A reply to David Beckworth

If potential GDP is what the CBO says it is, then the U.S. economy seems to be stuck in a rut. Proponents of NGDP targeting generally believe this to be the case. They also believe that were the Fed to adopt a credible NGDP target right now (with the NGDP path targeted back to its original path), then this NGDP path would become self-fulfilling. Moreover, they believe that the transition path back to normality would mostly take the form of RGDP growth (with perhaps a temporary blip up in the inflation rate).

I wish I could believe this too. But before I can, I have to find out what combination of logic and evidence underlies this belief. David Beckworth, a strong proponent of NGDP targeting, has kindly directed a reply to my query here. I'd like to offer a quick reply to the defense that he offers.

Theory

David quickly outlines two creditor-debtor problems that a NGDP target would help overcome.

The first problem is restoring the expected relationship between creditors and debtors that prevailed prior to the economic crisis. This is the 'risk sharing' problem recognized by David Andolfatto that a price level or strict inflation target cannot address. A NGDP level target would solve this problem by restoring nominal incomes to their expected pre-crisis paths when debtors signed their nominal debt contracts.

This is the "fairness" issue that talked about in my previous post here. In that post, I suggested that this problem may not be so significant because the price-level seems to be pretty close to its pre-crisis path (at least, if one draws the log linear trend beginning in 1990). But maybe I am missing something because evidently this "is a problem that price-level targeting cannot address." I presume this means that what is needed (given the current price-level) is more RGDP--and more RGDP in the form of greater employment, not productivity. Sure, but how is a nominal target supposed to increase RGDP? And what does restoring RGDP have to do with this "risk-sharing" argument? Of course creditors would like to see their unemployed debtors get back to work and service their debt. This has nothing to do with risk-sharing, as far as I can see.

The second problem is that there is a massive coordination failure among creditors now. Creditors could increase their spending to offset the debtor's drop in spending as the latter deleverages. The reason creditors have not--non-bank creditors are sitting on money assets while bank creditors are destroying them as they are acquired from the deleveraging debtors--is because they are uncertain about future economic activity. These actions by creditors create an excess demand for money or, equivalently, a shortage of safe assets.

David is not being as careful with his language as he should be: he cannot be anywhere near certain that the coordination failure he alludes to actually exists. It is only one of many different interpretations of current events. (An interpretation to be taken seriously, but not stated as if it were obviously true, and the reader obviously dense should he/she not see its veracity. Sorry, just a pet peeve of mine.)

As David knows, I have a lot of sympathy for the "asset shortage hypothesis" (I have written about it here, for example). In fact, any model that has a limited commitment friction that gives rise to debt constraints has a version of this idea embedded in it (this includes all New Monetarist models). The policy prescription coming out of these models is to expand the supply of "high quality" assets to meet the shortage. (Note, however, I have not seen anyone employ sticky nominal debt in these frameworks--would be worth exploring). The most obvious candidate here are U.S. Treasuries, which are used extensively as collateral in repo arrangements and as stores of value. Precisely how the Fed could improve this situation by removing these assets from the market (replacing them with assets that are roughly equivalent -- zero interest cash) needs to be spelled out more clearly. (David possibly has in mind the purchase of private assets, but this is not generally permitted under the Federal Reserve Act. In any case, why not have the Treasury issue bonds to finance the same purchases? Not sure what any of this has to do with a NGDP target).

Evidence

Okay, so what is the empirical evidence that a higher level of NGDP would make a difference now? The most obvious answer is that those advanced economies currently doing the best are the ones where aggregate nominal spending has remained on or near its pre-crisis trend. Case in point is Germany.

It is true that Germany largely escaped the world recession. But was this because agents around the world believed that German NGDP would not depart significantly from its path? Or was it because Germany had no real estate boom/bust episode? This is not evidence that stable NGDP prevents a crisis; it is evidence that avoiding a crisis prevents a decline in NGDP. We need to establish a direction of causality here, before making strong claims about what is happening.

A final but important piece of evidence is FDR's very own QE program in 1933. He had publicly called for the price level to return to its pre-crisis trend and then backed up the rhetoric with a devaluation of the dollar (relative to gold). As Gautti Eggertson shows, this policy dramatically altered expectations and sparked a robust recovery in 1933. This implicit price level target of FDRs was no different than a NGDP level target in this case.

Well, O.K. Although, I'm not sure one would want to compare the decline in the price-level in the early 1930s with what just happened recently; again; see the diagram here.
 
More theory

A NGDP level target would do the same today. It would commit the Fed to buying up as many assets as needed to restore aggregate nominal spending to some pre-crisis trend. Just the expectation of the Fed doing that may itself cause the market to do much of the heavy lifting.

The Fed is currently restricted to purchasing U.S. government bonds and agency debt. As such, the Fed has control over the composition of the total U.S. government debt outstanding (the composition between low-interest cash and higher-interest bonds). Under present conditions, I do not think that this composition matters very much (though I could be wrong). Perhaps David is urging Congress to expand the set of securities available for open market operations? If so, does he see any potential political problems with that?  (The answer should be "yes")

And what about this idea that the expectation of higher NGDP itself bringing about its own fulfillment? I know that Nick Rowe has gone on about this here and elsewhere. I think I'll need a separate post to investigate this claim.

In the meantime, here's a question for the NGDP proponents. I think that most people might agree that the Fed has built up a big stock of reputational capital designed to anchor a 2% inflation target. It may not be the perfect policy rule, but most societies around the world could only wish for such credibility in their monetary authorities. What if the Fed decides to adopt the proposed NGDP target, and fails? What then? What does that do to Fed credibility? Have you worked it out? Or does the solution concept you employ always rely on a self-fulfilling rational expectation?

There is something else. Whether we like it or not, policymakers are not indifferent to the composition of NGDP.

Adopting a NGDP target implies that policymakers can commit to (say) a 5% NGDP growth rate. But what if inflation turns out to be 4% and RDGP growth turns out to be 1%? (Or how about 7% inflation and -2% RGDP growth?) A credible NGDP target implies that policymakers remain committed to the 5% NGDP growth rate. But ask yourself this: Do you really believe that policymakers would leave policy unchanged in this circumstance?