When the target is nominal, results are phenomenal
A global economic crisis may be painful, but it can provide some useful lessons. Countries recovered from the Great Depression in the order that they exited the gold standard of the time, which is a major reason most economists no longer favor that monetary regime. The turmoil of the last few years has followed a pattern as well: The more a country’s central bank has done to keep nominal spending growing at a steady rate, the better that country has done. This international experience adds to an already-strong theoretical case for keeping nominal spending — the total amount of money spent in an economy — on a predictable path.
By definition, nominal spending is equal to nominal income (the total amount of money made) and to the size of the economy. The case for stabilizing the growth of that number starts with the understanding that central banks can’t fix everything that ails an economy and shouldn’t try. They cannot change its productivity or population growth, and therefore cannot change its long-term rate of economic growth. If regulations have made labor markets rigid, or rotten schools have yielded unskilled workforces, or property rights are insecure, central banks cannot overcome those problems.
What a monetary system can do is provide the stability to facilitate economic exchange. If a unit of money swings wildly in value, it will not be able to serve that function. Many people have therefore concluded that central banks should above all try to achieve price stability, fixing the average price level or letting it rise at a low and steady rate. To follow this rule rigidly, however, would require the central bank to act perversely in some instances.
A negative supply shock — say, a tsunami, or a disruption in oil imports — will lower real income and raise prices. If the central bank lowers the money supply to prevent the price hike, it will contract the economy further and thus magnify the impact of the shock on real income. Similarly, the central bank will have to greet a positive shock inappropriately, by raising the money supply to keep prices from falling when the economy is already booming.
Targeting nominal spending avoids these pitfalls. If the Fed were trying to keep total dollar spending growing at a 5 percent rate each year, for example, it would not need to loosen or tighten in response to supply shocks. Such shocks would alter only the composition of spending, with positive ones translating into more goods and services at lower prices. To stay on target, the central bank need respond only to shifts in the demand for money balances. It has to increase the money supply when people are more inclined to hold money balances — when, for example, they are scared of economic trouble and want liquid assets — and decrease the money supply when they are rapidly spending money. To put it another way, the central bank must decrease the money supply when money is circulating quickly and increase it when its turnover or velocity is low. And the more markets expect spending to stay on its target path, the more stable velocity should be in the first place.
One reason to avoid slumps in spending is that most debt contracts are written in money terms. Less spending means less income. So in our dollar-based economy, dollar-denominated debts — like mortgages — become much harder to service than people expected when they contracted them. A reduced and uncertain path of future spending also depresses asset prices, since the latter are based on the former. That’s a double whammy for homeowners, and it becomes a triple when people start abandoning their houses in response.
Falling nominal spending wreaks havoc in other ways too. People are strongly resistant to cuts in how much money they are paid, far more than they are to real pay cuts brought about by inflation. So when less money is coming in, workers have to be let go.
This theoretical case implies, first, that central banks should try to keep the total amount of money spent growing steadily; second, that when they go off path in one year they should try to make up for it in the next, to keep long-term expectations on track; and third, that they should announce the policy. No central bank has yet taken all of these steps, and especially the third. Some central banks have, however, kept nominal spending growing at a relatively steady clip even without making that result an explicit goal.
Consistent with the theory, their economies have shown greater stability than those of central banks that pursued different policies. Israel and Australia, where money spending has stayed on its trendline, have been relatively unscathed by the economic crisis. The United States experienced a “great moderation” when the Fed kept nominal spending stable, calamity when it let it drop, and a weak recovery when it took halting efforts to resume its growth. The European Central Bank has not taken even those efforts — it has actually tightened money in some instances in the midst of the slump — and the eurozone’s performance has been the worst of the bunch.
These different paths can be seen in Figure 1, where the blue line shows nominal GDP — a measure of total money spending — and the dashed black line shows its natural trend. The figure reveals that the Israeli and Australian central banks kept nominal GDP close to trend in the years during and after the crisis. The Fed, on the other hand, allowed a sharp fall in money spending and has muddled through ever since. Its first round of quantitative easing arrested the fall, and subsequent rounds have increased nominal GDP, but it has returned only partway to trend (based on statistics from the Congressional Budget Office). A far greater departure has occurred in the eurozone, where the ECB has allowed a gap between actual and trend nominal GDP to emerge and grow.
Figure 2 shows the changes in the money supply and velocity that lie beneath these nominal-spending paths: how far the money supply and velocity deviated from their trend. In the years leading up to the crisis, all the central banks were conducting monetary policy in a manner that caused changes in the money supply to roughly offset changes in how often money was used. That’s why nominal GDP closely fits the trend in all the economies during this time, as seen in Figure 1. For Israel and Australia, this process continued through the entire period. In the United States the offsetting mechanism broke down in 2008–09. The eurozone has not yet fully recovered from a similar breakdown that occurred in 2010. (The breakdowns are highlighted by gray bars.)
In the U.S. and the eurozone, the economy seems to have paid a price for central banks’ failures to maintain monetary stability. From 2008 to 2013, the economy of the United States grew 1 percent on average after inflation each year; the eurozone shrank 0.4 percent each year. Meanwhile Israel grew 3.5 percent on average and Australia 2.5 percent. These nations’ unemployment rates also moved in the way theory would predict given their monetary policies. Figure 3 plots the average unemployment rate for each of these economies during this time period against the average nominal GDP gap (the difference between actual and trend nominal GDP). The resulting scatterplot shows a strong negative relationship. It implies that for every percentage point that nominal GDP fell below its trend, the unemployment rate rose by almost half a point. The closer spending stuck to its trend, in other words, the better off was the economy.
Maintaining stable nominal spending was not a trivial accomplishment for Israel and Australia. They too were buffeted by the global economic shocks of 2008, and Australia had a housing boom and a surge in household debt. Both countries were able to keep money spending stable by aggressively easing monetary policy. The Israeli central bank cut interest rates in the fall of 2008 and later intervened in the foreign-exchange market to keep the shekel competitively valued. The Australian central bank also cut interest rates, acting in advance of the crisis. This preemptive action signaled to the public that the central bank of Australia would do whatever stabilization took. This reassurance seems to have kept money velocity stable, so Australian monetary authorities did not need to resort to monetary injections as much as other countries have. The central bank of Australia has not had to rapidly expand its balance sheet. Nor have interest rates had to stay as low in Israel and Australia as they have in the U.S. and the eurozone.
This record suggests that Europe and America might have had far milder recessions had their central banks acted more like their counterparts in Israel and Australia. Inflation targeting may have led the U.S. astray: The Fed refrained from taking the expansionary move of cutting interest rates in September 2008, when the economy and financial system were crashing, because it was concerned about inflation — which had been induced by a supply shock. Even at that, some observers have faulted the Fed for being too expansionary. They should be happier with the record of the ECB, which has consistently followed a tighter policy. The results suggest how misguided their line of thinking is.
The more closely a central bank has approximated a policy of keeping nominal spending on a predictable path, the better the economy served by that bank has done. That path would be even more predictable if central banks would explicitly adopt that goal. Both theory and experience suggest that they should, so that the economic pain of the last few years will not have been entirely in vain.
– Mr. Beckworth, formerly an economist at the U.S. Department of the Treasury, is an assistant professor of economics at Western Kentucky University and editor of Boom and Bust Banking: The Causes and Cures of the Great Recession. Mr. Ponnuru is a senior editor of National Review.