Almost all economists were taken by surprise by the 2008 Financial Tsunami. The few economists who anticipated it failed to gain an audience. They were like the lonely Cassandra of Greek mythology making predictions of eminent economic collapse throughout their careers but never taken seriously by their profession.
Since then, unnoticed by the public, an intense debate has been raging in the blogosphere among economists, involving professors and graduate students, some famous and others less known, on what caused the Financial Tsunami and how to help the economic patient recover. The arguments center on the desirability of changing Fed policy from targeting interest rates to targeting growth in nominal GDP (NGDP).
NGDP targeting is not a new idea. It has an intellectual pedigree that goes back at least 25 years before the crisis. The hero leading the current debate on NGDP is Scott Sumner, a professor of economics atBentleyUniversityinMassachusettsand a PhD graduate in economics from theUniversityofChicago. Sumner is a free market economist by persuasion and an admirer of Milton Friedman.
Monetary Policy Failure
Sumner started writing a blog in February 2009 called The Money Illusion, when he fired the first salvo about the endlessly perplexing problem of monetary policy. For him the defining problem has not been the financial crisis, but the dramatic fall in aggregate demand since the summer of 2008. He feels economists have “fundamentally misdiagnosed the nature of the recession, attributing to the banking crisis what is actually a failure of monetary policy.” Sumner claims that his ideas were inspired by Professor George Selgin, who previously taught at theUniversityofHong Kong.
Sumner had spent 25 years researching the Great Depression, liquidity traps, and forward looking monetary policy. He noted that in October 2008 the Fed (and the other central banks) had lost credibility, allowing market expectations for growth and inflation to fall far below their implicit target. In other words, the severe economic slump seemed to be caused by tight money; not tight in some absolute sense, but relative to what was needed to meet the Fed’s objectives to stabilize prices and maintain full employment growth. To his frustration, he found few macroeconomists saw things that way, even though it seemed a logical implication of mainstream macro theory.
Sumner’s blog was linked by Professor Tyler Cowen’s highly popular blog called Marginal Revolution. By the end of 2009 the economics’ blogosphere was intensely debating the problem Sumner had raised. The debate drew in famous economists including new Keynesians like Brad DeLong ofBerkeleyand Paul Krugman ofPrinceton, as well as vintage Monetarists like Allan Meltzer and Ann Schwartz. Sumner has been on a mission from God working tirelessly to persuade us all that central banks should target NGDP, and that they have the ability to do so even after interest rates fall to zero.
Two Years of Debate and a Surprise Victory
An assorted group of economists, mostly of the free market persuasion, have joined Sumner in developing and elaborating the subtle logic behind NGDP targeting and they continue to debate the new Keynesians and old Monetarists. Apart from Sumner, active members of the online group of Market Monetarists include:
Scott Sumner (PhD Chicago, 1985), Professor,Bentley University,Massachusetts
Nick Rowe (PhD Western Ontario), Assoc Prof,CarletonUniversity,Ottawa
David Beckworth, Asst Prof,TexasStateUniversityinSan Marcos
Josh Hendrickson (PhDWayneState), Asst Prof,UniversityofMississippi,
Bill Woolsey (PhD George Mason, 1987), Assoc Prof, The Citadel,Charleston,South Carolina
Marcus Nunes, Professor, Fundação Getúlio Vargas,São Paulo,Brazil
Niklas Blanchard, PhD candidate atBellevueUniversity
David Glasner (PhD UCLA), Federal Trade Commission,Washington,DC
Kantoos, PhD economist inGermany
Lars Christensen, Chief Analyst, Danske Bank
Fed Should Target NGDP
The amazing fact about the group is that most of the members are relatively junior in the economics profession and are concentrated in the teaching universities. For me this was an absolutely delightful finding. I have always wondered if the pressure to publish research in ever more specialized and compartmentalized fields in the major research universities is an unqualified healthy outcome for academia.
The online debates bubbled for two years and finally in October 2011 a totally unexpected development happened. Many of Sumner’s opponents made high-profile public endorsements urging the Fed to target an NGDP path. These individuals included Paul Krugman and Brad DeLong, who previously had been openly hostile to the Chicago School of Economics, Christina Romer,former Chairman of the Council of Economic Advisers in the Obama administration, and Jan Hatzius and colleagues at Goldman Sachs, who issued a paper endorsing the NGDP target. This was a huge victory for Sumner and his fellow Market Monetarists.
Both the Bank of Canada and the Fed have recently openly acknowledged the call for targeting NGDP. On 2 November 2011, Bank of Canada Governor Mark Carney testified to the Senate Banking Committee in Ottawa that while there are interesting aspects to targeting NGDP growth, the regime would not be as good for the economy as the current inflation-targeting policy and so it would not be an appropriate monetary policy for Canada. On the same day, Ben Bernanke at the Fed’s quarterly press conference responded that they had had a very interesting discussion of NGDP at the previous day’s meeting and there was some interest in adding this indicator to the Fed’s list of important indicators. These are not endorsements of NGDP targeting, but it is probably as positive a statement as could be expected at this early stage of consideration.
To understand what the Market Monetarists are demanding, it helps to go back to Milton Friedman, who demonstrated that inflation is everywhere and always a monetary phenomenon, thus restoring the role of monetary policy as a stabilization tool to policy respectability and ending a period of Keynesian preference for fiscal policy. Friedman also introduced into policy discussion the role of rule versus discretion arguing that the effects of fiscal and monetary policies on the economy were plagued by unknown and variable dynamic time lags, which made it very difficult to devise and implement a stabilization program without getting it wrong. More often than not policy makers ended up with unintended consequences, so that a counter-cyclical stabilization policy became a pro-cyclical de-stabilization policy, or expectations created offsetting effects that worked against the wishes of policy makers. Friedman’s insights inspired several generations of macroeconomists, five of whom were honored with the Nobel Prize: Robert Lucas in 1995, Edward Prescott and Finn Kydland in 2004, and Christopher Sims and Thomas Sargent in 2011.
Taylor Rule is Fed’s Bible
Friedman wanted central banks to adopt a fixed monetary rule so that the stock of money would be increased at a fixed rate year-in and year-out without any variation to accommodate cyclical needs. For Friedman, giving governments any flexibility in setting money growth would lead to inflation. He wanted to avoid conducting counter-cyclical monetary policy, the standard Keynesian policy recommendation at the time. For this reason, he maintained that central banks should be forced to expand the money supply at a constant rate, equivalent to the rate of growth of real GDP plus a targeted level or range of inflation of say 0-2%. This became known as Friedman’s k-percent rule. So if the trend rate of real GDP was 3% and the targeted inflation rate was 2% than the k-percent rule would be 5%.
Friedman won the intellectual argument over Keynes?. Central banks have since followed his advice, but with one important variation. Rather than applying Friedman’s rule to growth in the stock of money – which is determined by both supply and demand and is set in the market, thus making it a moving target – central banks chose to target the interest rate. In 1993, Professor John Taylor ofStanfordUniversityproposed a monetary-policy rule that stipulates how much the central bank should change the nominal interest rate in response to changes in inflation, output, or other economic conditions. For each one-percent increase in inflation, the nominal interest rate should rise by more than one percentage point. This became the benchmark rule used by the Fed and came to be known as theTaylorrule.
TheTaylorrule and the Friedman rule have a subtle difference. TheTaylorrule targets the price of money rather than the quantity of money in order to achieve price stability and employment growth. This is where we come back to the NGDP. According to the identity equations in the Quantity Theory of Money, targeting the quantity of money is similar to targeting the NGDP. Following a fixed monetary rule would be equivalent to following a fixed NGDP rule over the long run.
The interest rate represents the price of money under theTaylorrule and this is where problems arise. We know that the nominal interest rate must equal the real interest rate – that which exists at present – plus the expected rate of inflation, which is expected to happen tomorrow. This means the expected inflation rate need not equal the actual inflation rate. So targeting the nominal interest rate can be misleading if the expected rate of inflation is changing and especially if it jumps suddenly or reverses direction.
Old Mistakes Do Not Die
In the summer of 2008 the nominal interest rate became a very serious and misleading indicator. The nominal interest rates were low and falling. From 2007 to 2008 the Fed had tripled the monetary base and M2 was rising rapidly, but actual inflation rates were still low. Most economists concluded that money was not tight and if the Fed were to further ease up on money there would be an inflation risk.
Sumner, however, disagreed. He believed that money was actually very tight because year-on-year NGDP was rising at 4.2% in 2007:Q4; 3.6% in 2008:Q1, 2.6% in 2008:Q2, 0% in 2008:Q3, and -1.4% in 2008:Q4. Throughout this period the growth of NGDP was below a k-percent rule of 5%.
According to Sumner, the indicators of whether money was easy or tight were often contradictory and sometimes mutually conflicting. This was caused in part by rapid changes in expectations of inflation.
Milton Friedman had long cautioned that it was a mistake to take a low nominal interest rate as the sign of easy money. In commenting onJapanin 1997, he wrote, “Initially, higher monetary growth would reduce short-term interest rates even further. As the economy revives, however, interest rates would start to rise. That is the standard pattern and explains why it is so misleading to judge monetary policy by interest rates. Low interest rates are generally a sign that money has been tight, as inJapan; high interest rates, that money has been easy.”
Friedman sawJapan’s experience as a less dramatic replay of the great contraction in theUSduring the Depression. The Fed had permitted the quantity of money to decline by one-third from 1929 to 1933, just as the Bank of Japan permitted monetary growth to become low and even negative. The Fed pointed to low interest rates as evidence that it was following an easy money policy and it never mentioned the quantity of money. The Bank of Japan similarly referred to the drastic monetary measures it took in reducing the discount rate from 1.75% to 0.5% as evidence of the easy stance of monetary policy, but failed to realize that monetary growth was too little and too late.
Friedman in the same article lamented that, “After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”
Arbitrary Information Has No Value
For Sumner, any definition of easy or tight money is arbitrary, unless it is relative to the goals of policymakers. The policy objective of the Fed is to assure price stability and employment growth, which can be translated into a goal of 5% growth in NGDP. This policy goal then should be the Fed’s forecast because it has a mandate to deliver the goal. The role of the Fed is to announce the forecast and then work to achieve it by setting the monetary base and short term interest rates at a level expected to produce on-target nominal growth in the targeted NGDP. It makes no sense to talk about the ease or tightness of monetary policy in some absolute sense, as the many indicators often give arbitrary and conflicting indications. And if the goal is 5% growth in NGDP, then easy money is a policy expected to exceed the NGDP growth target, and tight money is a policy expected to fall short. By this criterion, money was extremely tight in late 2008.
On 2 November 2011, Fed Chairman Bernanke lowered the forecasts for growth and raised forecasts for unemployment for this year, 2012 and 2013. For Sumner this is exactly what Bernanke should not be doing. Instead he wants the Fed to change its policy framework to target NGDP growth and to announce it as their policy goal. This would shift inflationary expectations. Perhaps even more important is to have the Fed back it up with a pro-active policy to ease money. Indeed the previous announcement to keep long-term interest rates low for another two years was counter-productive and barking up the wrong tree. Sumner’s point is that you want inflationary expectations to rise, and this would lead to higher nominal interest rates.
Professor Frederic Mishkin, a New Keynesian economist atColumbiaand a former member of the Board of Governors at the Fed, has written a number one selling money textbook in theUSwhich has this to say about the role of monetary policy:
1. It is dangerous always to associate the easing or the tightening of monetary policy with a fall or a rise in short-term nominal interest rates.
2. Other asset prices besides those on short-term debt instruments contain important information about the stance of monetary policy because they are important elements in various monetary policy transmission mechanisms. (In 2008, housing prices were falling; and in the second half when NGDP was falling other asset prices also began to drop: commercial real estate prices plunged, the dollar soared against the euro, commodity prices fell by half, real interest rates soared as deflationary expectations settled in, and equity prices collapsed.)
3. Monetary policy can be highly effective in reviving a weak economy even if short term rates are already near zero.
Sumner’s ideas is apparently finding their way into the undergraduate curriculum.
When Quantitative Easing II was announced on 3 November 2010 there was one dissenting vote on the Federal Open Market Committee (FOMC) against monetary easing. When Operation Twist was announced on 21 September 2011 there were three dissenting votes against monetary easing. But, on 2 November 2011 after the FOMC meeting left policies unchanged, there was one dissenting voice in favor of further monetary easing. Is the tide turning in favor of easy money?
Milton Friedman, “Rx for Japan: Back to the Future”, Wall Street Journal, December 17, 1997. n
Jan Hatzius, etal. The Case for a Nominal GDP Level Target”, US Economics Analyst, Goldman Sachs Global ECS Research, Issue No. 11/41, 14 October 2011.
Scott Sumner, “Re-Targeting the Fed”, National Affairs, No. 9, Fall, 2011.