Arnold Kling recently had this to say:
I will excerpt from the Meltzer paper. But first, let me quote from the media release of Macdonald-Laurier.
“In a period of runaway monetary stimulus by the industrialized world…”
I do not think that Scott Sumner would characterize the monetary situation that way.
I use the Bernanke criterion from 2003, discussed in my previous post. According to the Bernanke metric, monetary policy since mid-2008 has been tighter than any time since Herbert Hoover was President. Kling continues:
In fact, while we are talking about non-monetary factors in economic performance, I might mention the much-discussed Fed study suggesting a 40 percent decline in median household wealth between 2007 and 2010. Timothy Taylor has the link and some helpful analysis.
I think that economists who believe that aggregate demand was a big factor in the recession (which means most economists, just not necessarily including me) are inclined to view this wealth decline as the cause, rather than taking Scott Sumner’s view that this was a monetary contraction. To rescue a role for money, you could try to argue that the wealth decline was the result of monetary austerity (impossible to disprove, but I do not believe it) or, more plausibly, that a vigorous monetary expansion could have maintained nominal GDP in the face of the huge decline in the relative price of houses and bank stocks.
Not surprisingly, I have all sorts of problems here. Start with the decline in wealth. It seems clear to me that something on the order of 70% of the decline was due to tight money. That’s just a ball park estimate, but the exact percentage isn’t critical for my argument. I base this on 60% of the wealth decline being residential housing, and 40% being other assets like commercial RE and stocks. I also estimate that the first half of the housing price decline was mostly autonomous, and the second half mostly reflected falling NGDP–i.e. tight money.
But let’s say I’m wrong about tight money causing the fall in wealth, even though previous big falls like 1929-33 were also due to tight money. Say that Kling is right. There is no reason why a big fall in wealth should have any impact on AD, as long as the central bank is following some sort of stable monetary policy: inflation targeting, NGDP targeting, whatever.
In late 1987 there was a stock market crash as big as 1929. I’m not arguing that it was identical to the recent wealth crash; it was much smaller, and more concentrated among the wealthy. Nonetheless because the Fed was targeting NGDP or inflation, there wasn’t even a tiny fall in AD. Not even a minuscule fall in AD, following a 1929-style stock market calamity. I mention that because I think a lot of average people have the 1929 crash in the back of their minds, and think it somehow contributed to the Great Depression. That false impression, which we got from believing what we were taught in our economics and history classes, has led many to be way too easily accepting of wealth explanations for the current recession.
I can’t emphasize enough that we need to purge from our minds almost everything we learned about economic history. Our teachers had flawed models, and never updated them when the 1987 crash showed the standard model of the Great Depression was completely bogus.
There is a way to test whether I am right. If we do the policy that Arnold and I favor:
I presume Meltzer would prefer a rule fixing the growth rate of a monetary aggregate (the monetary base seems to be his choice). On this issue, I tend to side with the market monetarists, but for non-monetarist reasons. A nominal GDP target will be imperfect because of forecasting errors. A monetary aggregate target will be imperfect because of velocity instability. I think I would rather take my chances on the forecasting errors.
then I claim future wealth crashes would not cause serious recessions–at least not through a demand side channel. (No one would dispute that a huge supply shock such as an asteroid impact would reduce both wealth and RGDP.)