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Wednesday, November 23, 2011

WILL THE PUBLIC TOLERATE A CONTROLLED INCREASE IN INFLATION?

The Reason for the Question and the Buggy Reply

There's an unusually stimulating economic blog, which deals with policy-oriented issues in informative, largely non-technical ways, called Worthwhile Canadian Initiative.      Created and run by a monetarist economist in Canada, Professor Nick Rowe --- with posts now and then by some other Canadian economists --- the blog has drawn more and more thoughtful followers because of Rowe's beliefs as a monetarist that both Canada and the US should deal with their ongoing economic stagnation by means of steady monetary stimulus on the part of the two countries' central bank.   In particular, the two banks should directly target NGDP --- nominal GDP (non-inflation adjusted GDP growth) --- that would stimulate a certain real level of economic growth and reduce unemployment to more acceptable levels.

Note that Professor Rowe isn't the only prominent advocate of what's called market monetarism.  Others include Scott Sumner, Lars Christensen, David Beckworth, Josh Hendrickson , and Bill Woolsey

The Theory

It's fairly new, dating back at most a few years ago, and it has only recently come into prominence as the major economic countries in the democratic industrial world continue to stagger on with low GDP growth --- this, mind you, whether or not their governments have pursued fiscal stimuli as in the US or austerity in West Europe (or variations of both in Japan).  For a good if very brief top-skimming account, click here.  For a recent defense of the theory of market monetarism, click here.   And for the best blog by a market monetarist along with Nick Rowe's, click here for Scott Sumner's very readable work.  And for a very stimulating exchange between John Taylor --- a Republican (like Greg Mankiw) who is a New Keynesian and favors the Federal Reserve targeting mainly low inflation (the Taylor rule) --- and several of these market monetarists, click here.

Buggy's Post

Prof bug himself embraces this new market monetarism.  It is far superior to original Keynesianism, with its stress on fiscal stimuli.  In fact, it's hard to find clear cases of discretionary (deliberate) fiscal deficits in the advanced industrial world: only FDR (and Hoover) in the 1930s, Nazi German at the same time, and the US again in the John Kennedy era (the resulting inflation of it and the Vietnam war playing havoc with the stimuli) and again in 2009-2010 in the current Obama era.  (As for the IS-LM model trotted out by Brad Delong and Paul Krugman, prof bug happened to have studied at Oxford with its creator, Professor John Hicks, a Nobel prize-winner, who always had qualms about its simplicities and explicitly argued for its being discarded in a 1980 article. Click here.)  New Keynesianism, which sought to deal with the New Classical Economics out of Chicago, Minnesota, Washington University in St. Louis, and elsewhere by grounding it in micro-economic behavior with more dynamic inter-temporal modeling, has always preferred monetary policy as a way of dealing with serious recessions, mainly by following the Taylor rule. 

Compared with all of these alternative macro-economic approaches --- including the New Classical Real Business Cycle Theory (fiscal and monetary policies can't influence GDP growth or unemployment levels by counter-cyclical targeting) --- market monetarists' stress on targeting NGDP in order to raise real GDP growth and reduce unemployment seems far superior.  Even a New Keynesian like Christina Romer (who also favored fiscal stimuli when she headed Obama's Council of Economic Advisers) has come around to embracing NGDP as the target.  Click here.   Even some of the Federal Reserve Governors, though a minority, have moved in that direction recently (click).

On To the Buggy Post

The "beauty of NGDP target as its proponents see it," according to the Wall Street Journal link two lines up,

" is that it doesn't differentiate between inflation and real GDP. So it doesn't matter whether the gap is closed by three parts inflation and one part real GDP or one part inflation and three parts real GDP. The point is that the gap gets closed, because the Fed is able to be as aggressive as it needs to be, and the economy avoids a prolonged slump and chronically high unemployment a la the Great Depression. And by targeting NGDP, or a stated goal for the total size of the economy, instead of a 3% or 5% inflation rate, the Fed is better able to avoid the backlash that might otherwise undermine its ability to achieve said objective."

And so the key issue is whether or not the Bernanke-led Fed and its governing members in the regions, along with key economic actors in the government and private spheres, will tolerate a rise in inflation in order to bring the economy back to full-employment (the natural rate) by closing the gap between existing GDP and potential GDP . . . the long-run trend.  Market monetarists believe that as the Fed closes the gap, its ability to then reign in inflation and reduce it to something like 2.0 to 3.0% yearly quickly and effectively.  Prof bug doesn't disagree.  He does wonder in his long posted comment at Worthwhile Canadian Initiative whether the public itself (voters) will accept the tradeoff. 

Click here for the relevant thread.  And meanwhile, be grateful that a new monetarist revolution seems to be unfolding before our eyes . . . thanks to a few relatively unknown economists whose persuasive, fairly non-technical arguments have begun to move center-stage in macroeconomics.