Now George Selgin, David Beckworth and Berrak Bahadir have a paper in the Journal of Policy Modeling that offers an answer to this question. Fortunately George Selgin gives a brief discussion of their argument at the Alt-M blog. Selgin wites,
Our argument, in brief, is that the Fed blew it by treating the exceptionally high post-2001 productivity growth rate, not as warranting an upward revision of the Fed’s interest-rate target, as neoclassical theory would suggest, but as an opportunity to maintain a below-natural interest rate target without risking a corresponding increase in inflation.The "Less Than Zero" book referred to above is worth reading for its own sake not just because of its use in the above argument. The full tile is Less Than Zero: The Case for a Falling Price Level in a Growing Economy (pdf) and is written by George Selgin and published by the Institute for Economic Affairs in London. In it Selgin argues that
We supply lots of evidence supporting our interpretation and, thereby, supporting the view that excessively easy Fed policy did indeed contribute substantially to the subprime boom. We also show how NGDP targeting would have prevented this outcome–and that it would have done so to an even greater extent than strict adherence to a Taylor Rule.
Readers familiar with my arguments favoring a “productivity norm,” as presented in Less Than Zero and elsewhere, will understand the claims made here here as a specific application of those more general arguments.
1. Most economists now accept that monetary policy should not aim at 'full employment': central banks should aim instead at limiting movements in the general price level.This argument makes the point that not all deflation is necessarily bad. It would be interesting to know what effect a productivity norm would have on New Zealand's inflation history given its somewhat dismal post-WW2 productivity experience.
2. Zero inflation is often viewed as an ideal. But there is a case for allowing the price level to vary so as to reflect changes in unit production costs.
3. Under such a 'productivity norm', monetary policy would allow 'permanent improvements in productivity...to lower prices permanently' and adverse supply shocks (such as wars and failed harvests) to bring about temporary price increases. The overall result would be '... secular deflation interrupted by occasional negative supply shocks'.
4.United States consumer prices would have halved in the 30 years after the Second World War (instead of almost tripling), had a productivity norm policy been in operation.
5. In an economy with rising productivity a constant price level cannot be relied upon to avoid '..."unnatural" fluctuations in output and employment'.
6. A productivity norm should involve lower 'menu' costs of price adjustment, minimise 'monetary misperception' effects, achieve more efficient outcomes using fixed money contracts and keep the real money stock closer to its 'optimum'.
7. The theory supporting the productivity norm runs counter to conventional macro-economic wisdom. For example, it suggests that a falling price level is not synonymous with depression. The 'Great Depression' of 1873-1896 was actually a period of '... unprecedented advances in factor productivity'.
8. In practice, implementing a productivity norm would mean choosing between a labour productivity and a total factor productivity norm. Using the latter might be preferable and would involve setting the growth rate of nominal income equal to a weighted average of labour and capital input growth rates.
9. Achieving a predetermined growth rate of nominal income would be easier under a free banking regime which tends automatically to stabilise nominal income.
10. Many countries now have inflation rates not too far from zero. But zero inflation should be recognised not as the ideal but '... as the stepping-stone towards something even better'.