NGDP isn't "the economy" By Scott Sumner

Which of the following three concepts is the outlier, i.e. very different from the other two?

1. Real GDP

2. Nominal GDP

3. The $/pound exchange rate ($ price of pounds = E)

I’d guess most econ students would say “the exchange rate.” If you asked most macroeconomists, however, they’d say RGDP is the outlier. Well, at least I hope they’d say that, the alternative is too horrible to contemplate.

Real GDP is (an admittedly crude estimate of) the total amount of final goods and services produced during a given period. Nominal GDP is the dollar value of that output. Both NGDP and exchange rates are nominal variables, and the difference between a real and a nominal variable is vast, much greater than the difference between two nominal variables. Indeed if I had put Keats’ Ode on a Grecian Urn in the number three slot, you could still make an argument that number one is the outlier. NGDP and poems are both abstractions, RGDP is concrete.

Nominal variables (actually their inverse) can be thought of as different ways of describing the value of a dollar. Thus 1/E is the value of the dollar in term of pounds. And 1/NGDP is the share of a nation’s output that can be bought with a single dollar. These are alternative definitions of the value of money. 1/CPI is the purchasing power of money in terms of a given basket of goods, and is thus a third definition. There are people who claim that the inverse of the dollar price of gold is “the” value of money. I believe that Louis Woodhill over at Forbes falls into that camp.

This distinction is easiest to see when there is hyperinflation. Back around 2008 the RGDP of Zimbabwe was barely changing, indeed it was probably falling somewhat. At the same time the Zimbabwe NGDP and the Zimbabwe$ price of US dollars was rising at trillions of percent per year. Indeed if we were able to get data for comparable periods of time, the change in the exchange rate and NGDP would have been almost identical. Ditto for the Zimbabwe price of gold and the Zimbabwe CPI.

Why does this matter? I often get commenters who accuse me of trying to control or plan “the economy.” But when the news media says “the economy,” they mean precisely one thing, real GDP. They do not mean nominal GDP. Then the commenters use arguments they read in Hayek to convince me that “the economy” is better off if left to market forces, free of government interference. They don’t need to convince me. With a few exceptions such as pollution and other externalities, I strongly favor having the free market allocate resources. Indeed I am more pro-market than even most conservative economists. Lots of conservatives think “tests” tell us something useful about school quality. In my view if a free market voucher system leads to high schools that put 10 times more resources into Friday night football than into math and English, then that’s the optimal school system, regardless of whether our students score as well as Finnish or Korean students. We are the rich country; they should be copying us.

Back to NGDP. So I’m not trying to “plan the economy,” I’m a pragmatic libertarian. I’m trying to have the government plan the value of currency, a product of which it is already the monopoly supplier. More specifically I want them to minimize the harm that an unstable currency can do to the economy.

Other commenters complain about my claim that a stable path for NGDP would prevent most recessions, accusing me of engaging in a tautology. Again they are confusing RGDP with NGDP. Perhaps that is forgivable, as the two variables are highly correlated in the US. But the very same dynamic that causes that confusion (the correlation between RGDP and NGDP) is also exactly what is wrong with their complaint against NGDP targeting. The fact that NGDP and RGDP are highly correlated in the US but not at all in Zimbabwe largely reflects the fact that at low to moderate inflation rates NGDP shocks tend to cause RGDP to move in the same direction. So much so that many confuse the two concepts. But that’s exactly why we need to stabilize NGDP.

BTW, the correlation at low to moderate inflation rates reflects the fact that wages and prices are sticky at those sorts of rates, and also that changes in inflation don’t completely dominate changes in RGDP.

To conclude, there is no essential difference in the degree of “socialist meddling” between planning the growth path of NGDP, and planning the CPI, and planning the price of gold. I don’t know how the Heritage Foundation does its monetary freedom index, but any nominal monetary target should count equally. Instead of worrying about money, libertarians need to worry about:

1. Why the US dropped out of the top ten in terms of economic freedom in the 2014 Heritage rankings.

2. Why despite the fact that we have fallen 2 places behind Denmark, the Heritage Foundation has not advocated replacing the US economic system with the Danish system. (I’m joking, given the size disparity that would be impossible.)

PS. When presenting my ideas at the AEI, I made an offhand remark about how the Fed needed to “steer the nominal economy.” There seemed to be a rumble of disquiet in the audience. When I figured out what was wrong I reassured them that I did not favor planning “the economy.”