Two Roads?: Theoretical Case and Historical Precedent for a Nominal Anchor (Part IV)

We have left to consider the a defense of an endogenous fiat money base. Like the gold standard, but more responsive, a nominal income standard will alleviate excess demand for money. Sumner argues that nominal income targeting provides a nominal anchor, meaning that it prevents dramatic swings in prices that would otherwise result from an unstable demand for money (2012, 152). He notes that “the current price level and current NGDP are far more affected by the future expected money supply than they are by the current money supply (144).” If prices reflect expectations, then it is critical that growth rate of one of the major determinants of prices, the money stock, be predictable. Much in the way that “dynamic equilibrium requires consistency of plans which . . . depends on a flexible price system,” a rule that makes the expansion of the stock of base money stock both responsive to prices and predictable will help facilitate coordination of plans among economic actors (Lachmann 1978, 116). As convergent expectations are requisite for Say’s principle to hold, and therefore, for markets to clear, a clearly defined rule that predictably governs growth of the base money stock will reduce policy uncertainty and thereby increase the efficacy of the price system to convey tacit information (Hayek 1943).

The benefits of a nominal income level target are especially of significance for the loanable funds market as it should stabilize inflation expectations. By this effect, it will also better enable credit markets to clear as interest rates, the price of money in the future, will not suffer from distortions stemming from nominal factors such as volatile demand for base money. A nominal income target can also ensure that the rate of inflation remain positive. The significance of this becomes clear upon considering a scenario where the real rate, r, is less than the rate of deflation, -π. The Fisher equation denotes that in the long run the nominal – observed – interest rate as the sum of the real interest rate and the inflation rate. This is formally stated as:

i = r + π

We can imagine a scenario where the market clearing nominal rate of interest is negative. That is the abovementioned case where the real interest rate is less than the rate of deflation:

               r < -π

This special case was recognized in 1913 by Ralph Hawtrey:

What if the rate of depreciation of prices is actually greater than the natural rate of interest? If that is so nothing that the bankers can do will make borrowing sufficiently attractive. Business will be revolving in a vicious circle; the dealers unwilling to buy in a falling market, the manufacturers unable to maintain their output in face of ever-diminishing order, dealers and manufacturers alike cutting don their borrowings in proportion to the decline of business, demand falling in proportion to the shrinkage in credit money and with the falling demand, the dealers more unwilling to buy than ever. (186)

A reduction in the quantity of credit demanded leads to a surplus of savings. If, due to an abnormally high rate of deflation, the equilibrium nominal rate necessary to clear the loanable funds market is negative, then this surplus is inevitable. Since credit doubles as money, a fall in credit outstanding leads to an equivalent drop in total output. A nominal income target stops this problem in its tracks and will allow markets to more efficiently liquidate inventory. Instead of a fall in output, markets will respond by more quickly reallocating previously overvalued goods as a general expansion of the money stock is unlikely to save from bankruptcy those firms that made the most egregious mistakes during the boom. A base money stock that responds to changes in demand for money will help facilitate the reallocation of resource toward their highest valued use. Compare this to a general fall in prices whose end date is unknown.

The danger of tremendous deflation is not a new concern as bankers have long been concerned about financial destabilization due to deflation. Even before the establishment of the Federal Reserve, private banks innovated the means to mitigate the damaging effects of an elevated demand for money during recessions and depressions. Banks would issue temporary currency to stem a deflationary impulse (Timberlake 1984, 6). Money demand shocks were endogenously offset by temporary increases in the money stock. Those who issued the currency provided it to banks that appeared to be illiquid, but were unavailable to those banks that were clearly insolvent (7). Like endogenous gold and credit stocks, the increase in temporary currency arose due to the deflationary impulse set off by a sudden increase in demand for money. This temporary currency was elastic enough to prevent a crisis from turning systemic. Absent activist central bank policies, the gold standard, was able to serve as a nominal anchor. Only as a result of gold hoarding policies from the Bank of France and the Federal Reserve did the gold standard prevent a runaway deflation like occurred due to central bank intervention in 1929 (Eichengreen 1996; Irwin 2012). It does not take much imagination to see that a nominal income level target will serve a similar role to what temporary currency played in moderating crises.