Price-Level Movements, Fixed Nominal Contracts, and Debtor-Creditor Equity

nominal GDP, NGDP Targeting, price level, monetary economics, Great Recession

Recently David Beckworth and Martin Sandbu, among others, have drawn attention to an interesting paper by James Bullard and Riccardo DiCecio unveiled in Norway earlier this year. In it, Bullard and DiCecio investigate a model economy possessing both a large private credit market and "Non-state contingent nominal contracting (NSCNC)." They conclude that, in such an economy, NGDP targeting is the "optimal monetary policy for the masses."

Here is David Beckworth's intuitive explanation for that finding:

The basic idea is that in a world of fixed-price nominal debt contracts (i.e. the real world), a NGDP level target provides better risk sharing among creditors and debtors against economic shocks than does a price stability target.

This is because a NGDP level target makes inflation countercyclical. During recessions, inflation rises and causes creditors to bear some of the unexpected pain by lowering the real debt payments they receive from debtors. During booms, inflation falls and allows creditors to share in some of the unexpected gain by increasing the real debt payments they receive from debtors. Debtors, in other words, bear less risk during recessions but also share unexpected gains during expansions.

NGDP level targeting, in other words, causes a fixed-price nominal debt world to look and feel a lot like an equity-world. In a similar spirit, some observers have called for a risk-sharing mortgages as a way to avoid another Great Recession. The point of this paper is that the same benefit that such risk-sharing mortgages would bring can be had by having a central bank target the growth path of NGDP.

Although Bullard and DiCecio's specific argument is novel, the idea that fluctuations in the general price level can actually contribute to optimal risk sharing in a world of fixed nominal debts is itself by no means knew. Bullard and DiCecio themselves refer to previous work making the same basic argument by Evan Koenig and Kevin Sheedy , while in my previous article here I traced the idea all the way back to Samuel Bailey's (1837) classic monograph, Money and its Vicissitudes in Value.

I myself first cottoned-on to the view that what's now called NGDP targeting is more conducive to what economists nowadays call achieving optimal risk sharing in a world with many fixed nominal debt contracts (but which used to be called avoiding "debtor-creditor injustice") while working on my PhD dissertation in the early 1980s. Back then I still didn't know about Bailey, though I did discover a few other works — all written some years before — supporting my perspective.

My conclusions eventually found their way into my dissertation, and thence into my first (1988) book, The Theory of Free Banking. I later expanded and refined them in Less than Zero (1997, especially pp. 41-5; new edition forthcoming!). Because my earlier discussion is especially informal and intuitive, I thought that persons interested in more recent works addressing the same issue, like those of Koenig, Sheedy, and Bullard and DiCecio, might find it of interest, if not helpful to their  understanding of these much more sophisticated works. So here it is, with no changes save (1) the addition of a new note; (2) the removal of two original notes that contained references only; and (3) the insertion of ellipses in place of a phrase that would seem meaningless here, where it has been stripped of its context.

***

To address the problem of debtor-creditor injustice, one must first understand how different kinds of price changes actually affect the well-being of parties on either side of a debt contract. One also has to have a definition of injustice. For the latter we may adopt the following: parties to a long-term debt contract may be said to be victims of injustice caused by price-level changes if, when the debt matures, either (a) the debtors on average find their real burden of repayment greater than what they anticipated at the time of the original contract and creditors find the real value of the sums repaid to them greater on average than what they anticipated; or (b) the creditors find the real value of the sums repaid to them smaller on average than what they anticipated and debtors find their real burden of repayment smaller than what they anticipated at the time of the original contract. When injustice occurs the parties to the debt contract, if they had had perfect foresight, would have contracted at a nominal rate of interest different from the one actually chosen.

It is not always appreciated that not all movements in the general level of prices involve injustice to debtors or creditors. Unanticipated general price movements associated with changes in per-capita output…do not affect the fortunes of debtors and creditors in the same, unambiguous way as do unanticipated price movements associated with monetary disequilibrium.* Where price movements are due to changes in per-capita output, it is not possible to conclude that unanticipated price reductions favor creditors at the expense of debtors. Nor can it be demonstrated that unanticipated price increases favor debtors at the expense of creditors. The standard argument that unanticipated price changes are a cause of injustice is only applicable to price changes caused by unwarranted changes in money supply or by unaccommodated changes in money demand.

This is so because in one of the cases being considered aggregate per-capita output is changing, whereas in the other it is stationary. In both cases a fall in prices increases the value of the monetary unit and increases the overall burden of indebtedness, whereas a rise in prices reduces the overall burden, other things being equal. In the case where per-capita output is stationary (the monetary disequilibrium case), the analysis need go no further, and it is possible to conclude that falling prices injure debtors and help creditors and vice versa. Were parties to long-term debt contracts able to perfectly anticipate price-movements, they would, in anticipation of higher prices, contract at higher nominal rates of interest; in anticipation of lower prices they would contract at lower nominal rates of interest. In the first case the ordinary real rate of interest is increased by an inflation premium; in the latter, it is reduced by a deflation discount. These adjustments of interest rates to anticipated depreciation or appreciation of the monetary unit are named the “Fisher” effect, after Irving Fisher who discussed them in an article written just before the turn of the century.

When per-capita output is changing, one must take into account, in addition to the Fisher effect, any intertemporal-substitution effect associated with changes in anticipated availability of future real income. Here (assuming no monetary disequilibrium) reduced prices are a consequence of increased real income, and increased prices are a consequence of reduced real income. Taking the former case, although the real value of long-term debts increases, debtors do not necessarily face a greater real burden of repayment since (on average) their real income has also risen. In nominal terms they are also not affected because, as distinct from the case of falling prices due to a shortage of money, their nominal income is unchanged. Thus debtors need not suffer any overall hardship: the damage done by the unanticipated fall in prices may be compensated by the advantage provided by the unanticipated growth of real income. If the parties to the debt contract had in this situation actually negotiated with the help of perfect foresight, their anticipation of reduced prices would have caused the nominal rate of interest to be reduced by a deflation discount — the Fisher effect. But their anticipation of increased real income would also reduce their valuations of future income relative to present income, raising the real component of the nominal rate of interest — the intertemporal-substitution effect. Since the Fisher effect and the intertemporal substitution effect work in opposite directions it is not clear that the perfect-foresight loan agreement would have differed from the one reached in the absence of perfect foresight — at least, the direction in which it would have differed is not obvious. So there is no reason to conclude that a monetary policy that permits prices to fall in response to increased production would prejudice the interests of debtors.

Similarly, to allow prices to rise in response to reduced per-capita output would not result in any necessary injustice to creditors, even if the price increases were not anticipated. Here the Fisher effect in a perfect-foresight agreement would be positive, and the intertemporal substitution effect would be negative, so it cannot be said a priori that the perfect-foresight nominal rate of interest would differ from the rate agreed upon in the absence of perfect foresight.

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*By "monetary disequilibrium" I mean unanticipated changes in nominal spending (MV or, equivalently, Py). Earlier in my book I explain that a monetary policy "that maintains monetary equilibrium [is one] that prevents price changes due to changes in the demand for money relative to income without preventing price changes due to changes in productive efficiency." I would have chosen my terms more carefully had I known better.

20 comments

  1. From my perspective, this is a very convoluted way of saying only variations in the objective exchange value of money result in creditor/debtor income distortions.

    Did I miss anything?

    1. Yes. For starters, there's the fact that most people have no idea what "the objective exchange value of money" means. The expression is familiar only to students of von Mises. Moreover, what you state using it is a bare assertion only; it hardly amounts to an argument, convoluted or otherwise. I suspect that, were you to proceed to clarify the meaning of "objective exchange value of money" to the uninitiated, and then to prove the point in question, you would have yourself a much longer statement, though perhaps a better one than mine. I welcome your attempts in that direction!

      1. No thanks. I was asking a serious question, sir. I just wanted to make sure there wasn't something I missed. My apologies if the word "convoluted" was taken as pejorative. It was not intended that way.

        1. No offense taken. And I apologize if I gave the impression that I didn't take your question seriously. I merely read it as stressing "convoluted." If the question is simply whether stabilizing the inner objective exchange value of money in Mises' sense is the same thing as stabilizing nominal income (the policy I'm defending), the answer is yes. See my discussion on pp. 261-2 here: https://pdfs.semanticscholar.org/f2ef/11a671109c64255a232df19b13aa07185da9.pdf

          1. Interesting piece you have linked. I started writing some comments but as I keep reading, I see you are addressing some of my concerns about early commentary in later sections. I find myself in agreement except one thing:

            I guess I had always assumed the argument what you are saying is implicit was in fact explicit. I am referencing the Making the Case for Gold section. It was what I felt I "learned" when I finished the Theory of Money and Credit. But I don't feel like looking right now, so I'll take your word for it that it was never explicitly stated. It's not impossible that I formulated my own conclusion from various different parts of the book.

            I understood Mises discussing the Gold Standard as a kind of separation of state and money as saying just this. But I agree the metaphorical speech Mises often used was often inadequate to his meaning and purpose.

            I will add one comment though. Gold seems more likely to be redeemed and have the "rules" enforced by the consumers than fiat. It at least has some other uses besides exchange which consumers view as valuable. It has at least a non-trivial commodity demand dimension which people might distinguish from its exchange value, depending on their proclivities. This is of course not logically necessary: we can imagine a coherent world with a fiat currency which isn't abused. It's just very unlikely to ever happen, given what we know about public policy actors.

  2. There is already an enormous stock of credit which was negotiated under the belief that we follow a price-targeting rule. To change that now has absolutely massive one-time distributional impacts. Seems too convenient to simply ignore that. In my opinion, moving to a different mandate lies deeply within the realm of fiscal policy and would need Congress to act.

    1. Regarding the first part of your claim, mlouis, I can only reply that you've missed the main point of the argument, which is precisely that, assuming that contracts have been negotiated under certain expectations regarding both the path of the price-level and the progress of productivity, allowing the price level to change unexpectedly in response to some productivity innovation itself unanticipated when the contracts were written is _not_ a cause of any regrettable redistribution.

      To quote Cromwell: "I beseech you, in the bowels of Christ, think it possible you may be mistaken." Think again of a situation in which the central bank has been maintaining a price-level target (it matters not whether it is a steadily rising target). All agents anticipate that it will stick to that target. They also share with the central bank a certain expected value of the growth rate of productivity. And they make all sorts of long-term contracts according to these expectations.

      Now suppose a big productivity surprise occurs. For the sake of argument, let it be a big negative supply shock–say a trade war, for instance. Then ask whether the policy of letting an upward P (or inflation) "surprise" occur will do more harm than having the central bank stick to its pre-shock P-level commitment by hook and crook, which means tightening money and reducing aggregate demand enough to avoid the rise in equilibrium prices that would follow were the level of aggregate demand kept stable. Think hard about what must happen to nominal WAGES in that case. Consider whether the decline in money earnings that must occur under your preferred policy is likely to help or to hinder people's ability to pay there debts. Then decide whether keeping P from rising is really a good way to avoid "massive one-time distributional impacts."

      As for the present Fed mandate, it is loose enough to accommodate what some have been calling a "flexible" price level target, where flexible is understood to means capable of being adjusted in response to unanticipated supply innovations.

      1. Thanks for the response but I disagree. Inflation has been stable for decades and there is a commitment to do so. Productivity has been highly variable and there is no commitment to target it (nor anything the Fed could really do to target it). What you would find in private exchanges of debt securities is that expectations on long-term inflation cluster tightly around 2% while expectations of long-term productivity vary quite a lot (I think anything from 0-4% is defensible). This is what makes a market – for many years buyers/sellers have been disagreeing about the value of securities…often based on their productivity assumption (which also impacts creditworthiness – another massive assumption). I know many bond managers…they tend to fall in the lower productivity camp and have thought long and hard as to why.

        By changing the rules of game at this late stage you essentially walk in and reward one side of this multi-$t market. The side of each deal which assumed lower productivity growth (very possibly an accurate assumption) is now made worse off by the central bank. This has massive redistributional consequences.

        1. "Productivity has been highly variable and there is no commitment to target it." Nothing I've said contradicts these facts. That productivity varies unpredictably is among the premises of my own argument; and my recommendation has nothing to due with having the Fed "target" productivity growth, which it could not possibly do if it tried. You assumption that allowing P to rise in response to an adverse productivity shock is one that won't stand scrutiny. It is the policy of P-level stabilization that's "one sided" in this case, for it shields fixed nominal debt creditors from adverse supply shocks, making not just their debtors but all other income earners bear the costs of those shocks disproportionately.

          1. "It is the policy of P-level stabilization that's "one sided" in this case, for it shields fixed nominal debt creditors from adverse supply shocks, making not just their debtors but all other income earners bear the costs of those shocks disproportionately."

            Anyone involved in credit markets knows this…it is priced into the market and has been for decades. If you take that away you've changed a key variable which has underpinned all debt contracts. It is has massive consequences. One of the key reasons you buy debt is to benefit in the "supply shock" scenario. Take that away and the price of all existing credits needs to fall. Further, much of the debt exchanged over the past 40 years would not have been exchanged on the same terms. I'm not even arguing whether this is "good or bad"…just that it is for sure fiscal policy.

            There are all sorts of asymmetric bets in markets (think options)…the asymmetry gets priced in. It is NOT a free lunch.

          2. Surely positive deviations of productivity growth from its mean or expected value are no less likely than negative ones. So is it really possible to argue that not allowing such shocks to have any effect on the course of the general price level would systematically harm creditors? Is there an appeal to some sort of asymmetrical distribution of shocks in your argument that I'm missing?

          3. Let's say you're an endowment manager. You study the economy thoroughly and conclude that you need a heavy bond allocation because future productivity will be 0% and inflation 2…therefore long bond yields should trend towards 2%. Your counterparty expects 4% productivity and 2% inflation and therefore wants to be underweight bonds. (We'll assume 0% labor force growth).

            Let's say your analysis turns out to be more accurate and productivity averages 0%…but then let's say the Fed adopts NGDP targeting and pushes inflation up to 5%. You've lost badly on your bond allocation as yields rise despite being 100% correct in your economic analysis. The less-accurate economic forecaster books a huge gain.

            Again, i'm not arguing that this is "good or bad" …i'm just arguing that countless such decisions have been made and are reflected in the current stock of debt. I don't believe it's the Fed's purview (nor healthy for well-functioning markets) for the Fed to step in and potentially choose winners in a giant market.

          4. OK. I think I understand your position. Let's say that the Fed has absolutely committed to maintain a P-level target. The average growth rate of TFP is 3 percent. Then comes a TFP shock by which TFP growth declines, temporarily, to 0%. Fed officials decide, for the sake of avoiding avoidable cyclical unemployment and other hardships that would otherwise ensue, to let P rise above its promised and widely-anticipated trend. Some clever creditor, who in fact anticipated the TFP slow-down, is thus deprived of the reward for his astuteness. That other creditors failed to anticipate the TFP surprise, or even gambled on an opposite surprise, is neither here nor there: the point is that the unexpected regime change redistributes wealth from our astute creditor to others less deserving on the basis of their own predictions.

            I hope that's a fair summary of your complaint. If so, my response is that the complaint would indeed have merit were the Fed in fact committed to a strict single price-level targeting mandate. But of course that isn't the case. The Fed's dual mandate instead not only allows but compels it to allow P to vary when doing so serves to counter cyclical movements in unemployment, and especially so in the case we've considered in which strict P targeting would in fact result in avoidable cyclical unemployment. In this context your astute creditor would be betting that the Fed would focus exclusively on one part of its mandate. But the Fed has no practical or ethical obligation to fulfill his expectation. Were it instead to adhere to my own recommended formula, it would be violating no commitment, for that alternative is not less but arguably more consistent with abiding by its actual, admittedly loose, mandate.

          5. I don't perceive the mandate to be very "loose." Yes, there is some flexibility but an average inflation rate of around 2% seems pretty well cemented. Keep in mind that $trillions of assets have already been priced predicated on an existing mandate…this goes far far beyond the decisions of some "redditor"…it speaks to the very underpinnings of capital markets and the rule of law (even if the law is "informal"). You'd normally expect such a giant shift from an emerging market, not the US.

            And this cost is weighed against the very nebulous and (in my opinion) very slight benefits to NGDP targeting vs inflation targeting. We're really going to risk disturbing the entire global credit market for this? We have no idea what the knock-on effects are of re-pricing all credit with one stroke of a pen.

            And that's all before we even get to the political feasibility of an NGDP target. Give us a few years of 0% productivity growth and 5% inflation and i bet you the Fed loses its independence. One of the benefits of inflation targeting is that any individual wage-earner subject to a flat wage can only experience a 2% reduction in their real wage. In your world, you'd potentially have a large subset of people experiencing 5% real wage declines and they would become politically engaged. You'd have a slew of candidates running on "End the Fed"..and they would gain traction. As much as economists would like to, you simply cannot separate economics and politics.

          6. I don't perceive the mandate to be very "loose." Yes, there is some flexibility but an average inflation rate of around 2% seems pretty well cemented. Keep in mind that $trillions of assets have already been priced predicated on an existing mandate…this goes far far beyond the decisions of some "redditor"…it speaks to the very underpinnings of capital markets and the rule of law (even if the law is "informal"). You'd normally expect such a giant shift from an emerging market, not the US.

            And this cost is weighed against the very nebulous and (in my opinion) very slight benefits to NGDP targeting vs inflation targeting. We're really going to risk disturbing the entire global credit market for this? We have no idea what the knock-on effects are of re-pricing all credit with one stroke of a pen.

            And that's all before we even get to the political feasibility of an NGDP target. Give us a few years of 0% productivity growth and 5% inflation and i bet you the Fed loses its independence. One of the benefits of inflation targeting is that any individual wage-earner subject to a flat wage can only experience a 2% reduction in their real wage. In your world, you'd potentially have a large subset of people experiencing 5% real wage declines and they would become politically engaged. You'd have a slew of candidates running on "End the Fed"..and they would gain traction. As much as economists would like to, you simply cannot separate economics and politics.

  3. Countercyclical lending would be good in principle. Question though. Risk sharing sort of means putting the risk on the borrower, right? I noticed some mortgage websites where risk sharing can only be applied to recourse loans. Recourse loans are already risky for borrowers, compared to non recourse loans. So how much risk does a borrower have to take on?

    Slightly off the subject but not completely, Prof, Fed guy Kashkari said that the Fed prunes wages. He admitted to it. Charts exist that prove it is so. So, that is a conspiracy by the Fed to make the capitalists happy at the expense of labor. Conspiracy does exist at the Fed!! So, since this is true, countercyclical behavior would force the Fed not to liquidate. It would force the Fed to behave. I don't think the Fed wants to behave.

    1. "Risk sharing sort of means putting the risk on the borrower, right" No, it generally means having the risk of unexpected developments shared by both sides of the contract.

      "Fed guy Kashkari said that the Fed prunes wages. He admitted to it.
      Charts exist that prove it is so. So, that is a conspiracy by the Fed." Uh, no: were it a conspiracy (and allowing it to be true, though Kashkari is hardly infallible), a Fed official wouldn't be advertising it.

  4. Doc,

    This article is written very clearly and at the right level for a layman. Thanks.

    It answers basic questions I've had about the effects of changes in price level on creditors and debtors, and about NGDP targeting. It creates more questions, but when it comes to money, I have learned to accept that as inevitable and regard it as progress.

    Cheers,
    M

    1. Thanks for your kind comment, M. Camp. I'm lucky to have readers like you.

  5. Good article. But none of this matters if money is largely neutral, which the data shows it is (Bernanke, FAVAR paper)…but, having said that, it's not a bad thing to target NGDP, since no harm will be done if money is indeed largely neutral. The data also shows btw that floating vs fixed (read gold standard) exchange regimes have no real effects, even though a few years ago I was burned transferring Euros into US dollars. Still, on average, none of this matters say the data (Stockman, 1988).

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