Friday, July 10, 2009

Another Way to View the Crisis: A Boom-Bust Cycle in Global Nominal Spending

Many observers, including myself, have spent many hours thinking about the source of the current economic crisis. Much of the discussion in this debate has centered on the role played by the list of suspects rounded up so far: a saving glut in emerging economies, excessive fiscal and monetary policy stimulus in advanced economies, the securitization of finance, underestimating aggregate risk, the lowering of lending standards, the failings of rating agencies, aggressive lending tactics, and poor choices made by lenders. The truth is some mix of all of these played a role. That makes it difficult to apportion responsibility (or blame) accurately and, thus, makes it challenging to draw the appropriate lessons from this crisis moving forward. So in an attempt to simplify matters, this post presents the economic crisis from a different perspective.

So what is this perspective? This approach begins with the understanding that the key to macroeconomic stability--whether nationally or globally--is to stabilize nominal spending. If an economy is running near full employment, then any sudden increase or decrease in nominal spending will give rise to changes in real economic activity that fall outside its natural rate area (i.e. is unsustainable). Why? Because there are numerous nominal rigidities that prevent prices from adjusting instantly. There is simply no way to suddenly jar nominal spending and not have real economic activity move as well. Note, that key here is not to aim for price stability, but to aim for nominal spending stability. As I noted before,
Nominal spending shocks, after all, are the real source of macroeconomic volatility while inflation is merely a symptom of these shocks. Moreover, inflation can sometimes can be hard to interpret--Is the high(low) inflation due to positive(negative) aggregate demand shocks or negative(positive) aggregate supply shocks?--and as a result monetary policy that targets inflation may make the wrong call.
Now apply this thinking to the global economy. From 1980-2002 global nominal spending (as measured by world nominal GDP) in current U.S. dollars grew about 5.0% a year. In PPP current international dollars it grew 6.1% a year. Suddenly, in the period 2003-2007 those numbers jumped to 10.7% and 7.5%. (Data from WEO databse April 2009.) This surge in global nominal spending was sudden and most likely unexpected given the trends for the 1980-2002 period. These developments can be seen in the figure below: (Click on figure to enlarge.)

In short, the world experienced a nominal spending boom over the years 2003-2007 that was unsustainable. Today, the excesses related to that boom are being worked out.

Now why bring up this perspective? Because I believe it has clear policy implications: policy makers should be watching nominal spending both at home and across the globe. Focusing too narrowly on inflation caused policymakers to miss this surge in nominal spending. Two institutions in particular should be watching global nominal spending. First, the IMF should be monitoring global nominal spending given its objectives for global financial stability. Second, the Federal Reserve should also be closely monitoring global nominal spending because (1) it is a monetary superpower and can currently shape to some degree global nominal spending and (2) it has also an enhanced mandate for financial stability. Stabilizing global nominal spending will not eliminate all financial risk, but it will go along way in preventing the buildup of economic imbalances.

1 comment:

  1. Interesting post, with very intriguing data. But I have a few suggestions:

    1. I think the graph needs work. The left scale is linear, and should be a log scale. But the trend lines are also linear, and should be curved upward if you are trying to show a steady growth rate with the linear scale. It's not obvious to me that a properly drawn graph would look as impressive.

    2. Thr ppp comparison is the one I am most interested in, and it shows a rise from 6.1% to 7.5% growth. The latter figure covers just an expansion phase of the cycle. That makes the nominal growth surge seem a bit less impressive.

    3. On the other hand I favor steady NGDP growth, so I agree 2003-07 was too fast, but I'm not sure it was as far out of line as the graph suggests.

    4. The surge in ppp numbers is partly due to China and India. It is an open question as to whether the Fed should try to offset fast NGDP growth in those two countries with a bit slower grow here. Again, I don't necessarily disagree with the conclusion, but this seems like the first stab at a topic that needs further scrutiny.