Policy utopianism

Criticism of Sir Mervyn King for his role in the banking crisis and calls for a nominal GDP target have something in common. And it's something I'm a little uncomfortable about.

What I mean is that they both have - in their more extreme forms - a tinge of utopianism, in two senses.

First, there seems an optimism about what policy can achieve. This is questionable. For example, any form of bank regulation is prone to the problem of asymmetric information - regulators know less than insiders and cannot spot bubbles in lending - and, consequently, of regulatory capture. The idea that the banking crisis might have been prevented is idealistic. Criticizing Sir Mervyn for not doing so is no more enlightening than pointing out that he's only human.

Similarly, NGDP targeting is apt to fail because a target requires a forecast and forecasts go awry at important times simply because the economy is inherently unpredictable. NGDP fell in 2008-09 not so much because the Bank was targeting inflation instead, but because it just didn't see the slump coming sufficiently far in advance to loosen policy enough.

Secondly, there seems to me an implicit presumption that, if only policy were correct, problems within the private sector could be overcome. This too is doubtful. Banks did not fail merely because they were badly regulated, but because there were (among other failings) principal-agent problems between shareholders and managers that encouraged excessive leverage and risk-taking. In other words, there was a faultline in the private sector that (conventional?) regulation, at best, could only have painted over.

Similarly, reading some calls for NGDP targeting gives me the impression that it is all we need to get full employment. I doubt this. Unemployment exists not just because of deficient demand or sticky wages (which are less (pdf) important than thought) but for other, more intractable reasons: efficiency wages, signaling problems, the shortish-run non-fungibility of labour, lack of skills or the vested interests of capitalists.     

Now, I realize that I might be attacking a straw man here. I'm quite open to the possibility that policy can be improved upon, and I don't doubt that more QE - the likeliest tool of an NGDP target - would create some jobs. What I don't like is the idea that there's some magic wand of policy that can solve our problems. And what I like even less is that such talk serves a nasty ideological function, of deflecting attention from the inherent shortcomings of private sector capitalism.

Comments

[Matt]

"NGDP fell in 2008-09 not so much because the Bank was targeting inflation instead, but because it just didn't see the slump coming sufficiently far in advance to loosen policy enough."

Isn't one of the main benefits of the NGDP targeting proposal the fact that it would be level targeting? Meaning that, although policy won't be loosened at the ideal time, there should be expectations of subsequent loosening to catch up to the target or vice versa and this should having something of a stabilising effect. In this sense price level targeting would be just as good a policy. I tend to think either type of level targeting would be an improvement on rate targeting in overcoming the zero lower bound problem. I agree that a lot of the other problems are present, but a large aggregate demand shortfall isn't helping anybody.

Another issue, which I imagine you might agree with me on, is that most of those who deny any aggregate demand deficiency, aren't focused on proposing policies that would potentially address any of the problems you cite anyway. Instead they seem to have somehow misidentified government debt and deficits or welfare dependency or some other not especially pertinent issue that fits their idealogical biases as the problem and are busily attempting to 'fix' these issues.

[Nick Rowe]

Chris:

1. What we really mean by "NGDP (level path) targeting" is targeting the forecast for NGDP. We want to make expected NGDP follow the fixed time-path. We will never be able to keep actual NGDP exactly on target, but as long as people expect near-future NGDP to stay at target, actual NGDP cannot wander far. If actual NGDP falls below the target path, people will expect temporarily higher than normal inflation and/or real GDP growth, both of which would make demand higher than it otherwise would be, and help prevent actual NGDP falling as much as it otherwise would.

2. Sure, targeting NGDP won't make the natural rate of unemployment magically disappear. Maybe it won't affect the natural rate at all. But there's a chance it might lower the natural rate, if, for example, there's hysterisis, so the current natural rate depends with a rather long distributed lag on fluctuations in actual unemployment (e.g. school leavers who enter the labour market in a recession and never fully recover from the lack of experience). That would be a nice bonus, but not something we would base our case on.

[Nick Rowe]

Ah. I see that Matt had already made basically the same point in his first paragraph that I made in mine. Sorry Matt.

[Nick Rowe]

"And what I like even less is that such talk serves a nasty ideological function, of deflecting attention from the inherent shortcomings of private sector capitalism."

Damn! You've rumbled us! We were hoping that by making capitalism work just a little bit less badly, we would help delay for a short time the inevitable revolution. Curses! Foiled again.

[Metatone]

What I don't like about your approach Chris is that it lets Meryvn King rewrite history to say that he saw the crisis coming, but was restrained from doing anything about it by "that evil, dour Gordon Brown" - which seems to fly in the face of the evidence.

I'm not actually at ease with the idea that the crisis couldn't be reasonably predicted, as it was reasonably predicted by most commentators who understand there is more to inflation than "wage-price spiral" (cue scary music.)

But crucially this isn't the claim Mervyn made, he claims they knew it was coming and said so loud and clear, but were prevented from action...

[Keith]

Developing better Monetary theory and practice seems like a good idea to me. It will not end the contradictions of Capitalism i.e. the paradox of supposing that greed can be a reliable basis for economics, but so what? It is unlikely a renewed social democratic or socialist system would abolish money and all trade. Managing the money and banking system at a macro level is going to be necessary what ever institutional reforms you make at the level of individual firms. As FDR put it "bold experimentation" is required in the after a crisis that shakes things up.

[chris]

@ Nick - you've raised one of my beefs with NGDP targets - that relying upon expectations to do work is to rely upon a weak lever.
In the UK, the public's inflation expectations have for a long time been well above the 2% inflation target. This tells us 2 things
- that policy doesn't obviously and hugely affect expectations.
- that the damage to agg D from the inflation target hasn't perhaps been as huge as some NGDP advocates suggest; higher inflation expectations should have boosted agg D (whether they did or not depends on an unobservable counterfactual).
As I said, I'm not accusing all NGDPers of utopianism; it might well be a small improvement. I'd just like emphasis upon the "small" as well as the "improvement."

[Home Movers]

I see your point, but would be really grateful and will appreciate highly if you publish some kind of prognosis...

[Nick Rowe]

Chris:

I don't understand the UK SRAS curve (or SR Phillips Curve if you prefer).

Once a sudden drop in expected future NGDP and hence actual NGDP and hence (given sticky prices) real GDP and employment happens, it's not easy to put Humpty Dumpty back together again. HD is easier to break than to fix. That's probably got something to do with the SRAS curve shifting unfavourably.

If E(NGDPLP) targeting could have (say) halved the magnitude of the recent recession, and done nothing else, I would consider that a big deal. But yes, as Friedman himself said, there are many many things that monetary policy cannot do.

[Paolo Siciliani]

@ Nick Rowe, "If actual NGDP falls below the target path, people will expect temporarily higher than normal inflation and/or real GDP growth, both of which would make demand higher than it otherwise would be, and help prevent actual NGDP falling as much as it otherwise would."

When private households are in debt and deleveraging they will reduce consumption by even more in response to expected higher inflation because they are afraid their salaries won't adjust in a slack labour market. This Ricardian response to higher expected inflation will prevent firms from investing their swelling cash reserves because they too will expect domestic demand to retrench further.

In conclusion, unless private households have expectations that their real wages will increase, expected higher inflation will be self defeating when private households are heavily indebted and the labour market is slack.

I have been saying this for a long time, but it seems I'm not alone anymore, finally:
http://www.j-bradford-delong.net/movable_type/

[curiouseconomist]

"Similarly, NGDP targeting is apt to fail because a target requires a forecast"

This applies to all countercyclical policies. I don't think anybody is saying the BoE could have perfectly hit an NGDP target, but forecast errors are small relative to the kind of error that would be necessary to create a recession of the same magnitude as the current one. It's also unlikely that NGDP would be consistently over-forecast for multiple years, so any recessions that would occur would be short lived.

Note that forecasts for GDP (real GDP, but with stable inflation forecasts that is approx. NGDP) were falling a long time before the trough of the current recession. In fact, they were consistently falling even before the beginning of the recession. This recession was not due to a failure of forecasting; it was due to a failure of policy. The BoE was slow to cut rates and it's cuts were far smaller than necessary, in large part due to its concern about inflation, which was above the 2% target from October 07 to May 09 (while GDP forecasts kept falling). That highlights the problem with inflation targeting and why NGDP targeting would likely have resulted in better economic performance. We're in a similar situation now, with the BoE fretting about inflation despite very weak growth in NGDP.

"forecasts go awry at important times simply because the economy is inherently unpredictable.""

Forecasts for aggregate economy-wide variables like inflation, unemployment and NGDP are quite predictable in "normal time" because they're not particularly affected by shocks in individual markets. It's much easier to forecast macro variables than, say, the demand for cars. In "bad times" macro variables become more unpredictable, but poor monetary policy exacerbates that by letting expectations become unanchored.

Note that the subprime mortgage crisis was a large shock with global repercussions, yet even though it began in 2007, the UK didn't actually enter recession until mid-2008. In the interim, GDP forecasts were falling at a slow and steady rate, and continued to fall as the recession continued. My point is that it wasn't as though there was some sudden and massive revision to forecasts - it was a slow process, and the BoE had plenty of time to respond to it.

It's tempting to think that because practically every major economy entered recession, individual central banks can't be to blame for their countries predicament. But then look at the exceptions. Poland didn't enter recession (I think it had a single quarter of negative real GDP growth), despite all other EU countries (and thus the bulk of its trade partners) doing so. Poland was not somehow fundamentally different in structure to every other EU country. It's central bank simply did a good job stabilizing NGDP.

"NGDP fell in 2008-09 not so much because the Bank was targeting inflation instead, but because it just didn't see the slump coming sufficiently far in advance to loosen policy enough."

The Bank's own forecasts (and the external forecasts) showed a consistent, steady drop in real GDP growth expectations for many months prior to the recession. Given its CPI inflation expectations, this implied nominal GDP would fall below its 97-06 trend.Under NGDP targeting, the BoE would have responded with looser policy.

Would it have been sufficient to prevent a recession? On a purely mechanistic interpretation (ie. ignoring expectations), probably not, although it certainly wouldn't have been as deep or long as it actually was. But taking into account expectations, I think it's possible that the recession could have been avoided entirely. The private sector would act as though income would be on target, which would itself push NGDP closer to target, even in the face of new negative shocks.

"Similarly, reading some calls for NGDP targeting gives me the impression that it is all we need to get full employment."

It is all that we need to minimize cyclical unemployment arising from insufficient aggregate demand. That's the concept of "full employment" most people are alluding to when discussing monetary policy, because that's all that monetary policy can really do.

Frictional and structural unemployment arise for other reasons (a number of which you mentioned) and thus require a different policy response. I don't think any NGDP targeting proponent has suggested otherwise (Scott Sumner often blogs about supply-side reforms in the labour market).

Sorry for the long, rambling comment.

[curiouseconomist]

One more thing...

"relying upon expectations to do work is to rely upon a weak lever."

http://www.bloomberg.com/news/2011-09-06/swiss-national-bank-sets-minimum-exchange-rate-of-1-20-against-the-euro.html?cmpid=

That shows the power of expectations when the central bank makes a credible commitment.

[Nick Rowe]

Paolo: "In conclusion, unless private households have expectations that their real wages will increase, expected higher inflation will be self defeating when private households are heavily indebted and the labour market is slack."

If you have a high nominal debt burden, you don't need high real wages, you need high nominal income. Nominal income is (almost) the same as NGDP.

[Paolo Siciliani]

Nick, what is needed is high nominal "disposable" income, which is not the same as NGDP when salaries do not adjust for inflation, hence private household will react to expected higher inflation by squeezing consumption, which is self defeating.

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