Economics One

Several people have asked me to comment on nominal GDP targeting, as recently proposed by Scott Sumner, Christina Romer and Paul Krugman. I did research on nominal GDP targeting many years ago and found that such targeting proposals had a number of problems, which I summarized in the paper “What Would Nominal GNP Targeting Do to the Business Cycle?” Carnegie-Rochester Series on Public Policy, 1985. Although much has changed in the past quarter century I find many of the same problems with the recent proposals.One change is that, in comparison with earlier proposals, the recent proposals tend to focus more on the level of NGDP rather than its growth rate. This removes some of the instability of NGDP growth rate targeting caused by the fact that NGDP growth should be higher than its long run target during the catch up period following a recession. But it introduces another problem: if an inflation shock takes the price level and thus NGDP above the target NGDP path, then the Fed will have to take sharp tightening action which would cause real GDP to fall much more than with inflation targetting and most likely result in abandoning the NGDP target.

A more fundamental problem is that, as I said in 1985, “The actual instrument adjustments necessary to make a nominal GNP rule operational are not usually specified in the various proposals for nominal GNP targeting. This lack of specification makes the policies difficult to evaluate because the instrument adjustments affect the dynamics and thereby the influence of a nominal GNP rule on business-cycle fluctuations.” The same lack of specificity is found in recent proposals. It may be why those who propose the idea have been reluctant to show how it actually would work over a range of empirical models of the economy as I have been urging here. Christina Romer’s article, for instance, leaves the instrument decision completely unspecified, in a do-whatever-it-takes approach. More quantitative easing, promising low rates for longer periods, and depreciating the dollar are all on her list. NGDP targeting may seem like a policy rule, but it does not give much quantitative operational guidance about what the central bank should do with the instruments. It is highly discretionary. Like the wolf dressed up as a sheep, it is discretion in rules clothing.

For this reason, as Amity Shlaes argues in her recent Bloomberg piece, NGDP targeting is not the kind of policy that Milton Friedman would advocate. In Capitalism and Freedom, he argued that this type of targeting procedure is stated in terms of “objectives that the monetary authorities do not have the clear and direct power to achieve by their own actions.” That is why he preferred instrument rules like keeping constant the growth rate of the money supply. It is also why I have preferred instrument rules, either for the money supply, or for the short term interest rate.

Rules for the instruments are what monetary policy needs, not excuses for discretionary actions. I welcome more research looking for better instrument rules which are explicit and operational enough to be evaluated with empirical economic models. Even an historical comparison of different rules would be welcome, and Allan Meltzer’s monumental History of the Federal Reserve would be a good foundation to build on. As he summarized in a speech this week, “Economists and central bankers have discussed monetary rules for decades. A common response of those who oppose a rule, or rule-like behavior, is that a central banker’s judgment is better than any rule. The evidence we have disposes of that claim. The longest period of low inflation and relatively stable growth that the Fed has achieved was the 1985-2003 period when it followed a Taylor rule. Discretionary judgments, on the other hand, brought the Great Depression, the Great Inflation, numerous inflations and recessions. The Fed contributed to the current crisis by keeping interest rates too low for too long.”

My Wall Street Journal article today is quite critical of recent interventionist fiscal and monetary policies in the United States. In my view, they have not only been unhelpful to the American economy, they have also been unhelpful to the world economy. The monetary and fiscal policies I am criticizing go back to before the start of the Obama administration, as I showed in this article on fiscal policy recently published in the Journal of Economic Literature and in this piece on monetary policy published in November 2008 by the Bank of Canada. So I view this criticism as being non-partisan, as has been my historical review of the swings between rules and discretion.

In a long rebuttal to my criticism in today’s Wall Street Journal article, David Glasner argues that I mischaracterized America when I wrote that it was a leader in economic freedom following World War II, when it helped Japan and Europe recover and helped create the GATT and other international financial institutions. It is certainly true that American economic policy was not perfect with its regulations and high marginal tax rates, but comparatively speaking the American model was a far cry from what was being set up in the large areas of the world which were not free either economically or politically. 

Another quite different part of his rebuttal is the argument that I had a different view of monetary policy as implemented in Japan in the early 2000s, when I was U.S. Under Secretary of Treasury for International Affairs, a period which I reviewed in my book Global Financial Warriors. I had similar views in the 1990s when I was a foreign honorary adviser to the Bank of Japan.

For several reasons, the economic policy situation in Japan in the 1990s and early 2000s, when I was in the Treasury, was quite different from the situation in United States today  In the 1990s, but especially in the early 2000s, there was a deflation in Japan: the GDP deflator fell from 1999 to 2003. In the United States we have seen no such prolonged declines in the GDP deflator in recent years.

Second, the purpose of increasing the monetary base in Japan, as I argued in those days, was to get the growth rate of the money supply (such as M2+CD) back up. As I showed when I was an adviser to the BOJ, a decline in money growth was largely responsible for the deflation and for the poor economic performance in the 1990s. So the goal of the Japanese policy in the early 2000s, which I was approving of while I was at Treasury, was to get money growth back up. It was not to try to drive up temporarily the price of mortgage securities or stock prices, which is what is frequently used to justify the quantitative easing by the Fed today. Here are my specific views on Japan written while I was an adviser to the BOJ.

A third difference is related to the rules versus discretion debate. If a central bank follows a money growth rule of the type Milton Friedman argued for—and which is quite appropriate when the interest rate hit zero in Japan—then the central bank should increase the monetary base to prevent money growth from falling or to increase money growth if it has already fallen. In other words such an easing policy can be justified as being consistent with a policy rule, in this case a rule for the growth of the money supply. The rule calls for keeping money growth from declining. But the large-scale asset purchases by the Fed today are highly discretionary, largely unpredictable, short term interventions, which are not rule-like at all. It is the deviation from more predictable rule-like policy by the Fed (which began in 2003-2005 and continues today) that most concerns me.

Today’s NPR Morning Edition presented two sides to the question “Does The Economy Need A Little Inflation?”  By “a little” they mean 5 percent per year for a few years.   The former IMF chief economist and Harvard professor Ken Rogoff argued in the affirmative and was featured in the radio segment, as he has been arguing this view along with his successor at the IMF, Olivier Blanchard, for a while now. I argued for the negative in the segment saying it would do more harm than good to the economy, a point Paul Volcker has been making forcefully. A recent column by George Will puts the issue in the broader context of U.S. economic policy and also comes out on the negative side.