Friday, October 21, 2011

NGDP level targeting, savings, and expected future inflation

I still really cannot get my head around NGDP level targeting. It’s lately been getting traction as the preferred method to get the US out off recession. What am I missing here? Why do I only see pitfalls ? Why are all neoliberal economists now suddenly behind it? Until I can get answers to the following, color me skeptical.

What happens when the fed buys up all of the financial assets from the private sector? I mean, this is how it expects people to go from hoarding money to actually spending it, right? Under NGDP targeting, the fed is expected to buy up all investment outlets (and possibly proponents will eventually propose to broaden the Fed’s mandate to buying up not just government bonds, but all sorts of private sector bonds, equities, commodities, real estate or what not....theoretically until the fed either owns everything, or until people are convinced to start buying stuff before the Fed purchases them out of the market). I mean this is the mechanism in a nutshell, isn’t it?

So let’s lay out some scenarios. Supposing the Fed does buy up most if not all government securities. (This is assuming it takes that much before Investors are actually convinced that gambling, risking money is more preferable to just hoarding in today's economic environment). So there are no more investment outlets for pensions funds, insurance funds, mutual funds. What then? Are we supposed to expect them to start investing in new startups? Risking equities? In even more exotic commodities? What if (and this is what I presume will happen) they just decide to return all that money back to the people? So now we’ve made insurance firms, money market mutual funds, pension funds redundant. And people who wanted to save money (either for retirement, for future education, for future health needs, or whatever rainy day) now can no longer do so, and instead have their money back instead. Will they use it spend on that new car, a bigger home, a new wardrobe? Or maybe they will they still insist on still saving that money? My guess is the latter, and they'd probably save even more, after all they still have to prepare for retirement, for future education, for future health needs, or whatever rainy day, and in the meantime they have no more outlets that earn interest.

And what about banks? Suppose that in the Fed’s quest to ensure that holy grail of consistent 5% inflation (even in the face of 10% unemployment), it ends up buying up most if not all of the banking system’s government bonds. So now banks have no more risk-free outlet. They have to put all their eggs in 100% risk-weighted assets. Basel wouldn’t approve. Will they actually put those new reserves in new loans? I think not. Maybe they’ll just return the depositors’ money, or start charging people for keeping their money. So will the people start spending their deposits instead? My guess is no. They have to save even more just to pay those new excessive banking fees, and have to save even more because, with increased inflation expectations, they now expect to need even greater savings to fund that retirement, future education, future health needs, or whatever rainy day.

So what happens if people are indeed convinced by the fed that inflation will indeed increase, and increase with absolute certainty? What prevents them from putting their money abroad? I mean, what mechanism prevents people who receive this newly-printed currency in exchange for their savings - from deserting to a foreign currency rather than spending it locally? A higher inflation expectation can cut two ways: It can cause people to spend their money now before it loses value, or it can cause people to put their savings in foreign currency, which is expected to keep its value. We’re right back to currency war, and now the US has just escalated the conflict. What would the likely international counterstrike be?

Nick Rowe says that a credible central bank is a bit like Chuck Norris.

Chuck Norris simply looks at the target variable, and it moves to wherever he wants it to go. It looks like magic. But it works because nobody wants Chuck Norris to carry out his implicit threat. So he doesn't need to.

This analogy comes from the market monetarist explanation of the ‘expectations shaping’ mechanism of NGDP targeting. I think the apt analogy would be Chuck Norris strapping himself with a bomb, and telling everyone that if nobody goes for the exits, then he will blow the whole place up. Everybody has to believe that Chuck Norris is willing to blow himself up if people do not follow his intent for them to take to the exits.

So Mr. Bernanke, are you ready to blow yourself and the system up, just so that the people will start spending the money that 99% of them do not really have?


Detroit Dan said...

Excellent comment! Thanks.

I put Nick Rowe and the monetarists in the same category as the gold lunatics...

Senexx said...

Came via Detroit Dan via Interfluidity.

I haven't read the responses yet but pretty much nailed my thoughts on the subject. A conclusion I only came to the other day.

You're chuck norris metaphor sounds like Goodhart's law to me.

Rogue Economist said...

Thanks, Dan. Senex, it's not necessarily like Goodhart's law. The reason I think monetary policy would be ineffective is because people are already indebted, many are already unemployed, and rates are already at zero. Putting rates at negative doesn't make the indebted go into more debt, or the unemployed to engage in more spending. The few who who may have most of the money can probably go around the confines of the fed's jurisdiction.

A nice metaphor for the Fed doing NGP targeting would probably be Charlie Chaplin, who, unable to to control and drive his runaway car, will try to move the road instead to where the car is going so it seems the car is going in the right direction.