The Atlantic breaks the “unassailable rule” of journalism (and gives market monetarism a big boost.)
This is from an excellent article by Matt O’Brien at The Atlantic:
There’s one unassailable rule when it comes to writing about the housing bubble: you must criticize Alan Greenspan for keeping interest rates “too low for too long.” Once you get past this ritual invocation, you can talk about whatever else you’d like, whether it’s securitization, too lax regulation, or even Fannie Mae. But first: toolowfortoolong!
But what if the unassailable rule is wrong?
The conventional wisdom goes something like this. In 2003, Greenspan cut the benchmark interest rate to 1 percent, and was too slow to begin hiking. Lulled by historically low mortgage rates, home-buyers took on way more house than they could afford. Prices, of course, went into the stratosphere. By the time Greenspan belatedly raised rates to 5.25 percent in 2006, the damage was already done.
So it seems clear that we can blame the artist-formerly-known-as-the-Maestro, right? Well, wait a second. While it’s undeniable that rock-bottom mortgage rates — at least rock-bottom for the pre-2009 world — helped fuel the subprime frenzy, it’s not true that these low rates meant monetary policy was excessively loose. That’s a common fallacy when it comes to the Fed: low rates do not necessarily mean policy is easy, nor do high rates necessarily mean that it is hard.
Nobody thinks the Fed ran a tight policy in the 1970s. And with good reason. Inflation spiraled out of control throughout the decade, despite interest rates that would qualify as exorbitant today. Compare that to our situation now. Rates are currently barely hovering above zero, yet inflation remains subdued. (No, really). As Ben Bernanke would tell you, looking at interest rates alone can be a misleading guide to the Fed’s stance.
Bernanke said this back in 2003. The future Fed governor explained that inflation and nominal GDP — which just refers to the total size of the economy — are the best indicators for monetary policy. And looking at them totally vindicates Greenspan’s low-interest rates in the 2000s. Here’s a look at core inflation from that period.
The argument that I bolded seems vaguely familiar—where have we seen that before?
Part 2: “Stance of monetary policy” bleg.
I’ve begun a paper on the subject of how economists think about the “stance” of monetary policy. By ‘stance,’ I mean whether they describe it as expansionary or contractionary, easy or tight. I’m sorry I have to define the term, but 5 years ago a journal referee told me he had no idea what the term meant, so please don’t be insulted it if was obvious to you.
So we all know that the stance of policy refers to its expansionary or contractionary nature, but my question is how do we define those terms? It’s well known that interest rates were discredited long ago, people like to mock how Joan Robinson said (in 1938) that easy money couldn’t have caused the German hyperinflation, after all, interest rates weren’t low. We know that Friedman and Schwartz showed that the monetary base wasn’t a good indicator during the 1930s. And we all know that the economics profession as a whole almost entirely abandoned the broader aggregates on the early 1980s. Even real interest rates have been shown to be an unreliable indicator in IS-LM models featuring rational expectations. So my question is this: Where is the profession today? I don’t even know where to start my literature search. Are there articles that discuss how the term “stance of monetary policy” should be measured? Is there general agreement among mainstream economists on some sort of reasonable metric? I’d greatly appreciate any help that people could offer, especially from younger grad students who see how it’s being taught today in PhD departments.
My current rough outline relies on many things discussed here: Bernanke’s 2003 speech where he said NGDP is the right measure. Svensson’s “target the forecast” approach and what that implies. Friedman’s dismay at the profession believing Japanese policy was easy during the late 1990s. Mishkin’s textbook, which says low rates are not easy money. (BTW, I have a post on Mishkin coming soon that will make the Inside Job interview seem like a love-fest by comparison. Stay tuned.)
My tentative hypothesis is that the profession made a cognitive error somewhere along the way. Many economists seem to have confused the terms “short run effect” with “what’s happening right now.” In fact, what’s happening right now is just as likely, indeed more likely, to represent the long run effect of earlier policies. That’s because long run effects last much longer than short run effects, and hence are much more ubiquitous.
For instance, we teach our students that the short run effect of tight money is higher interest rates (liquidity effect) whereas the longer run effects are lower interest rates (income, price level, and expected inflation effects.) Since the liquidity effects are quite brief, any current changes in interest rates are far more likely to reflect the longer run effects.
But searching my brain, I cannot recall ever hearing an economist say the following:
Interest rates are falling today as a result of a tight money policy adopted by the Federal Reserve three years ago.
Rather they always seem to assume the “right now” of interest rates is somehow equal to the “short run effect of policy.” That, despite the fact that in economics the term ‘short run’ has nothing to do with “right now,” and ‘long run’ has nothing to do with “in the future.” They refer to time lags between policy changes and the response of the macroeconomy.
If any of you know of an occasion where a well known economist, pundit, commenter, etc, actually described the stance of monetary policy using the correct definitions of short and long run, I’d greatly appreciate it. My hunch is that it would look “odd,” which would tend to confirm the near universal misuse of these concepts.
I’d also be interested in hearing about any journal articles that discuss what economists mean by the “stance” of monetary policy.
PS. Matt O’Brien’s article also discusses the Fed’s real mistake—bad regulation of banking.
PPS. Several people sent me a recent Arnold Kling post—I left a comment over there.
PPPS. I hope people realize that the real point of this post isn’t whether Fed policy was easy in 2003 (even David Beckworth might slightly disagree with me on that point), but rather the amazing sight of the press discussing the stance of monetary policy correctly.