Scott Sumner and Musical Chairs

Since 2009, Scott Sumner has been a big proponent of nominal GDP targeting. He sees nominal wages as slow to adjust and he has sketched a simple model, the musical chairs model, to explain why his policy should be adopted.

I am a new convert to these arguments. That is my loss. I had assumed, incorrectly, that Scott was proposing that central banks should simply adjust the coefficients on their interest rate policies, so called Taylor Rules, to raise the nominal interest rate when nominal GDP growth is above target and to lower it when nominal GDP growth is below target.I will refer to that variant of NGDP targeting, as growth rate targeting. An alternative, NGDP level targeting, would make these interest rate adjustments in response to deviations of nominal GDP from a target growth path. For an elaboration of that view, see, for example, the article by Evan Koenig, Vice President of the Dallas Fed.

Viewed in this light; NGDP targeting, of either variety,  is not a particularly new idea. Nor does it represent a departure from the body of New Keynesian economics that grew up in the decades since 1983, when Ed Prescott sought to banish money from macroeconomic models. Scott is saying much much more than that.

The  novel aspect of Scott’s proposal, and one that I endorse wholeheartedly, is the means that he advocates to achieve his goal. Scott proposes that central banks and/or national treasuries should set up markets for nominal GDP futures. Robert Shiller has made a similar suggestion. He proposes that national treasuries finance their borrowing by issuing securities that pay off a dividend that is proportional to nominal GDP. He calls these ‘Trills’; where a Trill is a claim to one trillionth of GDP in perpetuity.

In my own work, I have drawn attention to the remarkable stable connection between the real value of the stock market, and the unemployment rate. I interpret that connection through the lens of a causal theory in which expectations drive asset values, and asset values drive aggregate demand. I have suggested that central banks trade an exchange traded fund to stabilize real economic activity. Hold that thought as the word ‘real’ represents a significant point where Scott and I differ.

Trading Trills, trading GDP futures and trading an ETF, are all methods of targeting nominal wealth. I do not want to quibble over the exact method: and I readily concede that Trills or GDP futures have advantages over ETFs. The important insight here, is that wealth, or permanent income, drives aggregate demand and that expectations cause inefficient fluctuations in aggregate demand that can be stabilized through relatively straightforward interventions.

In the simplest macroeconomic models, GDP measured in wage units, is proportional to employment:

PY/W = bL

where P is ‘the’ price level, Y is real output, W is the money wage, L is employment and b is the inverse of labor’s share of income. Scott points out that money wages move slowly and that, as a  consequence, stabilizing PY will stabilize employment, and eventually, wages and prices. Scott bases his ideas on Samuelson’s neoclassical synthesis (see Pearce and Hoover). According to this idea, the economy is Keynesian in the short run, when prices and wages are sticky, and classical in the long-run.  

In Scott’s world, the economy homes in on the natural rate of unemployment just as surely as a heat-seeking missile converges to its target. Scott’s intellectual heritage is firmly monetarist. If Milton Friedman were alive today, one might imagine that Scott would find a supporter for his ideas.

My own heritage is different. I have sought to wed post-Keynesian insights with new-classical ideas by resuscitating the idea that the economy is not self-stabilizing. There are many equilibrium unemployment rates and any one of them may be an equilibrium. 

I wholeheartedly endorse Scott’s proposal for open market trades in GDP futures. And, like Robert Shiller, I would like to see the creation of a market for Trills. Unlike Scott, I do not endorse the proposal to stabilize either the level or the growth rate of nominal GDP. Trades in GDP futures should aim to stabilize the unemployment rate. And here is my biggest difference from Scott: trades in GDP futures should be seen as a complement to inflation targeting: not as a substitute.

As I explained in my 2013 book,  How the Economy Works, the economy is not a rocking horse, always returning to the same rest point, a metaphor that originates with Wicksell. It is a boat on the ocean with a broken rudder that requires active political interventions to steer it to a safe harbor.

Policy interventions have two dimensions: not one. Central banks should continue to set the overnight interest rate in an effort to target the inflation rate. They should adopt a second instrument, the purchase and sale of GDP futures, to target real economic activity. For more on this idea, stay tuned. I have forthcoming book in 2016  with Oxford Univesity Press with the working title: Prosperity for All. It will be available in mid 2016.