Right after I quoted Matt Yglesias in the last post, I saw Tyler Cowen weigh in with his own perspective on Yglesias, and the pro-stimulus crowd in general. I’d like to separate out several of Tyler’s comments, as a quick reading might lead one to think I am making the same argument as Krugman, DeLong, Thoma, etc.
You can take that [Yglesias] quotation as a stand-in for the more general Keynesian AD views about the current recession.
First, I am fully on board with Scott Sumner-like ideas to boost AD through monetary policy, as is Yglesias and are many other Keynesians. There is no practical disagreement, but it remains an open question how effective such measures (or a bigger stimulus) would be.
I feel good about this observation, as when I started making this argument in October 2008, I think it is fair to say that there weren’t many Keynesians, or non-Keynesians, arguing for a more expansionary monetary policy. Most were saying the Fed had done all it could. Tyler continues:
Consider a simple model, in which uncertainty goes up, first because of the U.S. financial crisis, now because of Greece and the Euro and the open questions about Spain and how well Europe can cooperate. I’m not saying that’s the only or even the prime cause of what’s going on, it’s simply an illustrative story.
With higher uncertainty, investors pull back, wait, and exercise option value. Aggregate supply declines, as does employment. As a result, aggregate demand declines too, and that includes real aggregate demand, not just nominal aggregate demand. Until the underlying uncertainty is resolved, the economy remains in the doldrums.
I have a couple responses here. I think the real problems that Tyler cites are much more closely linked to falling NGDP than most people imagine. Soon after NGDP (and NGDP expectations) started falling rapidly in August 2008, the financial crisis worsened. I think those events were related. It should also be noted that with a well-functioning central bank, these sorts of financial shocks do not reduce AD, or NGDP. If the Fed targets NGDP, then problems in one sector lead to resources being re-allocated to other sectors. There may be slightly higher frictional unemployment during this re-allocation, but nothing like the dramatically higher unemployment that results from a fall in the demand for all products (which we saw after August 2008.)
If Tyler is right, then a more expansionary monetary policy should boost not just AD, but also AS as well. This is because with higher NGDP, there will be less fear of defaults and bank failures, which is one of the shocks driving the recession in Tyler’s view. I won’t comment on real AD, as I don’t use that concept in my modeling, and am not sure how it fits into the picture. Tyler continues:
Note that there is still a case for fiscal policy, based on the idea of intertemporal substitution. With some labor unemployed, a sufficiently finely targeted fiscal policy can build a new road at lower social cost than before, by drawing upon unemployed resources. But even if that fiscal policy is a good idea, it won’t drive recovery, at least not for plausible values of the multiplier.
There is also still a case for countercyclical monetary policy. As real AS and real AD are falling (see above), there is also downward pressure on nominal variables. Aggressive monetary policy, or for that matter the velocity-accelerating aspect of fiscal policy, can limit the negatives of this process and check the second-order fall in employment.
I’m all for countercylical AD management, noting that for other reasons I prefer monetary to fiscal policy in most cases and even if you don’t agree with me there it suffices to note that the monetary authority moves last in any case.
That all said, the countercyclical monetary policy won’t drive recovery either, or set the world right again, it just limits the damage. We still have to wait for the uncertainty to be cleared up.
I mostly agree, but will make a few slightly different observations.
1. I don’t like the concept of “countercylical monetary policy.” It (often) implicitly suggests that the stance of monetary policy can be measured with interest rates or the money supply. The idea is that you cut interest rates and raise the money supply in recessions. But this is not a good way of judging the stance of monetary policy. The monetary base was increased and the discount rate was cut in the Great Depression. Yet money was very tight. My preferred metric for the stance for monetary policy is NGDP expectations. And I want monetary policy to always aim for an NGDP trend line with a 5% upward trajectory. I don’t want the Fed to ever say it itself “it’s time to change policy.” They should always have the same policy, passively adjusting the base until NGDP expectations are on target. As an analogy, under a gold standard a central bank should not have a policy ready for when the market price of gold falls below target. Rather they should always stand willing to buy and sell gold at the target price, making that the de facto market price.
2. If the Fed does this, then there is no case for fiscal policy, even in a recession. This is because (apart from trivial things like filling potholes) the lag for implementing highway building projects is longer than for monetary policy to impact spending. I agree with Tyler that when the Fed isn’t doing this, the opportunity cost argument for fiscal policy is defensible. And I also agree with his skepticism about much we can realistically expect from fiscal policy.
One final point, waiting for that “uncertainty to be cleared up” is mostly (in my view) waiting to find out how much NGDP growth the stingy Fed, ECB and BOJ will allow. I am pretty sure that Tyler thinks it goes far beyond monetary policy. Tyler continues:
Reading the Keynesian bloggers, one gets the feeling that it is only an inexplicable weakness, cowardice, stupidity, whatever, that stops policies to drive a more robust recovery. The Keynesians have no good theory of why their advice isn’t being followed, except perhaps that the Democrats are struck with some kind of “Republican stupidity” virus. (This is also an awkward point for Sumner, who seems to suggest that Bernanke has forgotten his earlier writings on monetary economics.) The thing is, that same virus seems to be sweeping the world, including a lot of parties on the Left.
Romer, Geithner, Summers, et.al. know all the same economics that Krugman and DeLong and Thoma do. If a bigger AD stimulus would set so many things right, they’d gladly lay tons of political capital on the line to see it through and proclaim triumph at the end of the road.
Just to be clear, I agree with Romer, et al, about fiscal policy, if indeed she is as skeptical as Tyler claims. (And based on her academic writings, she may well be.) I do agree with Tyler that my argument may sound a bit “awkward,” but I will make it anyway. By the way, I do more than “seems to suggests that Bernanke has forgotten his earlier writings,” I scream it from the rooftops. I quote Bernanke verbatim on the need for Japan to sharply raise its inflation target (to 3% or more), to do level targeting, that the Japanese problem is falling NGDP (and that banking distress is a symptom), that low interest rates don’t mean money is easy, that liquidity traps do not prevent central banks from boosting inflation. And I also quote him recently saying that three percent inflation expectations right now would be a bad thing.
But Tyler raises a good point. Why should people take me seriously when I claim that most of the recession is due to tight money, and could be easily solved with easier money? Certainly this is not the mainstream view at the elite universities (saltwater or freshwater.) If it was really this easy, why wouldn’t we have already taken the necessary steps?
This is why I love monetary economics. It is incredibly counter-intuitive. I had thought (by 2007) that almost all mainstream economists accepted that low interest rates didn’t mean easy money. In 2008 I found out I was wrong, very wrong. (I was lulled into complacency by the assumption that economists believed the concepts that they teach in textbooks like Mishkin.) Here’s my best argument. I have made part of it before, but I’ll extend it this time:
1. During the Great Depression almost all sober thinkers attributed the problems to financial distress. If you said the Fed could easily cure the Depression merely by a more expansionary policy, you’d be viewed as a crackpot. Irving Fisher and George Warren were viewed as crackpots for making exactly that argument. If you want a comparison to Bernanke, consider Keynes. In 1923 he wrote a quantity theoretic tract which argued that monetary policy could stabilize the economy. In 1936 he abandoned that view. Today his 1923 view is more widely accepted. Almost everyone now agrees that the Fed made a huge mistake in allowing NGDP to fall in half. The only debate is whether it could have been prevented under the gold standard (Friedman and Schwartz’s view) or whether it would have required abandonment of the gold standard (the new Keynesian view.) But the Fisher view was not accepted until many decades later.
2. When I studied at Wisconsin (a mainstream Keynesian university) in 1973, the 1960s inflation was attributed to fiscal stimulus (the Vietnam war deficits) and unions. I suppose you’d still find a few older microeconomists at obscure state universities teaching this view from their dog-eared copies of Samuelson, but not many economists take this view seriously any more. This is partly because the deficits were actually pretty small in real terms—the national debt/GDP ratio fell sharply in the 1960s and 1970s. But in 1973 (when I was at Wisconsin) the professors treated Milton Friedman as a crackpot. Friedman argued that it was easy money, not fiscal policy, which led to the inflation. What an absurd idea! Monetary policy is weak, everyone knows that. And interest rates had been rising during the 60s.
Do you notice that on these major issues the vast majority of mainstream economists were wrong at the time? And do you notice that they were wrong in a particular way? That they underestimated the role of money in driving NGDP shocks. Now think about my position vis-a-vis the mainstream view. I say the recession was caused by tight money. Most economists say it was caused by financial distress, and in any case, money was obviously easy. After all, rates are near zero. Will the Fisher/Friedman view be proved right once again?