Wednesday, January 5, 2011

Thoughts on the Tyler Cowen - Scott Sumner Debate

Tyler Cowen recently raised the question of whether the Fed could have actually implemented Scott Sumner's plan for a nominal GDP target during the crisis:
Let's say that at the peak of a financial crisis, the central bank announces a firm intention to target a path or a level of nominal GDP, as Scott suggests.  If everyone is scrambling for liquidity, and panic is present or recent, and M2 is falling, I wonder if the central bank's announcement will be much heeded.  The announcement simply isn't very focal, relative to the panic
Here are my thoughts on the matter.  First, an important premise of this debate is that a credible NGDP level target would anchor growth expectations of total current dollar spending around a target growth path.  The stabilization of such expectations in turn would keep current nominal spending  close to its target growth and make it less susceptible to negative economic shocks, like the housing and financial shocks of 2008.  This is an important point. Fluctuations in NGDP get transmitted either to real GDP growth or price level growth or both.  However, because prices do not adjust instantly, NGDP shocks have largely been transmitted to real GDP as can be seen in the figure below. Thus, a credible NGDP level target that stabilize NGDP growth expectations would go a long ways in stabilizing the real economy too.(Click on figure to enlarge.)

Second, from a NGDP targeting perspective any below trend decline in NGDP amounts to an effective tightening of monetary policy.  Thus, even if the Fed has done nothing but velocity falls then monetary policy is effectively tightening.  To prevent such tightening the Fed needs to respond to fall in velocity with additional monetary stimulus.  With this understanding, the figure below, which shows monthly nominal GDP, indicates that monetary policy effectively tightened in June, 2008 and did not start easing until June 2009.  Therefore, monetary policy was tight even before the big blow up on Wall Street in late 2008.  (Click on figure to enlarge.) 

Surely this tightening of monetary policy in mid-2008 made the financial system more vulnerable to shocks later in the year.  Moreover, it is possible the shocks themselves may have been smaller had monetary  policy  been looser.  There probably would have been a recession no matter what, but it would have been far milder had the Fed been explicitly stabilizing NGDP.  

Third, the experience of unconventional monetary policy starting in mid-1933 suggests that Fed could have done something to avert the collapse on nominal spending in late 2008-early 2009. The U.S. economy had been collapsing for close to three years when FDR began his own unconventional monetary policy in 1933.  As shown by Gautti Eggerton and others, FDR's policies radically changed expectations at a time when deflationary expectations seem set.  Adopting a NGDP target in late 2008 or early 2009 may have been the radical equivalent of FDR's money policies in the 1930s.  Had the Fed adopted a NGDP target  and marketed it with a massive PR campaign it seems plausible that nominal spending expectations could have been stabilized a lot sooner. Why would it have been any more challenging to make a NGDP level target work in late 2008-early 2009 than for FDR to make unconventional monetary policy work in 1933?

The way I see it, the question is not whether a NGDP level target could have worked.  The real question is why the Fed did not try something more radical like a NGDP or price level target. For more on Tyler Cowen's question see Scott Sumner and Ryan Avent


  1. I don't understand Cowen.

    There is a scramble to liquidity; the Fed announces that it will create however much liquidity (i.e. money) is necessary to keep nominal income on target. How is that not very focal to the panic? Why would it not be heeded?

    In any case, since liquidity demand rose, in part, because nominal spending started falling, then preventing nominal spending falling in the first place would have lessened the rise in liquidity demand, I think.

  2. Lee, I am with you on this one. As I mentioned above, Tyler should be asking why the Fed did not do something radical like NGDP targeting, rather than asking if NGDP targeting would work.

  3. Wouldn't nominal consumption targeting work even better than nominal GDP targeting?

    With nominal GDP targeting, one runs the risk of raising interest rates too much too soon just when investment spending picks up during a recovery.

    Nominal GDP targeting is still better than inflation targeting and much better than money supply targeting.