Brilliant or Crazy? I Really Don't Know.
Apropos of Rafe’s last post on Complexity Economics, I ran across an economic stability proposal that is either brilliant or crazy. I both haven’t thought it over enough and am probably not qualified to determine which.
Scott Sumner is an unconventional monetary economist. His idea is for the Fed to sponsor a nominal GDP futures market. Then the Fed buys and sells unlimited quantities of futures at a price corresponding to a 4% nominal growth rate. The abstract for his most recent formal paper defending the policy is here.
I believe the idea is that a combination of anchored expectation, prediction market, and market arbitrage effects will serve to make this a self-fulfilling prophecy. The money supply and composition thereof will adaptively adjust to whatever level is necessary to achieve a 4% nominal growth rate given the aggregate knowledge of all market participants about fine grained aspects of the economy.
Inflation, of course, will float in such a way that real GDP will still fluctuate. But due to various forms of price and wage stickiness, keeping nominal output growth stable will serve to modestly dampen business cycles. More importantly, it will prevent the Fed from exerting inflationary or contractionary pressure on the economy by misjudging the proper level of the money supply. The market will always be able to arbitrage what it sees as mistakes.
Think of this as crowdsourcing monetary policy.
Possible Insight 
It sounds brilliant, but I have to admit, I don’t quite understand the mechanism. How can the Fed commit to provide unlimited liquidity? Does it print more money when needed to buy and take money out of the supply as it sells?
rafefurst
March 1, 2009 at 8:30 pm
Yep, that’s theory. It already does much the same thing when it buys and sells Treasuries in “open market operations”.
kevindick
March 1, 2009 at 9:49 pm
The paper is awesome.
Daniel
March 2, 2009 at 12:44 am
@Kev, okay then, I think it has a shot, and yes I like the brilliant simplicity.
The question is what sort of “collateral damage” could occur when large external forces swamp the system. Like a real thermostat, if it gets too hot or too could outside, the heating/cooling system can break, the power supply can short, etc, leaving inhabitants worse off than if there was not an open-ended commitment to deliver as much heating or cooling as necessary. It’s not hard to imagine a scenario where the dollar itself “breaks” before the system settles back.
But, this is for sure the sort of policy that we need, IMHO. Aas long as we recognize that all policy has limitations and needs to be monitored and intervened upon with “practical wisdom” 🙂 (Sorry, couldn’t help myself).
rafefurst
March 2, 2009 at 4:15 pm
Best you make this concrete and limit the jargon.
Otherwise we won’t have the collective wisdom to judge it and then we will be back in the situation of trading risk and the powers that be saying afterwards – well we didn’t understand it. Shame. Just bankrupted the west.
So the challenge is how simple can you make it? How concrete can you make it?
Sorry running around after very concrete things and haven’t retrieved the password to the wiki where I store those refs. Haven’t forgotten. Just a deluge of detail here.
Jo Jordan
March 6, 2009 at 5:31 am
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April 26, 2009 at 8:10 am
I have a proposal myself on how to solve the financial crisis. I appreciate your comments.
1. The Fed Reserve must always ensure that the money supply exceeds GDP. The difference must exceed prevailing open market interest rates. This way, there’s always enough cash to finance all economic activities, subject to point 2 below.
2. The US Government must ensure the equal distribution of the fiat currency within the economy so that no one is holding too much cash and that no one is holding too little of it. This will eradicate poverty and avoid cash-hoarding.
3. If possible, ban usury altogether because usury is sucking cash out of the economy, which is contributing to the repetitive financial crisis.
4. The US Government must create investment avenues for the working class to buy government-issued securities. This way, fiat money does not have to come out of the banks as debt money. Instead, it will come out at free money.
All of these cn be achieved by introducing legal reforms.
ismail
April 3, 2010 at 1:16 am