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Clarifying NGDP Targeting

I would like to clarify for all non-economists out there what NGDP Targeting is really about. This article from ZeroHedge claims that NGDP Targeting is synonymous with issuing new debt and inflating old debt away. In fact, issuing debt has nothing to do with it. NGDP Targeting would establish a reliable rate of nominal economic growth, which is very similar to establishing a reliable growth rate of wages.

In North America and Europe we live in economies where most debt and labor contracts are fixed in nominal terms, as inflation has been low enough to neglect it for most of the last twenty years. Currently, businesses and consumers/savers have to adjust their individual spending and investment plans to lower NGDP levels AND growth rates, both of which have never recovered from their 2008/09 shock. This clearly makes paying off old debts more difficult. It also makes employed labor and capital more expensive, as the expected discount factor for Net Present Value calculations becomes smaller.

Meanwhile, adjustments take time, i.e. wages and prices are sticky, as Keynesians would say. I believe that Ludwig von Mises and Friedrich A. Hayek would concur with this Keynesian statement under a certain condition. They would say that wages and prices are sticky because of regulated markets, which is actually true in many cases today (think of labor unions, certificated jobs, quality regulations, etc.). Anyway, since the adjustments in wages and prices take time, we have higher unemployment and less investments in many sectors of the economy. Obviously, the worst affected sector in the US is housing, where the government has actively prevented prices and wages from adjusting to more sustainable levels by introducing subsidies, increasing minimum wages, more expensive health insurance, and, most of all, by NOT flushing Freddie Mac and Fanny Mae down the bankruptcy toilet.

As long as we have so many “nominal rigidities” in our economy, letting the rate and level of NGDP growth fall below values that most of the people expected five years ago leads to unnecessary hardship in our society. I like the idea of sound (and hard) money and I am not a friend of fiat money, but currently it is certainly the worst possible time to pursue such objectives as lowering the rate of inflation below what we have been used to in the last twenty or thirty years. It is true that NGDP Targeting would make up for lower real growth with higher inflation, which is why I have critisized it in this post. However, the idea of a level target for monetary policy is certainly one of the biggest (and quickest) improvements that we can implement nowadays to make this long-lasting crisis more bearable.

As a matter of fact, in the last two years headline inflation has been well below the rates of 2007/08, even though we have experienced almost a quadrupling of oil prices in 2009-11, compared with a doubling in 2007-08. Core inflation and GDP deflators (which is the inflation measure used in our national GDP accounts) show even larger “shortfalls”. Financial market inflation indicators like bond yields or inflation expectation surveys also hint at very low inflation rates going forward. Bond yields let you participate in the return of capital. The return of capital is lower when the nominal growth rate of the economy is lower. Despite all the talk about unsustainable government debt, the US Treasury 10-year bond pays you an annual return of only 2%! Mind you, this is an ALL-TIME LOW!

Basically, market participants are testing “how low can you go” with NGDP growth expectations. If the central banks do not react to this and continue with their tough talk on inflation, expectations will decline, decline, decline. This is what happened in Japan in the 1990s. At the end of the 1990s, expectations finally became settled at a very low 0% average NGDP growth rate, thereby contributing to the “Lost Decade”, where indebted businesses struggled to pay off their debts, as they were not only confronted with much lower real growth, but also with lower inflation rates. That is why I favor ANY level target regime over ALL current monetary regimes.

Achieving the target rate of NGDP growth would need a clear and credible commitment from the central bank, and at least some acceptance from politicians and from the voters. The central bank probably would have to print some money in order to prove its commitment. With this money it could indeed buy government debt, but it does not have to. Most importantly, the central bank does not have to increase the money supply by 14% in order to bring NGDP back on track. The current money-to-NGDP ratio is comparably high due to the people believing that cash is the best investment (deflationary environment!). If the central bank ended the deflation fear with a high growth commitment, people would soon reduce their cash holdings. Thus, the targeted inflation rate would be achieved with little, or even none, money printing. They probably would have to reduce the amount of cash in the economy thereafter to keep inflation in check.

It is not about printing lots of money once, but it is about promising a certain, stable flow of (a little) money printing well into the future.


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