I agree with Professor Hamilton’s argument that monetary policy was not the primary cause of the housing bubble, so I will focus on the futures targeting idea. I think it will help if we separate out several issues, to make it clear exactly where we disagree.
When Hamilton uses the “Mars” example, he is suggesting that monetary authorities might not have powerful enough tools to create five percent NGDP growth. But under a fiat regime any central bank could create hyperinflation, as long as it is not restricted to buying conventional assets like Treasury securities. Since the Fed has recently shown a willingness to buy unconventional assets, it has the resources to create hyperinflation if it wishes. I assume that Hamilton agrees with this, so henceforth I will assume that the debate is not about whether the Fed has enough tools to create at least five percent NGDP growth over the next 12 months, but rather whether doing so would cause other problems.
First, let me clear up one misconception. Hamilton thought I was claiming that in September 2008 the Fed had the ability to create five percent NGDP growth in 2008:Q4. That was not my claim. Rather, I argued that they could have created five percent expected NGDP growth over the following 12 months, and also that had they done so, the 2008:Q4 results would have been far better. Perhaps we would not have had five percent NGDP growth in Q4, but much closer to that number that the actual negative six percent. My basic argument (and it is also a theme in recent research by Woodford and others) is that changes in current AD are powerfully affected by expected changes in future AD. When expectations of NGDP going several years forward fell sharply last fall, current AD fell sharply. Firms see no reason to throw good money after bad. When it is clear that a major recession is imminent, firms respond by immediately slashing production. Had expectations of five percent NGDP growth over 12 months been maintained throughout the financial crisis, any near-term slowdown in NGDP would have been much milder. Unless I am mistaken, this is a well-established proposition in modern business cycle theory.
With this in mind, let’s concentrate on my argument that the Fed can create five percent NGDP growth expectations over 12 months, even in a financial crisis. I think it is useful to break this argument down into three components:
- Is five percent NGDP growth over the next 12 months the proper target?
- If so, should the Fed do as Lars Svensson has recommended and target the forecast? That is, should it set policy in such a way that its own internal forecasting unit expects exactly five percent NGDP growth?
- If it should target the forecast, can it do so more effectively by tying policy to market forecasts?
Obviously, I don’t know that five percent NGDP growth over the next 12 months is exactly right. Perhaps a different number or a different time period is preferable. Indeed, perhaps an entirely different variable (such as the CPI) is appropriate. But by any reasonable criterion policy was clearly too tight in the Svenssonian sense last fall. The Fed was even calling for help from fiscal policy. So let’s take a step back, and work toward my proposal in baby steps, in the hope that we can better see where Hamilton disagrees.
I think we all agree that the Fed ought to have some objective. Because of the “one tool/two targets” problem, most economists proceed under the assumption that it should be possible to express that objective as a single target (which of course may be a hybrid target incorporating a weighted average of nominal and real goals, such as NGDP, or the Taylor rule formula.) So the Fed’s goal is to achieve X percent growth in a particular nominal aggregate. Svensson says that they should set policy at a level where they are expected to hit that goal. I have never seen anyone object to Svensson’s proposal on the grounds that Hamilton uses to object to my proposal. So let’s assume that there are no objections to Svensson’s policy critierion. Obviously, we are still a long way from NGDP futures contracts. Svensson contemplates a discretionary regime where the FOMC decides which instrument setting is most likely to hit their target.
Now let’s expand the FOMC from 12 members to everyone on Wall Street. Does this make Svensson’s policy infeasible? I don’t see why it would. And now let’s have each voter write down their preferred instrument setting (for the base) and then pick the median vote as the actual policy setting. And now let’s compensate each member, ex post, on how well they voted. If actual future NGDP turns out to be above target, those who voted for relatively easy money are penalized, and vice versa. And now let’s change “one man, one vote” to “one dollar, one vote,” where each FOMC member gets to choose how many dollars they want to “bet.” Any problems yet? If not, we have just arrived at NGDP futures targeting.
I am using this procedure for two reasons. First, in the hope that if we move to NGDP futures targeting in baby steps, the change won’t seem so radical. (Sort of like gradually heating up a frog in a pan of water — although I am not comparing Hamilton to a frog!) The second reason is to make it easier to find out where we disagree, i.e. where Hamilton thinks the proposed policy breaks down.
I do think that Hamilton may have misinterpreted the proposal in one important respect. He suggests that if everyone had the same views, then traders would take an infinitely large long or short position. But this ignores the fact that each futures transaction triggers a parallel open market operation. This changes the money supply and thus the expected future NGDP. Thus, suppose everyone thought that under the current instrument setting, NGDP would come in below the five percent target. In that case they would begin buying NGDP futures contracts. Each purchase would trigger a parallel open market purchase of ordinary Treasury bonds by the Fed. As the monetary base increased, then all these like-minded investors would begin to expect faster NGDP growth. The purchases would continue until the expected NGDP growth rose to five percent.
Now let’s assume we are in a liquidity trap, or the “Mars” example, and that no amount of open market purchases would increase expected NGDP growth up to five percent over the next 12 months. In that case, the Fed would buy up the entire world stock of assets, including all foreign stocks and bonds. I will concede that in that case we would fall short of the five percent NGDP target. But, on the plus side, Americans would own the entire world stock of assets, and all income from capital will go to U.S. taxpayers. Of course, I don’t think this reductio ad absurdum case would actually occur, and I am sure that Hamilton doesn’t either. Under any reasonable model of base money demand there is no infinite demand for futures contracts. So I think we can assume that at some point the transactions would cause a large enough change in the base to equate the public’s expected NGDP growth rate with the five percent policy target. When that happens, the NGDP futures market will reach equilibrium and trading will cease.
Hamilton also raised this issue:
After all, which number is it that the Fed is asserted to be able to control, the advance estimate, the revised estimate, or some Platonic truth that our best measures can only imperfectly reflect?
In order for contracts to be settled after the 12-month forward NGDP is realized, we need a measurable estimate of actual NGDP, so that rules out the Platonic ideal. I prefer the revised estimate, as it should be closer to the actual NGDP, which is presumably what the monetary authority wishes to stabilize.
I thank Professor Hamilton for providing me with an opportunity to expand on my proposal, beyond the sketchy description in the original essay. It is a complex subject, and also one that might be unfamiliar to many Cato readers. I also see that George Selgin has a reply; I will respond within a few hours.