The Underground Economist
Nominal GDP Targeting Will Always End In Stagflation

Nominal GDP targeting works like this: instead of the central bank’s targeting a particular rate of inflation of consumer prices, it targets a particular rate of nominal (as opposed to “real” or inflation-adjusted) GDP growth. The theory behind this is that it enables a purely rules-based approach that provides automatic monetary stimulus to the economy during bad times.

The problem with this approach is that it assumes that recession is always something that needs to be treated, when this is far from being the case. While recession issometimescaused by external factors (political instability abroad, bad weather causing crop failures, etc), it is frequently caused by a buildup of uncompetitive firms in the economy. Such a buildup occurs naturally during good times because investors are willing to take bigger risks.

Without intervention, the least competitive firms die out or are restructured during a recession, reallocating their capital and labor to more productive uses. This allows the economy to recover fully. Fever is a good analogy. The immune system works better when the body’s temperature is higher, and many disease organisms do not, for the simple reason that they thrived in the first place at normal body temperature. If you always treat fever and other immune responses right away, not only will you not necessarily know how bad things are, you may allow the infection to spread and kill you.

Some uncompetitive firms will die off regardless of monetary stimulus, particularly if fiscal stimulus is not also applied. However, because the stimulus becomes larger the deeper the recession, an increasing number of uncompetitive firms will hang on each time, like antibiotic resistant bacteria if you never take your full course of penicillin. Because of this, each time there is a recession, the unemployment level and “real” GDP growth will never quite recover to where it was before the buildup started.

Because the difference between nominal and real GDP growth is inflation, we now have, by definition, stagflation. Of course, nominal GDP targeting isn’t the only way to result in stagflation:anyattempt to “smooth out” the business cycle must eventually result in stagflation, at least if it is at all successful, becausenobody knows what the correct rate of growth is at any given time.Try to juice the economy too much, and you get a buildup of uncompetitive firms that will make the next recession deeper. This is actually worse than the opposite, not juicing it enough, because while this has short term consequences, they’re bounded in time and severity, while the long term conseuquences of juicing the economy over and over are catastrophic.

Of course, once you’ve let enough uncompetitive firms build up, and worse once they’re among the biggest companies in your economy (GM anyone?), it becomes politically untenable *not* to juice the economy. The politicians’ and bankser’ only remaining choice is to keep the party going until the stagflation gets so bad that it starts to result in civil unrest, then hope they die or retire before the revolution comes. Or hope Volcker’s clone comes along to save us in time, because at some point (Greece, anyone?) the recession that a Volcker-clone would need to induce to fix things willtriggerthat revoution.

Nominal GDP targeting is essentially the policy China has been following, the one everyone has been holding up as “proof” that there’s another way to do things. I’m not sure there’s ever been in history so much physical evidence of unproductively deployed capital: empty cities, de-rated high-speed trains, local trains shut down because of the cost of the de-rated high-speed trains, commuters having to take buses because they can’t afford said trains. There is no soft-landing in store for China.

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