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No tiger mom would have let her daughter publish this piece for a fifth grade project, let alone in the New York Times. Amy Chua, in a little under 3000 words, explains her theory of power and prosperity in modern America. Absent from this essay, however, is a single reference to any scientific study. Not only does the article exclude any hyperlinks – appalling for any serious journalism in the 21st Century – it refers to several anonymous “studies” without providing any information about the authors, making it well-nigh impossible for a reader to track it down. 

The form is bad, but the message is worse. Chua and Rubenfeld (who, surprise surprise, extol Asians and Jews) argue that Asian success is largely a function of a superiority complex tempered by deep insecurity and a low discount rate, that is delayed gratification. They argue that initial wealth disparity is largely irrelevant:

The most comforting explanation of these facts is that they are mere artifacts of class — rich parents passing on advantages to their children — or of immigrants arriving in this country with high skill and education levels. Important as these factors are, they explain only a small part of the picture.

In fact, it would be comforting if the propensity towards prosperity could be captured in three, wishy-washy traits shared by a large group of people. Reality is much more complicated, as the authors surely understand, and a host of other factors do matter. Responsible journalism would demand that Chua and Rubenfeld at least acknowledge the limitation of this argument in this form, but readers are not made aware of any competing explanations.

The facts are also pretty shaky. The authors contend:

Today’s wealthy Mormon businessmen often started from humble origins. Although India and China send the most immigrants to the United States through employment-based channels, almost half of all Indian immigrants and over half of Chinese immigrants do not enter the country under those criteria. Many are poor and poorly educated. Comprehensive data published by the Russell Sage Foundation in 2013 showed that the children of Chinese, Korean and Vietnamese immigrants experienced exceptional upward mobility regardless of their parents’ socioeconomic or educational background.

The words here quietly pull wool over the eyes of a casual reader. Half of Indian immigrants do not enter the country under the intense criteria of employment-based channels. That means half do. I wonder what percent of caucasian, black, or latino children have parents that work in jobs important enough to qualify for such visas. The figure is certainly well below 50%.

While some Indian emigre are definitely “poor and poorly educated”, even the immigrants who enter without a Bachelor’s degree face the hard climb out of India to begin with. The initial culture and characteristic of Indians who have the wherewithal to pay for a ticket to the United States and the gumption to take that risk sets this group far apart from the immigrant culture. An observer need only walk through London – to which the entry barriers for an Indian are (or at least used to be) substantially lower – to see that the rich Indians of America are a lucky exception, not the rule.

It is interesting to compare the fate of Indians – who are by far the richest ethnicity in the United States, earning on average more than $85,000 annually – with their Sri Lankan, Pakistani, and Bangladeshi compatriots who earn $65,000, $61,000, and $46,000 respectively. Cultural differences are a natural explanation, but Indians are closer to all of these groups than they are with caucasians suggesting that there is something else going on. Of course, if one is inclined to think that this story is about Indians in general (as opposed to Indian-Americans) he need only see that Sri Lanka is twice as prosperous as India, Pakistan is not all that much poorer, and Bangladesh, while a little poorer, fares better on many social indicators.

This tells us that there’s something special about the type of Indians that make it to America. Whether it be education, intelligence, or an entrepreneurial spirit, it would be ridiculous – in the words of Chua and Rubenfeld – to compare this attribute to this group’s some stereotypically-selected characteristics not shared by caucasians.

It would be remiss to discuss Indian-American success without considering medical professionals, an oddly protected class. Wikipedia tells me that 35,000 Indians are physicians which is fivefold larger than what would be expected from a random distribution. However, the American Medical Association (approximately a cartel) and inefficiently strong health-related regulation prevent the equilibrium rate inflow of medical professionals keeping the wage rate of doctors artificially high, suggesting that many Indians benefit from an artifact of the law rather than some cultural force.

Groups rise and fall over time, and that may even be for the reasons suggested in the article. But by the authors’ own logic, the United States should be scared shitless of Japanese and Korean prosperity – surely these countries, with their laborious education and work ethic, must be more prosperous? New York Times readers may be interested to learn that the average American earns a whole $20,000 more than the Koreans, despite our “failing” school systems and complacence. Some may be tempted to argue that this is largely due to affluent immigrants, but remember that Caucasians earn at or above the national average.

Children of successful immigrants, like myself, are in many ways as privileged as blue-blooded protestants. And, similarly, many of us feel every bit as entitled (we work hard, but I doubt many of us think that we’ll actually ever earn $46,000 a year by the time we have kids). While at an archetypical level it may appeal to speak of certain traits – superiority, insecurity, and self control – shared by many successful immigrants, this is informed by neither theory nor evidence, but rather someone’s wish to project her idea of success onto a group as a whole.

Ultimately, some parts of this article are unimpeachably accurate. No doubt that attaining power and prosperity demands hard work, patience, and confidence. This is common sense, and not in any significant way restricted to immigrants. The authors further a sad misconception among liberal elites – that immigrants work hard while complacent Americans watch TV. This couldn’t be farther from the truth. Americans – particularly the stagnant middle – are among the most hard working (even overworked) in the world. Moreover, these workers are also incredibly productive by international standards, bringing in over $60 per hour on average.

I conclude by agreeing with Chua’s conclusion. It is crucial for America as a political entity to rekindle a sense of urgency and insecurity vis-a-vis China, but this is not at all a mirror of similar conclusions they draw to Americans as a cultural group. China’s ascendence is almost irrelevant on a per capita basis, where even the 80th percentile of urban workers hardly hold a candle to the 20th percentile of all American workers. China’s relevance is predicated on the control this one political entity has on such large a group of people.

More importantly, America’s glory to which the authors allude, while supervised by a sense of insecurity, was almost entirely political. Bipartisan consensus let America fight, and indeed win, the Cold War by putting a man on the moon, passing landmark civil and social legislation, and overseeing the most rapid rise in living standards in the country’s history. But, if anything, Americans work harder today while politicians flounder. This is a story of politics, not people.

I am open to disagreement on this issue, and a piece with actual references may be a nice start.

Monetary offset has been on my mind for a while now. Scott Sumner (among other market monetarists) are running victory laps (and to an extent, rightfully so) considering the relatively healthy growth last year despite significant fiscal drag. There’s no doubt, as stock and bond market reactions prove, that monetary policy has been helpful. But both the theory and empirics behind a strong and automatic offset – as favored by market monetarists – is weak. I should preface this by noting I’m largely in agreement with the market monetarist argument for nominal income targeting.

Let’s imagine (for now) that the zero bound did not bind – whether that be through the efficacy of unconventional monetary tools, a higher inflation target, or a Herculean ability for the Fed to handcuff its own hands years into the future and convince the market that it threw away the key. Standard economic theory supposes that in this world fiscal policy does not determine the price level given an inflation-targeting central bank arguing that if the government increases its budget and hence aggregate demand, the central bank will increase rates to maintain credibility. Hence government spending cannot decrease unemployment.

If we’re talking about totally discretionary stimulus this may be true. But consider a government that offers generous unemployment insurance (UI) with reemployment credits or guarantees employment (either generally or in a recession). Soon after recession, the government institutes very long UI and, in doing so, increases its primary deficit from 2% to 10%. Let’s say hysteresis effects are minimal and expansionary policies don’t simultaneously increase aggregate supply. Expansionary spending then, by Law of the Excluded Middle, either increases the price level or it does not. Given an upward-sloping supply curve (depressed as the economy might be), the former case is more likely. Monetarists argue that an independent central bank offsets policy in one of the following ways:

  • By force of expectation, given its credibility to an inflation target.
  • By being more cautious with its stimulus programs (or halting them altogether, depending on relevant magnitudes) than the counterfactual without stimulus or deeper austerity.

It feels like the first point used to be more popular than it is now, given that the Fed has zilch credibility on its inflation target (by definition, if it had any credibility, long term expectations wouldn’t be as low as they are). The second point is pretty fragile given behavioral features, decentralization of central banking decisions, and the need to have a precise ability to estimate price level elasticity of aggregate supply if it is low (which it is in a weak economy).

So after the government promises insurance to layoffs and credits to employers who hire said layoffs the central bank estimates the effect this has on the price level and accordingly decreases the rate at which it purchases assets. This creates a new wave of unemployed workers – that, after all, is the core of monetary offset models – which would require even more deficit spending to finance the promised unemployed benefits. This would require an even greater offset, requiring even more stabilization.

In this case two things can happen. Either the value of a credit default swap on Treasuries increases, as the market starts loosing confidence that we can service future deficits, or prices rise as markets expect the Fed to monetize deficits in an effort to prevent default. In a world where bond yields and CDS values aren’t soaring, the only possible conclusion is that the Fed stops offsetting government spending.

In fact, to the extent the market knows the Fed would never let the government default, the Fed’s offset would be offset by expectations of its future relaxation of its offset. This sounds a lot like the fiscal theory of the price level, and in some sense it is, but the distinction is that there must be some mechanism in place that requires the government to increase its deficit in response to monetary contraction. If there was no such mechanism – i.e. fiscal policy was only a one time, discretionary cash hand out – monetary policy could offset austerity perfectly well. (A helicopter drop of money and cash hand out financed by bond buying is actually the same thing, so offset could be surgically precise, as both Keynesians and monetarists agree). The only way fiscal theories could work in this environment is a government that engages in discretionary policy every time the central bank tightens policy which is unrealistic and, by definition, not rules-based. So the possibility of hyperinflation from ARRA was well, nonexistent.

There are second order effects too. If the interest elasticity of government spending is higher than the interest elasticity of investment (and studies suggest that this is probably the case), much of the benefit from easier money comes from cheap finance to beneficiary governments, reducing net outlays. Therefore tighter policy would decrease both the government’s primary and non-primary balance. This, by the way, is not negligible – the United States may face $75 billion in increased debt servicing to finance the same level of operations.

If the political situation is such that the government may only engage in a certain level of deficit spending (either by law as in Europe or institutional arrangement as in the US) offset would require the government itself to tighten its budget.

The point of the post so far is that monetary offset cannot be as theoretically sound as its proponents make it seem. There are multiple sources of positive and negative feedback, and actual results depend on the precise role of each which itself depends on the complex slew of automatic stabilizers, central bank learning mechanisms, and so forth. However, as outlined above, that economic conditions today resemble that setup seem unlikely given the preponderance of automatic stabilizers.

The empirical case for full monetary offset is stronger, but still wanting. Yes growth was a lot stronger than some Keynesian models suggested. That itself doesn’t mean anything, especially for anyone that (like me) believes in an at least approximate efficient market hypothesis. No model that can predict growth can exist. The question is whether growth today violates the Keynesian story. Perhaps a macroeconometrician will answer this better than I, but frankly the magnitudes don’t justify that explanation either. While fiscal drag was unfortunate, the United States certainly didn’t succumb to the same austerity as Europe and within the margin that it did plenty of other factors, including an improving supply side, can explain strong growth beyond monetary offset. As for Europe, where’s the offset?

Let me end this post with a final example which captures the point of the above reasoning. Imagine the government guaranteed employment at below market wage rates as a primary automatic stabilizer. In a recession, as deficits increase, monetary offset would force a growing number into government employment. The logical conclusion would be a huge deficit and huge government work force, but not unemployment by virtue of the government’s promise to employ. The only way total GDP would be affected would be a decreased output per worker, a supply-side phenomenon because the government makes for a bad employer. But supply-side concerns are not market monetarists’ concern. Is there any model with guaranteed employment monetary offset decreases total employment?

Of course, deficits would never get so out of hand before the central bank stopped offsetting. But even monetarists agree that monetary offset would not increase employment, only government deficit. By virtue of that transfer of liabilities, the private sector is allowed to deleverage which itself increases aggregate demand.

The feedback loops here are just way too complicated for the simple monetary offset story to be true.

Late Addendum: Scott Sumner comments on his blog (in response to another):

I’ve always argued that zero is a sort of benchmark, a starting point in the analysis. If the fiscal stimulus is large enough to bankrupt a country, then for fiscal theory of the price level reasons I’d expect a positive multiplier. In not (i.e. in the US) I expect the multiplier is zero on average, but may be above or below zero for the reasons you indicate. What matters is the expected multiplier, not the actual multiplier, and I see no reason to expect a multiplier that is significantly different from zero. In 2013 we saw about what I expected.

That’s fair enough. But the point here is bankruptcy conditions are non-negligible with automatic stabilizers. Not in general, but certainly if the offset is persistent (that is if the “expected multiplier” remains at or near zero).

Paul Krugman notes that persistent unemployment hurts the employed as well by decreasing their bargaining power, citing the low (voluntary) quit rate as evidence. This is an interesting claim with compelling evidence – wages grow a lot faster for everyone when unemployment is low.   But there’s something peculiar about the the recent recovery – it’s relatively powerless. Let me explain. Both the early and late 2000s recessions have been followed by so called “jobless recoveries” where output rises a lot quicker than employment. One would expect that this would be correlated with slower increase in bargaining power (using quit rate as a proxy) though there is no way to be sure, the JOLTS dataset we use to measure these things only goes as far back as the turn of the century.

But one would at least guess that a recovery in power would be in line with a recovery of the labor market. Using quits and unemployment as the relevant proxies, this would be incorrect:

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The above is a simple graph of unemployment and quit level since 2000. Economic theory predicts that sharp falls in output and employment should be followed by proportionally rapid recoveries (the so-called “v-shaped” recession). It is a well-known fact that the late 2000s recession hardly followed this pattern. But the way quits and unemployment differ in their respective dynamics is interesting. Even though the decline in unemployment after 2007 was hardly proportional to the crash, at least it was quicker – that is a higher absolute slope – than the early 2000s. Conversely, not only did quits fall much faster in 2007, they also recovered – in absolute and relative terms – much more slowly!

If you crunch the numbers you’ll see that after 2001 unemployment fell 30% as quickly as it picked up. The same figure for 2007 is 20%. So it’s slower, but at least comparable. On the other hand, in 2001 quits recovered 64% as quickly as they fell whereas for 2007 that figure stands at an anemic 28%. Quits after 2001 picked up at 0.61 points (indexed to 2007) every month, but only 0.43 points in 2007, despite the much sharper crash.

Some of this is not surprising. While a deeper recession would normally be followed by a deeper recovery, there are limitations on the extent to which this relationship can hold, especially noting second order effects of hysteresis and market inflexibility. But some of this is definitely surprising. Using the figures above, unemployment recovered almost 70% as quickly in 2007 as it did in 2001. Without some important structural changes, that figure would be in the same ballpark for relative quit recovery, which only stands around 40%.

Qualitatively this means the willingness of workers to quit their jobs is far less than the unemployment rate would indicate, even using the standards of the 2000s, which weren’t by any measure amazing years for labor. If JOLTS went as far back as the Clinton years we would probably see an even stronger relationship between quits and unemployment, something that’s falling apart.

So now I should answer the proverbial “what does this mean”. There are a number of candidate explanations. Loyal readers know that I’m not hostile to a partially structural read, but even that can’t explain everything, because structural arguments generally accept that unemployment rate (as opposed to employment level or participation rate) is a broadly accurate read of the economy, and that much of labor force exit is due to an aging population (or technology, or whatever). I haven’t looked at the numbers, but if we looked at the above data using employment-population ratio instead of unemployment, the late and early 2000s may not look so different.

Ultimately if we are to believe that the structural power relationship in the labor market has not changed noticeably since 2000, unemployment rate grossly overstates the pace of labor market recovery, and the Fed should not even be thinking about tightening of any type. On the other hand, to the extent that unemployment rate is a good gauge of overall labor market health, workers have seen a pretty substantial fall in their bargaining power since 2000 (and remember this is independent of employment levels, unless there are some severe nonlinearities in the data).

Another explanation comes to mind, though given the magnitude it is unlikely. Tyler Cowen notes that future inequality will likely be tolerated without Occupy-esque discontent as an aging country likes stability and calm. It may similarly be the case that older workers are less likely to quit their job as that implies an abrupt shift and uncertainty. Job changes may also require intrastate relocations, something else that has declined over the last few decades (though there’s a bit of chicken and egg, here).

All are pretty harrowing tales for American workers, though in the long-run the former is preferable. The growing unwillingness of workers to quit places strong disinflationary headwinds in the economy as the ability to hit a wage-price spiral becomes much more difficult. Edward Lazear and James Spletzer also estimated that low churn (of which quits are a big component) cost the US economy $208 billion dollars this recovery. More generally – and in this arena I have no expertise; I turn to leftists like Matt Bruenig – this has social consequences by placing a subservience of labor to capital. I’m generally wary of such distinctions, and it’s unclear that any of the proposed solutions like higher minimum wages and stronger unions would make much of a difference – but the possibility exists and it is important.

The powerless recovery is freaky. We are possibly seeing a greater dependence on employment when tight labor markets are a thing of the past.

Ezra Klein’s remarks on inequality led to a pretty rich discussion, for the most part, disagreeing with his proposition that inequality isn’t the defining challenge of our time. His response today is great, making a clear – and agreeable – case that full employment is the most urgent problem facing policymakers today. The problem, I think, is that this still conflates importance with urgency and that which implies the former most certainly does not so the latter. Most of his recent post is correct. Unemployment is depressing median wages and absolutely nothing is more important right now than job creation.

But I want to focus on another, somewhat tangential, part of his post. Ezra writes:

Within the general rubric of “inequality,” income inequality gets a whole lot more attention than wealth inequality. But wealth inequality is much more concentrated and, in various ways, much more dangerous for the social structure. In particular, it’s wealth inequality that really ossifies social mobility.

The children of the top one percent only occasionally manage to match their parent’s incomes. But they often receive massive inheritances that grow over time, installing them atop the economic ladder and giving them a political reason to fight like hell against progressive tax policies (the Walton family is a good example here). And this kind of inequality doesn’t have any of the salutary benefits of income inequality: Massive inheritances don’t make people work harder. They give them a reason to never work very hard at all, and to try to influence public policy so they never have to work hard in the future, either.

I’ve written something along the same lines before, but have revised my belief that wealth inequality is an important signal. I’ll first detail why I think wealth is not too important before noting some reasons why it might be in the future. For one, wealth inequality has almost always been bad and – unlike income inequality – is not showing significant deterioration. In fact, the richest one percent actually saw a decline in their power over the Clinton boom:

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Of course, the wealth Gini is at any given moment in time “worse” than the income Gini, but that’s like comparing apples and oranges. To consider why think about how wealth and inequality thereof accrues: savings and investment. At any arbitrary level of income inequality, wealth inequality will increase, with a higher propensity to save among the rich as the first order effect (and capital gains as an important feedback). 

It’s pretty shocking how static wealth distribution has been, then, given the increasing income inequality. It’s difficult to argue then that wealth inequality – which is hardly a changing feature, unlike income – actually matters for political process in the way Ezra suggests. As disgusting as the Walton family’s politics might be, they have if anything only ossified the existing wealth inequality, without any first order effect on income (as Ezra points out, why should useless trust fund babies care about income taxes when they aren’t actually doing anything productive enough to earn seriously). Arguing that it is important that wealth inequality ought to be more important by arguing that wealth inequality engenders policies to protect wealth inequality is begging the question.

A focus on wealth also obscures monetary policymaking. Quantitative easing almost certainly increases wealth inequality, though there are good reasons to believe it improves income inequality (which over the long run would decrease wealth inequality… as you can see the interplay and economic dynamics are complicated to say the least) through a tighter labor market. In fact, one reason why monetary policy over the past decade did not increase wealth inequality as much as it could have is America’s expensive, pro home ownership programs like interest deductions and guaranteed loans.

In a freer real estate market – one that many economists agree would be more efficient and fraught with less moral hazard – it is likely that homes ownership would be more concentrated, with much of the middle class renting from the rich. The easy money policies of the early and late 2000s, then, would have increased wealth inequality that much more. But that would not mean anything, and should not be the basis for any policy action.

On the other hand, some important things are changing and wealth inequality may be more important in the future. As Piketty and Zucman document in a must-read paper, the wealth-to-income ratio in rich countries has increased substantially over the Great Moderation challenging conventional economic wisdom that this ratio is constant over time and reflecting lower population and productivity growth coupled with higher savings.

However, their data is a lot less remarkable for the United States, where population growth is relatively robust, and savings low – the ratio has increased though not markedly so. Still, in an age of automation and increasing capital shares, the increasing ratio could become an important economic issue.

Ultimately, though, capital income is still income. The return of wealth is not as much a reason to worry about wealth inequality but for capital tax parity with income – something progressives worried about income inequality have long advocated.

The importance of wealth inequality boils down to this. It is difficult to argue, as I think Ezra does, that this matters in and of itself because wealth inequality has historically been around as high as it is, and few would have suggested this is a problem a few decades ago. Suggesting that high wealth inequality begets more wealth inequality is not just assuming the conclusion (that this is bad) but also is not empirically guaranteed (though I am less convinced of this, data show that the 1%/median wealth ratio has increased substantially).

The arguments that wealth inequality matter for other reasons go back to some form of income inequality, usually distribution of capital gains. These are central to debates about inequality of all stripes. Wealth is not at all irrelevant, though. Flows matter more than stocks but when we as a society realize that deeper safety nets and education for the poor are important, we’ll tax the flow of inheritance every year instead of income which is scarce relative to the flow of wealth.

Ezra Klein argues that inequality should not be shaping political discourse to the extent that it is. That’s probably true. But this article misses a few important points and, I think, doesn’t do the best job of characterizing the progressive argument. Or maybe we’re in agreement, and I’ve misunderstood – it’s hard to tell (though, given that I’m commenting on a Wonkblog post, more likely than not).

A quick preface. Arguing that “unemployment and growth, not inequality, will be the defining problem” of our age is dissonant beyond the mutual causality (which is not very well founded) Ezra acknowledges simply because inequality is only a problem when growth is a problem. I don’t remember much about the 90s – intellectually, my generation really was born of financial crisis and political gridlock – but it’s hard for many Americans to think of the Clinton era, despite rising inequality, as a bad time due to high rates of job creation and growth. Polls suggest that perception of inequality and class warfare are worse than usual – vindicated by both the Occupy and Tea Party movements.

As long as your income is growing – even if not nearly as quickly as financiers on Wall Street – it’s not hard to foolishly convince yourself that you have a same shot at those riches as the millionaire next door (Americans ubiquitously believe that equality of opportunity is a worthwhile goal). But when the music stops the story changes. Inequality is a problem, politically and economically, precisely because of secular stagnation.

That, by itself at least, does not mean inequality is the defining problem of our age. It’s worthwhile dividing problems into two categories: those that are urgent, and those that are important. It is also worthwhile noting that usually one does not imply the other. Let me be absolutely clear: the most urgent problem facing America today is unemployment. This is almost incontrovertible. Both progressives arguing that inequality is and conservatives arguing that deficits are urgent do discourse a disservice.

But candidates for the most important problem are more diverse still. Existentially, there is little more daunting than the tail risks from climate change. If the United States, China, and India do not legislate strict carbon taxes into law within the next two decades many other debates will become moot.

Less apocalyptic, but important over the long run still, are rising inequality and secular stagnation. But it is difficult to argue that growth is a uniquely more challenging problem than inequality. It is easy – and right – to rail against the stale debate that we ought to tax the one percent five percent more (as if that will solve anything), but (contra Dylan) most solutions to unemployment will actually increase both opportunity and equality. The Wonkblog post suggests most of the connection between inequality and growth come from a persistent demand shortfall resulting from income earned by those with a higher marginal propensity to save.

And while this has dominated some progressives corners of the blogosphere over the past week, it’s hardly the most important link between the two. Curing unemployment results in a tighter labor force which eventually results in what economists call a wage-price spiral as workers expect inflation to rise, and demand higher wages, forcing inflation to rise. As the unit cost of labor rises quicker than that of capital, we would hopefully see a return of labor share and general prosperity.

The best way to increase wages, employment, and equality would be for the government to contract labor supply by hiring all unemployed workers who want a job in menial, labor-intensive positions. This would increase inflation, reduce the primary balance, and force unskilled wages to increase more rapidly than cost of capital (human or physical).

Most things we do to reduce inequality would also increase growth, at least in the economic model (thematically, not rigorously) employed by proponents of secular stagnation like Paul Krugman or Larry Summers. The best way to deal with inequality would be to increase some form of handout, financed by a deficit, which would aid inequality and growth at the same time. In fact, other than the second-best solution of the minimum wage, it’s not easy to think of something that – within the Keynesian model many people in this conversation favor – would reduce inequality without improving growth.

Neither inequality nor growth are the “defining problem of our time”, but they are born of the same ill, low aggregate demand. In times when demand is high, society will tolerate much more inequality and growth will be limited by supply-side factors. In fact, that’s the reason growth per se is not a problem of our time. If we were experiencing inflation despite low growth rates, it is difficult for the wonks of the world to do anything about it. That is the realm of science and engineering.

But we’re not there yet and, as far as I can see, the most convincing arguments suggest that both inequality and growth are first cousins. You would really need a Republican to find a way to better one without bettering the other (and, arguably, the farm bill is a perfect example to this effect).

Cardiff Garcia has a good rundown on the minimum wage debate. He’s looking for someone to persuade him either way, and I’ll try to explain my qualified support for a minimum wage. For many, the debate is about the relative value of a minimum wage, which is theoretically inefficient, against wage subsidies which are not. However, as Paul Krugman pointed out earlier this year (though this is nothing new) the minimum wage and Earned Income Tax Credit (EITC) are really compliments, at least to the extent your goal is ensuring workers and not employers capture the benefits.

Here’s the pith in just a few sentences. As far as welfare goes, the government should not really be concerned about the wage paid by employers as much as the wage received by workers. If we decide that everyone needs $15 dollars an hour to live a comfortable life, then the government should not require that employers pay at this level, but promise to cover the differential between the market clearing rate (for unskilled laborers). The problem is labor supply is not perfectly inelastic, so this becomes subsidy for employers who can pay less.

There’s another problem with the EITC – it’s somewhat procyclical. There’s some econometric evidence to this effect, but it’s pretty easy to see that a program dependent on employment is not very countercyclical. This is not a problem per se but the marginal value of government spending – not just in increasing the welfare of the poor, but in moderating business cycles – is much higher in recession.

We should institute a procyclical minimum wage – relatively high when growth is good, and low when growth is bad. Actually, at least in the short run, this will address Tyler Cowen’s problem as well:

What about when the wage profile for low-skilled workers is sloping downward over time?  One would expect the opposite result to hold, namely that employers are less likely to hold on to workers when confronted with a mandated wage increase.

For much of the 1990s, the labor market for less skilled workers was in decent shape.  Since 1999 or so often it has been in bad or declining shape, excepting the “bubbly” years of 2004-2006.  Therefore a minimum wage hike today would be more likely to boost unemployment than the minimum wage hikes of the past.  And that unemployment is more likely to be long-term, corrosive unemployment than in previous decades.

I do understand that a minimum wage hike, in the eyes of some, is more “needed” today, perhaps for distributional reasons.  But can we admit it is more likely than average to lead to additional unemployment?

There are many ways to make a minimum wage procyclical, but a simple heuristic might be keeping the portion of the workforce on minimum wage constant over time. That means when the labor market is tight the minimum needs to be raised to keep the level constant, and vice-versa in a loose market like today. There’s a pretty good argument that a minimum wage is like fiscal stimulus the government doesn’t have to pay for, advocated most vocally by billionaire Nick Hanauer. He thinks that’s a good thing, but huge cash piles or not, a recession is precisely the worst time to ask the private sector to pay more.

This would work in tandem with a wage subsidy guaranteeing some minimum income that is acyclical. In good times, the required employer pay rate increases, easing the government’s deficit. The disemployment effect during this time will be relatively negligible as per Cowen’s logic but also because inflation is higher during boom times allowing the employer to erode the real wage rate if the employee turns out to be bad.

When times are bad, the wage employees need to pay falls, which increases demand for labor, and the government picks up the tabs. Sure it’s partly a subsidy to employers, but one precisely when they need it.

This has the free benefit of making the EITC a lot more countercyclical. It also eases political constraints of efficient stimulus. The government can choose to make the minimum wage zero in slow times – something I’ve advocated before – which would in effect be providing free labor to employers. This sounds a lot better once you consider that at least today employers seem to think the long-term unemployed are approximately useless.

A procyclical minimum wage in tandem with a wage subsidy is in effect a countercyclical stimulus program. It also directly encourages hiring in a way the standard program does not. Here’s to the market determined minimum wage.

November 14, 2011 – Munk Debate: “Be it resolved North America faces a Japan-style era of economic stagnation.”

Paul Krugman and David Rosenberg vs. Larry Summers and Ian Bremmer.

Larry Summers:

Paul, I would buy, not sell. You’re right that we will suffer needless unemployment and stagnation until more is done to address [our] demand deficiency […] My thesis is that as serious as [our] problem is, it is dimensionally much less than the problems that Japan faced in four respects. Japan’s problems were different in magnitude, different in the depth of their structural roots, different in the relative perspective they had […] and different in the degree of resilience their system had for adapting to them […]

Paul, you forecast in 1994 […] that Japanese potential GDP growth would be 3% or a bit more. By that standard, Japan is now producing half of the potential output that people were forecasting when its lost decade began. That’s a problem of a different magnitude than a U.S. gap, serious though it is, at 6 or 7%.

There is little wonder that Japan’s slow-down is so profound given the magnitude of the structural problems that hold Japan back: the most rapidly aging society in the industrialized world resulting in slow labour-force growth; epic insularity and inability to accept immigration; in the face of distress a massive retrenchment by its companies to their home markets; an utter lack of capacity for entrepreneurial innovation in the era of the social network. The United States remains, witness my colleague here, the only country in the world where you can raise your first 100 million dollars before you buy your first suit and tie.

Let’s look at relative perspective. When Japan went wrong in the 1990s, the world was working. The United States was flourishing and growing. […] The United States’ problems are the problems of every industrial democracy. And the U.S. share of the industrial world is steadily increasing.

[I]f you look at what passes for governance in Europe in recent years, I would suggest that our problems do not loom large relative to either the economics or to the politics in the rest of the world. We remain totally unlike Japan. We remain the place where everyone in the world wants to come and the place where everyone in the world wants to put their money.

Finally, we are a uniquely resilient society and we have seen this before. John Kennedy died believing that Russia would surpass the United States by the early 1980s. Every issue of the Harvard Business Review in 1991 proclaimed that the Cold War was over and that Japan and Germany had won, and that was before the best decade in U.S. economic history.

It will take time. There are steps that need to be taken but we are a society that works. We are a society whose principle problems — we all up here agree — can be addressed by a change in the printing of money and the creation of infrastructure. That is not the kind of fundamental problem Japan has. 

February 11, 2013 – World Economic Forum: “The Future of the American Public Sector”

Larry Summers in conversation with Chrystia Freeland:

Chrystia Freeland: [Tell us about the United States]

Larry Summers: Look I think people have counted the US out before. John Kennedy died believing that the Soviet Union would surpass the US by 1995. […] People make that mistake now with respect to our economy and with respect to our politics. I think if we seize the moment we have huge and unique opportunity in the world. This is a moment for broad renewal that corrects all the deficits we have […]

If we can in our public life, corporate life, and individual life turn our attention more to the future away from the present, this can be a profoundly important moment for the US.

CF: [Are you moving into the PK Camp?]

LS: I don’t know if I’m going to do camps. In 1993, here’s what the situation was. Capital costs were really high. The trade deficit was really big. And if you looked at a graph average wages and productivity of American workers, those two graphs laid on top of each other. Reducing capital costs and raising productivity growth was the right strategy. That was what Bob Rubin told Bill Clinton. That’s what Bill Clinton did. They were right. Today the long-term interest rate is negligible. The constraint is lack of demand. Productivity has vastly outstripped wage growth. And the syllogism reduce the deficit and you’ll get more wages does not work the same way. But, if you don’t get the deficit under control you will eventually get a macroeconomic catastrophe. […]

CF: Following on from your focus on growth, there is an argument that I hear more and more people taking seriously advanced maybe most boldly by Tyler Cowen that growth maybe innovation and productivity growth is over. The low hanging fruit has been picked and we’re in a stagnant period. Do you buy any of it?

LS. Not a bit of it. Everyone in this room here was required to turn off their device in this room a couple of minutes ago. The device you were required to turn off had more power than the Apollo project, it has better access to information than the Library of Congress and in terms of reaching people around the planet, you would trade JFK’s communication system for your iPhone. And in 5 years from now 5 billion people will have it. So I don’t know how anyone can say we are making fundamental progress.

The prophets of doom cannot have it both way. You cannot both say that the [robots are taking your jobs] and say nothing is happening that’s important for productivity growth. And in between those two if you want to have a dystopian idea, I think the must more fundamental idea is what technology is doing for the middle-skilled.

[Talk about inequality].

I think that is a much more serious problem than the idea that somehow there is nothing new. One other thing, I see my friend Francis Collins sitting here and he knows infinitely more about this than I do. But perhaps the wisest aphorisms I learned in grad school was [Rudi] who told us that things take longer to happen than you think they will, and then they happen faster than you think they could. It was famously observed that the computers were everywhere but the productivity statistics. And then you saw what happened. [I think the same thing will happen with genomics].

Larry Summers believes deficits pose an important problem and hence negative interest rates are not yet on his radar. Larry Summers refuses to accept Paul Krugman’s comparison of the United States to Japan. Also, an odd choice of boots.

November 8, 2013 – The International Monetary Fund:

Larry Summers:

There is I think another aspect of the situation that I think warrants our close attention that receives insufficient attention. The share of men, women, and adults that are working today is essentially the same as four years ago. Four years ago the financial panic had been arrested. TARP money had been paid back. Credit spreads had normalized. There was no panic in the air. That was a great achievement. But in those four years the share of adults who were working has not improved at all. GDP has fallen further behind potential as we would have defined it in the fall of 2009. The American experience in this regard and this experience is not unique as RR has documented in the wake of a financial crisis. Japan’s real GDP today is about half of what we [the Washington Consensus] believed it would be. It is a central pillar of both classical and Keynesian models that it is all about fluctuations and what you need is less volatility. I wonder if a set of older ideas (that I have to say were pretty firmly rejected in [Stan’s class]) that went under the phrase secular stagnation that are now profoundly important in understanding Japan and may be relevant to the United States today. […]

If you go back and you study the economy prior to the crisis. There’s something a little bit odd. Many people believe monetary policy was too easy. Everybody agrees there was a vast amount of imprudent lending going on. Almost everyone agrees wealth as it was experienced by households was in excess of its reality. Too easy money, too much borrowing, too much wealth. Was there a boom? Growth was not high, unemployment was not too low, and inflation was quiescent. Somehow even a great bubble was not enough to create an excess in aggregate demand. Now think about after the crisis.

[Insert Larry Summers analogy of choice]

You’d imagine that once things normalize you’d get more GDP than you would have had. Not that four years later you’d still be having substantially less. So there’s something odd about financial normalization if that was what the whole problem was and then continued slow growth. So what’s an explanation that would fit both of these observations? Suppose that the short term real interest rate that was consistent with full employment had fallen to negative 2 or negative 3 percent sometime in the middle of the last decade. Then what would happen? Even with artificial stimulus to demand coming from all this financial imprudence, you would not see any excess demand. And even with a relative resumption of normal credit conditions, you’d have a lot of difficulty getting back to full employment. Yes, it has been demonstrated that panics are terrible and that monetary policy can contain them when the interest rate is zero. It has been demonstrated less conclusively but presumptively that when short term interest rates are zero monetary policy can affect other asset prices to plausibly impact demand. But imagine a situation where natural and equilibrium interest rates have fallen significantly below zero. Then conventional macroeconomic thinking leaves us in a very serious problem because we all seem to agree that whereas you can keep the FFR in a low rate forever, it is very hard to do extraordinary measures for ever beyond that. […] This may all be madness and I may not have this right at all, but it does seem to me four years after the successful combating of crisis with no evidence of growth that is restoring equilibrium one has to be concerned about a policy agenda that is doing less with monetary policy than has been done before that is doing less with fiscal policy than has been done before and is taking steps whose basic purpose is for there to be less lending, borrowing than before. So my lesson from this crisis which the world has under internalized is that it is not over until it is over and that is not right now and cannot be judged relative to the extent of financial panic. And, we may well need in the years ahead to think about how we manage an economy in which the zero nominal interest rate is a chronic and systemic inhibitor of economic activity holding our economies back holding us back from our potential.

About face.

Note, I am not accusing Summers of hypocrisy in this case. Too few intellectuals – especially those of this prestige – change their mind. I’d be thrilled to hear Summers detail the revision of his priors. That is always an interesting process. I will add it does not seem to me – at least within the intellectual confines of a twenty minute video for Davos – that Summers really gets Tyler Cowen’s argument right. It is very easy to “have it both ways”, as Summers puts it. In fact, his latest at the IMF is provides precisely this reconciliation. Certainly Summers does not now believe that the iPhone will not reach the masses of Africa, that genomics will stop in its tracks, or that 3D printing will fail (any more than it would have in January of this year, at least). But suddenly that does not matter. In fact, that is precisely why this is interesting – everything Summers said in 2011 holds true and could still be argued today. It seems, given that the facts have not changed, that Summers is interpreting them through a different model.

There is also the possibility that Larry Summers judged that the audience at the Fourteenth Jacques Polak Annual Research Conference at the International Monetary Fund in honor of Stan Fischer is a lot, lot more sophisticated than jet setters at the Munk Debate or Davos.

Count me as eager to see whether Summers as successfully sheds his Keynesian-Classical (deficits matter in the long run) worldview as Paul Krugman. So long as the growth rate is above the interest rate, and he sure seems to think that will be the case, he cannot be saying something like:

But, if you don’t get the deficit under control you will eventually get a macroeconomic catastrophe.

It is not that his underlying model of the world is wrong. Just that the parameters that were always true, that no one really thought about, don’t matter anymore.

This deserves a post on its own, but there seem to be a few schools of thought on stagnation:

  • Cyclical demand shortfall (Larry Summers, Munk + Davos).
  • Secular demand shortfall (Larry Summers today, Paul Krugman).
  • Innovative constraints (Michael Mandel).
  • Other structural factors. Or an amalgam of the above. Or something else. (Tyler Cowen).

First of all, talking about “low demand” without reference to a given level of supply is stupid. Aggregate demand in Eurozone is really low right now. But if South India + Maharashtra (approximately the same population) had the same level of demand relative to their supply India would be, well, indescribable. I make this explicit because it is very important to distinguish between “demand” in Summers’ first two videos to that in his last. In the former two he is extolling America’s supply-side potentials. It is unclear to me the way he models supply with his new interpretation of the world. I am looking forward to reading many more posts on this hypothesis.

By the way, this is something I’ve been saying for a few months now, but most clearly detail in a post a few days before the conference:

I am glad others are thinking along the same lines. Hopefully central bankers consider a higher inflation target seriously.

Not:

Image

I’ve read a lot of posts recently claiming that the Fed should throw in the towel, because “US growth is not what it used to be”. That could be true. It’s very difficult to suss out structural changes, but it’s unreasonable to be puritanical that our problems can be solved with, and only with, more aggregate demand. At least if you define “solve” as returning to the 1990s boom. However, it’s a bit aggravating when people insist that this has anything to do with what the Fed should or should not be doing.

The Fed’s not in the business of increasing productivity growth or managing real GDP. As far as I know, no model suggests that the economy is hitting its potential when inflation is unanchored well below its long-run trend. In fact, aggregate supply doesn’t even matter right now. When consumers are leveraged to the hilt a fall in prices from a productivity boom would just increase balance sheet constraints in the economy as the real-value of debt rises. 

The camp of economists that talks about monetary policy juicing up a dead economy – or whatever it is – likes model heuristics like NAIRU or the natural rate of unemployment, potential output, whatever:

Weak payroll growth, despite a speedy drop in joblessness, forced Bernanke in September to backtrack from a June statement in which he said the Fed expected to halt its bond-buying by mid-2014, when joblessness would be around 7 percent.

But some economists argue easier policy is not the answer given the economy’s shifting fortunes.

“Easy money will likely lead to asset bubbles or higher inflation, because policy is miscalibrated relative to … the economy’s underlying potential,” said Joseph LaVorgna, chief U.S. economist at Deutsche Bank.

He said potential GDP growth had “meaningfully downshifted” and warned of “potentially serious negative long-run implications” of current monetary policy.

It’s not clear to me what monetary policy has to do with asset bubbles. We should either not care about those or, preferably, outsource that to the macroprudential regulators. Asset prices shouldn’t be a cornerstone of any monetary policy (which, incidentally, is why we should be skeptical of the wealth effect from quantitative easing). But let’s go back to what Deutsche Bank is saying. Quantitative easing and zero interest rates will cause inflation because potential GDP isn’t what it was. However, this would require accelerating inflation as “artificial” demand competes for a shrinking stock of free labor. We’ve got precisely the opposite phenomenon. Either demand is not high or the growth potential of the US economy has surged (and while that’s good for the future, it doesn’t do squat for us today).

More importantly, people obsessed with asset markets are confusing noise and signal. Yes, real estate and equity markets have picked up much quicker than the economy itself. This is a byproduct of their own demon – slowing population and productivity growthLet’s go back to the simple and elegant Harrod-Domar-(Solow) model. The wealth-to-income ratio (which determines asset prices) is determined as:

b = s/g where s is the national savings rate and g is the growth rate. The lower the growth rate the higher the wealth to income ratio. This is important because it suggests all this whining about interest rates and asset prices has very little to do with monetary policy. Interest rates have been in secular decline since the ’80s:

Image

 

As Piketty and Zucman thoroughly confirm, the wealth-to-income ratio increases as would be expected under conventional models. Any observer notices that this trend in interest rates is completely independent of monetary policy in the past few years. Growth has been slowing down which means much more wealth is chasing much less capital, resulting in a falling labor share, and low interest rates.

It is a tautological position to suggest the Fed should change course because low growth will cause asset market bubbles and hyperinflation. However, with the long-run supply side costs of persistently low demand (hysteresis) it might just be self-fulfilling. Let’s hope it doesn’t get there.

A fantastic new paper from Dave Reifschneider, William L. Wascher, David Wilcox – all economists at the Federal Reserve – tries to put some numbers on something economists have been worried about for a while: hysteresis, or the gradual contraction of labor supply due to deficient demand. (John Cassidy has a good rundown). The upshot is that hysteresis over the past five years may halve growth potential. This is (or at least should be) the most urgent, if not important, issue for policymakers.

The standard story will tell you this is, keeping structural constraints constant, an irreversible trend. As price level increases with a higher aggregate demand, the cost of production rises contracting aggregate supply. This is almost certainly a fairy tale. Consider why workers exit the labor force. After a point, the monetary and psychological cost of searching for a job exceeds the expected benefit –  ∫(chance of being hired at a given wage rate * wage rate) over all wage differentials. Assuming the costs remain constant, the best way to expand the labor force is to increase the opportunity cost of remaining outside: that is either increase the chance of being hired or the nominal wage rate.

A naive analysis would suggest monetary policy can’t do much in the way of the former, and that the nominal above should be replaced with real. (To some extent, this would be correct, the best thing we can do right now is offer reemployment credits and a payroll tax holiday). Indeed, the opportunity cost of a certain wage rate shouldn’t really be measured in the dollars I could earn, but the purchasing power thereof. However, those who exit the labor force have some form of support system: savings, welfare, and help from friends among others. It would not be unreasonable to assume that except for the most basic needs (catastrophic healthcare, charity, and certain welfare programs) none of this support is, unlike the wage rate, inflation protected. The nominal wage rate is the price level * real wage rate. By definition, increasing the real wage rate increases the cost of remaining out of the labor force. But clearly increasing the price level does as well.

There’s another, possibly deeper, reason: the money illusion (not the blog). People think in nominal terms. If you don’t believe this consider the fact that people across the world are simultaneously worried about both inflation and wage stagnation, even though my raise is your inflation. Increasing the nominal wage rate would give workers the perception that they are actually earning more in real terms. That’s all that matters as far as the decision to reenter the labor force goes. Anyone who believes in nominal wage rigidities for behavioral reasons (and, seriously, why wouldn’t you) should accept this as a natural extension of that irrationality.

And directly capitalizing on this, monetary policy can increase the chance that a given worker is hired. I touched on this earlier, but in brief downward wage rigidities are an important concern at all times, not just during a recession:

Firms that want to expand employment don’t have perfect information about the quality of potential workers. There’s the chance they may be way better than expected, in which case raising relevant wages to keep the worker is quite easy. But what if they’re not as productive as the firm wished? Heaps of empirical evidence shows that firms just don’t like cutting nominal wages. Inflation, then, is an insurance policy against imperfect information. Conversely, a firm that is downsizing because of changing (microeconomic) demand can choose to inflate away a workers’ wage rather than laying off employees en masse.  This is more relevant to the poor and casually employed where large-scale employers face more informational uncertainty.

These two effects – both derivative of higher inflation – are self-reinforcing. As the chance of being hired increases, the stock of free labor will fall increasing real wages further. As these together increase aggregate supply and aggregate demand at the same time, real wages will increase without a substantial increase in the price level (above that which is dictated by a expansionary central bank). This encourages more entry into the labor force, and the process fulfills itself until a wage-price spiral forces the central bank to increase interest rates. And farewell to the liquidity trap.

In the short run – and only in the short run – there is a risk of overshooting. That is, in the period where all savers adjust to a higher inflation rate, those who left the labor force for life cycle reasons may feel compelled to return as their savings are eroded. However this is, to a large extent, stemmed because most seniors at risk rely primarily on Social Security, which is inflation protected. More importantly  this – like anything else – requires a judgement call on behalf of policymakers about the composition of labor force exit – between retirees and discouraged workers. It would be smart to use the employment to working population rate, rather than U3 unemployment, as a key indicator of labor market health. 

This gets to the final point. If we’re going to stick to the current, state-contingent forward guidance, it makes little sense to consider the unemployment rate at all – doing so presumes knowledge of the natural rate of unemployment, which may have changed. Rather, the central bank should determine a rate of inflation with which it is comfortable – even something stupidly low like 2% – and focus. This doesn’t make monetary policy “easier” or “tighter” per se, only more accurate. For example, a concern some economists (see this interview with Barclay’s Michael Gapen) have with a lower unemployment threshold, signaling a longer period of low interest rates, is that if the natural rate of unemployment has increased, then the economy will overheat before the threshold is reached, forcing the Fed to increase interest rates and compromising its credibility:

That said, we emphasize that the benefit of this action is linked to the assumption that NAIRU is within the FOMC’s central tendency. Our own view is that NAIRU is higher, which would imply higher potential inflationary costs from lowering the unemployment threshold and a worse cost-benefit trade-off. San Francisco Fed President Williams has made similar arguments, saying that uncertainty around any NAIRU estimate is high and that policymakers may be better served by keeping the 6.5% threshold in place and conducting policy in a more discretionary manner once the threshold has been reached. Other center-leaning FOMC participants may also share this view and we read staff conclusions in this regard as providing justification for a lower unemployment rate threshold, but that view need not be binding on policymakers.

That’s curious, because it seems like they cite NAIRU either without realizing what it is and what it means, or without realizing that the Evans Rule has a clause for inflation and is constructed disjunctively. If the unemployment rate falls below the NAIRU, and inflation doesn’t pick up, THEN IT’S NOT THE NAIRU. If unemployment falls below the NAIRU, and inflation does pick up, the Fed has every right to increase the interest rate given the Evans Rule without compromising credibility.

If the Fed believes in any natural rate of unemployment – and, clearly, it does – the dual threshold of unemployment and inflation is completely tautological, as one implies the other. This presumes that the theory behind NAIRU holds. And if it doesn’t, having an unemployment threshold is completely useless because what the Fed really wants – for any given inflation rate – is maximum employment. 

Consider the uncertainty the unemployment threshold creates in financial markets. For one, it adds one more variable to be monitored whose interpretation by the central bank must be monitored. But there’s already so much talk that this threshold will be lowered that markets have no idea how to read the Fed’s reaction function. 

If the NAIRU is 0% and the Fed increases rates before we get there, then policy will be unnecessarily contractionary. If the NAIRU is 15% then by definition the Evans Rule will require an increase in rates until inflation falls to the target. All we know for certain is that inflation is well below target today, and so monetary policy is insufficiently aggressive. 

Just a short note this time. (Also see Scott Sumner on this.)

Excerpted from a recent St. Louis Fed Note:

Getting policymakers to agree on a specific rule of this form would seem relatively easy because GDP is well defined; there would be no debate about the variables as there would be with the Taylor rule. Moreover, the range of disagreement aboutgdpT also seems relatively small. The FOMC has already agreed on a 2 percent inflation objective, and there appears to be a consensus that potential output growth is probably in the range of 2.5 to 3.5 percent. The disagreement about nominal GDP target would be relatively narrow, in a range from about 4.5 percent to 5.5 percent.

So what prevents the Fed and other central banks from adopting nominal GDP targeting? Again, there are a number of reasons, but an important and sufficient reason is that nominal GDP targeting requires policymakers to be indifferent about the composition of nominal GDP growth between inflation and the growth of real output, and, in general, they are not. For example, let’s assume the target is 5 percent and nominal GDP is growing at 6 percent. Would policymakers react the same if the composition was 1 percent inflation and 5 percent real growth, or 5 percent inflation and 1 percent real growth? It seems unlikely. In addition, nominal GDP targeting suffers from the other considerations that prevent policymakers from adopting policy rules. For example, policymakers’ response to the alternative situations would depend on current labor and financial market conditions and activity; the composition of GDP, especially between consumption and investment; global economic conditions; and so on. In short, adopting a nominal GDP target is unlikely for many of the same reasons policymakers are unlikely to adopt a traditional Taylor rule—or indeed, any specific policy rule. The economy is too complex to be summarized by a single rule. Economies are constantly changing in ways difficult to explain after the fact and nearly impossible to predict. Consequently, policymakers seem destined to rely on discretion rather than rules.

 

Most of the piece is a good discussion of “rules vs. discretion” in monetary policy. That’s something I’m not going to get into right now. I was, however, a little surprised to see economists at the Fed mistake nominal income targeting for an indifference between inflation and growth of real output.

This is rather absurd claim because the (well argued, if disagreeable) thesis of the article is that changing dynamics of the economy undermines the efficacy of rules relative to discretion. But for policymakers to be indifferent between inflation and real output under a nominal income target, the economy must be perfectly static. An economist is indifferent between the two if and only if he believes that the rate of inflation will be constant, and the rate of real growth will be constant. In effect, he must ignore completely the possibility of severe demand shocks. But the possibility of severe demand shocks was the whole point said policymakers opted for discretion over rules. Being indifferent between inflation and output at a given point in time is completely different from being indifferent between inflation and output.

In reality, inflation changes relative to real growth all the time. The whole idea behind a nominal income target is its flexibility to these changing conditions allowing policymakers the ability to have different preferences for inflation and output given different economic dynamics. More importantly, individuals are – at some point – always indifferent between two quantities, given a certain level of each.

Ultimately, nominal GDP targeting is prone to structural changes. Lucky for the Fed, it’s their job to deal with aggregate demand.