A major breakthrough in popular economic thinking happened last weekend.
Goldman’s top economist Jan Hatzius came out in favour of the Fed setting a target for Nominal GDP.
Now, this is an idea that’s been bubbling around on blogs, and in economic circles for a while, but now everyone is talking about it. PIMCO mentioned it in a tweet this week. Krugman is bullish on it. The buzz is deafening (well, as much as buzz about monetary policy can get).
But… what is it, and why do people think it should work?
The economist most associated with NGDP targeting is Bentley University professor Scott Sumner, who writes the popular blog TheMoneyIllusion, where he offers his unorthodox views on the economy.In a lecture called What Can Asset Prices Tell Us About The Great Recession? he states:
“Now why is Nominal GDP so important? That’s the total dollar value of income in the economy. And if you think about it, most debts are contracted in nominal terms. So in a sense, the economy’s dollar income is a good metric for measuring people’s ability to repay these previously contracted nominal debts.”
Thus, when you get a severe break or a decline in nominal GDP, you get a severe debt crisis. The idea behind boosting nominal GDP then — even if it means doing so by accepting higher inflation — is that if the economy’s total dollar income rises, then at least those debts become more manageable.
Of course, there’s another problem with all this: How does the Fed pick a desired level of Nominal GDP and hit it. Bernanke doesn’t have a Nominal GDP button.
Well, because this topic is getting so much buzz this week, this blog post from economist Nick Rowe on the how of NGDP targeting got a lot of discussion.
To some extent, there’s a belief that merely stating the NGDP goal will create the expectations in people’s minds that will ultimately allow it to happen. But if it doesn’t, then the Fed has to counteract all that with asset purchases.
He uses a colourful analogy involving Chuck Norris to explain how it works:
There are two rooms at a party. The first room is nearly empty. The second room is nearly full. Because everyone wants to be where everyone else is. Then Chuck Norris enters the second room. He threatens to beat up 1 person at random in the first minute, 2 people in the second minute, 4 people in the third minute, and so on, until the room is empty. This is no longer an equilibrium.
A few people were nearly indifferent to being in the second room. So they leave even if the chance of them getting beaten up is tiny. That means there are fewer people left in the second room. This makes the second room slightly less attractive for those who want to be where everyone else is. And it slightly raises the probability of being beaten up by Chuck Norris. So more leave. Which repeats the process, so still more leave. And if you and I can see what’s coming, so can the people in the room, who don’t want to be the last to leave. There’s a rush for the exits, and Chuck doesn’t even have to lift a finger. OK, if someone didn’t hear the threat, or doesn’t recognise Chuck Norris, he might actually have to carry out his threat for a few minutes. But simply seeing all the others leave the room will be enough to induce most to leave the room very quickly.
Chuck Norris doesn’t have to beat up everyone in the room. He just has to threaten to beat up as many as it takes to clear the room. The number of people he will actually beat up is a lot less than the number he threatens to beat up. If his threat is credible, and everyone hears it, he doesn’t need to beat up anyone.
Eventually, if the Fed bought up every single asset in the economy, and swapped it for cash, NGDP would rise to the Fed’s target path. Prices would rise without limit as the Fed bought up the last remaining assets because the sellers could name their price. And people would hire the unemployed to build factories which they could float on the stock and bond markets and sell to the Fed at any price they liked. Or sell to the people who had already sold all their assets to the Fed.
But there is no way it would ever get that far. That’s like saying that Chuck Norris will eventually beat up everyone in the room. That’s not an equilibrium.
The implication, we think, from all this, is that you can’t just buy conventional assets like Treasuries or even Mortgage Backed Securities. If the idea is that it could get to the point where people are building factories that they could flip to the Fed, then that means the Fed has to buy factories. And we’re not sure if this is legal at all, but hey, it’s the theory. Obviously it’s never supposed to get that far.
Anyway, we expect you’ll hear more about this, especially if the economy re-falters, and if Congress remains so petulant with respect to fiscal policy. Chicago Fed President Charles Evans has been making a lot of hints along these lines as well.
To understand more about Scott Sumner’s thinking, you should watch this video of him talking about the failure of the Fed to loosen money supply adequately ahead of the great recession, and why an NGDP-targeting approach to monetary policy would work better.
Some more key points:
- Again, NGDP represents the economy’s total dollar income, and thus its ability to service debts.
- Just because nominal interest rates are low, it doesn’t mean that money’s loose enough… in fact, real interest rates actually rose in the second half of 2008, as inflation collapsed.
- The Fed must set a hard target and stick to it, not being content to just get in the vague general ballpark of where it wants to go.