I’ve already argued that the current depression was caused by an excessively tight monetary policy. But why did policymakers get it so wrong? I don’t think it’s just the Fed, there is a deeper problem in way the profession as a whole approaches these issues.
Yes, the Fed has made some bad decisions. But as we saw in the bank bailout case (when the original bad debt purchase plan was replaced by equity injections), policymakers do respond to strong criticism from the economics community. Unfortunately, I see little evidence that macroeconomists understand how the Fed (and ECB and BOJ) caused the current depression, and thus the profession as a whole is complicit in their policy errors. At the deepest level, this depression is a attributable to a failure of imagination, a failure to look beyond the surface of current events.
(In using the term ‘depression’ I don’t mean to suggest that we are in another Great Depression. I hope and expect this downturn will be much milder. It is already pretty severe, however, and is showing signs of the “debt-deflation” experienced during the Great Depression.)
Of course the policy errors were unintentional, nobody wanted this to happen. If the errors were inadvertent, then the profession must have misunderstood the nature of the problem, or the effectiveness of potential solutions. But why were these mistakes made? I can see at least seven areas where policymakers took a commonsense approach, whereas what was actually needed was a counter-intuitive perspective:
1. Misdiagnosing the problem. The scale of the sub-prime crisis that emerged in August 2007 was initially underestimated, but otherwise the problem was correctly understood as being sector-specific (assuming appropriate monetary policy.) Unfortunately, many economists failed to see that one year later the nature of the crisis changed suddenly, and dramatically. What started out as a financial crisis with little impact on nominal GDP, became a massive collapse in aggregate demand after July 2008. For the first year of the subprime crisis nominal spending held up pretty well (except in residential real estate, which had been declining since mid-2006.) After July 2008, however, prices and output began falling in a wide range of industries, and as a result the banking crisis intensified. Like any other other demand-side slump, the root cause was a failure of monetary policy.
Most pundits continue to misdiagnose the problem, mistakenly assuming that we needed to “fix” the financial system in order to generate a recovery. (One recent exception is Martin Wolf.) Bank bailouts will not work, however, if nominal spending continues to decline. Without a shift in monetary policy the banking crisis will only get worse, as falling AD makes more and more borrowers default. On the other hand if we use monetary policy to boost nominal spending it won’t merely help the macroeconomy, it would also greatly reduce the severity of the banking crisis.
2. Insufficient attention paid to nominal GDP. Most macroeconomists focus on real output and prices, but in an asymmetrical fashion. To grossly oversimplify, low inflation is usually viewed as a good thing, whereas low output is a bad thing. But the central bank doesn’t directly control either variable, rather it affects each through the impact of monetary policy on nominal spending. When there is a precipitous fall in nominal GDP, it is easy to overlook the role of monetary policy if one focuses separately on prices and output. Thus in the 4th quarter of 2008 nominal GDP fell roughly 5%, almost entirely due to a decline in real GDP. At first glance the approximate price stability might not seem so bad, after all isn’t price stability the Fed’s goal? At a recent economic conference I heard a number of conservative economists asking “Deflation, what deflation?” And falling real output could be due to any number of nonmonetary factors–including the problems in the financial system.
From the perspective of nominal GDP things seem much different. The Fed generally aims for a long run increase of about 5% in nominal GDP (3% real long run growth (assumed to be independent of monetary policy), and their implicit target of roughly 2% inflation.) The Fed may not be able to control real GDP, but it can certainly control nominal GDP with an aggressive enough policy (see my earlier proposal here.) So from this perspective the fact that nominal GDP fell 5% last quarter, and may be falling as much as 10% this quarter, is a flashing red light that monetary policy is far too contractionary to meet the Fed’s implicit spending targets.
3. Reversing causality. Many economists simply assume that the current contraction has been caused by the financial crisis. After all, isn’t that obvious? Actually, no. For nearly a year after the onset of the financial crisis nominal GDP continued growing at better than a 3% clip. Now it is plunging. Most seem to assume that this new state of affairs was somehow caused by the Lehman failure, and the subsequent loss of confidence in the entire financial system. My view is that this reverses the causality; it seems much more plausible that the current problems in the financial system are being caused by the recent (and expected future) sharp fall in nominal GDP.
An unexpected decline in nominal GDP puts stress on a banking system that is based on nominal debt. It is even more disruptive to a system that has become highly leveraged in expectation that the Great Moderation would continue, i.e., that central banks would insure that we never again saw a repeat of the plunging nominal GDP of the early 1930s. And it is devastating in a system that was both highly leveraged and already buffeted by severe losses in residential lending.
The 2007 subprime crisis did not cause the stock market crash of 2008, as stocks were still only modestly below record levels in early June 2008. The October crash occurred when investors began to see deflation and depression on the horizon, and saw that loan losses would spread from the already weakened subprime sector into the sort of commercial and industrial loans which would have been sound had nominal GDP continued expanding at close to 5%/year.
4. Assuming that monetary policy has been expansionary. Too many economists merely look at the sharp fall in interest rates, and the sharp increase in the monetary base, and assume policy has been expansionary. But the Fed also cut rates sharply and increased the base during the early 1930s. Just as during the Great Contraction, policy has been highly contractionary in the only sense that matters, relative to what is needed to meet the Fed’s policy target for nominal spending.
Nominal interest rates are not a reliable policy indicator. In another post I pointed out that a highly contractionary policy will generate deflationary expectations, and drive nominal rates toward zero. And once that occurs the real demand for bank reserves will rise sharply, especially if the Fed foolishly begins paying interest on reserves.
5. Backward-looking monetary policy. Too many economists use the structural modeling approach to policy; looking at the past performance of key variables like inflation and real growth. But this won’t be good enough when expectations are shifting rapidly from inflation to deflation. In October 2008 the stock, commodity, and bond markets all saw the oncoming collapse in nominal spending before the Fed, despite the fact that lagging 12 month inflation rates continued to exceed the Fed’s comfort zone. As a result, the Fed was far too timid in easing policy, indeed it is not clear they eased at all, as the cut in the target fed funds rate and injection of reserves was neutralized by the policy of paying interest on those added reserves.
The commonsense view is that markets are highly irrational, especially the stock market. This is because economists tend to assume that a sudden large change in equity prices is irrational any time they are not able to identify the fundamental cause. By October 2008, the financial crisis that occurred in September seemed to ease slightly, and thus commentators attributed the stock market crash to irrational investor fears. But just as in October 1929, and October 1937, the markets saw a collapse in aggregate demand well before the experts.
If economists fully embraced the need for a forward looking policy, we would have already given up on trying to model the monetary transmission mechanism. John Cochrane mentioned (in an email) that he was surprised that leading new Keynesians hadn’t latched on to my futures targeting idea; that it was so obvious in retrospect. Obvious perhaps, but only if one understands that effective policy must be forward-looking.
6. The liquidity trap fallacy. Recent events have demonstrated the degree to which economists’ perceptions are driven by uninformed assumptions. We teach our students out of textbooks (such as Mishkin’s best-selling money text) that say monetary policy is highly effective even when interest rates fall to zero. But apparently few economists believe what they teach, as the majority seem to favor fiscal stimulus based on what Keynes would call “voices in the air,” erroneous perceptions of past so-called “liquidity traps.”
Why are points 5 and 6 so important? Because if monetary policy is always capable of boosting AD, and if policy should be forward-looking, then the Fed has both the ability and duty to make sure that nominal spending is expected to grow at its target rate. The Fed’s failure to do so after September 2008 was not just a missed opportunity to address the economic downturn, it was the cause of the economic collapse. If doing X can easily prevent problem Y, then not doing X is the cause of problem Y.
The failure to effectively manage expectations led to a major loss of credibility, as nominal spending is now expected to undershoot the Fed’s implicit target for years to come. This policy failure makes the Fed’s traditional policy tools even less effective, and makes it even more essential that they adopt unconventional methods.
7. Irrational fear of hyperinflation. Some of the reluctance to try unconventional monetary stimulus (which almost everyone concedes would work if pursued a l’outrance), is the fear of excessive inflation, of overshooting the target. Economists see that a large increase in the monetary base has accomplished little, and can only imagine how aggressive policy would have to be in order to turn expectations around. This fear is partly based on a (mistaken) concern over policy lags.
In fact, an effective policy (such as futures targeting) would probably involve a much smaller increase in the base than what has already occurred. Once again the danger lies in confusing cause and effect; the huge increase in the real demand for bank reserves is an effect of the deflationary policy (and the interest payments on reserves) not an indicator of policy ease.
Despite the existence of policy lags, there isn’t much risk of monetary stimulus leading to high inflation in the near future. If the stimulus threatened to overshoot, we would see inflation expectations show up in the indexed bond market, and elsewhere. The greatest risk we now face is that it will take the Fed too long to recognize that the risks of inaction far exceed the risks of aggressive easing.
Of course most economists suffer from only some of these misconceptions. I have noticed that left-leaning economists tend to be more sensitive to the problems created by inadequate nominal spending, but often fail to see how monetary policy can address that issue (and thus how the contraction was caused by inadequate monetary policy.)
Those on the right are more likely to acknowledge that monetary policy drives nominal spending, even at the zero rate bound, but some fail to see just how much of the current crisis is driven by falling nominal expenditure. Others see the relationship between nominal shocks and business cycles, but assume that the Fed has already taken effective action, and that we merely need to wait for the “policy lags” to play out. Just why some free market economists ignore the overwhelmingly negative reaction to recent Fed policy in the financial markets, remains a mystery to me.