We Can’t Agree on Everything, George…

Otherwise we’ll have nothing to debate at the Southern Economic meetings in November. But seriously, I’d like to offer a conditional acceptance of your productivity norm. Here are the two conditions:

1. Assume that inflation expectations have been reduced to roughly zero. Ideally this would be done very gradually, to prevent any disruption of labor markets.

2. Assume that the Fed has adopted a forward-looking procedure that is not susceptible to “liquidity traps.”

I think the second point is rather important, and in my blog I will continue to argue for mild inflation for the time being. I agree that Japan is not a perfect match for the productivity norm, but the numbers are close enough that I fear combining mild deflation with what I regard as a very dysfunctional system of interest rate targeting combined with a backward-looking Taylor Rule. Nevertheless, I feel good that at least our ideal systems are converging; I could certainly live with a 2.5 percent NGDP target if implemented with a forward-looking policy regime, such as NGDP futures targeting.

I don’t have anything more to say about nominal wage stickiness and the effect of higher trend inflation on the size of business cycles, primarily because I am a bit of an agnostic on both points. I don’t worry too much about the Gesell proposal being adopted, partly for reasons I discussed in my reply to Hummel (which was posted after you sent this reply.) So let’s talk a bit about NGDP futures targeting, as this was the area where James Hamilton was most skeptical.

I now regret not discussing this issue more fully early on. If I am not mistaken, Hamilton argues that the price of NGDP futures would be much more informative that the quantity of futures traded (actually the net long or short position.) And in 1995 I did publish a paper suggesting that the Fed could use the price of NGDP futures as a guide to policy. But in 1997 Bernanke and Woodford published a paper (also in the JMCB) that was highly critical of this approach, citing a “circularity problem.” This means that if the markets understood that the Fed was looking at NGDP futures prices, and using them to target NGDP at five percent growth, then the equilibrium price would stay close to the target, in anticipation that any deviation would be “corrected” by a change in Fed policy. But in that case the market price might stick to the target, and thus fail to provide the Fed with early warning of velocity shocks.

Bernanke and Woodford also suggested an alternative. They said what the Fed really needed is the market prediction of the instrument setting most likely to hit the NGDP (or inflation) target. That is what my 1989 and 2006 papers proposed, as well as a 1994 proposal by Kevin Dowd that appeared in Economic Journal. So two very distinguished economists argued that what the Fed really needs is not the market prediction of the target variable, but the market prediction of the instrument setting most likely to hit the Fed’s target.

Not everyone sees my current proposal as achieving that goal. Therefore in 1997 I also proposed a way of eliciting market forecasts of the optimal policy instrument in a somewhat more straightforward manner. In that paper (also JMCB) I proposed a contingent auction of NGDP (or CPI) futures. Traders would fill out a set of schedules indicating how many NGDP futures they wished to buy and sell at a variety of different instrument settings. The policy instrument might be the monetary base, or the fed funds rate. For instance, if it were the base then the Fed would set the monetary base at the level that most closely equilibrated the aggregate net long and short positions of the traders. And before they bid on the contracts the traders would be told that this method would be employed to implement monetary policy. This provides an alternative method of ascertaining the market’s view as to which instrument setting is most likely to result in on-target NGDP growth. Some Treasury bond auctions use a similar procedure.

In my blog, some commenters have argued that this approach makes more sense. Robin Hanson, who is a leading expert on prediction markets, told me the same thing. So why do I cling to the futures market approach presented in my 1989 and 2006 papers? The main reason is that it does not require policymakers to decide which instrument is best. For instance, today most economists favor an interest rate instrument, so it is likely that the Fed would choose that approach. But then what would happen if there was no non-negative interest rate that equilibrated the net short and long positions, in other words, suppose we were in a liquidity trap? The beauty of my original proposal is that the central bank does not need to decide on a particular instrument setting. The market would literally be directing the open market operations, and each trader could look at whatever policy indicator that they thought was most informative.

Hamilton was also skeptical of my argument that a more expansionary monetary policy would have greatly reduced the severity of the financial crisis last fall. My argument had two parts. First, I agree with Frederic Mishkin that monetary policy is still highly effective at the zero rate bound. Thus a more expansionary policy could have prevented expected 2009 and 2010 NGDP from falling sharply last fall. And second, most of the second wave of the financial crisis was due to falling NGDP, not bad lending.

For the sake of argument assume that $1 trillion of the estimated $4 trillion in losses was due to poorly thought out mortgage lending, i.e. loans that would have been defaulted on even with stable five percent NGDP growth. Then assume that the other $3 trillion in losses, which became apparent only late last year when estimates of NGDP plunged sharply, represented higher quality residential mortgages, as well as commercial and industrial loans that would have been sound at a five percent NGDP growth rate. If I am right, and most of the financial losses last fall and winter were due to falling NGDP, then a modest uptick in nominal growth should modestly trim those losses. I think we have had a modest uptick in nominal growth in the past few months. Yes, it is very small relative to the huge decline in NGDP, which over the past 12 months has fallen about eight percent below trend. But nevertheless things are looking a bit better.

Take a look at today’s AP story showing how this modest upswing affected the IMF’s estimates of total losses from the financial crisis.

ISTANBUL, Turkey – Likely losses from the financial crisis in the three years to 2010 have been reduced by $600 billion to $3.4 trillion as the world economy grows faster than previously expected, the International Monetary Fund said Wednesday.

And now imagine not a slight uptick, but a much more expansionary policy in 2008, one that kept NGDP growing at five percent rate in 2009 and 2010, even if a somewhat weak fourth quarter was unavoidable. Then assume the recent uptick represented 20 percent of the total collapse in NGDP. What kind of estimate does that imply for the share of financial losses that are due to a weak economy? I think it is very possible that only about $1 trillion of the $4 trillion in losses is due to bad lending. After all, look how little economic growth it took to trim $0.6 trillion off those estimated losses.

One minor point; I didn’t say that the Fed has no influence over near term (quarterly) NGDP movements. I think by stabilizing longer term NGDP expectations they would also reduce quarterly NGDP volatility. However I agree with the view that there is an irreducible minimum of near term NGDP fluctuations that are beyond the influence of monetary policy. But that view is logically consistent with the view that longer term NGDP uncertainty can make near term velocity even more unstable than necessary.

Sometimes it is difficult to convey important distinctions that seem like slight nuances. So I thank all the referees for trying to work through these ideas, and apologize if they weren’t always expressed in the clearest possible fashion.

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.”