Welcome to a new blog on the endlessly perplexing problem of monetary policy. You’ll quickly notice that I am not a natural blogger, yet I feel compelled by recent events to give it a shot. By “recent events” I don’t mean the financial crisis, but rather the dramatic fall in aggregate demand since last summer. Indeed, one goal of this blog is to show that we have fundamentally misdiagnosed the nature of the recession, attributing to the banking crisis what is actually a failure of monetary policy. The intended audience is professional economists as well as others with a strong interest and background in macroeconomics.
I have spent 25 years researching the Great Depression, liquidity traps, and forward-looking monetary policy (especially policies that utilize market forecasts.) Last October I noticed that the Fed (and other central banks) had lost credibility, allowing market expectations for growth and inflation to fall far below their implicit target. In other words, the severe economic slump seemed to be caused by tight money–not tight in any absolute sense (more on that later), but relative to what was needed to meet the Fed’s objectives. To my great frustration, I found few if any macroeconomists who saw things that way, even though it seemed a logical implication of mainstream macro theory.
A blog is not the place for a lengthy dissertation, and so here I’ll merely list three views that underlie my unusual take on the current recession:
Premise 1: The only coherent way of characterizing monetary policy as being either too“easy” or “tight” is relative to the policy stance expected to achieve the central bank’s goals.
Premise 2: “Monetary policy can be highly effective in reviving a weak economy even if short-term interest rates are already near zero.”
Premise 3: After mid-2008, and especially in early October, the expected growth in the price level and nominal GDP fell increasingly far below the Fed’s implicit target.
In plain English, the first premise means the Fed should adopt the policy stance most likely to achieve its goals. It is a point forcefully advocated by Lars Svensson, who Paul Krugman recently cited as an expert on the role of expectations in monetary policy. The second is a quotation from Mishkin’s best selling monetary economics text (p. 607), i.e. it’s what we have been teaching our students. And I have encountered few if any economists who disagree with my third assumption. Indeed, if this were not so, why would Bernanke be calling for fiscal expansion?
The logical implication of these three premises is that the Fed has the ability to boost nominal growth expectations, and if they let those expectations fall far below target (as they did last fall) the subsequent recession (depression?) is their fault. Why does almost no one else see things that way? That’s what I’d like to explore.
At the same time, I assume that a blog must be more interesting than a research paper, so I’ll circle around these issues lightly. I’d like to mix together observations on current events, commentary on other economic blogs (Krugman, Cowen, Hamilton, Mankiw, etc.) and fun facts from monetary history. I’ll have plenty to say about misconceptions about Keynes, liquidity traps, the New Deal, and other related topics which have suddenly become highly topical. Many of my best ideas will pop up early, so if you come to this blog much later, you might check the February 2009 archive.
Thanks for reading. I welcome any serious comments.
Update, July 2009: ****FAQS:****
1. How can I say money was tight in late 2008?
Because markets expected NGDP growth to fall far short of the Fed’s implicit target.
2. But weren’t interest rates cut to very low levels?
Interest rates are a very misleading indicator of monetary policy. Both in the early 1930s and late 2008, falling rates disguised a tight money policy. The rates were actually falling for two reasons. Expectation of recession led to less borrowing and thus lower real interest rates. And inflation expectations also fell sharply.
3. But didn’t the monetary base increase sharply?
Yes, but this is also misleading for two reasons. During periods of deflation and near-zero rates, there is a much higher demand for non-interest bearing cash and bank reserves. In addition, last October 6th the Fed began paying interest on reserves, which caused banks to hoard bank reserves.
4. Wouldn’t charging a penalty rate on excess reserves cause all sorts of problems?
Not if done correctly. It need not hurt bank profits if it was combined with a positive interest rate on required reserves. The penalty can also be applied to vault cash, which is a part of bank reserves.
5. But what if banks cannot find good credit-worthy borrowers?
Then they can use the excess reserves to buy Treasury bonds. This will put the cash into circulation, and boost aggregate demand through the “excess cash balance mechanism.”
6. Isn’t the real problem . . . ?
No, the real problem right now is not a “real” problem. The real problem is a nominal problem. When the growth rate of nominal GDP falls sharply there is always a severe recession. We have a severe nominal shock, a problem which has been understood by economists at least as far back as Hume. At the time, it always looks like the “real problem” was some symptom of the monetary shock, such as financial panic. Thus in the 1930s people thought the collapsing financial system caused the Great Depression, only later did we discover it was too little money.
7. Aren’t business cycles caused by a misallocation of capital?
No. Misallocation of capital does occur, and it can have real effects. But even a major misallocation of resources such as the housing boom of 2003-06 does not cause a big enough misallocation to create a recession. That’s why the initial downturn in housing was handled well, with only a minor bump in unemployment between mid-2006 and mid-2008. The big jump in unemployment more recently was caused by a sharp fall in NGDP, i.e. tight money. By the way, there was no major misallocation of capital before the Great Depression. In that case the problem was 100% tight money after September 1929.
8. Have you seen Garrison’s Powerpoint slides?
Yes, several times. Using his terminology, we now face a secondary depression. BTW, please don’t ask me to read such and such a book on Austrian economics. The comment section is where you get to show me how useful ABCT really is, by making thought-provoking comments on the post. Until I finish my other projects, I won’t have much time to read anything.
9. How can the solution for this mess be the same thing that got us into this mess in the first place?
The solution is stable NGDP growth at about 5% a year, which is not what got us into this mess. It would be slightly more accurate to say that it is what kept us out of this mess between 1982 and 2007. We got into this mess when we stopped providing enough money for modest growth in NGDP.
10. Won’t your policies lead to high inflation in the long run?
No, but not doing my policies might. Countries that follow conservative “hard money” policies during deflation (the US in the early 1930s, Argentina 1998-02) end up seeing the government taken over by left-wingers. And if massive deficits are incurred because of a long recession, that makes higher inflation more likely in the future. Monetary stimulus reduces the need for fiscal stimulus, and thus reduces the risk that debts will be monetized in the future.
11. Aren’t market forecasts unreliable?
Yes and no. Markets are often wrong, but are still about the best forecasts we have. In this case other private forecasters, as well as the Fed itself, are also forecasting low NGDP growth. So whatever forecast we use, it still shows the need for further stimulus.
12. Isn’t monetary stimulus ineffective in a liquidity trap.
No. Temporary monetary injections are never very effective. Monetary injections expected to be permanent are always effective–even in a liquidity trap (according to well-known Keynesian Paul Krugman.) What we need is an explicit NGDP or inflation trajectory, including a promise to make up for any short term undershoots. This will increase the credibility of monetary policy.
13. Don’t we need both monetary and fiscal stimulus?
No. Monetary stimulus can make NGDP grow as fast as you like, as we saw in Zimbabwe. Once the Fed has set monetary policy at the level expected to produce on target growth, then there is no role for fiscal stimulus, it can only make things worse.
14. Isn’t there a risk of overshooting with monetary stimulus, due to the “long and variable lags.”
No. There are no long and variable lags in monetary stimulus. Money does have a lagged effect on sticky wages and prices. But wage growth is determined by inflation expectations. Thus as long as the Fed targets 12 month forward NGDP or inflation; we don’t need to be worried about damaging inflation. A temporary blip in inflation may occur from oil prices now and then, but it won’t feed into core inflation, and hence wages.
15. Isn’t the CPI a bad measure of inflation, because it ignores house prices and stock prices?
Stocks prices should not be included. House prices should be, and actual inflation was higher than the official rate in 2004-06, but not very much higher. This is one reason I prefer NGDP targeting, it does include new house prices.
16. How can I defend the EMH, when so many studies show people are irrational and markets are inefficient?
Market anomaly studies are products of data mining. At some level this is known by economists, but the problem is far worse than even most economists realize. These tests are not reliable. People are often irrational, but it’s not clear that irrationality has much impact on sophisticated financial and commodity markets. The anti-EMH position has yet to come up with useful public policy advice, or useful investment advice.
17. Wasn’t the housing bubble obviously just a big house of cards? And wasn’t that obvious to any thinking person at the time?
Apparently it wasn’t obvious to the big Wall Street banks who lost billions, and in some cases failed entirely. Nor to the many highly sophisticated investors who invested in those banks, or more directly in mortgage-backed securities. I agree that in retrospect this collapse seems like it should have been obvious, but the reality is it was not. Obama’s proposal for a minimum 5% “skin in the game” rule would not have prevented this crisis, as lots of the villains did have skin in the game, and lost billions.
18. Isn’t the only solution to get rid of central banking?
And then what? A gold standard does not stabilize the price level, as the real value of gold fluctuates like any other commodity. We had depressions under the gold standard. I think central banking is inevitable, but we do need to reform the system so that central bankers no longer try to out-guess the market. Monetary policy should be implemented by the market, using a futures targeting system. The market is best able to stabilize the price level, or NGDP.
19. Aren’t you just a monetary crank trying to solve all the world’s problems by printing money?
Yes, but like a broken clock the monetary cranks are right twice a century; 1933, and today. The other 98 years I am a Chicago-trained, libertarian, inflation-hawk. Twice a century I put on my Irving Fisher super-hero suit, and emerge from my deep underground bunker.
Sorry, but I don’t have time to respond to FAQs here. These are primarily for new visitors who don’t know where I am coming from, and want information to help them better understand a blog post. There will be plenty of opportunities for visitors to raise these issues in new posts. They pop up over and over again. Ad nauseum.