Background: The Supply Chain Knowledge Problem
Last year a wrote a post titled The Supply Chain Knowledge Problem addressing what I believed to be some of the core and fundamental drivers of the increase in prices over the last couple years. Describing the knowledge problem as the fundamental problem of economics (and society), 'know how' and 'know what' are spread across many minds and the knowledge required to make anything isn't possessed by any one person, company, or policy maker. And, especially can't be resolved by any central banker.
In reference to COVID and our economy I used an analogy of an environmental disaster like a forest fire and the recovery of our economy being analogous to an ecosystem.
"Just as restoring an ecosystem after an environmental disaster requires an understanding of ecology, we must understand the ecology of our markets and supply chains in order to restore our economy and avoid an even worse ecological disaster. We must recognize that the knowledge problem post COVID is more challenging than pre COVID made evident by recent price spikes and shortages that some people could be confusing for monetary inflation."
"COVID and our response to it unfortunately destroyed the ‘know what’ and ‘know how’ that was spread across millions of minds and across decades of building our supply chains. There is no simple blunt monetary or fiscal policy that can substitute for the ‘know how’ and ‘know what’ it’s going to take to rebuild them. It’s going to take time. Prices have to search and signal for the ‘know how’ and ‘know what’ to rediscover and rebuild what was lost."
I have been dreadfully concerned that if we get out of the way and just let 'P' do its job searching and signaling that there would be political pressure to paper over the damage with an excessive increase in interest rates by the Fed, or even worse politicians passing bills in the name of inflation reduction that might make matters worse. And even more dreaded, we'd experience complete economic amnesia manifested by calls for price controls.
At the same time, a person would be blind not to consider the impact of the expansive monetary policy of the Federal Reserve prior to, during, and after the pandemic, not to mention the aggressive but necessary fiscal response. This made the knowledge problem above seem even more intractable. How much of the current inflation is truly 'inflation' in the monetary sense, and how much is P just doing its job? How can we tolerate temporary price fluctuations and spikes so that P can do its job, and at the same time mitigate what constitutes actual monetary inflation at the same time?
To this point no economist or commentator has really come close to answering this call of concern. Too few were talking about the fundamental micro foundations of the knowledge problem, and too many had appeared to abandon it completely in pursuit of sky high interest rates.
Nominal GDP (NGDP) Targeting
Recently in the essay The Causes and Cure of the 2021-2022 Inflation Surge, David Beckworth provides the synthesis that I was looking for as both a student and consumer of economics. As I read it, NGDP targeting allows us to both address the challenges of monetary inflation while at the same time letting P do its job.
What is NGDP targeting? Beckworth explains:
"NGDP measures total current-price spending on final goods and services in the economy—it is the economy we see in the real world. Put differently, NGDP growth has both real GDP growth and inflation embedded in it. Using this measure creates a monetary policy framework that is called NGDP targeting."
Dr. Beckworth has been carrying the torch for NGDP targeting for quite a while so it's not totally new to me. But I never quite understood the power of it until he put it in the context of our current economic challenges and became the first economist to offer in my mind a satisfactory explanation and policy direction. (As I said above, and full disclosure, I am a consumer and student of economics, not an academic producer of economics, especially not macro, and heavily influenced by the mainline economic thinking of the Austrian, Public Choice, and New Institutional schools).
In the excerpts below Dr. Beckworth takes the knowledge problem discussed above head on with NGDP targeting:
The distinction, then, between rising inflation caused by supply shocks and inflation caused by excess aggregate demand growth is essential for successful central banking. But therein lies the rub: It is impossible to know this distinction in real time.
So what are central bankers to do? How can they overcome this knowledge problem?
Instead of trying to divine what part of inflation is due to aggregate demand shocks and should be managed, we should look directly at aggregate demand itself. This approach cuts out the middleman of inflation and goes straight to the underlying source of inflation movements that is amenable to monetary policy.
The amazing thing about this approach is that it provides a clever workaround to the central banker’s knowledge problem. That is, by forcing monetary authorities to focus on stable aggregate demand growth, it keeps trend inflation anchored but allows for temporary inflation caused by supply shocks.
NGDP targeting allows for price fluctuations caused by supply shocks while still aiming for a stable trend inflation rate.....NGDP targeting, in other words, is a two-for-one deal that gives central banks the inflation cure they are seeking.
He goes on to explain how this approach would have allowed the Fed to get ahead of the curve and act quicker last year regarding monetary inflation and how NGDP targeting can plot a course going forward. This sounds a lot better to me than the rather blunt approaches we have seen to this point with the Inflation Reduction Act and no end in sight interest rate increases that risk papering and plastering over the supply chain problems only to find them again later when we're remodeling our economy after the recession that's projected as a result. Without NGDP targeting, how many remodels can our economy take?
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