This time there are no excuses
Last time we had a severe AD shock it was easy to misdiagnose the problem. It coincided with a severe banking panic. Although I believe that the subsequent recession was caused much more by falling NGDP, than banking problems, I can understand how others might have reached different conclusions.
This time there are no excuses. No one in their right mind thinks the stocks of US manufacturing corporations with no loans to Greece or Spain are plunging because of debt problems in Europe. Stocks crashed 4% today because people are increasingly worried about the macroeconomy. Yes, there are real aspects to the Greek crisis. Greece will need to engage in austerity over the next few weeks. But Greece, Portugal, and Spain are not big enough countries to knock 25% off the price of oil in one month. Oil prices are plunging for the same reason as US equity prices are plummeting—fear of a sharp fall in AD (and hence economic activity) all over the world.
Problems in Greece don’t cause 5-year US inflation expectations to suddenly plummet from over 2% to 1.6% in just a few weeks. Falling AD does.
Just as in 2008, the monetary policy screw-up was triggered by a combination of a real shock (banking then, Greece now) and a dysfunctional monetary regime (interest rate targeting.) In 2008 a reasonable person could have attributed all the damage to the real shock. They would have been wrong in my view, but it was a plausible argument. Now there are no more excuses. Money is too tight. The falling asset prices are not directly caused by Greece, that country is much too small. The asset price declines are caused by monetary policy errors triggered by central banks that remained passive in the face of a debt crisis in Europe.
In 2008 people pointed to rapid growth in M2. I don’t think the monetary aggregates are reliable indicators; but even if they were, M2 has actually fallen thus far in 2010.
I don’t doubt there are other explanations. Maybe US stock investors suddenly realized that a new round of “recalculation” was necessary. But why would this need for extra recalculation in America have been triggered by problems in Greece?
In 2008 there were no bloggers pointing to tight money as the problem (although Earl Thompson did publish one article.) Today we have bloggers on the right (me), bloggers in the center (Ryan Avent), and bloggers on the left (Matt Yglesias) all pointing to the need for easier money.
Surely the central banks see the problem—will they have the courage to act?
Update 5/21/10: Tim Duy also has an excellent piece.
HT: Marcus
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20. May 2010 at 19:31
If it makes it any easier, you’re pretty far on the left to a lot of us. 🙂
20. May 2010 at 19:37
New entrants to the “Monetary Policy is Tight” block!
http://economistsview.typepad.com/timduy/2010/05/fed-disconnect.html
20. May 2010 at 20:18
[…] real shock will be blame this one on? Karl Smith is cautiously optimistic…but he mentions that he expects monetary […]
20. May 2010 at 20:35
I agree, except I’m uncertain why you discount the uncertainty being generated by political markets.
Financial stocks have greater controls imposed on them, which will mean lower profits and less spending. (Although I wonder how long before a derivative market opens in the Caribbean banking centers.)
Who knows what cap and trade will look like, but spikes in energy prices tend to cause downturns.
The troubles for health care in Mass. doesn’t look good for that Obama health care plan.
Higher taxes are coming, but the exact shape is uncertain.
Many jobs lost in the midwest are lost forever and relocation in the current housing market is causing friction.
California remains in trouble.
So while I don’t disagree with the cure you recommend, I’m less certain that other issues are making people nervous
20. May 2010 at 21:18
I wonder if anyone else read this Trichet post:
http://www.ecb.europa.eu/press/key/date/2010/html/sp100520.en.html
Maybe I’m missing something, but his take on things seriously unnerved me.
21. May 2010 at 04:50
Don… Trichet is serious. The ECB is infatuated with Euro-as-reserve-currency. He will destroy the Euro by virtue of destroying Europe, and will defend his peg until the end – then he will blame the fiscal authorities for the collapse, EVEN THOUGH fiscal adjustment is happening more rapidly than at any time in the past 40 years.
Not long ago, ssumner suggested that the ECB was playing the foil to the fiscal authority, and that it was tight because the fiscal packages were loose – but that the ECB would loosen as fiscal policy tightened. I suspect this was a misread. Trichet is a self-righteous eogmaniac obsessed with not going down in history as the man who caused inflation.
Bernanke isn’t, but Bernanke faces tremendous public pressure. The most reasonable notion is that he will wait until things are so bad that the public demands more Fed action, instead of the current Ron Paul audit-the-fed crud. Public sentiment was largely driven by the fact that the Fed didn’t do crud until the banks were in danger, then it bailed out the banks massively and immediately, leaving the rest of the economy in squalor.
Anyway, back in 2008/2009, I pegged 5 years of deflation, then hyperinflation as the most likely path…
21. May 2010 at 04:57
Scott – I agree with you on tight money. I also agree that problems in Greece should not cause stocks to sell-off to the extent that they have. Thus your view that investors are concerned about falling demand makes sense as part of the reason for the market sell-off. However, i view Greece as akin to the straw that broke the camel’s back. The US stock market has been much too expensive (as measured by 10-year cycle adjusted price to earnings ratios, for example) for the past several months. So, if it hadn’t been problems in Greece then it might have been a new round of housing foreclosures, continued tepid job growth, a financial regulation bill, or any number of other unpredictable catalysts that sparked a sell-off.
Any of these things could have caused a sell-off without causing a drop in AD expectations, i think….It just so happens that the Greek /EU problems have sparked both an equity market sell-off AND falling AD expectations.
21. May 2010 at 05:09
ThomasL, True, but I am a small government libertarian–so that certainly puts me to the right of the other guys I mentioned.
marcus, Thanks, I just added an update.
DanC, You said:
“Financial stocks have greater controls imposed on them, which will mean lower profits and less spending. (Although I wonder how long before a derivative market opens in the Caribbean banking centers.)
Who knows what cap and trade will look like, but spikes in energy prices tend to cause downturns.
The troubles for health care in Mass. doesn’t look good for that Obama health care plan.
Higher taxes are coming, but the exact shape is uncertain.
Many jobs lost in the midwest are lost forever and relocation in the current housing market is causing friction.
California remains in trouble.
So while I don’t disagree with the cure you recommend, I’m less certain that other issues are making people nervous”
Almost all those factors were already priced into the market a month ago. What’s changed is that NGDP expectations have fallen. If output falls it won’t be because firms can’t get financing, it will because falling NGDP causes a drop-off in orders. If the orders were there, they’d find some way to finance production.
Many jobs being lost in the midwest forever doesn’t cause a recession, it causes more jobs in other parts of the economy. That process even occurs in good times. Falling AD causes a recession.
Don the Democratic libertarian,
Trichet makes no sense at all. I have no idea what the ECB is trying to accomplish with monetary policy. Is it just to get inflation to zero? Then why did they allow rising prices prior to the crisis?
Statsguy, You said;
“Not long ago, ssumner suggested that the ECB was playing the foil to the fiscal authority, and that it was tight because the fiscal packages were loose – but that the ECB would loosen as fiscal policy tightened. I suspect this was a misread.”
I thought I made that argument for the Fed. But nonetheless, that’s a very good observation–it does go against my argument on fiscal policy.
21. May 2010 at 05:26
MBP, You raise a very good point, but I think I have one additional data point that helps my argument. I agree that stocks seemed fully priced last month. So let’s say you are right, and then a minor shock might have triggered a 10% to 15% correction. My argument would be as follows:
1. If the correction was stock market focused, then commodity prices would not have crashed.
2. If the stock market was mostly reacting to falling AD expectations, then commodity prices would have crashed.
I have talked about oil being down 25%, but a recent Econbrowser post shows all the metals down very sharply. This means forecasts of world demand going forward are being scaled back. So while I agree with your point about stocks being fully priced, I think it is more than just a stock correction.
21. May 2010 at 06:20
One, I think the frictional unemployment in the Midwest is beyond levels we have ever seen before. You could claim that unemployment during the great depression was just a temporary situation while workers reallocated. I’m just not sure if communities can reach tipping points that freeze a bad situation.
Second, while much bad news was priced in, I am not sure if the view of the potential profits of banks going forward hasn’t shifted downward.
I think political markets are shifting more then commodity or stock markets. Germans are getting fed up and are, perhaps, getting ready to change the rules of the game. What will Congress look like next year? More pro-business or anti-business. How much will taxes increase? What form will regulations take?
How much debt can we switch to future generations? Is Barro right that future expectations of higher taxes reduce expenditures today?
Simply, I think political market fears are increasing. As more people look to the government for solutions, and lose faith in markets, how could you not see confusion increase?
21. May 2010 at 06:38
Scott could you explain how the Fed would effect the loosening of credit you recommend? My understanding is that it has pumped in gobs of liquidity but that it is sitting as excess reserves in the banks. Couldn’t/wouldn’t the banks lend these funds out if they thought it made good business sense? Thanks if you can explain.
21. May 2010 at 16:19
Scott,
Is it the absolute level of NGDP expectations that causes the decline we are seeing right now? Or is it simply due to a decrease in that level?
22. May 2010 at 07:16
DanC, I disagree about frictional unemployment–I see cyclical unemployment as the main problem. If NGDP was a trillion dollars higher, then many of those “frictionally unemployed” would be working. I.e. they are actually cyclically unemployed.
The factors you discuss affect long term growth, but don’t have much effect on the ups and downs of the business cycle. RGDP often grows strongly when left wing governments are doing all sorts of things that hurt long term growth prospects (Under President Johnson, for instance.)
MamCR, In October 2008 they Fed started paying interest on those ERs. That was a huge mistake. They are paying banks to hoard money. They should charge an interest penalty on ERs to encourage banks to move the money into the economy. They can also do QE, and can set a higher inflation or NGDP growth target, to reduce real interest rates. Bernanke knows all this stuff, he recommended the Japanese do this in the 1990s, when he said they should raise their inflation target to 3 or 4%. He just refuses to take his own advice.
Mark. markets move on new information. The absolute level was already too low, but recent market movements reflect even lower expected NGDP growth.
22. May 2010 at 07:40
I guess we disagree about how forward looking people are.
If you drive from Rochester through Buffalo, Youngstown, Cleveland, Toledo, Detroit to Flint it is hard to imagine how these areas will recover in a generation (or two).
I don’t know how long the cycle will last, how much AD will need to increase when so much housing capital has disappeared, and the value of human capital (in manufacturing) has dropped to near zero. The talented flee, private investments stops, and the disinvestment never seems to stop.
22. May 2010 at 19:21
Debate is not helped when allegedly reputable organisations such as the Australian Treasury engage in what is effectively outright statistical fraud to defend government policy (in this case, fiscal stimulus).
23. May 2010 at 11:59
DanC, Yes, but those problems are structural, not cyclical. It’s not like those towns were doing well before the recession.
Those are in states (NY, Ohio, Michigan) with bad public policies, even compared to neighboring manufacturing states like Indiana and Wisconsin. (Which are the two most manufacturing-oriented states in the country.)
Lorenzo, Thanks, that is pretty sad.