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Nominal GDP Targeting: New-Fangled Monetarism or Old-Fashioned Keynesianism? Can This New Fad Save the Fed?

In the wake of the financial panic and economic recession of 2008, numerous macroeconomic policies are being re-evaluated. Some economists argue that the crisis demonstrates a need to move away from Ben Bernanke-type discretionary monetary policy and instead adopt some monetary policy rule. One such proposed rule is nominal GDP (NGDP) targeting, made popular by a set of economists that have been given the moniker “market monetarists.”

Market monetarism is largely a blogosphere phenomenon, with the most prominent blogs amongst the group being Scott Sumner’s The Money Illusion, Lars Christensen’s The Market Monetarist, and David Beckworth’s Macro and other Market Musings. The most well-known of the group, Scott Sumner (2012; 2011), has authored two scholarly works that outline his vision for monetary policy, and Christensen (2011) has authored a working paper summarizing the work of the group.

But market monetarism and NGDP targeting have started to break through into the mainstream media, think tank, and policy worlds as well. Economist Tyler Cowen dubbed the day that the Federal Reserve announced QE3 as “Scott Sumner Day,” partially crediting the influence of Sumner’s blogging for the Fed’s expansionary move. CNBC pundit Larry Kudlow has warmed to NGDP targeting, and thereby changed his previously critical tune on Bernanke. James Pethokoukis, a columnist for the hugely influential American Enterprise Institute, has been using market monetarism to try to convince the GOP to learn to stop worrying and love the helicopter.

Unfortunately, despite market monetarism’s recent popularity, nominal GDP targeting fails to achieve the end of aiding macroeconomic coordination. Market monetarist theory and policy is unsatisfactory primarily because Market monetarists use a faulty theoretical framework in analyzing economic activity, they misunderstand how expectations enter into economic decision making, and they do not recognize the actual consequences of the monetary policy necessary to stabilize NGDP expectations.

Market monetarists see what they call “monetary disorder” as the cause of the 2008 financial meltdown and subsequent recession (Christensen 2011, pp. 2-3). In doing so, they explicitly reject the notion of capital investment as a source of the business cycle (Sumner 2012, p. 132). They also claim to believe in markets, assuming them “to be efficient and forward looking” (Christensen 2011, p. 29).

They stress the forward-looking nature of markets because, for market monetarists, expectations seem to trump all other considerations. As such, they view expected NGDP growth as a better indicator of monetary policy than either interest rates or the actual money supply (Sumner 2012, pp. 143-51). They view interest rates as the price of loanable funds, but they do not recognize that the interest rate is actually a ratio of the prices of present goods over the prices of future goods, or that this time transaction occurs not only in the loanable funds market, but more importantly throughout the entire production structure.

At the same time, it is argued that the current price level and NGDP are much more dependent upon current expectations about the future money supply than they are on the current money supply (Sumner 2012, p. 144). Because markets are forward looking, successful monetary policy will be one that stabilizes expected NGDP, because sudden changes in expected NGDP are what cause macroeconomic disturbances (Sumner 2012, p. 130).

The supremacy of expectations in their analysis can be seen in their explanation of The Great Recession. It is claimed that the source of the 2008 financial meltdown was contractionary to Federal Reserve policy resulting in investors realizing that the Fed either could not or would not prevent a decline in NGDP. NGDP targeting supposedly would temper recessions when the economy is faced with negative supply shocks by sustaining aggregate demand when real output falls (Christensen 2011, pp. 20-22; Sumner 2012, p. 147).

Given their focus on aggregate spending, it is not surprising that market monetarists have been criticized for adopting a Keynesian vision of the macroeconomy. They do not accept such claims at all. Their advocacy of monetary stimulus, they say, is not due to any desire for discretionary policies, but due to their belief that monetary policy has been too tight (Christensen 2011, p. 28).

At the same time, they reject returning to a rigorous gold standard, thinking it would contribute to macroeconomic problems because, many prices, it is alleged, are sticky. Additionally, a gold standard cannot prevent irresponsible governments from monetary instability (Sumner 2012, pp. 161-62).

Problems with NGDP Targeting

There are several problems with market monetarism that can be classified under three main categories: its theoretical framework and vision of economic activity, the form of expectations and the extent to which they enter into economic decision making, and the actual consequences of their suggested monetary policy.

Faulty Analytical Framework and Views of Economic Activity

The most fundamental reason that NGDP targeting misses the mark is due to a generally faulty analytical framework that entails an unsatisfactory understanding of economic activity. It misunderstands the nature of price coordination and leaves the inter-temporal capital structure out of the analysis.

While market monetarists staunchly reject claims that they are Keynesians, it is understandable why people would think so. They assert that recessions are due to insufficient Aggregate Demand. Income is thought to be created by money flows instead of by provision of productive services accounted for in money prices. They ignore, reject, or dismiss the importance of the capital structure. Investment is driven solely by expectations—or conventional wisdom—about nominal spending. A collapse in investment leads to recession and unemployment because of sticky prices (Sumner 2012, p. 161). Decreased aggregate demand and sticky prices and wages combine to result in idle factors of production and unemployment. Monetary policy, however, can serve as the universal cure for persistent price disequilibria. All of this sounds rather Keynesian1

In fact, their entire analysis is predicated on the acceptance of the New Keynesian aggregate supply-aggregate demand framework. Even on its own terms, there are analytical problems with AS/AD analysis (Colander 1995; Garrison 1996). Most relevant and troublesome for evaluating NGDP targeting is that there is no such thing as aggregate demand that equates with aggregate supply at a single price level.

In fact, the social economy is made up of a vast network of distinct markets that are integrated into a complex division of labor through the inter-temporal production structure and the use of a general medium of exchange. Productive activity, therefore, is the result of a vast number of decentralized decisions made by a multitude of different entrepreneurs at different places in the production structure. Capital is not a blob of homogenous schmoo (Foss and Klein 2012, pp. 105-30), so investment is not a homogenous ‘I’ (Garrison 2001). Sound analysis of macroeconomic discoordination must take these facts into account.

It is possible for people to decrease their demand for consumer and producer goods if they increase their demand to hold money. This would only lead to wastefully idle resources, however, if prices for these resources remained above market-clearing levels. This will not persist, of course, if prices are allowed to adjust (Hutt 1979, pp. 138-39).

If the demand for a product falls, the incentive to reap profits and avoid losses will lead both entrepreneurs and workers to reduce their selling prices. Unless frustrated by government edicts or the fear of strike threats, entrepreneurs will seek to adjust their selling prices to market clearing levels. Such price reductions and cost cutting encourages continuous sales and employment. Real earnings of the firms concerned will stabilize, allowing them to continue production and, hence, to demand land, labor, and higher order capital goods from other firms in the production structure (Hutt 1979, pp. 53-56).

Instead of allowing markets to clear via price adjustments according to subjective preferences, market monetarists advocate that monetary authorities bring about market stability by increasing the money supply. Such inflation, however, will not necessarily equilibrate the specific demand for and supply of money on the part of the individuals who are experiencing the excess demand. If prices and wages are that sticky, there will need to be a significantly large increase in NGDP to maintain equilibrium.

However, this raises the entire question of sticky wages. Several theoretical problems with the theory of sticky wages exist (Bellante 1995; Hulsmann 2003; Rothbard 2004, pp. 780-85). On the one hand, if there is only one or a handful of firms charging higher efficiency wages, for example, then employment will be restricted in only those industries and employment will expand in other industries. This would not lead to a general increase in unemployment. On the other hand, if all firms pay so-called efficiency wages, why is this higher wage not considered the market wage?

More importantly, to focus on “sticky wages or prices” is again to focus on the wrong issue. At best sticky prices do not explain why a recession begins. They would only explain why a recession is prolonged. Additionally, if markets do not equilibrate due to minimum wage and other price controls, this is hardly a free market. The solution would be to eliminate government intervention, not to intervene even more by arbitrarily increasing the money supply. On the other hand, if labor markets do not equilibrate due to long-term labor (including union) contracts, this results in voluntary excess supply of labor.

In fact, history reveals that prices and wages do adjust downward if allowed. Even in the case of long-term contracts, workers and employers can and do negotiate new market-clearing wages. For example, performing arts unions worked together with Broadway production companies and musicians agreed to a 25 percent pay cut for a period following the 9/11 terrorist attacks in New York City which caused the tourist trade to temporarily fall off (Daniels and Vann 2003). A number of labor unions did the same thing in response to the Great Recession (Uchitelle 2010). The United Auto Workers recognized that sometimes one has to agree to a lower wage to keep one’s job when the demand for labor falls. Two years ago Pittsburgh Symphony Orchestra musicians agreed to a not insubstantial 9.7 percent pay cut. In response to their actions, the Symphony’s music director, Manfred Honneck, volunteered to take a 10 percent cut (Druckenbrod 2011).

Additionally, decreases in demand are always experienced in particular markets. When there is either a decrease in demand or a decrease in supply in the face of elastic demand, total expenditures will drop. Note however, that spending is the effect of the changes in the preferences of buyers and sellers, not the cause of the decrease in demand or supply. Salerno (2006) shows how this applies to the broad social economy. Market-clearing prices (and quantities) are determined on every market by the interaction of individuals’ value scales on which goods are valued in relation to one another and to money. It is only after market equilibrium prices and quantities and, therefore, the value of money, have already been determined that “spending” occurs.

Faulty Understanding of the Role of Expectations

A particular manifestation of market monetarists’ unsatisfactory economic framework is their understanding of the form of and extent to which expectations enter into their analysis. Certainly no one should dispute that expectations play an important role in economic decision making. All action takes place in the present while the results of action will be reaped at some point in the future. Consequently, all action, including production, is forward looking. All action must therefore be based on speculations about the expected outcomes of various potential actions (Rothbard 2004, pp. 4-7; Ritenour 2010, pp. 33-36). However, for understanding the nature of macroeconomic fluctuations, it is crucial that we have a proper understanding of the nature of the expectations that affect investment decisions.

As indicated earlier, market monetarists seem to believe that actions of investors are determined almost exclusively by expectations of future nominal spending (or NGDP). The problem with such a perspective is two-fold.

While sound economic theory recognizes that expectations of outcomes in the future are a prerequisite of action in the present, economics cannot provide insight into the content of these expectations or how expectations change over time. Expectations are not autonomous entities, but are bounded by a person’s goal, his past experience in attempting to achieve his goal and his entrepreneurial ability. Hence expectations are not monolithic, which is why entrepreneurs must incorporate thymology into their decision making (Salerno 2010, pp. 215, 220). Treating expectations as universal and monolithic opens the door to grave errors of economic theory.

For example, the market monetarists claim that it is expectations about future NGDP that solely determine present investment decisions and hence the direction of the economy. This claim fails to recognize that recessions are not merely the result of decreases in aggregate spending following a boom. They are the result of entrepreneurial error (Hulsmann 1998; Rothbard 2000, pp. 8-9). It is possible, for example, for entrepreneurs to reap profits even in an environment of declining total spending. What matters is not aggregate spending, but the spread between the price of products and the sum of the prices of the factors of production. If the total quantity of all spending in the social economy falls and overall prices fall, firms can still reap profits as long as they identify those projects at which the factors are underpriced relative to the future price of the product they can be used to produce.

Additionally, the form of expectations assumed is the source of a particular inconsistency in the market monetarist literature. This inconsistency, in turn, is also related to their failure to understand recessions as the result of a cluster of entrepreneurial error. Market monetarists assume that markets are efficient and forward looking. At the same time recessions are due to decreases in expected NGDP. If markets are efficient while forward looking, how can there be a cluster of entrepreneurial error? It seems that if market participants make efficient adjustments while looking forward, there should not be widespread mistakes made by entrepreneurs. If so, how can there be recession? Perhaps the response might be, as Christensen (2011, p. 5) implies, that although people have expectations that are indeed rational, they are not perfect. Even so, if market participants properly forecast that the Fed would not or could not continue to increase NGDP through 2008, why should there be a recession? If their forecast was correct, they should have acted accordingly and markets would clear, and at the very least there would not have been widespread persistent unemployment.

Consequences of Monetary Policy

Market monetarists’ affection for NGDP targeting once again demonstrates that an unsound theoretical framework will often lead to unsound economic policy. One of the biggest problems with trying to reduce economic fluctuations via NGDP targeting is the real effects of monetary inflation necessary to stabilize actual or expected NGDP. It is necessarily true that newly created money will enter the economy at particular points. Monetary inflation, therefore, will affect demands for certain goods first and then subsequent demands for different goods as the new money is spread through the economy. The step-by-step adjustment process during which the new money is absorbed necessarily results in real changes in relative prices and a real redistribution of wealth (Mises 1929, pp. 85-88; Mises 1938; Salerno 2010, pp. 202-03).

Credit expansion necessarily stimulates malinvestment by encouraging production processes that are too roundabout relative to social time preferences (Strigl 1934, pp. 120–33; Mises 1949, pp. 547–62; Garrison 2001; Rothbard 2004, pp. 994–1004; Hayek 2008, pp. 189–329; Huerta de Soto 2006, pp. 347–84; Salerno 2012). Without an increase in voluntary savings, longer production processes are not all able to be completed. This is the heart of the malinvestment problem.

NGDP targeting advocates end up fostering the monetary illusion that scarcity can be overcome and prosperity can be achieved via monetary inflation. In fact, issuing fiduciary money via credit expansion promotes unsustainable boom activity because it provides both the incentive and the means for entrepreneurs to undertake projects for which there are insufficient real resources to complete. The necessary consequence of monetary inflation—even if the desire is to stabilize actual or expected NGDP growth—is the boom/bust cycle, in which resources are squandered, capital is consumed, and society is relatively impoverished. Such an outcome is the exact opposite of the desires of those advocating NGDP targeting.


[1] See Hutt, W. (1979) and Huerta de Soto, J. (2006) on the fallacies of Keynesian economics. The same critique of Keynesian economics in this literature also applies to Market Monetarism.

  • 1 See Hutt, W. (1979) and Huerta de Soto, J. (2006) on the fallacies of Keynesian economics. The same critique of Keynesian economics in this literature also applies to Market Monetarism.
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