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I often get commenters asking my opinion on the optimal NGDP growth rate. This is a difficult question, which can be addressed from a number of perspectives.
Josh Hendrickson has a new policy brief at Mercatus, which advocates the “Friedman rule” for NGDP targeting. This would involve setting the growth rate for NGDP at a point where risk free short term interest rates would be close to zero and there would be no opportunity cost of holding currency. Because currency can be produced at near zero cost, economic efficiency suggests that nominal interest rates should be low enough that the public doesn’t waste resources trying to economize on the use of currency, which doesn’t pay interest.
I’d encourage people to look at Hendrickson’s policy brief, which is very clear and well written. For those who want a more technical analysis, Josh also has a Mercatus working paper.
I see two arguments for keeping NGDP growth low enough to insure near-zero nominal interest rates:
1. A low trend rate of NGDP growth minimizes the opportunity cost of holding currency, which (as mentioned above) is the rationale behind the Friedman rule.
2. A low rate of NGDP growth lowers the effective tax rate on capital income (interest, dividends, rents, capital gains, etc.) because in the US and most other countries the income tax applies to nominal capital income, not real capital income. (Ask me what happened when I sold my 2-family house in Newton MA, back in 2017.) Because capital income taxes are inefficient, faster NGDP growth discourages capital formation and slows economic growth.
I can see three arguments for slightly faster NGDP growth:
1. Faster NGDP growth reduces the risk of the zero bound problem with interest rates. I actually don’t think the zero bound is a problem, but as long as central banks are obsessed with interest rate targeting, the zero bound does make monetary policy a bit less effective.
2. Faster NGDP growth reduces the problem caused by money illusion, the reluctance of workers in declining industries to accept nominal wage cuts, even though they would be perfectly willing to accept the exact same real wage cut achieved via inflation.
3. Faster NGDP growth imposes an implicit tax on currency hoarding balances, the large stock of $100 bills that are held to avoid taxes.
I have advocated an NGDP growth rate of 5%/year, and more recently a rate of 4%. In practice, the target should probably be in per capita (or worker) terms (say 3.5% or 4.5%) but I’ve ignored that minor complication in this post.
My current advocacy of 4% is based on two factors:
1. I believe that a 4% growth rate does a decent job of balancing the costs and benefits discussed above. Not perfectly, but well enough that any welfare loses are probably small.
2. It’s easier to sell the idea if you are not simultaneously attacking current monetary policy in two directions. Thus a proposal for 2% or 6% NGDP growth would be seen as an implied criticism of both inflation targeting in general and the Fed’s specific 2% inflation target.
In contrast, given the Fed’s current view that trend RGDP growth is roughly 2%, proposing a 4% NGDP will correctly be seen as roughly consistent with the Fed’s 2% inflation target in the long run. Instead, the goal is to make inflation more countercyclical, which is of course consistent with the Fed’s dual mandate. Thus proponents of a 4% NGDP target don’t have to apologize for ignoring the Fed’s Congressional mandate, or for abandoning the Fed’s goal of 2% inflation, on average, in the long run.
But I’d also be thrilled if we went to a 3% or 5% NGDP target, as long as it was a level targeting regime. Instability of NGDP is a far bigger problem that getting the average slightly wrong.
PS. People should check out Josh Hendrickson’s excellent twitter account. I particularly enjoyed his tweets on Marco Rubio’s strange decision to put out a policy paper based on MMT ideas. In fairness, I don’t expect politicians to be particularly well versed in macro, just as I know little about bankruptcy law. But I do recommend they not put out papers on subjects in which they are not well versed. Thus in my view Congress was correct to give the Fed a broad mandate, and let the Fed fill in the details. Congress’s mistake was to not ask the Fed for a high degree of specificity as to how they interpret the law, so that it would be crystal clear when the Fed had failed to achieve its Congressional mandate (as during 2008-13). That’s the flaw that lies behind my various accountability proposals.
PPS. Off topic, but this FT story relates to my recent post on the dangers of libertarians allying themselves with rightwing authoritarian parties.
READER COMMENTS
TMC
Jun 16 2019 at 3:39pm
What happened when you sold your 2-family house in Newton MA, back in 2017?
Scott Sumner
Jun 17 2019 at 2:25pm
I had to pay lots of capital gains taxes on gains that merely reflected inflation—not real income.
James
Jun 16 2019 at 4:03pm
If the procedure is to base open market operations on a futures market, that implies two levels of slip. The futures market will forecast with error and there will be some imprecision in how precise open market operations can be.
One alternative that has been proposed in the comments here is to have government agencies or nonprofits pay reciprocal consulting fees. For example, if NGDP is $1 trillion short of target, the Fed could pay $500 billion to the Treasury for consulting services and the Treasury could then pay $500 to the Fed for consulting services. Some people would object that these transactions cannot affect the economy because they are not “real” but if the goal is just to affect nominal GDP, these transactions would be as effective as long as accountants believe so.
Scott Sumner
Jun 16 2019 at 5:07pm
James, Those transactions don’t affect NGDP, as they have no impact on final goods. As an analogy, if I do $1 trillion in consulting services for a friend, and he pays for it with $1 trillion in consulting services for me, it has no impact on NGDP.
Unless income is being generated, there is no impact on NGDP.
James
Jun 16 2019 at 11:58pm
Scott,
All government expenditures, including consulting fees, are included in NGDP.
Scott Sumner
Jun 17 2019 at 2:27pm
James, Only final goods. So who would earn this $1 trillion in income? Remember, GNP=GDI.
James
Jun 19 2019 at 3:02pm
By the expenditure method or the income method 500 billion from the treasury and 500 from the fed for a total of 1 trillion.
Are you suggesting that payments for consulting services are not final and therefore not part of GDP?
James
Jun 19 2019 at 4:46pm
Do you believe there is any possible transaction such that (1) both the buyer and the seller are government agencies and (2) the transaction is included in gdp?
If there is any transaction that satisfies these criteria then it is possible to hit any gdp target (nominal or real) without engaging in open market operations.
Jackson Mejia
Jun 16 2019 at 10:08pm
Although it is for different reasons, it is interesting to note that some neo-chartalists likewise advocate for a risk-free rate of interest close to zero
Benjamin Cole
Jun 17 2019 at 7:27pm
The world appears to be glutted with every kind of capacity, in manufacturing, agricultural output, commodities, or labor supply.
Europe and Japan are close to deflation and both are already offering negative interest rates. In the US the Fed has consistently undershot its putative 2% inflation target.
Given the compulsions and predilections of central bankers, all of the above suggest that a more robust NGDPLT is appropriate. Start with 5% as a minimum and creep up from there over the years to see if results improve.
Arthur Eckart
Jun 18 2019 at 6:00am
Given RGDP or the velocity of money is unstable, why is it better to target NGDP?
Price stability, i.e. the 2% target, or little actual inflation, has worked so well to smooth-out business cycles.
Of course, the 2007-09 recession was an exception caused by a severe boom/bust cycle in the housing market and a huge oil shock. Also, monetary policy may have been too restrictive for too long before the recession, and we had an economic “long-boom” in 1982-07, which included the Information Revolution and high consumption in the global economy.
Nonetheless, we should’ve had a much stronger recovery, which can’t be blamed on the Fed, but can be blamed on the mix of fiscal policy and other economic policies out of Washington.
Arthur Eckart
Jun 18 2019 at 6:28am
Wouldn’t the instability of RGDP in targeting NGDP cause more policy adjustments by the Fed and wouldn’t the additional adjustments cause even more instability, because of lags in the adjustment process?
robc
Jun 18 2019 at 9:02am
The Hendrickson paper seems to suggest an NGDP targeting plan that mimics, as much as possible, free banking with commodity-backed currency.
Wouldnt the easier method be to just have free banking with commodity-backed currency? We get all of the benefits with none of the central planning. What am I missing?
John Hall
Jun 21 2019 at 3:35pm
I’m not sure I buy the paper’s argument, as it applies to NGDP targeting. The practicality of a central bank implementing a nominal GDP targeting rule so that the nominal interest rates is 0% would need to be addressed. If the opportunity cost of holding currency is zero, then what kind of asset purchases do they need to make?
Scott’s second argument for low NGDP growth is predicated on the government tax laws, rather than anything apriori. One could just as easily argue that the nominal rate of interest should equal the rate of inflation over the long-run, so that real interest rates are zero.
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