Periodically I visit Scott Sumner’s blog The Money Illusion. I keep asking myself if the market monetarism he and a few others are pushing is important. I have come to think it is. Like change-the-world important. Like Nobel-worthy important.
I would usually bounce to Sumner’s blog from a glowing link from Marginal Revolution, and I have found his insights illuminating, though I haven’t always understood them. I noticed quickly that he was always making references to NGDP (nominal GDP), which I found annoying and odd. There is perhaps no concept so deeply engrained in an economist’s DNA than the idea that what matters is real. The first thing we do with any data series is make sure it is represented in real terms, not nominal ones. I don’t care what is going to happen to my nominal income; I care what happens to my real income–what I can actually buy, not the arbitrary prices that I have to pay for stuff. Similarly, relative prices matter, not nominal ones.
As a prescription for sound economic policies related to long-term growth, it is the real stuff that matters. In the long run, markets eventually adjust to shocks and the quantity theory of money holds: if we increase the quantity of money there is no real effect because prices eventually rise. That isn’t a terribly controversial idea. But it is the short run that is the rub. Orthodox economics is about equilibria, but life is about disequilibria. 10% unemployment is a disequilibrium outcome.
Another way to say this is that something is sticking. Prices for most goods and services do not change frequently, and wages move even more slowly. But demand and supply can (and do) change very rapidly. When New York and Washington were attacked on 9/11/01, there was an immediate and profound shock to demand for things like restaurants and a lot of other consumer goods that all of a sudden seemed vastly less important to consumers than they were on 9/10/01. But the prices charged by restaurants and the and wages paid to their employees did not immediately adjust to the lower demand. Thus there was an immediate gap between the observed price and the equilibrium prices (fortunately demand recovered before too long). Most restaurants did not print new menus, but they did respond to the shift in demand by laying off workers, reducing their hours, buying less food from suppliers and a lot of other decisions to cope with the loss of business. I haven’t seen the data, but I bet that New York restaurants pretty much stopped hiring new people in the wake of 9/11.
A terrorist attack or a hurricane are real shocks. But there are nominal shocks, too, that can be equally as devastating to the economy, if not more so. Often these occur because a speculative bubble pops, which has ripple effects throughout the economy. Nothing real has happened, but expectations have changed which causes spending to change, often very rapidly. Because of price stickiness, real interest rates do not necessarily reflect that rapid changes that are occurring with respect to spending. And because prices are sticky, real GDP is dragged down with nominal GDP. That is bad. It is the real stuff that affects people’s lives.
Sumner and the market monetarists are pushing a revolution in macro designed to put the Fed’s focus on nominal GDP. His provocative claim is that the balancing act between employment and inflation that the Fed is charged with can be accomplished not by worrying about output and prices separately, but by worrying about their combination–which is NGDP. If NGDP is too high, contract; if it is too low, expand. In Sumner’s view the low expected inflation revealed by interest rates during the financial crisis of 2008 was not a silver lining (as media reports liked to claim). Instead, the low inflation was the proximal cause of the recession. When spending tanked in 2008, NGDP (and RGDP) took a nose-dive. Sumner argues that even though the Fed did increase the monetary base, its policies were highly contractionary, just as they were in 1932. What the Fed needed to do was credibly commit to higher inflation in the future by injecting more money into the economy. Instead, interest rates and inflation stayed low and unemployment soared.
When a negative nominal shock occurs, people contract their spending and aggregate demand falls. The traditional Keynesian approach is to increase the money supply (monetary policy) or increase the deficit (fiscal policy) to stimulate spending. But when interest rates are low, people like Paul Krugman and Brad DeLong scream that there is a liquidity trap and that only fiscal policy is an option. Their arguments are motivated primarily by their love of government spending more than devotion to actual Keynesian arguments, but that is somewhat beside the point. Sumner argues that there are always monetary options, even in a liquidity trap. Put simply, creating inflation is easy: just debase the currency. Anyone can do that.
But isn’t debasing the currency a reckless way to run a country? As a long-term policy, of course it is. But this isn’t printing money to fund government expenditures or payoff bad debts. It is about intentionally creating inflation expectations. The downfall of Keynesian fiscal policy is that it only works by assuming people are myopic and won’t realize the impact of government policies. In the real world, government spending restricts private spending because people are not stupid; they realize that government spending today will raise taxes in the future. Increasing NGDP through expansionary monetary policy not only allows people to realize the impact of government policies, it depends on it.
The recipe is simple: when the economy experiences a negative nominal shock, inject money into the economy. People will spend more because they know that their money will be worth less in the future because of future inflation. And (this is important), when nominal growth is too high, the rate of inflation needs to fall.
What is new in NGDP-targetting is not so much the basic macroeconomics, but the policy perspective. Here are the key points of that perspective:
- Instead of ignoring the rational expectations revolution, market monetarism embraces it.
- It also embraces the key insight of the Noe-Keynesians, which is that prices are sticky.
- It is rule-based and completely transparent, rather than relying on the discretion and hidden agendas of central bankers.
- It is a short-term perspective on what matters in the short-term: total spending (recessions really suck, after all, and are best avoided).
- Policy makers don’t dictate market outcomes, they respond to them (hence the “market” in the market monetarism).
- There is no need for fiscal policy, which at best does nothing and, at worst, is exploited by the worst aspects of redistributive politics
Market monetarism is not an economic panacea. There will still be business cycles , and real growth still requires all the tough policy choices that are hard to make in a world where politicians care only about the coming electoral cycle. But it may turn out the a group of economic bloggers in obscure places are pushing a view that will end up making the economists at elite universities cringe with shame when the finally accept its utility and simplicity as an approach to preventing the pain of recessions like the current one. Time will tell.
Next: the politics of the new macro.