The fallacy of nominal GDP targeting

Book cover Cantillon An Essay of Economic TheoryIn a truly remarkable piece for the Financial Times yesterday, Wolfgang Münchau took another swipe at the Euro-sceptic and ECB-critical community in Germany, which he accuses of inflation-paranoia and of simply not getting ‘modern central banking’. Well, I know of many qualified commentators – many non-German – who swallow a tad harder when reflecting on the new reality of unlimited and open-ended QE in the US and unlimited bond buying by the ECB. As the central bank bureaucrats declare that they will not stop printing base money until the economy grows faster and the unemployment rate drops, damn it, some of us may be excused for wondering what the long-term and unintended consequences of this might be. But, according to Münchau, we are entirely mistaken as we have evidently been “fed misinformation about the functioning of a modern economy.”

Unlimited QE is, according to Münchau, the result of new theories of how central banking works. You see, with open-ended QE the Fed “has become much more determined in guiding future expectations,” which is supposedly what the economy needs: bureaucrats who centrally and administratively guide expectations. Strangely, though, this does not sound all that modern to me.

There is no denying that, of late, things have not been going according to plan but this is no reason for Münchau to question the role of central banks in this crisis, let alone the very concept of monetary central planning, of the idea that some ‘wise men and women’ in Frankfurt, Washington or London, fix the supply of base money and certain prices (interest rates) in order to control, guide and manage overall economic performance. Like many of his FT colleagues, Münchau is in awe of the power elite that supposedly runs our economies and our societies to our benefit. Difficult times only seem to require more determined politicians and more determined central bankers. And when central planning fails, the central planners simply need a new plan. Or a new target.

Not surprisingly, Münchau is an advocate of nominal GDP targeting, the new fad in monetary central planning. There is allegedly nothing wrong with monetary policy. The central bankers only need a new target, and, naturally, a more comprehensive one. The trained mathematician Münchau lectures us how this works:

“This is a debate about nominal income targeting, where a central bank no longer stabilises the inflation rate directly but focuses instead on stabilising nominal gross domestic product. You can think of nominal GDP as the sum of real GDP and inflation. If real growth falls, the central bank would thus have to drive up inflation. Conversely, if real growth rises, the central bank would have to bear down on inflation much harder than it would do under the pure inflation targeting regime used by central banks such as the ECB.”

There is a dangerous naivete about all of this, a blindness toward real-life complexity. There is also a kind of narrow-mindedness, of which Münchau accuses the central bank critics, but of which he himself is the prime example. Münchau and other advocates of GDP-targeting are consistent macro-economists, which means they necessarily ignore many important micro-economic phenomena.

Here is the prime fallacy behind the nominal GDP target and, in fact, all of Münchaus’ argument: It tacitly assumes that money is neutral, which money never is. Let me explain.

The idea that central banks should target nominal GDP presupposes firstly, that stability in nominal GDP is in fact desirable and possible, and that we can ascertain what the ‘right’ level of nominal GDP should be, and what the appropriate relationship between inflation and real GDP is. Such stability rarely exists in human affairs and in particular in economic phenomena, and such a static and non-dynamic view of the economy strikes me as rather – well, not modern. Secondly, and even more importantly, it presupposes that there are direct and stable links between the quantities that the central bank does indeed control directly – that is the monetary base, bank reserves, and certain interest rates – and the macro-economic variables, growth and inflation, which are the ultimate target of its policies. This relationship – between base money and inflation and growth – is, however, very complex and far from stable, and many things can and must happen on the way from changing one to changing the other. And not all of these things are pretty.

Let us assume the central bank fears that real GDP is running too low and that the central bank now has to, according to Münchau, ‘drive up inflation’. How does the central bank do it? – The answer is, it does what it always does, just more of it. The central bank buys certain financial assets from the banks and credits the banks’ accounts at the central bank with newly created bank reserves. Thus, the banks have more – and, we can assume, cheaper – reserves than before, which means they now have an incentive to lend more money. Loan rates on credit markets should drop as more credit gets extended. Investment projects that were previously shunned due to relatively high costs of funding are now profitable. New lending and new borrowing occurs. This may indeed lift real GDP – although only temporarily – and ultimately lift the average of prices, the price level, an effect that, in contrast to the GDP boost, is usually permanent. However, it is clear that many other things must have changed as well as a consequence of what the central bank just did: certain financial assets will have gone up in price and down in yield; bank balance sheets will have expanded; financial leverage will have increased; capital has been reallocated; the relationship between voluntary saving and investment in the economy has been altered; relative prices have changed; income and wealth distribution have changed. It takes either incredible naivete to assume that all these changes are so benign that we can safely ignore them, or childlike optimism in the wisdom and farsightedness of central bankers to assume that all these effects can be anticipated and incorporated in the design of these policies.

The macroeconomic fallacy is to believe that an expansion of the money supply has two effects and two effects only: it lifts growth (good) and it lifts inflation (sometimes good, sometimes bad, sometimes unimportant). That this is too narrow a view, we know since Richard Cantillon invented modern economics. Cantillon lived 300 years ago, so Münchau may object that he did not understand the ‘modern economy’, and besides, Cantillon did not obtain a PhD from MIT, as did Bernanke and Draghi, Münchau’s heros. But in Cantillon’s defense we may say that he experienced first-hand – and indeed actively participated in – one of the most remarkable experiments with paper money in all of history. I am talking about the famous John Law scheme in France from 1716 to 1720. Cantillon knew Law and invested in his paper money scheme. In fact, Cantillon achieved what most modern hedge fund managers dream about. He rode the bubble – the famous Mississippi bubble – to its peak and took his profits before the bubble collapsed. In contrast to Law who ended impoverished and had to flee France, Cantillon retired a wealthy man and recorded his astute observations about the effects of monetary expansion. One of his most notable discoveries was the fundamental non-neutrality of money. As Cantillon stated, when new money is injected into the economy, it does not raise all prices simultaneously and to the same degree but some faster than others, and some more than others.

This is important and has far-reaching consequences. ‘Easy money’ does not just directly affect growth and inflation, or any desired combination of the two. It does not just affect the statistical average of prices, the price level, or the statistical aggregate of economic transactions, real GDP, or any other statistical macro-variable. ‘Easy money’ always means changes in relative prices, changes in resource allocation, and changes in income and wealth distribution. In particular, ‘easy money’ lowers interest rates, which are crucial in a market economy for coordinating investment activity with the public’s time preference, i.e. the public’s propensity to save and thereby support and sustain the capital stock. Monetary expansion means distorted interest rate signals and thus necessarily capital misallocation. This fundamental insight is the basis of all monetary theories of the business cycle, that is, of the insight that monetary expansion leads to booms that must be followed by busts. Every monetary expansion creates distortions, the liquidation of which cause the next recession. Every monetary expansion creates economic instability. This was already the basis of the business cycle theories of the British Classical economists of the Currency School in the 19th century, but more importantly, it was the basis of the so far most convincing business cycle theory, the one developed by Ludwig von Mises in 1912 and 1924, a theory that is now widely known as the Austrian Theory of the Business Cycle.

This theory explains why modern fiat money central banks can never be a source of ‘stability’, whether that means the stability of the inflation rate or the stability of nominal GDP. Central banking, whether old fashioned or modern, is always a source of instability. This theory also explains why modern central banking has now maneuvered us into a veritable economic cul de sac. Repeated attempts over the past decades to buy near-term economic growth at the price of persistent marginal debasement of money has now left us with such a distorted and over-indebted economy that any further monetary expansion has to be ever more scarily aggressive to even cut through the thicket of accumulated imbalances and have any effect on inflation and GDP, whether real or nominal. This policy will ultimately end in hyperinflation when the public loses confidence in this charade.

I don’t know if those German ECB critics who get Münchau all riled up know anything about Cantillon or Mises. For all I know, they may suffer from the same macroeconomic tunnel-vision that afflicts Münchau. The difference is this: In the final assessment they are correct and Münchau is wrong. The road to economic hell is paved with easy money.

In the meantime, the debasement of paper money continues.




Print Friendly
Share on LinkedInShare on TwitterSubmit to StumbleUpon to redditShare via email
Detlev on the Keiser Report - Boom & Bust Vicious Cycle
Stimulus, to infinity and beyond


  1. Zog says

    A very clear exposition, Detlev.

    I can only think that these kind of individuals (Bernanke, Krugman etc.) are politically motivated hence blind to the evidence. I believe that we see the same trait in other complex areas such as climate change, where those of a political, almost religious, persuasion happily spend all day building computer models oblivious to the wealth of data which debunks their beliefs.

    The sad thing is that what they are saying appeals to the masses who like to believe that we don’t need “austerity” and have an easy way out. Hence our present system of social democracy puts these people in a position of power. Until, of course, events overtake them.

    • Huge Fan says

      Zog makes an interesting point that I’ve noticed myself, and would like to expand on.

      I know a great number of people whom I consider to be generally very intelligent, logical, and rational. Most of them don’t read very widely but they still clearly express an intelligent persona capable of understanding more than your average Joe. You can observe this in the way they talk about every day problems and events, but suddenly when the matter jumps to anything politically related, such as elections, the economy, or climate change, it’s like they become different people. The inconsistency’s I sometimes find to be staggering. A person arguing for evolution on the basis that even if it MAY be wrong, it’s still the best available explanation for life on Earth (which shows that they are at least capable of dropping past belief systems if they conflict with new data), will then jump to irrational insults when I try to explain why fiat money is flawed.

      I guess we can attribute it all to Orwells prediction of “doublethink”.

  2. algorithmic says

    Zog: I believe many people are now willing to sacrifice to a certain extent. What they do not want it austerity for the masses and keeping the party going for the top , which is essentially what’s been going on. ..

  3. algorithmic says

    Great article Mr Schlichter. I like the way you introduce to the reader the notion of the very real and incredibly complex implications of every QE round, and the denial of the decision makers to this reality.

    To anybody who has not been living in a cage for the last fifteen years, it is clear that the current financial system is unsustainable. Also it is quite frustrating to see in the year 2012 the whole world is depending on a few wise men, as you point out, who somehow are considered the leading light and are left practically unchallenged to decide for the fortunes of the many.

  4. Single Acts of Tyranny says

    “You can think of nominal GDP as the sum of real GDP and inflation. If real growth falls, the central bank would thus have to drive up inflation”

    So if the economy is going to hell, people are getting poorer and/or unemployed, increase prices instead of letting them adjust (fall) to reflect the new market value? This is a variation of what FDR tried in the 1930′s

    Not so modern. Not so smart.

  5. Huge Fan says

    Detlev I’d like to thank you on an excellent article, it’s a nice break from my school economics work to read your take on actual economic concepts such as nominal and real GDP. I take college level Micro and Macro Economics (last year of high school) in a public school, and my teacher frequently tries to pass on the most illogical notions on how economies work. The latest charade was when she orchestrated an entire 2 hour lesson on how War in general, and buying war bonds in particular, boost real GDP and are therefore beneficial for the economy. Some of this nonsense boggles my mind but I’ve kept relatively quite out of concern for my grade.

    Seriously, your articles sometimes feel like the only links to sanity I have.

  6. Dr James Thompson says

    A good article, showing yet again the unintended consequences of central control of the economy. As a thought experiment, what if these wise men told us they were going to assist the marketplace by altering weights and measures? If they were able to alter weights so as to inflate the apparent amount of potatoes I could buy for a fixed sum of money I might very well buy more of them, and this could be good for potato producers, allowing them to invest more in producing potatoes, thus eventually leading to a real drop in the price of potatoes, at which point the deception about weights could be quietly reversed, and GDP would have been boosted in real terms. Keynsianism doesn’t sound so good when it is obviously based on fraud, does it?

  7. JR says

    “fix the supply of base money”

    You are still locked into this idea that it is the quantity of money, base or otherwise, that determines its value, so inflation. You will ultimately be wrong in your ‘monetary analysis’. Value is given by quality. The balance sheets of central banks could be contracting significantly & the value of their obligations still fast be approaching zero if the ‘assets’ of these banks are junk.

    Monetary expansion does not necessarily mean distorted interest rate signals and thus necessarily capital misallocation. It depends on the quality of the credit being expanded. Central, & commercial, bank credit has been expanded mercilessly in the last couple of decades yet no hyperinflation. Quite simply, government & central bank credit still trades ‘money good’.

    It’s a credit bubble. Irrational & in no way predictable.

    • says

      You are projecting ideas on me. You are not understanding my points. I never said that a certain increase in the quantity of money will lead to a rise in inflation. That is monetarism (of the naive kind), and I am not a monetarist. I maintain, however, that monetary expansion must always distort interest rate signals and lead to capital misallocation. That is necessarily always the case (please see my book). And no, this cannot be undone by using the credit in a specific way. Interest rates are market prices. If you lower them artificially – by printing money and injecting that money into the loan market – you are distorting price signals. Period. That this money is still accepted by the public – ‘money good’ – and that it has not lead to hyperinflation (yet) has nothing whatsoever to do with the fact that this money distorts various markets. Distorting markets and (hyper)inflation are two different phenomena. But to fight the consequences of distorted markets, central banks issue ever more money. Again, the quantity of money is not the most important point here. It is confidence. When the public loses confidence in this ever more bizarre charade, and money becomes a hot potato the game is up.

  8. bill says

    I am struck by this wonderfully clear exposition for I am deep into Churchill,the Wilderness years by Martin Gilbert which amply sets forth the mood and the woeful priorities of Britain circa 1932/8.Almost all favoured Appeasement and it was quite daring to oppose it.Indeed the Government of the day actively promoted disarmament and suppressed all references to German rearmament.It even attempted to oust Churchill, a voluble policy opponent, from his seat in Parliament !
    Today we have QE while,on the whole, the people sleep and trust in their Political choices and is this circumstance not comparable to the aforementioned Appeasement? The latter did not then carry the negative
    connotations so familiar to us today; rather it was very respectable.
    In any event I find the parallel disconcerting and this time round,aside from the admirable Ron Paul,there is no political heavyweight arousing the Nation to whom,once affrighted,the people might turn for salvation.

  9. Rafael Wagner says


    thanks for citing the work of Cantillon, this brought me somehow to White’s book about the 1790′s fiat money inflation in France – a fascinating, alarming story.

    I do not have much knowledge of the Japanese economic experience of the last 10+ years. But the BOJ has been through a high number of QE exercises, yet property prices remain depressed (relative to where they were), the Nikkei is down, price inflation is damp etc. Is this a possible scenario for the US & European QE experience? Or is there a material difference in the attitude & execution, and hence result, of US & Euro monetary expansion versus what Japan has been up to for so many years? Maybe a tough one to answer, but if you have an opinion to share, I would be thankful. Truly,


    • says

      Rafael, yes, in principle the same could happen in the US or the Eurozone. We have essentially the same process in Japan as in these other countries. And to a certain degree, we are already seeing similar results in the West: despite QE and massive expansion in base money, the wider monetary aggregates are not growing as quickly, banks are neither shrinking nor growing (at least not growing at any meaningful rate), and wider measures of CPI are tame. At the same time, public sector debt is accumulating- in Europe despite all the “austerity” that predominantly takes place in the columns of excitable political commentators. We have seen all this in Japan for many years, and we are seeing it now in the US and Europe. This is why sometimes people tell me that fears of inflation are overblown: Look at Japan, they say. They have been doing it for two decades.
      Can the entire world keep running these policies for decades? I doubt it.
      1) Japan was the first to conduct QE 12 years ago, if memory serves. But the policy was implemented in a stop-and-go fashion. There were long periods over which the monetary base was stable, and there were times when it even contracted, that is, the BoJ implemented an ‘exit strategy’, occasionally. In fact, the central bank’s balance sheet has not expanded much over the past decade, although new QE measures were started recently, and I expect QE to continue and accelerate in the future. Bottom-line: while the Japanese were early, they have not been the most aggressive and committed QE-ers out there. They have long been surpassed by most other major central banks.
      2) Here is another difference that explains why they could be more cautious with QE: the Japanese have long been massive savers, although that habit has weakened of late, a trend I expect to continue as well. The BoJ did not have to aggressively print money and buy debt to keep rates low and to keep state debt ballooning. Mr and Mrs Watanabe were happy -sadly – to save money and give it to the state in return for pension promises. The state then wasted the money on Keynesian stimulus, building bridges to nowhere and building public swimming pools. None of this will ever pay for the pensioners. Japan is a country that now produces more diapers for the elderly than for babies, and the state is the most indebted state on the planet, so this will end badly. But, the Japanese saver allowed this charade to go on for longer than it is likely to last in other countries. The Japanese saver took some of the pressure off the central bank.
      3) As is clear from the above, Japan today does not constitute a solution, an endgame. It is approaching monetary meltdown just like the West. There were simply some mitigating factors that allowed it to drag out the inevitable for longer. The choice, ultimately, is the same for Japan and for the West: print money until you destroy it, or stop printing money and allow the liquidation of debt.

      • rafael says


        it is difficult not to be agreeable with your views of and forecast for Japan. On a global level, the big question is if strong spending by governments, fuelled by central bank mechanisms and made in the hope of creating adequate economic growth, ultimately leads to the sort of money destruction experienced often enough in history. There are some incredibly fascinating opinions and narratives out there on this big question, and yours are very compelling.

        Just a brief comment on new money injections. In your book you mention how some participants receive the benefits of new money before others, for example banks. The last reported quarterly profits by the banking industry in Canada were at an all-time record. Dividends on common shares were generously increased by all or most of the six big banks. Loan growth was good. And all this despite long ago forecasts that margins would tighten and profits slip. I do see this as evidence that the extremely accommodative monetary policy is having an impact. A very large part of CDN banking business is mortgages and low rates have fed the real estate market amazingly. Consumer income/debt ratios are also approaching historic highs, close to the US/UK tipping points. So maybe this is the last chapter on growing bank profits, or perhaps it’s the canary in the mine? Just like the Bear Stearns funds that failed in July 2007, there are always signs. Thanks for your continued writings.

  10. says

    A friend sent me a note today claiming that last Thursday Forbes ran an article titled: “Signs of the Gold Standard are emerging in Germany.” Not quite on topic for the post here, but in line with your discussion on gold as a standard.

    He continued that Forbes quoted a report by Deutsche Bank from a week earlier: “Gold is not really a commodity at all. While it is included in the commodities basket it is in fact a medium of exchange and one that is officially recognised (if not publicly used as such). We see gold as an officially recognised form of money for one primary reason: it is widely held by most of the world’s larger central banks as a component of reserves. We would go further however, and argue that gold could be characterised as good money as opposed to bad money which would be represented by many of today’s fiat currencies.

    The conclusion from our overview of gold functionality is that the key difference between good and bad money is scarcity (imposed supply discipline could be another way of describing this). Fiat currencies can be scarce but this scarcity may change on a whim which may both impact its tenure as currency and/or relegate it to being characterised as bad money. Gold is truly scarce, having a concentration of around 3 parts per billion in the Earth’s crust.”

    My contact went on to say how George Soros, Vladimir Putin, and John Paulson are tripping over themselves to buy gold.

    Do you see this occurring or is it just rumour?

    • says

      Hi Brian, no, it is not just rumor. The debate about hard versus soft money, and about a potential resurgence of a gold standard, is real and has been gaining momentum. The question is this: will the advocates of sound money win? Here I am skeptical.
      The article you mentioned was by Ralph Benko who I know. Ralph is a very good commentator and advocate of a return to a gold standard. Here is another piece he published yesterday about a return to gold in China:
      It was Ralph who pointed out to me that Germany’s Die Welt had run a favorable piece on the gold standard recently, that also quoted me and Paper Money Collapse. For those of you who read German, here is the link:
      Of course, I wish the advocates of a gold standard luck but the challenge will not be to convince the public of the benefits of hard money as a guarantor of stability in the long term, but to convince them of the need to accept the full range of consequences of a return to gold, many of which are painful: liquidation of accumulated imbalances, the shrinking of banks, the correction of many asset prices, and, maybe most importantly, the need for balanced budgets forever (and not the ‘lite’ version of 3% deficits that is the declared but never reached long term goal of today’s much reviled “austerity” policy). Gold means the end of the big welfare state, of big finance and of corporatism. Of ‘get rich quick’ and of easy short-term fixes. And of cheap credit and deficits. Good riddance, I say. But the politicians, bankers and populists of all types will resist. And a public that has grown up in the fairy tale land of modern welfare corporatist socialism might resist as well.

  11. Adriano says

    Hi Detlev,

    well I would say maybe there is still hope.

    It seems not all “mainstream” economists are crap…

    You may be aware of the work of William White, who used to fight Greenspan and who is credited of early predictions of the GFC (

    Claudio Borio (, a less famous White’s collegue, is also an interesting character…
    A snapshot just as a starter:

    “…In promoting global financial stability, policies that address current-account imbalances cannot be the priority. Directly addressing the weaknesses in the international monetary and financial system is more important. Our key hypothesis is that the international monetary and financial system lacks sufficiently strong anchors to prevent unsustainable credit and asset booms, resulting in what we call “excess elasticity”. Reducing this elasticity requires stronger anchors in the financial and monetary regimes, underpinned by prudent fiscal policies.”

    Here is a recorded interview on “Rethinking monetary policy – lessons from the crisis” (be advised, when you get towards the end hold on your chair, you could fall off, I nearly did!)

    Keep up with the good work.



Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>