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George Selgin has a very thoughtful post that starts off as follows:

Although my work on the “Productivity Norm” has led to my being occasionally referred to as an early proponent of Market Monetarism, mine has not been among the voices calling out for more aggressive monetary expansion on the part of the Fed or ECB as a means for boosting employment.*

I’m very happy that there are dissenting voices like George Selgin, as I’d hate for market monetarism to become a cult. In my view the most distinguished proponent of NGDP targeting is Bennett McCallum, and I seem to recall that he is also skeptical of the need for monetary stimulus at this time. (He favors growth rate targeting.) If Hayek were alive, he’d probably be skeptical. I also seem to recall that Larry White is skeptical. (Someone correct me if I’m wrong on any of these.) So there’s plenty of intellectual firepower arguing that NGDP targeting doesn’t imply the need for more stimulus.

George continues:

There are several reasons for my reticence. The first, more philosophical reason is that I think the Fed is quite large enough–too large, in fact, by about $2.8 trillion, about half of which has been added to its balance sheet since the 2008 crisis. The bigger the Fed gets, the dimmer the prospects for either getting rid of it or limiting its potential for doing mischief. A keel makes a lousy rudder.

I have a counter-intuitive take on this issue. I believe additional stimulus would actually reduce the Fed’s footprint on the economy. In Australia, where trend NGDP growth is about 7%, the base is only 4% of GDP. In the US where NGDP growth has averaged about 2% since mid-2008, the base is about 18% of NGDP. In Japan where NGDP growth is negative, the base is about 23% of GDP. Of course Japan has slightly lower bond yields that the US, which has much lower bond yields that Australia. It’s a demand for money story. Now I don’t favor 7% NGDP growth, I think that’s too high, but if we had averaged 3% or 4% NGDP growth since mid-2008, I believe that the Fed’s footprint right now might well be a bit smaller than 18% of GDP. And the economy would be doing better.

The second reason is that I worry about policy analyses (such as this recent one) that treat the “gap” between the present NGDP growth path and the pre-crisis one as evidence of inadequate NGDP growth. I am, after all, enough of a Hayekian to think that the crisis of 2008 was itself at least partly due to excessively rapid NGDP growth between 2001 and then, which resulted from the Fed’s decision to hold the federal funds rate below what appears (in retrospect at least) to have been it’s “natural” level.

I basically agree with George on this point. I’ve never followed Krugman’s practice of looking at how we are doing in comparison to the peak of the previous business cycle, which was late 2007. In most cases a cyclical peak is above the economy’s natural rate of output, i.e. the economy is somewhat overheated. Here’s where things get tricky. In principle, the Fed should have an explicit trend line, and then we wouldn’t have to guess where we are. We could then ignore RGDP, the unemployment rate, and any other real variable—just focus on NGDP. But since they don’t have an explicit NGDP target path, both George and I are forced to make an independent judgement about what sort of starting point seems reasonable. I’ve always used mid-2008, for several reasons. NGDP and RGDP growth had been slow for 6 months, suggesting we were no longer at the peak. Unemployment had risen from about 4.5% to 5.6%, which the Fed considers to be roughly the natural rate of unemployment. I certainly don’t think it’s possible to know the exact natural rate of unemployment, and I’d rather not look at it at all for policy purposes. But when starting out one needs to make some sort of assumption about whether we are near equilibrium, or whether employment needs to adjust. A 5% NGDP growth target from late 2007 would have been too high in my view, and 5% path from mid-2009 would have been too low. But I acknowledge that’s a judgment call.

My third reason for hesitating to endorse proposals for doing more than merely sustaining the present 4-5 percent NGDP growth rate is the one I consider most important. It is also one that has been gaining strength since 2009, to the point of now inclining me, not only to keep my own council when it comes to arguments for and against calls for more aggressive monetary expansion, but to join those opposing any such move. My third reason stems from pondering the sort of nominal rigidities that would have to be at play to keep an economy in a state of persistent monetary shortage, with consequent unemployment, for several years following a temporary collapse of the level of NGDP, and despite the return of the NGDP growth rate to something like its long-run trend. Apart from some die-hard New Classical economists, and the odd Rothbardian, everyone appreciates the difficulty of achieving such downward absolute cuts in nominal wage rates as may be called for to restore employment following an absolute decline in NGDP. Most of us (myself included) will also readily agree that, if equilibrium money wage rates have been increasing at an annual rate of, say, 4 percent (as was approximately true of U.S. average earnings around 2006), then an unexpected decline in that growth rate to another still positive rate can also lead to unemployment. But you don’t have to be a die-hard New Classicist or Rothbardian to also suppose that, so long as equilibrium money wage rates are rising, as they presumably are whenever there is a robust rate of NGDP growth, wage demands should eventually “catch down” to reality, with employees reducing their wage demands, and employers offering smaller raises, until full employment is reestablished. The difficulty of achieving a reduction in the rate of wage increases ought, in short, to be considerably less than that of achieving absolute cuts. U.S. NGDP was restored to its pre-crisis level over two years ago. Since then both its actual and its forecast growth rate have been hovering relatively steadily around 5 percent, or about two percentage points below the pre-crisis rate.The growth rate of U.S. average hourly (money) earnings has, on the other hand, declined persistently and substantially from its boom-era peak of around 4 percent, to a rate of just 1.5 percent.** At some point, surely, these adjustments should have sufficed to eliminate unemployment in so far as such unemployment might be attributed to a mere lack of spending. And so, my question to the MM theorists: If a substantial share of today’s high unemployment really is due to a lack of spending, what sort of wage-expectations pattern is informing this outcome?

Let me admit right up front that the relatively slow adjustment of wages and prices is not 100% consistent with the natural rate model that I have in the back of my mind. Krugman has made the same concession. George was kind enough to send me a graph showing wage growth and NGDP growth over the last decade, which will help me to answer this question:

The unemployment rate peaked at 10% in 2009, and has since fallen to 8.2%. Notice that a huge gap opened between NGDP and wages in 2009, and that gap has partially closed. Just eyeballing the graph, it looks to me like perhaps 40% of the gap has closed. And that’s pretty consistent with the fall in unemployment from 10% to 8.2%, if you assume 5.6% is the natural rate. (I.e. a 1.8% drop is roughly 40% of the 4.4% drop needed.)

But George is right that there is another problem here; why haven’t wages adjusted more quickly? Recall that in the 1921 recession (caused by severe deflation) wages fell quickly, and employment grew rapidly after wages adjusted. What’s wrong with our modern labor market? Or is the market fine, but I’m in error assuming the natural rate model explains recessions? Here are some possible answers, none of which is completely satisfactory in my view:

1. Right before the recession Congress passed a 40% boost in the minimum wage, to be phased in over 3 years. This means that other wages had to fall just to hold the overall wage growth steady. Not a major factor, but it played some role.

2. The extension of unemployment insurance from 26 weeks to 99 weeks is (as far as I know) unprecedented in US history. It’s roughly the maximum level in Denmark. This presumably made workers a bit less desperate, and may have slowed the process of wage cuts. Note, this is completely separate from the normative question of whether the extended benefits were justified. My views on that issue are complicated, and I won’t get into them here.

3. There is powerful empirical evidence that there is money illusion at the zero wage rate increase point. Indeed George provides evidence for that sort of money illusion, when he notes later in his post that they’ve been given exactly zero percent wage increases at the University of Georgia for the past 5 years in a row. What are the odds that this was coincidence? I.e. what are the odds that in at least one of those 5 years the actual equilibrium wage change would have been minus 1% or minus 2%, and the administration decided to avoid wage cuts for contractual reasons, or morale reasons, or whatever. The survey data clearly shows the zero rate point is significant. Now some people argue that this shouldn’t matter, as the average wage increase is still positive, slightly under 2%. But that includes people working in healthy industries who are getting 4% increases, and other workers getting zero percent. It’s an average. So even at this level the zero boundary may be imposing some wage rigidity. Keep in mind it’s not that wages aren’t adjusting at all, the curve is clearly flattening, and the gap with NGDP growth is gradually narrowing. It’s just that the rate of adjustment is slower than expected.

I know that those three reasons won’t satisfy everyone, but they are the best I can do right now. And if I’m right that means that slightly faster NGDP growth would reduce unemployment by alleviating all three factors. It would reduce the ratio of the legal minimum wage to per capita NGDP. It would speed up the time in which Congress would bring maximum UI benefits down to 26 weeks (they have already started this process.) And it would reduce the “money illusion at negative nominal wage increases” problem. If wages are still above equilibrium, then even a fully expected boost in NGDP growth could reduce unemployment. If I’m wrong, it would merely lead to higher wage and price inflation.

I would add that David Glasner’s study of stock prices and inflation expectations suggests that markets think more NGDP and inflation would help right now, whereas during the 1970s I recall that inflation hurt the stock market. Indeed David showed that the stock market started rooting for monetary stimulus at roughly the point where market monetarists began to worry that money was too tight.

Because I think George’s point has some validity, I’ve gradually scaled back my calls for monetary stimulus. In 2009 I wanted the Fed to try to return to the previous trend line. Over the past year or so I’ve been calling for the Fed to try to go only about 1/3 of the way back to the previous trend line. That’s partly because some wage adjustment has occurred, and partly because even going 1/3 of the way back would call for significantly higher NGDP growth. Indeed if they even delivered 5% growth from here on out, with no trend reversion, I’d be pleasantly surprised . I read the markets as expecting closer to 4%, which is the actual rate over the last 7 quarters. (Oddly the quarterly growth rates have been eerily stable at about 1% per quarter.)

That’s my basic argument. But I would add that I see more downside risk to the global economy than upside risk. The US is so large that is has some influence on the global business cycle, and my hunch is that stimulus here could help the entire world economy at this moment.

Update: George Selgin had a follow-up post written before mine, but which I didn’t see until afterwards. I think our views are actually quite close.

Lars Christensen has a post replying to George that makes some excellent points, which partly but not entirely overlap with this post. I’d just like to clarify one point:

This is a tricky point on which the main Market Monetarist bloggers do not necessarily agree. Scott Sumner and Marcus Nunes have both strongly argued against the “Hayekian position” and claim that US monetary policy was not too easy prior to 2008.

I’ve probably left that impression, but I’d prefer to claim that I’ve argued “weakly against” the Beckworth view. I’ve occasionally acknowledged that NGDP growth might have been too high in the 2004-07 period, but I’ve also claimed:

1. It’s debatable, as under level targeting some catch-up from the previous recession was reasonable.

2. The excess NGDP and RGDP growth was unusually low for an economic expansion, and hence tells us little about the perception that our economy was in a sort of unsustainable bubble prior to 2008. But I’ve also been careful to acknowledge that David might be right about growth being somewhat too high.

I would add that it now appears the US trend RGDP growth fell to perhaps 2.5%, or even less during the early 2000s. This implies the housing boom was a bit more excessive than otherwise, as GDP was a bit further above trend than I initially realized. Now if the Fed was doing 5% NGDP targeting that fact would not matter, but because it was doing 2% inflation targeting, the drop in trend RGDP growth effectively made the overheating a bit more than I initially judged. Given what’s happened since 2008, it would have been better for the Fed to have had a bit tighter policy prior to 2007, aiming for a 4% to 4.5% trend line (but with level targeting to allow some catchup from 2001-02), and then a considerably easier policy after 2008, to have a smoother overall path in nominal aggregates. Even Christina Romer considers 4.5% to be the new trend line, and her overall views are quite “dovish.” She still favors full return to the previous trend.

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This entry was posted on July 08th, 2012 and is filed under Monetary Policy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.



