Fed causing the financial crisis by failing to stabilize nominal spending in the first place convinced me that the Fed had committed a colossal policy mistake in 2008.  This failure to respond to the drop in nominal spending I later came to recognize as a passive tightening of monetary policy (something that is easy to show using an expanded equation of exchange).

As time went on, it also became apparent to me that the Fed was not forward looking enough.  For example, as early as mid-2008 breakeven inflation from TIPs was indicating an aggregate demand slowdown was ahead.  The Fed, however, at the time put more weight on backward-looking headline inflation measures as was evident in its decision to not cut the target federal funds rate in the September, 2008 FOMC meeting.  Modern macroeconomics and experience tells that one of the most effective ways the Fed can influence aggregate demand is by managing expectations. Shape nominal expectations properly and one can immediately affect aggregate demand.  As Scott Sumner likes to say, the implication of this insight is that monetary policy works with leads not lags.  

Now here we are in 2011 and the Fed has yet to, one, correct its passive tightening of the past three years and, two, properly shape aggregate demand expectations by adopting something like a nominal GDP level target.  It has been incredibly frustrating to watch the incredible amount of human suffering caused by these monetary policy failures.  Consequently, I have been blogging away at these issues along with like-minded folks such as Scott Sumner, Nick Rowe, Bill Woolsey, Josh Hendrickson, Marcus Nunes, Nicklas Blanchard, Kantoos, and David Glasner.  We all have been making the case that  the prolonged economic slump has been mostly due to passively tightened monetary policy that could easily be loosened, even at the interest rate zero bound.

Our collective efforts have been summarized in a recent paper by Lars Christensen, who labels us as a group Market Monetarists.  He argues that we are a burgeoning economic school born out of the Great Recession experience whose views have largely taken shape in the blogosphere.  What defines us, he says, is (1) our belief that this crisis has it origins in monetary policy failure rather than problems in the financial system, (2)  our emphasis on using market signals to determine the stance of monetary policy, (3) our view that monetary policy's influence on nominal spending is not constrained by the interest rate zero bound, and (4) our push for nominal GDP level targeting as way to get monetary policy back on track.

While I largely agree with Christensen's assessment of our views, there are some additional points worth noting.

First, though Market Monetarism has been largely a blogging phenomenon it has had important voices in other mediums.  Ramesh Ponnuru has been pushing the Market Monetarist view at the National Review and at Bloomberg while MKM Chief Economist Michael Darda has been promoting it in the MKM investment newletter and on interviews on CNBC and Bloomberg Radio.  And even within the blogging medium there are other prominent voices like that of Matthew Yglesias, Ryan Avent, and Brad DeLong who often are sympathetic to Market Monetarists views.

Second, Market Monetarists prescriptions are not all that different than those of prominent New Keynesians like Michael Woodford and Paul Krugman.  We all agree that when the zero bound is hit the monetary base and t-bills became perfect substitutes and so the Fed should buy longer-term treasuries or foreign exchange as part of a plan to hit some explicit nominal target.  A big difference, though, between New Keynesians and Market Monetarists is that where the former sees the move from t-bills to other assets as a discrete jump from conventional to unconventional monetary policy, Market Monetarist see it as simply moving down the list of assets that can affect money demand.  The zero bond for us really is not a big deal, but simply an artifact of monetary policy using a short-term interest rate as the targeted instrument.  We approach monetary policy with much  less angst than New Keynesians.


Third, Market Monetarist stress NGDP level targeting because doing so would forcefully shape expectations. Here is why.  Under such a monetary policy regime, the Fed would announce (1) its targeted growth path for NGDP and (2) commit to buying up as many securities as needed to reach it.  Knowing that the Fed would be willing to buy up trillion of dollars of assets if necessary to hit its target would cause the market itself to do much of the heavy lifting.  That is, the public would adjust their portfolios in anticipation of the Fed buying up more assets and in the process cause nominal spending to adjust largely on its own.  This would reduce the burden on the Fed and make it a less polarizing institution.

Finally, one critique of Market Monetarist is they lack an active research agenda and fail to take advantage of formal modeling methods like DSGE models.  While I cannot speak for all Market Monetarists, I can say that Josh Hendrickson and I have several research projects that formally evaluate the Market Monetarist  view.  For example, we have one paper where we make use of the search models developed in the New Monetarist's literature to formally develop a monetary theory of nominal income determination.  We also make use of structural VARs to examine the importance of nominal spending shocks in one paper and the portfolio channel of monetary policy in another paper.

With that said, Lars Christensen has done us a favor by documenting the rise of Market Monetarism.  It will be interesting to see what will be the long-run impact of the Market Monetarist bloggers .  I am glad to have been a part of the journey so far.

P.S. Lars Christensen is of the Market Monetarist persuasion too and now is blogging.