Friday, July 26, 2013

The Sumner on our discontent

Bentley University macroeconomist Scott Sumner has a new paper explaining his proposal for a prediction market for nominal GDP, and how that would make monetary policy less disruptive to the economy (and our lives) than it has been in the past. Highlights;
... it may be helpful to think in terms of  “prediction markets” rather than “futures markets.” Corporations and other organizations often use prediction markets to utilize the “wisdom of crowds.” Thus, businesses might offer prizes to those employees who most accurately forecast corporate sales revenue over the following 12 months. The purpose of these markets is not to encourage gambling, but rather to derive the optimal estimate of the future path of important economic variables.
....In order to develop a market-driven monetary policy, it is necessary to first think about how to induce market participants to make socially constructive decisions—that is, to engage in open-market purchases or sales that are expected to lead to on-target growth in nominal spending. A “market-driven” monetary regime is one where there is free entry and where traders are rewarded based on their skill at forecasting nominal GDP growth. 
That last sentence is pregnant with possibilities. One of which Sumner spells out for a Fed that uses the Federal Funds Rate (the interest rate banks pay each other to borrow funds overnight) as its primary tool;
...there is a relatively simple way to reward monetary-policy decision makers. For example, assume that the Fed has a 3.65 percent nominal GDP growth target and that the committee sets the fed funds target at 2.25 percent, based on the preferences of the median voter on the Federal Open Market Committee (FOMC). Then the six hawkish FOMC members who advocated a fed funds target above 2.25 percent will presumably be concerned that the lower actual instrument setting will be too expansionary and will push the nominal GDP growth rate above 3.65 percent. The six dovish FOMC members would have expected below-target nominal GDP growth when the fed funds target was set at 2.25 percent.
Which brings the part we like best;
Next comes the first step toward a market-driven monetary policy regime. Assume that the salary of each voting member of the FOMC is tied to the accuracy of his or her NGDP forecasts. Thus, if actual NGDP growth turned out to be “too high”—that is, above 3.65 percent—then all those FOMC members who preferred a more contractionary policy stance (a higher fed funds stance) would receive a pay bonus, and those who voted for an even more expansionary policy would see their pay reduced. 
Their money is where their votes are. Now, those incentives need to be linked to the monetary base (ultimately what we, the people, use to buy stuff);
The Fed would peg the price of NGDP futures at $1.0365, but only during the period where it was the target of monetary policy. During this period, changes in investor sentiment would affect the quantity of money, not the price of NGDP futures. For market expectations to determine monetary policy, there must be a link between NGDP futures purchases and sales, and the quantity of money. This link can be achieved by requiring parallel open-market operations for each NGDP contract purchase or sale. Because investors buying NGDP futures are expecting above-target growth in NGDP, the Fed should automatically reduce the monetary base each time an investor buys an NGDP futures contract, and it should automatically expand the base each time an investor sells an NGDP contract short. For instance, each $1 purchase of a long position in an NGDP futures contract might trigger a $1,000 open-market sale by the Fed. A purchase of a $1 short position would trigger a $1,000 open-market purchase by the Fed. In that case, investors would be effectively determining the size of the monetary base.
The wisdom of the crowd would not be in guessing the number of jelly beans in the jar, but determining the number. Which would tend to push nominal GDP to the announced target. Sumner argues that had such a regime been in place in 2008, we would have avoided the worst of the financial crisis/Great Recession.
By harnessing incentives, as economists of all political stripes profess to believe.

The above scheme isn't the only one possible. Rather than focus on the Federal Funds Rate the Fed could use the price of gold, foreign exchange rates, or some other variable to accomplish the same thing; market-driven monetary policy.

Which would not be perfect...just better than the way we do things now.  But Sumner isn't a wild-eyed radical, he's willing to be patient and cautious;
The first step will involve the Fed creating and subsidizing trading in an NGDP futures market, and perhaps in GDP-deflator and real-GDP futures markets as well. Over time, it will become possible to observe those markets’ track records. In particular, the Fed will be able to study whether the NGDP futures market can accurately predict policy errors. If so, then the next step will be for the Fed to use NGDP futures prices as one element in the monetary-policy decision-making process. Once it has achieved a comfort level with using this market, the Fed should make currency and reserves convertible into NGDP futures at a fixed price. This is the index futures convertibility approach that Woolsey advocates, which still gives the central bank some discretion over monetary policy—much like the classical gold standard. Eventually, the Fed may move to a full-fledged NGDP targeting regime, where it passively implements market instructions to adjust the monetary base.
Sumner also takes a well deserved shot at the Zero Bounders who loudly proclaim that the Fed is out of ammunition when the Fed Funds Rate is near zero; thus in a liquidity trap. But that is not at all true, it's more of a self-fulfilling prophecy. When you realize that short-term interest rates are NOT the transmission mechanism of monetary policy, you see how phony the Zero Bound is. It's an excuse. An excuse to engage in fiscal policy--taxation, spending--that isn't needed, or that can be effective.

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