Nick Rowe often talks about “The People of the Concrete Steppes;” commenters who don’t like explanations based on central banks steering expectations, and demand to know what “concrete steps” the central bank should take. Of course Nick’s right that in the short run central banks steer the nominal economy by setting expectations. But expectations have to be about something. In my view (and I think Nick’s as well) money matters; an increase in the money supply will raise nominal aggregates in the long run via something like the “hot potato effect.” Indeed this effect is the only transmission mechanism capable of explaining why the price level is not currently 1000 times higher, or 1000 times lower than it is. Pure interest rate models can’t do that.
But my bigger problem with the people of the concrete steppes is that they don’t seem to practice what they preach. They want to know what concrete steps were taken by policymakers, but don’t seem to have bothered to look at the data.
Most of these people want a concrete step in terms of one of two variables, interest rates or the money supply. Did the Fed raise rates or cut the money supply growth rate, or not? And if not, how can the Fed be said to have caused the 2008 recession?
In this post I’m going to combine two older posts, hoping that the combination with be more persuasive. I’m going to try to show the Fed did both, they tightened policy in very concrete ways, no matter how it is defined.
Let’s start with the money supply. One of the most famous concrete steps arguments was put forth by Paul Krugman, who criticized Milton Friedman’s claim that the Fed reduced the money supply during the Great Depression. Krugman pointed out that only the broader aggregates fell, and that the base actually rose sharply. So the Fed didn’t directly reduce the money supply, but rather pumped in lots of money, but this extra money failed to boost the broader aggregates (due to banks hoarding excess reserves and people hoarding currency.) So let’s assume that changes in the base are the most concrete of all possible concrete steps. Can that tell us why a mild recession began in December 2007?
Notice that between early 2003 and the summer of 2007, the base rose from 720 to 860 (billions of dollars.) Then just when the sub-prime crisis began to hit the US banking system, the Fed tightened policy, and base growth came to a standstill for nearly a year. Fortunately, base velocity continued to grow a bit, so the initial recession was fairly mild. The growth rate of NGDP slowed sharply, but did not completely halt. But if you insist on looking at things from a “concrete steps” perspective, then the Fed took a big enough concrete step to create a recession in late 2007 and early 2008, and the only real mystery is why the recession wasn’t even worse.
Of course we all know that the base did increase a lot in the more severe phase of the recession, but that’s obviously because the demand for base money grows sharply when rates are near zero. Indeed that would have occurred even without the infamous “interest on reserves program.”
The near zero interest rates brings me to the second objection by the concrete steppes people. It didn’t seem like tight money, because the Fed wasn’t raising interest rates. Oh really? Are you sure about that? I often point out to people that high interest rates can’t be tight money, because interest rates are never higher than during hyperinflation. And I always get the following reply:
“Well, of course, but I mean real interest rates. The Fed tightens monetary policy by raising real interest rates.”
Fine, so let’s call higher real rates a tight money policy in the eyes of the people of the concrete steppes. Did monetary policy become far tighter in the second half of 2008?
I defy anyone to show me another period of US history when the risk-free, ex ante, real interest soared 3.5% in the space of less than six months.
You want concrete steps? The Fed provided enough concrete in 2008 to entomb 1000 Jimmy Hoffas.
Commenter Steve provided some very interesting links, which shed further light on the mistakes of 2008. In earlier posts I pointed out that after the infamous (post-Lehman) September 16 2008 Fed meeting, the Fed refused to cut rates, citing an equal risk of inflation and recession. This despite the fact that TIPS spreads showed only 1.23% inflation over the next 5 years (roughly correctly, as we now know.) I had assumed that the Fed’s mistake was being backward-looking, but Steve’s link showed they also might have been getting their inflation forecasts from USA Today, as the big story that day was Hurricane Ike:
As much of the Gulf remained in darkness, gasoline prices jumped nationwide. Ninety-eight percent of the Gulf’s natural gas and crude production was halted.
And the WSJ had the same view:
“September 15, 2008, 10:34 AM
Ike Watch: Hurricane Didn’t Slam Refining, But Gas Prices Will Rise”
“So even if Ike’s wrath was less than many feared, the storm will still leave some scars on the U.S. economy at a vulnerable time.”
Then Steve made this interesting observation:
I’m not trying to spam this blog but I have fire in my belly this Friday eve.
My rationale for posting Hurricane Ike stories is that few people appreciate the magnitude of the short-term supply side shock that struck at the same time Lehman failed. Shutting down Refinery Row was huge, and it definitely affected the Fed.
Then there’s the ECB in April 2011. Krugman demonstrated in an event study that the GIPSI sovereign spreads began to blow out on exactly the same day the ECB raised rates in April 2011. What happened between April 2011 and the prior ECB meeting? Well, a civil war in Libya and a tsunami in Japan. Basically Ghadafi did to Europe what Napoleon wasn’t capable of.
The point is that SUPPLY SHOCKS ARE ABSOLUTELY ***FATAL*** TO AN INFLATION TARGETING REGIME!!! It’s painfully obvious, Hurricane Ike swamped the entire US economy and Libya conquered the entire European continent all thanks to inflation targeting.
I notice that the commenters who apologize are never the commenters who should apologize.
It seems the world’s major central banks have been very naughty. They are supposed to focus on core inflation, and ignore commodity price spikes. But they peeked. They’ve behaved like they are afraid of being blamed for high headline inflation. Time to change the target? What sort of target might work better during periods of supply disruption?
PS. I’m not claiming that either slow base growth or high real interest rates are good indicators of tight money. They aren’t. I agree with Ben Bernanke that the “only” good indicators of the stance of monetary policy are nominal aggregates like inflation, or even better NGDP. Of course both of those fell in 2008-09, as money was tighter than any periods since the 1930s. I’m simply saying that if one thinks those sorts of concrete steps are what matters, then money was really, really tight.
PPS. In this post I discussed Krugman’s criticism of Friedman.