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Thoughts on the Michael Woodford Paper….

Unless you’ve been sleeping under a rock for the past few days you’ve likely heard about Michael Woodford’s presentation at Jackson Hole.  The paper he presented (see here) is an expansive review of current Fed policy and potential policy options.   Like all of Professor Woodford’s work, it’s quite excellent in its detail and thoroughness regarding some highly theoretical and uncharted territory.

The primary takeaway from Professor Woodford’s paper was his  endorsement of NGDP Targeting.   This view has been praised by Paul Krugman, Christina Romer, the Market Monetarists (of course) as well as several media outlets.  The paper has been described by Ezra Klein as “the year’s most important academic paper”.

NGDP Targeting is a fairly new policy idea that has come about with the Market Monetarist school.  Scott Sumner and David Beckworth have been particularly vocal about it.  In essence, they believe the Fed can stimulate the economy by establishing a firm commitment for nominal GDP and anchoring expectations through this verbal commitment.  Essentially, the Fed says: “monetary policy will remain extremely accommodative until we hit X% NGDP”.  The goal is to anchor expectations so that economic agents have a greater certainty regarding their futures.  According to Market Monetarists this doesn’t even require further Fed action (like QE) and can be achieved simply via a firm verbal commitment (though Beckworth has described in great detail why he believes QE’s portfolio rebalancing effect can be stimulative).

Personally, I am skeptical of what the Market Monetarists refer to as the “Chuck Norris” effect.   Ie, Chuck Norris doesn’t kick your ass.  He just threatens to kick your ass and it has the same effect.  The only problem is that I used to watch a lot of martial arts movies when I was younger.  In particular, I used to watch a lot of Bruce Lee.  And anyone who has seen “Way of the Dragon” knows that Bruce Lee kicked Chuck Norris’s ass.  Bruce Lee once famously said:

“willing is not enough, you must do.”

Fed policy works primarily because market participants know the Fed can “do”.  For instance, in setting the Fed Funds Target the verbal commitment to set the target rate “works” because the Fed is always willing to smash a few bond traders into the pavement if they don’t behave.  And with a bottomless pit of reserves anyone who decides to compete with the Fed on price will inevitably lose.  The verbal commitment is powerful (very powerful), but “willing is not enough, you must do”.  This is why I’ve been skeptical of QE as it’s been implemented.  Monetary policy is about price, not quantity.  So the “doing” is all in setting prices.  I’ve said that QE could “work” if the Fed were to come out and set the long bond at, say, 1% (though, to be clear, I do not endorse this specific approach).  The Fed would then be verbally committing to this price and would essentially challenge the bond traders to move the market.  As the reserve monopolist, the Fed would win and after smashing a few bond traders into the ground they’d slowly learn their lesson – you don’t fight Bruce Lee.  The verbal commitment is powerful, but “willing is not enough”.

Regarding NGDP Targeting I am definitely skeptical that the Fed’s commitment to a NGDP target will have the stimulative effects that some hope it will.  I still fail to see the transmission mechanism whereby balance sheets are meaningfully impacted in a manner that alters current income.  Fed policy usually works through altering credit markets by making inside money less expensive and inducing borrowers to borrow.  Obviously, at the zero bound with low demand for credit this policy approach has run aground.  QE could “work”, but it’s been implemented incorrectly or at least inefficiently in my opinion since monetary policy is about price and not quantity.  The portfolio rebalancing effect is interesting, but I have my hesitations about the unintended consequences of targeting nominal wealth as a form of putting the cart before the horse.  Ie, the Bernanke Put has its negative side effects.  But I am not against trying policies with the understanding that I could definitely be wrong.  At this point, the economy is so abysmal and unstable that we should be trying more.

I won’t belabor the point here because I am tired of debating (and seeing others debate) the merits of “my side versus your side”, but I think the key to Dr. Woodford’s speech was not in championing any single approach, but in describing how a multi-faceted approach is most appropriate.  This was the most important takeaway from Professor Woodford’s presentation.  Indeed, Professor Woodford writes in his conclusion:

“the most obvious recipe for success is one that requires coordination between the monetary and fiscal authorities. The most obvious source of a boost to current aggregate demand that would not depend solely on expectational channels is fiscal stimulus — whether through an increase in government purchases, tax incentives for current expenditure such as an investment tax credit, or subsidies for lending like the FLS. At the same time, commitment to a nominal GDP target path by the central bank would increase the bang for the buck from fiscal stimulus, by assuring people that premature interest-rate increases in response to rising economic activity and prices would not crowd out other types of spending than those directly affected by fiscal policy.”

Read that again because it’s extremely important.  Woodford is not just endorsing NGDP Targeting.  He is recommending a multi-faceted approach.  I’ve talked to both David Beckworth and Scott Sumner and both seem agreeable to the idea of multi-faceted policy approaches (tax cuts in particular are attractive) though they obviously prefer the NGDP route.   One of our goals with Monetary Realism is to help bridge the divide between so many schools of thought.  No school is 100% right.  And in these uncharted waters we need to be attacking our economic disease with everything we’ve got.  That means unified policy approaches and not the partisan bickering we seem to see all over the place.

I do believe Professor Woodford may have written the most important academic paper of the year.  But not because it endorsed any single specific policy.  But because he calls for bridging the divide between what has become an ideological debate between monetary and fiscal policy.   We did this in 2008/9 when the country most needed it.  And we should do it again.  We can cut taxes AND implement a strategy of NGDP Targeting.  That’s like having Bruce Lee AND Chuck Norris on your side.  And who in the world would be crazy enough to challenge those two?   The only question is whether we can coordinate policy in a manner that actually gets things done.  Or whether we will continue to bicker about whose ideology is right while Rome burns.

Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC.Orcam is a financial services firm offering asset management, private advisory, institutional consulting and educational services.He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.
Cullen Roche

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