Balance Sheet Recessions Are Really Nominal Income Recessions

I recently lamented the Fed's ongoing dereliction of duty as seen in the sustained declined of households' expected nominal income growth:

In that post, I noted this observed decline was problematic for two reasons: (1) current nominal spending decisions are influenced by expected nominal income growth and (2) past nominal debt contracts were based on certain expectations of nominal income growth that did not happen. Here is what I specifically said on the latter point:

The figure also indicates that real debt burdens are higher than many households expected prior to the crisis. Look at the dashed line. It shows the average expected dollar income growth rate over the 'Great Moderation' period was 5.3%. Now imagine it is early-to-mid 2000s and you are taking out a 30-year mortgage and determining how much debt you handle. An important factor in this calculation is your expected income growth over the next 30 years. If you were average, then according to this data you would be forecasting about 5% growth rate. But that did not happened. Household dollar incomes declined and are expected to remain low. Nominal debt, however, has not adjusted as quickly leaving higher than expected real debt burdens for households. 

An important implication of this development is that households' deleveraging over the past few years may not be so much about their weakened balance sheets as it is about the unexpected decline in their expected nominal income growth. Josh Hendrickson and I are working on a paper where we develop this point more fully and, among other things, report the figure below. It plots expected household nominal income growth against the percent change of nominal household debt:

This figure suggests that for households, expected dollar income growth matters a lot for deleveraging. It also implies "balance sheet recessions" are a byproduct of nominal income shortfalls. One policy implication, then, is that the Fed should have maintained aggregate nominal income growth at its expected path. It failed to do so in 2008 and has yet to fully make up for this shortfall.

I bring this up, because a new paper by Kevin D. Sheedy (hat tip Simon Wren-Lewis) shows that NGDP level targeting dominates inflation targeting for this very reason. It is much better at stabilizing the real debt burdens of households precisely because it is much better at stabilizing the growth path of nominal income. Here is his abstract:

Financial markets are incomplete, thus for many agents borrowing is possible only by accepting a financial contract that specifies a fixed repayment. However, the future income that will repay this debt is uncertain, so risk can be inefficiently distributed. This paper argues that a monetary policy of nominal GDP targeting can improve the functioning of incomplete financial markets when incomplete contracts are written in terms of money. By insulating agents' nominal incomes from aggregate real shocks, this policy effectively completes the market by stabilizing the ratio of debt to income. The paper argues that the objective of nominal GDP should receive substantial weight even in an environment with other frictions that have been used to justify a policy of strict inflation targeting.

Fed officials should take note. So should ECB officials since this finding is particularly poignant for the Eurozone. It is time to fully embrace NGDP level targeting.

The Seen and Unseen: Structural Budget Deficits Edition

On Friday I discussed the cyclically-adjusted U.S. budget deficit and asked any Keynesian to reconcile its decline with the steady growth of aggregate demand. Robert Waldman graciously replied, but he really didn't answer my question. His response focused on the pace of the recovery and changes in the overall budget balance. My question was about the structural budget balance. This distinction is an important one. So let me try this one more time.

The structural budget balance is the best way to gauge the stance of fiscal policy, as noted by Paul Krugman:

[M]easuring austerity is tricky. You can’t just use budget surpluses or deficits, because these are affected by the state of the economy. You can — and I often have — use “cyclically adjusted” budget balances, which are supposed to take account of this effect. This is better; however, these numbers depend on estimates of potential output, which themselves seem to be affected by business cycle developments. So the best measure, arguably, would look directly at policy changes. And it turns out that the IMF Fiscal Monitor provides us with those estimates, as a share of potential GDP...

Here is the IMF's cyclically-adjusted or structural budget balance for the United States:

So what does this figure tell us? It shows that fiscal policy, independent of business cycle influences, has been tightening since 2010. It has gone from a deficit of 8.5% in 2010 to an expected one of about 4.6% in 2013.  In other words, the reduction in the federal budget deficit over the past three years is more than just the government adjusting its balance sheet in response to improvements in the private sector's balance sheet. It is also the result of explicit policy choices to impose fiscal austerity. And these explicit policy changes have been relatively sharp.

Many observers have overlooked the implications of this structural austerity experiment. Three years of explicit fiscal austerity in a depressed economy should, all else equal, lead to even more economic weakness. But it has not. Nominal GDP growth--a proxy for aggregate demand (AD) growth--has been remarkably steady. There is no evidence AD over the past three years has been adversely affected by this austerity. Friday's job report underscores this point.

So what explains this development? The answer is not that fiscal policy has no effect, but rather that all else is not being held equal for U.S. aggregate demand growth. Specifically, Fed policy has effectively responded to the fiscal austerity, Eurozone shocks, China slowdown shocks, and other shocks to AD. Though this is a great accomplishment, it is far from adequate and is ultimately frustrating to watch. For it speaks to both the power and shortcomings of current Fed policy.

It is not surprising to me that Keynesians and other observers fail to see this structural austerity. The Fed has offset it over the past three years and therefore kept it out of sight, out of mind. The ECB, on the other hand, has not and so it is more apparent to observers. But just because it is not seen, does not mean it is not there.

Pushback

Despite my enthusiasm about what today's employment report means, Josh Barro says it does not vindicate the Market Monetarist's view.  Moreover, he believes we probably should not expect our view to ever be fully vindicated for political economy reasons:

Market monetarism, as advanced by [Ramesh] Ponnuru and the economist David Beckworth, among others, holds that aggressive monetary policy is a sufficient force to smooth out business cycles.And over the last year we’ve just had a mini-experiment along these lines. Congress and the president have imposed fiscal tightening by raising taxes and allowing sequestration’s haphazard spending cuts to come into effect. And the Federal Reserve has (with occasional tentativeness) gotten more aggressive in its easing, setting a specific target for unemployment and running an open-ended program of asset purchases since the fall.

The results so far are good but not great. Job growth is steady and economic growth is modest but positive. Sequestration’s human impacts are real, but a macroeconomic drag is not yet apparent. This looks a lot better than Europe, where the central bank hasn’t been so aggressive and many economies have slid back into recession. Yet we should worry about the limits of the market monetarist approach. Monetary and fiscal policy are both constrained by political forces, not just economic ones.

The political economy critique is a fair point. I remain optimistic, though, that QE3 will evolve to some kind of conditional monthly asset purchasing program where the Fed changes the size of the asset purchases to match economic developments. And once that happens we are well on the way to a nominal GDP level target.

Mike Konczal, meanwhile, pushes back on my response to his post that the Fed needs to adjust its pressure on the gas pedal:

We don’t often get a serious shift in expectations. That’s why I’m not sure how much the “gas pedal” from David Beckworth’s response is at play. Beckworth notes that the purchases in QE3 don’t automatically react to turbulence in the economy, and hopes that the Federal Reserve will buy more if the economy gets weaker. But if the expectations of where the Fed wants to end up are the real limiting factor for a robust recovery, why would a small change in purchases matter? This is partially why Greg Ip said the FOMC statement this week was “asymmetric,” even though the Fed said it might “increase or reduce” purchases: an increase is a small move, but a reduction is a genuine retrenchment.

If the public understood that the dollar size of the Fed's asset purchases were also conditional, then Fed policy should have a more meaningful effect on expectations. We may never know, however, if Josh Barro is correct about the political economy limits of monetary  policy.

Is the Fed's Able to Offset Austerity? Insights from the Employment Report

The April employment report came out today and is better than expected. The number of new jobs exceeded the median forecast, the previous two months job numbers were revised upward, and the unemployment rate fell to 7.5%. This report is not what one would expect if fiscal austerity were overwhelming the Fed's efforts to shore up the economy. But the report also is not what one would expect if the Fed were unloading both barrels of the gun at the economy. The April employment rate, therefore, reveals both the strength and weakness of the Fed's efforts.

On the first point, Mike Konczal and Paul Krugman claimed earlier this week that the contraction of U.S. fiscal policy in 2013 was trumping the Fed's QE3 program and, in so doing, undermining the views of Market Monetarists like Scott Sumner and me. The employment report and its revisions to the previous months throw some cold water on their claim. But this should not surprise anyone, since fiscal austerity has been happening from 2010 and it has yet to stop the steady progression of nominal GDP (NGDP) growth.

This can be seen in the figures below. The first figure shows that the cyclically adjusted (i.e. structural) budget balance as a percent of potential GDP has been shrinking since 2010. This is the budget balance due to policy changes, not from changes to the economy. It shows fiscal tightening over the past three years:

And what has this fiscal tightening done to aggregate demand (i.e. NGDP) growth since that time? The figure below shows it has done nothing:

This broader 3-year experiment of fiscal policy versus money policy is the one Konczal and Krugman should be examining. Instead, they focus on the first quarter of 2013 and miss the forest for the trees.

With all that said, the stable employment and AD growth is far from what is needed for the economy to reach escape velocity. Therein lies the shortcoming of QE3 and the other, previous asset purchasing programs of the Fed. They have been enough to stabilize growth, but not enough to shore up a robust recovery. And that is frustrating to watch.

This frustration led me to propose earlier this week that the Fed make the size of its monthly asset purchases under QE3 conditional on how fast the economy was reaching the Fed's targets. Ryan Avent came up with a similar proposal. And then the Fed announced later in the week that it was prepared to do something just like this:

The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.

It is as if Fed officials were reading our blog posts! Okay, maybe not. More realistically, they too see the problems with QE3--it is applying the same pressure to the gas pedal irrespective of how the terrain on the road changes--and want to improve it. Unfortunately, the Fed did not get more specific than this statement so we don't know how or when this will happen. Josh Barro thinks it is unlikely it will ever happen. I hope he is wrong, otherwise we face a long journey to full employment.

Update: Robert Waldman replies to the post. Here is my response to Waldman. 

There is No Debt Crisis In Europe

As much I criticize the Fed for its shortcomings, it pales in comparison to the failures of the ECB. Under its watch, aggregate nominal income and broad money growth has faltered in the Eurozone. This, in turn, has created an economic crisis. Note that causality runs from a weakened economy allowed by the ECB to a debt and financial crisis in the Eurozone, not the other way around. This is a point Ramesh Ponnuru and I have stressed before:

[Observers] tend to think of Europe’s current crisis as the result of overspending welfare states. And these states would indeed be better off with lower spending levels and less regulated labor markets. But many of the nations swept up in the euro-zone crisis, such as Spain and France, had spending and tax revenues well aligned before it hit. The true problem has again been monetary. Europe has for a decade had a monetary policy well suited to the circumstances of Germany but not to those of the rest of the euro zone and especially its periphery. Nominal income in Germany has stayed on a fairly steady trend line. In the periphery, however, it first went way up and then crashed. For the euro zone as a whole, nominal spending has fallen far below its previous trend—and has been continuing to fall farther away from it. Monetary policy therefore remains very tight in the euro zone overall. One effect of that drop-off, in Europe and in the U.S., has been to make debt burdens more onerous.

The graph below underscores this point. It shows that below-trend growth in Eurozone NGDP--the NGDP gap--has been matched by a rise in Eurozone government debt. The Eurozone crisis, then, is a nominal GDP crisis, not a debt crisis:

I bring this up because today we learn just how bad conditions are becoming in the Eurozone: unemployment hit 12.1% in March, 2013! Michael Darda of MKM Partners observes that this is the highest unemployment rate in the Eurozone over the past few decades. And on a country-by-country basis the unemployment numbers are even more harrowing, as shown by Ryan Avent. What more will it take for the ECB to act more aggressively? Apparently, intense human suffering is not enough. Maybe the advent of Abenomics in Japan in conjunction with the Fed's ongoing QE3 program will spur the ECB into action out of fear of losing external competitiveness. How ironic it would be if Europe's periphery became the main beneficiary of Abenomics. 

Is Monetary Policy Capable of Offsetting Fiscal Austerity?

Mike Konczal has a new article where he claims there is a great natural experiment unfolding in the U.S. economy, one that Ramesh Ponnuru and I proposed back in 2011:

We rarely get to see a major, nationwide economic experiment at work, but so far 2013 has been one of those experiments — specifically, an experiment to try and do exactly what Beckworth and Ponnuru proposed. If you look at macroeconomic policy since last fall, there have been two big moves. The Federal Reserve has committed to much bolder action in adopting the Evans Rule and QE3. At the same time, the country has entered a period of fiscal austerity. Was the Fed action enough to offset the contraction? It’s still very early, and economists will probably debate this for a generation, but, especially after the stagnating GDP report yesterday, it looks as though fiscal policy is the winner.

So Mike Konczal's assessment of this experiment is that monetary policy has not been able to offset fiscal austerity. Paul Krugman  agrees as do other observers who question the effectiveness of monetary policy in a liquidity trap. I agree that there is an interesting experiment going on, but Konczal and Krugman (K&K) oversell what it means and ignore other recent developments that shed light on the efficacy of monetary policy.

For starters, this experiment is only measuring whether QE3 is powerful enough to offset fiscal austerity. It is not measuring whether the actual proposal Ramesh and I laid out in 2011, a nominal GDP level target (NGDPLT), is capable of offsetting fiscal austerity. QE3 is a big change in Fed policy, but it is still far from a NGDPLT in terms of efficacy. One way to see this is to note that QE3 constrains asset purchases to a fixed dollar amount of $85 billion per month no matter how fast or slow the economy is converging to the Fed's inflation and unemployment targets. Consequently, if a spate of bad economic shocks--more Eurozone uncertainty, sequestration, China slowdown concerns, etc.--suddenly increased money demand the $85 billion injection may not be enough to offset it. In this case, aggregate demand would slow down and stall the convergence to the Fed's target. 

QE3, then, is like taking a road trip and applying the same pressure to the gas pedal regardless of whether one is driving up a hill, down a hill, or on a flat terrain. The trip's length would depend on the changing terrain of the road (the shocks) and would be hard to know ahead of time even though you know your trip's destination (the target). This is better than taking a QE2 road trip, where you don't know your destination, but there is still much uncertainty about how long the QE3 trip will take. Now imagine you turn on cruise control at 70 MPH so that your car automatically adjusts the amount of gas based on the terrain. There would be much more certainty about the trip and much better expectations management. This would be much closer to a NGDPLT and provide the real test of  whether monetary policy can offset fiscal austerity. It could be operationalized by conditionalizing the size of the QE3 asset purchases each month so that constant progress to the Fed's targets were being maintained. QE3, therefore, is farm from ideal and, as Matt O'Brien observes, it is not even clear the Fed is fully on board with it.

With that said, one can still learn a lot about the potential of monetary policy to offset fiscal austerity by looking at the fiscal consolidation in the United States over the past few years. As I have noted before, fiscal austerity has been happening in the U.S. economy since about mid-2010. And yet, the Fed has kept NGDP growing on a remarkably steady growth path (albeit, below its pre-crisis trend path). This performance is even more remarkable when you consider that there have been other negative AD shocks buffeting the U.S. economy. K&K ignore this achievement and its implications for monetary policy offsetting fiscal austerity.

Evan Soltas notes that further insights about monetary policy's ability to offset fiscal austerity can be gleaned by comparing the U.S. economy to the Eurozone economy over the past few years. Below are some figures that make this comparison. The first one compares government spending in both regions in absolute dollar and euro amounts. The figure shows that both regions experienced a similar flattening of government spending beginning around 2010. (Total federal expenditures actually decline in the United States. I couldn't find a similar measure for the Eurozone.)

If we now look at government spending as a percent of NGDP, we see that government spending's share has been falling in both regions. The U.S. decline has been the sharpest. 

So we have two large economies experiencing fiscal austerity as seen above. Both are receiving the fiscal austerity 'treatment'. What effect is that treatment having on their NGDPs?  The figure below shows the respective NGDP growth rates in both regions:

The U.S. series shows a stable NGDP growth rate of about 4%, consistent with the NGDP level figure linked to above. The Eurozone NGDP, however, shows a pronounced decline starting in 2010. So both regions have fiscal austerity, but only the United States has stable aggregate demand growth. The easiest explanation for the difference is monetary policies: the Fed has been far more aggressive than the ECB in responding to the slump. Yes, this is not definitive evidence, but it certainly is suggestive that monetary policy makes a big difference in offsetting fiscal austerity. 

P.S. Scott Sumner, Ryan Avent, Marcus Nunes, and Matt Yglesias reply as well. 

Update: A commentator correctly notes my first few graphs ignore the fiscal drag created by tax changes. So I grabbed the IMF's estimate of structural budget balances as a % of potential GDP and made the following figure:

While it does show a higher level of fiscal austerity for the Eurozone, it also indicates the rate of fiscal tightening is very similar in both regions. In other words, fiscal consolidation is happening at a similar pace across the two regions though they start from different points. Given this similarity, one would expect to see some similarity in the NGDP growth rate graph since the tightening began in 2010. But there is none. The gap, then, can still be explained by the differences in monetary policy.

The Ongoing Dereliction of Duty

Last year I made the case that the Fed's failure to keep nominal income growth expectations stable was a dereliction of duty:

[We] have long made the case that a nominal GDP (NGDP) level target would firmly anchor the expected growth path of nominal income.  Doing so, in turn, would stabilize current nominal spending since households and firms are forward looking in their decision making.  For example, holding wealth constant, households generally will put off purchasing a new car or renovating their homes if they expect their nominal incomes to fall and vice versa.  This is why Scott Sumner likes to say monetary policy works with long and variable leads. This understanding implies, therefore, that the reason for nominal spending remaining below is its pre-crisis trend is that the Fed has failed to restore expected nominal income to its pre-crisis path. This failure amounts to a passive tightening of  monetary policy.

Since then, the Fed has improved its management of expectations by introducing the conditional asset purchasing program of QE3. While this program is progress, it is still far from adequate. This can be easily seen by looking at data from a question on the University of Michigan/Thompson Reuters Survey of Consumers where households are asked how much their dollar (i.e. nominal) family incomes are expected to change over the next 12 months. The figure below shows the average response for this question up through March, 2013:

The fall of household dollar income expectations and its failure to fully recover is stunning. It suggests that the now lower expected future income growth is depressing current household spending, a point forcefully made by Mariacristina De Nardi, Eric French, and David Benson of the Chicago Fed. Digging into the data, they find that expected nominal income growth deteriorates across all age groups, educational levels, and income levels over the past few years. This is not some sectoral-specific development, it is a systemic nominal problem. They also find that the collapse in expected dollar income growth explains much of the decline in aggregate consumption since the crisis erupted.

But there is more. The figure also indicates that real debt burdens are higher than many households expected prior to the crisis. Look at the dashed line. It shows the average expected dollar income growth rate over the 'Great Moderation' period was 5.3%. Now imagine it is early-to-mid 2000s and you are taking out a 30-year mortgage and determining how much debt you handle. An important factor in this calculation is your expected income growth over the next 30 years. If you were average, then according to this data you would be forecasting about 5% growth rate. But that did not happened. Household dollar incomes declined and are expected to remain low. Nominal debt, however, has not adjusted as quickly leaving higher than expected real debt burdens for households.

This is something that the Fed could correct. QE3 is a step in the right direction, but more needs to be done with this program to raise expected nominal income growth. One way to do this is to make the size of the asset purchases conditional. That is, instead of conducting fixed $85 billion purchases every month until the economic targets are hit, vary the size of the purchases depending on the progress of the recovery. For example, if inflation and unemployment are not moving fast enough to their target, then increase the dollar size of the of asset purchase and vice versa. For if $85 billion is not enough for the nominal economy to gain traction, then it must be the case that money demand is rising enough to offset the benefits of the $85 billion injection. If this conditionality were added and widely understood, QE3 would better manage expectations and pack a larger punch. No more dereliction of duty.

Update I: Per Nick Rowe's request I have added the following two figures.  The first one shows expected household dollar income growth plotted along side NGDP growth over the past year. The former does seem lead the latter.  

 

The second figure shows the mean and the median expected household dollar income growth. Interestingly, the gap between the two series is relatively stable until the crisis, after which it narrows.

Update II: The first two figures above use a three quarter center moving average to smooth the series. The last figure--the one directly above showing the mean and median--shows the raw, unsmoothed series.