The Consequences of GDP Targeting

 | Dec 29, 2011 | 4:30 PM EST
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On Wednesday, I wrote about the limits of monetary policy, and I'd like to stay with that line of thought and look at the impact of continued quantitative easing or targeting nominal GDP (NGDP) directly.

Targeting nominal GDP is just open-ended quantitative easing. Instead of the Federal Reserve announcing a fixed quantity of dollars available to banks over a specified period, it produces dollars without restriction until the economy exhibits real inflation.

Before going any further, let's define inflation. There are two kinds: price inflation and real inflation. Price inflation is when the cost of goods increases faster than incomes. Real inflation denotes an increase in the quantity of dollars in the economy from increased bank lending. When economists talk about inflation, they don't differentiate between the two; it's assumed that price inflation either leads to, or is a forerunner of, real inflation. There is a belief that real inflation is good for an economy, thus good for everyone in that economy. In reality, either type of inflation benefits asset owners while punishing those without assets.

In an inflationary environment, the cost of goods rises and the benefits of that increase accrue to the owners. This is called rent-seeking -- an increase in the value of assets or the return that is not correlated to any action taken by the owner to cause the increase. Since most assets are controlled by a small portion of the population, an inflationary environment benefits this smaller group at the expense of the larger group of non-asset owners.

The result of a persistent inflationary environment is that wealth is accumulated and concentrated into fewer hands, away from the broader populace. Taken to an extreme, the result is a bifurcated economic class structure of haves and have-nots with no middle class.

Limitless QE and NGDP targeting are welfare for the wealthy, with costs borne directly by consumers as the result of both price and real inflation.

After three years of monetary stimulus, the Fed has been able to put a floor under the prices of stocks, bonds and commodities. This has helped the less than 10% of the population that controls the majority of these assets, but has done nothing to stop the contraction in housing, let alone bring about a reverse. The vast majority of personal wealth in the U.S. is in the form of home equity, which has been cut by more than half in the past five years. Targeting nominal GDP does not help this group, nor does it help housing; it just makes the situation worse. Instituting an overt system of creating inflation while much of the population is not in a financial position to benefit from it will cause an aggregate drag on the economy.

By implementing such a process without first resolving the housing crisis, policymakers have decided that protecting the value of assets for the benefit of their owners is worth permanently aliening tens of millions of citizens still recovering from the financial destruction of the past few years.

Worse, NGDP targeting only increases real inflation and economic activity if consumers can access bank loans -- and that is only possible by resolving the housing crisis first. Otherwise, the additional money available to banks will cause asset prices to rise further but will not cause economic activity to increase, bringing stagflation. If that happens, asset prices will collapse just as they did in the mid-1970s.

Investors should be mindful that watching bank loan activity as the Fed embarks on NGDP targeting is crucial to determining the prospects for the performance of all asset classes. (Get in the habit of checking the Fed's H8 report every Friday afternoon.)

If bank lending doesn't increase as the Fed expands monetary policy, stock speculators are likely to begin selling rather than buying into the stimulus.

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