Let’s Make a Deal

Okay, Scott; I won’t insist on two percent NGDP growth; why don’t we just split the remaining difference, making it 2.5, and call it a day. I’m also very happy to accept your suggestion that, for safety’s sake, a move toward free banking ought to be coupled with an arrangement in which the reserve base is adjusted by means of NGDP futures contracting. If free banking really works as my theory says it might, the contracting will in fact lead to steady growth in the base (that is, in bank reserves). Otherwise, the base will vary more. Either way, though, there’s no need for anything beyond a sort of night-watchman version of “monetary policy.” Like I said, a computer could handle it. Indeed, it seems to me that neither of our proposals can be expected to work as planned unless the monetary authority’s wings are clipped in a manner that altogether rules out a revival of monetary discretion. To this extent, at least, it seems we both favor doing away with central banking in the usually understood sense of the term-the one in which central bankers’ agonize every couple months or so about the right monetary policy stance.

I’d like nevertheless to make a remark or two concerning the dangers you see in a full-blown productivity-norm regime. The Japanese example is, indeed, troublesome to me: I frankly don’t understand why, earlier this decade, short-run rates there remained obstinately stuck at zero despite the fact that the rate of (total factor) productivity growth exceeded the rate of deflation. I suppose that expectations had been traumatized somehow. Nevertheless, I think Japan’s experience actually offers some support for both of our positions. Consider that, during the first part of its “lost decade” of the 90s, Japan’s inflation rate (according to the GDP deflator) was positive; whereas by the time inflation gave way to substantial deflation, at the end of the decade, Japanese total factor productivity growth had fallen very low-most estimates put it around .5 percent. There was, in short, no point during the lost decade when Japan’s situation resembled a productivity norm.

From roughly 1999 through 2005, on the other hand, Japan’s deflation rate did more-or-less match its rate of productivity growth. But by then the Japanese economy was growing again, if only modestly. This happened in part precisely because the Japanese government had at last turned to quantitative easing: had it not done so Japan’s deflation might well have proceeded well beyond productivity-norm bounds. In short, Japan’s case suggests that deflation (insofar as it doesn’t exceed the bounds of productivity growth) and zero interest rates are each of them red-herrings: Japan’s economy tanked when its NGDP growth rate fell dramatically, and it began to recover when the rate stabilized again, even though it stabilized at a very low value. (It has since slumped badly again.)

Turning to the problem of downward nominal wage adjustments, the argument you raise reminds me of Akerlof, Dickens, and Perry’s influential paper on “The Macroeconomics of Low Inflation.” [1] I remember puzzling over their own version of it and eventually concluding that it wasn’t a good reason for resisting productivity-norm deflation, let alone for tolerating inflation. For starters, it begs the question: if we are to resort to monetary expansion as a means to avoid downward pressure on money wage rates, even when that pressure reflects a relative drop in demand only (with positive demand pressure elsewhere), then where do we stop? Should we regret the fact that equilibrium nominal wage rates in, say, the hoop-skirt and slide-rule industries, or at firms like the Tucker (automobile) Corporation, are no longer positive? Could even the most expansionary monetary policy possibly have kept them so?

Okay, that’s being extreme. But there’s a more fundamental point here, which is that there’s a big difference between downward pressure on nominal wage rates that signifies falling real (that is, relative) demand for products made by the labor in question, and downward pressure that merely signifies a general drop in demand. The difference is, simply, that in the former case it isn’t clear that nominal wage rates need to change at all. The “flexible wage” equilibrium may be one in which they stay the same, with labor shifting from the low- to the high-demand firms and industries. That’s transparently the case where labor is both homogeneous and perfectly mobile. Of course, these assumptions don’t generally hold. But even so it’s far from clear that using general wage inflation as a means for getting relative wage rates down in depressed firms and industries without resort to nominal wage cuts serves to preserve rather than to undermine overall economic efficiency.

Finally, I admit that in proposing a link between the NGDP growth rate and the amplitude of the business cycle I’ve gone way out on a limb. It’s very hard to make a theoretical case for this connection. But here goes: as trend NGDP growth increases, prices become less sensitive to current economic conditions (the greater price-dispersion argument), including any short-run fluctuation in NGDP growth (remember how I said that we have to assume that NGDP growth it isn’t targeted perfectly). This flattens the short-run Phillips Curve, making real output vary more around its natural level.

Oh well, at least I’ve given it a shot.

Now I’d like to say a thing or two about Jeff’s remarks. First of all, Jeff, I’m sorry about all that jargon in my last post. You know it isn’t my style. But I was after all making a digression on where mainstream macroeconomics had gone wrong; and I wanted to put it in terms that the “mainstreamers” I have in mind would regard as reasonably concrete, just in case any of them was listening! I’m sorry if in doing so I seemed to forget my real audience.

I hope I may kiss and make up by saying that my reaction to the idea of charging interest on bank reserves is much the same as Jeff’s. That is, I don’t much like it. For starters it reminds me of schemes like Gesell’s for punishing “hoarders,” which amounted to making them scapegoats for central bankers’ mistakes. Also, if the goal is to reduce reserve demand, the more efficient way to do that is to hurry up and abolish statutory reserve requirements, as Jeff suggests. In any event I’m bound to oppose any reform that risks driving the demand for reserves, and especially reserves held for interbank settlement purposes, to zero, for then how will the value of the fiat dollar be determined once we free bankers succeed in allowing commercial banks to substitute their own notes for outstanding Federal Reserve notes?

Finally, I’ve found the exchange between Scott and Prof. Hamilton very helpful. The practical workings of NGDP futures targeting were, I confess, something of a mystery to me. But in response to Prof. Hamilton’s probing Scott has clarified them a lot. Perhaps there’s still a flaw in the idea — and I hope Prof. Hamilton will not relent if that’s so. Still I hope there isn’t, because the scheme seems to offer more promise than any other monetary targeting scheme I’m aware of for making monetary discretion perfectly superfluous.


[1] Brookings Papers on Economic Activity, 1996.

Also from this issue

Lead Essay

  • In this month’s sure-to-be controversial lead essay, Bentley University economist Scott Sumner argues that almost everything economists and economic policymakers thought they knew about the role of monetary policy in the recent recession and financial collapse is wrong. Sumner contends that the resources of monetary policy were not exhausted, as many economists believed, but were barely used. Flying in the face of conventional wisdom, Sumner maintains that monetary policy in the run-up to the finacial crisis was not highly expansionary, but was in fact disastrously contractionary. Sumner offers a short history of monetary economics to put into historical perspective the role of allegedly failed monetary policy in the financial crisis and recession. He proposes a strategy for central bankers — targeting forecasts of nominal GDP — that might help avert future crises. In conclusion, Sumner warns of the political dangers of misdiagnosing the crisis: unless the record is set straight, free markets will once again take the fall for a failure of monetary policy.

Response Essays

  • University of California, San Diego economist James D. Hamilton disputes Scott Sumner’s claim that the sub-prime crisis was a fluke with few lessons for macroeconomics. According to Hamilton, the booming U.S. housing market represented a “huge misdirection of capital,” and the overexposure of key financial institution to the housing market’s downward correction crippled lending and sent the economy into a nosedive. Hamilton agrees that the Fed might have limited the damage had it kept the growth rate for nominal GDP higher, but he disagrees with Sumner about the tools available to the Fed to achieve this. Hamilton notes that tools available to the Fed depend on which of the possible specifications of the money supply and its velocity actually determine nominal GDP. Hamilton says unconventional paths to monetary stimulus were open the Fed in late 2008 and that “the preferred policy … would have been to acknowledge more aggressively the losses financial institutions had absorbed on existing loans, impose those losses on stockholders, creditors, and taxpayers, and retain as the Fed’s first priority the stimulus of nominal GDP rather than trying to lend to everybody.” Hamilton concludes with some worries about Sumner’s favored tool for targeting nominal GDP growth.

  • University of Georgia economist George Selgin agrees with Scott Sumner that “tight money was the proximate cause of the post-September 2008 recession” and that “a policy of nominal income growth targeting might have prevented the recession.” Selgin encourages Sumner to acknowledge the role easy money played in the subprime crisis, and argues that Sumner’s five-percent nominal income growth target is “unnecessarily and perhaps dangerously high.” Selgin favors a two or three percent target, which he contends would be less likely to perpetuate boom-bust cycles.

  • San Joses State’s Jeffrey Rogers Hummel begins with a brief history of economic thought about the causes of the business cycle, which leads to a call for “a measure of epistemic humility.” Hummel signs on to much of Sumner’s story about the Fed behavior in 2008, and accepts his criticism of the widespread use of interest rates as the main indicator of monetary policy. But Hummel departs sharply from Sumner’s prescription for better monetary policy — a rule to target the forecast of nominal GDP growth. “The … critical defect of Sumner’s Rule,” Hummel argues, “is its blithe assumption that money, unlike any other good or service, requires not merely government provision but detailed, sophisticated, and flexible government management.” Hummel raises doubts that even the best such rule would be well-applied, and calls for the “abolition of the Fed, elimination of government fiat money, and complete deregulation of banks.”