Consider the following from Raghu Rajan:
As the United States comes to see the political limits of continuing fiscal expansion, with even some Democratic senators taking fright at the barrels of red ink leaking out into the distant future, monetary policy seems to be the primary method through which stimulus will be delivered to the U.S. economy. Indeed, a paper from a respected macroeconomist at the San Francisco Federal Reserve suggests that if the Fed desired to deliver “ future monetary stimulus consistent with the past — and ignoring the zero lower bound — the funds rate would be negative until late 2012.” He continues that “this suggests little need to raise the funds rate target above its zero lower bound anytime soon.”
Of course, some who are convinced that the Fed contributed to the recent crisis by keeping real interest rates negative too long in the period 2002 to 2004 would wonder if stimulus “consistent with the past” is appropriate. Has the Fed, like the Bourbons, learnt nothing and forgotten nothing?
Perhaps more worrisome is the view that the main problem is aggregate demand is too low. In response to ultra-low interest rates, the thinking goes, households will cut back on savings while firms will invest more, demand will revive, and the workers who have been laid off will be rehired.
But this recession is not a “usual” recession. It followed a period of ultra-low interest rates when interest sensitive segments of the economy got a tremendous boost. The United States had far too much productive capacity devoted to durable goods and houses, because consumers could obtain financing for them easily. With households recovering slowly from the overhang of debt resulting from the binge, and with lenders extremely risk averse, it is unrealistic to expect households to spend beyond their means again, and unwise to try to tempt them to do so.
If households are going to want fewer houses, industries such as construction will have to shrink (as should the financial sector that channeled the easy credit). A significant number of jobs will disappear permanently, and workers who know how to build houses or to sell them will have to learn new skills if they can.
I can’t tell you how maddening it is to read this sort of thing. Let’s start with the San Francisco Fed. As Milton Friedman pointed out back in 1998, persistently low interest rates are evidence of tight money, not an indication of monetary ease. The reason is simple; monetary policy cannot be defined solely by a path of interest rates. Any given interest rate path will leave the price level indeterminate. This isn’t just my theory, or Friedman’s theory, but a generally accepted part of modern monetary economics. Now of course the SF Fed knows all this, and they would presumably argue that they are using some sort of Taylor Rule to tie down the price level, and then forecasting future instrument settings based on forecasts of the likely path of prices and RGDP over the next few years. But here is what drives me crazy. They are forecasting monetary policy failure, and then describing the interest rate path that would be appropriate if monetary policy indeed fails, just as people expect it to do. And then they are saying that that is the appropriate monetary policy. How does that make any sense?
Rajan responds to the SF Fed by arguing that Fed policy during 2002 to 2004 blew up the housing bubble. But how? He doesn’t say, but I can’t make any sense out of his assertion unless I assume that he believes low interest rates imply easy money. But if low interest rates mean easy money, then why would housing prices in Japan have fallen for about 20 years in a row, whereas housing prices in America soared in the 1960s and 1970s?
Let’s say Milton Friedman and I are wrong, and low interest rates really are easy money. I still don’t get why easy money would cause banks to make all sorts of loans that would never be repaid, and then buy lots of MBSs which were about to implode in value. Why would it be rational for banks to do that? Is there some sort of model taught at the Chicago business school that explains the connection? I do know that Rajan was one of the very few people in the world who warned of trouble ahead for the financial system during the housing bubble. So he deserves lots of credit for that prediction. But I honestly don’t see how easy money could cause the American banking system to collapse, even if money was easy (which of course it wasn’t in 2002.)
Suppose I am wrong and money was easy. And suppose I am wrong that easy money did blow up the housing bubble. I still have no idea why he doesn’t think we need more aggregate demand right now. The job losses in construction that he mentions have little to do with the severe recession that hit the US in August 2008. Most of the housing construction jobs were lost long before that, and had little effect on the US unemployment rate. Our current high unemployment has little or nothing to do with labor being allocated to the wrong industry. Labor was reallocating nicely out of construction from mid-2006 to mid-2008, with only a trivial impact on the unemployment rate. What happened then?
But even if I am wrong about all of those things, I still don’t see his argument. He is essentially making a sort of Hayekian or Austrian argument about the recession. But Hayek favored NGDP targeting. Hayek pointed out (correctly in my view) that any reallocation would occur much more smoothly if NGDP was stable. Instead, NGDP fell much more sharply than inflation, almost 8% relative to trend between mid-2008 and mid-2009. So even if you buy Rajan’s entire argument, we still need more AD.
And here is the oddest thing of all. Right after he argued that monetary stimulus is a bad idea because we don’t want any more AD, he says we need some fiscal stimulus because we need more AD:
Even while I think monetary policy is too a blunt tool, there may well be some role for fiscal policy. There is a humanitarian need to extend benefits to the unemployed. These are often the same people who have not benefited from the growth over the last few decades (the unemployment rate for the highly educated or skilled is much lower than for the poorly educated or unskilled), who have bought houses they cannot afford, and who are drowning in debt. Moreover, while I do think we have to reorient the nature of goods produced in the economy, we also do have weak aggregate demand. Unemployment benefits are likely to be spent and contribute to demand.
I’ve recently been obsessing over everyone talking about fiscal stimulus and ignoring monetary stimulus. But this is even more perplexing. Rajan thinks we need more stimulus, but he is opposed to using the most efficient tool possible–the one that doesn’t increase the budget deficit.
Here is the basic problem. Rajan’s analysis is discretion at its worst. Rajan is looking out the window and noticing that there are unemployed construction workers, and then assuming that demand stimulus would not help them get jobs in other industries. How can he know that? Introspection? Without some sort of nominal rule, some aggregate that we can use as a guide to policy, we are completely flying blind. We are back to the interwar Federal Reserve. And Rajan gives no hint as to how we could know when the economy has too much AD. None. Just his intuition. Well my intuition says we need more AD, and so does every single policy rule I have ever seen (inflation targets, Taylor rules, price level targets, NGDP targets, etc.)
HT: Tyler Cowen