Scott Sumner’s general views on macroeconomics are so much in harmony with my own that, in commenting on the present essay, I’m hard pressed to steer clear of the Scylla of fulsomeness without being drawn into a Charybdis of pettifoggery.
The best I can do is to risk a little of each. So let me start by indicating the considerable extent of my agreement with Sumner. Like him, I believe that monetary policy should strive, not to achieve any particular values of interest rates, employment, or inflation, but simply to maintain a steady growth rate of overall nominal spending. Such a policy seems to me, after all, the most straightforward, practical counterpart of the textbook ideal of keeping an economy’s “aggregate demand schedule” from shifting, or at least from shifting in an unpredictable manner, so as to keep output at its long-run or “natural” value instead of causing it to fluctuate around it. Although the simplest textbook story would seem to warrant a policy aimed at preserving an absolutely constant value of aggregate spending, Sumner rightly argues that a constant growth rate of spending may also be consistent with keeping real output (as well as other real macroeconomic variables) at their “natural” levels. I believe that he is also correct in claiming that, if an economy is accustomed to some steady rate of growth of spending a mere reduction in that rate can be depressing.
It follows from all this that I also share Sumner’s view that monetary policy became excessively tight at some point in 2008. Certainly it was too tight starting in November of that year, when nominal GDP growth turned negative. I believe it was also too tight in September, when the growth rate, though still positive, plunged from just over 2.5 percent to zero.
I am, on the other hand, less inclined than Sumner is to believe that monetary policy was excessively tight before September, for reasons I’ll come to shortly.
Finally, I share Sumner’s view that the extent to which monetary policy is either tight or loose cannot be established simply by observing either the level of short-run nominal interest rates or the growth rate of the monetary base or of some monetary aggregate. Short run interest rates depend just as much on the demand for as on the supply of credit; and any given growth rate of the monetary base (or of any monetary aggregate) may be either too slow or too fast depending on whether the real demand for the assets in question is growing more or less rapidly than the supply. Indeed, Sumner’s response to those who, relying on interest rate or money stock data alone, have insisted that monetary policy has been adequately (if not more than adequately) accommodative since September 2008 is very similar to my response to David Henderson and Jeff Hummel’s claim, based on similar data, that easy money played no part in inflating the housing bubble.
Now to disagree a little. First, what about the boom? Sumner’s silence is so conspicuous that one might imagine that he sees no role at all for overly-easy money in causing the subprime crisis. That stance may appear especially odd given Sumner’s evident desire to distinguish his views from those of a run-of-the-mill “monetary crank,” for he might readily do this by admitting — as genuine cranks fail to do — that central banks are just as capable of creating too much as too little money.
But for Sumner the way out isn’t quite so simple, because he has chosen to treat the average rate of NGDP growth “between the early 1990s and 2007″ as his preferred policy target. Doing so makes it awkward, to say the least, for him to admit that rates only modestly above this target were associated with the pumping up the housing bubble in the first place, and also with the preceding dot-com boom.
So my one substantial disagreement with Sumner is that I think five percent an unnecessarily and perhaps dangerously high figure — one that is less likely than lower rates to maximize welfare in the long run, yet more likely to perpetuate boom-bust cycles. Instead I favor a spending growth rate target closer to three or even two percent. Such a target would succeed in keeping the rate of factor price inflation at a modest level, while holding the rate of CPI inflation close to zero, and even allowing it to fall below zero with surges to productivity. (I also think “final sales of domestic product” a better measure of overall demand than nominal GDP, though this is a relatively minor point.) My reasons have to do in part with the sort of considerations Milton Friedman put forth in his famous (but too-often brushed-aside) essay on “The Optimum Quantity of Money,”[1] and also with the tendency, in the absence of complete indexation, of wages and other input prices to lag behind output prices when nominal incomes (and firm revenues) grow rapidly enough to raise equilibrium prices in both factor and output markets. This tendency can cause a temporary “profit inflation” that may in turn cause asset prices to be bid up. Eventually, though, input prices catch up, bringing both profits and asset prices back down. Surges in the rate of nominal income growth — even ones that seem relatively modest in percentage term, are especially likely to fuel unsustainable booms.[2] The less rapidly equilibrium factor prices are made to rise, the less likely it is that input sellers will find themselves playing catch-up, and the lower the risk of money-driven cycles.
The relevance of this perspective, regarding the dangers of a five percent spending growth target, to the last two boom-bust cycles may best be seen by inspecting the patterns of spending, price level, and wage growth over the course of the last 19 years or so:
Evidently, with a trend rate of growth of nominal GDP of around five percent, even relatively small deviations around the trend can be destabilizing in the presence of nominal rigidities. As Bill Niskanen has observed, during the Greenspan era, “[a]lthough the standard deviation of demand around this [5.4 percent] trend was only 1.3 percent, this variation had significant effects on asset prices and the real economy.” [3]
In arguing that five percent nominal GDP growth is excessive, I don’t mean to deny that there is some risk involved in moving to a lower rate, that is, to a rate as much as three percentage points below what has been customary. Nor do I wish to deny that it may be prudent to approach the preferred target gradually. But the costs involved in implementing such a target sooner rather than later are in my opinion likely to be small compared to those of even one more round of boom and bust.
Of course it may well be true, as Sumner suggests, that the gradual deceleration of income growth that took place between January and September 2008 was particularly ill-timed, in that it coincided with a collapse in asset values that was already placing a severe strain on the credit system. What argument could there have been, on the other hand, for failing to take advantage of the fait accompli of decelerated spending — and correspondingly tempered expectations — as of early September 2008, to inaugurate a less trouble-prone regime, instead of rushing to reestablish the status-quo ante?
The sudden move from decelerating growth to genuine collapse of spending in the latter part of September was, of course, another matter. Personally, I follow John Taylor in blaming that collapse not on the decision to allow Lehman Brothers to fail, but on the scare tactics Bernanke and Paulson used in their efforts to cow Congress into approving the Treasury’s massive bailout scheme.[4] Whether Bernanke’s doom-saying helped trigger the collapse or not, the Fed ought to have put a stop to it, and could have done so (in both my and Sumner’s opinion) by conventional means. Indeed, at least one of the Fed’s innovations at the time — its decision to begin paying interest on bank reserves in October — appears to have been perfectly counterproductive, in a manner all-too-reminiscent of the Fed’s foolish doubling of bank reserve requirements during 1936 and 1937.
To summarize and conclude: I largely agree with Scott’s arguments, and particularly with his claims (1) that tight money was the proximate cause of the post-September 2008 recession, and (2) that a policy of nominal income growth targeting might have prevented the recession. I disagree with him concerning how rapidly income should have been allowed to grow. The actual difference — a mere three percentage points or so — seems too small to rule out the possibility of that our views are informed by the same fundamental beliefs, and that we may eventually come to an agreement.
Notes
[1] In The Optimum Quantity of Money and Other Essays (Chicago: Aldine, 1969), pp. 1-30.
[2] See my Less Than Zero: the Case for a Falling Price Level in a Growing Economy. London: Institute of Economic Affairs, 1997 and also David Beckworth, “Aggregate Supply-Driven Deflation and its Implications for Macroeconomic Stability,” The Cato Journal 28 (3) (Fall 2008): 363-84. Other recent papers that reaches broadly similar conclusions using a New Keynesian macroeconomic framework is Niloufar Entekhabi, “Technical Change, Wage and Price Dispersion, and the Optimal Rate of Inflation,” University of Quebec, March 2008 and Stephanie Scmidtt-Grohé and Martín Uribe, “Optimal Inflation Stabilization in a Medium-Scale Macroeconomic Model,” July 15, 2006.
[3] William A. Niskanen, “An Unconventional Perspective on the Greenspan Record.” The Cato Journal 26 (2) (Spring/Summer 2006): 333-5.
[4] John Taylor, Getting off Track (Stanford: Hoover Institution Press, 2008), pp. 25-30.