A wonkish note on 'NGDP-targeting'

from Merijn Knibbe

At this moment, NGDP-targeting is all the rage. According to this idea, central banks have to target the level of Nominal Gross Domestic Product instead of the interest rate or inflation, with as one of the implications that monetary policy is perceived to be ‘tight’ when interest rates are low – but NGDP is declining. This has interesting implications and I’m not sure wheter the proponents of NGDP targeting are aware of these:

1. In our monetary transactions economy and according to the rules of national accounting it holds that:

Total nominal production = total nominal income = total nominal expenditure.

Production is defined as ‘value added’, i.e. sales minus purchases of goods and services, which leaves the amount of money available for wages, interest and profits. Value added of the government is supposed to be equal to total wages paid by the government.

Total income is defined as wages, interest and profits but, as interest paid by the banks is difficult to charge to particular bank services, net interest of banks (FISIM, google it) is added to ‘profits’ in the national accounts. Which leaves ‘total income’ as the sum of total wages and total profits (you can disagree with this, especially when you want to calculate the rent-part of bank profits, but this is the present national accounting situation).

Total (final) domestic expenditure is defined as household consumption plus household investments (mainly new (!) houses) plus government consumption plus government investments plus business investments plus exports, minus imports.

This means that targeting NGDP means targeting nominal expenditure as well as nominal income as well as nominal production.

Which, looking at it from the income side and especially in the present situation in which business profits are quite high and employment is way to low, means that either (much) more people have to get a job against the going wage rate or that wage levels have to be increased.

Which, looking at it from the expenditure side, means that either household expenditure or government expenditure or business investments or net exports have to increase.

Which, looking at it from the production side, means that either more products (barring purchased inputs) have to be sold at the same prices or prices have to be increased, or prices and/or amounts of purchased inputs have to decline.

Long story short: the logic of NGDP-targeting dictates that, in a situation of a large nominal output gap and tight money (never mind low nominal interest rates), money has to be created to enable investments in energy saving devices and energy saving rebuilding of homes and efficiency enhancing improvement of the infrastructure and whatever. And oh, wage cuts don’t really help.

(Scott Sumner is of course famous for propagating NGDP-targeting, but he clearly overstates the ability of the Fed and other central banks to push on a string, i.e. to create M-3 money in a situation of a liquidity trap (I’m not talking about the IS/LM model here, I’m talking about the situation). It’s the famous neo-classical ‘It’s the central banks who create money in circulation as this enables neo-classical modelling and neo-classical social engineering’ fallacy all over again. To be concrete: this idea enables people to propagate idea’s like that a more so called ‘flexible’ labour market in Spain will solve 25% unemployment as a matter of routine…. But central banks do not create money in circulation. We do (with a little help, from the normal banks). Sumner in fact does not seem to distinguish between currency in circulation and currency not in circulation or, if he does, he should write this down more clearly. And he is rather vague and fuzzy when he uses phrases and definitions, ‘base money’ meaning ‘the unit of account’ in one sentence and ‘the amount of base money’ in another sentence. The same for ‘NGDP’, which is not well defined is his blogposts. Also, he should think about the fact that societies without banks (like most of seventeenth, eighteenth and nineteenth Europe) did know lively capital and money markets which enabled credit and money creation ‘at will’ when you wanted to buy bread or, for that matter, wanted to build a mill worth about ten to fifteen times your yearly income. Again: central banks did not create this credit-money which enabled markets to flourish (these banks did not even exist at the time), buyers and sellers did. And he should really learn to distinguish between money as a means of exchange (for instance the ‘receivables’ on the asset side of the balance sheets of companies) and money as a means of payment (nowadays often ‘legal tender’, but Dutch stamps which since some time have their own ‘stamp’-unit of account might in some cases also do), see for instance the Ph. D. thesis of Fieke van der Lecq, “Money, coordination and prices“.)

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