Zachary David on NGDP futures targeting
By Scott Sumner
Jim S. directed me to a Zachary David post criticizing my NGDP futures targeting proposal. He links to my Mercatus paper on the plan, but seems to ignore its contents. Most of the objections that he raised are answered in the Mercatus paper. He may not agree with my arguments, but he should have at least acknowledged them.
For instance, he suggests that there might be little interest in trading NGDP futures contracts, but doesn’t tell us why that would be a problem. (It isn’t.) He wonders why NGDP futures would be such a good idea, given that the private sector hasn’t already created such a market. Perhaps that’s because the private sector is not legally allowed to do monetary policy.
Breaking down the mechanics you get:
1. You believe NGDP will be lower than the Fed’s posted market of x% at expiration
2. So you sell a futures contract to express this view
3. The Fed responds by increasing the monetary base
4. Thus raising expected NGDP against your view
So… by selling that futures contract you have just raised the expected settlement value against yourself. It’s like if selling a futures contract in copper triggered a mechanism which automatically lowered the existing quantity of copper. Expressing your view immediately causes your view to be less right. I’m not suggesting that people don’t respond to prices all the time — e.g. a farmer seeing a high price for future grains and subsequently planting more of them. But in general, a well-functioning market shouldn’t have an infinitely liquid counter-party triggering automatic causal effects against every position.
Notice that he suggests a way in which this market would differ from other markets, and then explains that his reasoning was actually incorrect—futures purchases in other markets do trigger supply responses—and then ends up telling us how he thinks a “well-functioning market” should behave, without providing any justification.
I think such a mechanism not only defeats the purpose of price discovery, but in Sumner’s market it might lead to other hilariously manipulative scenarios. Consider: because the Fed is pegging the price of the futures contract and buying/selling infinite quantities, a smart player could load up on assets whose prices would be affected by a large expansion of the monetary base, then sell a tremendous amount of NGDP futures to trigger open market purchases, then sell the aforementioned assets and subsequently repurchase the NGDP futures at the same price for a tidy profit.
Note that the purpose of my proposal is not “price discovery” any more than a $35/oz. peg of the dollar to gold is aimed at “price discovery” of gold prices. Taking the gold standard analogy one step further, one could argue that a “smart player” could have loaded up on gold during the 1920s, and simultaneously sold short an asset that would be likely to decline in price under a contractionary monetary policy. And then the manipulator could have sold the gold back to the central bank at the same price. Does this seem too good to be true? That’s probably because it is. Everyone else would have the same opportunity, so it’s very unclear at whose expense this manipulator will profit.
Under NGDP futures targeting, manipulation would be even more difficult. If you sold the asset back immediately, it would not significantly impact monetary policy. Now consider what would happen if you held the NGDP futures until maturity. If you bought NGDP futures to trigger a contractionary monetary policy, and it succeeded, you would lose money on the NGDP futures (unlike the previous gold example where you break even on gold.) In that case, you need even bigger profits on your side bets. The problem is obvious—other “manipulators” will be taking the opposite strategy. If they respond to you by selling NGDP futures, moving monetary policy closer to the correct level, they will breakeven on the NGDP futures and profit (at your expense) on their side bets in other markets.
In any case, his criticism doesn’t even apply to Bill Woolsey’s version of the policy, one of the four versions I discussed in the Mercatus paper, and the version I have more recently concluded is the best. Under this plan the Fed simply makes dollars convertible into NGDP futures at a fixed price, without any automatic link between NGDP futures purchases and the base. It’s analogous to a gold exchange standard where the central bank is not required to follow any sort of “rules of the game”. Perhaps David didn’t read that far.
There’s also a long discussion of NGDP data revisions. David worries that this might reduce interest in an NGDP futures market, as investors wouldn’t have confidence that the initial estimate would hold up over time. This is one reason I like the Woolsey version of the plan, it’s easier to head off this sort of criticism (which I would argue are not a problem in any of the 4 versions). Under what Woolsey calls “index futures convertibility”, it makes no difference if no one buys or sells NGDP futures, just as under a gold standard it makes no different whether anyone takes the central bank up on the offer to exchange unlimited amounts of dollars for gold at $35/oz.
Think of NGDP futures targeting as highway guardrails—does it matter if cars never brush up against them? No, and it also doesn’t matter if there is no trading of NGDP futures contracts.
PS. Note that the policy discussion in this post is entirely different from my proposal that the Fed set up and subsidize trading in NGDP futures for research purposes. In that case the price is not fixed, and it matters very much if there is little or no trading volume.
PPS. This made me smile:
As a result, I predict there would be little to no volume in any NGDP futures contract.
In fact, I set up a futures market for one-year NGDP contracts at Hypermind with just $5000 in subsidy, and there was active trading, albeit a modest volume. Imagine the volume of trading if the prize money had been $50,000. Then imagine $500,000. Then imagine $5 million. Then imagine $50 million. Then imagine $500 million. Then think about the fact that even $500 million is chump change to the Fed.