by Keith Weiner
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At the Cato Monetary Conference this week, Scott Sumner said he had a “modest” proposal, that there should be a highly liquid futures market in Nominal Gross Domestic Product (NGDP). This caught my attention, as the futures market is a topic near and dear to my heart (I write about it every week).
Sumner is known for his view that the Fed should target NGDP as the basis for monetary policy. So a futures market that predicts it would be convenient. Let’s look at his idea more closely.
What, precisely, is to be traded? If I buy an NGDP future, what is delivered at contract maturity? It’s clear what I get when I buy a wheat future or crude oil future. With Nominal GDP futures, there’s nothing to receive because NGDP is not a commodity or even a security.
A futures contract is a derivative, but an NGDP future would not be derived from anything.
So how is an NGDP contract supposed to settle? The only thing I can think of (Sumner doesn’t say) is that the NGDP contract will pay based on the published NGDP number. For example, if NGDP comes in at $19T, then the contract might pay out $19,000 (depending on how many NGDP units are represented by the contract).
GDP numbers are revised a few times after they are published. Is the NGDP contract to pay when the initial number comes out, even though it might be wrong? Or will NGDP be the only contract where both parties’ capital must be locked up for months until the Bureau of Economic Analysis publishes the final number?
Moving on to the next problem, let’s look at a real futures contract like wheat. Suppose the bid price on a March wheat future is $7.00 and the ask price on spot wheat is $6.50. There’s 50 cents of profit to anyone who can buy wheat in the spot market, sell it in the futures market, and store it for the duration. This is called carrying, which is an act of arbitrage.
Arbitrage anchors the price of wheat futures to the price of wheat in the spot market. Both prices can move up and down in response to changes in supply (demand being pretty stable in wheat) or speculation that supply will change.
By contrast, the NGDP market is for speculators only. It has no connection to a real price, and no arbitrageurs. I am all for making gambling legal, if people want to bet on NGDP, the weather, or the horse race. But that’s not Sumner’s point. He believes that this market will predict NGDP accurately enough to manage the economy without causing recessions and depressions.
Sumner declares this market won’t merely be liquid. It will be highly liquid. Let’s consider that.
Each market has a different degree of liquidity. The liquidity comes from the character of the thing being traded, not from a government proclamation. For example, copper is more liquid than lumber. Silver is more liquid than copper and gold is more liquid than silver.
A liquid market has a continuous bid and ask. That does not mean someone is always buying or selling. On the contrary, it means someone stands ready to buy or sell at any time. Who and why?
In my wheat example, I mention the carry arbitrage. Suppose the cost to carry—interest and storage—is 30 cents. Each trader has to decide his minimum profit threshold. Suppose Joe is willing to do it for 20 cents. He needs to get at least 50 cents on the deal. He can sell a March for $7.00, which is why he bids $6.50 on spot. Joe will not pay one penny more, unless the price of March wheat goes up.
Joe and his competitors are why there’s always a bid (and ask) in wheat.
Obviously, there is no carry arbitrage with NGDP futures. There won’t be much liquidity either.
An NGDP market may convenient for monetary planners, but without a reason to exist it won’t work the way Sumner hopes.
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3 comments
1 ping
Greg Jaxon
2015-11-16 at 23:35 (UTC 2) Link to this comment
Hi Keith,
Thanks for this debunking of Sumner’s market mechanics.
I’ve been arguing NGDP-targeting on and off with two of his supporters since his Money Illusion blog came to our attention.
In the beginning, I gave Sumner some credit for aiming closer to the “right” level of circulation credits than any of the other central planners.
After a while I began to think that he is first and foremost bidding for a Central Planning License, and only secondarily thinking like an economist.
For what it’s worth the good part of NGDP targeting is that it is a poor approximation for the total size of a Real Bills market, if one existed.
It is, after all, the GDP activity that gives rise to a “demand for money”. If the GDP were an immediately observable quantity, it would make sense as a “target” (…well with serious adjustment to get the government spending and other shenanigans out of the total).
I understood his NGDP futures market as being THE new entry point of fresh lucre from the Fed.
As I heard the story, NGDP over/under-shoots would literally be the $Billions/month flow that adjusts the “money supply”.
This is of course utterly insane, and hardly changes the game at all: squishy numbers emerge from government agencies which then fall under crony capitalist influences and money is printed directly into a few insider pockets. Same old Same old…. central planning.
Just say “BS”, and save your mental energy.
Central planning is not going to win by dint of its rationality; it wins by force and fraud.
It has been a year since Sumner attempted to establish the “highly liquid market” he advertised.
It isn’t something that’s going to emerge organically. so eitherthe Fedwill “reform” and adopt it (hence the “rules-based” initiatives, or the Fed will fold the game and economics schools will lose the career paths they’ve been feeding and maybe they’ll start teaching Austrian approaches. We can always Hope.
-g-
Daniel R. Grayson
2015-12-21 at 20:37 (UTC 2) Link to this comment
Most of your questions are answered in Sumner’s paper on the topic at http://mercatus.org/sites/default/files/Sumner_NGDPTargeting_v2.pdf
Keith Weiner
2015-12-21 at 22:29 (UTC 2) Link to this comment
Daniel: Thanks for your comment. That is a different paper from the one he distributed at his Cato talk.
In the paper you link, Sumner uses the term “futures market”. However, that is not the right term to use to describe this artificial Fed construct. Sumber proposes that the Fed stand ready to buy or sell in unlimited quantities, at a fixed price. I would want more time to think about the perverse incentives applied by this, and the likely perverse outcomes. I have written at length about the distinction between arbitrage in a free market and speculation, front-running, lobbying, and outright spoliation under central planning. Based on that theory alone, one would expect Sumner’s scheme to enrich select cronies at the expense of everyone else.
It’s ironic that Sumner seems to want the market to decide some things, but not others. He opposes the market deciding the interest rate. He does not want the market to decide the target NGDP growth number. He does not want the market to decide if money supply even drives NGDP. These are given, a priori, and Sumner wants the market only to help determine the right money supply.
I would like to write more about this.
Open Letter to Mercatus Centre - The Gold Standard Institute International
2020-07-23 at 22:13 (UTC 2) Link to this comment
[…] then assert that nominal GDP targeting will work well. I have written before about some of the frivolous ideas behind this […]