NGDP Level Targets; Incentives and Feedback
As I said awhile back, I think The Fed Did It.
Think of a zillion spreadsheets carrying business plans and personal plans forward a few years, each projecting current trends. Aggregate cash flow -- that's "Nominal GDP". NGDP. Money. Some of those spreadsheets, some of those plans, will fail and others do better than expected, but generally the aggregate cash flow rises each year as population goes up, as productivity goes up, and as inflation goes on. If it falls or rises a little away from the expected trend implicit in all those individual plans, we adapt. If it falls sharply below trend, then cash isn't going around as expected and plans start failing simply because cash isn't going around: businesses fail and it's not their fault. Things are broken. We have a recession, a bad one. In fact, people act by plans and promises, betting on their projections, so we get a recession as soon as the expected NGDP growth fails so that people stop buying and employers stop hiring.That's my version of the Scott Sumner explanation of the recession. So...
I'm looking at the monetary policy argument between Sumner, DeLong, and now Woolsey, pointing out at least one DeLong error, which DeLong summarizes at DeLong Smackdown Watch: Nominal GDP Targeting Via Index Futures - Grasping Reality with a Shiny Red Nose: Merry Christmas, Everyone!
Right now, in December 2010, we want to give people an incentive to take actions that expand the money supply if they think that nominal GDP at the end of 2011 is likely to be lower than $17.5 trillion and to contract the money supply if they think that nominal GDP at the end of 2011 is likely to be higher than $17.5 trillion.... Touche...I think....
I think I follow most of it, perhaps all of it -- well, not all of it, but I'm not sure that my confusion is a result of not following. I'm still confused about incentives and feedback in the proposed market.
Woolsey's idea, which Sumner defers to, is that the Fed would offer dollar contracts, in effect loans at an interest rate depending on future NGDP; these would be hedged, in fact Woolsey says that
the Fed's goal should be to remain fully hedged. The market expection should be that NGDP remain on target. The long positions of the bulls should be exactly offset by the short positions of the bears. If the market expectation is that NGDP will be above target, then the purchases of the bulls will be greater than the sales of the bears...and the Fed can use this as a guide to bring NGDP growth back on target.
In other words, the Fed will say "we will define the NGDP growth path, and if you bet against us expecting us to fail then we will use that as a guide to get back on track and thus make sure that you don't make any money." This strikes me as an inadequate incentive. If the bulls/bears bet, then they will provide the feedback by which they don't make money; if they don't bet, there will be no feedback and they could make money by betting. Bulls and bears alike are being asked to make self-negating prophecies. My thoughts turn to Curry's Y combinator and the standard "paradox",
Y not = not(Y not)but that's probably just me.
I really don't see how this will work; if I'm right (unlikely), then we do need a secondary market to provide the guidance, a "derivatives" market of a sort, a prediction market: we need to let people bet instead on their self-fulfilling prophecies of how much expansion/contraction the Fed will have applied, on net, in their efforts to get to the NGDP target level. My preference is still, as I've said, to use some version of the Wilshire Index, to have the Fed use some version of a daily-rebalancing stock/bonds/money portfolio as a primary tool of monetary policy, to help with what DeLong calls "a Minskyite downturn--a flight to quality because of a collapse in the market's risk tolerance and a shortage of safe assets." The bears can make money if the Fed has to raise its stocks+bonds percentages in trying to reach the desired NGDP, and the bulls can make money if it has to lower them; if bears outweigh bulls or vice-versa, then that portfolio percentage will adjust. (It may adjust anyway if the Fed board actually believes they won't otherwise make target; unlike Sumner and Woolsey, I'm not really confident of an autopilot solution. But of course autopilot would be better if we could be sure it would work.)
Or then again, maybe not.