A new paper by Vipin Veetil and Richard Wagner discusses a heterodox theory of business cycles, and then uses this theory to criticize NGDP targeting. Here is the abstract:

This paper argues that NGDP targeting is unlikely to produce macroeconomic stability. Contrary to the policy objective, NGDP targeting may increase macroeconomic turbulence. DSGE models that prove the effectiveness of NGDP stabilization policy rest on two assumptions. The first assumption is that macroeconomic volatility is a consequence of exogenous shocks to an otherwise stable system. The second assumption is that central banks can act upon aggregate variables. Neither of these assumptions is accurate. An economy is an ecology of interacting agents, some of whom have rivalrous plans. Macroeconomic volatility is an endogenous and intrinsic feature of such an economic system. Furthermore, central banks act upon some agents in the economic system, not on aggregate variables. The percolation of central bank actions through production networks can impede coordination efforts of economic agents during recessions, thereby increasing macroeconomic volatility.

I read the entire paper and was not able to discover any clear link between the underlying theory and the critique of NGDP targeting. More specifically, it’s not clear what would happen if you had replaced “NGDP” with RGDP, or inflation, or M2, or the price of gold, or indeed any other possible monetary policy framework. In other words, when they criticize NGDP targeting I’m constantly asking myself, “Compared to what?” Which monetary regime is better?

For instance, they suggest that adjusting M to offset changes in V will inhibit the necessary re-coordination of economic activity after some part of the economy experiences turbulence. That rules out NGDP targeting. That led me to expect them to advocate money supply targeting, where you don’t offset changes in V. But that doesn’t appear to be their preferred solution either:

NGDP stabilization, in other words, will impede creative evolution within the ecology of plans of a society. Lavoie (1983) recognized this problem in his paper “Economic Calculation and Monetary Stability”. Lavoie argues that a rule of fixed rate growth of money supply is not sufficient to solve problems associated with inflation because inflation necessarily diverts resources from one use to another. Such diversions are problematic
because they will tend to produce readjustments in so far as the diversions are inconsistent with the plans that economic agents would have formed in the absence of inflation. Lavoie’s view of the economic system is very different from that of the DSGE view. Lavoie (1983, p. 164) sees an economy as a “complex network of production relations”

How can one argue that NGDP targeting is a bad idea without suggesting a benchmark alternative?

I’m also a bit confused as to why they think NGDP targeting would harm an economy:

Macroeconomic turbulence is reflection of microeconomic coordination problems. The decline in velocity of money during recessions does not indicate an increase in the demand for money per se, but merely the postponement of spending as economic agents make new plans to create coordination. Increasing the quantity of money to accommodate the decline in velocity of money as prescribed by NGDP targeting will do little to solve microeconomic coordination problems. DSGE models present a picture of an economy where central banks can directly act upon aggregate variables. From an ecological perspective, central banks act upon some agents within an economic system, who in turn pass the effects of central bank actions to other agents through production relations.

Here it seems like words are getting in the way of meaning. I don’t doubt that economists sometimes talk about monetary policy directly impacting NGDP, but surely they always have in the back of their minds the idea that it must first impact the behavior of individuals. NGDP aggregates prices and output, and thus NGDP cannot change unless at least some individuals adjust their output or pricing decisions. Does anyone disagree?

Similarly, what’s the point of denying that a decline in V represents an increase decline in money demand? It may occur for various reasons, but it is what it is.

Proponents of NGDP stabilization point to such abrupt downturns in the growth of nominal GDP as occurred in 2008 as something that could be eliminated by having the Fed stabilize nominal GDP. We do not doubt that a sufficient monetary expansion could offset any decline in nominal GDP, provided only that V remains positive. To conclude that nominal stabilization implies real stabilization, however, is possible only if monetary change is always neutral.

This is exactly backwards. People who favored a more expansionary monetary policy in 2008 did so precisely because we believed money is non-neutral in the short run. Back in late 2008, I recall speaking with a new classical economist who opposed monetary expansion precisely because he thought it would merely lead to higher inflation. Economists who believe money is neutral typically oppose NGDP targeting.

The primary problem I have with this paper is that their theory of the business cycle doesn’t seem consistent with the empirical evidence. They suggest that economic dislocation in one part of the economy can have a sort of “cascading effect” on the overall economy, because the actions of economic agents are interrelated. They criticize the standard view, which is that in a large diversified economy the impact of micro level disturbances tend to balance out:

Economists for many years believed in the dictum that small changes at the micro level cancel out to produce little or no change at the macro level. In Lucas’s (1977, p. 20) words the cancelling of small changes in a large system is “the most important reason why one cannot seek an explanation of the general movements we call business cycle in the mere presence, per se, of unpredictability of conditions in individual markets”.

In contrast, I see the business cycle as being (in Fisher’s words) a “dance of the dollar”. Unstable monetary policy shows up as unstable NGDP. Since wages are sticky, employment tends to move with NGDP in the short run, and unemployment is countercyclical. Recessions occur when a sharp decline in NGDP growth leads to a rise in unemployment:

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Now of course this doesn’t prove that stabilizing the growth rate of NGDP would help to smooth out the business cycle, but it’s certainly better than an alternative theory that seems completely at variance with the empirical data. Thus the March 2011 Japanese tsunami is often considered the single most disruptive real shock to hit a major economy in decades. It disturbed all sorts of supply lines in Japanese manufacturing, and closed down the entire nuclear power industry for years. The media were full of reports that Japan would be driven into recession, and indeed industrial production did decline for a few months. But unemployment was unaffected because it’s NGDP, not real shocks that drives the unemployment rate:

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In contrast, unemployment spiked when the BOJ allowed NGDP to decline in 2009.

A large diversified economy is going to have a relative stable labor market, unless:

1. The central bank has an unstable monetary policy (unstable NGDP).
2. The national government disrupts the aggregate labor market with unwise regulations, such as an extremely high minimum wage.

HT: Ben Klutsey, Patrick Horan