George, every time I read your arguments it makes me want to chop a few more tenths of a percent off my proposed NGDP growth target. This was no exception. However I am still not completely convinced by your arguments.
Let’s start with this claim:
(3) regardless of the feedback rule employed, the variance of realized nominal spending growth is positively related to its mean value.
I agree with everything you said up to this point, but I am not convinced of this. But in the spirit of compromise let’s first discuss where I am persuaded. I like your discussion of how a very high trend inflation rate degrades the price system. Here is an example that drives home that the “menu cost” argument is about much more than just menus. My father was a real estate broker from about 1965 to 1985. When he started out he had a pretty good store of knowledge that he could use to advise clients about housing values. When he saw a home for sale, he could recall what similar homes had sold for in earlier years. By 1975, however, prices were rising so fast that this store of human capital rapidly depreciated. In principle he could have memorized a price index table, and also memorized the dates at which each home was sold, but this is beyond the cognitive ability of most individuals. If the higher trend rate of inflation caused homes to be listed at the “wrong” price, then this would have made the real estate broker industry less productive, and thus would have increased both transactions costs and price dispersion around the equilibrium value of homes.
So I see the main impact of the degradation of the price system as being less efficiency, not more NGDP volatility. I’ll acknowledge that once you introduce any sort of real impact from higher trend inflation, it is always possible to construct a model where that somehow makes it harder for the central bank to stabilize NGDP growth. It’s just that I don’t see a plausible model where this occurs. I think we may be subtly swayed by the fact that real world cases of high inflation are associated with more volatility — but that is because they almost always lack an explicit target.
Although I am not convinced that NGDP growth rates would be more volatile, there is much in your argument where I do agree, and I’ll add suboptimal price dispersion to the two other factors supporting a low NGDP target: the implicit tax on cash, and the tax on capital that results from a non-indexed tax system. (And as an aside, the complexities of indexing all financial transactions to inflation are enormous, so the tax problem is important.) So now it is three to two in your favor. By the way, I also agree that factor price adjustments (especially wages) are generally more costly than final goods price adjustments, which is why I favor NGDP targeting.
I also agree that price declines due to factor improvements don’t cause much of a problem. But here is what I do worry about. In the U.S. the trend rate of real GDP growth is about three percent. Population growth is about one percent. So if total factor productivity grows at about two percent per year, we would average roughly one percent deflation and two percent NGDP growth under your plan. Average nominal wage rates would grow at about one percent per year. If there is an irrational psychological barrier to small nominal wage cuts, and if that barrier is less significant if real wages are cut an equal amount through inflation, then a low trend rate of nominal wage rate increase could increase labor market distortions. I don’t want to make too much of this issue, as there are two arguments that cut the other way. Because of “life cycle effects,” the average worker becomes more productive over time, and thus each worker gets a larger pay increase, on average, then the overall average wage of workers at any given age. In addition, if we went to a Congressionally-mandated NGDP rule of five percent NGDP growth, the same psychological importance now given to zero percent pay raises might simply be shifted up to four percent wage increases. Indeed we might be almost there already. Nevertheless, I have seen studies that show a discontinuity in contractual wage increases right at the zero percent point, so I don’t think my worry is completely unfounded.
In a perfect world I think you have the better of the argument here, so let me distinguish between three scenarios.
- In a world where wage and debt contracts were negotiated under a five percent expected NGDP growth rate, and where the banking system is already weakened for other reasons, it is best to aim for five percent NGDP growth until the crisis is over, and then bring the rate down gradually. I’m not saying you disagree here, but I just wanted to emphasize that even if I accepted your entire argument, I would not have changed the central thrust of my recent essay, which was a critique of policy in late 2008.
- Now let’s assume the crisis is over, but we still have a less-than-enlightened Fed, which doesn’t seem able to operate in a zero rate environment. In that case a higher trend rate of NGDP could be justified on the basis that it would make it less likely that policymakers would bump up against the zero rate bound. You suggested that an equilibrium sub-zero nominal rate is unlikely under a productivity norm, but I am not convinced. Japan has averaged something like one percent productivity growth and one percent deflation (in the GDP deflator) for the past 15 years. And, of course, their short term nominal rate was stuck at zero for a good part of that period. I’m not saying the Japanese case exactly matches your proposal, but it’s close enough that I don’t have confidence that we would always be able to avoid sub-zero equilibrium nominal rates — especially if policy mistakes were made. This doesn’t necessarily apply to the optimal monetary regimes that you and I contemplate, but rather is an attempt to save capitalism from having its reputation trashed by inept central bankers, who use a policy procedure that leaves them prone to deflationary mistakes.
- Now let’s assume we do have an optimal monetary regime, preferably forward-looking enough that liquidity traps are avoided. In that case, you probably win. I doubt that my observation that there is a discontinuity at zero nominal wage changes is enough to overcome the two (now three) arguments on your side. So let’s go on to look at your proposal for free banking.
I always have trouble visualizing what sort of macroeconomic outcome would result from a regime of free banking. At least your proposal for a fixed reserve base helps anchor the price level. Then the only real macro issue is whether it could stabilize the demand for reserves. (There is also a longstanding microeconomic debate about whether competitive currency issue leads to wasteful non-price competition, as banks compete to get people to hold their non-interest-bearing banknotes.)
I think you make a fairly persuasive case for the proposition that free banking could cushion the financial system against one important type of money demand shock — indeed the type of shock that arguably caused the Great Depression. I am thinking of a scenario where people wish to hoard cash and/or bank deposits, perhaps because of financial instability. As long as these balances are hoarded, banks would have an incentive to accommodate any increase in demand for money by issuing banknotes or expanding bank accounts. If I am not mistaken, this is because banks need only hold reserves in order to meet deposit outflows or banknote redemption. And obviously if money is being hoarded, this does not trigger any call on the banks’ reserve base. So if I have the intuition right, this part of your argument seems fine.
To make it work perfectly you need to assume that, as you put it:
To get to stable base income velocity you have to assume (one) that total bank-money transactions are a relatively stable (if nevertheless changing) multiple of income transactions.
I could easily foresee this assumption failing to hold — for instance, if the ratio of total transactions to income transactions were to change dramatically. Recall that total transactions (which includes those occurring in financial markets), are much larger than income transactions.
At the same time I can’t really argue with your conclusion, which strikes an appropriately non-dogmatic stance:
What all this boils down to is that there are forces at work in the banking system that can make stabilizing nominal income easier, and that policymakers should take as much advantage of those forces as possible. Doing so will make it easier to achieve some desired growth rate of nominal spending by simply controlling the growth rate of the monetary base-something any central banker, or even a computer program, can do.
I would just add that even if free banking combined with a fixed reserve base of fiat money could deliver improved macroeconomic stability, a regime of free banking and a reserve base adjusted by the market to deliver stable expected NGDP growth could do even better. So perhaps I can nudge you a bit in my direction on the idea of using the market to help stabilize NGDP expectations by appropriately adjusting the size of the fiat reserve base.