I saw this in the Journal of Economic Perspectives, under recommended reading:

Claudio Borio asks “The Financial Cycle and Macroeconomics: What Have We Learnt?” “The financial crisis that engulfed mature economies in the late 2000s has Learnt?” “The financial crisis that engulfed mature economies in the late 2000s has prompted much soul searching. Economists are now trying hard to incorporate financial factors into standard macroeconomic models. However, the prevailing, in fact almost exclusive, strategy is a conservative one. It is to graft additional so-called financial “frictions” on otherwise  fully well behaved equilibrium macroeconomic models . . . The main thesis is that macroeconomics without the financial cycle is like Hamlet without the Prince. In the environment that has prevailed for at least three decades now, just as in the one that prevailed in the pre-WW2 years, it is simply not possible to understand business fluctuations and their policy challenges without understanding the financial cycle.” Bank of International Setttlements, Working Paper #395, December 2012. At http://www.bis.org/publ/work395.pdf.

First a bit of history.  In the 1920s the standard view among elite macroeconomists was that the business cycle was a “dance of the dollar,” to use Irving Fisher’s metaphor.  Then came the 1930s, and monetary policy got pushed to the sidelines.  This oversight eventually led to a series of mistakes which culminated in the Great Inflation.  Only then was money rediscovered, and AD brought back under control.

I’m begging the economics profession to avoid another long and fruitless detour into non-monetary theories of the business cycle, although even as I type these words I know I will fail.  The average reader will be far more impressed by Brad DeLong’s long and thoughtful post, than this puny post.

There is nothing in the slightest way mysterious about the current recession.  If in 2007 you told the world’s elite macroeconomists what the path of NGDP would look like over the next 6 years, most of them would have predicted a deep recession and slow recovery in the US, and a deep recession, slow recovery, and then double-dip recession in the eurozone.  And that’s exactly what happened.  Adding finance won’t improve that story one iota.

Let me anticipate some objections:

1.  But why did NGDP fall so sharply?  Because a failure of monetary policy.  No one denies that the banking crisis played a role in that failure, but it wasn’t a necessary role.  There is no evidence that central banks lose control of NGDP during a financial crisis.  Look at 1933.  You can make a slightly stronger argument that they lose control at the zero bound (a completely different argument, BTW) but even that is wrong.  There is no case in recorded history of a fiat money central bank trying to inflate and failing.  When Brad DeLong asked Bernanke why not 3% inflation, Bernanke didn’t say; “can’t do it.”  He said it’s a bad idea.  The Fed also thinks NGDPLT is a bad idea.  The idea that the ECB is out of ammo doesn’t even pass the laugh test, as they’ve repeated raised interest rates during the recession, driving eurozone unemployment ever higher.  Elite macroeconomists continue to publish papers that are meaningless if the BoJ is able to sharply depreciate their currency, and yet they’ve just showed that they are capable of sharply depreciating their currency.  That’s not supposed to happen, if you believe that central banks are incapable of debasing their fiat currencies.

2.  ”There are lots of structural problems.”  Of course, there always are structural problems, but then why isn’t unemployment in the US much higher than 7.6%?  We have roughly the unemployment rate you’d expect from the demand shock alone.  So unless demand shocks miraculously don’t cause unemployment when you have structural problems, the unemployment rate should be far higher if structural problem were capable of explaining an extra 2.6% unemployment.  (And this skepticism about the importance of structural problems comes from a conservative economist who has argued the extended UI benefits added about 0.5% to 1.0% to the unemployment rate at the peak, not a 100% demand-sider with his head in the sand about supply-side issues.)

Is there really any harm in adding finance, to make the models a bit more realistic?  Damn right there is.  It will cause us to make the exact same mistake we made in late 2008, trying to fix the banking system while ignoring the huge slide in NGDP expectations, until it is too late.  If you don’t correctly diagnose the crisis, how are you going to get effective solutions?

Economists are too blinded by framing effects—it looked like finance was the root cause of the recession.  But debt doesn’t make workers want to work less, it makes them want to consume less.  There is a difference.  We need economists to look through these framing effects, and see that the standard model that demand shocks cause high unemployment worked fine; it’s our policymakers who failed us.

I never thought I’d say this, but macroeconomists just aren’t autistic enough.

And where has the University of Chicago been?  Who is carrying on the tradition of Milton Friedman?  He taught us to look beyond the financial crises of the 1930s, into the root cause of the Great Depression.  It’s all about M*V.  Do we have to learn that lesson all over again?

In some ways this recent crisis was even more inexcusable, as those poor fools in the 1930s didn’t have a Monetary History of the US telling them what went wrong 8o years earlier.  We did, and still had an excessively tight monetary policy.

Hamlet without the prince?  Sounds kind of interesting, in a post-modern sort of way.  Maybe Gus van Zant could direct.

HT:  Timothy Taylor

PS.  I’ve been asked about the recent Japan debate.  I agree with Nick Rowe:

In other words, I have deliberately set up a case in which Richard Koo would be right (maybe for the wrong reasons, but let that pass). I have deliberately made worst-case assumptions so that the higher interest rates caused by loosening monetary policy creating economic recovery would cause Japan to default on its debt, either literally or via very high inflation.

Does this mean that “Japan cannot afford recovery”?

No. It means that Japan is already dead. It just doesn’t know it yet.

Sure, the Bank of Japan could abandon Abenomics, tighten monetary policy, reduce the inflation target, squash all hopes of recovery, and bring nominal interest rates back down again. But if the past is any guide to the future, this means the debt/NGDP ratio will keep on growing. Because Japan will be scared to tighten fiscal policy in a recession when the Bank of Japan won’t offset that tightening by loosening monetary policy. Which means that recovery, when it does finally come, will cause an even bigger default, because the debt/NGDP ratio will be even bigger.

And recovery will come eventually, one way or another. If not by happenstance, then because there is a limit to the debt/NGDP ratio that the young generation in an OLG economy will be willing to buy from the old.

If Japan is already past the point of no return, then recovery will mean default. But delaying recovery will simply mean an even bigger default.

Now I’m going to cry over spilt milk, and ask: why oh why didn’t they do Abenomics earlier, before the debt/NGDP ratio had grown so big? What was all this talk about “balance sheet recessions”, where monetary policy was impotent to increase Aggregate Demand, so fiscal policy had to be used to prevent AD from falling? And how did we suddenly switch from “monetary policy is impotent” to “monetary policy is very dangerous because it will increase AD which will only cause inflation and higher interest rates which will cause default because loose fiscal policy has made the debt/GDP ratio so big”?

In my view Japan isn’t dead, although I certainly admit it might be.  The real question is why people continue to insist that monetary policy is ineffective at the zero bound, even as Japan shows it is effective.  Nick and I told Japan what to do back in 2009 (and Bernanke even earlier)—why did it take them so long?  And why hasn’t the ECB moved yet?

One of my favorite commenters has done an excellent post discussing Richard Koo’s views on the Great Depression.  Here’s a small portion of the post (by Mark Sadowski, but published on Marcus Nunes’s blog):

The key point is there was no shortage of debt to be placed on the asset side of Federal Reserve member bank balance sheets. Member banks’ share of credit market debt declined from 18.3% in 1929 to 14.8% in 1933 before increasing to 17.4% in 1937, so it would seem, in line with our previous reasoning,  the decline in member bank balance sheets was more due to the shortage of deposits than the shortage of credit market debt.

Extending Koo’s diagram to the final year of the expansion reveals that member banks increased their holding of private debt from 1933 to 1937 almost as much as their holdings of public debt. Furthermore, the rate of increase in general government debt during the contraction from 1929 to 1933 (34.8%) was almost as great as its rate of increase during the expansion from 1933 to 1937 (36.2%). And finally, the rate of increase in nominal GDP was so great during 1933-37 that credit market debt as a percent of GDP declined in every single sector (i.e. household, business and financial), including the government sector, which fell from 72.0% to 60.2% of GDP.

We don’t have detailed sector balance sheets for these years, but according to “Studies in the National Balance Sheet” by Raymond W. Goldsmith and Robert E. Lipsey, private sector assets fell from $923.4 billion to $665.0 billion between 1929 and 1933, or by $258.4 billion. Private sector financial assets fell from $540.9 billion to $389.9 billion or by $151.0 billion, accounting for 58.4% of the decrease in private sector asset value. Private sector holdings of stocks fell from $186.7 billion to $101.5 billion, or by $85.2 billion, accounting for 56.4% of the decline in private financial asset value, and nearly a third of the total decline in private sector assets.

We hear a lot in the media today about the effect of QE on the stock market. Well, in an act that was essentially the QE of its day, FDR took the country off the gold standard in April 1933 and allowed the price of gold to rise from $20.67 an ounce to $35.00 an ounce by January 1934. This price was high enough to attract a large gold inflow from abroad which the Treasury monetized by issuing gold certificates to the Federal Reserve. The monetary base, which had been rising at roughly a 6% annual rate since around mid-1930, skyrocketed upward, reaching a maximum year-on-year rate of increase of 23.0% in February 1935. In turn, the stock market, which reflected an economy starved for aggregate demand (AD), soared as well. The Dow Jones Industrial Average (DJIA) more than tripled from March 1933 to November 1936, before the decision to start sterilizing gold inflows in December 1936 meant prematurely removing the punch bowl, leading to the 1937 Recession:

A few comments:

1.  The 1933 devaluation was actually more powerful than QE, because of its big impact on expectations.  However the recovery was aborted in July 1933 when FDR raised wages by 20%.  After growing 57% between March and July 1933, industrial production showed no increase over the following two years.

2.  In my view there is no such thing as “balance sheet recessions.”  Changes in balance sheets reflect sunk costs and benefits, and hence don’t impact the incentive to produce new output.  Recessions are caused by a fall in NGDP relative to sticky wages–which means bad monetary policy.

Marcus Nunes discusses Clive Crook’s analysis of Paul Krugman, and then adds the following:

All this comes out clearly in Krugman´s May 6 column for the NYT, but I want to be specific in my comment, so I´ll concentrate on one of his favorite arguments, and show it´s misleadingly wrong. Krugman writes:

F.D.R. cut back sharply in 1937, plunging America into recession; the Recovery Act had its peak effect in 2010, and has since faded away, a fade that has been a major reason for a slow recovery.

Wow! In 1937 real government purchases recoiled 4.2% and the economy tanked. In 2012 real government purchases were 4.8% below the 2010 level and the recovery is slow!

Surely something is going on that´s making comparable ‘fiscal austerity’ so much less damning in 2012 than in 1937.

And that ‘something’ is monetary policy.

Bruce Bartlett has a characteristically thoughtful piece on Keynes:

Brad DeLong, an economist at the University of California, Berkeley, has posted a long list of conservative attacks on Keynes that have used his homosexuality as a reason to reject his economic theories. But even economists who had no interest in this aspect of Keynes’s life, like the economist James Buchanan, have criticized Keynesian economics for its excessively short-term focus and negative long-run consequences.

Unfortunately, Keynes himself was to a large extent responsible for giving this criticism of his work currency. That is because he titled his most important work “The General Theory of Employment, Interest and Money.” The term “general theory” obviously implies that it is applicable at all times, in all economic situations.

This was an unfortunate error, because the core insight of Keynesian economics is that there are very special economic circumstances in which the general rules of economics don’t apply and are, in fact, counterproductive.

This happens when interest rates and inflation are so low that there is no essential difference between money and bonds; money, after all, is simply a bond that pays no interest. When this happens, monetary policy becomes impotent; an increase in the money supply has no stimulative effect because it does not lead to additional spending by consumers or businesses.

This is interesting.  Both John Hicks and Milton Friedman also thought the liquidity trap was the core insight of the General Theory.  In Friedman’s case, perhaps I should say the core “idea,” as he didn’t think much of the concept.  But Keynes himself actually thought his theory was much more general, and so do many of his followers (who like to quote Keynes’s statement that it is unlikely that there has ever been a case of absolute liquidity preference.)

I think Hicks and Friedman were right and Keynes was wrong.  Keynes certainly saw the impact of FDR’s dollar depreciation policy of 1933.  When FDR finally gave in to pressure from people like Keynes, and stopped devaluing the dollar, Keynes congratulated him for ignoring the advice of the “extreme inflationists.”  Keynes once said that the only monetary regime that was worse than a pure gold standard was a pure fiat money regime.  That’s the real reason Keynes worried about monetary policy ineffectiveness at the zero bound; he opposed what Lars Svensson calls the one foolproof escape technique—devaluing as much as it takes to generate higher inflation rates.

Bartlett continues:

Keynes called this situation a “liquidity trap.” Under such circumstances, government spending can be highly stimulative because it causes money that is sitting idle in bank reserves or savings accounts to circulate and become mobilized through consumption or investment. Thus monetary policy becomes effective once again.

This is an extremely important insight that policy makers have yet to grasp, even though interest rates on Treasury bills are just a couple of basis points above zero and inflation is virtually nonexistent.

Here I think that Bartlett has things exactly backward.  I believe most policymakers do agree with Keynes and Bartlett, i.e. they wrongly believe that monetary policy is ineffective at the zero bound.  That’s why it took the Japanese 20 years to even attempt a policy of inflation.  That’s why New York Fed President Dudley now says that Fed policy was too tight in 2009, but wasn’t saying that in 2009.  That’s why the non-German European governments haven’t been pressuring the ECB to boost NGDP.  That’s why Ed Balls opposes a higher inflation target for the BoE.

In the 1930s FDR knew how to debase a currency.  Modern policymakers seem to have forgotten how, and thus embarked on a long and fruitless detour into the morass of fiscal stimulus.

HT:  Caroline Baum

PS.  I may be on Bloomberg radio (Boston) tomorrow morning around 9am.

Here’s Karl Smith:

Volker’s clout on the FOMC grew the entire time and when he became Fed Chairman in 1979, he dropped the hammer.

.  .  .

The Fed drove the funds rate up from 5% in 1976 to 19% in 1981. I know, I know, Scott Sumner is scowling. Here is the growth rate of NGDP over the same period.

.  .  .

Trending upwards, towards 15%, through the 60s and 70s. Pausing in 1976 and then in two big slams going all the way to a low of 3% in 1982.

I don’t think many people doubt that the policies of the Volcker Fed drove interest rates up and inflation rates down during the early 1980s, but since the general topic of government debt is so contentious its worth reviewing.

I certainly “doubt that.”  The increase in the fed funds rate from 5% in 1976 to 19% in 1981 was caused by easy money policies of Burns, Miller and Volcker, as I explain in this post.  NGDP growth peaked at 19.2% in 1980:4 and 1981:1.

Then in the spring of 1981 Volcker got serious about inflation.  The Fed adopted a tight money policy, and NGDP growth, inflation, and nominal interest rates all began declining, a process that would continue for decades.