THE FINANCIAL STABILITY CASE FOR A NOMINAL GDP TARGET.

• Author: Beckworth, David

Ten years after the financial crisis there is a new appreciation for the role household debt and financial fragility play in the business cycle. Though some economists recognized their importance going into the crisis, many observers did not and were blindsided by the severity of the Great Recession. Motivated by this experience, a spate of research over the past decade has refocused attention on the impact household balance sheets and the financial system have on the economy.

One line of this research has focused on household finance and how it contributed to the economic downturn in the United States (Mian and Sufi 2010, 2014; Mian, Rao, and Sufi 2013). It documents how the buildup of household debt, especially mortgage debt, during the housing boom made households susceptible to the decline in housing prices starting in 2006. This decline precipitated deleveraging by households and, in turn, curtailed consumer spending and economic growth. (1) Another vein of this research has looked at the role the financial crisis played in the U.S. economic slowdown (Brunnermeier 2009; Gorton 2012; Ricks 2016; Bernanke 2018). It shows how a systemic run on institutional money assets caused a collapse in wholesale funding and triggered a severe credit crunch. In turn, this breakdown in financial intermediation caused economic activity to contract. (2)

While the household balance sheet and financial panic views are distinct, they are also interrelated: household deleveraging affected the health of financial firms during the crisis while the reduction in credit supply exacerbated household financial problems. Along these lines, Gertler and Gilchrist (2018) and Aikman et al. (2018) show both factors were jointly important to the emergence of the Great Recession. (3) Jorda, Schularick, and Taylor (2013, 2015, 2016), relatedly, in their cross-country studies find countries with high household debt levels tend to have a higher incidence of financial crises. Highly leveraged household sectors and financial crises, in other words, are often a jointly determined process.

This new appreciation for household debt and financial fragility can be seen from a broader perspective as the long-time coming consequence of the advanced economies credit regime that emerged in the 1980s. Jorda, Schularick, and Taylor (2017) show that private sector credit growth relative to GDP accelerated during that decade, creating a "financial hockey stick" pattern of leverage for advanced economies. They show this development has dampened business cycle volatility overall while making advanced economies more susceptible to spectacular financial crashes.

This renewed interest in household balance sheets and financial system stability has led to several different policy recommendations. First, the IMF, BIS, and policymakers in many advanced economies have called for macroprudential regulation. This approach focuses on the stability of the entire financial system and works by adjusting buffers--such as countercyclical capital requirements and caps on loan to value ratios--to respond to aggregate financial shocks.

This approach, however, is not without its challenges. It is hard to know what is a true financial vulnerability, what are the appropriate indicators to follow, and how to define financial stability. (4) In addition to these knowledge problems, macroprudential goals may conflict with other policy goals and be subject to rent seeking by affected parties. (5) For these reasons, macroprudential regulations, which have been implemented to varying degrees in different countries, are not yet fulfilling all of their desired goals (IMF 2018; BIS 2018).

A second policy recommendation put forth by some observers is the need for state-contingent debt contracts (Shiller 2008; Mian and Sufi 2014; Eberly and Krishnamurthy 2014; Piskorski and Seru 2018). These are financial contracts whose payouts are contingent on certain economic outcomes. In this context, the push has been for mortgages whose principal and payments are indexed to local economic conditions. A weakening local economy would lower the real mortgage burden on households while a booming one would raise it. Such mortgages would resemble equity more than debt and lead to better risk sharing between debtors and creditors. In turn, this improved distribution of risk should improve the stability of the financial system. Shiller (2004), more generally, shows how these and other state-contingent contracts could radically transform our world into a more equitable and flourishing place.

Some progress has been made on this front with income-contingent student loans, contingent convertible corporate bonds, and a few state-contingent mortgages. (6) Most debt, however, remains written in fixed nominal terms. The dearth of contingent debt contracts suggests that the cost of writing and enforcing them is prohibitively expensive. For now, then, state-contingent contracts do not provide a practical solution to the household debt and financial stability concerns of advanced economies.

A third policy recommendation that addresses these concerns is to use monetary policy to create better risk sharing between debtors and creditors. Specifically, a monetary regime that targets the growth path of nominal GDP (NGDP) can be shown to reproduce the distribution of risk that would exist if there were widespread use of state-contingent debt securities (Koenig 2013; Sheedy 2014; Azariadis et al. 2016; Bullard and DiCecio 2018). The basic idea is that the countercyclical inflation created by an NGDP target will cause real debt burdens to change in a procyclical manner. As a result, debtors will benefit during recessions and creditors will benefit during booms. Fixed nominal-priced loans will act more like equity than debt and therefore promote financial stability.

This policy recommendation has the potential to be the most tractable of the above three proposals since it only requires a NGDP-targeting monetary regime. While switching to such a monetary regime is a nontrivial task, it would accomplish the same goals of state-contingent debt contracts and complement the efforts of macroprudential regulations. However, of the three proposals this one has received the least attention. This may be due to the fact that the recent work on this proposal been largely theoretical since no country explicitly targets NGDP. This policy proposal, consequently, is ripe for further attention and development.

This article attempts to shed more light on this proposal by providing the first empirical assessment of it. It does so by exploiting an implication of the theory: those countries whose NGDP stayed closest to its expected precrisis growth path during the crisis should have experienced the least financial instability. Put differently, some countries experienced more stability in aggregate nominal spending than others and these differences should be systematically related to financial stability if the theory is true. So even though no countries were targeting NGDP during the crisis, there is still a way to test the theory.

This article uses this understanding to provide an empirical test of the third policy proposal. It does so by outlining a method for estimating the expected growth path of NGDP for advanced economies and then seeing whether the gap between it and actual NGDP is systematically related to various measures of financial stability. This exercise is only a first look and is not the final word, but the results indicate more attention should be given to this third proposal. The findings strongly suggest that a stable NGDP growth path supports financial stability. These findings, therefore, lend support to the existing arguments for why advanced economies should consider adopting an NGDP level target.

In the sections that follow, the article further outlines the arguments of Koenig (2013), Sheedy (2014), Azariadis et al. (2016), and Bullard and DiCecio (2018). It then derives the expected growth path of NGDP for 21 advanced economies using IMF data and the "sticky forecast" approach of Beckworth (2018). Next, the article uses this measure to create an NGDP gap that is used in some scatterplots, a panel vector autoregression, and a panel local projection model to determine the relationship between the NGDP gap and various economic variables. The article then concludes with some policy considerations.

Better Risk Sharing through NGDP Targeting

The key insight of Koenig (2013), Sheedy (2014), Azariadis et al. (2016), and Bullard and DiCecio (2018) is that in a world of incom plete markets where there is nonstate contingent nominal contract ing, an NGDP target can reproduce the risk distribution that would occur if there were complete markets and state contingent nominal debt contracting. (7) An NGDP target, in other words, can make up for the lack of insurance against future risks that could affect debtors' ability to repay their debts. Conversely, an NGDP target can also make up for the lack of insurance against potential returns creditors might miss out on because their funds are locked up in fixed-price nominal loans. Bullard and DiCecio (2018) show that this result holds even when the modeled heterogeneity among debtors and creditors approximates that of the actual income, financial wealth, and consumption inequality in the United States. They note this makes NGDP targeting "monetary policy for the masses."

The intuition behind these formal findings is that debtors and creditors who have committed to fix-nominal debt contracts and therefore to fixed money payments can be subject to both price level and real income shocks. The former shocks have long been understood and generally seen as bolstering the case for a price-level or inflation target. Most famously, Irving Fisher (1933) made the case for price level stability as a way to avoid unexpected deflation and a rise in real debt burdens that could trigger a cascade...