Brett Sheckler

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Practical Implications of NGDP Targeting

Kevin Drum offered a post today in which he observed the surge of interest in the idea of Nominal GDP (NGDP) level targeting. This is an idea that people like Scott Sumner have pushed for a long time now–a proposal that the Federal Reserve should abandon its practice of simultaneously targeting low inflation, employment, and GDP growth, and instead, it should explicitly target only one metric: the overall level of NGDP.

In his posting, Kevin wondered aloud what NGDP level targeting would mean. In practical terms, what would the Fed actually be doing if they were targeting NGDP levels?

Following is a slightly-cleaned-up/expanded version of a comment I offered in response to Kevin’s question.



I have been bouncing some of this stuff back and forth with Scott on his blog, and here is how I think it all lays out:

1. The direct value of NGDP level targeting (per se) is that it forces the Fed to clearly state what it is shooting for, and it does so in a way that gives them cover to essentially ignore accelerations in inflation that will inevitably come with any resumption of world-wide growth (temporary accelerations that will come from oil-price increases as worldwide demand begins to grow again if nowhere else).

2. Once the Fed identifies the NGDP level targets it intends to shoot for (and once the Fed announces the growth-rate trajectory they intend to pursue to get us back on track) it will become crystal clear if their mix of actions is being successful or not. (This is a huge deal because, today, we really have little idea what the Fed is actually focused on doing. They give lip service to promoting recovery, but what they really seem most focused on is keeping inflation below 2%, which essentially means they are focused on not allowing the economy to recover–because oil-price increases that will come with recovery will inevitably push inflation over 2%.)

3. With a target clearly identified, the Fed will essentially be forced to start working through its quiver of tools: things like further quantitative easing (purchases of assets like Treasury bills or mortgage backed securities); shifting their policies regarding paying interest on (or penalizing) excess bank reserves; etc. At the end of this line of tools is the use of outright helicopter drops.

Helicopter drops can range from things like putting pressure on banks to refinance mortgages at lower rates even if the mortgage holder has a higher risk of default and/or holds a mortgage that is underwater (an action that puts more dollars in people’s pockets by reducing their monthly mortgage payment) all the way to cooperating with the Treasury along the lines of an idea Matt Yglesius has laid out.

Matt’s idea is that the Fed would buy, say, $300 billion in Treasury bonds and the first thing it would do with those bonds is light a match to them. [Voila, the Fed just created $300 billion out of thin air.] The Treasury now has $300 billion it just raised from their bond sale, and using these proceeds, the Treasury would send a $1,000 check to every man, woman, and child in America. The Fed and Treasury would also announce, up front, that they will continue doing this until they hit their NGDP targets).

Matt’s plan is an illustration of what I would describe as a pure helicopter drop: (first) the Fed can create dollars out of thin air; and (second) with the cooperation of the US Treasury, those newly-created dollars are delivered directly into households’ pockets.

The reality is that, somewhere in the continuum between straight-up quantitative easing and a pure helicopter drop along the lines of what Matt has described, the Fed has a tool that will be guaranteed to work. NGDP level and trajectory targeting will force them (and give them cover) to use all of these tools.

My belief is that, sooner or later, something along the line of pure helicopter drops will be required. I believe this is the case because, when push comes to shove, we still need to face up to the fact that American households are deeply, deeply, deeply in the red.

Compared with previous generations, even when one accounts for higher incomes, households today are holding more than $5 trillion in excess debt (i.e. on an income-adjusted basis, they carry at least $5 trillion of debt burdens over and above what previous generations carried), and most households also face the reality that they have absorbed trillions of dollars of wealth destruction in recent years.

As I have stated before, after 60-plus years of expanding real household debt (i.e. the ratio of household debt to GDP) we have probably reached the end of our expansion phase and are now in a debt-destruction phase–a phase that is dominated by the paradox of thrift (or, more appropriately for our circumstance, the paradox of debt-destruction).

We are witnessing the downward spiral unfold as we speak. Since 2007, household debt is being destroyed, but the process of reducing debt drives down household incomes. In the terms that matter, then, household debt continues to be as crushing, if not more crushing, than the day the process started.

In my view, the only way we get out of this mess is to drive down real debt-burdens, either by getting back to a trend of real increases in wages (which is really tough to do in a world where debt-destruction needs to happen), or via direct injections of purchasing power into households’ pockets (i.e. helicopter drops).

If the Fed were to adopt a regime of NGDP level targeting, I can see a number of ways that could turn around our economic prospects in the short- and medium-term (even without helicopter drops). I suspect, though, that after a period of a few years (after everything settles down) we will come to understand that our central problems of (1) too much debt and (2) over-reliance on debt-creation as the engine that drives expansion of demand will come back to the forefront.

More on that later…

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Conversation with Scott Sumner

As I mentioned in my previous post, over recent weeks I found myself in a conversation with Scott Sumner about the inevitability of debt-creation and debt-destruction cycles, and about what that means for effective monetary policy under today’s conditions.

Anyone who is interested in these questions may want to check out our back-and-forth in the comments section of this posting:

This conversation becomes even more interesting in light of the recent groundswell in support of Scott’s longstanding proposal that the Fed should shift its policy to one of explicitly targeting Nominal Gross Domestic Product (NGDP)as opposed to targeting some balance of low inflation and full employment. Scott has been pushing this idea for a long time, and now it seems the idea is quickly gaining traction on a lot of different fronts.

I think this is a HUGE deal, and a hugely positive turn of events (for reasons I will offer in a coming post).

As with any blog comments sections, there are comments a reader may want to skip over (comments that were all posted in the first few days). Within those early comments, though, Scott and I begin our conversation–a conversation that then continues to unfold after all the other commenters have moved on.

The discussion peters out a bit at the end… Actually, we picked it up again in a discussion surrounding one of his more recent posts about Matt Yglesius (, but I think there is a lot in here that people who care about this stuff might find interesting.

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Useful Charts

In the past few days I have found myself engaged in a conversation about (1) the notion that, at least under our current structures, our economy will inevitably see debt-creation and debt-destruction phases; and (2) my contention that unless we learn how to manage them more effectively, debt-destruction phases are exceedingly painful events.

Unfortunately, the commenting platform where the conversation is occurring does not support charts, so I decided to put up some charts that would inform the discussion here.

The first chart shows accumulated Household Sector Debt as a percentage of the US Gross Domestic Product from 1952 to the present. As one can see, prior to 2008, the only significant reduction in the ratio of household debt to GDP occurred in the recession that began in February of 1980. Other instances in which HH-Debt-to-GDP saw modest declines occurred either in a time of war (the late 60s to early 70s) or times of recession.

Interestingly, the one period in which economic growth was relatively robust while HH-Debt-to-GDP increased relatively modestly was the 1990s.

The next chart offers a different and, I believe, more interesting look at the relationship between changes in household debt and periods of recession.

This chart maps percentage changes in nominal household debt against periods of recession. Looking at this chart, the thing that immediately jumps out at you is the way that decelerations in household debt creation seem to almost inevitably lead into periods of recession. Eight out of the last nine recessions were preceded by decelerations in household debt creation. The one exception in the bunch was the recession that followed the events of 9/11.

There were also two instances where decelerations in household debt creation did not lead to a recession. The first of these was the deceleration that led into the 1967 economic slowdown. This was a significant slowdown, but it did not translate into a full-fledged recession. The second instance was a modest deceleration in the mid-1990s.

Another interesting thing to note from this chart is the way the ending of the recession was preceded by a reversal of the trend in household debt. In all recessions prior to the 9/11 recession household debt ceased decelerating and began to accelerate at least one quarter prior to the ending of the recession. This is not surprising, since the principal monetary tool used to end recessions is the lowering of interest rates to entice enterprises to begin borrowing again. And as Kydland and Prescott showed in their 1990 study Business Cycles: Real Facts and a Monetary Myth, household expenditures are the component that drives expansions and contractions in the overall economy (at least during the period we are looking at).

Note: This second chart reflect data from the Federal Reserves Flow of Funds tables, and in order to highlight the correlations, the first quarter of each year includes a seasonal adjustment. Without the seasonal adjustment, the chart takes on a gap-toothed look.

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Our Central Economic Challenge

At this point everyone I talk to about this stuff knows I believe that the discipline of economics has failed in a catastrophic way. Remarkably, one can lay out the nature of this failure in very few words:

(First) What if you acknowledge that, when it comes to the nation’s total household debt, there are only three possible states? In all instances, the household debt must be (1) increasing, (2) decreasing, or (3) holding steady.

(Second) Even a brief glance at history will tell you that only one of these states is consistent with a healthy and expanding economy. Household debt must be increasing in BOTH real and nominal terms.

(Third) What if you recognize that real household debt cannot expand forever? Yes, debt is something we owe ourselves; but if you want to understand the world, you cannot lose sight of the fact that household debt is owed by borrowers (borrowers with limited real capacity to borrow).

In short, economies only run properly when household debt is expanding, but this debt cannot expand forever.

When framed in these terms, this formulation sounds both simple and obvious. However, if the above statement is true, then it means that mainstream economic theory fundamentally misunderstands how economies work. It also, by-the-way, means that America and much of the world need to rethink our approach to managing our economic systems.

If you accept the logic presented above, then you are forced to accept the notion that our economy must go through phases—phases of debt-expansion and debt-destruction. A debt-expansion phase can last a long time—more than 60-years in our last stint (1946 to 2008)–but they cannot last forever. Debt-destruction phases last a long time too, and when a debt-destruction phase comes to a large economy, those phases are called depressions, or in Japan’s current case, long periods of deflationary stagnation.

Here is how the system works:

  1. An increase in debt drives growth in demand. (We pledge more resources from our future to buy things today.)
  2. A decrease in debt diminishes demand.
  3. When household debt is growing, things feel good. Demand is strong. People are pledging future resources, creating purchasing power, and the economy has the fuel it needs to drive growth.
  4. But when debt stops growing and begins to fall, this is when things fall apart. The so-called paradox of thrift kicks in. Reducing debt means reducing demand. Decreased demand translates to decreasing employment and earnings for many Americans and decreased asset values. As a result, the burden of debt we are attempting to pay down becomes even heavier, putting even more downward pressure on demand.

What you end up with is a deflationary cycle where falling wealth and falling earnings for many households causes the entire economy to be crushed under the weight of outstanding debts.

To get a sense of how this works, imagine how crushing your current debts would feel if someone were to cut in half the value of your wages and the value of your accumulated wealth. And imagine how tough it would be to be a creditor in a time when many of the loans you made in past years are unlikely to be repaid.

In a nutshell, after a 60-plus year debt-expansion phase, the American economy has now entered into a necessary-but-painful debt destruction phase. As the chart below illustrates, our debt-destruction phase has just begun. And sadly, as many households know from harsh reality, the paradox of thrift outlined above has begun to play out. Since 2007, the median household has seen a decrease in their income; they have seen a decrease in employment prospects; and, with dramatic erosion in home values and in stock market indices, they have almost certainly seen a dramatic decrease in their overall wealth.

If the above is an accurate understanding of how the world works, the implications are astounding. It means you can take much of what economists have told you up to now and drop it in the trash. It means that, unless we face up to our reality and do something truly radical, we face exceedingly hard times for years (perhaps even decades) to come. It means that, in the long run, we probably need to rethink the proper economic stance on questions like income distribution, optimal tax levels and structures, and how governments should go about monitoring and managing our economic system.

In coming days and months, we will attempt to broaden and deepen our understanding of how the system works and what is going on, and we will begin to delve into theses far-reaching implications.

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