I have an open mind on this question, but so far I don’t see much evidence that it is. Let’s break this down into two parts:
1. Does finance have an important impact on the path of NGDP.
2. Does finance have an important impact on RGDP, through mechanisms other than its impact on NGDP?
A whole lot of miscommunication could be prevented if people would at least briefly frame their arguments in terms of these two questions, even if they prefer to spend 98% of their time ignoring these two questions. That’s because it makes it much easier to understand what they are talking about. For instance, consider a big drop in lending. Is that a supply or demand shock? Is it something that impacts RGDP directly, or only via it’s impact on AD? It could be either, or both, and it’s often hard to tell from a person’s blog post which channel they are talking about. (Kudos to Arnold Kling for being crystal clear.)
Finance certainly has an impact on NGDP under a gold standard, as does drug smuggling, and also under a poorly run fiat regime, especially at the zero bound. It’s not at all clear that finance has any impact under a well run fiat regime. For instance, NGDP took off like a rocket after March 1933, even as much of the US banking system was shutdown.
Finance certainly might have an impact on RGDP, even if NGDP is well behaved, but I haven’t seen much evidence for that proposition. At least not in the US. For instance, RGDP took off like a rocket after March 1933, even as much of the US banking system was shutdown. And no, I’m not repeating myself.
This post is partly in response to a recent post by David Glasner, which contains this observation:
Now, as one who has written a bit about banking and shadow banking, and as one who shares the low opinion of the above-mentioned commenter on Kaminska’s blog about the textbook model (which Sumner does not defend, by the way) of the money supply via a “money multiplier,” I am in favor of changing how the money supply is incorporated into macromodels. Nevertheless, it is far from clear that changing the way that the money supply is modeled would significantly change any important policy implications of Market Monetarism. Perhaps it would, but if so, that is a proposition to be proved (or at least argued), not a self-evident truth to be asserted.
Market monetarists have differing views of money. For myself, I don’t find the aggregates to be at all interesting, and hence pay no attention to “money multipliers.” I know there are people out there who are obsessed by the supposed implications of certain accounting relationships, but I try to avoid the subject as much as possible. If it does arise I simply refer to Krugman’s brilliant dismissal of one pesky blogger—Krugman said “it’s a simultaneous system.” In other words, accounting tells you nothing about causation.
Finance certainly looks important. But that’s mostly because monetary policy has a huge impact on finance. Since 99.999999% of people don’t know how to identify monetary shocks, they reverse the causation—assuming finance is impacting NGDP. Remember 1931? I thought not. But how about 2008?
The focus on finance may have a downside that many people overlook. Here’s a small passage from my Depression manuscript:
Enthusiasm for Hoover’s proposal was not confined to the NYT. The June 27  issue of the CFC (p. 4635) enthused “President Hoover has electrified the whole world and possibly turned the tide of business depression”. A “Hooverstrasse” was proposed for Berlin. The British compared the proposal to a new armistice and suggested that the move ranked in importance with the U.S. entry into World War I. Of course Hoover’s debt moratorium was subsequently shown to be ineffective in arresting the ongoing depression. Nevertheless, the financial community had great hope for the plan, which indicates they saw the debt crisis as inhibiting recovery.
Between June 2 and June 27the Dow soared by almost 29 percent, and the next day’s NYT (p. 7N) suggested that “War Debt Plan Aids Commodity Prices. . . Sharpest Advance Since Last Summer Shown in Most Groups in Fortnight”. Although the reaction of financial markets to the moratorium was unquestionably enthusiastic, the reasons are unclear. Perhaps it was felt that the moratorium would reduce gold flows to countries with a high propensity to hoard (i.e. the U.S. and France.) The June 27th CFC (p. 4653) suggested that Hoover’s goals were limited and that it was hoped that the agreement could lead to a climate of “international good will”.
On June 30th the NYT (p. 1) quoted a bank official as indicating that “it would be a mistake to over-emphasize the proposed debt adjustment as an economic factor in itself”. Unfortunately, Hoover strongly opposed two initiatives that might have provided meaningful help for Germany; a coordinated international policy of tariff reduction, and a coordinated attempt to lower the world gold ratio through expansionary monetary policies. Those who have followed the recent events in Europe will see an obvious parallel. The Europeans have worked hard to develop a debt relief plan for countries on the periphery, but have failed to take the one step that could actually make a big difference, an ECB policy aimed at faster nominal growth in the eurozone.
 Hoover criticized the theory that deflation was resulting from a “maldistribution” of monetary gold stocks.
So they focused on debt relief thinking that would solve the problem, when the real problem was tight money. Of course the ECB made the identical mistake in 2011-13. Two European depressions, both caused by policymakers thinking finance was the problem when monetary policy was the real problem. Let’s hope it never happens again.
PS. There is one important sense in which I pay more attention to finance than just about anyone else—the EMH. The markets tell me the impact of QE. I trust them more than anyone else, including myself. As soon as the market start seeing QE as deflationary I’ll nominate Steven Williamson for a Nobel Prize.