Over the last 10 months I have become increasingly aggressive in my criticism of the current state of macroeconomics. I talked about all of the double standards. Fiscal policy is discussed in terms of whether it can create jobs. Monetary policy is discussed in terms of its impact on inflation. Which sounds better, jobs or inflation? Obviously jobs. Yet there is nothing in macro theory that would justify this dichotomy. Indeed, if anything an AD shock driven by government spending would be expected to be more inflationary than equivalent shock created by monetary policy. That’s because the private sector can usually spend money a bit more efficiently than the public sector.
If your intuition still tells you that monetary policy is more of an inflation threat than fiscal policy, you are probably right. But that is because, and only because, you intuition is correctly telling you that monetary policy is a far more powerful tool for boosting NGDP. Which begs the question of why so many economists support fiscal stimulus, and so few criticize the Fed.
Another point of confusion is to assume that because I am a Chicago libertarian, there is something right wing in my argument. Here is Matt Yglesias making a similar argument. And of course Krugman recent acknowledged that monetary policy is the best way of stimulating the economy.
And then there is my argument against the Fed’s policy of paying interest on reserves. I don’t know how many times I have read, or been told by other economists that the policy couldn’t possibly have been a big deal, after all the current rate is only 0.25%. Of course they conveniently ignore the fact that the rate being paid was much higher in the early stages of the program (October and November 2008) when all the damage was being done. But it is far worse than that.
One of the most famous mistakes in Fed history was the decision to double reserve requirements in 1936 and 1937. How many times have you heard about this example? How many times have people said “Let’s not make the mistake this time that we made in 1937, prematurely tightening policy.” It’s the example always used in textbooks to show why higher reserve requirements are a tight money policy.
What the Fed did last October was essentially the same. The interest on reserves program also dramatically increased the demand for reserves, and this also greatly reduced the money multiplier. So why isn’t this getting equal criticism? It seems all people can think about is interest rates. But if we are going to play that game, then shouldn’t we at least think about real interest rates? James Hamilton suggested that the Fed began to pay interest on reserves to prevent a big increase in inflation. OK, but if nominal rates are stuck near zero, wouldn’t a big increase in inflation represent a sharp fall in the real interest rate? So why wasn’t this a really tight money policy? I know, you’re thinking “but the interest paid today is only 0.25%, surely that can’t be significant?” I give up.
Or at least I gave up until I decided to check to see what impact the famous tight money policy of 1937 had on nominal interest rates. If you look at Friedman and Schwartz page 454 you will see a graph. I can’t tell exactly, but it looks to me like both short term interest rates series rise from about 0.15% in 1936 to 0.40% in 1937. So rates did go up, and it looks like the increase was about 0.25%. Sound familiar?
So we are constantly bombarded with reminders that we must avoid the mistakes of 1937. Then when I point out that we already made exactly the same mistake back in October 2008, people say, “yeah, but the interest rate is only 0.25%, surely a quarter point can’t make much difference?” And then when I check the data for 1937, I find that the infamous Fed tight money policy raised rates by exactly the same measly quarter point.
A few weeks ago I called out the profession, basically saying they were making fools of themselves, confidently talking about ‘easy’ and ‘tight’ money without having the faintest ideas what the terms mean. Often using the meaningless nominal interest rate indicator. Then when called on it, they revert to real rates. But they still insist Fed policy was easy last year, despite overwhelming evidence it was extremely tight. Ex ante real interest rates on 5-year government bonds soared 360 basis points between July and November 2008.
There were lots of comments after that post, but not one economist has been able to refute my argument. Not one economist has been able to show that the economics profession has attached any coherent meaning to the terms ‘easy’ and ‘tight’ money. And this confusion continues to cause great damage, and indeed is ultimately behind our recent monetary policy failures. At least one economist has realized there is a problem, although he differs with me as to what the solution is. Thank God for Arnold Kling:
I am prepared to offer pushback against the Sumner-Hetzel viewpoint. However, it really deserves the status of the “null hypothesis.” In a more reasonable world, everyone would be starting from the presumption that Sumner and Hetzel are correct. Those of us arguing folk-Minskyism and telling the Recalculation Story should be the ones fighting an uphill battle to bring our ideas into the policy debates. That this is not the case, and that SC [the scholarly consensus] is now on the fringe, is one of the most remarkable stories of this whole macroeconomic episode.
See how grouchy I get when my blog goes down a couple days.
PS. NGDP will fall over 1% this year. Last time it fell that sharply? Nineteen thirty-eight.