The fallacy of nominal GDP targeting

The road to economic hell is paved with easy money

by DETLEV SCHLICHTER

In a truly remarkable piece for the Financial Times yesterday, Wolfgang Münchau took another swipe at the Euro-sceptic and ECB-critical community in Germany, which he accuses of inflation-paranoia and of simply not getting ‘modern central banking’. Well, I know of many qualified commentators – many non-German – who swallow a tad harder when reflecting on the new reality of unlimited and open-ended QE in the US and unlimited bond buying by the ECB. As the central bank bureaucrats declare that they will not stop printing base money until the economy grows faster and the unemployment rate drops, damn it, some of us may be excused for wondering what the long-term and unintended consequences of this might be. But, according to Münchau, we are entirely mistaken as we have evidently been “fed misinformation about the functioning of a modern economy.”

Unlimited QE is, according to Münchau, the result of new theories of how central banking works. You see, with open-ended QE the Fed “has become much more determined in guiding future expectations,” which is supposedly what the economy needs: bureaucrats who centrally and administratively guide expectations. Strangely, though, this does not sound all that modern to me.

There is no denying that, of late, things have not been going according to plan but this is no reason for Münchau to question the role of central banks in this crisis, let alone the very concept of monetary central planning, of the idea that some ‘wise men and women’ in Frankfurt, Washington or London, fix the supply of base money and certain prices (interest rates) in order to control, guide and manage overall economic performance. Like many of his FT colleagues, Münchau is in awe of the power elite that supposedly runs our economies and our societies to our benefit. Difficult times only seem to require more determined politicians and more determined central bankers. And when central planning fails, the central planners simply need a new plan. Or a new target.

Not surprisingly, Münchau is an advocate of nominal GDP targeting, the new fad in monetary central planning. There is allegedly nothing wrong with monetary policy. The central bankers only need a new target, and, naturally, a more comprehensive one. The trained mathematician Münchau lectures us how this works:

“This is a debate about nominal income targeting, where a central bank no longer stabilises the inflation rate directly but focuses instead on stabilising nominal gross domestic product. You can think of nominal GDP as the sum of real GDP and inflation. If real growth falls, the central bank would thus have to drive up inflation. Conversely, if real growth rises, the central bank would have to bear down on inflation much harder than it would do under the pure inflation targeting regime used by central banks such as the ECB.”

There is a dangerous naivete about all of this, a blindness toward real-life complexity. There is also a kind of narrow-mindedness, of which Münchau accuses the central bank critics, but of which he himself is the prime example. Münchau and other advocates of GDP-targeting are consistent macro-economists, which means they necessarily ignore many important micro-economic phenomena.

Here is the prime fallacy behind the nominal GDP target and, in fact, all of Münchaus’ argument: It tacitly assumes that money is neutral, which money never is. Let me explain.

The idea that central banks should target nominal GDP presupposes firstly, that stability in nominal GDP is in fact desirable and possible, and that we can ascertain what the ‘right’ level of nominal GDP should be, and what the appropriate relationship between inflation and real GDP is. Such stability rarely exists in human affairs and in particular in economic phenomena, and such a static and non-dynamic view of the economy strikes me as rather – well, not modern. Secondly, and even more importantly, it presupposes that there are direct and stable links between the quantities that the central bank does indeed control directly – that is the monetary base, bank reserves, and certain interest rates – and the macro-economic variables, growth and inflation, which are the ultimate target of its policies. This relationship – between base money and inflation and growth – is, however, very complex and far from stable, and many things can and must happen on the way from changing one to changing the other. And not all of these things are pretty.

Let us assume the central bank fears that real GDP is running too low and that the central bank now has to, according to Münchau, ‘drive up inflation’. How does the central bank do it? – The answer is, it does what it always does, just more of it. The central bank buys certain financial assets from the banks and credits the banks’ accounts at the central bank with newly created bank reserves. Thus, the banks have more – and, we can assume, cheaper – reserves than before, which means they now have an incentive to lend more money. Loan rates on credit markets should drop as more credit gets extended. Investment projects that were previously shunned due to relatively high costs of funding are now profitable. New lending and new borrowing occurs. This may indeed lift real GDP – although only temporarily – and ultimately lift the average of prices, the price level, an effect that, in contrast to the GDP boost, is usually permanent. However, it is clear that many other things must have changed as well as a consequence of what the central bank just did: certain financial assets will have gone up in price and down in yield; bank balance sheets will have expanded; financial leverage will have increased; capital has been reallocated; the relationship between voluntary saving and investment in the economy has been altered; relative prices have changed; income and wealth distribution have changed. It takes either incredible naivete to assume that all these changes are so benign that we can safely ignore them, or childlike optimism in the wisdom and farsightedness of central bankers to assume that all these effects can be anticipated and incorporated in the design of these policies.

The macroeconomic fallacy is to believe that an expansion of the money supply has two effects and two effects only: it lifts growth (good) and it lifts inflation (sometimes good, sometimes bad, sometimes unimportant). That this is too narrow a view, we know since Richard Cantillon invented modern economics. Cantillon lived 300 years ago, so Münchau may object that he did not understand the ‘modern economy’, and besides, Cantillon did not obtain a PhD from MIT, as did Bernanke and Draghi, Münchau’s heros. But in Cantillon’s defense we may say that he experienced first-hand – and indeed actively participated in – one of the most remarkable experiments with paper money in all of history. I am talking about the famous John Law scheme in France from 1716 to 1720. Cantillon knew Law and invested in his paper money scheme. In fact, Cantillon achieved what most modern hedge fund managers dream about. He rode the bubble – the famous Mississippi bubble – to its peak and took his profits before the bubble collapsed. In contrast to Law who ended impoverished and had to flee France, Cantillon retired a wealthy man and recorded his astute observations about the effects of monetary expansion. One of his most notable discoveries was the fundamental non-neutrality of money. As Cantillon stated, when new money is injected into the economy, it does not raise all prices simultaneously and to the same degree but some faster than others, and some more than others.

This is important and has far-reaching consequences. ‘Easy money’ does not just directly affect growth and inflation, or any desired combination of the two. It does not just affect the statistical average of prices, the price level, or the statistical aggregate of economic transactions, real GDP, or any other statistical macro-variable. ‘Easy money’ always means changes in relative prices, changes in resource allocation, and changes in income and wealth distribution. In particular, ‘easy money’ lowers interest rates, which are crucial in a market economy for coordinating investment activity with the public’s time preference, i.e. the public’s propensity to save and thereby support and sustain the capital stock. Monetary expansion means distorted interest rate signals and thus necessarily capital misallocation. This fundamental insight is the basis of all monetary theories of the business cycle, that is, of the insight that monetary expansion leads to booms that must be followed by busts. Every monetary expansion creates distortions, the liquidation of which cause the next recession. Every monetary expansion creates economic instability. This was already the basis of the business cycle theories of the British Classical economists of the Currency School in the 19^th century, but more importantly, it was the basis of the so far most convincing business cycle theory, the one developed byLudwig von Mises in 1912 and 1924, a theory that is now widely known as the Austrian Theory of the Business Cycle.

This theory explains why modern fiat money central banks can never be a source of ‘stability’, whether that means the stability of the inflation rate or the stability of nominal GDP. Central banking, whether old fashioned or modern, is always a source of instability. This theory also explains why modern central banking has now maneuvered us into a veritable economic cul de sac. Repeated attempts over the past decades to buy near-term economic growth at the price of persistent marginal debasement of money has now left us with such a distorted and over-indebted economy that any further monetary expansion has to be ever more scarily aggressive to even cut through the thicket of accumulated imbalances and have any effect on inflation and GDP, whether real or nominal. This policy will ultimately end in hyperinflation when the public loses confidence in this charade.

I don’t know if those German ECB critics who get Münchau all riled up know anything about Cantillon or Mises. For all I know, they may suffer from the same macroeconomic tunnel-vision that afflicts Münchau. The difference is this: In the final assessment they are correct and Münchau is wrong. The road to economic hell is paved with easy money.

In the meantime, the debasement of paper money continues.