Unintentionally, Kocherlakota makes a strong case for NGDP Level Targeting

In “Blackouts and the Burden of Uncertainty”, he writes:

From the mid-1980s through 2008, central banks had the tools, the will, and the knowledge to protect the economy from sharp swings in the demand for goods and services. They raised interest rates to head off surges, and lowered rates to prevent severe slumps. As a result, households and businesses could count on an economy in which aggregate demand grew relatively steadily. Nobody had to think about, or plan around, the possibility of persistent shortfalls in prices and employment.

That has changed. Since 2008, central banks haven’t been able or willing to defend against a sharp and highly persistent fall in aggregate demand. They have used much of their toolkit, and seem reluctant to employ the tools that remain. As a result, the flow of demand has become uncertain.  Market participants and others are focused on what could go wrong, and how central banks might — or might not — respond.

Before 2008, global aggregate demand was like electricity in the U.S. — just something in the background that everyone could count on. After 2008, it became like electricity in India — desperately needed, but subject to random and persistent shortages. Just as the uncertainty of electricity provision hobbles India’s economy, the uncertainty of aggregate demand impairs the global economy. To reduce uncertainty and promote higher growth, both systems need overhauls.

How should the world overhaul its system for providing aggregate demand? To me, this is the key question facing macroeconomists today. Answering it will require a big change in the discipline. Before 2008, most macroeconomists studying the U.S. and Europe largely ignored the possibility of long-lasting shortfalls in demand. This may (at least arguably) have been appropriate for most questions of interest before 2008. Now, however, they need different models and approaches to understand the effects of aggregate-demand uncertainty, and figure out how best to eliminate it.

The chart gives a visual of Kocherlakota´s ‘allegations’.

Note that during 1985 – 2007, NGDP (Aggregate Demand) growth was very stable (comparatively). In other words, “Before 2008, global aggregate demand was like electricity in the U.S. — just something in the background that everyone could count on.”


But note, after 2007 NGDP growth was initially quite unstable, “running off at high speed” through the Southwest corner of the “stability compound”. Contrast that with NGDP “running off at high speed through the Northeast corner of the “stability compound” in 1970 -84. While the 1970s defined the “Great Inflation”, the 2008-09, by symmetry, characterized a strong disinflation period. In 1985 – 07, aggregate demand growth is contained wholly within the “stability circle, and we had the “Great Moderation”.

Again note that contrary to Kocherlakota´s musings, after the “recovery” from the Great Recession was established in early 2010, what we observe is a very stable aggregate demand growth and not random and persistent shortages”.

However, given the low level of NGDP and it´s rather low average growth, the post 2010 period could be called “Depressed Great Moderation”!

From that perspective, again contrary to Kocherlakota, there´s no need to “overhaul the system for providing aggregate demand”, and also no “big change in the discipline” is required.

It is clear that the Fed can target NGDP growth at a stable rate. After all that´s what it did from 1985 to 2007 and from 2010 to 2015. What´s missing now is the definition of an adequate NGDP level and the most promising growth rate along that level path.

If that´s done the economy will, once again, prosper in a state of nominal stability.

Output Gap targeting is voodoo economics too

A James Alexander post

We have already outlined why inflation targeting is voodoo economics. The juxtaposition of two articles in Saturday’s FT (which I pay for in hard copy, but are behind a paywall) neatly illustrate why targeting NGDP expectations is so important. Debt is nominal but you need nominal growth to pay it back. Especially if you have a smaller nominal economy than expected you will have problems with that debt – and much else besides.

We had already issued an alert about George Osborne’s likely problem from not targeting NGDP growth, and so it comes to pass as the FT reported: 

Paul Johnson, director of the Institute for Fiscal Studies, says the bad news on nominal GDP is much more serious for the public finances than the small headline reductions in real growth forecasts. “The cash coming into the exchequer will be lower, and . . . freezing benefits and increasing pay by just 1 per cent turn out to be less of a real [spending] cut than intended,” Mr Johnson says.

With £18bn knocked off the level of nominal GDP, standard calculations would suggest that if the chancellor kept policy unchanged, this would feed through to a cut in tax revenues of about £9bn every year, enough to wipe out the projected surplus in 2019-20.

The last Labour government learnt how quickly public finances can deteriorate when nominal GDP undershoots. Julian McCrae, deputy director of the Institute for Government, recalls that when he was in the prime minister’s strategy unit in 2008, “we kept nominal [public] spending the same, but that meant huge increases in real terms”.

The second article reported a new and important study that showed why targeting either inflation as the Bank of England says it targets, or real GDP as it actually does, is so dangerous. They also illustrate that while the Output Gap is a valid concept it is unmeasurable, so targeting it is a form of voodoo economics, just like inflation-targeting.

Essentially, because inflation is not measurable, real (inflation-adjusted) output is not measurable either. And thus the output gap between actual real output and “theoretically optimal” real output is just pie in the sky too. All we have is total nominal output (or income or expenditure). Real measures of output (income or expenditure) are just not good enough quality given the challenges of correctly calculating an inflation index with which to deflate actual, nominal, figures to the supposedly underlying real, ones.

An important new survey

Support for this view, as reported by the FT, has come from the recently released exhaustive review into UK economic statistics conducted by Charles Bean The review makes many excellent points. Some opponents of NGDP Targeting, and even some sympathisers, dislike the idea because of the supposedly more often revised NGDP figures. We have dealt with those very weak, lacking-knowledge, criticisms already.

Bean goes through some of the obvious points about the lack of hedonic adjustments in the price indices. Even in the US hedonics is not that widely used. And as I have explained, without a transparent, specific, index for quality adjustments the inflation index itself does not really make sense.

A  choice section is where the high cost of making hedonic adjustments is cited by the UK’s Office of National Statistics (ONS) as a reason for not doing them. So we just have to live with highly unsatisfactory data instead. Or rather we have to live with the awful consequences of a wrong-headed pursuit of wrong numbers by central banks, ie inflation-targeting.

JA Gap Vodoo The section on the lack of any quality adjustments to services is equally damning.

Quality change is not unique to physical goods. Non-tangible characteristics, such as service reliability, effectiveness, or customer satisfaction can vary over time, which means that the quality will not be constant. However, quantifying movements in quality without clearly defined characteristics can nevertheless prove conceptually much more difficult when compared to physical goods.

To be fair, an additional area of challenge to GDP measurement as whole, not just to the deflators comes from intra-firm transactions by multi-nationals, usually with an eye to minimising tax burdens, but other issues can drive these too such as regulatory arbitrage by banks.

This section explored two potential rationales for inter-subsidiary transfers, redomiciling and intellectual property transactions. But these issues are not exhaustive and the challenges from intra-MNE transfers are more diverse. Transfer pricing can also be used to distort non-intellectual property transfers and debt can be shifted around the arms of a company creating distortions through interest rate payments.

Continued integration of global markets is expected to perpetuate the trend to greater foreign asset ownership – of both foreign ownership of UK assets and UK ownership of foreign assets. Therefore intra-MNE transactions of the sort discussed above may increase, worsening potential statistical measurement problems.

These issues make the Ireland and Luxemburg GDP number particularly hard to compile and, frankly, to believe. It is no wonder that these two developed countries are always the last to be accepted by EuroStat into the Euro Area GDP calculations, if at all.

The genuine challenges of measuring actual or nominal GDP should be recognised. Market Monetarists believe nominal stable growth in NGDP is all important to prevent downturns becoming dangerous, unemployment-creating recessions, due to the sticky wages problem. Targeting nominal growth expectations, and keeping those stable is thus far superior to targeting actual NGDP growth. This is partly because it is inevitably backward-looking, but also due to these genuine issues on measurement. If mistakes are made in NGDP looking back, it won’t matter, bygones are bygones.

And it must be so much worse to target things as hard to grasp and calculate as either Real GDP or its ugly sister, inflation. This is to say nothing of which inflation measure to target – either its very overestimated form the CPI (HICP in Europe) or its merely overestimated form the GDP Deflator as in the US.

The  pursuit of the “Output Gap” as voodoo – or worse than voodoo

And then on top of all this pile of uncertainty is added a theoretical amount of real output that economists claim they think should be produced. OK, I understand the concept.

But what to make of pursuing the difference between a theoretically amount of optimal real output and the essentially unmeasurable amount of real output? The pursuit of the output gap or, more colloquially, “slack”.

The dolls used in voodoo are real dolls, but they have no actual physical link with the people they are supposed to represent. Sticking pins in the dolls will not harm the individual. Unfortunately, pursuing unmeasurable concepts like “slack” or “inflation” could well harm people. In some sense, targeting the output gap or inflation is worse than voodoo. Medical doctors first have to take the Socratic Oath: do no harm. If only inflation hawks and slack-hunters took the same vow.

It is, of course, absolutely right that the gap or slack should be minimised but how anyone can have any confidence in the number is beyond belief. Hundreds, perhaps thousands or PhD theses and articles have been written on such an impossible to actually quantify number. What a waste of effort!

Just target nominal growth expectations and avoid sticky-wages caused unemployment and recession. Then leave it to the non-monetary experts, the politicians and the public to argue about what is really going on, ex-inflation and how to make things better if necessary. But please don’t get distracted from the main task of providing nominal stability.

Monetary policy for the present depression, not for the next recession

At Bloomberg View, Clive Crook has a pretty depressing piece – “Monetary Policy for the Next Recession”:

By pre-crash standards, the big central banks have made and continue to make amazing efforts to support demand and keep their economies running. Quantitative easing would once have been seen as reckless. The official term of art — unconventional monetary policy — tacitly acknowledged that.

But QE isn’t unconventional any longer. It mostly worked, the evidence suggests. The world avoided another Great Depression. Yet even in the U.S., this is a seriously sub-par recovery; growth in Europe and Japan has been worse still. Now imagine a big new financial shock. It’s quite possible that all three economies would fall back into recession. What then?

And concludes:

What if ordinary monetary policy isn’t enough? What if central banks can’t discharge their inflation-target mandate without a hybrid fiscal-and-monetary instrument? QE has already posed that question — it’s a hybrid too — but in a much more subtle way. When the discussion turns to the Fed sending out checks, the issue is impossible to ignore.

It needs to be addressed. Independence for central banks only makes sense if they have the means to do the job they’ve been given. At the moment, they’re dangerously under-equipped.

He shouldn´t be enquiring about monetary policy for the next recession. All should be focused on monetary policy for the present depression”.

It´s amazing how many have been sold on the idea that the Fed is “out of ammo” or, equivalently, “dangerously under-equipped”.

The fact is that the Fed is not working it´s “firehoses” as it could. The only plausible answer to the “puzzle” is “because it chose not to”!

The charts below depict inflation (headline & core PCE) over different periods. This is followed by the chart depicting nominal spending (NGDP) growth (the Fed´s “firehose”) over the same periods.



The “Great Inflation” goes hand in hand with high and rising NGDP growth, i.e., the Fed is “inflaming” the economy.. Thereafter there is the “Volcker-Greenspan Adjustment” leading to the “Great Moderation”, which extends to 2007, a period during which, for much of the time, the Fed provides the “right” amount of “liquidity”.

Bernanke´s Fed thought that amount was “too much”. First, it “closed the taps” and then opened them up but with much less “water pressure”, insufficient for the “spending grass” to grow to heights it had reached during the “GM”!

This very simple story is sufficient to guide monetary policy. First to enable the economy out of the depression and then keeping it from falling into another!


Surprise! Martin Feldstein, unwittingly, makes the case for nominal stability

In the WSJ, MF writes “The U.S. Underestimates Growth”:

…This is why we shouldn’t place much weight on the official measures of real GDP growth. It is relatively easy to add up the total dollars that are spent in the economy—the amount labeled nominal GDP. Calculating the growth of real GDP requires comparing the increase of nominal GDP to the increase in the price level. That is impossibly difficult.

But John Cochrane gives a “convenient” interpretation of MF in “Feldstein on Inflation“:

The basic idea is that inflation may be overstated, because it doesn’t do a good job of handling new products. As a result, real output growth may be a bit stronger than measured.  Marty runs through a lot of sensible conclusions.

He doesn’t talk about monetary policy, but that’s interesting too. So what if inflation really is (say) 3% lower than we think it is, and therefore real output growth is 3% larger than it really is?
That would mean we are a lot closer to “normal” of course.

It´s not Friedman´s Chicago any longer!

Note: Nominal Stability a.k.a. NGDP Level Targeting