Saturday, September 13, 2014

Endogenous Credit Creation and Nominal Income Targeting: In Defense of Nominal Income Level Targeting

Many Austrian economists are skeptical of the efficacy of a nominal income level targeting policy for a central bank. For example, Alex Salter argues that nominal income (he discusses NGDP) should not be treated as an object of choice for central bankers. His perception that nominal income level targeting treats nominal income as an object of choice is representative of a widespread Austrian critique concerning prices and the role they play. The argument misses important nuance in comparing fiat regimes with hard money regimes. Given that the target is predicted by a futures market, it is not actually an object of choice. The central bank would not attempt to determine nominal income. Instead, it would respond to the best estimation of aggregate demand available. (That the target inflation rate is an object of choice is up for debate. For now I will assume that there is no inflation target embedded in the policy.) In this post, I will confront this objection by analyzing the mechanisms through which a regime that targets nominal income would function. I will also confront other objections as necessary.

Nominal income level targeting is a policy suggestion that unfolds from Say’s law. In a market where there is an excess supply of goods, there is an excess demand for money (Clower and Leijonhufvud 1973; Yeager 1956). That is, nominal cash balances are not high enough to clear all markets at curent prices. Under a gold standard, increases in demand for money lead to an endogenous increase in the money stock. This increase is not instantaneous as the supply of gold is relatively inelastic. Nor are these changes in the gold stock neutral. The economic effects of the entry of this money depend on the injection point – i.e., where is the gold first spent or deposited? It is true that under a pure free banking system, the injection point is guided by real demand. It is also true that the endogenous mechanisms that guided the production of base money – gold – do not exist under the modern system of fiat currencies. The primary endogenous mechanism of money creation available under the present system is credit expansion. In markets where there are excess supplies of goods, the creation of credit helps clear these markets. Without a similar endogenous mechanism for the creation of base money, demand deficiencies are more likely to persist. Despite the objection from Salter that nominal income is an outcome and should not be targeted by the monetary authority, the lack of an endogenous mechanism to control the base money stock makes a nominal income level targeting regime necessary.

Whether or not the central bank practices nominal income level targeting, the fact remains that the central bank still operates.  We should not be given to the “Nirvana Fallacy.” Salter admits that nominal income level targeting might be preferable to the current regime. I think there is theoretical reason for fully embracing the norm. (I don’t have an answer for the public choice critiques at this time, so my defense concentrates on monetary theory.) The choice for policy makers is not between a free banking system and a system with a central bank. There is no policy choice that leaves the central bank on the sideline to do nothing in our present world of fiat currency regimes. We must ask, then, which policy will minimize nominal distortions? Which policy will promote healthy, flexible credit markets that can neutralize problems stemming from monetary disequilibrium?

Economic analysis allows us to imagine what an ideal regime would look like. As Hayek argued in Pricesand Production, MV stabilization is a theoretical ideal, but that ideal includes not just some aggregate stabilization. Monetary injections are provided at precisely the points where demand for money has increased. Such a norm is impossible for a central bank to implement directly. It is for this reason that Selgin and White promote a free banking standard under which the money stock responds to changes in demand for fiduciary currency (White 1999; Selginand White 1994). What is not typically appreciated in the argument about nominal income level targeting is that this policy norm would also be aided by financial intermediaries whose actions help stabilize nominal income much like in the Selgin and White free banking model.

Nominal income level targeting is not, on its own, an economic panacea. Expansion of the money stock always has non-neutral effects. Since injections occur through the financial sector, injections will affect interest rates. This is not as big of a shortcoming as the critics of nominal income level targeting claim it is. If the money stock is insufficient to meet the demands implied by expected nominal income, then we can expect interest rates to rise as an elevated demand for money does not allow markets to clear. As heightened demand for liquidity pushes up interest rates in this manner, all else equal, the market rate of interest is pushed above the natural rate which is the rate that reflects time preference. Credit markets are in disequilibrium.

In the case of disequilibrium, an expansion that offsets MV serves the same role that gold flows and gold production did under the gold standard. The difference is that the response of the base money stock to changes in demand for money occurs much more rapidly than it did under the gold standard. The employment of a nominal income futures market will allow the adjustment of the monetary base to offset changes in liquidity preference that affect credit markets in a way that emulates the response of the base money stock to changes in demand for money under a gold standard.

As mentioned above, monetary expansion by the Federal Reserve is channeled through the financial sectors. Some may voice objections relating to the channel of expansion (Selgin 2012). The Federal Reserve expands the money stock by buying from and selling to primary dealers of securities. Selgin correctly argues that confronting this problem will promote stability. Similarly, some worry that the policy will have asymmetric effects in different geographic regions and that efficient markets hypothesis will not hold with respect to the NGDP futures market (Murphy 2013). I agree with the first proposition, but even under the current circumstances, the alleviation of a general excess demand for money will be more stabilizing than the next best option, whether or not the allocation of the expansion of the base is improved.   If I am right that nominal income targeting will help offset distortions in the interest rate caused by liquidity preference, I do not believe the first objection is problematic. The implementation Selgin’s policy suggestions would certainly improve a nominal income targeting regime! Nor are the other objections fatal to the efficacy of nominal income targeting. My response to these require elaboration.

Markets can handle small shocks quite well. It is in the face of large negative shocks that are self feeding – for example, a scenario of heavy deflation that makes credit markets dysfunctional, thus leading to further deflation – that markets have difficulty remaining anywhere close to the expected nominal income growth path. To be more specific, under a scenario of heavy deflation, both goods markets and intertemporal markets fail to clear as a rise in demand for money constrains liquidity. Bad central bank policy, like that of the Bank of France and the Federal Reserve leading into the Great Depression, can destabilize the economy and lead to such a situation. Under a nominal income targeting regime, problem caused by fluctuations in money demand are alleviated. Dramatic fluctuations in nominal income due to changes in money demand will be prevented. The shocks that are most damaging to the functioning of a healthy economy are neutralized. Even better, monetary policy that promotes this sort of disequilibrium - much like gold hoarding policies of the Great Depression - are not allowed under a nominal income targeting rule. 

So what of the significance of inaccuracies of expectations and asymmetric demand for money? The critics are correct that no measure is perfect. So long as the futures market actually reflects nominal income within a limited margin of error, credit markets can adjust the money stock for these small perturbations. The beauty of nominal income targeting is that it ensures that the credit market will be able to function, and thereby offset these problems. By increasing the base money stock and thereby aiding liquidity, a nominal income level target promotes more robust credit markets that can adjust the broader money stock to conform to particular circumstances not accounted for by the employment of the equation of exchange. In this sense, nominal income targeting and free banking should not be thought of as totally distinct. The endogenous response of the money stock that is at the core of free banking theory is very much present in modern credit markets. Without a well functioning credit sector, nominal income level targeting falls short of its goal. 

Final thought: A nominal income level target requires a credible commitment from the central bank to not bail insolvent institutions. This is where the public choice critique must be answered.

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