Loyal MR readers will know I’ve long had sympathy with ideas such as ngdp targeting, even though I think they require more rule-oriented behavior than our political system is able to supply.  It’s still worth pushing in that direction.

There is however one tendency in some of the writings on ngdp which I would frame differently, so I will lay this out in a little more detail. I”m not sure anyone has written anything which I consider literally wrong, but I get nervous at what seem — to me — to be the implications.

Here is one example from Bill Woolsey:

The typical Market Monetarist perspective is that nominal GDP has shifted to a 14 percent lower growth path.    For real output and employment to remain on its previous growth path, the price level and nominal wages need to also shift to 14 percent lower growth paths.   They haven’t.   Instead, they are only about 2 percent lower.

My worry is that some Market Monetarists speak of ngdp as if it is some block of stuff, handed down from on high (of course in the past our central banks have not been targeting ngdp).  It’s as if ngdp determines the size of the room, and a carpenter is then asked to build a house within that room.  If the room is too small, a large house cannot be built.  Or, if you are not given enough clay, you cannot build a very large sculpture.  Along these lines, if the growth path of ngdp is not robust enough, the economy cannot do well.

I get nervous at how ngdp lumps together real and nominal in one variable, and I get nervous at how the passive voice is applied to ngdp.

My framing is different.  My framing is that the private sector can manufacture its own ngdp.  It can do so by trade and it can do so by credit and of course velocity is endogenous to the available gains from trade.  Most of the major central banks are, today, not obsessed with snuffing out recovery and increases in real output.

To say “ngdp is low,” or “ngdp is on a low growth path,” or “ngdp is below trend,” and so on — be very careful!  Those claims do not necessarily have causal force.  Arguably they are simply repeating, in a new and somewhat different language, the point that the private sector has not seen fit to engage in more trade, credit creation, velocity acceleration, and so on.  Formally speaking, the claims are not wrong, but I don’t find them useful as an explanation for why economic growth or recovery, at some point in time, is slow.  It is one way of repeating or re-expressing the slowness of economic growth, albeit with some transforms applied to the vocabulary of variables.

This matters when we consider sticky nominal wages.  Sometimes it is suggested that the “inside workers” have frozen up or taken up so much ngdp with their sticky wage demands that the outsiders cannot find the ngdp to fuel their activities.  It’s as if there is not enough ngdp to go around, just as there was not enough clay to make a sufficiently large sculpture.  I would like to see this modeled (I will report back on any credible citation you offer me), but note in the meantime it is not how the most popular or most influential sticky wage models work.  Once you see the private sector as being able to manufacture its own ngdp, this argument does not seem to have enough force to prevent the outside laborers from exploiting available gains from trade.

The outside laborers are sometimes locked out, but that is when businesses simply do not wish to expand output.  Once businesses are wishing to expand output, the sticky wages of the insiders should not prove an insuperable obstacle to hiring the outsiders at lower wages.  The private sector can support this by manufacturing its own ngdp and if demand is low, well, the wages for the new workers will be lower too, as indeed is the case at Caterpillar and many other companies.

I also see that we have undergone some reflation — current ngdp is about ten percent above the pre-crash peak — so there ought to be enough clay, even if we accept that metaphor.  And the number of laborers in the work force is down.  Here are some related comments from Scott Sumner.

I do believe in the nominal stickiness of many wages, but only in the short run and only for some classes of workers.  Especially when the quality of jobs can and does change so readily, I don’t see the nominal stickiness of wages as lasting for more than a few years, at the most, at least not for the United States.  For legal and regulatory reasons, Western Europe is often a different story.

In any case, these are my worries about some of the current framings of ngdp.

Here is more from Eli Dourado, excerpt:

NGDP is almost 10 percent higher now than it was at the pre-crash peak. The number of people employed, even with population growth, is still below the pre-crash peak. Even assuming that insider nominal wages are totally inflexible, nominal output per worker has grown fast enough that insider real wages have probably adjusted. Furthermore, in five years, a non-trivial fraction of insiders retire or change jobs.

There is much more at the link.

From Angus:

The 10 treasury bond is yielding around 1.7% (none of what follows relies on the exact values of the numbers).

The 10 year TIPS yield is around  -.7%.  So a common calculation of inflation expectations, so called break-even inflation is at 2.4%.

From this information, I arrive at two important (at least to me) questions:

(1) Is this a reasonable measure of inflation expectations and (2) If so, what does it mean about the economy?

I question (1) because of concerns about the lack of liquidity in the TIPS market, the old issues of market segmentation, and just generally because equilibrium conditions in financial markets that aren’t enforced by pure arbitrage don’t actually seem to hold in the data.

I did a bit of research and found a couple Fed branch bank papers on the topic (see here and here).  Both papers conclude (if I am reading them correctly) that the break-even inflation calculation of inflation expectations probably understates expected inflation!

So that leads to question 2. If Inflation expectations are above 2.4%, but the 10 year treasury is yielding 1.7%, why are people holding 10 year treasuries? Because the equilibrium real interest rate on safe securities is negative, like around -1.0%? 4 years after the crisis, risk aversion is so high that people are willing to accept a negative return for in exchange for safety? So either the supply of safe assets is very small, or the demand for safe assets is overwhelmingly high?

If inflation expectations at the 10 year window are rising, but returns on 10 year treasuries are simultaneously falling, then the equilibrium real rate of interest on safe assets is getting lower and lower (in our case more and more negative).

Does this mean that 4 years after the crisis, people’s willingness to undertake risky investments is actually falling? If so, isn’t that a very bad sign for the direction of future economic activity?  The Baa seasoned bond yield is 4.9%. If inflation expectations are 3%, then the real return to capital is 1.9%?

Or does it mean somehow that the supply of safe assets is shrinking faster than the demand for safe assets is falling? Can we just blame Europe?

Or are we just making a big mistake in calculating inflation expectations?