Monetary policy has always been the Achilles’ heel of conservative economics. We’ve repeatedly seen conservative policymakers work hard to create a successful free-market economy, only to have their efforts undone by a devastating period of deflation. In the 1920s, the U.S. economy did well with all levels of government spending only about 10 percent of GDP. All those efficiencies were lost in the subsequent decade. Nominal GDP fell by half between 1929 and 1933, opening the door to big-government statism. Similarly, the neoliberal reforms in Argentina during the 1990s were discredited by the deflation of 1999–2001. In each case, markets got blamed for what was actually the fault of a dysfunctional monetary regime.
Unfortunately, many conservative economists are too dismissive of the costs of deflation. They claim that wages and prices can adjust to any increase in the value of money. But if this were so, there is no reason to believe that wages couldn’t adjust to any decrease as well — and high inflation would also be of no concern. In fact, deflation tends to be far more costly than the sorts of mild inflation that we tend to see in the U.S.
Once the devastating costs of deflation are acknowledged, one can no longer imagine an earlier age when the dollar was “as good as gold.” A gold standard stabilizes the price of one good, gold itself, at the cost of allowing instability in the overall price level. Long-term inflation was near zero under the 19th-century gold standard, but like the man who drowned in a lake with an average depth of three feet, long-term price-level stability can mask a great deal of short-term instability. Prices were at about the same level in 1913 and 1933, for example.
Nor can we avoid the pitfalls of previous gold-standard regimes by getting government out of the picture. If governments did not hold gold reserves for monetary purposes, the value of gold would be even more closely tied to fluctuations in the industrial demand for the metal. In recent years, almost all metals prices have become highly unstable, as rapid industrialization in Asia has pushed up their prices relative to those of other goods. Fixing the nominal price of gold will not lead to price stability.
For better or worse, conservatives need to acknowledge that we live in a fiat-money world, and we need to figure out a way of managing paper money that does the least damage to the broader economy. That means we can’t dodge the hard questions of macroeconomics and blithely assert that we oppose the Fed’s “meddling” in the economy.
There is no laissez faire in fiat money. If the Fed holds the money supply constant, it will be changing the interest rate and the price level. And if it holds interest rates constant, it loses control over the price level and money supply. As a result, many economists now favor some sort of inflation-targeting regime. The most famous example is the Taylor Rule, which did keep inflation tolerably low and stable for two decades. But inflation targeting has several defects that in my view make nominal income (or GDP) stabilization a better goal.
One well-known argument against inflation targeting is that there are times when price-level fluctuations are desirable. George Selgin pointed out that during a productivity boom, it might be better to have a mild deflation in order to prevent labor markets from overheating. Conversely, a negative supply shock ought to make inflation rise: We don’t want to force all non-energy prices to fall to make up for an oil embargo.
Most of the problems that are believed to flow from an unstable price level actually result from nominal-income instability. The aggregate nominal income in the economy is the sum of each person’s income, measured in current dollars. Since most debts are nominal (i.e. not indexed to inflation), nominal income is the best measure of a person’s ability to repay their debts. In 2009, the U.S. saw the biggest fall in nominal GDP (NGDP) since 1938. It is thus no surprise that we had a debt crisis: Borrowers almost always have trouble repaying debts when nominal income comes in much lower than was expected when the debts were contracted.
Some people overlook this problem because they focus on the most spectacular debt problems, the cases where borrower behavior would have been irresponsible regardless of the future path of NGDP: the subprime mortgages in America, the government borrowing in Greece, or the decision by the Irish government to absorb the liabilities of irresponsible banks. But those cases are merely the tip of the iceberg; the sort of systemic debt problem now faced by the Western world goes far beyond these isolated cases, and can be explained only by the fall in nominal income.
Would my proposal for NGDP targeting merely bail out reckless borrowers? No; I am asking the Fed to provide a stable policy environment for the negotiation of wage and debt contracts. Right now, a sudden fall in NGDP growth tends to lead to mass unemployment, lower profits, and sharply higher debt defaults. An unexpectedly large increase in NGDP would cause problems of its own when the stimulative effects wore off.
In fact, it is our current policy that is unfair. Government workers in 2009 were being paid salaries negotiated under the expectation that NGDP would rise at about 5 percent, as it had (on average) for several decades. When actual NGDP fell 8 percent below trend, those wage contracts boosted the share of national income going to the employees still working, at a cost of much higher unemployment for the rest of us.
Targeting nominal income has another advantage: The NGDP data is much harder to manipulate than CPI data. The official CPI core inflation rate showed housing prices rising between mid-2008 and mid-2009, even relative to the price of other goods. That’s right, during the greatest housing price crash in American history, the government insisted that housing prices were rising, even in relative terms. And housing makes up 39 percent of the core CPI, so this was not an inconsequential error.
Then there is the problem of measuring the price of consumer goods. It is very hard for government statisticians to determine how much of a price increase reflects inflation and how much reflects quality improvements. To estimate NGDP, they need only know the revenue earned from sales, and not separate prices and quantities.
If the Fed decides to target NGDP, it will need to choose an optimal growth rate. Friedrich Hayek recommended that central banks try to stabilize nominal income — that is, an NGDP growth rate of zero, which causes slight deflation as the economy grows — which was roughly the Japanese policy between 1994 and 2008. And that’s precisely the problem; for better or worse, the poor performance of the Japanese economy has made many economists skeptical of even mild deflation.
There are two NGDP target paths that might be politically acceptable. Bill Woolsey has proposed a 3 percent nominal expenditure growth target, which would probably result in a near-zero long-run rate of inflation. We’d get the long-run price stability of the 19th-century gold standard without the business-cycle instability created by short- and medium-term fluctuations in NGDP. Alternatively, a 5 percent NGDP target path would lead to the roughly 2 percent inflation that seems to be the Fed’s definition of “price stability.”
Even if a 3 percent nominal growth is preferable, a financial crisis is the worst possible time to lower the NGDP trend growth rate. The Fed clearly thought that 5 percent nominal growth was fine during the Great Moderation, but the near-zero nominal growth over the past few years has had a disastrous impact, much worse than it would have, had it been expected and factored into wage and debt contracts negotiated in earlier years. If we are to move to a 3 percent NGDP growth path, it should be done gradually, and during a period when we aren’t dealing with banking problems that were partly caused by falling nominal income.
In an ideal world, we’d remove all discretion from central bankers. The Fed would simply define the dollar as a given fraction of 12- or 24-month forward nominal GDP, and make dollars convertible into futures contracts at the target price. If the public expected NGDP to veer off target, purchases and sales of these contracts would automatically adjust the money supply and interest rates in such a way as to move expected NGDP back on target. It would be something like the classical gold standard, but with the dollar defined in terms of a specific NGDP futures contract, instead of a given weight of gold. The public, not policymakers in Washington, would determine the level of the money supply and interest rates most consistent with a stable economy.
This sort of policy regime addresses many of the liberal arguments for big government. Right now conservatives don’t have good counterarguments to Paul Krugman’s insistence that all the laws of economics go out the window when we are in a “depression.” Classical economics assumes full employment; how credible are classical arguments against federal job-creation schemes when unemployment is 9.8 percent? Yes, government intervention doesn’t even work very well when there is economic slack. But with NGDP futures targeting, there is no respectable argument for fiscal stimulus, as the money supply would already be set at the level expected to produce the desired level of future nominal spending.
In a world of NGDP futures targeting, liberals would no longer be able to mock those who invoke Say’s Law (supply creates its own demand). It would be transparently obvious that any auto demand created by a bailout of GM would be at the expense of less demand in some other sector of the economy. Nor would the Washington elites be able to intimidate people into bailing out the big banks by pointing to the specter of an economic depression. Banks would fail, but the money supply would adjust so that expected future nominal spending continued to remain on target. Creative destruction could do what it’s supposed to do, with jobs lost in declining industries being offset by jobs gained in creative new enterprises.
There are two types of conservatism. One is pessimistic, resentful, dismissive of any claims of progress in governance. It relies on nostalgia for a mythical golden age, before big government ruined everything. It is scornful of intellectual inquiry into new policy approaches. Nominal GDP futures targeting is part of an optimistic, forward-looking conservatism; it is progressive in the best sense of the term. It is based on time-tested conservative principles, such as the fact that markets can set prices and quantities better than government can, but also builds on the serious academic work of scholars such as Milton Friedman, who understood the devastating effects of a serious plunge in nominal output. There’s no going back, but we can build a monetary regime that undercuts the liberal arguments for big government while providing an economic environment where capitalism can flourish.
— Scott Sumner received a Ph.D. in Economics at the University of Chicago and is currently a professor of economics at Bentley University, where he has taught since 1982.