Friday, September 30, 2011

Expectations Matter More than Size

Martin Wolf says its time to unload both barrels of the gun and resort to true helicopter drop-types stimulus.  He has the right idea, but it could be better implemented through an explicit price level or nominal GDP level target.  Doing so is important because as Josh Hendrickson notes no one at the Fed or the ECB knows exactly how much to print. What the central banks can do, though, is properly shape expectations about future nominal spending and price growth.  Doing so would cause the markets themselves to do much of the heavy lifting (through expectation-induced portfolio rebalancings) and in the process ensure the Fed's goals are realized. Josh Hendrickson sums it up this point nicely:
The Federal Reserve’s focus on the size of its asset purchases represents a grave mistake. There is no model that tells us the precise size increase in the central bank balance sheet will get us to a desired level of nominal income. Those who continue to claim that the magnitude of monetary and fiscal policy haven’t been large enough fail to recognize this point. This is the lesson of the Lucas Critique. Expectations matter.
Update: Here I go into more detail as to how the Fed would work to shape expectations through a nominal GDP level target.


  1. Excellent post. I concur, I think. The Fed should talk about targets, not mechanisms.

    However, I wonder if a Fed statement like, "We will buy $100 billion of bonds until we see 5 percent unemployment or 5 percent inflation, or 7 percent nominal GDP growth, might make sense.

    The market would know the Fed will just keep buying (printing money) until a target is hit. And they have the presses. Bernanke should have a picture of himself taken smiling, hand resting on a printing press. "Care to take issue?," could be the tagline.

    I would still prefer dropping the money in paper bags in lower-income neighborhoods (as they would spend it). But, buying bonds may do the trick as well.

  2. David, In the August 16 post to which you link above, you advocate higher inflation and/or the threat thereof as a means of inducing households to part with their cash and spend more. I don't see the advantage of this (particularly as it risks sparking of a wage price spiral) when households can perfectly well be induced to spend more by feeding money into household pockets (e.g. via a payroll tax reduction). Same result, but no extra inflation.

    Of course the latter policy requires cooperation from politicians. If the latter won’t play ball, that just proves the idiocy of giving politicians a say in technical matters, like what size stimulus the economy should get. Politicians and the democratic process are fine for deciding strictly political matters, like what proportion of GDP is allocated to the public sector and how that should be split as between the military, education , etc. But the decision as to whether inflation is subdued enough to warrant stimulus, and if so, how much, is way above their tiny brains.

  3. Legalize the money drop and let the Fed do what it wants. Give every citizen a sum. When is inflation not inflation? When it is paid for. When is debt not debt? When it isn't issued.