Goldman Idea Could Let Inflation Out of the Bottle: Amity Shlaes

There are bad ideas, and there’s the proposal that economists from Goldman Sachs Group Inc. (GS) released Oct. 14. They suggested that the Federal Reserve Board target a nominal gross-domestic-product growth rate of 4.5 percent to decide how much money to inject into the economy. The econo- speak name for this practice is “NGDP targeting.” The question is whether that unlovely abbreviation makes it into mainstream English and becomes policy.


In practice, NGDP targeting means the Fed will create money by a variety of methods, such as purchasing bonds, until the U.S. growth rate hits the magic level on paper. The extra money pours into the hands of consumers and companies, who spend. Voila: 4.5 percent growth.
The “on paper” part is important. “Nominal” means the Fed may disregard, at least for the moment, what share of that growth is real and what share is inflation.
It all accords with the Fed’s dual mandate of a low inflation rate and strong growth as codified in the Federal Reserve Act: to maintain “long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

It Sounds Good

The NGDP idea sounds good to a lot of people, including the former chairwoman of President Barack Obama’s Council of Economic Advisers, Christina D. Romer. She praised NGDP targeting in the New York Times on Oct. 29 as a plan worthy of former Fed Chairman Paul Volcker. Romer’s praise, in turn, won the blessing of Paul Krugman, the economist and New York Times columnist.
Whence the enthusiasm? First, a general despair over current economic-growth rates. The previous four recoveries brought growth averaging about 4 percent in their first two years. But the economy averaged a ghoulish 2.5 percent growth during the first two years of the current recovery. This was notwithstanding Fed interventions, such as quantitative easing. So any idea that leads to 4.5 percent growth sounds brilliant.
The target idea is also attractive because it’s a rule, one that even seems to resemble those that respectable economists have advanced in the past. One is the Taylor Rule, named after a former undersecretary of the Treasury, John B. Taylor. It says the Fed should manage the interest rate to move with inflation. An NGDP target also sounds like something Milton Friedman might have advocated.“Rules Instead of Authorities,” Friedman headed a subsection on Fed reform in “Capitalism and Freedom,” his primer. Generations of students underlined those four words.
Finally there is a great desire to do something, anything, to reconfigure the Fed. Romer suggests that requiring the central bank to target nominal GDP would be as dramatic a shift as Volcker’s decision to force a recession to fight inflation after he became Fed chairman in 1979. Romer and the Goldman Sachs authors focus on the growth part of the dual mandate. Romer’s plan for growth includes devaluing the dollar to goose exports, and possibly more quantitative easing.

Flawed Defenses

But none of these defenses of targeting nominal GDP holds up. Everyone wants stronger growth. By “4.5 percent growth,” however, we generally mean real growth. Under NGDP targeting, it’s possible for the Fed to get a growth rate of 4.5 percent, of which 3.5 percentage points are inflation and only 1 percentage point real. That hardly accords with the spirit of the line in the Fed statute about increased production.
In short, the big vulnerability of NGDP targeting is that it’s a license to inflate. It will inevitably undermine the Fed’s mandate to maintain price stability.
It’s also false to assume that economists such as Taylor and Friedman would view NGDP favorably, even if it sounds like a rule they would support. In response to my query about NGDP, Taylor sent a description of the reform he seeks -- not widening the Fed’s growth mandate, but rather removing it.

Taylor’s Reform

Taylor says he would like to see reform happen in this order: 1) Congress enacts a single mandate for price stability; 2) Congress enacts reporting requirements for the Fed on what its strategy or policy rule is; and 3) the Fed picks a strategy relating to money and interest rates and tells the public what that strategy is.
Friedman, in turn, noted in “Capitalism and Freedom” that any goal or target set should be one that Fed authorities have the “clear and direct power to achieve by their own actions.” That is, not something big and ephemeral such as a higher GDP growth rate. Friedman recommended a “legislated rule instructing the monetary authority to achieve a specified rate of growth in the stock of money.”
One distinction here is mandate. In both the Taylor and Friedman plans, the Fed’s mandate narrows to money alone. In both of them, there is less discretion, not more, for the Fed.

Managing Expectations

To be bold in the way the NGDP fans would like is to risk destroying the very legacy that Romer praises -- that of Volcker. In his day, Volcker did such a convincing job reducing the expectations of inflation that mortgage interest rates came down and continued to drop long after he left office.
To signal that you don’t care very much if inflation accelerates, which the NGDP target plan does, invites citizens to change their expectations about inflation. That, in turn, will raise interest rates far above any currently contemplated.
It’s surely important to have rules and targets, but not more discretion masquerading as a rule called the NGDP target. Here’s hoping this particular abbreviation remains locked away in the economists’ closet.