It’s Not About Credit, it’s About NGDP

Because Raghu Rajan’s posts on macroeconomics tend to drive me nuts, let me start off on a positive note, where I partly agree with him:

1. It’s probably not a good idea to set a 4% inflation target.  (In my view targeting NGDP would be a much better idea.  If we must target prices, let’s level target the CPI on a 2% trend line from July 2008.   We are currently well below that trend line.)
2. I don’t think Keynesians should be arguing that lower real interest rates are the key to recovery.  A bold and credible monetary stimulus that was expected to produce much faster NGDP growth might well raise long term risk-free interest rates.
3. At times Keynesians overstate the extent to which all our problems are demand-side, and ignore the structural problems in the economy.

Having said all that, Rajan grossly underestimates the demand-side problem that we still face.  Here’s one example:

Second, household over-indebtedness in the US, as well as the fall in demand, is localized, as my colleague Amir Sufi and his co-author, Atif Mian, have shown.* Hairdressers in Las Vegas lost their jobs because households there have too much debt stemming from the housing boom. Even if we can coerce traditional debt-free savers to spend, it is unlikely that there are enough of them in Las Vegas.

If these debt-free savers are in New York City, which did not experience as much of a boom and a bust, cutting real interest rates will encourage spending on haircuts in New York City, which already has plenty of demand, but not in Las Vegas, which has too little. Put differently, real interest rates are too blunt a stimulus tool, even if they work.

This is the wrong way to think about macro issues.  Start from the fact that the Fed controls aggregate demand, or NGDP, whether they want to or not.  The least bad policy is one that provides macro stability and low inflation (NGDP targeting, in my view.)  When the least bad policy is in effect, policy will necessarily be a bit too expansionary for 50% of cities, and a bit too contractionary for the other half.  There’s no way of avoiding the one-size-fits-all problem in a common currency area.  Right now most cities have way too little demand.

And is it even true that NYC doesn’t face a demand shortfall?  How would Rajan know?  I don’t doubt that most of the people he knows are employed—the same is true for me.  But what does the data show?  It took me 15 seconds to Google this report.   The NYC unemployment rate is currently 9.7%, or 1.5% above the national rate.  Perhaps NYC has a very high natural rate of unemployment, then his argument about “plenty of demand” might be defensible.  But at a minimum Rajan should provide some evidence, as most economists would regard a 9.7% rate as well above the natural rate.

Rajan concludes with this observation:

With a savings rate of barely 4% of GDP, the average US household is unlikely to be over-saving. Sensible policy lies in improving the capabilities of the workforce across the country, so that they can get sustainable jobs with steady incomes. That takes time, but it might be the best option left.

Perhaps a Keynesian can chime in and correct me if I am wrong, but I don’t think the Keynesian argument (which he is attacking) is that the US saving rate is too high.  I had thought that the Keynesians made a distinction between planned saving and actual saving.  Thus when people become pessimistic and try to save more, they don’t actually succeed.  Instead income falls until macro equilibrium is restored.  Indeed the fall in income might well lead to lower investment, and in a closed economy model that means lower realized saving.  Conversely an expansionary policy that made Americans richer might actually lead to an increase in realized saving and investment, even though the initial stages of the expansion might involve an attempt by the public to save less.

My bigger problem with Rajan’s entire approach to macro is that he’s always talking about finance, credit, lending, saving, etc.  The problem is much more basic.  We have far too little NGDP to employ everyone who wants to work at the current salary levels.  We need either much more NGDP or the same NGDP and much lower salaries.  You know which one I favor.   (Hint: it’s the only solution that has a prayer of actually being implemented in the near term.)  If the Fed provides the right amount of NGDP, all those finance issues will take care of themselves.  Real interest rates will find their Wicksellian equilibrium.  Saving, lending, borrowing, etc, will be determined by the public.

The Fed shouldn’t be trying to encourage either consumption or saving.  They should encourage stable growth in NGDP, and let the market allocate that spending according to the preferences of the public.  Since mid-2008 NGDP has grown at the slowest rate since Herbert Hoover was President.  Rajan’s had all sorts of interesting things to say about all sorts of issues, but he doesn’t see the elephant in the room.  Not enough nominal spending for anything close to full employment.

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