July 08, 2013
Inflation and Debt
From Debt and Incomplete Financial Markets: A Case for Nominal GDP Targeting, by Kevin Sheedy (LSE), presented at the NBER Summer Institute:
This paper has shown how a monetary policy of nominal GDP targeting facilitates efficient risk sharing in incomplete financial markets where contracts are denominated in terms of money....
...In an environment where risk derives from uncertainty about future real GDP, strict inflation targeting would lead to a very uneven distribution of risk, with leveraged borrowers' consumption highly exposed to any unexpected change in their incomes when monetary policy prevents any adjustment of the real value of their liabilities. This concentration of risk implies that volumes of credit, long term real interest rates, and asset prices would be excessively volatile. Strict inflation targeting does provide savers with a risk-free real return, but fundamentally, the economy lacks any technology that delivers risk-free real returns, so the safety of savers' portfolios is simply the flip-side of borrowers' leverage and high levels of risk. Absent any changes in the physical investment technology available to the economy, aggregate risk cannot be annihilated, only redistributed.
That leaves the question of whether the distribution of risk is efficient. The combination of incomplete markets and strict inflation targeting implies a particularly inefficient distribution of risk when individuals are risk averse. If complete financial markets were available, borrowers would issue state-contingent debt where the contractual repayment is lower in a recession and higher in a boom. These securities would resemble equity shares in GDP, and they would have the effect of reducing the leverage of borrowers and hence distributing risk more evenly. In the absence of such financial markets, in particular because of the inability of households to sell such securities, a monetary policy of nominal GDP targeting can effectively complete the market even when only non-contingent nominal debt is available. Nominal GDP targeting operates by stabilizing the debt to-GDP ratio. With financial contracts specifying liabilities fixed in terms of money, a policy that stabilizes the monetary value of real incomes ensures that borrowers are not forced to bear too much of the aggregate risk, converting nominal debt into real equity.
Posted by Menzie Chinn at July 8, 2013 10:22 PMdigg this | reddit
(Note: there are some weird typos in the material quoted above, like it transferred badly from the source.)
I'm of mixed minds about this paper. I agree with the general thrust, that credible overall policy structure helps "complete" the risk structure of financial markets, but I think the idea has a bunch of limitations and risks, to be blunt, causing the same kind of meltdown we recently experienced.
What was the "great moderation" if not a period in which events came together with the assistance of government to create a mood that this, whatever this is, will continue. That helped "complete" the risk structure of the financial markets, but of course that proved illusory. Rather than just say a weird tail event happened, I prefer to say the system itself careened off course over time in the shared mistaken belief that its course was correct. That drifting over time only becomes visible when it reveals a tail event - kind of like putting your feet up and taking a nap on your boat and waking up only when you realize that sound is waves breaking on nearby rocks.
The essential problem is in the word "complete". The paper uses it and "incomplete" over 100 times. That word has a real meaning, one I'm sure you know, which traces to Godelian incompleteness and our inability to describe systems "completely".
So yeah, the proposed method would add some "completeness" but it wouldn't be actual "completeness" because that system contains systems that change and is contained in systems that change. The risk I see is the method could create the kind of complacency which lets markets drift immune for a while from the power of the larger including contexts (and those changes arising from within). The cost of that has proven to be immense and long-lasting.
Posted by: jonathan at July 10, 2013 09:29 AM
There is no need to target nominal GDP.
All that is necessary is a change in the definition of GDP, like the Bureau of Economic Analysis will do in 2014.
After they reclassify certain expenses as assets, GDP will automatically grow 3% in 2014, with no change at all in economic activity.
Growth by Declaration.
"It is so because we say it is so."
Economists, politicians, and pundits will then announce our economy is growing at a rate of 3%.
But America will know based on what they see in their neighborhoods and what they hear about business growth from those they know that this is not true.
Those who claim to have their stethoscopes on the heartbeat of the economy will look even more clueless.
Posted by: K Smith at July 11, 2013 08:53 AM
jonathan: Thanks for flagging typos; fixed (I hope) now.
Posted by: Menzie Chinn at July 11, 2013 12:41 PM
jonathan writes "What was the "great moderation" if not a period in which events came together with the assistance of government to create a mood that this"
if you review FOMC notes from the greenspan era, going all the way back to the eighties, the FOMC strongly considered nominal income targeting after its experiment with monetary base targeting.
M targeting did not work well because the velocity turned out to be too unstable. The problem with "income targeting" was politics.
Some would argue (myself included) what the FOMC (Greenspan) was doing was a defacto form of nominal income targeting.
There are also results (there is a late 90s Orphanides paper) that shows somewhat of an equivalence between a nominal income target and a Taylor-rule reaction function that includes inflation and output (or, unemployment), with equal weights on inf and output.
So in some sense, many would argue that the great moderation was in large part due to the fact that the fed was (pseudo) nominal income targeting.
Along comes Bernanke who favors inflation targeting. Review the meeting minutes Sept 2008 when the fed funds rate was 2% and Lehman was defaulting. They saw the signs of recession, business weakness, but put more weight on inflation. three weeks or so later they were cutting cutting cutting rates to zero. three weeks!
Credit worthiness models are geared off nominal income and debt to income (I work at a bank).
I have not read the whole paper but IMHO this is spot on. The mortgage crisis was made far worse because the Fed destroyed the ability for too many borrowers to repay (which they do, out of nominal income) with bad inflation-targeting policy.
Posted by: dwb at July 11, 2013 01:35 PM
Let's be honest - the drive to targeting nominal GDP is mainly a trick to justify the continuation of easy monetary policy that benefits the holders of risky assets and debtors (if not, why do its advocates not suggest a conservative target like 4% starting from the present level of NGDP?). Such arguments in favour of NGDP targeting should therefore be viewed sceptically. The terms of a debt contract are negotiated freely by both lender and borrower, and any risk borne by the borrower can be expected to be reflected in the price. Much of the risk borne by entrepreneurs will be associated with general economic conditions anyway, and if entrepreneurs wanted to offload such risk they could fund themselves with equity instead of debt. So, if NGDP targeting went ahead, it would be reasonable to expect debt interest rates to rise to reflect this risk shift. Somehow I suspect that that is not what the advocates of NGDP targeting have in mind!
Posted by: RebelEconomist at July 13, 2013 02:13 PM
I have been waiting for something to be posted here that gave any substance to the article. One of the most glaring problems is that the foundation of the articla is based on a fallacy. The socialization of risk does not reduce risk but increases it.
Those who engage in risky behavior do not reduce this behavior if the consequences of their actions are spread to others not experiencing loses. They are encouraged to take greater risks. The whole Progressive theory that spreading risk simply perpetuates the problems with risk and increases them. Risk without failure is disaster.
Posted by: Ricardo at July 15, 2013 05:13 AM
There is strong evidence that Greenspan was actually targeting gold to determine the money supply up until the mid-1990s. Graphs showing the stability of the price of gold during this time seem to support the contention.
In the mid-1990s Greenspan stopped tarketing gold when it signaled deflation. He thought he knew more than the market so he went to a "Greenspan" standard, a seat-of-the-pants standard. But 2000 the price of gold had fallen to about half of what it was in 1987, most after 1995. That was a huge deflation and set the stage for the Clinton recession of 2000-2001.
Posted by: Ricardo at July 15, 2013 05:31 AM
There is no evidence to support the claim that Greenspan was targeting gold and the recession started in March 2001, which makes it the Bush recession.
Posted by: joe at July 15, 2013 01:25 PM
sigh, I see RebelEconomist is still rehashing the easy money arguments.
No, Joe, Greenspan was not targeting gold.
Posted by: dwb at July 20, 2013 04:29 AM