The magic fairy NGDP wand

It's been a good day of blogging. And it seems like the day has not ended yet. Scott Sumner posts his most recent reply to me here: Second Reply to Andolfatto.

Alright, time to take a step back and put things in some perspective. What exactly is my beef with NGDP targeting anyway?

The somewhat surprising answer is: nothing, per se. I am, however, somewhat perplexed with many of those who strongly advocate NGDP targeting. I believe they are overstating the case for NGDP targeting. And in doing so, I believe that they are diverting attention away from the real economic and political forces that are potentially holding growth back. It may be comforting to believe that most of our major economic problems can be solved by having the Fed simply wave a magic fairy NGDP wand. Yes, well, I'm sorry, but I remain skeptical.

Back in April 2012, I asked David Beckworth to provide me with what he viewed as a theoretical foundation for NGDP targeting (see here). David pointed me to a very nice paper by Evan Koenig, which emphasized the role of nominal (unindexed) debt.

That led me to believe that the rationale for NGDP targeting rested on the idea that such a policy would smooth out shocks to the price-level in a way that inflation-targeting would not. This led me to write down a simple OLG model with nominal debt here and here. What I found was a case for stabilizing the price-level, but not necessarily the NGDP.

Now why did I find this result and why does it seem to contradict the prescription offered by Scott and others? I think I have traced the source of the discrepancy.

Scott et. al. like to organize their thinking around a static textbook AS-AD model. The friction is some sort of nominal price rigidity. Consider a negative AD shock. That has the effect of depressing the P and increasing the real debt burden (e.g., in the context of a sticky nominal wage, it increasing the real wage bill for the business sector, leading to layoffs, and a decline in Y). An NGDP target would stabilize NGDP by stabilizing both P and Y. O.K., good.

Now consider a negative AS shock. This causes P to rise and Y to fall. As NGDP (=PY) may not be very much changed, the policy would advocate little if any intervention. However, a strict PL target would require reducing P. Reducing P would mean increasing real debt burdens, which would further decrease Y. Conclusion: a PL target is destabilizing.

Now, I know that Scott finds mathematical models "annoying" (to me, this is like saying one finds musical scores annoying and that one can always play music better by ear). But please, go take a look at my model (academic economists should find it very simple and straightforward).

My model is explicitly dynamic--you know--kind of like the way reality is. The shock I consider does not fit easily into either the AS or AD category. The event is a "bad news" shock--a downward revision in the forecast of future capital return (or the after-tax return to capital). The impact effect of the shock is like a negative AD shock, because it depresses the demand for investment (and leads to a flight to government money/debt, which causes a surprise decline in P). The contemporaneous AS remains unaffected.

On the other hand, the decline in current capital spending manifests itself as a smaller future productive capital stock, so the that future real GDP is expected to decline. (Whether it actually declines depends on the realization of the shock: it may be either higher or lower than expected). So in this sense, my shock looks like a negative AS shock too.

Now, let's imagine that this bad news is persistent. Then absent intervention, P remains depressed and Y remains depressed. Moreover, because debt is not indexed, and because a surprise drop in P hurts the initial group of investors in my model, the amount of capital investment that occurs on impact is too low (relative to a world in which debt could have been indexed). The PL target rule corrects this inefficient reallocation of purchasing power (away from investors, toward consumers, in my model).

What is the effect of targeting NGDP in my model? To stabilize NGDP, capital spending has to be stabilized and, to the extent that future productivity is lower (in according with earlier expectation), capital spending has to be increased. We can obviously think of policies that achieve this result. In fact, my model is consistent with the proposition that higher inflation leads to higher output (via a Tobin effect). But whether such a policy is desirable is open to debate. In particular, is it really a good idea to encourage more investment in a sector (e.g., housing) in a sector where the returns have fallen? Moreover, people are heterogeneous (my model takes this into account). There would be winners and losers. I don't here very much talk about this prospect from the NGDP targeting crowd.

So there you have it. Please stop telling me that NGDP targeting is "obviously" and unambiguously a good thing. I agree that it is -- if you insist on organizing your thinking with Econ 101 tools. And you know what? Maybe this toolkit is the correct toolkit to use. But again, forgive me if I just do not see this as obvious. This is supposed to be science, not religion.

Finally, maybe someone can speak on the following issue (see here). There is a difference between wishing for a NGDP target before the crisis, and wishing for the policy to be implemented right now. I have some sympathy for the idea that it would have been nice to have the policy in place earlier (I think it would have largely been innocuous). But I am having a harder time seeing the benefits of such a policy imposed right now by the Fed with the tools it has available. In particular, even if "debt overhang" was a major drag on the economy following the end of the most recent recession, what evidence do we have that it is still a *major* force holding the recovery back (especially, as I pointed out in my earlier posts, the price level seems to be close to its long-run trend path). What is the mechanism that people have in mind?

Thanks very much to all of you who have commented and pointed me to readings. I don't always have the time to get to them, owing to the demands on my time here at work, but I do appreciate it! And thanks to Scott for his thoughtful replies to my posts. It's been a fun discussion.