There is nothing tautological about market monetarism
By Scott Sumner
Bill Woolsey directed me to a post by Kevin Grier (commenting on Lars Christensen):
OK, so the first graph is the path of Nominal income (PY) relative to trend. The second is the path of real income (Y) and the third is the path of prices (P). Nothing objectionable about the graphs in themselves.
You can see NGDP has fallen a lot (relative to trend), mostly due to lower real GDP. Since we are dealing with accounting here, we really only need two of these graphs. the third one is implied by the other two.
But people, what just sets my teeth on edge and puts a bee in my bonnet is the idea that, and I quote:
The message from the graphs above is clear – the Italian economy is suffering from a massive demand short-fall due to overly tight monetary conditions (a collapse in nominal GDP).
Nominal GDP IS nothing more than the product of prices and output. To say that a fall in nominal GDP relative to trend “caused” the fall in the path of prices and output relative to trend is just gibberish.
Try it in the abstract without the sacred labels. “The fall in XY caused the fall in X and the fall in Y”.
Ummm, maybe the fall in Y caused the fall in X and as a result XY also fell?? Or the fall in X? Or some third factor caused both X and Y to fall and as an unavoidable consequence of arithmetic, XY also fell?
Labeling PY as “Monetary conditions” and then saying Y fell because PY fell and blaming that on monetary conditions is not an economic theory. It’s not even an un-economic theory.
First let me remind readers that although their names sound similar, real and nominal GDP are completely unrelated. Just as the product of an odd and even number is always 100% even, and not sort of even and sort of odd, nominal GDP is a 100% nominal variable. Real GDP is more similar to the output of the kiwi fruit industry than it is to nominal GDP. The fact that RGDP and M*V are strongly correlated in the US is a stunning, mind-boggling fact that is not predicted by classical economic theory. There are many countries where the two variables are not correlated.
Nominal GDP can be compared to other nominal variables like the money supply and inflation. Is there anything controversial about saying that a fall in the money supply reduced output? How about claiming that deflationary monetary policies reduced output? Those are the sorts of things you’d hear from old monetarists and Keynesians. Conversely, a real business cycle economist would predict that a fall in NGDP (or M or P) would not reduce output.
Grier is right that Italian output might have fallen for other reasons. Normally if that were to occur (a negative supply shock) you’d expected Italian prices to rise while Italian output fell. But Italy is now part of a monetary union. In that case you might expect a negative supply shock to produce falling output and stable prices. The fact that prices also fell is indicative of the fact that the monetary union it belongs to was itself creating a negative demand shock, for Italy and for the union as a whole.
To be more specific, the fall in RGDP suggests that Italy was not just experiencing a negative demand shock (which we know from falling NGDP) but was “suffering” from it. If only prices had fallen, Italy would not be “suffering.”
Of course a set of graphs does not “prove” anything. But I doubt Grier would have reacted the way he did if the first graph had shown M2 growth falling below trend, and being correlated with deflation and depression. And yet that would be a very similar type of claim. And it would be equally true that a set of 3 graphs showing falling M2, RGDP, and prices did not “prove” anything. RBC economists would have argued for reverse causation.
Outsiders frequently argue that there is something “tautological” about the claim that falling NGDP causes falling output. It’s no tautology, and as we saw in Zimbabwe it’s not even always true that falling output is associated with falling NGDP. The real issue is this: Which nominal variable should we target to get the best macro outcomes. Old monetarists said the money supply. Mundell might say exchange rates. Some Austrians might say the price of gold. Conservative Keynesians might say inflation. Liberal Keynesians might say a weighted average of inflation and the output gap. Market monetarists say the level of NGDP.
If it were a tautology it could not be tested. Our claim is that if the Fed pegs the price of NGDP futures contracts along a 3%, 4%, or 5% growth path, then RGDP will be more stable in the future than in the past.
Bill Woolsey also has some good comments. This caught my attention:
Finally, we can imagine a Walrasian Auctioneer determining the real output of all the products using an arbitrary numeraire. And all output and resource use is determined. Presumably, we could measure real GDP using any good as numeraire.
We could measure nominal GDP in terms of kilobytes of computer memory. Oddly, this measure of NGDP would not be correlated with RGDP in the way that money NGDP is correlated with RGDP. Ask yourself why. After all, the quantity of kilobytes times kilobyte “velocity” equals NGDP in kilobyte terms.