One of the biggest reasons I don’t find much merit in the idea of NGDP targeting is that it’s not clear to me that changes in real GDP (RGDP) always follow changes in nominal GDP (NGDP). Likewise, I’m convinced that downward shocks to RGDP lead to downward shocks in the money supply, as opposed to vice versa. While I advocate a counter-cyclically elastic money supply, I don’t think that monetary stimulus can help avoid the correction of the real economy that results from fiduciary over-expansion. Scott Sumner’s recent post on what he would expect had the Federal Reserve begun targeting NGDP by mid-2008 only deepens my suspicions.
Sumner thinks that had the Fed been targeting NGDP in mid-2008, the financial crisis wouldn’t have happened. I find this claim very unconvincing. If we are to believe Gary Gorton, the financial crisis was mainly caused by a breakdown in wholesale credit channels, because the bulk of the collateral being used in these markets had become information sensitive. What this means is that the collateral began losing value, or trading below par, forcing investment banks, and other wholesale debtors, to increase the amount of collateral to maintain the same level of short-term borrowing. For Sumner to be right, NGDP targeting would have to, somehow, maintain the value of the collateral. The main asset acting as collateral, at the time, was the mortgage backed security (MBS), and related assets (i.e. the collateralized debt obligation [CDO]). The value of these assets were dependent on the nominal demand for housing.
Could NGDP targeting have maintained the demand for housing? The answer, in my opinion unambiguously, is ‘no.’ MBS’ are financial assets composed of mortgage debt, where the pooling of loans allows asset holders to spread the risk of loans with higher probabilities of default. Prior to the financial crisis, MBS’ were considered to be some of the safest, or relatively information insensitive, assets. Their safety, however, relied on the expectation that the default rate, on average, would be below a certain percentage. The default rate is a factor of various variables, such as homeowner income, the cost of the home, et cetera. But, during the boom, continuously rising prices effectively decreased the real cost of debt, since homeowners who couldn’t afford their mortgage could simply re-sell the house for a higher price than they bought it for — they would earn a profit! The rise in the home prices, in turn, was fed by continuous loan origination, but by 2005–06 loan originators were running out of people to loan money to.
There’s only so much room to lower lending standards. Thus, by 2005, the pace of loan origination starting to fall, and with it home prices began to plateau, then stagnate, and finally gradually fall. As home prices fell, the default rate increased. While it took roughly two years for it be obvious, the securitized assets based on these loans were also losing value — that is, the supply of safe assets shifted to the left (supply decreased). Financial firms which relied on MBS’ and CDO’s as collateral for short-term borrowing quickly saw the assets side of their balance sheet deteriorating, and this is what caused the financial crisis of 2007–09. There was a bank run. It didn’t look like a bank run, because it wasn’t ordinary depositors who were worried about banks making good of their deposit liabilities. Rather, it was wholesale depositors worried about being repaid, because it suddenly became obvious that banks simply didn’t have the assets to sell to access the liquidity to repay their debts.
The point is, for the financial crisis to have been avoided, it would have been necessary for the Fed to continue the housing boom. We normally think of Fed policy affecting asset prices more directly, but in this case the boom in asset prices was directly linked to the boom in home prices. Given the lack of a sufficient volume of new mortgage debtors, I don’t think it was possible to maintain the housing boom (not to mention it would have been undesirable).
We would have still seen the significant fall in real incomes (because of falling home prices and large household debt), and we would have still suffered from a dramatic fall in output. Wholesale credit markets would have still dried up, and banks’ would still be forced to deleverage. But, I agree with Sumner that the recession would probably have been milder had the Fed better accommodated the rise in the demand for money. This being said, I’m also sympathetic to a certain aspect of the Post Keynesian endogenous theory of money — well, actually, this is an aspect of mainstream banking theory, too (even if Post Keynesians think they’re the only ones who acknowledge it). The Fed can only accommodate the demand for money indirectly, by inducing banks to make loans. If the banking system is damaged and credit channels are dried up, then this channel becomes less effective. The same is true if uncertainty makes borrowing too costly, which is Richard Koo‘s major argument against monetary policy.
Historically (see Gorton’s Misunderstanding Financial Crises), to avoid the problem of moribund banks, there has been some process of balance sheet strengthening. For example, prior to the Federal Reserve, clearinghouses would pool member banks’ assets and issue their own currencies, almost as a temporary bailout. Following the financial crisis, the Federal Reserve bought large quantities of MBS’, but I’m not sure how effective this tactic actually was. It seemed to have a greater impact only years after the brunt of the damage had already happened.
Thus, my main concern with NGDP targeting is that the theory papers over concerns of resource misallocation. Typically, when we think of misallocation we think of too large of a housing sector, or too many construction workers, but there was also a massive misallocation of financial capital. Even if the Fed were targeting NGDP, the likelihood that the assets people had invested in at the time were going to see a large drop in value would be enough to cause a shock to RGDP, and therefore a shock to NGDP. It was out of the Fed’s control. I do think that accommodating the rise in demand for money would have eased the transition, but I don’t think this is a panacea. Also, I think there’s merit in the broad “regime uncertainty” story. I don’t believe our government suddenly became more interventionist than it was before, but I’m of the opinion that a lot of the transaction costs that make structural adjustments more difficult went, in a sense, unseen during the boom — fiduciary overexpansion made transaction costs less expensive. This is one reason why I find the “evidence” against fiscal austerity superficial and unconvincing. NGDP targeting is only a little bit less unconvincing than the case for fiscal stimulus. I prefer a Hayekian, microfounded explanation of the business cycle.