The latest stupidity: NGDP

The latest dumb idea circulating the orthodox economics blogosphere is NGDP targeting. In this scheme, the Fed, instead of saying "inflation is too high" or "employment is too low" instead says "we want NGDP to be x%". After this proclamation, the economy will start growing at the required rate to hit the declared NGDP target.

Magic, no?

So, what will the Fed do if the economy doesn't suddenly start growing? They will buy more and more Government debt, driving the interest rate further and further out the yeild curve to zero.

"But isn't that just quantitative easing?" you ask.

It is.

"Isn't the Fed doing that now?" you ask.

It is.

"So, what's the difference?"

There is none. But if you believe monetary policy is effective, and you live in a world where it clearly isn't being effective, you've got to do something.

In my view, the Fed fully knows that the economy is growing too slowing and unemployment is too high. They've done everything in their arsenal by bringing the Federal Funds rate to zero, and have gone a step beyond by bringing longer term rates down to zero as well. None of it is working, because changing the duration of outstanding Government debt does not solve the problem of an undercapitalized private sector. The economy needs a larger deficit to start growing again, but economists don't understand accounting, and so do not understand sectoral balances etc.

MMT understands this dynamic very well, and need give no quarter to orthodox macroeconomics, just as oxygen need give no quarter to phlogiston.

Ages ago I read some book on the sociology of philosophy, and the big lesson in it was how all the philosphers you read about knew one another, either directly or indirectly, and how ideological movements compete with one another. If your school of thought is ascendent, then you gain fame by forming a (hopefully) ascendent spliter group. If your school is in decline, you build bridges with those who might think a little different to try and build a bigger tent. And if you are on the outside, you should just be a crank and attach the most dominant group around to try and get their attention, and have them give you credibility by engaging.

The NGDP crowd is a splinter group off orthodox macro. MMT are the cranks. They will not win through accomodation.

Recapitalize the non-Govt Sector, not the Financial Sector

When you have a credit bubble -- ie. banks make loans that do not get paid back -- then the subsequent credit bust de-capitalizes banks (as they must write down assets and equity) constraining their ability to lend anew.

As the non-government sector needs additional financial assets to grow, if banks cannot lend (capital constrained) then the economy as a whole starts to trouble.

This, in a nutshell, is where the "Too Big to Fail", "We Must Bail Out the Banks" argument comes from, and it is true, as far as it goes.

Nevertheless, there is more to the story. First, if banks were making loans that did not get paid back, then they were not doing their primary job which is to make good credit decisions. Bad credit decisions should be punished, and the owners and operators of such companies should be fired and/or wiped out. This is how markets work. Rewarding such behavior only encourages more bad practices in the future, and people (rightly) start to wonder why we have a financial system at all.

Second, if banks fail, that contraction in private financial asset growth can be balanced by "capitalizing" the rest of the non-Governmental sector directly (through some combination of tax cuts and spending increases -- whatever increases the deficit). Since economists at Harvard and Princeton do not understand that the Government is the sole creator of net financial assets (equity) for the private sector, they do not know that this policy lever is on the table. So we are where we are.

From Macroeconomic Resilience

My policy proposal has three legs all of which need to be implemented simultaneously:

* Allow Failure: Allow insolvent banks and financialised corporations to fail.
* The Helicopter Drop: Institute a system of direct transfers to individuals (a helicopter drop) to mitigate the deflationary fallout from bank failure.
* Entry of New Banks: Allow fast-track approvals of new banks to restore banking capacity in the economy.

The argument against allowing bank and corporate failure is that it will trigger off a catastrophic deflationary collapse in the economy while at the same time crippling the lending capacity available to businesses and households. The helicopter drop of direct transfers helps prevent a deflationary collapse and the entry of new banks helps maintain lending capacity thus negating both concerns.

QE2 is about rates, not prices

A big thank you to Fernando for stepping up and playing the Monetarist. If there's a better source for why Monetarists have no understanding of money, and therefore the economy, I cannot think of it. And if any of your are wondering, Fernando is not a plant! He's the real deal. I could not make him up if I tried.

In the last couple of posts I outline why QE2 is a non-event. I assert that 1) you cannot move consumption forward, and 2) inflation expectation has no channel that leads to CPI. Fernando makes two claims:

[If there was a positive inflation expectations shock]... I would buy commodities and demand a rise in my salary.

When people expect more inflation they tend to spend more today, velocity rises.

The scenario was a sober minded Brazilian rich in Cruzeiros circa 1979.

Fernando has not responded yet, but I think it's fair to assume that, in the face of inflation, the commodities he would buy would be commodity futures, not actual sheafs of wheat. So Fernando is swapping one financial asset (nominal savings) for another financial asset (commodity futures). This would increase the price of commodity futures, but as far as I know, futures are not part of CPI. Going long futures only makes sense if the anticipated inflation comes to be, and Fernando continues to come up goose egg for any actual mechanism for this inflation. If everyone anticipating inflation goes long futures, it will have no impact on actual inflation and that positioning will come to naught.

Real life actual third world countries take a different approach to expected inflation.

The impotence of monetary policy

This post by Krugman sums it up. It's a pity things are even worse than he suspects:

A problem with the current BOJ policy, however, is its vagueness. What precisely is meant by the phrase “until deflationary concerns
subside”? Krugman (1999) and others have suggested that the BOJ quantify its objectives by announcing an inflation target, and further that it be a fairly high target. I agree that this approach would be helpful, in that it would give private decision-makers more information about the objectives of monetary policy. In particular, a target in the 3-4% range for inflation, to be maintained for a number of years, would confirm not only that the BOJ is intent on moving safely away from a deflationary regime, but also that it intends to make up some of the “price-level gap” created by eight years of zero or negative inflation.

…

BOJ officials have strongly resisted the suggestion of installing an explicit inflation target. Their often-stated concern is that announcing a target that they are not sure they know how to achieve will endanger the Bank’s credibility; and they have expressed
skepticism that simple announcements can have any effects on expectations.

OK, so say the BOJ or Fed announce a higher inflation target. Now what? Inflation means higher price levels, and for a price, you need a transaction. Announcing a target does not create a transaction, and therefore, does not influence a price. The BOJ's concerns that their credibility is on the line are right on -- the standard monetary mechanism (overnight interbank interest rates) has no impact on prices.

Unconventional monetary mechanisms, like changing other rates, have no impacts for the same reason. The only thing that has impact are transactions, a transfer of nominal assets from the Govt to the non-Govt sector. And this is fiscal policy, not monetary policy.