The Unexpected Implications of Expectations

As Market Monetarists, we always stress that expectations matter. But how can we test this hypothesis? One way we do this is to use financial evidence such as TIPS spreads to show how changes in monetary policy expectations directly affect market conditions. Evan Soltas recently tried to use a different method: surveys. He put together a series of graphs documenting changes in forecaster expectations around the time of the financial crisis, and claims that the graphs suggest that a "sudden collapse of short-to-medium expectations...could be more important than current-quarter NGDP."

But I disagree with Evan on how we should interpret such results. I took a look at the Survey of Professional forecaster data and restrict my analysis to the Great Moderation period since 1990. I also focus in on the 1 year forward NGDP forecast, as the 1 quarter forecasts give qualitatively similar results.

Like Evan, I too observe that current nominal GDP expectations are related to real variables, such as unemployment. However, the overall relationship is quite weak. NGDP expectations can only explain about 5% of the variation in unemployment. Moreover, the slope estimate is likely to be biased downwards as autocorrelation means the true slope is even closer to zero.

However, even if the correlation were stronger, it still would not say anything about the causal effect of future expectations on current conditions. Any observed correlation could simply be rational expectations at work, with causation running from unemployment to NGDP. Because unemployment is high now, it would be rational to assume that future nominal GDP will be slightly lower. Even if the Fed were more powerful, there would still be some imperfection in the implementation of monetary policy that would cause expectations to shift downwards.

To control for this, we need to look not at the change in expectations, but rather changes in surprises. A big theme in nominal GDP disucssions is that nominal prices are sticky. Therefore, when NGDP falls below trend, because past nominal contracts were set under the expectation of the higher trend, markets fail to clear and we have a fall in real growth. Therefore, if this transmission channel were true, when NGDP falls below what was expected, we should expect to see a significant impact on unemployment.

In other words, we should consider whether actual nominal GDP hit forecasts or if it fell short. This way we can construct an error index that measures to what extent forecasters over or underestimated. Positive numbers denote when actual nominal GDP outperformed the forecast, and thus the dramatic fall into negative territory during the financial crisis reflects the unexpected nature of the nominal GDP shock.

While it certainly did fall during the financial crisis, if you use ordinary least squares regression on this index against variables of interest, such as unemployment, you will not find any kind of systematic correlation. However, if you consider only the extreme cases in which the forecast undershot reality by more than 4%, then you do get a significant negative correlation:

Perhaps this evidence suggests that expectations have a nonlinear impact on unemployment, but at that point we are drawing epicycles that the regression evidence does not warrant.

Does this all mean that expectations are useless? On the contrary. When investigating these expectation surveys, I did manage to uncover the following chart comparing forecasts and actual nominal GDP growth. I lagged the actual NGDP by 1 year, so it is easier to compare how the forecast compares with actual growth.

What we can see is that the forecasters, while not perfect, still do a rather good job of identifying times of distress. Given that forecasts do carry information, then this opens up a role for policy to lean against the wind. The Fed, instead of waiting for all the data to come in, could use a joint forecast-contemporary data criterion. If the forecasters are projecting slow future growth, then the Fed could announce that it is aware of a potential problem and prepare the necessary policy machinery, conventional or otherwise, to combat that threat.

Expectations matter, but we need to be clear on why. While they may have a direct impact on growth, expectations also serve as a crucial lens into the future and can carry information content for policy makers. Armed with such tools, monetary policy can turn towards the future, lean against the wind, and in doing so remedy demand shocks before they start to hurt. 

The Fed Should be a Day Trader

According to  Philadelphia Federal Reserve President Charles Plosser, the economy is "immune" to the Fed's stimulus efforts. Therefore we shouldn't even try to ease. I think Matt Yglesias does a very good job with responding to this argument, so in this post I want to draw attention to another fallacy Plosser makes that, as a result, makes the shift to a forward looking monetary regime even more important.

From a Thursday morning interview, the WSJ represents Plosser's views as:

“Monetary policy shouldn’t be a day trader,” Plosser said Thursday morning in an interview with Dow Jones Newswires and The Wall Street Journal. “I don’t think that’s a healthy focus for central banks…Policy making is too focused on short-term and not long-term views.”

On face, it seems sensible. Of course the Federal Reserve shouldn't act in an erratic manner like a day trader, and of course it should focus on long-term views. But does one imply the other? I would say no -- to focus on long-term views, it makes sense to act like a day traders and look at real time market expectations of the long term.

Specifically, it should make sense for the Federal Reserve to worry about long-term inflation expectations, as they, by definition, represent the long-term views of the market. Given that the 5-year breakeven is barely above 2%, this means that, given what the market perceives of the economy and policy interventions, annual inflation is forecasted to be around 2% for 5 years. Given that inflation since the 2008 peak has been around 1.1%, a period of higher than average inflation should not be problematic. By the premise of efficient markets, the relatively low breakeven suggests that the Fed should take additional action. Perhaps there is some argument for why the breakeven is skewed, but traditional deviations from efficient markets, such as momentum trading, does not seems to form the basis of any of Plosser's arguments.

Plosser's comments also point out a more glaring hole: if the Federal Reserve isn't going to use indicies looking forward to guide monetary policy, what should it do instead? If we aren't allowed to forecast using the knowledge of the market, then the Fed is left to waiting for the data to come in and then to adjust economic policy many quarters after the original shock. This is actually worse for long-term views, as it opens the possibilities for downside for the financial market that isn't controlled for with policy.

To improve on the current situation, we could subsidize and construct an NGDP futures market in order to measure market expectations of future NGDP growth, and then the Federal Reserve can use those futures as a leading indicator on whether they should ease or tighten. These futures can even help in the unwinding process, as it lets the Fed know when the money supply has increased too quickly even before the actual numbers come in. Acting like a day trader is not inconsistent with an appreciation for long term fundamentals - the trick is to find a day-to-day measure and then use it to put the economy on stable, long run foundation.

Nominal and Real GDP: A Barrier to a Statistical Approach

Scott Sumner regularly talks about how almost all discussions of inflation become much clearer in terms of NGDP. This is because people have a hard time differentiating between inflation as a result of more aggregate demand (demand-push) and inflation as a result of less aggregate supply (cost-pull). The difference is summarized in the textbook aggregate demand/aggregate supply diagrams below:

Aggregate demand expansion = Inflation

Aggregate supply contraction = inflation

The first kind of inflation changes NGDP, while the second has minimal impact. This way, when we are in a recession and demand more inflation, what we really mean is that we need more of the first kind of inflation because we need more NGDP. If we were in the second situation, we wouldn't be demanding more or less NGDP because the supply shock would have had minimal impact.

Another example in which NGDP makes explanations easier is in discussions of whether deflation is bad in an economy. Often times, liberal economists will point to the recent recession and say deflation is bad, while libertarians might point to the late 19th century, early 20th century and say that deflation is good. The more correct answer is that stable NGDP is best. So because the first kind of deflation reduced NGDP, it was bad, while the second type of deflation kept NGDP steady, and therefore was good.

While NGDP is simple, it makes it hard to statistically show NGDP boosts RGDP. You can't look at a graph and point to any correlation; a skeptic could just say that it's the RGDP that's driving the movements in NGDP, and not the other way around. In the end, to explain the relationship between nominal and real output in AD shocks, I have to find specific channels, such as nominal debt. On the other hand, inflation and output make much more sense in terms of trying to find statistical relationships. These concepts are far enough in people's minds that a relationship doesn't seem like a tautology. However, when you start directly talking about NGDP and RGDP, it's too easy for people to think the observed relationship between NGDP and RGDP is just because the second is a component of the first.

NGDP Autoregressions and the Lucas Critique

Is NGDP growth sticky? In other words, does above NGDP growth in one period affect GDP growth in the next? Evan Soltas has previously shown that RGDP appears to be sticky. He constructed some impulse response functions and found that there is no instantaneous self-correction mechanism. On the nominal side, there is substantial evidence indicating that inflation is sticky. The correlation coefficient for the relationship between the current inflation rate and the inflation rate measured one quarter ago is 0.75. Another way of saying this is that about 50% of the variability in current inflation can be predicted by inflation one quarter ago.

Does NGDP, the sum of inflation and RGDP, suffer from the same stickiness? If it does, this could have serious implications for NGDP level targeting. If it takes a long time for past NGDP surges to slow down, this could affect the speed at which central banks can change expectations of NGDP. central banks may need to take even more drastic action to adjust NGDP at the necessary speed, causing monetary policy to be blunt and not credible.

To answer this, I looked at the NGDP time series from 1947 to today and constructed a multiple regression model to explain the current NGDP continuously compounded annual rate of growth as a function of the NGDP growth rate for the past six quarters. As only the coefficients for the past two quarters were statistically significant at the 95% confidence level, I settled with testing NGDP as an AR(2) model. The results of my regression are listed below:

Call:

lm(formula = n[, 1] ~ n[, 2] + n[, 3])

Residuals:

     Min       1Q   Median       3Q      Max 

-14.5968  -2.1681  -0.1866   2.0848  13.5262 

Coefficients:

                 Estimate  Std. Error t value   Pr(>|t|)    

(Intercept)  2.82257    0.47431   5.951     8.93e-09 ***

n[, 2]         0.43320    0.06257   6.923     3.67e-11 ***

n[, 3]         0.13255    0.06250   2.121     0.0349 *  

---

Signif. codes:  0 '***' 0.001 '**' 0.01 '*' 0.05 '.' 0.1 ' ' 1 

Residual standard error: 3.943 on 251 degrees of freedom

Multiple R-squared: 0.2631,     Adjusted R-squared: 0.2572 

F-statistic:  44.8 on 2 and 251 DF,  p-value: < 2.2e-16 

From this, we can say that about 26% of the variability in current NGDP growth is explained by past NGDP growth. To get a better idea of what the relationship looked like, I also plotted the predicted values of NGDP versus the actual values:

While the intercept is not statistically significant different from zero, the slope is 1, with standard error of 0.10, suggesting that the model does do a reasonable job of estimating actual NGDP. So does this data prove NGDP is sticky, making instantaneous NGDP expectation adjustment impossible?

As with most economic questions, the answer is "not necessarily". Perhaps NGDP is sticky because of certain nominal frictions in the economy, such as staggered wage contracts or menu costs. These traits, while they endow nominal shocks with real effects, also mean that nominal levels in the economy have momentum. If wages are suppressed for extended periods of time, the economy would be able to stay at higher levels of aggregate activity for longer. Alternatively, information itself can be sticky. So even if economic agents stand at the ready to change prices and to be flexible, they don't observe economic conditions quickly enough, acting in a way that creates nominal momentum.

A first pass analysis would suggest that these frictions would fundamentally limit the ability of NGDPLT to achieve stability. If elevated current NGDP always predicts elevated future NGDP, then there would be no way for a central bank to credibly commit to quick NGDP corrections.

However, given some recent discussion of Milton Friedman's thermostat, we have to ask if this result is regime dependent. Take inflation for a concrete example. The Federal Reserve has, for most of its recent history, targeted the rate, not the level of inflation. What this means is that if the Fed overshoots one year, there's no expectation for the Fed to compensate with lower than normal inflation for the next year. There's no expectation for monetary policy to correct the elevated inflation, which allows all the frictions mentioned above to keep inflation persistent. But if there's an expectation that the Fed will engage in corrective policy as in level targeting, then inflation may not be as persistent. Higher inflation today would actually predict lower inflation tomorrow as the central bank quickly acts to restore the original price level trend. Applied to NGDP targeting, if people perceived that current NGDP growth was higher, they would have an expectation that future NGDP growth would be slower. They could then act on that expectation and quickly restore trend NGDP. We could also test this hypothesis by testing if inflation or NGDP autocorrelations are higher in rate targeting countries than level targeting countries. However, I do not know of any central banks that have a formal committment to any kind of level targeting, so I'm not sure how robust my results would be.

This discussion of autoregressions and NGDP stickiness is also an instance where the Lucas critique defends the effectiveness of monetary policy. While I can run a multiple regression and find "evidence" that NGDP growth is sticky, because my arguments are not microfounded I have no theoretical reason for why NGDP growth would stay sticky in a level targeting regime. So to fully understand how nominal persistence can affect NGDP targeting, we need a microfounded model that can analyze the intertrelated process of nominal frictions, policy and expectation formation: a hole that market monetarists must be able to fill.

Monetary Policy: A Blunt Club or a Surgeon's Scalpel?

And a reason why NGDP futures are a critical credibility tool

Should monetary policy be viewed as a blunt club or a surgeon's scalpel? While we often discuss central banks credible actions to accurately hit a policy target, there is less discussion on whether central banks can precisely hit a target. Because while both blunt clubs and surgeons' scalpels can wound and hurt, a club "beats around the bush" while a scalpel (ideally) targets a specific, well defined area. In the language of monetary policy, we know central banks can raise the level of nominal GDP growth, but can they precisely control the magnitude of the increase? How much of a base injection does the central bank do to make the potatoes hot enough without burning our fingers? This precision problem is at least as important as the accuracy problem because it is a key reason for why explicitly declaring a five percent nominal GDP level target is not sufficient. Because there are real costs of extremely high inflation, the central bank is likely to shy away from policies that might "accidentally" lead to excessively high inflation. If economic variables become more volatile, the lack of monetary policy precision can become a major barrier to monetary policy accuracy.

The core of my argument starts from a mechanics-credibility theorem, which states that if policy does not have a concrete mechanism, it can not be credible. This theorem means raising nominal GDP can be credible. We know that central banks have an infinite number of ways to inflate: currency depreciation, asset purchases, forward guidance, nominal GDP futures targeting, among other options.

However, what does the theorem say about policies to raise nominal GDP to a specific, precise level? What do we have to guarantee this? A typical market monetarist response would be that expectations bridge the gap. Because private agents believe that the central bank will raise nominal GDP to reach trend growth, the market will do the work for the central bank. They will invest in riskier assets, hire more people, engage in more research and development projects, and other ventures up until current nominal GDP returns back to the trend line. Once we're back at trend growth, the central bank can just moderate the economy without too much work because the perfectly credible declaration will induce the market to stabilize itself. 

Although this logic is appealing, it is nonetheless circular. According to this line of argument, a precise target is credible because the central bank will inevitably hit the target, but the reason the central bank is precise is because it is credible. Before we can wave the magic wand of expectations, we need to show that there exists a vanilla, "elbow grease" monetary action that can credibly hit a target with both accuracy and precision.

In normal times, the relationship between the short term nominal interest rates is reasonably stable, and central bankers can manipulate the short term rate quite effectively to stabilize nominal GDP. This is a game that the Federal Reserve has played for the entire Great Moderation. However, once the economy is in a liquidity trap, the short term rate loses its effectiveness, and other more drastic measures are needed. Now that we're in uncharted territory, here is where the precision problem arises.

Take asset purchases for example. As noted by Miles Kimball, these asset purchases can have large effects, if implemented on a large scale. There are certain monetary frictions that allow quantitative easing to break out of the liquidity trap, but for those frictions to exert an appreciable effect quantitative easing must take place at a large magnitude. A specific friction that I see is Kiyotaki and Moore's liquidity friction, which states that the bonds central banks purchase are not as liquid as the cash that central banks dish out. Bonds cannot be sold as quickly, so the large stock of bonds represents a promise that the central bank will maintain a higher monetary base in the future. This is how the central bank gets around the Woodford, "double the monetary base in this period and all subsequent periods" credibility problem. While central bank declarations of a future elevated monetary base may not be seen as credible in light of inflation targeting, committing to large scale bond purchases commits the central bank to a brief period of above average inflation by locking in the larger monetary base. In the words of Brad DeLong:

But purchasing bonds for cash has another effect. Cash is a perfect substitute for short-term Treasury bonds now. It won't always be the case. When interest rates normalize, the price level will be roughly proportional to the high-powered money stock. Not all of today's purchases of bonds for cash will be unwound when the economy exits the zero lower bound. If we believe that the high-powered money stock will be roughly $1 trillion after exiting the zero lower bound, and if we believe that a fraction λ of marginal bond purchases won't be unwound, then an extra $100 billion of quantitative easing boosts the expected price level ten years hence by 1%--and boosts expected inflation after the next decade by an average of 0.1%/year. That is enough to spur higher spending and a more rapid and satisfactory recovery.

The problem with this approach is that it is not robust to shifts in expectations. Working with Brad's terminology, λ is positively correlated with the scale of bond purchases. As a result, expected inflation is non-linear with respect to bond purchases. Initial bond purchases may not raise inflation expectations by much, but past a tipping point at which λ start rising quickly, inflation expectations could drastically shift. Even if such bond purchases occur at a steady rate so as to avoid sudden changes, expectations can still suddenly shift if an unforecasted shock occurs. If key economic parameters, such as money velocity, become increasingly unstable, expectations fragility will only grow worse. An example of this kind of "expectation fragility" is with the Swiss National Bank's currency floor. While the fundamental value is below the floor, we get suppressed volatility. Once the fundamental value rises, even if it's purely because of static, there can be lots of chaos as a previously fixed price is now allowed to move. In the context of monetary policy, given the large stock of currency reserves, a slight unforecasted rise in inflation expectations can be the trigger for a massive investment reallocation.

Lars Svensson, in his paper on a "foolproof" way to leave a liquidity traps, also highlights this uncertainty:

It is difficult to determine how large an open-market operation would be needed to reduce the long interest rate, because of difficulties in estimating the determinants of the term premium of interest rates (that is, the difference between long and short interest rates and its dependence on the degree of substitutability between short and long bonds). However, Bernanke (2002) has proposed an elegant operational solution to this problem. The central bank simply announces a low (possibly zero) interest-rate ceiling for government bonds up to a particular maturity, and makes a commitment to buy an unlimited volume of those bonds (that is, potentially the whole outstanding volume) at that interest rate. This commitment by the central bank is readily verifiable – since everyone can verify that the central bank actually buys at the announced interest rates – and achieves the desired impact on the long interest rate, without a need to specify the precise magnitude of the open-market operation required. The central bank may have to buy the whole outstanding issue of the long bond, though.  

In the absence of an expectations mechanic, there is a wide range of uncertainty on the policy response. Other forms of unconventional monetary policy, including currency depreciation or forward guidance, all suffer from this "how much is too much?" problem. Once you inject a few non-linearities into the stories, and have market expectations change at unknown threshold, you realize that prospects for precision are grim.

When the monetary policy result is uncertain, central banks are less likely to use the tools to raise nominal GDP. They may fear excessively high inflation or other side-effects of over-expansionary monetary policy, and choose to be "cautious" and live with high levels of unemployment instead. This is the reason why limits in precision can become limits in the accuracy or effectiveness of monetary policy.

A historical counter-example to this theory of uncertainty would be FDR's dollar devaluation program, which Scott and Marcus Nunes have shown to be very effective in restoring both the price level and output during the Great Depression. Yet I  don't find their example to  contradict my argument about the imprecision of monetary policy at the zero lower bound. Perhaps FDR got lucky. Perhaps the price level was already so depressed that you would have needed hyperinflaiton. Perhaps, back then, finance was not as tightly coupled and the investment effects of getting out of treasuries wouldn't have been as strong. Nonetheless, in our faster, more leveraged, more volatile world, this granularity and imprecision of monetary policy is a bigger impediment.

Scott Sumner often uses Australia as another example, pointing out that their monetary base to nominal GDP ratio is much lower than that in the United States. This shows that Australia has not had to inject as much money into their banking system to stabilize nominal GDP, demonstrating that the stabilizing nominal GDP growth should not be very difficult. But Australia is unique in that it never was at risk of the zero lower bound. While part of this may have just been good monetary policy, it still leaves open the possibility of a large, unforecasted shock that puts a county at the zero lower bound.

However, one form of nominal GDP targeting seems to sidestep these problems: nominal GDP futures targeting. This would allow market participants to instantly improve estimates of future inflation by bidding on futures contracts. Their bidding one way or another would immediately translate into changes in central bank open market operations such that nominal GDP always stays on track. This approach sidesteps the non-linearity of expectations because it allows the market to aggregate all the necessary information and automatically has the central bank adapt to the new found information. Even if expectations did shift in response to unforecasted shocks, the policy response would be immediate and taken in decentralized steps as individual investors bid on futures contracts. In this case, mechanics-credibility theorem is satisfied because the mechanic by which the Fed earns its nominal GDP credibility directly interacts with market expectations while avoiding the circularity problem. Market expectations of nominal GDP feed into futures market volumes, which directly changes the monetary base. The market answers the questions of "how much" with the level it thinks is "just right".

This is one of the key advantages of an nominal GDP futures targeting regime relative to a conventional "wait-and-see" regime. It cements in credibility, and rolls with the waves of external volatility. In a sense, it floats like a butterfly and stings like a bee. It takes monetary policy from the world of "Bernanke Smash" to "Sumner Slice", and allows for greater accuracy and precision in the control of a central nominal aggregate: nominal GDP.

Levels and Rates to Fill the NGDP Data Gap

An implementation of levels and rates to quickly estimate NGDP growth

An important problem with NGDP targeting is data frequency. NGDP data only comes in every quarter, and is also subject to large revisions. This is one of the stronger arguments against NGDP targeting, as the lack of data makes it hard for the market to check that policy makers are hitting their targets. Expectations don't always match reality, so it's important to have a concrete and frequently updated data source to monitor the economy.

Evan, in his musings on level and rate targeting, offers a theoretically robust alternative in the current world of flexible inflation targeting. From his post (my emphasis):

Third, given a mixed rate/level targeting regime, the Fed has what should be the rate and what should be the level backward. In the long run, the Fed has almost no control over the unemployment rate, yet almost total control over the price level; in the short run, it does have some control over real variables such as unemployment. Given those constraints, it makes far more sense to level-target the variable which the Fed controls in the long and short runs, i.e. the price level, and to rate-target the variable over which the Fed has some control in the short run, i.e. change in nonfarm payroll employment or quarterly real output growth.:

As I commented before, such an arrangement would be aligned with Okun's law, which states that year over year falls in unemployment is approximately equal to year over year real GDP growth minus 3. As a result, in Evan's formulation, the combination of change in unemployment and the change in the price level would approximate an NGDP target. His other alternative, nonfarm payroll employment, is what I want to test in this post.

Armed with the requisite FRED data, I looked to see if I could find a simple econometric relationship between YoY NGDP growth, YoY nonfarm employment growth, and YoY Headline CPI growth. In other words, I tested the relationship:

NGDP Growth = a*Inflation + b*%ΔEmployment + Constant + Error

As I'm interested in how the rule would help guide policy in the most recent "Great Recession", I calibrated the data on pre-crisis, 1948-2006  data and then saw how the model predicted NGDP growth "out of sample" for 2007-2012. It turns out that nonfarm payroll, inflation, and NGDP do form a rather tight relationship (note that I use headline inflation. Core inflation does not substantially change the conclusions). The precise rule that I get from the calibration is:

NGDP Growth = 0.517*Inflation + 1.083*%ΔEmployment + 2.968

But if we're looking for a more general, simpler rule of thumb, we can approximate it to:

NGDP Growth = 0.5*Inflation + 1*%ΔEmployment + 3

From here, we can compare the time series of the simple approximation to actual NGDP growth.

We can easily see that the measure does quite well throughout the historical period. I've already divided the graph as Marcus Nunes does for each central banking "regime", and it's clear that the composite measure exhibits the same trends as Marcus shows in his NGDP graphs.

What you do see is that, even in the out of sample period, the time series match up well. Around the end the composite measure does spike to 6% while actual NGDP growth is around 4%. However, in spite of that differential, the rule still makes very good out of sample predictions for the 2007-2012 time period:

Interestingly enough, the regression coefficient has been around one, which means there's an approximate one to one relationship between actual NGDP growth and the composite measure. About 80 percent of the variance in the composite measure is explained by the variance in NGDP growth. Of course, the relationship is not perfect, but it's really quite amazing how well the out of sample prediction holds up. So before the Fed establishes an NGDP futures targeting regime to help with the data availability problem, it can still use monthly available statistics such as CPI and changes in nonfarm payroll to approximate an NGDP target. When actual NGDP data comes out, that quarterly data can be checked against the composite measure. The higher data frequency would help cement in the Fed's credibility as the regime could be checked, thereby smoothing and enabling a transition to a full fledged NGDP level targeting regime.

P.S. While playing with the data, a statistically significant relationship between inflation and employment growth emerges. 95 confidence interval on the slope returns (0.04, 0.22). Pseudo-Philips Curve, anyone?

A Currency Union by any Other Name

...still suffers from the same adjustment problems

Recently there's been a spurt of discussion on the part of Simon Johnson and Paul Krugman on Optimum Currency Areas and productivity growth, and Nick Rowe is still a bit confused. Why should productivity growth differentials matter? Nick lists out a variety of thought experiments and finds no satisfactory answer. As he says, "There must be something else. Some other hidden (to me) assumption they are making. What is it?" With some thought, I believe the "something hidden" is something that market monetarists (including Nick Rowe) have written extensively about: nominal GDP.

Why nominal GDP? Because it's the "something" that can link "productivity differentials, current account deficits, and exchange rate regimes".

First, let's talk about the relationship between higher productivity growth and higher nominal GDP. At least within the United States, productivity growth has a strong correlation with nominal GDP growth. A 1 percentage point in YoY multifactor productivity predicts about a 0.66 percentage point increase in nominal GDP growth. This observation is likely compounded by the Balassa-Samuelson effect, which would imply higher inflation in the regions with higher productivity growth. In terms of the AS/AD model, if the AD curve has a price elasticity of greater than 1, positive AS shocks boost nominal GDP. Fiscal policy is not an answer, as politicians are rarely going to pull back during a boom. And if monetary policy intervenes to cool down the growth, this puts the brakes on nominal GDP growth for the rest of Europe, thus compounding the asymmetric shock problem. Either way, a permanent productivity differential can lead to permanent nominal GDP growth differentials, even if the central bank targets mean nominal GDP growth.

Nominal GDP also can help explain exchange rate regimes and current account deficits. As Scott often reminds us, "You decide whether a currency is under or overvalued by looking at whether aggregate demand is at an appropriate level." And what measures aggregate demand? Nominal GDP. Consequently, if we shift discussion to nominal GDP growth rate differentials, we can talk more intelligently about exchange rate issues. The rate of nominal depreciation of one country's currency vis-a-vis another should equal the difference between the first country's NGDP growth rate and the second country's NGDP growth rate. Thus, if one country has lower NGDP growth than the second, the currency of the first should also depreciate. However, this cannot be the case in the present environment. As Evan Soltas has noted, the Euro has recreated the world of the gold standard. The Euro prevents currency depreciation. Instead of depreciating currencies, we have falling nominal GDP. Countries like Spain and Greece are forced to grind through internal devaluations, imposing massive costs on their citizens.

By refocusing on nominal GDP, a lot of the questions Nick and others are asking become much clearer. Why does a permanent differential in productivity growth matter? Because it implies a permanent differential in NGDP growth, which causes pressures for an exchange rate to change. But because the euro pegs the exchange rates all together, the pressure manifests itself as internal devaluation, which carries very severe negative consequences on count of sticky wages/prices and safe asset shortages. Why does a permanent differential in productivity levels not matter as much? Because if productivity growth rates are the same, there is no differential in nominal GDP. Therefore there's no pressure for currency adjustment. Productivity growth may not force trade deficits, but it can still cause nominal GDP differentials.

Why do fiscal transfers matter? Because in a gold standard world, fiscal transfers between regions (countries) can affect regional NGDP growth. Fiscal transfers are a crude way of "taking" aggregate demand in one region and putting it in another. Fiscal transfers do what domestic central banks can not; stabilize country level NGDP growth. This is politically justifiable if shocks are temporary and distributed among the countries. But when one country has permanently higher real growth and nominal GDP growth, that country will be permanently paying transfers to the others. This is the political problem to which Krugman and Johnosn refer. These permanent NGDP differentials necessitate a one-sided transfer union, which we do not have. As a result, we see the painful process of internal devaluation in periphery countries.

A narrative in terms of nominal GDP also subsumes discussions about unit labor costs. By the New Keynesian business cycle model, lower nominal GDP growth rates arise because of higher real wages or labor costs. So the lower nominal GDP growth in the periphery raises the real wage, rendering the periphery uncompetitive. This is then a more concrete reason why internal devaluation is the only option in a world without transfers or national currencies. Unit labor (and capital) costs need to adjust.

We can now try to answer Nick's thought experiment on a country filled with both low-productivity "Greeks" and high-productivity "Germans", If you separated them, you would observe that the Greeks would have lower growth in nominal production relative to the Germans. This would manifest itself in a growing income gap over time. But what keeps countries together? First, there's "labor mobility". There's no reason  why the Greeks have to stay Greek; maybe they can intermarry and become high-productivity Germans. Second, there's "transfer payments", along the lines of social welfare. High productivity Germans are taxed to pay transfers to the low productivity Greeks. And as in the currency union, the Germans will likely complain about having to subsidize the laziness of the Greeks. If the Greeks can't fight for these policies in the sober halls of Parliament, they can threaten an "exit".This is the basic story behind nationalist secession.

Drachmatic Monetary Policy

The trauma of drachmatazation and how monetary policy could be conducted

A recent blog post from Evan mentioned some of the problems in drachmazation, and as my list of thoughts steadily grew longer, I thought I would explicate them more fully in a blog post.

In his post, Evan mentioned that:

To get the new drachma and circulation and to phase out the euro, the government could offer a favorable initial exchange rate for depositing cash as an incentive  -- say, by establishing an initial one-to-one official convertibility rate, pledging to maintain that for a month, and then scheduling progressive official devaluations for which euro could be returned at banks for new drachma. The Bank of Greece would then exchange new drachma for euros with commercial banks at the official rate, using the euro to pay off some of the early-maturity debts partially in euro, partially in new drachma. 

I find this to be an interesting point, but I think his arguments about the legal status of the Euro are a bit more important. Without a legal mandate that the Euro can't be used in the future, there would truly be no incentive for people to go exchange their euros in the transition. If the conversion rate did not offer enough drachmas for every Euro, then not enough people would go. If too many drachmas were offered, then there would be additional inflationary pressures. Moreover, if the borders controlling capital inflow were porous, foreigners could go in and exchange their euros for drachma at the favorable rate. However, if capital controls are tight enough and the legal mandate for the use of the Euro certain, then domestic Greeks would have an incentive to exchange Euro for drachma, while foreigners would have no incentive to do so.

Evan concludes his post on possibilities for the future of Greek monetary policy. As a market monetarist is wont to do, he floats the idea of an NGDP target to limit the inflation expectations when the Greek government becomes dependent on the central bank for financing. While it sounds good in theory, this is an important example of where NGDP targeting fails in stabilizing crises. If the Greek government is going to be in such bad shape after the exit, what guarantee do we have that any of the data will be reliable? If it's not even certain who's withdrawing money and what currencies are being spent, how does one measure the net value of all the transactions to get an NGDP number? Given the turmoil, it's also unlikely that a deep NGDP futures market would be established, so there would be no way to evaluate whether NGDP is on trend or not. Once it becomes logistically impossible to maintain a credible NGDP targeting, all of the expectations-based arguments used to support NGDP level targeting start to buckle. If the public suspects that the central bank may overshoot, they can go with the momentum and send NGDP off its trend. The same would be true if there were expectations that NGDP was falling and the central bank wouldn't respond quickly enough. Although, in the end, the level target would function, the lack of true credibility would make for wild short term gyrations. In this situation, a composite inflation and rate change of employment target might function better, as quick statistical surveys could get a snapshot of these statistics. This data consideration is a very important point once NGDP targeting starts to spread to other countries. If financial markets aren't deep enough for NGDP futures targeting, and quarterly NGDP statistics are hard to verify, it may be better to work with what we have with regards to inflation and unemployment data.

The Danger of Promises

Promises are powerful, so don't make a promise you can't keep

Evan Soltas had an interesting post on the power of promises in the context of currency bands and monetary policy, but we should also remember that banks shouldn't try to make promises they can't keep. We all should be very worried when we see graphs that show sudden decreases in volatility, as Evan shows in his post. Whenever policymakers suppress volatility, we need to wonder where those pressures have gone, and why they have disappeared. More often then not, manufactured stability leads to calm periods punctuated by sudden change; they become Type 2 extremistan regimes, as pictured below:

So why did the currency peg work? The peg only makes sense in the context of Scott Sumner's argument that the currency peg is a form of monetary policy commitment. The undervalued currency increases aggregate demand, thereby filling the output gap. However, it should be observed that, given the undervalued currency, maintaining the peg leads eventually to above trend NGDP growth and an economy that's running "hot". However, the "hot" economy would call the currency peg into question. This is a classic example of Mundell's policy trilemma. The SNB cannot pursue an exchange rate peg, independent monetary policy, and capital mobility at the same time. Conditions are stable now only because the exchange rate peg matches the objective of an independent monetary policy. However, once the output gap starts to narrow the credibility of the exchange rate peg will be questioned.

This is where the expectations channel starts creating weird dynamics. If the market expects the SNB to pursue monetary policy that prioritizes internal conditions, then the market should expect that currency to appreciate in the future as the output gap is filled. However, because of inertial central bank policy, this will only occur when the currency is undervalued to such an extent that it is no longer feasible for the central bank to maintain the peg. At that point, we should expect to see a very sudden adjustment as the SNB comes under fire from speculators. This then creates a vicious loop, as the SNB's attempts to maintain the peg only increase the supply of currency, of which speculators buy increasing amounts as they now know that the currency will appreciate.

When the SNB is forced to rebalance the currency, it will shake up markets as it unwinds its large balance sheet of foreign assets. Since the bank would have been accumulating these assets for a long time, their sudden liquidation is likely to be a "fat tail" event, which, on one hand may not cause that much damage, but on the other hand may cause positive feedback loops to devastate markets in unknown ways.

While this analysis is in the specific context of the Swiss central bank, this argument has implications for NGDP targeting in developing countries as well. The problem with the SNB's currency peg is that it prioritizes one objective (exchange rate) over all others (including NGDP). However, when domestic politics rears its head, a internal measures such as NGDP will end up trumping external measures such as the exchange rate. The crisis arises from a sudden reversal in priorities.

This exchange rate-NGDP tension is very important for developing economies. If these countries pursue capital mobility, then they may need to compromise part of their monetary policy to maintain an exchange rate band. Thus, this is another source of possible fragility in a NGDP target, as other objectives, such as the exchange rate, suddenly come to the forefront.

Edit: Evan Soltas gave me a further explanation on how the "peg" is really a floor, as well as an explanation of the general macro conditions in Switzerland. I failed to take the time to analyze them, so the conclusions are slightly different. There's still possibilities of non-linear dynamics, and those are explained in the comment thread. I've also written a new post reflecting back of these issues here.

Complexity in Monetary Policy: The Mechanisms Do Matter

Beware manufactured stability: "expectations management" is inherently fragile

A recent working paper adds to the discussion on monetary policy and growth.  In the model, monetary policy affects growth by allowing credit-intensive industries to engage in larger projects.  It does so by easing liquidity needs and, thus, giving firms the "breathing space" to invest.  The paper finds evidence for this by looking at industry-level financial constraint variables as well as the performance of the industry in response to monetary policy.  The key finding is that countercyclical monetary policy can have a significant positive impact on long run productivity growth, especially for recessions.  This result is robust to controlling for:

...the interaction between these measures of financial constraints and country-level economic variables such as inflation, financial development, and the size of government which are likely to affect the country’s ability to pursue more countercyclical macroeconomic policies (5).

Moreover, the regressions shed light on another unique internal link from monetary policy to growth: countercyclical monetary policy promotes higher levels of R+D spending.  While the model explains it through liquidity needs, the concept of "signal-processing" causing firms to invest inefficiently likely applies.  This suggests that if we really are in a "great stagnation" of growth and innovation, a stable nominal economy vis-a-vis monetary policy will be increasingly important.

To extend the model, if monetary policy exerts a diverse range of effects on what is considered money through safe asset creation, the effect of countercyclical monetary policy is probably stronger than what the interest rate would state.  By increasing liquidity through countercyclical policy, this allows firms to invest more:

The intuition for this proposition is simple. Firms need to hoard liquidity in order to weather liquidity shocks if the aggregate state is bad. This liquidity hoarding is costly...because of the lack of commitment of consumers. Reducing interest rates in bad times lowers the amount of hoarded liquidity, by increasing the ability of firms to leverage their net worth. This effect is weaker when the aggregate state is good because in that state, short-term profits are enough to cover reinvestment needs so that no liquidity needs to be hoarded to weather liquidity shocks that occur in that aggregate state of the world. Hence a higher marginal benefit of reducing interest rates in bad times relative to good times. This effect is strong enough to overcome a countervailing effect arising from the fact that lowering interest rates in bad times leads to an implicit subsidy from consumers to entrepreneurs, explaining that optimal interest rate policy is countercyclical (14, my emphasis).

And now the Nassim Nicholas Taleb homonculus starts screaming into my ear.

To what extent does this mechanism of monetary policy just create more interlocking fragilities?  I've previously argued that one of the problems with NGDP targeting is that it hides the complexity of the ecology of markets.  In this model, the world is encouraged to increase complexity because of a monetary regime that promotes more stable growth.  The firms with "unshakeable" expectations can leverage themselves to the hilt to try to maximize future growth.  But finance is fragile; what would happen if an unseen risk arises?  More seriously, although a debt crisis would wipe these firms out, nobody would be able to tell in the short run while those debt instruments are still there.

The issue here is that "average growth" is nowhere near as important as "variant growth".  While growth is stable most of the time, the impact of tail events rises as markets become more interconnected.  Leverage is inherently dangerous in an interconnected world because it enables complex cascading effects that go beyond the ability of our models to predict.  This uncertainty is heightened by the fact that even slight miscalibration errors can cause monstruous miscalculations.  These problems aren't solved by monetary policy either because financial crises are aggregate supply problems.  If credit mediation crashes, resources are no longer allocated efficiently, raising unit costs for all factors of production.

A possible way to get around this is if we can commit to more equity instead of leverage.  From Taleb's 10 principles for a Black-Swan free society:

5. Counter-balance complexity with simplicity. Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products. The complex economy is already a form of leverage: the leverage of efficiency. Such systems survive thanks to slack and redundancy; adding debt produces wild and dangerous gyrations and leaves no room for error. Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have proved to be mild; debt bubbles are vicious.

This way, the net worth of companies can be converted into equity stakes, and funding can be obtained this way.  Given the outsize role of large events, this shift to a more black swan free society should occur before the adoption of monetary policies that could increase fragility.  In this world, monetary policy would allow for increased efficiency of markets while also preventing Black Swans from coming to roost.

Nominal GDP Targeting and Complexity

The Complexity View

I've recently started rereading passages of The Black Swan: The Impact of the Highly Improbable and I find it fascinating. The prose is fluid, and the arguments are powerful. Much of the book mocks economic theory, as models tend to minimize the role of large shocks that defy normal distributions.  In the book, Taleb inserts the following chart that shows how much these "outliers" influence the stock market.

Taleb places the blame for these large swings in the market on the shoulders of the Federal Reserve.  He argues that stabilization policy actually makes the economy more fragile, making it more likely to go down in a dramatic fashion once the "big one" hits.  He sums up this argument in the following quote from a section titled "Beware Manufactured Stability" in a supplementary essay.

...fear of volatility, leading to interference with nature to impose "regularity" makes us more fragile across so many domains.  Preventing small forest fires sets the grounds for more extreme ones; giving out antibiotics when it is not very necessary makes us more vulnerable to severe epidemics... 

Which brings me to another organism: economic life. Our aversion to variability and desire for order and our acting on it has helped precipitate severe crises... Another thing we saw in the 2008 debacle: the U.S. government (or, rather, the Federal Reserve) had been trying for years to iron out the business cycle, making us exposed to a severe disintegration. This is the sort of reasoning I have against "stabilization" policies and manufacturing a nonvolatile environment ...

In a sense, the reduction of volatility in the Great Moderation was only an illusion of stability.  We were, as Taleb would say, "sitting on a pile of dynamite," unaware of the risk that lay underneath.

Impact on NGDP Targeting Policy

This kind of critique seems rather damning against nominal GDP targeting.  The typical analysis of NGDP targeting hinges on the assertion that low volatility implies high stability.  But what if this isn't true?  What if these times of low volatility are just times of high fragility?  Some analysis of the arguments for NGDP targeting even suggest mechanisms by which this is the case.  Debt problems are waved away because NGDP is stable, financial opacity becomes a non-issue because monetary policy compartmentalizes it,  perceptions of "safe" assets  change because expectations of nominal growth are maintained.  Stable expectations permit these innovations because agents can plan ahead, allowing for higher growth.

However, this higher efficiency comes at the cost of redundancy.  Taleb jokes in an interview with Russ Roberts that:

An economist would never design a human being with two lungs and two kidneys. It's wasteful. Deadweight loss.  

He follows up with:

So, the opposite of spare parts would be debt. And nature doesn't like debt. Nature likes redundancies. This mechanism of overreaction is redundancy.

And this is what terrifies me about NGDP targeting.  The incredibly stable regime creates an environment in which redundancy is eschewed in favor of fragility.  Perhaps it would be better to have a more resilient economy that wouldn't be able to accumulate as much capital, but one that has lower levels of debt.  The cost of a mistake in an NGDP targeting world would be incredible.  Even if, theoretically, under a stable monetary regime, there are no demand-side recessions, would you be willing to bet the stability of the entire global financial system on it?  Even if it were true, can you guarantee the Fed will be able to maintain a "stable monetary regime" for perpetuity?

I'm not trying to say the current monetary system is ideal; the dismal employment numbers firmly reject that view.  But when we look onto NGDP targeting as the solution to the global economic malaise, we need to be careful that we don't put all of our eggs into one basket.  NGDP targeting is an incredible tool for monetary policy; but it can't be a panacea for all of these troubles.  

This critique of NGDP targeting brings up another key issue for the design of policy.  Optimal policy has to do more than maximize welfare, it must also be robust to errors.  While in the game playing, platonic world of models NGDP targeting should create incredible reductions in volatility and instability, what are the possible effects on global fragility?  Policy engineering needs to take into account Murphy's Law: "If anything can go wrong, it will."  The only question is how we prepare.

NGDP Targeting: What if it fails?

Recently in the economics blogosphere, the monetary paradigm of nominal GDP level targeting (NGDPLT) has been gaining steam.  NGDP targeting takes a departure from the classic regime of inflation targeting by the growth rate in NGDP, allowing for balance between employment and inflation.  This then leads to a wide variety of benefits, as the new regime is robust to supply shocks, can craft stable expectations of overall future growth, and can reduce fears of any specific industry going through a crisis.  It's particularly attractive for financial crises, as if NGDP growth is stable, previously sustainable levels of debt are less likely to become unsustainable.  If the economy's productive capacity is constant, there's no reason for it to be less able to service its debt.

However, this view seems almost too simplistic.  Even though the US economy was incredibly stable during the over the 20 year Great Moderation, it all came down to a screeching halt with the 2008 financial crisis.  Similarly, even though Britain managed to stay out of a major recession for 16 years, NGDP fell by about 4.7% during the crisis.  Given that there had been such a long legacy of stability, how did expectations suddenly become unanchored?  Even if the US Federal Reserve made a bad policy decision at that point to focus on oil prices and other supply shocks to the detriment of nominal stability, why did the expectations of prudent policy in the future not "solve back" the concerns?  In the end, the crisis culminated into the worst disruption since the Great Depression: hardly a desired result for a responsible regime.

The unhappy ending in 2008 seems to suggest that responsible policy can break down into chaos given a large enough of an exogenous shock.  This problem is very close to what Nicolas Nassim Taleb discusses in The Black Swan: in exchange for low volatility, the economy goes along with high fragility, such that one large shock can cause non-linear, disproportionate harm.  So in the end, the question is about credibility.  How is it established?  How is it maintained?  If decades of prudent monetary policy were not enough to anchor expectations, why should we expect the Federal Reserve to be considered "credible" when the next large financial bubble appears?  If shadow banking markets start to grow shadows and systemic risk goes through the roof, why should we expect the Federal Reserve to be considered "credible"?  Especially if non-monetary factors as posited by Bernanke play a key role in recessions, why would nominal stability be enough?  And when everything crashes down, how will we deal with the mess of debt and contracts that were only sustainable under the old regime?  NGDP targeting seems to play on circular logic.  Boost aggregate demand to hold the expectation; with the expectation there's no need to boost aggregate demand.

So when a policy maker messes up, and lets a NGDP crisis unfold, the crisis emerges.  This is where the black swan hides, cloaked by the rhetoric of stable expectations and the "perfect" monetary policy.