Lars Svensson´s analysis bolsters the case for NGDP Targeting

In his latest Vox column Svensson writes:

A dangerous thing concerning debt is what Irving Fisher (1933) called ”debt deflation.” It is usually described as deflation causing the real value of nominal debt to increase. Loan-to-value and loan-to-income ratios also increase, since the debt is fixed in nominal terms but the nominal value of assets and income fall. This may hurt the economy through bankruptcies, deleveraging, and fire sales.

• But the important thing with the concept of “debt deflation” is not deflation, that is, negative inflation. The important thing is that the price level becomes lower than previously anticipated.

This implies that real debt and loan-to-value and loan-to-income ratios become higher than anticipated and planned for. Everyone has probably not realised that this is something that the Riksbank has caused with its “leaning against the wind” policy, by neglecting the objective of price stability and conducting a monetary policy that has resulted in inflation below target.

The majority of the Riksbank Executive Board maintains in their latest policy decision and in the minutes that “although a lower repo-rate path could lead to inflation attaining the target slightly sooner, it could also increase indebtedness and thus the risks to economic development in the longer run” (the minutes from the meeting on September 4, 2013, summary).

As we can see in Figure 1, the price level in Sweden has now fallen significantly below the level it would have been at if inflation had been on average 2% since 1997. In this context, the Riksbank stands out among the other central banks that have had inflation targets for the same length of time. The other central banks have kept average inflation on or very close to their targets, as I have shown in another Vox column. For instance, in Figure 1 we see that the Bank of Canada, which also has an inflation target of 2%, has kept average inflation almost exactly at 2% since 1997.

In “Three dogs; two didn´t bark”, I comment on a wonderful post by Nick Rowe, who says:

The real world (OK Canada) looked very much like that imaginary world from around 1992 to 2008, the golden years of inflation targeting. We can’t tell which of the three policies the Bank of Canada was following, just from looking at the data. All we know from 1992-2008 data is that either IT or PLT or NGDPLT seemed to work pretty well, but we don’t know which. It took a shock to let us see the difference.

In brief, it’s because deviations of inflation from target, or deviations of the price level from the implied target, were the guard gods that didn’t bark right when we needed them to bark. And deviations of NGDP from the implied target was a guard dog that barked loud and clear.

In Svensson´s chart above it is clear that the ‘Canadian dog’ didn´t bark, but the ‘Swedish dog’ had been barking like crazy for many years! One would think that the performance of the Canadian economy has been much better than the performance of the Swedish economy. Let´s take a look.

The charts show that while inflation in Canada has averaged close to 2%, in Sweden it has averaged only 1.3%. But real growth has been the same in both countries (3.3% on average excluding the post crisis years, and 2.6% if they are included).

The ‘dog’ that barked in both countries at the same time was the ‘NGDP dog’. This is shown in the charts below:

Note in the NGDP and Trend charts that up to end 2010 Swedish spending was on a convergence path to the trend level. This is reflected in the higher real growth rate for Sweden in the previous chart. Since then Swedish NGDP has flattened by even more than Canada´s, a fact reflected in the lower real growth rate in Sweden more recently.

Bottom Line: Keeping NGDP close to the trend level is much more important than keeping inflation (or the price level) on target. As Nick Rowe implies, we want a dog that only barks (and does so loud and clear) when the house is ‘broken in’!