Arnold Kling  

Scott Sumner Explains Himself

Public Opinion on Marijuana Le... Rare Agreement?...

First, he writes,

I see a three step process. A monetary shock (money supply or demand) causes flexible asset prices to change immediately (stocks, commodities, exchange rates, etc.) This causes output to rise, and consumer prices and wages respond with a lag.

Next, he writes,

An expansionary monetary policy increases long run NGDP for reasons that have nothing to do with interest rates. (Recall that interest rates are only affected in the short run.) Instead, more money increases expected long run NGDP via the excess cash balance mechanism. This increase in expected future NGDP raises current asset prices (stocks, commodities, real estate, etc), which then leads to more current AD.

For some reason, I had missed this aspect of Sumner's thinking before. Some reactions:

1. Commodity prices and stock prices have been rising for quite some time. They spiked more in recent days, but they were already quite high. Why is the economy still weak? Perhaps falling real estate prices were offsetting rising commodity and stock prices?

2. I find this monetary transmission mechanism pretty scary. You are trying to drive up prices in bubble-prone asset markets in order to increase output. It seems to me that the risks of overshooting must outweigh whatever benefits you obtain. Sure, nominal GDP moves slowly enough so that you do not have to worry about overshooting that target. But meanwhile, you move from one bubble (Internet stocks) to another (real estate) to another (commodities). That can't be healthy. I felt much more favorably disposed toward monetary expansion when I thought that the transmission mechanism was through general prices rising faster than wages.

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CATEGORIES: Macroeconomics

COMMENTS (9 to date)
Lord writes:

1. Higher, but still below where they were, and real estate, the most effective of these, is still negative.
2. This is normal and how money enters the economy, through its most money sensitive sectors. Something always has to lead, it doesn't have to be limited to one, but one will always be larger than anything else. The problem isn't bubbles, but not enough of them, but as long as one does, others will develop supporting it, some of which will develop their own momentum spawning bubbles of their own. This is the core of creative destruction. What isn't healthy is when it is not occurring.

Scott Sumner writes:

Thanks for the comment on my post. Just to clarify a few points:

1. I don't believe in bubbles.
2. If bubbles exist (and they may) I don't think it is necessary to create them in order for monetary stimulus to work.
3. Stock prices change for all sorts of reasons having nothing to do with monetary policy. That's even more true of commodity prices, which are set in world markets.
4. The key is that higher expected future NGDP drive the process. My point was that some prices are obviously more flexible than others. I regard this as a stylized fact, which is not particularly controversial. I believe these flexible prices play a role in the monetary policy transmission mechanism.
5. Stock prices are higher than in March 2009 partly because the forecast for RGDP growth and inflation (by the IMF) in April 2009 turned out to be much lower than what actually occurred. The level of stock prices is still rather low, relative to 2007. And corporations are doing better than workers in this recession, as they make nearly half their profits in overseas markets, many of which are booming.
6. I also think the prices rising faster than wages mechanism is part of the story, although I now prefer NGDP per capita rising faster than wages.

fundamentalist writes:

Sumner should really pay more attention to pros in investing. They pay a great deal of attention to what the Fed intends to do. The stock market tanked earlier in the year when it became clear that the Fed would end monetary pumping. It languished all summer until it became clear again that the Fed would resume monetary pumping. Machlup explained in the 1930's that most new money goes into assets, especially the stock market and most working (not academic) financial experts know it.

And Sumner ignores Uncle Miltie's warning that the lags between policy and effect are long and varied. Today, monetarists think that expectations overcome those lags. Their faith in expectations takes on theological fervor at times. They seem to believe expectations trump every other economic law.

mlb writes:

To say you don't believe in bubbles is to say you don't believe in wide-scale misallocation of capital. Given the number of unused homes in the US I don't see how you could possibly come to that conclusion.

If it is just about NGDP why doesn't the Fed put out an RFP for $1T worth of teddy bears, or why dont we just invade another country at a cost of $1T. Higher NGDP = more jobs; problem solved.

To me it is all about return on capital, not capital invested. I do think the market is the best mechanism for ensuring good returns on capital, BUT only if is getting the right interest rate, FX signals, etc. Clearly this is not happening.

I'm sure QE will result in some more NGDP, but I am also sure a good chunk of it will be wasted. They key for me as an investor is to figure out where that waste will occur, get in early, and get out before a crash. I hate that my job has been reduced to that, but that is the signal the Fed is forcing on me. Unlike Scott (and most other economists) I am actually allocating large chunks of capital in the economy..and I can tell you it is far from being optimally invested.

Charles R. Williams writes:

1. When you look at the global dollar dominated economy as a whole, the inflation rate is high. The only parts of this economy where a low rate of inflation can be observed is in domestic assets and domestic production inputs that cannot be exported (labor). A higher rate of core-CPI inflation is supposed to bring labor markets back into balance and reflate housing assets. Workers will be content with flat wages when gasoline jumps to $5 per gallon? A 3-4% increase in housing prices will stem the flood of foreclosures? Sure.

2. The quantity theory of money is based on three propositions that once held but are no longer operative. First, the central bank controls money supply, second, there is a stable or predictable relationship between money and output, third, changes in the money supply affect output rather than simply prices.

Money creation has been largely privatized. The fed can control the economics of the regulated domestic banking sector by fiddling with its cost of funds on the margin. Suppose the fed buys treasury bonds. They create money in the form of excess reserves on which the fed pays an above market interest rate. Such actions may affect the reported money aggregates but this is no more expansionary than printing $100 bills and renting railcars to store them in.

With respect to velocity, the global financial sector has worked overtime for the last 30 years to turn assets into liquid assets. Such assets can be converted to cash instantly and if their value is insensitive to proprietary information (AAA), they can support deposits in the shadow banking system, entirely beyond the ability of the fed to affect them or even to monitor what is going on. The monetary aggregates have become curiosities that are informative of the state of the economy so long as the fed behaves itself. They are currently meaningless.

Suppose the fed can increase aggregate demand. It is unclear how this could affect output rather than prices. When unemployment is as high as it is today you can hire people for less than what employed workers currently earn. The issue is that no one wants to hire. Labor is no longer a commodity with a sticky price. A job represents an investment on the part of both the employee and the employer supported by a more or less explicit contract. And part of that understanding is cost of living adjustments. Increasing aggregate demand has an instantaneous effect on the cost of living through the exchange rate mechanism.

Jankiel writes:,2486/

Keith Eubanks writes:

The stock market may very well rise on expectations of NGDP growth, and that may, or may not, translate into growth in RGDP.

Prof Sumner is anticipating that the differential in price changes will lead to more production. With an inflation, not all prices change at the same speed: some faster (commodities), some slower (wages). If product prices rise first, employers keep more income for a given level of production. If this increased nominal income is applied to hiring more labor (now cheaper in real terms) or acquiring more productive capital assets, production can rise and pull the economy forward.

However, if this increased income for employers is instead plowed into consumption or existing assets, we get stagflation.

Two questions for contemplation:

1. Will a volatile or stable currency encourage more investment and production?

2. Should an organization like the Fed have the power to force a real pay cut on the vast majority of Americans? Noting wages are a private contract.

Joe Calhoun writes:

I found Sumner's approach appealing at first, but the more I read the less I like. The appeal of NGDP targeting to me is that it makes monetary policy consistent and predictable which is what I think monetary policy should be. It also places the onus back on the politicians to correct bad economic policies rather than having the politicians depend on the Fed to bail them out. If the Fed targets constant 5% NGDP growth and it turns out that it is composed of 4% inflation and 1% real growth well that's not a problem for monetary policy but rather an issue with taxes or regulatory policy or something else. It transforms excessive inflation from a monetary issue to a fiscal/political issue. And if you think about it, that's where issues of sub par real growth should be resolved, indeed must be resolved.

The problem, as it is with so many other approaches, is in measuring inflation. If you hit 5% NGDP growth using a measure of inflation (pick one) and you also produce a "bubble" somewhere it would seem your choice of inflation indicator wasn't a very good one. Sumner doesn't seem to have a problem with blowing serial asset bubbles as long as NGDP keeps chugging along using some price index to measure inflation. I think that is a serious mistake and that the last decade is pretty good evidence that asset prices have to figure into that inflation yardstick. I don't know if Sumner has said what his preferred inflation gauge is but if it is just some price index that doesn't incorporate asset prices, I'd say NGDP targeting is likely to be no better than what we've got now.

In Sumner's defense, he also advocates a lot of other economic policies that would be a drastic improvement over what we have now. If he were able to implement all those changes along with NGDP targeting we'd probably get a better outcome but by itself it isn't a panacea.

Lance Paddock writes:


One economist/money manager agress with you on the cost of bubbles.

The wealth effect outside of housing is rather small to boot.

I suspect this attempt to drive up asset prices will destroy any supposed benefit. In fact, I believe when these ebubbles burst it leads to further defaltionary pressures, and no amount of expectations, animal spirits or other non fundamental factors can overcome their cost.

One can choose not to believe that assets can go into bubbles as Scott claims, but the history of all assets that move a few standard deviations above trend is an eventual fall all the way back to trend and below. Every last one that can be found.

Stocks especially can easily be determined as in bubbles, since the aggregate cash flows that investors are trying to obtain have reliably fluctuated within a narrow range over reasonable time frames. Unless one wishes to posit that those cash flows will somehow become far more plentiful than history, common sense or theory would suggest, we can say with great confidence the range of likely returns longer term. Given that, how can we not spot when they are low, and thus in a bubble?

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