Monday, October 24, 2011

Can Knut Wicksell Beat Up Chuck Norris?

Nick Rowe argues that NGDP targeting is a way of dealing with coordination failure. Businesses don’t want to hire if nobody’s buying, and households don’t want to buy if nobody’s hiring. So they’re all hoarding money instead. The way to fix it is that you have Chuck Norris threaten to beat up anyone who hoards money. Then businesses start hiring and households start buying (or else they both buy riskier assets, and the people who sold those assets do the hiring and buying, because they also don’t want to be beat up for hoarding the proceeds).

In the simplest version of the argument, beating people up is a metaphor for inflation. But if you don’t believe the Fed can produce more inflation (as many economists believe that the Bank of Japan has tried and failed to produce a positive inflation rate over the past 20 years), you can take beating people up as a metaphor for reducing asset returns. Even if the Fed can’t produce inflation, it can bid down the returns on a lot of assets until people get fed up and start buying riskier assets that can finance new expenditures. Some people don’t even think the Fed can do that, because maybe people have such a strong need for safety that they will only hoard more cash if other safe asset returns go down. I’m not 100% sure myself, but, for the sake of argument, I’m going to assume that the Fed can, if it is aggressive enough in buying safe assets, convince people to buy enough risky assets to get the economy going again.

Nick’s point, though, is that the Fed can do this without actually reducing the return on safe asests (and presumably without producing a lot of inflation either). Chuck Norris can clear a room without actually beating anyone up. The threat is enough. Similarly, in Nick’s view, the Fed can fix a coordination failure by threatening to reduce the return on safe assets, but it won’t have to carry out that threat if it’s credible. In fact, asset returns will go up, because the improved economy will make businesses more profitable, thus raising the return on risky assets and inducing people to abandon safe assets even if the yields go up. Paradoxically, by credibly threatening to push asset returns down, the Fed succeeds in pushing them up.

OK, fine. I’ll note that Ben Bernanke is no Chuck Norris, but perhaps President Romney will replace him with Chuck Norris, or with the antimatter counterpart of Paul Volcker (who was the Chuck Norris of inflation fighting). I’ll also note that Chairman Norris will enter with a considerable handicap, given that many are uncertain about the Fed’s ability to succeed in convincing people to abandon safe assets. If the threat were credible and everyone knew it to be credible, then everyone would know that stock prices are going up and they really ought to sell their bonds as quickly as they can, and we’d immediately be on the path to the good equilibrium. But even with Chuck Norris as Fed Chairman, a lot of people are going to think, “What if the Fed fails? At least cash is safe.” The threat alone quite possibly won’t be enough: Chuck Norris may well have to beat up a bunch of people – QE, Walker style – before the room clears.

But OK, I’m not opposed to violence, when it’s the only way to get something done. Only here’s my concern: how do we know that coordination failure is the real problem?

Flash back to 2006. There was no coordination failure then. Firms were hiring. Households were buying. Commerce was functioning smoothly. Very smoothly, too, in the sense that the economy was neither overheating (no rising inflation, no labor shortage) nor driving interest rates abnormally high. (The 10-year TIPS yield ranged from 1.95% to 2.68% in 2006, consistently below the perceived long-run real growth rate of the US economy.)

Yet that smoothness was based on being completely out of touch with reality – or at least out of touch with what most people today regard the reality to have been. By most accounts, housing prices were inflated, making people feel wealthier than they really were, and lots of seemingly safe assets were available, which, as it turned out, were not at all safe. Even with interest rates relatively low, this deception was apparently necessary in order to get households to buy and firms to hire in sufficient quantities to achieve full employment. Since the deception is no longer feasible, interest rates will presumably have to be a lot lower – even if we rule out coordination failure – in order to induce enough buying and enough hiring today to achieve full employment.

But how much lower? We can’t say exactly. Today 10-year TIPS are yielding close to zero. Is that low enough, if it weren’t for coordination failure? Maybe. Maybe not. Your guess is as good as mine. I can certainly imagine that could we fix the coordination failure (if there is one) and still end up producing well below our capacity.

That’s where Knut Wicksell comes in. Wicksell was the early 20th century economist who argued that prices would tend to go up or down depending on whether the interest rate was below or above its “natural” level (which varied over time). Modern interpretations allow for sticky prices and wages, so instead of falling prices, you get unemployment when the interest rate is too high. As I suggested in a post last year, and in the paragraph above, the “natural interest rate” could be negative, in which case a higher inflation rate is the only way to achieve full employment.

For practical purposes I advocate the same policy that Nick does – nominal GDP targeting – but I’m a bit less optimistic about how quickly and smoothly we could approach the target. And, given a choice, I’d probably favor a more aggressive target than Nick would. One of the implications of the Wicksellian analysis (which is not so clear if you think coordination failure is the only problem) is that more aggressive targets are easier to hit, because they imply higher inflation rates and therefore a lower floor on the real interest rate.

The important thing is to set a target path and stick to it even if you keep missing the first few targets by larger and larger margins. If the natural interest rate is negative, the early targets may be impossible to hit, but if you continue trying to hit the subsequent targets, those targets will imply higher inflation rates. Suppose your target path rises by 5% per year. A 10% increase in NGDP over two years may not imply enough inflation to get the real interest rate down to its natural level, but if NGDP doesn’t rise at all in those two years, the target path will now imply 20% NGDP growth over the subsequent two year period. That would require a lot of inflation – certainly enough to be consistent with a very negative natural real interest rate. Chuck Norris may take his hits in the first few years, but Knut is eventually going down.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.


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