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A Flaw in Goldman's Nominal GDP Targeting Proposal

Anthony Randazzo
October 18, 2011, 7:14pm

Goldman Sachs most recent economic analysis makes the case for the Fed to re-interpret its dual mandate and target a nominal GDP level. We've argued against the dual mandate in the past, and the critique that price stability targeting is inherently destabilizing remains. But there are more reasons why this idea for nominal GDP targeting is a bad idea.

First, here is the Goldman perspective:

We believe that the best way for the Federal Open Market Committee (FOMC) to deliver significant additional easing would be to target a nominal GDP path such as the one shown in Exhibit 1, indicating that it will use additional asset purchases—and all other available policy instruments—to ensure that actual nominal GDP reverts to trend over the medium term. The target path would remain in place until nominal GDP has converged to it, and would thus constitute a temporary change to the Fed’s monetary policy framework. The instruments for pushing nominal GDP back to the target path could include a commitment to keep the federal funds rate low for as long as needed to put the economy well on its way back to the target path, as well as additional large-scale asset purchases. [...]

Simulations using a highly simplified model suggest that a nominal GDP target could improve economic performance substantially compared with a standard Taylor rule. In the model, the economy receives a significant boost through lower real long-term interest rates, via a delay of the first funds rate hike and temporarily higher expected inflation... Pairing a nominal GDP target with additional asset purchases would enhance the credibility of the shift in the short term. And the shift in the target would raise the likelihood that the asset purchases will be effective—making the whole greater than the sum of the parts.

Okay, here is the problem: Goldman is right to point out that nominal GDP has shifted off of its pre-2007 trend. We are about 10% off in nominal GDP in 2011 as the long-term trend of 4.5% would suggest we should be at. However, the technical aspects of increasing Fed purchases being damaging to the economy aside, the historical trend is pricing in the very same federal subsidies that led to the destabilized economy slowing down in the first place. 

For instance, economic growth from 1992 to 2006 was heavily dependent on the housing sector, but we'd never have seen such growth—or nominal GDP expansion during that period—without the expanded housing subsidies generated by Fannie and Freddie and their support for the RMBS market. Furthermore, over the past few decades, the financial sector has become an increasingly larger share of GDP. That would not have happened without regulations that allowed the financial sector to build fortunes on the back of taxpayer guarantees and taxpayer funded insurance programs for deposits that investment banks could use to gamble with. 

Pull out just those two government props to industry and you have a changed economic scenario. I assume those bad subsidies should go away, changing today's economic scenario, so to suggest that we should use the Federal Reserve to revert to a trend that prices in those subsidies is ludacris. 

The interesting thing is that we would have a stronger economy long term with more economic freedom. It would be more stable and could produce an even larger nominal GDP growth trend than 4.5%. It isn't clear exactly since we don't have a free society or free economy. But we do know it would be stable and would not need the Fed to step in a savior like Goldman proposes here. I, for one, don't think we should try to get back to the way things used to be but should look forward to the way things ought to be. 


Anthony Randazzo is Director of Economic Research


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