Oliver Davies and Miles Kimball on a Method for Nominal GDP Targeting

Picture of Oliver Davies. Links to the  original post on Oliver Davies’s blog  and to  One-Month Money on Amazon .

Picture of Oliver Davies. Links to the original post on Oliver Davies’s blog and to One-Month Money on Amazon.

I enjoyed reading Oliver Davies’s book with Ruggero Bozotti: One-Month Money: Why money ruins our economy - and how reinventing it could end unemployment and inflation forever…The book’s diagnosis of the problem and argument for the importance of reinventing money are very much on target. Unlike my own proposal, the “Neutral Money” policy Oliver and Ruggero advocate does not depreciate paper money within the month, but then depreciates it 100% at the end of the month. In addition, the same rules apply to all media of exchange, which also can only be used once in a month (at least to purchase final goods and services). Furthermore, the media of exchange have a quantity that is fully controlled by the central bank; private banks can no longer create media of exchange. (The central bank makes sure to create enough to make up for the reduction in privately created money with the 100% reserve requirements.) 

Beyond being one of the many possible ways to eliminate the zero lower bound, I think of this as designed to put a straightjacket on velocity so that it is exactly once per month or 12 times per year. This then helps guarantee that one can hit one’s nominal GDP target, since MV = PY, and M is tightly controlled through 100% reserve requirements. 

My view is that, once one eliminates the zero lower bound, central banks that are consciously targeting nominal GDP could probably do a pretty good job of hitting those nominal GDP level targets without such draconian measures, so that “one-month money” is probably not necessary to stabilize the economy. But it is always good to have a backup plan (in what I consider the unlikely case) that it is very hard to hit nominal GDP targets even after the zero lower bound is eliminated in the way I have advocated.

One place where Oliver and Ruggero oversell their system a bit is that appropriate adjustments to the nominal GDP target to allow for changes in the natural level of real output are nontrivial. (I wrote about this in “Optimal Monetary Policy: Could the Next Big Idea Come from the Blogosphere?” and “Why the Nominal GDP Target Should Go Up about 1% after a 1% Improvement in Technology.”) With the zero inflation target I would advocate, the nominal GDP level target adjustment need are exactly the changes in the natural level of real output. (With a 2% inflation target, which I have argued is too high in the absence of the zero lower bound, there is an additional 2% addition to a trend in the nominal GDP level target.) 

After reading One Month Money, I had a very interesting conversation with Oliver on the phone. Here is his account of that conversation and his reactions to it:

Two weeks ago, I had the pleasure of speaking with Miles Kimball. For those unversed in the who’s who of the economics world, Miles is a Professor of Economics and Survey Research at the University of Michigan and blogs at Confessions of a Supply-Side Liberal and Quartz. As one of the few professional economists who believe our monetary system is in dire need of an overhaul, he has developed a proposal for removing the Zero Lower Bound (ZLB) without outlawing cash. In a gist, Miles’ proposal would allow the central bank to implement a deposit fee on its cash window, thereby creating a negative rate on physical currency. Miles is also the first person with academic credibility to read my book, and his feedback, delivered over a marathon phone call that lasted nearly three hours, was very positive.

Let’s start with Miles’ elegant reframing of how a neutral monetary system would work. Neutral money affects two variables: the Money Supply (M) and the Velocity of Money (V), which, crudely speaking, means the amount of times the money supply is spent during a given time period. As anyone with exposure to introductory macroeconomics will know, the Money Supply (M) multiplied by the Velocity of Money (V) is equal to Prices (P) multiplied by Quantities (Q), which is also known as “nominal GDP. ” The equation looks like this: M*V = P*Q = nominal GDP.

So how does neutral money work? It’s pretty simple. Step 2 of neutral money (expiration) fixes V at a constant, since every dollar in circulation (M) is guaranteed to be spent exactly once each month. Simultaneously, Step 1 (100% reserve banking) gives the central bank direct control over M. With V fixed, a 10% increase to M will also boost M*V, and hence nominal GDP, by 10%. In other words, under neutral money, the central bank has direct control over nominal GDP, or aggregate demand. If the central bank doesn’t want demand to fall, then demand won’t fall. No ifs or buts or maybes.

As I have enormous respect for Miles’ work, I was greatly encouraged by his acknowledgement that neutral money would achieve its stated goal of ending the business cycle. Does this make Miles a neutral money convert? Not quite. Or not yet. As someone who has pitched his plan to eliminate the ZLB to a number of central banks, he understands the importance of politics. And as far as monetary overhauls go, neutral money is undeniably radical, more so than his ZLB proposal. Miles therefore concluded that a system like his would need to demonstrably fail before consensus could be reached on adopting neutral money.

Quite frankly, I couldn’t agree more. While a chapter in my book explains why neutral money is superior to negative cash interest rates, my thinking has evolved slightly since publication. The choice shouldn’t be between neutral money or negative cash interest rates. Rather, we should first try to eliminate the ZLB, which is easier to implement, and then, if that falls short, we should adopt neutral money.

Does this conclusion mean we should shelve neutral money until a negative cash rate system fails? Not at all. Neutral money, although the most radical, is also the most soundproof. As Miles’ mathematical reframing proves, neutral money is guaranteed to work. We should therefore think of neutral money as the last stage on the road to a more perfect monetary system, with these other proposals as important milestones along the way. Each proposal, whether Kimball’s, or Buiter’s (who proposes abolishing cash altogether), or even 100% reserve banking, will dramatically reduce the political hurdles blocking the adoption of neutral money.

So how might it all play out? Obviously this is highly speculative, but it could look something like this. In stage one we might adopt Miles’ system, which removes the ZLB. In a second stage we might implement 100% reserve banking, which would improve the stability of a monetary system where rates can turn negative. At this point, with fractional reserve banking removed, and with the public accustomed to negative rates, the only remaining political hurdle would be expiration — an inconvenience which, by that time, should be considerably diminished by technology.

So like all explorers setting out on an expedition, we should be prepared not just for the first, second, or third leg, but also the last. And that means we start thinking about practical implementation of neutral money today.

My conversation with Miles ended on a rather flattering note. He asked if I would be interested in writing a sequel (of sorts) to One-Month Money. In it I would focus on all the problems that would still remain in an economy free of business cycles. Miles has spent a lot of his time thinking about these supply-side problems, and wants a platform on which to properly express his ideas.

Food for thought…