NGDP futures targeting means never having to say you're sorry
By Scott Sumner
There are many arguments for rules over discretion. Here’s one that I haven’t seen before.
Policymakers are only human, and don’t like to admit to making mistakes. Especially when those mistakes might have harmed millions of people. In contrast, markets don’t have egos. Markets don’t mind admitting mistakes. Indeed hardly a week goes by without some sort of “correction” in asset prices. By ‘correction’ I mean retracing a previous asset price movement that was caused by expectations that, in retrospect, later seemed unwise.
One can find many examples of central banks letting their egos get in the way of good policy. In 1936 and early 1937, the Fed raised reserve requirements sharply. Later in the year it was obvious that they had made a mistake. But in the Fed minutes it is apparent that FOMC members were reluctant to do anything that would be an implicit admission that the previous policy might have contributed to the steep recession of late 1937.
Here’s another example. In April and July 2011, the ECB raised interest rates under the leadership of Jean-Claude Trichet. They did so because they were worried about headline inflation. In retrospect, we know that that fear was mistaken, and indeed eurozone inflation over the past 7 years has been far too low. But in early 2011 there had been a brief inflation spike due to international factors like rising commodity prices, and also VAT increases associated with austerity.
Now let’s consider how soon it took for it to become obvious that the ECB had erred. We do know that the eurozone almost immediately went into a double dip recession. But how soon was that apparent to the markets? Unfortunately we lack a eurozone NGDP futures market for the eurozone, but the German stock market is suggestive:
Unfortunately the scale is cut off, but the two relevant horizontal lines are for 7500 and 5000, so soon after the second rate increase on July 13, the German stock market plunged from the low 7000s to the low 5000s, a quite sizable drop (comparable to the recent Chinese stock crash.) It seems reasonable to assume that this is about when the markets perceived the double dip eurozone recession, which we now know was beginning at roughly this time. The German market had rallied over the previous year on hopes for recovery, and then “corrected” when the double dip recession occurred.
How long did it take for the ECB to perceive its error? Maybe not too long—they could see what was happening in the markets. But a sudden reversal of ECB policy toward loosening would have been an admission of error, an error that did great damage. And human nature being what it is, that’s not easy to do.
How long did it take the ECB to admit error? One indication is that they began cutting rates on November 9, 2011, about 4 months after the previous increase. And why November 9th, why not September or October? I can’t be certain, but consider the following. On November 1, 2011 Trichet resigned, and was replaced by Mario Draghi. Draghi could shift course without any embarrassment, because he had no stake in the previous decision. Coincidence? Perhaps, but if not then this leads to a dilemma:
1. The “credibility” argument suggests central bankers should have very long terms, so that they can carry out their promises.
2. The “correction” problem suggests they should have very short terms, so that someone new can come in and correct any previous errors.
Or maybe we should turn policymaking over to an NGDP futures market, where egos don’t get in the way. Markets can correct without any embarrassment, they are shameless.
PS. If you are too young to understand the reference in the post title, consider yourself lucky.