Rogue Economist Rants

Why NGDP targeting?

2012-05-05T06:28:36-07:00

These days I keep reading about NGDP targeting, as it keeps being mentioned more and more everywhere. It seems to be another zombie idea taking on more life of its own. It's basically the idea that the current crisis will permanently be solved by the Fed credibly communicating to the people that it will start targeting 4-5% annual growth in nominal GDP level, from here on.

Wow. Imagine, business planners and executives will have no more compunctions about claiming to their investors that they will attain at least 5% nominal revenue growth year in year out. If they don't achieve it via additional sales volume, the Fed is going to make sure they achieve their targets via inflation. Recessions will be a thing of the past. Woohoo! There will be NGDP growth year after year, courtesy of the Fed, regardless of overall business sentiment. Nobody will ever lose again on a business investment, provided everyone invests their money in the most entrenched TBTF companies.

And business investors themselves will have no more worries about their subpar investing prowess. 5% NGDP growth means at least a positive return on their investments, no matter if they put their money in companies run by incompetent managers. If the Fed will work to ensure 5% NGDP growth every year, it wouldn't really mater if the return comes via aggregate demand growth. It can very easily be achieved by asset price appreciation. So fire away, investors. If you don't get the price appreciation via normal market forces, the Fed will come in and goose it up for you.

Now, how again is the Fed supposed to attain this yearly NGDP growth? Via monetary policy? Quantitative easing, Operation twist, swapping Treasuries for reserves? Hasn't this been largely ineffective in reviving demand for the last 2 years? Exactly how is confiscating government treasury assets from the private sector going to make them want to spend more money? And in keeping rates low, or causing more inflation, how is the Fed supposed to convince savers to stop saving, rather than doubling up on saving to make up for the lost yield?

The thing is, monetary policy has overstayed its usefulness as a countercyclical policy. You can only use it so many times to revive an economy from recession. If you don't tighten it back to previous levels, you eventually get to the zero bound, which is where we are. The Fed can't increase rates, but neither can it decrease them below zero. So monetarists have been convincing the fed to buy up other types of financial assets, to lower rates on any and all instruments that are NOT YET at the zero bound. Eventually, where does this take us? They're already proposing the Fed buy up stocks, commodities, and other financial assets.

See, despite all these market distorting moves the Fed has already done, economists are still arguing Bernanke is not doing enough. They continue to encourage him to communicate to the market - that he will do whatever he can to induce inflation until the people do it themselves. The thing is, Chuck Norris may continue promising the people he will beat them up unless they do as he wants, but if Chuck has no arms and legs, people are just going to wonder how he's going to make good on his promise.

And if asset substitution, or buying up financial assets, or further monetary loosening still doesn't work in increasing NGDP? Perhaps the fed can just target inflation directly by regular currency depreciation. The US will then be just another currency manipulator. Will that really get people to start spending their money in the domestic economy, or will it encourage those who can to flee the currency?

It's the height of futility to insist that the Fed be run on autopilot, based on an automatic rule - "Do we have 5% NGDP level growth already? No, buy more assets, yes, stop, higher than 5% already, sell." The thing is, if we insist policymakers to stop thinking and analyzing the economy, and just follow these policy rules automatically, what we'll have is not a clean, well-functioning economy. We'll have instead the economic equivalent or a runaway car whose speed only varies with the slope of the road it's on. It will still go faster and slower, but it won't care who or what is in its path.

PS. That time again. No more posts for me till maybe later this year. Don't worry, the zombies will still be there.

Why Nations Fail, a review

2012-04-24T19:49:12-07:00

"Why Nations Fail" is different from a lot of development books. It neither focuses on specific policy proposals, and neither does it focus on specific micro or macroeconomic theories that lead lead a nation towards economic development. Quite simply, this book wants to tell you why the same specific sets of policies will work in one nation, and lead nowhere in another. It wants to tell you how you know which nations can run with a specific set of development actions, and end up achieving their objectives.

This book is also different from your regular pseudo-cultural economics books which explain away economic development in successful countries to their specific cultural, anthropological, sociological, or religious makeup. Neither does it barrage you with pseudo-explanations that attribute success to geographical location as the differentiating factor. And neither does it shirk by merely pointing out that successful countries just had the luck of having a really brilliant leader who knew what to do. Yes, these can be big factors that certainly help, but the book in fact explains how each of these common success theories fall short. After all, how many times have we seen countries located strategically next to emerging economies, and led by seemingly smart and charismatic leaders, that still fall short of economic progress, while their neighbours, with seemingly less resources, more run of the mill leaders that come and go, leap into the industrialized world?

No, this is a book that focus on institutions. It distinguishes between institutions that can be considered extractive from those that are more inclusive. It then explains how inclusive institutions create the right incentives for local people to invest, to strive, and to take initiative, and how extractive ones discourage them. If you've been with me on this blog for some time, you know I have a great deal of respect for institutional explanations, and how these institutions create very concrete transmission channels and mechanisms for economic policy. You can have the right policy, but it you do not have the right institutions for it, then no amount of effort will result in successful implementation. To have the right institutions, you need to know how it aligns its objectives with people's incentives and helps them overcome their constraints.

At the macroeconomic level, before you even think of specific goals and policies, you need to ask whether people can see themselves getting more prosperous if they work harder, invest their savings, and take risks with new ways of doing things. Do they see that rewards go to those who make the effort and investment, or do they risk losing the fruits of their labour to an extractive regime that expropriates and gives everything to someone else more closely connected to the ruling elite? Do they know for a fact that they will have a voice going forward, to ensure that their economic interests are protected and represented, or will they lose out to an elite that's suddenly given a monopoly on their industry?

In my mind these are the questions that must run in the minds of the multitude of people who ultimately make the difference between a nation taking off and a nation not making it. Steve Waldman posts that depression is a revealed preference, as a polity, and we are choosing continued depression because we prefer it to the alternatives. In the same vein, nations can choose slavery, apartheid, or pluralism, rule by absolute royal decree or rule of law, upward mobility for newcomers or stable representation for incumbents, openness to creative destruction or loyalty to existing regimes. these revealed preferences often also reveal whose interests are most given importance in society. Whether these interests are those of one person, a few elites, or the greater multitude makes all the difference for a nation's rise, and it continued stay up there.

The book provides enough stories and anecdotes from history to make this view of development vivid. Soviet Russia, ancient Rome, Maya city states, sub-saharan Africa, medieval China and Japan, medieval England, Spain and Europe, even the neolithic age, as are a bunch of other historical places and times make it to this thick book as examples. it's like reading history all over again, but with the end of analyzing why one people or nation makes it, while others don't, and still others fall. Highly recommended for both history and economics buffs.

Written by Daron Acemoglu, MIT professor of Economics; and James Robinson, Harvard professor of Government.

Natural rate brain twisters

2012-04-19T08:36:17-07:00

Mike Sankowski has a good primer over at MMR on the fallacies about the 'natural rate'. His main points:

The NRoI doesn’t exist
If the NRoI does exist, it’s not stable
Then, even if it does exist and is stable, it’s power is so weak it’s not useful to consider it in policy.
Then, even if it does have a powerful impact on our economy, we have such a problem measuring it and observing it and knowing it in real time, we shouldn’t consider using it as any sort of guide for policy.
Then, even if we can observe and measure it and consider using it as a policy guide, the NRoI is focusing on the wrong goal and should not be used as a policy guide

I'll just add that it boggles me how economists purport to be able to calculate the ‘natural rate’ or the ‘equilibrium rate of interest’ in the ‘absence of the capital markets’. Since everything is linked to the capital market, how are they able to compute for the natural rate without it, and how do they at all know it is the ‘equilibrium’? Furthermore, what is the conceptual significance of a rate of interest in the absence of a capital market?

The natural rate means something different for everyone, even for economists, so there can never be one objective measure for it. Personally, I have my own personal ‘natural rate of interest’, but that is personal to me. I’m sure the ‘natural’ rate would be different for you, and different for the next person. Furthermore, the ‘natural’ rate would be different for me tomorrow, and different again next week. It depends on a lot of personal factors that affect how I value whether or not to take out that next loan or make the next investment. Kind of like the risk premium, it’s going to be a different value for everyone, and its value would change as their personal circumstances change.

There’s no economy-wide risk premium, and there’s no economy-wide natural rate. Averaging out everyone’s natural rates to get at one overall natural rate to target still ends up with people with higher than average personal natural rates who still end up misallocating funds (and ending up affecting everybody else’s natural rate). I tend to equate the natural rate with risk premium. Having said that, even economists who argue about the merits of calculating a natural rate will calculate the risk premium as exogenous to the interest rate set by the central bank. So how can something calculated exogenously to the natural rate also be endogenous to it?

Are you still with me? Maybe not. That's how convoluted it gets when you start thinking of an economy's so-called natural rate. Mike is right - to calculate it is to focus on the wrong goal and it should not be used as a policy guide.