Although it has gained many converts since 2008, thanks especially to tireless crusading on its behalf by Scott Sumner, David Beckworth, and Lars Christensen, among other "Market Monetarists," the suggestion that the Fed ought to stabilize, not the inflation rate, or employment, but the growth rate of overall spending on goods and services, still strikes many people as odd, if not positively barmy.
Being, as it were, a sort of Market Monetarist avant la lettre (for I first came to regard a stable level of overall spending as the sine qua none of a sound monetary regime while writing my dissertation ages ago), I naturally find the monetary policy credos of bona fide Market Monetarists as incontestably appealing as apple pie and baseball are to most full-blooded Americans.
My particular understanding of the case for stable spending is, nonetheless, mine alone, and as such somewhat distinct from that of my Market Monetarist brethren. So I thought I might venture, with all due humility, to try my hand at conveying that understanding to those curious but skeptical unbelievers among my cherished readers, by way of an imaginary exchange of questions and answers, where the questions are the unbelievers', and the answers are my own.
What exactly do you mean by "overall spending on goods and services"?
I mean the total quantity of money — of dollars, in our case — that
consumers buyers hand over to sellers in exchange for finished or "final" goods and services (as opposed to intermediate goods or factors of production) over the course of some definite period of time.
A popular, rough measure of such spending is called "Nominal Gross Domestic Product," or Nominal GDP, which according to the IMF "measures the monetary value of final goods and services — that is, those that are bought by the final user — produced in a country in a given period of time (say a quarter or a year)." For 2016, total U.S. Nominal GDP was about $18.9 trillion, which was just under 3.6 percent higher than its level in 2015.
Strictly speaking, Nominal GDP measures the value of goods and services produced, rather than goods and services actually sold to consumers: the difference consists of changes to firms' inventories. A different statistic, "Final Sales to Domestic Purchasers," distinguishes actual sales from output. Final sales for 2016, at over $19.36 trillion, exceeded Nominal GDP, which means that firms' inventories were declining. The year-over-year growth rate of final sales, at 3.64 percent, was also slightly higher than that of Nominal GDP.
Why is it desirable that spending should be kept stable?
Because a stable level of overall spending, meaning in practice a level that grows at a modest and steady rate, helps to avoid recessions on one hand and unsustainable booms on the other.
What exactly do you mean by "recession"?
I mean a circumstance in which businesses as a whole are losing money — that is, taking in less than they spent, allowing for a "normal" return such as they might have earned by just investing the same amount in safe bonds. Alternatively, if you will allow me to oversimplify a bit for the sake of brevity, one might say that during a recession the "average" firm is losing money.
OK, I can see what you mean by that. But then, is the fact that a firm loses money necessarily to be regretted? Surely some firms ought to go out of business, or at least to cut back on it!
Of course some should! And that's not necessarily a problem. So long as the losses of some firms are matched by the extraordinary profits of others, there needn't be any persistent unemployment, either of labor or of other resources. Instead, if the pattern persists, resources will move from the losing to the gaining businesses. And that's just what has to happen if there's to be as little waste as possible.
If, on the other hand, spending as a whole shrinks, there are more unprofitable firms that have to dispense with workers than profitable ones seeking to hire more of them.
So the monetary authority would be justified in allowing the money stock to increase in the case where spending will shrink otherwise, but not to help firms that are in trouble despite stable spending growth?
That's correct. Resorting to money creation to help particular firms or industries, when the "average" firm isn't in trouble, only serves, first, to delay desirable changes in how inputs (the materials and labor businesses bring together in assembling their products) are employed and, eventually, to raise the prices of both those scarce inputs themselves and the product made using them.
But then why worry if the "average" firm loses money?
I repeat: for that to happen, it must be the case that the receipts of industry taken as a whole fall short of its expenses, or of its expenses plus a normal profit. In that case, few if any firms are inclined to hire more workers and to otherwise expand production, while others must curtail production and lay off workers. That spells general unemployment, that is, a recession.
Why should more money creation be useful in this case?
A decline in the "average" firm's revenues can only happen if people are spending less on goods and services, that is, if they decide to hold more money. Some expansion of the money supply can serve to make up for that extra demand for money, reviving spending just enough to make our average firm break even again. Individual firms might still fail; but then others would prosper. So long as total spending by the public on goods and services is stable, or increasing at a modest rate, firms as a whole — hence the average firm — can't be losing money.
So all that's needed to avoid hard times is to keep money flowing?
Whoa! Not so fast. What I'm saying is that so long as there's no decline in overall spending, either absolutely or relative to some modest growth rate, there won't be recessions. But there can still be hard times: production could suffer because of wars, or bad harvests, or trade embargoes, or all sorts of other bad things. In economists' lingo, there might be "negative supply shocks." But there's nothing central bankers can do about them — indeed, no monetary system of any sort can do anything about them. Nothing that's likely to help, anyway.
OK. So suppose they just stick to worrying about spending. How can the authorities know whether they are allowing for sufficient money growth, that is, whether monetary policy is or isn't sufficiently "easy"? Must they keep track of how many firms fail?
Of course not! They just have to keep track of total spending itself. To do that, they can look at the statistics like Nominal GDP, or Final Sales to Domestic Purchasers.
Well, don't get the wrong idea. It's still a tricky business. Those spending statistics don't come out very often. They also tend to get revised. So there's plenty of guesswork involved, and corresponding room for mistakes. But the principle is still sound — and even allowing for mistakes, a monetary policy that's based on wrong principles is bound to be worse.
OK. I get the idea that too little spending can be bad news. But can there really be such a thing as too much spending as well?
There sure can be! Just as too little spending means that the average firm suffers a loss, too much means that the average firm is making extraordinary profits, meaning profits well beyond what it needs to stay in business.
Is that bad?
It is, because it must lead to inflation in the long run — or an inflation of input prices at any rate — and may result in an unsustainable price boom in the short run.
How does too much spending cause a boom?
As I said, excessive spending causes the average firm, or firms as a whole, to enjoy extraordinary profits, at least for a time. Stock prices reflect firms' expected profitability, so it's natural for stock prices to rise when profits themselves rise unexpectedly, as will tend to happen if spending on goods and services itself accelerates unexpectedly.
And why should the boom not be sustainable?
Because, when firms are enjoying extraordinary profits, they endeavor to acquire more inputs so as to expand production. But when all, or most, firms are trying to do this, they only succeed in bidding-up input prices, because in normal times there are only so many inputs to go around. As input prices go up, so do firms' unit production costs. Their once extraordinary profits therefore cease to be so. When word of this hits the street, stock prices go back down as well.
O.K., I see why too much spending can cause an unsustainable boom. So, does that mean that the monetary authorities need to look out for such booms so as to put a stop to them?
Not at all! Monetary authorities are no better at telling whether a boom is sustainable or not than ordinary investors. If anything, they tend to be worse, in part because they have less to lose if they're wrong.
So what should the authorities do to prevent unsustainable booms?
I've already told you: they need only pay attention to total spending, that is, nominal GDP or some similar measure, making sure that it isn't growing too rapidly. So long as it doesn't, there won't be any unsustainable booms — at least, none for which monetary policy is to blame.
But how rapidly is "too rapidly"?
Now there's a good question! There's room for expert disagreement on this point, but the disagreements aren't dramatic ones. Some would have spending grow enough to result in an average inflation rate of 2 percent, which is the rate most monetary authorities favor. That means letting spending grow at a rate equal to the economy's long-run real growth rate, plus another two percentage points, or at around 4-5 percent per year.
Yours truly, on the other hand, has argued that the most stable arrangement is one that lets spending grow only enough to compensate for growth in the economy's workforce and capital stock, which in the U.S. today would mean having it grow at a rate of 2 or 3 percent per year. Since having spending grow at a steady rate means letting the inflation rate mirror the rate at which the economy's overall productivity improves, such a modest rate of spending growth would actually result in mild deflation much of the time. Since the deflation would reflect falling production costs, it wouldn't be a bad thing.
Of course there are those who hold other views, most of which (though not all) lie somewhere between the two I've just described.
Hmm. You are starting to get fancy. Why not just have the monetary authorities target a particular rate of inflation, or, if one prefers, deflation, instead of targeting spending?
Because stable spending is what's required to keep firms from either generally losing money or generally enjoying unsustainable profits. A stable inflation (or deflation) rate isn't generally consistent with that outcome.
Because an economy's inflation rate depends on two things. The first is how much people spend. The second is how many real goods and services firms are able to supply using the inputs they buy. If the rate of growth of spending is itself stable, the inflation can still vary as productivity (the output produced from any given amount of inputs) varies. So long as productivity fluctuates, a stable flow of spending requires a fluctuating rate of inflation. Keeping inflation stable, on the other hand, would mean letting spending fluctuate. And we've already seen that fluctuations in spending aren't consistent with avoiding unsustainable booms and busts.
I suppose. But just how much harm could possibly come from, say, sticking to a constant rate of inflation?
Plenty, actually. Let me give you a for instance. Remember what I said about negative supply shocks — you know, wars and bad harvests and all that?
Yeah, sure. Causes of hard times that monetary policy can't fix.
Exactly. But while no monetary policy or regime can undo the harm done by a negative supply shock, the wrong sort of policy can make things worse. Suppose, for example, that a country becomes the victim of a blockade. Because fewer goods are available, people are bound to be worse off. If spending stays stable, the shortage of goods will also mean higher prices all around.
Right! So why not at least take steps to prevent the inflation? People are already suffering enough!
No, no no! You've got it all wrong. The inflation in this case is just a reflection of the fact that goods are scarcer than usual. The economy is only suffering from one "bad" thing — not two! Suppose the authorities decided to "do something" about the inflation. What would it be? The answer is that they'd have to tighten money, and limit spending, to keep prices from going up. In other words, to make up for the greater scarcity of goods, they'd be making money more scarce as well! So instead of just finding that their incomes don't buy as many goods as before, now people get fewer goods and less income to buy them with!
So stable spending really does beat stable inflation. You know, I think I'm starting to get it!
Kudos to you!
But you still haven't explained which view regarding just how quickly spending ought to grow is the correct one.
That's true. But really, the actual spending growth rate matters a lot less than having spending grow at some steady and predictable rate. For once people and businesses become accustomed to that rate, the mere fact that they know and can predict it will suffice to rule out serious business cycles, at least so far as monetary policy can do that. So why don't we leave it at that for now. Getting people to see why responsible monetary policy is fundamentally about keeping spending stable is hard enough as it is, without trying to convince them that a spending growth rate of 4 percent is a whole lot better than one of 2 percent!
O.K., I get that. But all this talk about the right monetary "policy" makes me uncomfortable. Why entrust the management of money to a bunch of bureaucrats in the first place?
Congratulations! By asking that intelligent question, you have earned a place at the head of the class!
The truth is that, so long as we rely on discretion-wielding central bankers to manage national money stocks, we're unlikely to witness the sort of stable spending that I believe is most consistent with overall macroeconomic stability. There are all sorts of reasons for that, some stemming from political pressures, others having their source in central bankers' limited knowledge.
I personally think we can do better. One option is to impose a monetary rule or mandate or both giving central bankers no option save that of maintaining a stable flow of spending. That would at least stop them from undermining stability by pursuing other goals. But I believe we can do better than that, by reproducing some features of the remarkably stable "free banking" systems that blossomed in several places in the past, and especially those features of free banking systems that served to automatically stabilize spending. For the time being, though, we are stuck with monetary systems to which bureaucrats hold the reins, so we must do whatever we can to make the best of a bad bargain.
In any event, whatever monetary system one prefers, it remains the case that, if that system is to work reasonably well — if it's going to manage money better than central bankers have — it will have to succeed somehow in achieving and maintaining a stable flow of spending.