Let me start by saying that the idea of a NGDP target does not sound outlandish to me. But I feel the same way about price-level and inflation targeting. The first order of business for a central bank is, in my view, is to provide a credible nominal anchor. Probably not much disagreement about this out there.
Proponents of NGDP targeting, however, like Scott Sumner and David Beckworth, for example, seem to believe very strongly in the vast superiority of a NGDP target–not just as a policy that would mitigate the effects of future business cycles–but also as a policy that should be adopted right now by the Fed to cure (what they and many others perceive to be) an ongoing “aggregate demand deficiency.”
What I am curious about is not that they believe this, but how strongly they believe in it. I respect both of these writers a lot, so naturally I am led to ask myself how they came to hold such a strong belief in the matter. What is the theoretical underpinning for NGDP targeting? And what is the empirical evidence that leads them to believe that an NGDP target right now is a cure for whatever ails us right now?
One way to seek answers to these questions is to spend hours perusing their past blog posts. I’m sure they must have answered these questions somewhere. But I figure it will be more efficient for me to just state my questions and have them (or somebody else) point me in the right direction for answers.
First, let us consider the (or a) theoretical justification for NGDP targeting in general. Actually, David was kind enough to point me a nice paper on the subject: Monetary Policy, Financial Stability, and the Distribution of Risk (Evan F. Koenig). Here is the abstract:
In an economy in which debt obligations are fixed in nominal terms, but there are otherwise no nominal rigidities, a monetary policy that targets inflation inefficiently concentrates risk, tending to increase the financial distress that accompanies adverse real shocks. Nominal-income targeting spreads risk more evenly across borrowers and lenders, reproducing the equilibrium that one would observe if there were perfect capital markets. Empirically, inflation surprises have no independent influence on measures of financial strain once one controls for shocks to nominal GDP.
Alright, fine. The argument hinges on the existence of nominal debt obligations. Well, not just debt that is stated in nominal terms, but debt that is fixed in nominal terms (renegotiation is ruled out). This is, of course, a story that goes back at least to Irving Fisher (1933): The Debt-Deflation Theory of Great Depressions.
I’ve always liked the Fisher story. And it obviously has an element of truth to it. But admitting this is different than asserting that the mechanism is quantitatively important, especially for generating decade-long recessionary episodes.
First of all, as I alluded to above, people can and do renegotiate the terms of nominal debt obligations if things get too far out of whack. True, renegotiation (including outright default) is costly and imperfect, but it happens nevertheless. And to the extent it does, nominal debt is not as “fixed” as some make it out to be. It would be good to know how much renegotiation does or does not happen out there.
Second, even if renegotiation is quantitatively unimportant, we should consider the dynamics of debt creation and retirement. At any point in time there is an outstanding stock of nominal debt, with terms negotiated in the past on the basis of future price level paths (among other things, of course). We should also keep in mind that new debt agreements are being formed, and old agreements are being retired and modified (refinanced) continuously throughout time. How big are these flows relative to the outstanding stock of debt?
I think the answer to the previous question is important for understanding how long the real effects of a “negative price-level shock” can be expected to last. If “debt turnover” is high, then such a shock cannot reasonably be expected to generate a decade of subnormal economic performance.
We are presently more than 3 years out from the sharp decline in the price-level that occurred in the fall of 2008. How much new nominal debt has been issued since then–debt that would have presumably been negotiated with expectations of a new price-level path? Does anybody know? In particular, if one is advocating a return to the old price-level path right now, what does this mean for the creditors who have extended loans over the past 3 years? Should we care? Why or why not?
I have not even touched upon the practical feasibility of NGDP targeting–I’ll save this for another day. But for now, I’d like to know the answers to my questions above. Who knows, I too may become one of the faithful!
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