This morning Jim asked me how long it will take for the Australian economy to get back on a sustainable growth path. I was not able to answer directly. I suggested that what happens to economic growth in Australia will depend on what happens in the rest of the world. I added that if the U.S. starts to grow again in 2010 then that will have a positive impact on growth prospects for Japan and China and for commodity exporters like Australia.

Jim asked: “How confident are you about the U.S. starting to grow in 2010?” I started making excuses about my lack of knowledge of the U.S. economy and my poor knowledge of short term macroeconomics. That was when Jim said: “You know that political leaders all over the world have been saying that they will do what it takes to restore confidence and get sustainable recovery.” I nodded as Jim went on: “What they seem to be implying is that they will just keep increasing government spending until people become more confident. Does that make you feel confident?”. I shook my head. Jim then asked: “So what will it take to restore investor and consumer confidence and get sustained recovery?”

I told Jim that was a very good question. That only bought me about a second to gather my thoughts. The only sensible answer that I could think of was that restoring confidence was a matter of establishing a general expectation in the U.S. (and other major economies) that GDP would grow at about the same rate as the trend rate of growth in their productive capacity.

Jim interrupted: “That means boosting aggregate demand. Isn’t that what governments are trying to do now?” My response was that our focus should be on establishing the expectation of sustainable growth in the monetary aggregates rather than just a short-term boost in aggregate demand, with the expectation of a subsequent contraction as soon as inflation raises its ugly head again.

Jim interrupted again: “Next you will be telling me that Milton Friedman was right and what we need is a rule requiring the monetary authority to maintain a specified rate of growth in the stock of money.” I admitted that I still thought Friedman was on the right track, but technical difficulties involved in targeting the money supply would make it more sensible to target growth in nominal GDP (i.e. PY rather than M).

Jim said: “So what you are saying is that if the U.S. central bank were to announce a target rate of growth of nominal GDP and start making appropriate adjustments in monetary policy to achieve that target, then this would restore confidence and promote a sustainable recovery.”

I wish I had sufficient confidence to tell Jim that he had hit the nail on the head. Instead I suggested that rather than trying to put words in my mouth he should take a look at Scott Sumner’s blog: TheMoneyIllusion.

Postscript:
I particularly liked the following posts on Sumner’s blog: Why did monetary policy fail?; and The Economics Babel.