The recent surge in interest in Nominal GDP Targeting, as an alternative to money targeting or inflation targeting if the central bank is to commit to a nominal target of some sort, has prompted some pushback.   This is not surprising.  But one of the responses is most peculiar.  This is the allegation (1) that the surge comes from liberals opportunistically adopting an idea that was originally proposed by conservatives, and (2) that they will not stick with this “fad” in the longer run because it is only designed to fit current circumstances of high unemployment and low output.   Remarkably, every component of this argument is wrong.

 I have in mind, especially, the views of Benn Steil and Dinah Walker of the Council on Foreign Relations, as expressed in “Why  Nominal GDP Targeting is a Fad“:  
 ”NGDP targeting having once been the intellectual stomping ground of economists on the right (notably Scott Sumner), its newest supporters come overwhelmingly from the left (such as Christy Romer)…. We think the rage will be short-lived. The reason is that NGDP targeting’s newest supporters are bad-weather fans. That is, they like it now, when NGDP is well below its 2007 “trend” line, meaning that the policy implies extended and more aggressive monetary loosening. But what happens when NGDP goes above its target, as it eventually will? NGDP targeting then requires tightening….”

Let’s consider the analytics first, and hold off awhile on the less edifying political labels.   The nominal GDP proposal was originally studied and supported by many prominent economists in the 1980s.  The problem at the time was a need for monetary discipline, anchoring expectations, and reducing inflation.   Nominal income targeting was not designed as a way of getting easier monetary policy, but rather the opposite.   It is equally good for either purpose:  the target can be set high or low, depending on the times.

Originally, the leading competitor for the role of monetary anchor was money supply targeting (monetarism).  This was the regime that was adopted in the early 1980s by the central banks of the largest economies. But they were forced to abandon it subsequently.  Later on, the leading competitor became Inflation Targeting;  but it too ran into difficulties in the 2000s.   The general argument for nominal GDP throughout has been that it is robust to a variety of shocks, positive and negative.   It dominates money targeting in that it is robust with respect to velocity shocks.  It dominates inflation targeting in that it is robust to supply shocks. 

In other words, Nominal GDP Targeting is not a short-term expedient but is fit precisely for the long run.

It is true that a major reason why the nominal GDP proposal has been revived over the last two years is that it could help deliver easy monetary policy in the short run, which is what the economy has needed recently.  Some supporters may indeed view it as a short-term expedient, to be jettisoned when the economic recovery has become better established.   And I can see the attraction of the proposal that the Economist magazine has made for the UK: that the Bank of England commit to keeping interest rates low until nominal GDP has re-attained a level 10% higher than today’s level.  But I personally favor keeping it as the framework in the longer term, with loose nominal GDP targets set annually at a horizon of two years.  The width of the bands and the degree of commitment could be similar to whatever it would be under the alternative of inflation targeting.

The targeted nominal GDP growth rate would not be the same every year, let alone every decade.    If the US were to adopt the framework now, 4 ½ % would not be a bad number for the center of the target range.  (A lower number would be appropriate for some, like Japan, and a higher number for others, especially emerging market countries.)

Steil and Walker support their argument that the proposal is not fit for the long run with an attractive graph.  It shows that in many of the years since 1981 when the rate of growth of nominal GDP was above 4 ½ %, which they claim would imply monetary tightening under the proposed regime, unemployment was above 5 ½ %, prompting the Fed to loosen (wisely, in the authors’ view, if I understand them right).

The problem with this argument is that of those eight years when the Fed is shown loosening  in response to unemployment above 5 ½ % (by my count), seven of the years came during the first part of the sample: 1983, 1985, 1986, 1987, 1990, 1992, 1993.   (The only year from the more recent half of the sample is 2003.)  Why is this a problem for the argument?  In the 1980s and even the 1990s, it seems to me that nobody would have set a target so aggressive as to require monetary tightening when nominal GDP reached 4 ½ %.   Back then we were coming down from high levels of inertial inflation and this process was understood to be gradual.   Furthermore, the rate of growth of potential output was higher than today as well.   Thus the numbers chosen for the nominal GDP target would have been higher than today.  They would not have forced the Fed to tighten when unemployment was 7%.

Now to the political labels.  Recall that Steil-Walker claim that the nominal GDP proposal was originally put out by economists on the right and has recently been adopted opportunistically by economists on the left as a short-term fad.   But the originator of the nominal GDP proposal in the UK was Sir James Meade (1978, 1982), who (it turns out) was an “interventionist” and member of the Social Democratic Party.  The earliest proponent in the US was James Tobin (1980, 1983), also a Nobel Prize winner and also on the left.   (I am trying to avoid the confusing word “liberal” which in the US usually means on the left but in the UK continues usually to mean pro-free-market.) 

The recent revival of Nominal GDP Targeting came from a group of bloggers who describe themselves as conservatives (Scott Sumner, Lars Christensen and David Beckworth,)   Even those now proposing a one-time threshold for the level of nominal GDP are not noticeably  clustered on the left of the political spectrum.  The current British chancellor is, of course, a Conservative.   Perhaps what is confusing some observers is the reflexive, but wrong, assumption that Labor/Democrats always favor more expansionary policy than Conservatives/Republicans.

In other words, it would be more correct to say that the idea was a proposal of the left picked up by the right than the other way around, as Steil and Walker claim.   But there are plenty of nominal GDP proponents from each side of the political spectrum, currently as in there were in the 1980s, as well as many whose political views are not immediately apparent.  That is all to the good.   This proposal is neither liberal nor conservative.  Nor is it one that I, personally, will be abandoning as soon as the economy returns to full employment.   With money targeting and inflation targeting discredited, Nominal GDP Targeting is left.  Right?

[Notice to readers:  Starting today, my blogposts will also appear at On Deck, the blog space of Project Syndicate.   Some are elaborated versions of Project Syndicate op-eds.  Others, like this one, stand alone.]

        The world is waiting to see whether China has successfully achieved a soft landing, slowing down the economy from its overheated state of a year ago to a more sustainable rate of growth. Some China-watchers fear it could hit the ground in a crash landing as have other Asian dragons before it. But others, particularly American politicians in this presidential election year, talk only about one thing: the trade balance.
        Here the important message is that long-term forces of adjustment are at work in the Chinese economy.  Foreign perceptions need to be adjusted as well. It is true that not long ago the yuan was substantially undervalued and China’s trade surpluses were very large. But the situation is changing.
        China’s trade surplus peaked at $300 billion in 2008, and has been declining ever since. In fact it even reported a trade deficit in the month of February ($31 billion, its largest deficit since 1998). It is not hard to see what is going on. Ever since the Middle Kingdom rejoined the world economy three decades ago, its trading partners have been snapping up exports of manufacturing goods, because low Chinese wages made them super-competitive on world markets.  It was known as the unbeatable “China price.”  But in recent years, following the laws of economics, relative prices have adjusted to the demand.
        The change can be captured by real exchange rate appreciation. This comprises in part nominal appreciation of the yuan against the dollar, and in part Chinese inflation. Government officials would have been better advised to let more of the real appreciation take the form of nominal appreciation (dollars per RMB). But since they didn’t, it has shown up as inflation instead. (See charts below, which show both nominal and real appreciation, against the dollar or against an index.)
        The natural process was delayed. In the first place, as is well-known, the authorities intervened to keep the exchange virtually fixed against the dollar, in the years 1995-2005 and 2008-2010. In the second place, workers in China’s increasingly productive coastal factories were not paid their full value. The economy has not completed its transition from Mao to market, after all. As a result of these two delaying mechanisms, Chinese continued to undersell the world.
        But then two things happened. First, the yuan was finally allowed to appreciate against the dollar during 2005-08 and 2010-11, by 25% cumulatively [=17% + 8%]. Second, and more importantly, labor shortages began to appear and Chinese workers at last began to win rapid wage increases. Major cities raised their minimum wages sharply over each of the last three years [FT, Jan. 5]: 22% on average in 2010 and 2011 (somewhat less this year, in response to slowing demand: 8.6 % in Beijing, 13% in Shenzhen and Shanghai).  Meanwhile another cost of business, land prices, rose even more rapidly.
        As a result, whereas all signs still pointed to a substantially undervalued yuan as recently as four or five years ago, this is no longer the case. One important measure of undervaluation — a comparison of China’s prices with what is normal given the country’s level of income (the so-called Balassa-Samuelson relationship) – showed the renminbi as undervalued against the dollar by as much as 36% on 2000 data (Frankel, 2005) .  Even after an improvement in the international  price data, Balassa-Samuelson regressions estimated the undervaluation at roughly 30% in 2005  and 25% as recently as 2009.   (Others had other ways of estimating undervaluation; see Goldstein, 2004, and those surveyed by Cline and Williamson, 2008.)   
       The renminbi’s real appreciation against the dollar over the last three years has amounted to 12%, reducing the degree of undervaluation by roughly half, depending on whether one measures it against the dollar or against all countries.  More is to be expected, as Chinese relative wages continue to rise.  In any case, China’s real exchange rate is already closer to this measure of equilibrium than are most countries’ exchange rates (Cheung, Chinn and Fuji, 2010).

      In response to the new high level of costs in the factories of China’s coastal provinces, five types of adjustment are gradually taking place. First, some manufacturing is migrating inland, where wages and land prices are still relatively low. Second, some export operations are shifting to countries like Vietnam and Bangla Desh where wages are lower still. Third, Chinese companies are beginning to automate, substituting capital for labor. Fourth, they are moving into more sophisticated products, following the path blazed earlier by Japan, Korea, and other Asian countries in the “flying geese” formation. Fifth, multinational companies that had in the past moved some stages of their production process out of the US, or out of other high-wage countries, to China are now moving back (”reshoring”). Productivity is still higher in the US, after all. All five of these ways of reallocating resources represent the economic process operating as it should. A sixth seems still to lag behind, despite the consensus in favor of it: expansion of the services sector.
        None of this comes as news to most international observers of China. But many Western politicians (and, to be fair, their constituents) are unable to let go of the syllogism that seemed so unassailable just a decade ago: (1) The Chinese have joined the world economy; (2) their wages are $0.50 an hour; (3) there are a billion of them, and so (4) their exports will rise without limit: Chinese wages will never be bid up in line with the usual textbook laws of economics because the supply labor is infinitely elastic. But it turns out that the laws of economics do eventually apply after all — even in China.

       My next post will recall the precedent of Japan’s trade balance.

[A version of this post was published by Project Syndicate, which has the copyright.]

Chinese relative prices have risen as much (since 2009) via inflation as via RMB appreciation

(click her for larger image) 

References

     Chang, Gene Hsin, 2008, “Estimation of the Undervaluation of the Chinese Currency by a Non-linear Model,” Asia-Pacific Journal of Accounting & Economics Vol.15, No. 1, April, 29-40.

      Chang, Gene H. , 2012, “Theory and Refinement of the Enhanced-PPP Model for Estimation Equilibrium Exchange Rates — with Estimates for Valuations of Dollar, Yuan and Others”, SSRN abstract=1998477,  Feb. 2.

      Cheung, Yin-wong, Menzie Chinn and Eiji Fuji, 2010, “China’s Current Account and Exchange Rate,” in China’s Growing Role in World Trade, edited by Rob Feenstra and Shang-Jin Wei (University of Chicago Press, 2010).

     Cline, William, and John Williamson, 2008, ‘Estimates of the Equilibrium Exchange Rate of the Renminbi,” in Debating China’s Exchange Rate Policy, edited by M.Goldstein and N.Lardy (Peterson Institute for International Economics), 155-165.  

      Frankel, Jeffrey, 2005, “On the Renminbi,”  CESifo Forum, vol.6, no.3, Autumn (Ifo Institute for Economic Research, Munich): 16-21.

      Subramanian, Arvind, April 2010, “New PPP-Based Estimates of Renminbi Undervaluation and Policy Implications,” PB10-08, Peterson Institute for International Economics.

 
            The Fed has come in for a surprising amount of criticism since its decision in the fall of 2010 to launch a new round of monetary easing — Quantitative Easing 2.  Ben Bernanke and his colleagues are right not to give in to these attacks.

            Critiques seem to be of four sorts. (Some are mutually exclusive.)

            1)  “QE is weird.”    Quantitative Easing entails the central bank buying a somewhat wider range of securities than the traditional short-term Treasury bills that are the usual focus of the Fed’s open market operations.    This has been a bold strategy, which nobody would have predicted 3 or 4 years ago.   But it has been appropriate to the equally unexpected financial crisis and recession.    Some who find QE alarmingly non-standard may not realize that other central banks do this sort of thing, and that the US authorities themselves did it in the more distant past.    It is amusing to recall that when Ben Bernanke was first appointed Chairman, some reacted “He is a fine economist, but he doesn’t have the market experience of a Wall Street type.”  The irony is that nobody who had spent his or her career on Wall Street would have had the relevant experience to deal with the shocks of the last three years, since none of them were there in the 1930s.  But as an economic historian, Bernanke had just the broader perspective that was needed.   Thank heaven he did.

            2)   “Monetary easing under current circumstances has no effect.”  It is true that, with short-term interest rates already near zero for the last two years, further monetary expansion is likely to be of less help than in a normal recession.  (The classic “liquidity trap” has been re-born as the “zero lower bound.”)    But monetary policy can work through other channels besides short-term interest rates.  Seven such mechanisms are: long-term interest rates, expected inflation, the exchange rate, equity prices, real estate prices, commodity prices, and the credit channel.   QE is worth a try, given that the economy is still weak and given the constraints that keep fiscal policy sub-optimal.

            3)  “Monetary ease will lead to inflation.   What we need now, if anything, is monetary tightening.”   This is the view, for example, expressed recently by some conservative economists, including John Taylor.   It seems to me way off base.  With unemployment far above the natural rate, GDP well below potential, and inflation (slightly) below target, it is clear that the Fed’s November 3 decision to ease further  was appropriate.

            4)  “The Fed is firing a volley in a destructive international currency war.”   This is the criticism that has come from some of our trading partners:  in particular, China, Germany and Brazil.   I don’t generally do “My country, right or wrong.”   But my country is right on this one.    Monetary easing is not a beggar-thy-neighbor policy.  The colorful phrase “currency wars“ seems to have confused some people.  The current situation is precisely the point of floating exchange rates:    when some countries feel that their high unemployment calls for monetary expansion (US) at the same time that others feel that their overheating calls for monetary tightening (Brazil, India, Korea, China…), an appreciation of the latter currencies against the former is precisely the way that floating rates accommodate the differences.    This is why Milton Friedman favored floating rates, so that each country could pursue its own desired policies independently.   I realize that the pressure which US monetary easing puts on countries like China to allow appreciation is unwelcome. China is finding it increasingly difficult to cling to its exchange rate target by means of controls on capital inflows and sterilized foreign exchange intervention.   But capital flows are a far more legitimate way to let China feel the pressure than the alternative:  Congressional threats to impose WTO-inconsistent tariffs on Chinese imports if it won’t allow faster appreciation of the yuan.

            I was glad to see that today’s decision by the Federal Open Market Committee to stay the course was unanimous.   The Fed is right not to give in to misguided criticisms.   This is what we have central bank independence for.

Click here for a TV interview on today’s FOMC decision, and inflation & TIPs.

[Comments can be posted on the Belfer site.]

     Some conservatives are attacking current U.S. monetary policy as being too expansionary, as likely to lead to excessive inflation and debauchment of the currency.   The Weekly Standard is promoting a letter to Fed Chairman Ben Bernanke that urges a reversal of its policy of QE2, its new round of monetary easing. The letter is signed by a list of conservatives, most of whom are well-known Republican economists, some associated with political candidates.  Apparently the driving force is David Malpass, who was an official in the Reagan Treasury, and he is taking out newspaper ads later this week.  This follows similar attacks on the Fed by politicians Sarah Palin, Mike Pence, and Paul Ryan. 

     If the National Journal, Wall Street Journal and Politico are right that the Republicans are trying to stake out a position that Democrats are pursuing inflationary monetary policy, they are on shaky ground.   I will leave it to others to make the important point of substance:  the risk of excessive inflation is low now compared to the risk of an alarming Japan-style deflation, with the economy having only begun to recover from its nadir of early 2009.   Or to acknowledge that Quantitative Easing is only a second best policy response to high unemployment.    (Fiscal policy would be much more likely to succeed at this task, if it were not for the constraints in Congress.)

     I will, rather, respond to the political component of the National Journal’s question by pointing out some insufficiently understood history:

1. Republican President Nixon successfully pushed Fed Chairman Arthur Burns into an excessively easy monetary policy in the early 1970s — leading to high inflation which the White House tried to address with wage-price controls.  Nixon, of course, also devalued the dollar, and took it off gold, thereby ending the Bretton Woods system of fixed exchange rates.
2. Republican Presidents Ronald Reagan and George H.W. Bush tried aggressively to push Fed Chairmen Paul Volcker and Alan Greenspan into easier monetary policy, especially in election years.  This is documented in Bob Woodward’s 2000 book Maestro.   The White House succeeded in making life unpleasant enough for inflation-slayer Volcker that he eventually declined to be reappointed, prompting Treasury Secretary James Baker to exult “We got the son of a bitch!” (p.24).  Baker is also the man usually credited with the Plaza Accord and the associated 50 % depreciation of the dollar from 1985 to 1987.
3. Democratic Presidents Jimmy Carter and Bill Clinton are the two presidents in the last four decades who scrupulously refrained from pushing their Fed Chairmen (Volcker and Greenspan, respectively) into inflationary monetary policy.  
4. Under Republican President G.W.Bush, monetary policy once again became excessively easy, during 2003-06, contributing substantially to dollar depreciation, the housing bubble and the subsequent financial crash.

     Thus if the other party were to accuse Democrats of pursuing excessively inflationary monetary policy, it would be akin to them accusing Democrats of pursuing excessively expansionary fiscal policy.    Perhaps such accusations will strike some who don’t pay close attention as superficially plausible, even after all these years.  But they nonetheless fly in the face of history.   Another case of the pot calling the kettle “red.”   Yes, I know, the usual saying is about the color black.  But red is the color of deficits, overheating, … and Republicans.

    I document the history in “Responding to Crises,” Cato Journal 27, 2007. 

Menzie Chinn, Prof. of Economics at University of Wisconsin, is guest posting this week:

I want to thank Jeff Frankel for the opportunity to be a guest writer on his blog.

A lot of attention has been devoted to how oil price and food price shocks have affected the US economy, both along the output and price dimensions. A general presumption has been that as long as inflation expectations remain well anchored, then one need not worry about 1970’s style stagflation (recession is another matter).

However, there are many places in the world where inflation expectations are not well anchored. Or at least we can’t tell if they’re well anchored or not. Figure 1 presents data for several key groups (using the IMF classifications): Industrial countries, LDCs excluding oil exporters, oil exporters and developing Asia.

Figure 1: Inflation rates defined as 12 month changes in CPIs, in selected groupings: Industrial countries (blue), oil exporters (black), developing countries excluding oil exporters (red) and developing Asia (green). NBER defined recession shaded gray. Source: IMF, International Financial Statistics accessed June 20, 2008.

It’s clear that inflation is surging in the oil exporting countries. This is occurring as reserves balloon (see Brad Setser has diligently tabulated on a number of occasions; e.g., [1]), often under pegged-to-the-dollar exchange rate regimes, and the monetary authorities are unable to sterilize money base expansion. Here, I can’t resist writing the identity:

Money Base = Foreign Exchange Reserves + Net Domestic Assets

As foreign exchange reserves increase, money base must increase, unless the central bank can (and will) sterilize by making offsetting reductions in net domestic assets.

This is why Feldstein has called for de-pegging from the dollar for oil exporter currencies [2] (for contrasting recommendations, see Paulson’s comments [3]).

Of course, this mechanism does not apply in all instances, there are oil exporting countries not under fixed exchange rates, but reserve accumulation nonetheless is making its way into money base creation. As government revenues increase, spending is also pushing up prices.

So, no surprise that inflation is rising in this group. But what is surprising is how much inflation has risen in the non-oil-exporting LDCs, and in Developing Asia (this group excludes NICs like Korea).

Figure 2: Inflation rates defined as 12 month changes in CPIs, in selected East Asian countries: China (red), Malaysia (blue), Philippines (green), Thailand (black), Vietnam (teal). NBER defined recession shaded gray. Source: IMF, International Financial Statistics accessed June 20, 2008.

Inflation has risen as food and energy prices have risen. Vietnam is the most striking example. And China, of course, has been in the spotlight, largely because of its economic mass. But note how Thailand and the Phillipines inflation rates have accelerated.

Now one might say this is all obvious - - but in several of these countries (e.g., China), energy prices were heavily subsidized. Raising these subsidized prices will - - in a mechanical fashion - - raise the recorded CPI. If prices were perfectly flexible, higher energy and food prices only represent a higher relative price for these goods. I’ll let the reader determine for him or herself whether that’s a plausible assumption. In any case, the net effect over the longer term is uncertain. Raising the subsidized prices means higher prices on those specific goods (possibly feeding into wages). But the lower government outlays for subsidies means smaller deficits (holding all else constant) and hence lower money base creation.

Is there hope to be derived from the fact that there are more inflation targeters now than there were during the previous episode of inflationary pressures, three decades ago? In a paper written two and a half years ago, Andy Rose documented the fact that inflation targeting has proven to be a relatively durable form of monetary regime. That is, compared to the “fixed” exchange rates, an average duration of an inflation targeting regime is longer. One observation I would make is that most of those inflation targeting regimes were implemented in a relatively benign global economic environment - - at least benign from the inflationary standpoint. While oil prices have been rising since 2002, it appears that the surge in food prices, on top of oil and non-food commodity prices - - is what has changed matters (Figure 3 recaps a graph from this post).

Figure 3: Log indices. NBER defined recession shaded gray. Source:.
(Of course, these oil and food price shocks may end a lot of exchange rate reimges as well).

By the way, Thailand and Philippines are classified as inflation targeters by Rose. Korea, also classified as an inflation targeter, has also experienced accelerating, but nonetheless lower, inflation (at about 4 percent). So, the jury is still out on the question whether the commitment to inflation targeting during this episode will result in a substantive difference in how matters play out.

On a more speculative note, one idea that has struck me is that, as inflation rates rise, it may become more difficult for the East Asian countries to maintain their exchange rates against the dollar at their current levels. Recalling (in logs):

q^j = s – p^j + p ^US

In words, the real exchange rate for country j against the USD (defined as up is weaker) will strengthen as the domestic price level rises, holding all else constant. That may in turn a be a harbinger of the end of the tendency for the East Asian countries to export capital to the US (although the overall US current account balance will tend to remain driven largely by domestically driven by the saving/investment balance in the US, and we know where the current trajectory of the US budget deficit is going…[4]).

Figure 4: Trade weighted broad real currency values, in logs. NBER defined recession shaded gray. Dashed line is at June 2005, the month before the CNY revaluation. Source: BIS accessed June 23, 2008.

So far, this remains speculation. However, over the past couple months, China’s real currency value has appreciated in trade weighted terms, which is remarkable when one keeps in mind the dollar’s depreciation over this same period. It remains to be seen whether the other currencies follow suit. That may hinge upon how these countries respond to inflationary pressures.