The dismal state of the economy continues to cause many Americans significant hardship. Not even college graduates have been spared annual income for individuals with only a bachelor's degree fell by 3.5 percent last year. Thus, it is perhaps not surprising that a significant proportion of Americans have looked for villains to blame for these difficulties. But the real problem is not some malevolent minority instead, public opinion has turned against the very policies that are needed to ameliorate our problems. In order to resolve the situation, we need to significantly reform this country's monetary architecture.
The housing bubble and subsequent financial crisis left behind a significant amount of private debt that has impaired many households' and businesses' ability to spend. In order to lessen this economic pain, a combination of large government deficits and higher inflation expectations is needed. The problem is that most of the public opposes higher deficits and inflation.
This opposition explains why, during the recent GOP primary debate here at Dartmouth, most of the candidates attacked Federal Reserve Chairman Ben Bernanke's record. Recent polls have shown that an overwhelming majority of Americans, including self-identified Democrats, say they are concerned about inflation. Yet over 4/5 of Americans either over-estimate the true rate of inflation or admit to not knowing the true rate of inflation. The GOP candidates' attacks on the Fed represent an attempt to please the general populace, not just Republican primary voters.
The ignorance of the general public and many of our professional pundits is further illustrated by the schizophrenic way in which many people discuss the effects of fiscal and monetary policy. Many people seem to believe that in the short run, fiscal policy can be used to increase growth without any effects on inflation, and that monetary policy can be used to reduce inflation without any effects on growth. This has been most apparent in Britain, where much of the press has simultaneously called on the fiscal authorities to scale back their austerity plans in order to increase growth and on the monetary authorities to adopt a more contractionary policy in order to reduce inflation. These two demands are inherently contradictory, yet this kind of misinformed public opinion has swayed macroeconomic policy in most first world countries, harming everyone.
As far as I can see, the only politically feasible way out of this mess would be for central banks (the institutions charged with conducting a country's monetary policy) to adopt a policy of targeting the level of nominal gross domestic product. Though imperfect, an NGDP target would adequately deal with our current problems and, more importantly, can probably be sold to the general public.
NGDP is simply the sum of all spending in an economy, not adjusted for inflation. If the Federal Reserve adopted a 5 percent NGDP level target, the Fed would commit to keeping NGDP on a path that grew by 5 percent per year. If the real amount of economic activity grew by 3 percent per year, this policy would produce inflation of about 2 percent per year. By focusing on the level of NGDP, rather than the rate of change of NGDP, the Fed would have to make up for past mistakes. Given that NGDP is almost 10 percent below its pre-crisis trend, the Fed would have to get NGDP to temporarily grow by more than 5 percent per year in order to catch up to the 5-percent growth path that the economy was on before the crisis.
In order to do so, the Fed would have to commit to keeping short-term rates low and tolerating temporarily higher inflation until the economy has caught up to its previous trend. So why not just adopt a formal inflation target, as many economists have suggested? The problem is that the general public is completely unwilling to permit the Fed to adopt a higher inflation target. Selling an NGDP target would probably be easier, as it could be described as the Fed trying to raise incomes (which is "good") rather than merely raising inflation (which is "bad").
While NGDP targeting may not be the economically optimal monetary policy rule, it may be the only politically feasible policy available. Given the dire nature of the current economic situation, we should make use of this possibility.
