[There is] flawed reasoning behind the newborn infatuation with nominal GDP targeting. Its advocates, which include my colleague, R.A. and Goldman Sachs, now include Christina Romer...
A nominal target can affect expectations in two ways. First, it influences markets’ expectations of what the Fed will do, thereby amplifying monetary actions...But there are many, potentially superior, ways to achieve the same thing, such as a promise to keep short-term interest rates at zero for a specified period of time, to target bond yields, or to keep rates low until a particular inflation or unemployment rate is achieved...Second, a nominal target should encourage firms and workers to behave in a way that makes the target self-fulfilling.
NGDP advocates base their arguments on a flawed premise: that with a different framework the Fed would have been less concerned about inflation and more about output, and would have thus eased more aggressively.
Basically (and yes, this is a simplifaction), what the Fed can do to affect the macroeconomy is 1) print money and buy stuff, and 2) convince people that it will print money and buy stuff in the future.
Many people want the Fed to print money and buy stuff because they believe that printing money will increase economic growth and therefore reduce unemployment. Others don't want the Fed to print money and buy stuff, because they fear that this will lead to inflation. Political pressure from these two groups, but especially from the latter, tie the central bank's hands in practice, even though in theory the central bank is supposed to be independent and do whatever it thinks is best.
However, some people believe that the Fed doesn't always have to actually print money and buy stuff in order to boost economic growth. If the Fed manages to convince people that it will print money and buy stuff in the future, these people say, businesses and consumers will anticipate this and economic growth will rise in advance. Then the Fed won't actually have to print money and buy stuff, so the danger of inflation will be averted.
"NGDP targeting" is a way to convince people that the Fed is willing to print money and buy stuff. Specifically, it is a way to convince people that the Fed is willing to print as much money and buy as much stuff as is necessary for economic growth to rise. If the Fed says "we are now adopting an NGDP target," some economists think, people will believe that the Fed is willing to print quite a lot of money and buy quite a lot of stuff, and their reluctance to buy things will crumble.
There are reasons to be skeptical of this. The main reason is that people will probably not take the Fed seriously at first. After all, the Fed has proven pretty unwilling to print money and buy stuff lately, even in the midst of a long grinding depression. Why should people believe that the Fed's behavior has fundamentally and hugely changed?
They shouldn't, so what the Fed will have to do in order to make NGDP targeting work is to prove that it is not bluffing. The only way to do that is to actually print a bunch of money and buy a bunch of stuff. In other words, throw a few people against the wall to show it means business.
But everyone knows the Fed will probably not do this, because of political pressure from conservatives. As soon as the Fed started actually printing money and buying stuff, conservatives would howl, and the Fed would cut it out. And at that moment, everyone would know that the NGDP target was a lie, and it would be dropped.
How do we know that political pressure from conservatives is so strong? Well, ironically, one way that we know this is from the popularity of NGDP targeting itself! As Greg Ip writes:
There is, of course, one rather unseemly advantage to NGDP targeting, that Paul Krugman alludes to here: it is a surreptitious way of temporarily raising the inflation target without the toxic politics of doing so explicitly...One should normally be wary of a monetary policy that achieves its objectives through subterfuge, but desperate times call for desperate measures.
In other words, NGDP targeting is popular in large part because the words "NGDP targeting" are less offensive to the hard-money types, inflation hawks, Republican politicians, John Taylor's army of clone cyborg stegosauruses, etc. This is probably because A) "NGDP" sounds less scary than "inflation" or "printing money" to non-intellectual conservatives and B) the advocates of NGDP targeting focuses on the fact that it acts through rational expectations, which intellectual conservatives are supposed to like.
That in itself tells you exactly how likely it is that an NGDP target would hold up if anyone called its bluff...i.e., very unlikely. Hence, it is very likely that the bluff would be called. Hence, knowing that the bluff would be called, the Fed will not adopt an NGDP target. Game theory in action.
I do think that "print money and buy stuff" is a good thing to try to get out of a recession. However, it strikes me as a bit farcical to think that the only way to implement this policy is to simultaneously A) convince businesspeople that the Fed is willing to print massive amounts of money, and B) convince Republicans that the Fed is not going to print massive amounts of money. It's just not going to work. Has our politics really gotten so dysfunctional that this is our best idea? Well, you can answer that one for yourself.
(Note: anyone who does not know the meme referenced in the Bernanke picture is either old, or obviously doesn't spend enough time surfing the web and getting into flame wars on Facebook...)
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