Thursday, 17 May 2012



Via Scott Sumner's increasingly famous blog ( ), I came across that post about Evan Soltas and his defense of NGDP targeting:

Now, I am quite favourable to using a NGDP target as an aggregate of the "dual mandate" most Central Banks tend to have - i.e. instead of stating that you got a target of 2% inflation and a real growth target of circa 3%, you can just state that you got an objective of 5% NGDP growth. That's fine. That's also mostly cosmetic.

And although I am quite indebted to Scott Sumner for providing me with the impetus to write a blog, I will use Evan Soltas' post to state why I think NGDP targeting is limited. That's because he does write beautifully and made a succinct easy-to-debate summary of NGDP targeting in 6 points.

Another useful pointer was provided by Saturos, a regular commenter on Scott's blog and who referenced a nice article on NGDP targeting: "Should we replace Mervin King with a robot?"


Evan Soltas: First, NGDP targeting would prevent most recessions. Most recessions are "nominal" -- that is, they are not caused by a sudden change in "real" variables, like the resources we have available to us or our ability to use them productively. Recessions occur because of declines in aggregate demand, the sum of individual decisions to spend money, or rather in declines in expectations of future demand. What this means is that if the Fed maintains stable expectations for future demand, then nominal recessions will not happen.

This is my most serious quibble with Evan's post and with Scott Sumner's writing in general. Arguably, I haven't read their blogs in their entirety and since the beginning but, generally, they are prone to asserting that targeting NGDP will lead people to change their behaviours, via "rational expectations" and leave it at that. I think that any theory that relies on "rational expectations" need to fully explain its mechanisms because, well, that particular economic idea has a justifiably very poor reputation among people dealing with the real world rather than models.

Thankfully, Se├ín Keyes (see article linked above) comes to our rescue with a nice explanation of said mechanism - 

Here is where our market monetarist central bank comes in. Its role is as the great persuader. It creates [...] expectations of prosperity.

To change minds, the market monetarist central bank must be credible. Let's say that the Bank of England is not perfectly credible, in that its board of governors is divided between policy hawks (those who want to tighten monetary policy) and doves (those who want to loosen it). People might reasonably doubt its commitment to reflating the economy. How would the Bank of England persuade the economy back to health?

First the Bank would need to set an explicit target for NGDP growth. It would have to promise to buy unlimited quantities of assets (using newly created money) to achieve this target. As it set about its task, month by month, trillion by trillion, people would come to accept its commitment to the policy and begin to spend in the expectation of future inflation. The expected numbers would drive the real numbers. Spending would rise and the real resources of the economy would be fully employed, which would achieve the Bank's 5% NGDP growth target.

This is a very nice theoretic transmission mechanism but it's not exactly proven to work. I recall an article describing Chinese people saving even more as the threat of inflation meant they had to reduce the consumption part of their income even more in order to achieve their prudential savings objectives after inflation.
Certainly I am not the only one to point out such short-comings: Robert J Samuelson writes in the Washington Post ( )
Although Bernanke didn’t say so, there are other reasons why Krugman’s policy [Here, Krugman's policy refers to a demand for higher inflation, which is essentially what Sumner recommends] could backfire. Consider:

• Prices might increase faster than wages, reducing workers’ purchasing power and (probably) dampening spending.

• Experiencing higher inflation, consumers might become more fearful of the future and, to protect against the unknown, might increase saving and reduce spending — the opposite of what Krugman intends. This happened in the 1970s, although at higher inflation rates than Krugman proposes.

• Something similar could happen in financial markets. Investors — not knowing whether inflation would return to 2 percent and fearing it might go higher than 4 percent — might demand much higher interest rates to prevent erosion of their money. This, too, would undermine Krugman’s strategy.

None of this is preordained [emphasis added]. Krugman’s theory could be right.(...) But in this debate, I side with Bernanke. Flirting with more inflation is treacherous. If inflation expectations change, the consequences are hard to predict. The double-digit inflation in the 1970s (peak: 13 percent) resulted from well-intended mistakes and unleashed many damaging side effects.

Bottom line: I am far less convinced than Scott Sumner or Evan Soltas that targeting NGDP - and thus, in our present situation, increasing inflation - would have the consequences they think it will have on Aggregated Demand (AD). Indeed, like Samuelson, I suspect it may very well have the effect of destroying AD yet further. At any rate, I can think of policies more likely to sustain AD without nearly so much risks of misfiring as that of cranking up the money printing machine.

More on the other points later...