Is it all just a terrible mistake?

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? 

Stay tuned.


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46 Responses to “Is it all just a terrible mistake?”

  1. Gravatar of Indy Indy
    31. May 2010 at 10:38

    I’ll copy my comment (regarding Yglesias’ capacity concept) to Cowen’s post, I was wondering if you had any thoughts:

    ——–

    The bigger Macroeconomics question is why are we reasoning from “capacity”?

    Think of it this way. Let’s say you had a giant buggy-whip-making machine and suddenly buggy-whips become obsolete and demand collapses practically overnight because of the automobile.

    Now, what do you have in this machine that can only make something nobody wants any longer (or what they only want now at a price so low that the machine can only be operated at a marginal loss)?

    Do you have “Industrial Capacity”? Or do you have Scrap? You have scrap. What errors in our economic-policy reasoning about “insufficient aggregate demand” will result from the confusion of the later for the former?

    This means that the permanent demand shift has also caused a kind of supply shock.

    The buggy-whip machines must now be subtracted from your ledger for “capacity”, added to the inventory of “scrap”, melted down and turned into different, more useful machines. The “inter-temporal” period of transition will likely be painful, but is that really avoidable by the government placing a lot of pointless orders for buggy-whips?

    It’s kind of the equivalent of an unexpected “depreciation shock” in the Solow model. Machines which ordinarily last 10 years surprising only “lasted” a year or two. Though they still stand there and look like capital – they’re not – they’re now useless and the capital stock has been significantly diminished if people are intellectually honest about the accounting.

    Now, the same is true of any process or setup – the output for which is no longer demanded at feasible prices. Just because you have a lot of devices set up in sequence that – if put in motion – could be called a “giant-gas-guzzling-luxury-SUV metal stamping facility” and though it seems you have this idled industrial capacity just sitting there, waiting to be used, that doesn’t actually mean it’s feasible-employable “capacity” any more.

    It’s capacity if the drop in orders and partial-idling seems temporary and likely to return. It’s no longer capacity if the whole thing has become obsolete or unworkable and needs to be effectively shuttered and torn down or reconstituted. I suppose some dilapidated housing stock in the more crime-ridden blighted areas of Detroit might also qualify as “false capacity” – if no one can or will ever live in those houses at any price – it’s not “housing stock” – it’s pre-demolition stock.

    Employees that require specific training, licenses, thousands-of-hours-of-experience, etc… are also part of the same phenomenon – it seems to me. A skilled construction foreman essentially has a lot of valuable human capital that suddenly depreciates into nothing (scrap skill) when it becomes clear that there’s been a massive over-building which won’t clear for a decade. A person becomes unemployed, but the skill that person had – his human capital – disappears from “human capacity”.

    Sudden-physical-and-human-capital-depreciation shock is probably similar to what happens to a country after a war or major natural disaster – like the Haiti Earthquake. I wonder if what makes this recession different from the others is that it’s less like a temporary-idling-until-recovery and more like a permanent capacity-depreciation-disaster.

    ——

    And as far as employment goes, I wonder if scrap-human-capital causes an oversupply shock of no-currently-marketable-skills labor – but minimum wage prices for unskilled labor -however close to equilibrium they were before the crisis – are sticky by legal mandate.

  2. Gravatar of ssumner ssumner
    31. May 2010 at 10:54

    Indy, I don’t think ‘capacity’ is a useful concept for policymakers, and oppose policies like the Taylor Rule that attempt to utilize the concept.

    Having said that, I do think we have lots of excess capacity. During my life there have been 9 recessions. During the previous 8 car sales fell, and bounced back after the recession ended. I expect the same to happen again. Buggy whip makers disappear in both good time and bad–that has nothing to do with recessions.

    You said;

    “Sudden-physical-and-human-capital-depreciation shock is probably similar to what happens to a country after a war or major natural disaster – like the Haiti Earthquake. I wonder if what makes this recession different from the others is that it’s less like a temporary-idling-until-recovery and more like a permanent capacity-depreciation-disaster.”

    At the time, people also feared that was true of the Great Depression. Now we know the GD was merely a demand shock (worsened by bad supply-side policies.)

  3. Gravatar of Alex F. Alex F.
    31. May 2010 at 12:42

    But wouldn’t your argument be stronger if you could give not just reasons to convince us that people are making a mistake but also why people are making it? Cui bono?

  4. Gravatar of Morgan Warstler Morgan Warstler
    31. May 2010 at 13:03

    Scott I know you are a professor and for that you can be forgiven certain non-market eccentricities.

    But this stuff isn’t rocket science at least in describing it and making more people grasp what you mean…

    Ex: Your position on QE is “stop paying interest on reserves” why not say that OVER AND OVER. that exact sentence. something that could become policy and everyone can grip hold of and not let go.

    Another side question: Why do you always skip over price? Rule #1: Capital is ALWAYS available when the price is right, if everyone thinks the price is right, and no capital is available, see rule #1 – property values need to fall.

    That’s what boggle the mind, from the first bailout onward, why isn’t the effort to force the banks to go mark to market, sell off their deeply distressed assets to the smart fuckers holding cash and get back to business as usual?

    I know real estate investors who call the banks all day long looking to buy those inland empire homes for 20 cents on the dollar, and the banks laugh.

    Is that what you say happens after we stop paying interest on reserves? The banks finally have to unwind commercial and residential paper and eat losses?

    If so why?

    I’m just trying to distill your working concepts down into bite sized morsels someone like me can grok.

  5. Gravatar of RobbL RobbL
    31. May 2010 at 13:51

    Okay, I’ll bite. How is there low interest rates and tight money? Isn’t that the equivalent of a car dealer who advertises low prices and then refuses to sell you a car? Why would he or she do that?

    If a bank thinks that it is lending too much money or only getting deadbeats coming in to get loans, why don’t they raise their interest rates? Why would they advertise 5% mortgages and then not approve anyone? This is giving me a headache.

  6. Gravatar of marcus nunes marcus nunes
    31. May 2010 at 16:00

    Hiding behind the wall of “The Mandate” – no matter that with inflation BELOW target he´s failling.
    http://www.nytimes.com/2010/05/31/business/global/31deflation.html?pagewanted=1&partner=rss&emc=rss

  7. Gravatar of Mark A. Sadowski Mark A. Sadowski
    31. May 2010 at 16:41

    Tyler Cowen is quoted as saying:
    “That all said, the countercyclical monetary policy won’t drive recovery either, or set the world right again, it just limits the damage.”

    Gosh that’s so upside down it needs to be rephrased as:

    “That all said, a countercyclical neoliberal policy won’t drive recovery either, or set the world right again, it just limits the damage.”

    Particularily when one considers the case of Greece and the Baltic states.

  8. Gravatar of Lord Lord
    31. May 2010 at 18:21

    I do wonder how much this was a financial recession and how much an energy recession. With oil such a broadly used energy source and so difficult to substitute away from, it may represent the loss in productive capacity and why a faster recovery can’t be tolerated, or at least, believed to be such. It remains high but substitutes are often higher still and while conservation is probably a growing area of the economy, it is probably not enough to make up for the loss due to higher energy costs. This may be more a supply shock than demand shock in the end, and not that the people can’t be employed but the energy they need to produce can’t be afforded.

  9. Gravatar of StatsGuy StatsGuy
    31. May 2010 at 18:22

    TC:

    “That all said, the countercyclical monetary policy won’t drive recovery either, or set the world right again, it just limits the damage.”

    Like Mark, I too will try to rephrase this – as this blog has observed in the past, an NGDP regime can hit any nominal target; the question is what portion of growth is real vs. inflation. Now look a the next line from Tyler:

    “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.”

    I’ve made this argument in the past, but TC frames it slightly differently. Essentially, he’s arguing the problem is not so much demand, but rather failure to close the savings/investment gap due to uncertainty about _future_ demand, and hence the real problem is future supply. This is slightly different than a pure demand side story, but framing it this way suggests a question – are there additional ways to help resolve future uncertainty and or to close the investment gap? (are they synergistic, at some level?)

    The fiscal method, debt, creates even more uncertainty about future demand – because the debt must be paid back (or inflated away). Que all the Austrian arguments here.

    However, Krugman has made one very excellent point in the past – to the extent that interest rates are “low” on US debt, this is a signal that the government should be using those low rates to make investments if it can manage to find decent investments (not, say, extending unemployment benefits yet again). But in doing so, they shouldn’t be worrying about the multiplier – they should be worrying about good investments (e.g. not “clean” coal).

    Alternatively, the government may not want to increase demand – perhaps they want to decrease national consumption to hit some sort of sustainable target (I doubt this; Obama is not the Green party). But if that were the case, deflation is a lousy possible mechanism. Better a consumption tax and aggressive labor laws, otherwise debt overhangs and future uncertainty will ensure that the increase in leisure hits the population very unevenly.

  10. Gravatar of StatsGuy StatsGuy
    31. May 2010 at 18:23

    Aside: Have you ever noticed that your blog’s initials are TMI?

  11. Gravatar of Philo Philo
    31. May 2010 at 18:30

    Causation is tricky. You write: “I say the recession was caused by tight money. Most economists say it was caused by financial distress . . . .” These views can both be correct. Vary monetary policy while holding everything else constant: you get recession with tight money (actual), no recession with easy money. Therefore, tight money caused the recession. But vary the occurrence of a financial crisis while holding everything else fixed: you get recession with a crisis (actual), no recession without one. Therefore, the financial crisis caused the recession.

  12. Gravatar of Mike Sandifer Mike Sandifer
    31. May 2010 at 19:21

    I have two observations.

    1. Based on charts I’ve seen going back several decades, there is a rapid fall in nGDP just months before a recession. Just to be explicit, does this mean that all of these recessions could have been avoided, or at least shouldn’t have been as severe as they were? The Fed keeps making the same mistake?

    2.) Isn’t the complexity of stimulus packages another problem for transmission through market expectations? I’m guessing it was harder to predict the effects of the Obama stimulus than a monetary expansion.

  13. Gravatar of Greg Ransom Greg Ransom
    31. May 2010 at 21:57

    Values in massive sums were discoordinated thru housing, CDO instruments, CDS instruments, etc. — the disco ordination could only be continued with ever accelerating money expansion. There was massive over leverage by people who would never cover their bets.

    The idea that massive deleveraging and massive default was optional — and that somehow all of these rotten to the core “bets” were sound and everyone was going to pay their bills if only the Greenspan Put was every accelerated is crazy talk.

    Not even hyperinflation could sustain the rotten housing/CDO/CDS regime with its massive unsustainable discoordinations — and underlying insolvencies.

    In light of the fact of massive discoordination and insolvency and fake near money derived from rot-ridden promises to pay, it is mere assertion without plausibility or evidence to say this:
    “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.)”

  14. Gravatar of Richard H. Serlin Richard H. Serlin
    31. May 2010 at 22:58

    “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.”

    Here’s where there’s a problem.

    Knowing something is best for the economy and country and getting it enacted with 41 Republicans in the Senate armed with a filibuster (one where any morays about using it are completely gone) is a another thing.

    Plus, you have the public which understands little of the economics, but intuitively feels that deficits are dangerous and irresponsible and that short run deficit spending to end a severe recession is very different than long run and regular deficit spending. To most of the public arguments that Republicnas make like a family tightens its belt during hard times seem sensible. They just don’t have the economics training to understand that an economy of families, businesses, etc. is in many ways very different than one single familiy.

  15. Gravatar of Richard H. Serlin Richard H. Serlin
    31. May 2010 at 23:05

    Then there’s Bernanke. He may understand very well that there should be greater monetary stimulus, but he needs, for this and all future issues, the cooperation of a majority of the members of the FOMC who all have equal votes. And some of those members — who decide monetary policy — I kid you not don’t even have bachelor’s degrees in economics.

    This is because members of the FOMC are not chosen separately for the FOMC, and thus chosen for their specialized understanding of monetary policy. Instead, they come from other bodies, where they must do things like decide on banking law and regulation, so they may be expert in law or running a bank, but not even have a bachelors degree in economics.

  16. Gravatar of Richard H. Serlin Richard H. Serlin
    31. May 2010 at 23:17

    “If it was really this easy, why wouldn’t we have already taken the necessary steps?”

    A crucial thing in economics that’s so often assumed away: Information, understanding, is often so far from perfect. What micro percentage of the voting public is expert in this area of economics so that they would pressure politicians to do the right thing rather than what would make things worse?

    How many members of the nine currently on the FOMC don’t even have bachelors degrees in economics — two. How many others have little and/or outdated understanding, and just to them the idea of zero inflation really seems to make sense.

    Look at the qualifications and records of the people who decide this, the members of the FOMC, and any traditions of not wanting to do anything unless there is a strong majority, and then you may really see why the FOMC is acting like it’s acting, rather than assuming all members must be rational and perfectly informed and super expert, and have some great reason.

  17. Gravatar of Richard H. Serlin Richard H. Serlin
    31. May 2010 at 23:27

    Please note that while Krugman thinks that fiscal policy can be very effective, especially a lot of it, he does also think monetary policy can be effective. Here’s what he said just a few days ago:

    …while I dearly wish the Fed would try harder, it’s not all that easy, because just pushing out money doesn’t do anything. You either have to buy lots of long-term assets — we’re talking multiple trillions here — or credibly commit not just the current FOMC, but future FOMCs, to pursuing higher inflation targets.

    at: http://krugman.blogs.nytimes.com/2010/05/25/inflation-deflation-japan/

    Krugman is not at all against strong monetary policy. He just isn’t that confident that the votes on the FOMC are there for it, and so far they aren’t, so that would just leave fiscal policy.

  18. Gravatar of Alex F. Alex F.
    1. June 2010 at 00:48

    “Here’s where there’s a problem.

    Knowing something is best for the economy and country and getting it enacted with 41 Republicans in the Senate armed with a filibuster (one where any morays about using it are completely gone) is a another thing.

    Plus, you have the public which understands little of the economics, but intuitively feels that deficits are dangerous and irresponsible and that short run deficit spending to end a severe recession is very different than long run and regular deficit spending.”

    I don’t buy this. The bailout was just as complicated and unpopular. They pushed it through. But when it comes to do something against unemployment, the senate is suddenly incompetend and the American public just won’t accept it??? The whole “they just don’t get it”-explanation is so unplausible. This can’t be just a mistake.

    Another question: wouldn’t negative interest rates on reserves force banks to realize their losses? Isn’t the whole negative interest idea a way to force people to lend even if they don’t have any real rate of return?

  19. Gravatar of Alex F. Alex F.
    1. June 2010 at 01:22

    By the way, when it comes to the asymmetry a lot of people see between positive and negative interest rates, there is a nice rhyme in “Sylvie and Bruno” by Lewis Carroll:

    A man may surely claim his dues:
    But, when there`s money to be lent,
    A man must be allowed to choose
    Such times as are convenient!`

  20. Gravatar of scott sumner scott sumner
    1. June 2010 at 05:33

    Alex F, That’s mostly what my blog is about. I’ve discussed lots of factors; the Puritan instinct (we must be punished for our sins), misidentifying the stance of monetary policy (thinking low interest rates and a big monetary base mean easy money), and thinking monetary policy is powerless at zero rates, etc, etc.

    Mogan, Stopping IOR by itself probably isn’t enough. You also need a higher target. If you do those things, then asset prices won’t have to fall as much. The “true value” of assets is completely contingent on monetary policy.

    I’ll keep your suggestions in mind and try to be more accessible.

    RobbL, You asked:

    “Okay, I’ll bite. How is there low interest rates and tight money?”

    Tight money causes deflation, deflation drives interest rates to zero. Interest rates are highest when monetary policy is at its most expansionary (during hyperflation.) That’s the short answer, there is much more to be said.

    Thanks marcus, I was thinking of commenting on that–I still might.

    Mark, Yes, no one policy can solve all our problems.

    Lord, Certainly energy prices could not have caused a world recession, as prices were rising on increased demand for energy in a growing world economy, and have been falling since mid 2008 on less demand associated with a weak world economy. If you told me oil would be over $100 by this summer, I’d immediately become much more optimistic on the economy. Energy prices can cause recessions when driven by shocks to the supply of energy (i.e. 1974) but that didn’t happen this time–it was energy demand that drove prices.

    Statsguy, You said;

    “I’ve made this argument in the past, but TC frames it slightly differently. Essentially, he’s arguing the problem is not so much demand, but rather failure to close the savings/investment gap due to uncertainty about _future_ demand, and hence the real problem is future supply. This is slightly different than a pure demand side story, but framing it this way suggests a question – are there additional ways to help resolve future uncertainty and or to close the investment gap? (are they synergistic, at some level?)”

    I’m having trouble following this. I want to use the AS/AD model in Tyler’s textbook, and he seems to want to use another model that I don’t understand. I believe he is saying that even if we get 5% NGDP growth, unemployment will stay pretty high. If not, then we have no disagreement. If he is saying that, I consider that problem AS related, regardless of whether it is caused by S/I imbalances or one of a million other real problems.

    I agree with the later part of your comment on deflation being a bad way to address the sort of real policy goals that Obama might have (such as conservation.)

    Is TMI significant in some way?

    Philo, I agree, but I think monetary policy is a much more useful way of thinking of causation in that case. I plan a future post to discuss this issue, but the example I think of is what if Colombian drug dealers demanded more dollars, and the Fed didn’t increase the monetary base. The US-located base would decline, interest rates would rise, and we’d go into a recession. It would have been really easy to increase the base in response to their demand, and in the past the Fed would have done that. In that case would you blame the recession on the drug dealers or the Fed? You know where I stand.

    Mike, I agree with your second point. The problem with your first observation is that this indicator would also give off false signals.

    Greg, You said;

    “Values in massive sums were discoordinated thru housing, CDO instruments, CDS instruments, etc. — the disco ordination could only be continued with ever accelerating money expansion. There was massive over leverage by people who would never cover their bets.”

    I completely agree, and have often said that the Fed was right in not continuing to prop up that house of cards after mid-2007. Between mid-2007 and mid-2008 housing prices fell and banks took losses. That was all very appropriate. But then they went too far, and allowed NGDP to fall after mid-2008. That caused even sound businesses and sound loans to go belly up. They should have kept NGDP growing at 5% forever. We would have occasional mild recalculation periods like 2007-08, but not severe recessions like 2008-09.

    Richard, Those are all very good points. Just because a policy hasn’t been adopted, doesn’t mean it’s a bad policy. We know the experts made mistakes in the 1930s and 1960s, why couldn’t they be making mistakes today. And yes, there are all sorts of problems in getting things done, even if you know what should be done.

    Alex, No, the negative IOR is not a way to force lending, the goal is to reduce bank hoarding of money–getting it out circulating in the economy. I don’t care whether they lend or park the money in T-bills. (And yes people, I know that is also technically lending, but not what Alex had in mind.)

    Thanks for the poem.

  21. Gravatar of Morgan Warstler Morgan Warstler
    1. June 2010 at 06:56

    Scott,

    Ok I’m still not understanding… why is it a good thing for asset prices no to have to fall as much? You have some kind of love mis-priced assets?

    Its just a giant leap you made. My goal for monetary policy is higher cost of credit, banks not having many good ways of making money trading, a move towards what I’ll call virtual, mutual, local banking. I’d really like to see FDIC banks be forced to actually HOLD the loans they write.

    Maybe this is a tad micro, but I’d much prefer to keep the currency stable (yes I know, no inflation…yet) and just force those people and banks overextended into bankruptcy and let the cash holders get deals of a lifetime.

    There’s nothing wrong with a nation of renters. In fact, renters are far more mobile, and it teaches us a good lesson in a wired age. MOVE WITH YOUR FEET where the state taxes are lowest based on property not income, regulations are fewest, and in general people root for the University of Texas.

    Whats the real downside here?

  22. Gravatar of Philo Philo
    1. June 2010 at 08:22

    In the scenario you described, you asked: “would you blame the recession on the drug dealers or the Fed?” Well, I was talking about *causation*; you have shifted the topic to *blame*. The drug dealers and the Fed would be comparable *causal factors* in the recession, but, because of its responsibility for the overall condition of the economy, only the Fed would be *to blame* for it.

  23. Gravatar of StatsGuy StatsGuy
    1. June 2010 at 10:25

    Regarding this from TC:

    “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 to admit, I reread this several times trying to puzzle apart the argument, and could be interpreting it through my own lens. So here is more elaboration on my guess:

    In the presence of (excess) uncertainty and risk aversion, investment is suboptimal (with optimal being relative to the ideal situation without excess risk – whatever ‘excess’ means in this context). The excess, presumably, is due to future demand instability resulting from uncertainty over future monetary policy. This reduces future supply. This is all intuitive – but I’m not sure I see how a reduction in expected future supply reduces expected future demand.

    My general understanding is this holds in the long term, but in the short/medium term supply-equals-demand is required under circumstances of monetary loop closure (that is, _trajectory_ targeting monetary policy). Otherwise it might happen, or might not, depending on the alignment of demand, property rights over supply, and whether the capital structure matches the needs of those with the property rights (or has been “malinvested”), wage flexibility, etc. If I’m missing something, I’d appreciate the pointer.

    In the absence of a trajectory-targeting monetary policy, the risk of investment is “overcapacity” and yet more price deflation. However, there’s a sharp implication here that someone like TC would not appreciate. In the presence of overcapacity, NGDP targeting guarantees demand by effectively redistributing property rights through the price mechanism. This is why gold standard purists hate fiat money – it means that an obligation, unused, decays in value, and it’s this threat which sustains aggregate demand.

    An NGDP target is like telling capitalists: “use it or lose it”.

    Accepting NGDP targeting is like agreeing that – in the long term – gold-standard capitalism accumulates property rights in a manner that is perverse and self-destructive.

    AKA, but for good monetary policy, Karl Max wins.

  24. Gravatar of Lord Lord
    1. June 2010 at 12:27

    If oil was over $100 this summer, it would be over $200 by next spring and we would be back in recession again next year. When oil increases gradually it won’t create a recession, but when it doubles in short order it can and that can be from supply inadequacy as much as disruption. If it can be supported at 3% of the economy, it can’t necessarily be supported at 6%. However much oil is anticipated to rise, it can always rise double that to clear the market, and sufficient amounts of the economy

  25. Gravatar of Lord Lord
    1. June 2010 at 12:29

    must be idled as they become unprofitable.

  26. Gravatar of General glut – Economics - General glut - Economics -
    1. June 2010 at 13:21

    [...] Dorman argued that policymaker incentives aren't so clear. Nick Rowe also responded. As did Scott Sumner. Others have chimed in. The discussion continues.There are a couple of issues lurking within the [...]

  27. Gravatar of David R. Henderson David R. Henderson
    1. June 2010 at 18:54

    Arnold,
    Good post. The joke is that TMI means “too much information.” It’s what you say to someone who, for example, tells you lots of details about his digestive system.
    Best,
    David

  28. Gravatar of scott sumner scott sumner
    2. June 2010 at 04:46

    Morgan, You ask;

    “Ok I’m still not understanding… why is it a good thing for asset prices no to have to fall as much? You have some kind of love mis-priced assets?”

    You are confusing nominal and real asset prices. Of course I want asset prices to achieve their equilibrium levels in real terms. I favor a free market. What I don’t support is a monetary policy that needlessly reduces their nominal values.
    If the money supply fell in half, and all wages and prices fell in half, we might be at equilibrium. But nobody would have enough income to pay off their nominal debts, which would not have fallen at all. I want NGDP to grow about 5% a year, and let all asset prices find their equilibrium w/o government interference and bailouts.

    I agree with you on renters, and I’d hope my easy money policy raised interest rates. Zero rates are a sign of failure, in every economy where they have been tried.

    Philo, I am fine with that. Either the financial crisis or the Fed could be said to have caused the crisis, but the Fed is to blame.

    statsguy, Some of your later observations violate the superneutrality of money a bit more than I am comfortable with. That is, changes in the trend rate of inflation should have no real effects.

    My sense is that there are two issues regrading Tyler Cowen. One is his view of the likely real problems that would still occur if NGDP grew at 5%. I think they are much smaller than he does. The other is language—I call any real effect under the assumption of 5% NGDP growth a “supply shock” or change in aggregate supply, even if it intuitively seems demand-related. He (and others) use terms like “real AD” that just leave me scratching my head.

    Lord, No, oil prices follow close to a random walk–they aren’t predictable that way.

    David, Thanks, but don’t you mean “Scott”. Don’t let Arnold know that you confuse him with me! :)

  29. Gravatar of If World War III happens due to the recent North Korea missile tests, how will Britain be affected? If World War III happens due to the recent North Korea missile tests, how will Britain be affected?
    2. June 2010 at 05:45

    [...] TheMoneyIllusion » Is it all just a terrible mistake? [...]

  30. Gravatar of StatsGuy StatsGuy
    2. June 2010 at 06:16

    ssumner:

    “statsguy, Some of your later observations violate the superneutrality of money a bit more than I am comfortable with.”

    True, which is why I’m surprised to see Tyler Cowen leaving open room for this type of argument. (I’m still confused.)

    I think, however, while superneutrality may or may not hold for any given trajectory of money, I think TC’s argument is not about the level so much as the volatility of the monetary trajectory. Chronic volatility creatures chronic AD risk, which perhaps (???) can lead to chronic underinvestment, which could affect long term growth. That’s separate from the menu cost argument.

    The problem is that the current trajectory (disinflation) is thought to be not sustainable due to sovereign debt issues, implying that the trajectory will need to change sharply at some indeterminate future point.

  31. Gravatar of Morgan Warstler Morgan Warstler
    2. June 2010 at 07:21

    Scott,

    “I want NGDP to grow about 5% a year”

    Does this mean you want government bonds to pay 5% on a 1yr bond? Is it that straight forward?

    Thanks for taking the time.

  32. Gravatar of Paulie Carbone Paulie Carbone
    2. June 2010 at 10:12

    Does this mean you want government bonds to pay 5% on a 1yr bond? Is it that straight forward?

    What up Morgan? The answer is no.

  33. Gravatar of Mark A. Sadowski Mark A. Sadowski
    2. June 2010 at 16:31

    I always thought TMI stood for Three Mile Island. ;)

  34. Gravatar of Lorenzo from Oz Lorenzo from Oz
    2. June 2010 at 21:04

    Statement A: This is why I love monetary economics. It is incredibly counter-intuitive.

    Statement B: 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.

    Conclusion: in times of stress, economists go with the intuitive narrative.

  35. Gravatar of scott sumner scott sumner
    3. June 2010 at 10:27

    Statsguy, That’s a good point about how higher volatility reduces investment. And the uncertainty surrounding government debt also may be reducing investment.

    Morgan, No, I don’t want to peg interest rates. However, there is some correlation between NGDP growth and nominal rates, although it also depnds on the level of NGDP relative to trend. So when NGDP is well below trend, then it can rise 5% w/o driving up nominal interest rates very much. But when we are at trend, then nominal interest rates tend to be fairly close to NGDP growth.

    Paulie. That’s right.

    Mark, I thought so too.

    Lorenzo–Good observation.

  36. Gravatar of Morgan Warstler Morgan Warstler
    3. June 2010 at 20:49

    OK, so I’m reading you right, you don’t like to say “peg” but ultimately the main lever you’ll pull, based on trend, is short term rates.

    I want to make sure I’m getting this, so far I have:

    1. Sumner wants to stop paying interest on reserves.
    2. Sumner wants to set short term rates as the main lever for targeting NGDP at 5% relative to trend.

    These are so far my clearest taken MI policy prescriptions.

    So far so good, right?

  37. Gravatar of ssumner ssumner
    4. June 2010 at 06:01

    Morgan, Read my post:

    http://www.themoneyillusion.com/?p=1184

    That’s my ideal, and if it doesn’t involve interest rate targets. I prefer NGDP targeting. And I think once rates hit zero they should adjust the monetary base until NGDP expectations are on target.

  38. Gravatar of Philo Philo
    4. June 2010 at 09:29

    I wonder if Tyler Cowen doesn’t find your answer somewhat lacking in content. You point out that “the vast majority of mainstream economists were wrong at the time [the 1930s;] . . . they underestimated the role of money in driving NGDP shocks.” You assert that most mainstream economists are now making the same mistake. But Cowen was asking: Why? Your “explanation” is that “monetary economics . . . is incredibly counter-intuitive.” This is saying hardly more than that it is easy for people doing it to get it wrong.

    Maybe you should admit that you have no simple answer to the question why most economists and near-economists (economic journalists, etc.) are getting it wrong. I’m not sure why Cowen thinks you should be embarrassed to admit this.

  39. Gravatar of Morgan Warstler Morgan Warstler
    4. June 2010 at 10:27

    Scott, thx, but again that’s the most complicated explanation in the frigging world.

    This was far more helpful: http://www.themoneyillusion.com/?p=3862

    This actually gets to the heart of what I consider to be real questions in your thinking.

    This is my oddball belief: Underlying most of what ails us in our economy is the failure of “Government Productivity,” indeed they even stopped measuring it at all at the Federal level in mid 90′s. Cancelled because of budget concerns… can you believe that shit?

    But basically they never ran past 1% from the 70′s on. Meanwhile, many sectors of our economy routinely saw productivity gains of 3-5% annually without batting an eye.

    Note: If we had cuts in Public Employee compensation of 40% at the Federal, State, and Local level through meaningful workforce reduction – web based automation, policies based on online self-service, simplicity as a rule over complexity (tax code, regulations, etc) we’d be saving more than $500B per year…. minus the say $100B going to technology / web companies for running GOV2.0, say $400B.

    And if we had that as our policy over the past ten years growing towards this moment, we’d be facing a much different economy today.

    But you throw in the towel, kind of accept the cancer as untreatable (see your post), and say NGDP will be 5% with a whole slew of Fed moves I haven’t begun to understand.

    And I think it is precisely driven by your unwillingness to confront Public Employees and apply the same brutal standards of productivity gains to them that we CHEER FOR in private sector.

    We don’t have to pay PE less money (some though), we need to cut their headcounts and capitalization costs immensely. Say 4-5% a year over next 10 years.

    We could gut the Social Security Administration with web based systems and still make sure every citizen got their funds deposited. That’s doable across government. particularly in Education. All that is mostly untouchable is Protective Services (fuck Prison guards though) – where manpower/force in and of itself is needed.

    The economic growth that would come from letting technology companies automate/privatize basic government functions would be stunning. See gains of past ten years.

    At issue is that Private Sector productivity gains must be matched by Public Sector gains. I think this should be your mantra.

    Krugman loves inflation because he fundamentally is ok with undermining the stored wealth of the rich.

    I think the way to nail Krugman then is to hammer on Government Productivity, because fundamentally he should have no problem securing the cause of government by trading on the method of government.

    It seems like your NGDP target specifically alleviates the good crisis work we see working in places like NJ.

  40. Gravatar of scott sumner scott sumner
    5. June 2010 at 09:48

    Philo, I think it is a valid argument, given that most modern economists now think the 1930s consensus was wrong. If the modern economists had the same view of the 1930s today, that they had back then, then I wouldn’t have an argument at all. But when economists continually underrate the importance of monetary policy at the time (1930s, 1960s, etc) and then continual revise their views in the way I want them to do today, I think that is meaningful information.

    Morgan, You completely misunderstand me. I also want to slim down and reform the public sector. But that won’t solve the problem of recession. Wanting to do one thing doesn’t preclude another action somewhere else. In 1929 having a small government didn’t prevent the Great Depression.

  41. Gravatar of Morgan Warstler Morgan Warstler
    5. June 2010 at 12:04

    Whoa. Why do we want to solve the problem of recession?

    There’s supposed to be a business cycle, where the bold sometimes win, and the bold sometimes lose, and the timid swoop in and buy up distressed assets.

    In my mind, if the banks had to sell off equity in themselves to stay afloat (i.e no cheap reserves to borrow), prices would have plummeted to their true level.

    At which point the economy would have started growing again immediately…. “look at all these kick ass deals to be had!”

    Let’s assume that 10% of homeowners would have become renters inside of one years time. Basically everyone who shouldn’t have gotten a house, loses theirs.

    Why do you assume this causes a downward spiral? Why don’t you simply shrug off the mass housing valuation loss we’d all feel, and trust it’ll soon bounce back up to something slightly less painful to think about. Why not RIP OFF the band-aid?

    We’ve been through this in the dotcom bomb, so it isn’t unprecedented. It effected millions of people with wildly different rags to riches to rags stories.

    No biggie. Why do you care about a bunch of house flippers ending up with a loss on their books?

    ——

    I’m going back to my Government Productivity thing for a second here. We’re talking MANY HUNDREDS OF BILLIONS in annual savings – suddenly the entire Debt2GDP changes.

    And there’s another MASSIVE dot com like boom – that’s sustainable. We’re talking about technology companies making 3x what they make on advertising, and still being 80% cheaper than Public Employees.

    Again, it seems timidity is you approach.

    Can you explain to me why?

  42. Gravatar of ssumner ssumner
    6. June 2010 at 11:58

    Morgan, Your view was very popular in the 1920s, but the Great Depression completely discredited that view. Suddenly people who talked cavalierly about how millions of workers needed to lose their jobs to preserve the precious “business cycle” didn’t seem so persuasive. I guess the Great Depression happened so long ago that that cavalier attitude is coming back. I am much more concerned about putting 8 million people back to work than I am about creating cycles in the economy.

    You seem to think the government has been propping up the economy recently, whereas since 2008 they have driven it lower with tight money. How has that helped?

  43. Gravatar of Morgan Warstler Morgan Warstler
    6. June 2010 at 17:20

    I keep saying this and you skip right over it:

    There is not such thing as tight money if the price is right.

    This is not cavalier – this is the only rational response. Banks are not lending ON PRICE, if you drag in a deal that’s priced 40% below what lenders of all stripes are seeing elsewhere apples to apples – you will find money. You will find MULTIPLE lenders.

    Dude, find the guys with cash who do real estate development, and talk to them, they aren’t “sitting on the sidelines” – they actually are out hustling for deals, but the prices they have in mind, the banks holding the paper they aren’t meeting them.

    Look, this is the PROMISE of our system to an entire class of investors – buy low. You haven to accept this part of it too.

    Prices are still too high. Stop pushing the string and lets some people really lose. Right now we have banks foreclosing and people not even moving out.

    Mark to market. And overnight, you’ll see action like crazy. You’ll see jobs created.

    You still haven’t listed a downside here.

    And if at the end of it all comes down to “excess capacity” you aren’t any different than Krugman.

  44. Gravatar of Doc Merlin Doc Merlin
    6. June 2010 at 18:25

    @ Morgan Warstler
    That won’t happen, because of the way our banking legal structure is. In our world because of legal absurdities, a bank that actually marks their assets properly will be closed and sold by the FDIC, as being “undercapitalized.” It isn’t really undercapitalized, it isn’t as if it is being unable to pay its depositors… it just doesn’t meet the legal requirements to operate as a bank.

    In truth this entire crash wasn’t a real crash, but a crash caused by legal absurdities such as these (and some that are worse).

  45. Gravatar of Morgan Warstler Morgan Warstler
    6. June 2010 at 20:12

    @Doc

    Well yeah. But that’s not how Scott sells it. He ACTS LIKE his policy is actually the best one, when in fact we’re dealing with a distant also ran.

    The over-riding win here is… when you are going to fuck with the market, subsidize, regulate etc:

    1. do it in the most direct way possible. try to limit fall out directly.
    2. do not rule make on top of rules.
    3. set the rule, and keep it the same, breed confidence in tomorrow.

    And what we have is actually a aberration caused by FDIC. It operates as essentially free marketing for banks. It lets us not think critically – which is the policy goal – you don’t have to pay attention and you still can’t lose your money.

    Ok, so banks now have piles of money to lend. To me the clear policy is do not allow FDIC banks to sell off loans they write. Make FDIC banks play the long boring game.

    Again, a KISS rule. We’re going to have FDIC, so limit it’s effects directly.

    All of a sudden, we don’t have a CDO, CDS nightmare on our hands.

    What’s the downside?

    A higher cost of credit? Who the cares about that? Besides, the whole reason for selling loans was to try and offset Bricks and Mortar costs in old fashioned banking.

    We’re virtual these days, banks no longer need B&M overhead – that means what they lose in loan churn, they make up for in much lower capitalization costs.

    So suddenly small local mutual virtual banks break out in every small town. We’re talking bankers working out of their home. Never touching cash. All FDIC.

    We cannot refuse to think clearly because past actions have been cloudy.

    We are better. We are younger, smarter, and better networked than all the past cavemen who fucked shit up before.

    Think big.

  46. Gravatar of ssumner ssumner
    7. June 2010 at 08:33

    Morgan, Yes, on excess capacity I am similar to Krugman. I think we have some. Except I don’t favor targeting that variable, or even trying to estimate it.

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