Lighthouse Investment Management
Letter to investors - December 2012 Page 4
Monetary policy: The N-Word
N as in "nominal". Nominal GDP targeting, the latest burlesque of monetary fiction.But first things first.There is a land, where people calculate a "potential GDP". How do they do that? By simply extrapolatingtrends. Potential GDP is "the level of economic activity achievable with a high rate of use of its capitaland labor resources". In the past, the differences from observed GDP were not very large:The difference between GDP (blue) and potential GDP (red) is called the "output gap" (black dottedline). It currently stands at 6% of GDP, or roughly $1 trillion.Let's zoom in on the most recent period:
Lighthouse Investment Management
Letter to investors - December 2012 Page 5
Alright, we are growing "below trend". But what if that trend has changed? The CBO (CongressionalBudget Office) recently "revised its estimate of potential output in 2022 downward by roughly 7percent"
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. One more revision like that and the entire output gap would be gone.Seriously, which manufacturer would keep idle machines since the 2007/2009 recession for half adecade, waiting for demand to pick up? Admittedly, the labor market has idle capacities(unemployment), but would those "idled" (construction workers) really be able to jump at news jobs inthe health care sector?After a flawed measurement of economic activity, and coming up with an imaginary output gap, whatelse might our economic elite come up with?Stagnating real GDP and high unemployment are no fun. After exhausting every traditional and non-traditional tool of monetary and fiscal policy, what else could be done to make that GDP grow?Nominal GDP equals real GDP plus inflation.
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"An Update To The Budget And Economic Outlook: Fiscal Years 2012 To 2022", by: Congress of the United States -Congressional Budget Office, August 2012, page 40
Lighthouse Investment Management
Letter to investors - December 2012 Page 6
So if real GDP doesn't want to grow... Eureka! you just have to cause more inflation, and nominal GDPwill obediently join its potential GDP:We assumed real GDP (black line) growingat a mediocre 1.5% per annum. The initialoutput gap being 6%, and potential GDPassumed to be able to grow by 2% perannum.With 2% inflation (blue line), nominal GDPwould never be able to "catch up" topotential GDP (dotted black line).But add some zest by turning up inflationto 4% annually, and you have nominalGDP shining bright in no time (red line).
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Except for one little error of judgment: if elevated inflation led to wealth creation and jobs, Zimbabwewould be the richest country on earth
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.As real incomes of US employees stagnate since more than a decade, rising prices would either lead tofalling volumes, or force households further into debt.Also, how would this be different from a communist command-style economy? The level of GDP wouldbe known in advance, either achieved by real growth or by inflation. The final step to making numbersup completely then is a small one.A small problem remains: How does a central banker create inflation? You cut interest rates to zero.Nothing. You massaged the yield curve until there was no more yield left in it, begging people to borrowcheap money. Nothing. You printed trillions of dollars. Still nothing. So you are getting desperate.If you were the Fed chairman, how would you pull this one off? The Fed's reputation is already damaged(since, for example, it was completely oblivious to the brewing 2008 financial crisis and housing bust), soyou need to tread carefully. If you float stupid ideas yourself, the press will probably take them apartand you get a lot of political flak. An old trick: have someone else, presumably of pristine reputation,float the idea, and then pretend to only reluctantly give in and grudgingly adopt the new policy (since,down in your heart, you -
cough
- try to defend the value of the currency).Roll in Michael Woodford, Ph.D., professor at Columbia University and "probably the world's pre-eminent monetary policy theorist"
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according to a Keynesian lap-dog-journalist from the Financial
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A "pleasant" side effect of elevated inflation and hence higher nominal GDP would be increased tax receipts forthe government as asset prices are inflated and individuals pay capital gains taxes on those inflated assets.
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Zimbabwe achieved an inflation rate of 6.5 sextillion percent in November 2008. In 2009, Zimbabwe abandonedits currency; money from other countries is used instead.
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