I see lots of discussion in the press about how the housing bubble made Americans poorer, and that this explains the low level of AD.  Yet the conclusion doesn’t follow from the premise.

Every bone in my body tells me the conventional view is correct.  We built too many houses and got too deeply in debt.  Now we need to spend less, and that means we need to produce less (as trade is too small a share of GDP to make up the gap.)  Intuitively this seems true, but it’s actually false.  To see why, consider the following parable:

A pioneer family in the American Midwest has run into trouble.  Locusts ate their wheat crop, and now they can’t pay back the local moneylender for the loan they used to get started in farming.  He threatens to burn down their house if they don’t repay within another 12 months.  What do they do?  I’d argue they need to tighten their belts and consume less.  They also need to work much harder.  But in a closed economy (they are self-sufficient) how can this be?  They consume what they produce.  No, they consume part of what they produce.  They need to consume less consumer goods.  Since they are self-sufficient, money plays no role (and that means, THANK GOD, no NGDP shocks.)  They need to “spend” less on clothing and pots, by spending less time making clothing and pots.  And they need to spend more time clearing another 40 acres of land, by cutting down trees.  They need to actually work harder, and plant twice as many crops as the year before.

You may not like the exports of wheat that are implicit in this example.  Then assume the problem is poverty caused by locusts eating one half of their crops.  Now they need to clear twice as much land to feed themselves, knowing the locusts will eat half of whatever they produce.  Either way, they need to invest more.  In an open economy they also made need to export more (depending on the situation in other “countries.”)

What’s true of the pioneer family is also true of the modern US economy.  We need to tighten our belts by saving and investing more.  But the Keynesians are wrong in assuming that more saving means less GDP.  We need to have the Fed stabilize NGDP growth, so that more saving means more investment (and exports.)

A more sophisticated argument accepts this analysis as a long run proposition, but rejects it’s applicability for the US in 2008.  People like Tyler Cowen and Arnold Kling might argue that a modern sophisticated economy can’t easily switch from producing one type of good to producing another.  During the re-allocation of resources, and retraining of workers, there may be a good deal of unemployment.  I accept this in principle, but believe the effect is so tiny as to not have important cyclical implications.

Perhaps the most famous example of the US finding itself producing the wrong set of goods occurred in late 1941.  We had been producing lots of cars and other consumer products in our factories (the economy had mostly recovered from the Depression by December 1941.)  And suddenly in late 1941 we realized that we needed to entirely stop producing any cars, and start producing tanks, airplanes, etc.  And even worse, we had to do so with a largely untrained workforce, as a large share of our regular workforce was drafted into the military, and replaced by housewives, unskilled rural workers, etc.

So if re-allocation led to recession and high unemployment, then 1942 should have been the mother of all recessions.  Obviously it wasn’t.  And the reason is also obvious—NGDP rose sharply.  Some might argue that we knew the new products we needed in 1942, but not in 2008.  But I can’t see why that would be.  The price system gives us the signals telling us what to produce, even without the sort of central planning we had in 1942.  Keep NGDP growing at a steady rate, and booms will burst out in non-housing sectors.  I said booms, not bubbles.  This re-allocation is efficient, just like clearing land was efficient.

Another objection is that the Fed can’t prevent a fall in wealth from decreasing NGDP.  So even if reallocation is not a problem, falling AD is.  We had a near perfect laboratory test of this hypothesis in 1987.  But first a bit of history.  In 1929 there was a big stock market crash, and consumer spending fell sharply in 1930.  This led many Keynesians to hypothesize that the stock crash actually caused the fall in AD during 1930.  We now know that hypothesis is false, thanks to Alan Greenspan.  This is because the 1987 crash was almost identical is size to 1929; if you overlay the two graphs for September/October, they line up almost perfectly.  And because Greenspan kept NGDP growing at a steady rate, there was no collapse in consumer spending, and not even the teeniest slowdown in economic growth.  Thus 1988 and 1989 were the two most prosperous years of the entire decade.  Even the first half of 1990 saw very low unemployment.  So the Keynesians were wrong about the Great Contraction.

Many people will send in comments to the effect that 1987 was different due to blah, blah, blah.  And 1942 is not a good example of reallocation due to blah, blah, blah.  Maybe you are right.  But it won’t affect my views, because no one can point to a counterexample, that would disprove my “NGDP drives the cycle” hypothesis.

Someone needs to find a counterexample to the two following “it’s funnies”:

1.  It’s funny that big drops in wealth never seem to result in recessions, unless the Fed lets NGDP growth slow sharply.

2.  It’s funny that major episodes of re-allocation never seem to result in recessions, unless the Fed lets NGDP growth slow sharply.

For me, those two claims are the bottom line.  We know what classical economics says should happen; I say it will happen if NGDP growth is stable.  A commenter named Skip linked to an interview with Bob Lucas.  Skip made the following observation:

In his interview when asked about his thoughts on Real Business Cycle theory he essentially says that he thinks RBC theory is basically right WHEN MONETARY POLICY IS GOOD.

Yep.

PS.  Here’s the link Skip provided:

http://media.bloomberg.com/bb/avfile/Economics/On_Economy/vv9VRoc8DQl8.mp3

PPS.  This exercise has made me a bit more accepting of the Keynesian argument that it’s time for lots more infrastructure.  I was initially skeptical, as I assumed that good monetary policy would raise real rates back up to normal.  Now I think they’d only go part way back to normal, at least for a while.  Of course I’d hope we follow the Swedish lead and have the private sector build and operate as much of that infrastructure as possible.  (So don’t worry Morgan, I’m not going soft.)

One learns macroeconomics by learning a bunch of “it doesn’t matters.”  And then learning when they do and don’t apply.  Here are a few:

1.   It doesn’t matter whether you have a 10% wage tax or a 10% consumption tax.

2.  It doesn’t matter if you increase M by 10% as all nominal quantities rise by 10%, except the nominal interest rate, which is unchanged.

3.  It doesn’t matter if you depreciate your currency by 10%, because your price level will rise to offset any advantages to exporters.

4.  It doesn’t matter who is legally liable, the parties will negotiate the same (efficient) outcome either way.

5.  It doesn’t matter whether you buy a one year bond paying 3.0% or a two year bond paying 3.4%.  Because both have a 3% expected return over the next twelve months.

6.  It doesn’t matter if Korea puts a 10% tax on imports and a 10% subsidy on exports; their effects cancel out.

7.  It doesn’t matter if you can earn a higher interest rate in Australian banks than Japanese banks, as the expected gain is offset by an expected depreciation in the Aussie dollar.

8.  It doesn’t matter if Europeans exempt exports from their VAT, as their exchange rate rises to offset any advantage to exporters.

9.  If doesn’t matter if the trend rate of inflation rises, as the steady state nominal interest rate rises in proportion.

10.  Tax cuts don’t spur demand, because they leave the public no richer than before—hence they are saved.

11.  It doesn’t matter whether the payroll tax is put on workers or employers.

Update:  I forgot Modigliani/Miller—It doesn’t matter whether you finance with debt or equity.

Micro has lots of quasi “it doesn’t matters,” where it doesn’t matter in the way the average person might expect:

1.  It doesn’t matter if you require companies to offer worker benefits; they’ll just pay lower wages to offset the cost.

2.  It doesn’t matter if you force banks to charge lower fees in one area; they’ll just charge higher fees in another.

3.   It doesn’t matter if you require jobs to be safer, or products to be more durable, companies will simply adjust the wage/price.

In these micro cases it does matter for allocative efficieny, but that’s another story.

The various macro neutrality conditions form a beautiful theoretical structure.  Unfortunately, some of them are not always true.  The trick is to figure out when and where they apply.

Most people approach macro from the opposite perspective.  They’ll start with the exceptions, and then gradually those exceptions will take over their entire mental universe.  Here’s an example:

Because wages and prices are sticky in the short run, a sudden increase in the money supply will often depress nominal interest rates for a period of time.  If wages and prices were completely flexible, monetary policy would have no effect on interest rates.  Indeed this has been proven via a special type of monetary policy shock called a “currency reform.”  In a currency reform the government might take 100 old pesos and convert them into one new peso.  The money stock falls by 99%.  Importantly, they also make all wages and prices completely flexible at this point in time, by executive decree.  Thus a worker employed on a 120,000 peso a month labor contract, automatically slides over to a 1200 new peso a month labor contract.  There is no effect on unemployment, and no effect on nominal interest rates.

The majority of people see monetary policy very differently from me.  For them the side effect becomes the policy itself.  Changes in nominal interest rates are no longer a temporary effect of money supply changes in the face of sticky prices, but the policy itself.  This gets them in trouble in the longer term, as the neutrality conditions do eventually hold, and cause the interest rate-focused person to become hopelessly confused.  Countries fall into deep depression and deflation “despite” the ultra easy monetary policy of near-zero interest rates.  Or countries fall to succeed in international trade, “despite” repeated devaluations of their currency.  And so on.

Don’t get me wrong, the non-neutrality conditions are very important in the real world.  Negotiations do require transactions costs, hence liability often matters.  But that doesn’t mean the Coase theorem tells us nothing.  It correctly tells us that there is no rationale for regulating workplace smoking, for instance.  And wage/price stickiness is very important, indeed in my view it explains the Great Contraction (but not the slow recovery.)  But it’s not so important that it produces a permanent trade-off between inflation and unemployment (as we saw in the 1970s.)   And non-traded goods are very important, which explains why PPP doesn’t hold between the US and China.  But they aren’t so important that they prevent rising inflation in China from increasing its real exchange rate, when the Chinese government is too slow to adjust the nominal rate.

Macro is all about balancing the “it doesn’t matters” with the “it does matters.”  Let me give you an example of where I used this framework today.  Nick Rowe has a very interesting post arguing that if we are in a liquidity trap and if the Fed is pegging rates, then higher default risk on T-bonds is expansionary, as it lowers the risk-adjusted cost of private borrowing.  Private debt with the same risk as the now risky government debt sees its yield fall to the rate on T-bonds.

I used the expectations hypothesis to try to refute Nick’s argument.  I’m still not sure I’m right, but here’s my thought process.  The expectations hypothesis of the yield curve says the expected return from holding a 10 year bond for one year, should be the same as the expected return from holding a one year T-bill.  But if the T-bill yield is near zero, then the expected one year return on T-bonds is also near zero, despite their 3% yield to maturity.  So if a 1% default risk it added on, (as Nick assumed) the expected one year yield goes negative.  Now everyone sells all the T-bonds to the Fed, and the Fed must buy because Nick assumed they hold rates steady.  You are left with nothing but cash in circulation, and there is no relative gain for private sector debt, because cash has always been a zero yield/zero default risk asset.

Now I know some of you commenters are chomping at the bit to tell me that the expectations hypothesis of the yield curve is “false” and has been “disproved.”  But that’s where it’s important to always keep in mind what matters, and what doesn’t.  Because even if you are right it doesn’t help Nick’s argument.  That’s because if T-bonds and T-bills are not close substitutes, and if T-bonds yield 3%, then you are not in a liquidity trap in the first place.

I’m not saying that my reasoning is necessarily right here.  But I thought it might be interesting for you to see how my mind works on these problems.  I start with all the beautiful neutrality conditions, and then start considering where they might not hold, for how long they might not hold, how empirically important the non-neutralities are, and what sort of implications they have for the rest of my theoretical edifice.  You need to balance a lot of different factors, and I’m sure I often make mistakes when doing so.  When you read other economists, you can see the ones that tend to have this theoretical edifice in the back of their minds, and those who don’t.  I won’t name any names.

Update:  I will name one economist that definitely does have the beautiful neutrality conditions in his mind; Paul Krugman.  Here he has a similar response to Nick’s hypothesis.

A few months back I did a post that annoyed lots of readers.  People seemed to think I was a moral relativist, whereas I was actually making aesthetic and methodological arguments, not a moral argument.  I was trying to suggest that our confidence (often bordering on self-righteousness) about our own value system is unseemly and dangerous.  I certainly wasn’t suggesting that as long as other cultures think X is OK, then I think it is acceptable for them to do X.

During my break I read an interesting 500 page Norwegian novel about angels, written by Karl Knausgaard.  This quotation reminded me of the Marias Javier quote I included in the earlier post.  Here’s Knausgaard:

As we know, the actual theory of evolution was developed by Charles Darwin and published in The Origin of the Species in 1959.  This was a huge success in scientific terms, and to this day has completely dominated our view of living things and their history.  Other theories have been pushed out into the cold.  It’s easy to imagine that the battle between them was fought out at the end of the nineteenth century, but this wasn’t so, by then the path had already been cleared for Darwin’s theory, the victory seemed assured.  To find the real struggle, one must go back to the sixteenth and seventeenth centuries.  There it is harder to decipher, as the different attitudes, which seem to us like complete opposites, and totally incompatible, could then exist side by side.  Not merely within one and the same culture, but within one and the same person.  And because these people not only thought differently about the world than we do, but also thought differently about themselves, it’s almost impossible to gain a clear picture of what they really believed.    Reason and emotion, historical events and mythological episodes, hard facts and wild speculation, were all mixed up inside them.  And all this, that was going on inside their heads, went on to permeate their bodies.  The thoughts that thought, the heart that beat, the lungs that breathed, the hair that grew, the wounds that healed, the eyes that saw, the ears that heard, all merged together, just as they do in us, without us realizing it, just as they didn’t realize it: only in retrospect does the human aspect become clear, in the form of what separates them from us.  The things they thought that we don’t think  The things they believed that we don’t believe. The things they saw that we don’t see.  And from this we can draw the following conclusion: one day, in a few hundred years’ time, the human race of the future will look on us in the same way.  What for us is an obvious truth, something we regard as so self-evident we don’t even think about it, because we can see it, it is like this, will to them be completely incomprehensible.  Perhaps they’ll laugh at us, perhaps just be fascinated by us, even say they have respect for us, but no matter what they say, they will end up feeling superior to us.  For they know.  They can see.

A good area to apply Knausgaards’s idea is sex scandals—where the feelings are typically strong and the reasoning is typically weak.

Try to sketch out a set of criteria for what determines whether a sexual indiscretion counts as a scandal, a firing offense, or a crime.  It’s not easy.  People seem slightly embarrassed to condemn others solely for sexual indiscretions.  It seems too prudish.  So the condemnations are often couched in terms of the “real issue” being lying under oath, or sexual harassment, or some other crime.  But as we saw with Weinergate, those protestations can’t be taken too seriously.  When people say “it’s not about sex,” you can be pretty certain that it is very much about sex.  Anthony Weiner was the one forced to resign, not the drunk driving Patrick Kennedy.

I’m sure people could come up with many explanatory factors, which shift around over time, indeed in this area culture often evolves quite rapidly.  There is the “great man” factor.  Roman emperors, Turkish sultans, and other powerful men could get away with murder.  Even as late as the Kennedy administration, sex scandals were covered up by the press.  The fact that JFK still has a high reputation, whereas Weiner is viewed as loathsome, suggests that getting caught is also important.  It’s partly about discretion.  It also depends on whether you are liked.  People judge a man’s record in all sorts of areas much more harshly when they don’t like the guy’s personality (as Barry Bonds and LeBron James have discovered.)  It also depends on how recently the event occurred.  The IMF president was roundly criticized after a recent rape accusation, whereas Bill Clinton got a pass after Lisa Myers interviewed a woman accusing him of committing rape more than a decade prior to the interview.

Of course I have my own views on these issues, as you can probably guess.  But I’m not interested in arguing right and wrong, what intrigues me is the reasoning process that goes into these cases.  I think it’s fair to say that we believe we are more enlightened than the puritanical Victorians.  That some sort of moral progress has occurred.  But there are even earlier periods of history where people were far more lascivious than we are.  I don’t think we typically believe that those cultures had progressed even more than we have (although Hugh Hefner might hold that belief.)

Perhaps our sense of moral progress comes from an increasing acceptance of utilitarian values.  Thus gay rights are often advocated for essentially utilitarian reasons, whereas bigamy is rejected for the same reason.  In ancient times people were much less utilitarian, and bigamy was more acceptable than gay marriage.  But if utilitarianism explains our current sexual ethics, how does one explain this map:

Are the utilitarian considerations really that different from one country to another?  Of course it’s also true that laws in various countries differ in many other respects, such as speed limits.  But that raises even more fundamental questions.  With speeding, the fine is generally proportional to the amount by which the speeder exceeded the legal limit.  That’s much less true for age of consent laws.  One day can make a big difference and, as far as I know, fines are not usually imposed for violations–prison or probation are more typical punishments.  Why is that?  Speeding puts others in danger, just like underage sex.  Are we actually relying on utilitarian reasoning?

I don’t have any answers here, indeed it’s hard to imagine any policy in this area that doesn’t have some flaws.  But I do find it interesting that the people I meet have so much confidence in their opinions about where various lines should be drawn, especially given that either American or Spanish age of consent rules (or more likely both) will probably look completely absurd to the average person born 100 years from today.

PS.  I don’t often use the term ‘lascivious.’  I’m reminded of the Lascivious Costume Balls held at the University of Chicago when I attended during the late 1970s.  I’m told that they no longer occur, as our society is moving back in the direction of the Victorians.  That’s something I never would expected in 1978–at the time I assumed that things would keep getting less puritanical as time went by.  I forgot that even hippies grow old.

PPS.  I predict society will get more utilitarian, and hence the outrages that future generations see in us will revolve around our less utilitarian characteristics; our restrictions on pain medication, our treatment of animals, our obliviousness to the risks of biological research, our views on organ markets, our attitudes toward war, and just about everything having to do with sex.   But just because their views are different, doesn’t mean they will be right.  They won’t be able to see things from our point of view, just as we can’t see things from the point of view of those who saw angels.

A year ago I did a post called “Two untimely deaths.”  Here’s an excerpt:

Milton Friedman died on November 16, 2006, one year before the sub-prime crisis.  I’d like to suggest that his death was the closest equivalent to the death of Strong in 1928.  In 1998 Friedman pointed out that the ultra low interest rates were a sign that Japanese monetary policy was very contractionary, at a time when most people characterized the policy as highly expansionary.

There is little doubt that Friedman would have recognized the low interest rates of late 2008 were a sign of economic weakness, not easy money.  But what about the big increase in the monetary base?  First of all, the base also rose by a lot in Japan, and in the US during the Great Contraction.  Second, Friedman would have clearly understood the importance of the interest on reserves policy, which was very similar in impact to the Fed’s decision to double reserve requirements in 1936-37.  And in his later years he became more open to non-traditional policy approaches, for instance he endorsed Hetzel’s 1989 proposal to target inflation expectations via the TIPS spreads.  Note that the TIPS markets showed inflation expectations actually turning negative in late 2008.

Why was Friedman so important?  I see him as having played the same role among right-wing economists that Ronald Reagan did among conservatives.  Reagan was really the only conservative that all sides respected; social conservatives, economic conservatives, and foreign policy (or neo-) conservatives.  After he left the scene, the conservative movement cracked-up.

Friedman was respected by libertarians, monetarists, new classicals, etc.  Last year I criticized Anna Schwartzfor adopting the sort of neo-Austrian view that she and Friedman had strongly criticized in their Monetary History.  If Friedman was still alive, and strongly insisting that money was actually far too tight, then I doubt very much that Schwartz would have gone off in another direction.  It would be like Brad DeLongdisagreeing with Paul Krugman on macroeconomic policy.  Once in a blue moon.

Today there is no real leadership among right wing economists.

[BTW, I kind of regret the shot at DeLong—I’m increasingly impressed by his brilliance, despite the fact that we often disagree.]

Now this issue is resurfacing.  Here’s Will Wilkinson:

TIM LEE asks an important question: why are conservatives and libertarians so uniformly hawkish about inflation? Mr Lee (a friend and former colleague) notes that this regularity is far from inevitable. Milton Friedman, a revered figure in right-of-centre circles, famously pinned the severity of the Great Depression on contractionary monetary policy. Scott Sumner, a professor of economics at Bentley University who identifies himself as a “neo-monetarist”, has argued that Friedman would have supported monetary stimulus. And he has argued, on neo-Friedmanite grounds, that tight monetary policy both precipitated and exacerbated our recent recession. I happen to think Mr Sumner is correct, but his expansionary prescription remains anathema on the right. Why?

.   .   .

Milton Friedman was one of the 20th century’s great economists as well as one its most formidable debaters. This made him a powerful check on the influence of anarcho-capitalist Austrians, obviously much to the chagrin of Rothbard. “As in many other spheres,” Rothbard wrote, “[Friedman] has functioned not as an opponent of statism and advocate of the free market, but as a technician advising the State on how to be more efficient in going about its evil work.” Rothbard’s fulminations notwithstanding, Mr Friedman died a beloved figure of the free-market right. Yet it does seem that his influence on the subject of his greatest technical competence, monetary theory, immediately and significantly waned after his death. This suggests to me that Friedman’s monetary views were more tolerated than embraced by the free-market rank and file, and that his departure from the scene gave the longstanding suspicion that central banking is an essentially illegitimate criminal enterprise freer rein.

I’d add a couple points here.  During his period of greatest influence he was known as somewhat of an inflation hawk, as high inflation was the big problem and the old Keynesian model didn’t have good answers.  The right was happy with that monetarist critique of Keynesianism.  And second, the most important section of Friedman and Schwartz’s Monetary History of the United States was the chapter on the Depression, where they were highly critical of the Fed’s deflationary policies.  Even inflation hawks don’t think rapid deflation is a good idea.  But the subtext of their monetary history was even more important.  The Great Depression had discredited capitalism in the eyes of most intellectuals.  By showing that the problem was tight money, not laissez-faire policy, Friedman and Schwartz opened the door to the neoliberalrevolution.  The New Keynesian technocrats who ran the world economy from 1983 to 2007 are much more comfortable with laissez-faire than their old Keynesian predecessors.

And here’s Tim Lee:

This has gotten me thinking about the broader connection between peoples’ views on monetary policy and their broader ideological worldviews. With the lonely exception of Scott Sumner, virtually every libertarian or conservative who has expressed a strong opinion about monetary policy has come down on the side of the inflation hawks. Over the last three years, a wide variety of fiscally conservative Republican politicians have attacked the Federal Reserve for its unduly expansionary monetary policy. I can’t think of a single Republican on the other side.

Yet it’s not obvious why this should be. There’s a coherent ideological argument for abandoning central banking altogether in favor of a gold standard or free banking. In a nutshell, the argument is that no single institution will have the knowledge necessary to “steer” monetary policy, and so we should prefer a monetary system that decentralizes control over the supply of money.

But whether you like it or not, we do have a central bank and it’s important that it function effectively. Logically, it seems like libertarians should be equally worried about both the threat of too much inflation and the threat of too little. After all, one of Milton Friedman’s most famous books argued that the Depression was worsened by the Federal Reserve’s unduly contractionary monetary policy. Yet (again, aside from Sumner) no free-market thinkers or politicians made this argument even in the depths of the 2009 contraction.

So why is right-of-center opinion so lopsided? I can think of two possible explanations. One is that we’re still having the monetary policy debates of the 1970s, when right-of-center thinkers, following Milton Friedman, argued that the era’s persistently high inflation was the fault of unduly expansionary monetary policy. They were right about this, and a whole generation of free-market intellectuals has been on guard against the threat of inflation ever since. And this is obviously reinforced by the reciprocal trend on the left: because most of the inflation doves are on the left, people who are in the habit of disagreeing with left-wingers are discouraged from adopting their arguments on this issue.

Those are good points, but I’ll add a few more:

1. I t makes me uncomfortable to level this charge (as there is nothing I hate more than others questioning my motives) but it’s a bit awkward when you have conservative bastions like the Wall Street Journal bashing the Fed’s tight money policies in 1984, when inflation was 4% (and Reagan was in office) and making the opposite change when inflation is even lower, and Obama is in office.  I actually have a fairly positive view of the motives of most intellectuals on both the left and the right.  I assume they are well-intentioned.  But if a person strongly opposes a set of policies and hopes a new government will soon reverse them, it may at least subconsciously affect that person’s enthusiasm for monetary stimulus that would make the economy look much better, almost assuring the incumbents re-election.

2.  However I don’t believe even subconscious bias is the main issue.  The current policy stance looks much more expansionary than it really is (due to low rates and the hugely bloated monetary base.)  So there are certainly worrisome indicators that even the best macroeconomists could point to, especially given the (overrated) worry about “long and variable lags.”  It’s not all populism.  I was at a conference last year full of conservatives who knew just as much monetary economics as I do and they were almost all were opposed to QE2.  And conservatives weren’t criticizing the Fed in September 2008, when easier money might have helped McCain.

3.  I have very mixed feelings about seeing my name mentioned in both pieces.  Naturally I’m happy that people are paying attention to my ideas.  But I also worry about a world where I’m the name people mention when looking for someone who will carry on the tradition of Milton Friedman.  And this isn’t just false modesty.  No matter how highly I regard my own views, or those of similar bloggers like David Beckworth (who also could have been cited), the hard reality is that we don’t have the sort of credentials that carry a lot of weight among the elites.  (BTW, this doesn’t apply to Nick Rowe, who is probably has a much higher profile in Canada than we quasi-monetarists have in America.)

Cryptic prediction:  Before 12 moons have passed, a star will arise in the East to lead Milton’s scattered tribe into the promised land of respectability.

PS.  Thus far we’ve been called “quasi-monetarists.”  I would have preferred “new monetarists,” but Stephen Williamson’s already grabbed that name.  Will calls us neo-monetarists.  I’m growing increasing fond of ‘post-monetarist’—particularly for the futures targeting idea.  Weren’t post-modernists like Foucault skeptical of central authority?  And is it just me, or does “quasi” have a slightly negative connotation?

Here’s Rajan:

Recoveries are rarely without blips, especially when they are as weak as this one. But, regardless of whether the factors behind the latest slowdown are fleeting or enduring, there will be calls on the US Federal Reserve to do something.

What does that mean?  Does he want them to do nothing?  What would it mean to do nothing?  Keep interest rates unchanged?  Keep the money supply unchanged?  Keep expected inflation unchanged?  Keep the price level unchanged?  Set the money supply at zero?  He doesn’t say.  Bernanke did QE2 because core inflation had fallen to 0.6%.  If Rajan disagrees with the Fed’s 2% implicit inflation target, then say so.  And he should tell us what he favors instead.  “Do nothing” is not a policy.

There is, however, scant evidence that the real problem holding back investment is excessively high wages (many corporations reduced overtime and benefit contributions, and even cut wages during the recession).

Wage reductions are exactly what you’d expect to see if sticky wages are a problem.  Thus if the Walrasian equilibrium wage falls 4% and actual wages fall 2%, the sticky wage theory predicts high unemployment.  Indeed the biggest weakness of the sticky wage theory is that wages aren’t falling even more—wage growth has slowed from about 4% to 2%, but then leveled off.  Sticky wage proponents like me have a hard time explaining that fact.  Rajan has things exactly backward.  BTW, the sticky wage theory applies to all output, not just corporate investment.

A third channel through which easy money might work is by pushing up the value of assets like stocks, bonds, and houses, making people feel wealthier – and thus more likely to spend. For this channel to be sustainable, though, the wealth gains must be permanent. Otherwise, what goes up will come down, leaving households even more frightened of financial markets.

I thought Chicago economists accepted the EMH.

Clearly, someone is paying a price for ultra-low interest rates: the patient and uncomplaining saver. Interestingly, if traditional spenders such as firms and young households are unwilling or unable to take advantage of low interest rates, low rates could even hurt overall spending, because savers like retirees receive lower financial incomes and curtail spending.

Rajan assumes the Fed can reduce interest rates by increasing the money supply.  This occurs because prices are sticky–once prices adjust rates go back to their original equilibrium.  But if he accepts short run price stickiness, how can he argue that monetary stimulus will reduce real spending?  Is the SRAS upward sloping, or not?

Some Japanese now wonder whether their ultra-low interest-rate policy could be contractionary.

Equally worrisome are the distortions that easy money creates.

From a University of Chicago economist!  Milton Friedman must be rolling over in his grave.  Friedman pointed out that low rates in Japan were a sign that money had been very tight.  Funny how extremely “easy money” always seems to produce deflation (US 1932, Japan 1997, US 2009) and ultra-tight money (very high rates) often gives us hyperinflation. 

There are many things that the US needs to do to create sustainable growth, including improving the quality of its work force and infrastructure. Easier money is not one of them.

The interest rate is not the price of money, it’s the price of credit.  Money is not easy.

PS.  This Nick Rowe post covers some similar ground, but is actually much more interesting.  I highly recommend it.  Interestingly, I wrote my post before his, but didn’t post it until now.  Our two posts contain an almost identical passage.  Here’s Nick:

Talking about monetary and fiscal authorities “doing nothing” is just as problematic. Does it mean holding a rate of interest fixed? Holding the money supply fixed? Holding the exchange rate fixed? Holding the price of gold fixed? Holding the inflation target fixed? Holding the NGDP target fixed? Or what?

Great minds think alike.  🙂