There is a growing body of economists now trumpeting NGDP level targeting as the best way to get the US economy out of recession. This idea seems to be propounded mostly by Scott Sumner.
Now that rates are at the zero bound, the Fed can no longer stimulate the economy via its regular policy tool – decreasing interest rates. But this fact, as its proponents say, does not limit the Fed’s ability to stimulate the economy via unconventional tools, i.e., NGDP level targeting. The basic idea seems to involve the Fed involving in programs to loosen monetary base, QE being such a program. As the monetary base gets larger, this increases everybody’s expectations of inflation, thereby getting people to spend more now, instead of later. The increasing monetary base, along with the additional economic activity nudged into existence by the increasing inflationary expectation, will then lead to an increase in nominal GDP.
NGDP targeting proponents seem to recommend a 5% annual NGDP growth as a target.
I have attacked and berated additional monetary easing numerous times in this blog in the last few months, but in the interest of open-mindedness, I would like to learn more about this NGDP level targeting and its policy assumptions. If I can get some answers from anyone reading this who may know more about the idea, I could change my mind and my violent opposition to it.
Firstly, operationalizing NGDP targeting, as I understand it, will be via an increase in bank reserves (since this is the policy tool left for the Fed to loosen monetary policy). As such, the way for this new reserves to go out into the broader economy is via increased lending/investing activity by banks.
Since the objective of an effective NGDP level targeting central bank is to grow NGDP by 5% a year, I present the following chart which shows where NGDP should go, from now until 2020. Given the annual growth, we can now calculate what incremental nominal GDP is added for each succeeding year from now until 2020.
Now again, if my understanding is correct, all this additional NGDP will be due to additional lending. Am I wrong? Inaccurate? I know I’m oversimplifying things, since I’m assuming no organic growth, assuming instead that every $1 of incremental NGDP equals $1 of additional debt in the system. But I’m also assuming that there was no additional deflationary counter-pressure necessitating a greater than $1 debt for each $1 NGDP growth. In reality, if NGDP targeting were to be successful, there would probably more loosening than growth in the early years, while gradually less loosening to growth ratio would be needed, as the economy begins to grow back its legs.
But for simplicity sake, my chart shows me that to get to the policy objective of growing from $14.7 trillion GDP in 2010, to $23.9 trillion in 2020, we would be adding about $9.2 trillion of new money/new debt into the system in the coming 10 years. Is this accurate? To put this additional debt into perspective, given 310 million US population, this means $30,000 new debt per capita in the next 10 years. That’s 30 grand of additional debt per man, woman, and child now living in the US in the next 10 years.
Now the next column assumes that banks follow the Basel-approved leverage cap of about 10x capital. That means over the next 10 years, for banks to be able to lend $9.2 trillion, it has to set aside/raise almost a trillion in new capital. Where will this new capital come from?
Now I’m oversimplifying again, since not all incremental debt will need some form of capital to back it. If US banks were to simply buy new government debt in the next 10 years to attain each year’s NGDP growth target, then no additional capital need be raised. But then, this means, QE and /or NGDP targeting, is really just a mechanism to allow for more fiscal policy action, and/or deficit government spending. In which case, it is compatible to greater fiscal policy. Is this an accurate description?
Now again, we’ve also seen instances of banks being able to lend without setting aside capital. All banks need do is pass the loans on to another investor who intends to keep it as an investment. Now we know that there are millions of people from the rising investor class in the developing world who could be ‘prime’ candidates to pass these new debts along to. They are people who likely still cannot distinguish a leveraged mortgage security from a regular fixed income bond, and who cannot identify a toxic asset if they were staring at it with their very eyes. These are people who ‘theoretically’ can fund the capital needs of the new lending, by taking it away from the originating bank’s balance sheet. Multinational US banks can do this right now. Now, is this side effect a possibility that proponents have considered, and is the possible meltdown of the rest of the world worth it, for the sake of being able to conduct this NGDP targeting experiment?
Update: Many thanks to Andy Harless for engaging me in the comments, and for reminding me that QE2 involves buying bonds not just from banks, but from the entire bond-buying public. Do read the comments for more analysis.