As I briefly mentioned in my last blog post, the credit for Fed’s latest monetary stimulus is given mostly to a group of theoretical monetary economists called market monetarists. This post will recapitulate their main idea and act as a critique of some parts of their arguments.
Market monetarists reject the idea that central banks have lost ‘ammunition’ to stimulate the economy. They, in fact, believe that monetary stimulus is the only thing that can help the economy at this moment. Even under the zero-lower bound (ZLB) constraint. Evidence? A rise in stocks and investor confidence after the news of QE3, QE2, QE1, and fall of Spanish and Italian bond yields after ECB actions (in August 2011, December 2011, and most recent ones in July and September 2012). However, they claim, this isn’t enough, as central banks can do much more in impacting aggregate demand.
Aggregate demand can, from a monetary perspective, be stimulated in two ways: quantitative easing (or any other way of increasing the money supply), and long-term signalling on easier monetary policy in the future.
As far as quantitative easing is concerned I agree with a part of their argument; current QE efforts create money for banks that isn’t being released into the real economy. It makes perfect sense for banks to hoard cash and deposit money in central banks overnight when alternative investments over low interest rates are relatively more risky. However, I don’t agree that higher sums of QE would be more helpful to increase demand. I fail to see why this would after some threshold value induce banks to release the money back to the real economy.
The second favourable idea is to credibly signal long term easier monetary policy, when interest rates are no longer zero. The central argument is that this signal of easier money in the future and expectations of rising demand will induce people to spend more today. This does make sense as businesses would make investments today if they would be certain that these investments would pay off in the future. It’s the uncertainty of today that’s killing off their investments and hiring. So a credible signal of monetary policy would be enough to break the uncertainty surrounding their investment decisions.
I don’t believe that it’s this simple. First of all it takes a lot of effort for a central bank to influence future expectations. And why would the people react positively to announcements from the central bank? Does a business owner really base his decisions on signals from a central bank? No, he bases his decision on signals from his local bank. So does a consumer. But that’s what this means; the central bank indirectly signals to consumers and businesses that they are fighting uncertainty. The direct signal is being sent to major investors like banks. They are the ones who are supposed to re-start the investment cycle, but banks are being constrained from the regulatory perspective. Investor confidence does tend to increase after these announcements (as I’ve shown in the previous post), but business confidence doesn’t catch up so quickly. Consumer confidence is even slower to respond. The currently available data proves this (see here, here or here). And I predict that neither business or consumer confidence will surge after these announcements by the end of this year. They only way to reach an increase in confidence comes from increasing the disposable income of consumers (higher incomes through more jobs and higher wages, or via lower income taxes) and lowering regulatory uncertainty and the tax burden for businesses.
However, market monetarists still argue that the easiest way to achieve this signalling would be to target nominal GDP growth. The ‘rule of thumb’ target would be 5% (2% inflation plus 3% real GDP growth which is a potential GDP growth path). This implies that if nominal GDP falls to around 2% per year, the Fed should allow for temporary higher inflation to reach the 5% nominal growth target. So depending on which of the two parameters falls, the central bank should allow the other parameter to overshoot in order to reach the target. In periods of low real economic growth (as we have now) this would imply the Fed increasing inflation. Here's from my earlier text on NGDP targeting:
"The idea can literary translate to the following: If the Fed prints more money, this drives up prices (the classical causal relation in monetary economics where more money in the economy makes it lose its value and triggers an increase in prices as people now need more currency to buy the same goods as before). Higher prices of goods and services will increase the GDP measured in current prices (nominal GDP). This is an easy way to reach the target without increasing real growth at all. For the current 1% rate of real growth the Fed may pump up inflation to 3,5% in order to reach its target. But this doesn't mean the economy grew at 4,5% - it's real growth is still weak."
For example, the practice of the Bank of England prior to the crisis was close to this way of conducting monetary policy. They did have formal inflation targeting but were far more willing to allow inflation to overshoot, rather than they would see it undershoot its 2% target. This kept nominal GDP within the 5% mark.
Scott Sumner texts
In two excellent papers for National Affairs and the Adam Smith Institute (one focused on the US, one on the UK), Scott Sumner summarizes his main points on why NGDP targeting should be favoured as the dominant monetary policy.
He argues that in the short run nominal and real GDP seem to align closely together while inflation is sticky (prices and wages adjust slower than decisions on production or spending). In the recent recession it was the rapid fall of nominal GDP in 2008 and 2009 that caused the unemployment to rise to above 10%. He argues that action from the Fed can achieve the same shift but in a different direction if it increases nominal GDP, which will push up real GDP. However, this can’t be done in a longer period since boosting nominal GDP via higher inflation will in the long run only result in higher prices, i.e. disaster (no one can print their way into prosperity). That’s why current proposals for NGDP targeting are a strictly short-run monetary stimulus that can be used to get the economy out of a recession and on to its potential output path.
His critique is mostly focused around the Fed not responding in a timely manner, but I find an error in his argument when he compares the recovery of the 1980s with the current one. He emphasizes that the 1980s recovery, after significant declines in real GDP, saw an upsurge of real and nominal GDP by the end of 1982 (RGDP=7.7%, NGDP=11%), followed by a mild inflation of 3.3%. However, the recovery of nominal GDP at the time wasn’t triggered by higher inflation, as market monetarists call for today; it was triggered by structural reforms initiated by the Reagan administration. These included a multitude of similar reforms required now all across Europe and the US.
|Source: St.Louis Fed, FRED database|
Observing the graph above, the inflation rate was decreasing rapidly during the 1980s recovery, so it couldn’t have caused nominal GDP to increase so substantially. Or am I missing something?
Sumner does make a point that the current policy debate is focused around how we see the problem – is it an aggregate demand shock, or is it a structural problem? I think it’s structural, and that the remedy should be structural reforms. Proponents of fiscal and monetary stimuli think it’s aggregate demand, and that we need to address the short-term issue of poor nominal (or real) GDP growth to prevent the economy from falling further into a depression. And that’s the crucial difference.
Now I have no problem in using NGDP targeting over inflation targeting as a monetary policy strategy in the long run (I’m particularly intrigued by Sumner’s ideas on an NGDP futures market which would make monetary policy more market-based and remove the ‘central planning’ characteristic of the Fed and make it more supervisory), but I don’t see it effective as a short-run stimulus to start-up a recovery.
The biggest problem I have with this approach is that it assumes that the crisis was just another aggregate demand shock which can be resolved by short-run stimuli. This perhaps was the case with the 2001 recession (which was initiated by a series of shocks like the 9/11 attacks, dot-com boom, and corporate scandals like Enron), and it may even be applicable today if the shock was being constrained on the housing market alone. But that’s not what happened. The housing market bust was just a trigger for the unsustainable system to fall. The answer cannot be to wait for businesses and consumers to continue what they’ve been doing before, the answer must be in creating and finding new jobs and new patterns of production and labour specialization.
The crisis was a signal for entrepreneurs to discover new equilibria in the economy and new patterns and paradigms of growth and development. Patterns that are based on a less extensive role of the state, and based more on innovation, higher productivity and better incentives to create value.
Market monetarists want the Fed to return nominal GDP to a higher growth path, and want the Fed to commit to this regardless of inflation or unemployment, which is what the current dual mandate of the Fed focuses on. Even if we accept the claims that tight money made the recession much worse, monetary policy didn’t cause the recession. At least not single-handedly. There was a multitude of factors that skewed the financial system where a bubble on the housing market (also induced a great deal through favourable policies) only released the dangers of trying to eliminate risk from the financial system. When this exogenous shock hit the financial system it fully uncovered all the systemic instabilities of an overprotected labour market, overregulated businesses, declining productivity and an underachieving economy. This was true for both US and Europe. Peripheral Europe was even worse as they added corruption and rent-seeking to the whole story. Plus their economies were dependent on consumption and borrowing from abroad. (see the full analysis on the Eurozone here)
Back in the US, a lot of business got outsourced to Asia which made a lot of workers in the West redundant, but no one fired them until it became too costly to keep them on. However this was a natural transition due to a technological change of the new decade. Now there must be a process or rediscovering new skills and new ways to create and sustain value in the West. This is what we should be focused on; creating new jobs, not restoring old ones. Creating a new long-run growth path for the economy, not pegging a target for the old growth path.
When thinking about how to solve a recession one needs to first understand what caused it. Focusing on monetary policy alone would be wrong. Reforming the welfare state, reforming the financial system, stop bailing out zombie banks, and rediscovering new patterns of production and specialization is the way forward.
Update (30/09/2012): From a recent presentation by James Bullard, President of the St. Louis Fed, I found a couple of interesting facts, but mostly this:
"In some well-regarded research, Athanasios Orphanides has emphasized that the early 1970s were characterized by a productivity slowdown, but that policymakers at the time did not recognize the slowdown. Policymakers kept policy very easy in response to output and employment growth they regarded as “too slow.” The eventual result was double-digit inflation and double-digit unemployment, simultaneously."
"In my own work with Stefano Eusepi of the New York Fed, we investigated the consequences of a misperceived productivity slowdown... We found that it would take policymakers several years to learn that their policies were inappropriate; in the meantime, about 300 basis points of unintended inflation would be created. The consequences of naïve NGDP targeting, without appropriate adjustment, might be more severe today."