No need to plug that knife wound, you’ve got pneumonia

If there is one thing almost every macro book agrees on, is that a large, sudden, and unexpected drop in nominal expenditure relative to trend is a really, really bad thing.   Aggregate demand shocks destabilize the economy, and lead to needless unemployment.  I don’t know about you, but I don’t recall reading; “Severe AD shocks are really, really bad, except when the economy is also suffering from some other structural problem.  Then they’re just dandy!”

As an analogy, suppose you had pneumonia, and then someone stabbed you in the gut.  You show up at the hospital, and the doctor says “there’s no need to patch up that knife wound, your real problem is pneumonia.”  I think you’d look for another doctor.  A severe AD shock causes lots of unemployment; that’s true whether you start from full employment, or whether you already have lots of unemployment from structural problems.

So when economists react to the sharpest fall in NGDP since 1938 by announcing that the economy really needs tighter money, I’m inclined to react as if a doctor ordered leeches for someone already bleeding from a knife wound.  I’m going to look for another economist.  In fairness, many proponents of structural causes of the recession do understand this point.  Tyler Cowen favors monetary stimulus, even though he thinks much of the problem is structural.  Even Arnold Kling thinks it’s worth a shot.

I was reminded of all this by a recent debate between Raghu Rajan and Paul Krugman.  Rajan has said elsewhere that we need tighter money.  Krugman strongly disagrees.  Here’s part of Rajan’s response to Krugman:

First, Krugman starts with a diatribe on why so many economists are “asking how we got into this mess rather than telling us how to get out of it.”  Krugman apparently believes that his standard response of more stimulus applies regardless of the reasons why we are in the economic downturn. Yet it is precisely because I think the policy response to the last crisis contributed to getting us into this one that it is worthwhile examining how we got into this mess, and to resist the unreflective policies that Krugman advocates.

I believe both Krugman and Rajan are wrong.  Rajan thinks the real problem is structural, and that more monetary stimulus might just blow up another housing bubble.  You already know what I think of that argument, so I’d like to focus on Krugman’s response.  Krugman rightly argues that we need much more AD and then suggests that it doesn’t matter why AD fell, we have the tools to boost it now.  I agree we need more AD, but I also think it does matter how we got here.

Both Rajan and Krugman believe the severe fall in NGDP in late 2008 was caused by the financial crisis.  Rajan thinks that means our dysfunctional financial system is the real problem, whereas Krugman thinks the current low level of AD is now the real problem.  In contrast, I think the sharp fall in NGDP during 2008-09 was caused by tight money, and that the solution is easier money.

But why does it make a difference that Krugman and I disagree as to how we got here, isn’t the important thing that we both agree that we need more monetary stimulus?  Yes and no.  Yes, in the sense that you need to patch that knife wound regardless of how you got it.  But if Krugman is right that tight money didn’t cause the fall in AD, then it creates doubt as to whether easy money can patch the wound.

Most economists disagree with my view that if the Fed had done 5% NGDP growth targeting, level targeting, from mid-2008 forward, we wouldn’t have had steep fall in NGDP.  The standard view is that the financial crisis was an exogenous shock, and a devastating shock, and the drop-off in lending would have caused aggregate demand to fall in any case.  Suppose my opponents are right, and the Fed couldn’t have prevented a severe decline in NGDP in late 2008.  Doesn’t that raise doubts as to whether the Fed could now fix the problem?  After all, even in 2010 banks continue to maintain a much more restrictive lending regime.  If that’s the “real problem” then arguably it is just as much a problem today as in 2008.

Of course I don’t think this would prevent easy money from triggering a robust recovery, and perhaps Krugman share’s my view.  But even if he does, it isn’t something you can just assume away.  I don’t face that problem because I believe the big fall in AD was caused by tight money—in September 2008 the Fed’s 2% target rate was way above the Wicksellian equilibrium rate.  But Krugman doesn’t believe that tight money caused the recession, he believes the financial crisis caused the big drop in NGDP.  So he faces a much bigger burden in showing that monetary stimulus can fix the problem.  He needs to show that monetary policy could not have prevented NGDP from falling in late 2008, but now the Fed can boost NGDP.  That’s certainly possible, but it’s not a given.

BTW, unless Rajan’s just making up facts, it seems to me that his response to Krugman is pretty persuasive on the issue of the financial crisis.  He has lots of evidence that Krugman is flat out wrong in asserting that government encouragement of low cost housing didn’t play a major role in the housing bubble.  Here’s just one example:

So Krugman shifted his emphasis. In his blog critique of a Financial Times op-ed I wrote in June 2010, Krugman no longer argued that Fannie and Freddie could not buy sub-prime mortgages.[v]  Instead, he emphasized the slightly falling share of Fannie and Freddie’s residential mortgage securitizations in the years 2004 to 2006 as the reason they were not responsible. Here again he presents a misleading picture. Not only did Fannie and Freddie purchase whole sub-prime loans that were not securitized (and are thus not counted in its share of securitizations), they also bought substantial amounts of private-label mortgage backed securities issued by others.[vi]  When these are taken into account, Fannie and Freddie’s share of the sub-prime market financing did increase even in those years.

In 2008 the left gleefully argued that the banking crisis represented a failure of laissez-faire.  As a result they over-reached, even defending the GSEs.  They would have been better off arguing that the GSEs were private (which isn’t really true, but is sort of plausible.)  By defending the GSEs, they implicitly acknowledged their public dimension.  Now more and more evidence is coming in that the problems with our financial system all start with the letter ‘F’.  (Fannie, Freddie, FDIC, FHA, etc.)  And what does ‘F’ stand for?

HT:  Patrick R. Sullivan


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69 Responses to “No need to plug that knife wound, you’ve got pneumonia”

  1. Gravatar of W. Peden W. Peden
    20. September 2010 at 07:45

    Fiscal stimulus?

    Just to clarify, what do you think were the key causes of tight money back in 2008?

  2. Gravatar of Silas Barta Silas Barta
    20. September 2010 at 08:27

    If there is one thing almost every macro book agrees on, is that a large, sudden, and unexpected drop in nominal expenditure relative to trend is a really, really bad thing.

    And there, in a few words, is where I strongly think modern macro has lost its way. It’s saying that, if people decide, en masse, to ditch the BUY BUY BUY CONSUME CONSUME CONSUME mentality and start being more judicious with their expenditures, then that is, almost by definition, a really horrible thing, and we have to do everying in our (monetary policy) power to get their heads straight again so they can go back to BUYING BUYING BUYING CONSUMING CONSUMING CONSUMING.

    When you’ve decided from the outset that a good economy MUST involve the current level of spending (plus the God-decreed 5% trend) you made a big mistake somewhere. The “economy” — in the only sense we care about — is our collective ability to satisfy wants, not a volcano god that needs to be appeased.

    (Yes, I did read the rest of your post.)

  3. Gravatar of Philo Philo
    20. September 2010 at 08:58

    Causation is tricky. In practice we are determinists: we think that the total situation at time t0 determines–causes–the total situation at time t1, and therefore it causes *each aspect* of the total situation at time t1. The tricky part comes when we try to identify *some particular aspect* (call it ‘C’) of the total situation at time t0 as the cause of *some particular aspect* (call it “E”) of the total situation at time t1. Sticking with the plausible counterfactual analysis of causation, this amounts to saying that if C were replaced by not-C *while everything else about the situation at time t0 remained the same*, we would not have got E at time t1. Real difficulties sometimes arise because the notion of “keeping everything else the same” is not nearly as clear as it seems. But there is also a quite needless difficulty: once we have found *a cause* of an effect we tend to think of it as unique–as *the* cause. In fact, it is obvious that many different aspects of the total situation at time t0 may qualify as causes of E at time t1.

    Now, what caused the sharp fall in NGDP in late 2008 (a particular aspect of the total situation in late 2008)? “Both Rajan and Krugman believe the severe fall in NGDP in late 2008 was caused by the financial crisis. . . . In contrast, I think the sharp fall in NGDP during 2008-09 was caused by tight money . . . .” I gather you are disagreeing with Rajan and Krugman; I think this is a mistake. You should view your tight money analysis as an additional true remark which does not contradict their financial-crisis analysis. The financial crisis caused the drop in NGDP–true! Tight money caused the drop in NGDP–also true!

    This suggests two ways to avoid repetitions of our recent experience: (1) shore up the financial system; (2) practice better monetary policy. While both are worth doing, it is easy to find arguments that (2) is more important. But these arguments do not at all involve *rejecting* the financial-crisis analysis.

    You may reply that the Fed sharply tightened monetary policy in the late summer of 2008. If there had been no financial crisis, *but they had tightened just as much as they did*–which would have required some extraordinary open market operations–there would have ensued the same sort of drop in NGDP. Well, what constitutes “keeping everything else” (apart from the financial crisis) the same”: as applied to the Fed, would it be *same OMOs*, or *same degree of tightness of policy*? I, and most observers, choose the former, though I don’t know how to defend that choice.

    (Your other criticism of Krugman is well-taken: if, as he says, looser money wouldn’t have worked in 2008, why think it will work now? He at least owes us an explanation.)

  4. Gravatar of Greg Ransom Greg Ransom
    20. September 2010 at 09:21

    So what do you recommend if the inflation rate “unexpectedly” hits 5, 6, 7 percent.

    Or 10, 11 or 12 percent?

    Wouldn’t it require a “unexpected drop in nominal expenditure relative to trend” in order to get that under control?

    Are you opposed to that?

  5. Gravatar of Ryan Ryan
    20. September 2010 at 09:45

    Prof Sumner –

    No one makes the argument that we need “tighter money.” That’s quite a straw man. Most people who hold the view you’re talking about are people who think that loose money caused a malinvestment bubble, and that maybe we shouldn’t fire up the printing press to try to solve our problem. There is a big difference between a “tighter money” argument and a “loose money got us into this mess” argument.

    I have heard many big-name economists make the claim that the public has increased their rate of savings since late 2007, and that this is a good thing. Yet, nearly all of those big names continue on to make the point that we need to further increase the money supply. Perhaps you can explain how an increased rate of savings can simultaneously be good for the economy, and yet we need more monetary policies that punish savers. From where I sit, this is not just a contradiction, but it verges on senselessness.

    Naturally, making all people relatively poorer in the future will force them to spend whatever little money they have today, rather than lose it to inflation. But there’s no real choice involved here, is there? How much capital do you expect will be accumulated in such an atmosphere, wherein saving is a sure-fire way to lose your income?

    How many goods and services will be produced, new technologies developed, and human needs met, if we are perpetually being coerced into a choice of spend-now-or-lose-it-all? What could is a policy of perpetual inflation if it discourages production?

    Most importantly: Do you really think asking such questions is an argument for tighter money!?

  6. Gravatar of Benjamin Cole Benjamin Cole
    20. September 2010 at 09:59

    OT, but worth fighting: It seems that any QE policy is often presented as “massive.”

    See:

    “The short-term price action for Treasuries will be heavily influenced by the FOMC (Federal Open Market Committee) and thewording of the policy statement in regard to the potential foradditional QE (quantitative easing) in the foreseeable future,”said Ward McCarthy, chief financial economist and managingdirector, fixed-income division, Jefferies & Co in New York.

    McCarthy called much of the speculation about the Fed implementing more quantitative easing at the Sept. 21 meeting or at the November or December meetings unwarranted.

    “The FOMC will not announce another massive expansion of the balance sheet through asset purchases, but may attempt to frame financial and economic conditions that would warrant another massive expansion of the balance sheet,” he said.

    Sumner’s plan calls for $100 billion a month in QE.

    I think the anti-QE’ers are framing the issue with terms like “massive” to heighten inflation fears. They are presentng QE as necessarily huge and unwieldly.

    Qe’ers need to stay on point, re-assert constantly that QE can be gradual, monitored, safe.

  7. Gravatar of Josh Josh
    20. September 2010 at 10:42

    Silas,

    The most simplistic income-expenditure view of demand is Y = C+I+G+X

    So it’s not entirely clear to me why more demand means more of only consumption.

  8. Gravatar of marcus nunes marcus nunes
    20. September 2010 at 10:44

    “Explaining” present predicaments with the gold standard. Scott you are referenced.
    http://www.voxeu.org/index.php?q=node/5536

  9. Gravatar of Josh Josh
    20. September 2010 at 10:46

    Ryan,

    Unexpected inflation (deflation) is redistributive.

  10. Gravatar of Silas Barta Silas Barta
    20. September 2010 at 10:52

    Josh: It’s likewise unclear to me why jawboning people into investing when they don’t want to is better than jawboning them into consuming when they don’t want to.

    The economy should be judged by whether it satisfies wants, not by whether it generates more exchanges — the latter are only good to the extent that they facilitate the former.

  11. Gravatar of Ryan Ryan
    20. September 2010 at 11:19

    Josh –

    The non-neutrality of money demands that inflation expected or otherwise is redistributive. At least when it’s “unexpected” (I assume you mean “not policy-induced”) it’s not a deliberate redistribution. Here I am assuming that we all agree that redistributive changes in the value of money are unequivocally bad. (Even if one thinks some redistribution is necessary, monetary inflation strikes me as a horribly inefficient way to impact a given redistribution policy’s target demographic.)

  12. Gravatar of ssumner ssumner
    20. September 2010 at 11:58

    W. Peden, As NGDP growth expectations fell steadily between April and October, the Fed kept its Fed funds target at 2%. That pushed the policy rate further and further above the Walrasian equilibrium rate. From a monetarist perspective they didn’t print enough money to offset the fall in velocity.

    From my perspective, the biggest mistake was acknowledging that NGDP would fall sharply, and that they would not try to “catch-up” later. The lack of anticipated catch-up had a devastating impact on expectations.

    Silas, You said;

    “And there, in a few words, is where I strongly think modern macro has lost its way. It’s saying that, if people decide, en masse, to ditch the BUY BUY BUY CONSUME CONSUME CONSUME mentality and start being more judicious with their expenditures, then that is, almost by definition, a really horrible thing, and we have to do everying in our (monetary policy) power to get their heads straight again so they can go back to BUYING BUYING BUYING CONSUMING CONSUMING”

    I’ve explained this to you before, but you may have forgotten. I am not advocating more consumption, I am advocating more NGDP–which is completely unrelated.

    Philo, You said;

    “The financial crisis caused the drop in NGDP-true! Tight money caused the drop in NGDP-also true!”

    But that’s the point, they don’t agree with this. They don’t think tight money caused the crash, or that easier money could have prevented it.

    There are a million different real shocks that could destabilize the equilibrium rate, and the Fed can’t anticipate them all. I’m all for trying to prevent a repeat of the financial crisis, but for reasons having nothing to do with monetary policy. Until we understand that the last half of the financial crisis was caused by tight money(not foolish lending), we won’t be able to fix the problem.

    I am asking for consistency on definitions. There were lots of OMOs in the 1930s and most economists now say money was tight. There were lots in 2008 and economists say money was easy. This inconsistency causes bad analysis.

    BTW, I actually agree with your philosophical observations on causality, and my only response is that I am trying to get people to look at causality issues from a perspective that I think is better on purely pragmatic grounds, not because of some sort of deep ontological argument.

    Greg, I favor having the government pay no attention to inflation, even if it is 100%. If NGDP growth is too high, ex post, then try to bring it back to the trend line.

    Ryan, You said;

    “No one makes the argument that we need “tighter money.””

    I don’t agree. There are people on the Fed who want tighter money. Rajan wants tighter money.

    This problem can be fixed without firing up the printing presses, we already have plenty of money in the system if the Fed would take steps to boost velocity.

    I’ve never seen a shred of evidence that easy money caused the housing bubble. Money in the 2000s was much tighter than in the 1960s, 1970s, 1980s, and about the same as the 1990s.

    Tight money does not help savers. I’m a saver, and my assets were severely hurt by the tight money of 2008. I want a return to the less tight money of 1982-2007, when my assets increased in value.

    Yes, tight money does help T-bond holders, but how many savers keep all their money in T-bonds?

    Benjamin, Good point. BTW that number I put out there assumed the Fed was also doing other things. If not, it might need to be bigger.

    Josh, Exactly.

    Marcus, Thanks, I also read his longer paper.

    Silas, We are talking about AGGREGATE output. You are essentially saying “It is unclear to me why people prefer to have jobs, rather than be homeless.” If we don’t produce SOMETHING, who will have jobs? You’ve rejected C and I, do you want more G????

    Ryan, But when in a recession a bit more inflation will cause a lot more real growth—and that helps savers.

  13. Gravatar of David Stinson David Stinson
    20. September 2010 at 12:12

    I am not sure why, even if one believes that the problem is in part structural (as I do), the maintenance of monetary equilibrium shouldn’t continue to be an important objective.

    In fact, it seems to me that, if an element of restructuring is required, it is even more important to maintain monetary equilibrium so that investor confusion as between the real and the nominal is limited.

  14. Gravatar of Silas Barta Silas Barta
    20. September 2010 at 12:25

    @ssumner:

    Silas, We are talking about AGGREGATE output. You are essentially saying “It is unclear to me why people prefer to have jobs, rather than be homeless.” If we don’t produce SOMETHING, who will have jobs? You’ve rejected C and I, do you want more G????

    There can be full employment with at any level of GDP; the only question is how much of a real pay cut people are going to take. Forcing people to consume or invest (else their money evaporate) doesn’t avoid the necessary cut in real per-person output; it just re-arranges it. When policy makes people engage in purchases (of whatever) that they don’t want, that’s simply a different way to absorb the cut, because they had to be prodded to make the purchase.

    What I want is for for people to buy and sell, hire and take jobs because those exchanges make each party *better off*, not simply because it’s the next best alternative to seeing their savings shrivel up. Exchanges are desirable when they’re welfare-enhancing, not simply because they prop up historically-useful metrics. Yet so often you write as if there’s no distinction.

  15. Gravatar of Lord Lord
    20. September 2010 at 12:43

    The largest government failure was the ideology of market fundamentalism among our regulators. It let them and everyone else abrogate their responsibilities. The sooner that is buried, the sooner we can progress.

  16. Gravatar of David Stinson David Stinson
    20. September 2010 at 12:50

    Addendum:

    Is saying that the recession was caused by the “financial crisis” really just a non-Austrian way of saying that it was caused by malinvestments?

  17. Gravatar of honeyoak honeyoak
    20. September 2010 at 13:00

    Scott, while agree with you that expansionary monetary policy would have helped the US economy not get into the slump that it is in, I am not as convinced as you are about a “robust recovery”. I cannot seem to find an example of any country that has had a severe banking crisis and subsequently had robust growth due to expansionary monetary policy. If you look at england (whose banking system is factors bigger than the US on a relative basis), their bank has purchased 200 billion pounds worth of government debt(about 20% of gdp),they have a lower unemployment rate 7.8% (vs 9.6% at the US) and higher inflation (at 3% vs 1.1%). Don’t get me wrong, you have convinced me (a former inflation hawk) that inflation will alleviate a lot of human suffering and economic malaise. I see the US having lower unemployment and higher inflation with your preferred policies. I do not foresee a re-energizing of the “animal spirits”(though I could be wrong). The thing is that I see expansionary monetary policy as necessary but not sufficient for a robust recovery.

  18. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    20. September 2010 at 13:47

    I still don’t understand how you views are different from Krugman’s. You said:

    “In contrast, I think the sharp fall in NGDP during 2008-09 was caused by tight money”

    I think you define tight money as monetary policy that is expected to cause too low AD, and I think Krugman would agree. In September/October 2008 he wrote that Bernanke will have trouble achieving normal levels of AD.

    “Both Rajan and Krugman believe the severe fall in NGDP in late 2008 was caused by the financial crisis.”
    You are using the word “caused” in a very specific way. If we could translate Krugman’s and Rajan’s thoughts into your language, it would sound like this: Krugman believes the severe fall in NGDP was caused by tight fiscal and monetary policy. Rajan believes the severe fall in NGDP was caused by too easy monetary policy in 2003-04 and by the lack of structural reforms.

    “Of course I don’t think this would prevent easy money from triggering a robust recovery,”
    Perhaps Krugman thinks that it was real problems, and not low AD that caused the failure of Northern Rock in summer of 2007 and the failure of Bear Stearns in the spring of 2008. But he always had a solution – inject public capital into financial institutions so they can function normally. This way the real problem is solved, and only the nominal AD problem remains.

  19. Gravatar of Lorenzo from Oz Lorenzo from Oz
    20. September 2010 at 14:34

    Silas: Scott’s point is precisely that tighter money stops people making lots of welfare-enhancing exchanges. You seem to be dividing the world into “good” exchanges and “bad” exchanges. (Who makes exchanges to “prop up historically-useful metrics”?: no one I would suggest.)

    The trick is to have enough money circulating to enable exchanges to take place, but not so much as to undermine the cross-temporal use of money (too much penalty–too much expected loss of value–in holding for future use) or so little as to undermine the cross-temporal use of money (too much penalty–too much expected future value foregone–for current use). The greater the expected benefit from holding on to money, the less appeal the risks of exchange and investment are going to have. Deflationary periods will be risk-salient periods.

    Enough inflation to minimise the costs of wage and price stickiness seems to be about the desirable level. After all, nominal wage stickiness is one of the big costs of deflation, though not as big as the general deferral of exchanges.

    A lot of the problem is that people see interest rates as the “price” of money (hence assuming that if interest rates are low, money is plentiful: as Milton Friedman kept, and Scott keeps, pointing out, it ain’t necessarily so). What you can get for you money is its price (whether in terms of goods and services or other currencies): interest rates reflect, in part, the expected future price of money (aka “inflationary expectations”) and that–the expected rate of change of the price of money–is not the price of money. It is the value of money as an asset without being the price of money. Getting your head around that seems to be a major trick in monetary economics.

  20. Gravatar of Silas Barta Silas Barta
    20. September 2010 at 15:02

    @Lorenzo_from_Oz:

    (Who makes exchanges to “prop up historically-useful metrics”?: no one I would suggest.)

    What I said was this: “Exchanges are desirable [from the standpoint of society] when they’re welfare-enhancing, not simply because they prop up historically-useful metrics.” Nobody makes an exchange they expect to make them worse off, but certain *economists* are trying to force people into making exchanges they otherwise would make. Yes, I’m better off giving a mugger my wallet, but I’d rather not be in a position in which giving away my wallet would make me better off, ya know?

    If I would prefer to hold off on making purchases (or buying crappy investment instruments), and then I hear that the government is going to rapidly devalue my monetary savings, then yes, *at that point* it would be a real good idea to spend it on something, anything, before it starts to vaporize. But I’d still rather not be effectively forced to start spending in the first place.

    Plus, the fact that I didn’t find it worthwhile to buy that junk before this aggressive devaluation means it isn’t as efficient as if I had been allowed to buy something when *not* under fear of my money being devalued. So you can’t simply treat that exchane as if it were juts as welfare enhancing as if I bought something I would actually want to buy even with a stable currency.

    As for the rest of your comment: I finally got a Sumner acolyte to have an exchange with me on these issues, and your points are answered somewhere there.

    Yes, I “get” that the price of money is what it can buy. That still doesn’t mean that by propping up the number of exchanges, we necessarily make everyone better off. Maybe … the economy should re-tool toward making stuff people actually want to spend their valuable money on, rather than delaying this reckoning?

    If your economic theory tells you that it would be a brilliant idea to print up new money and loan it at 0% to entrenched, incompetent big banks, then your economic theory sucks.

  21. Gravatar of Silas Barta Silas Barta
    20. September 2010 at 15:03

    Sorry, that should be “but certain *economists* are trying to force people into making exchanges they otherwise wouldn’t make.”

  22. Gravatar of greg ransom greg ransom
    20. September 2010 at 21:00

    By what criteria could NGDP be too high?

    What calibrates “trend”?

    What underlying real capital structure would assure a stable and sustainable trend line?

    Would _any_ asset structure / relative price structure assure a stable trend line?

    Would any structure of consumption and investment?

    if so, how possibly so?

    Scott writes,

    ” If NGDP growth is too high, ex post, then try to bring it back to the trend line.”

  23. Gravatar of Bonnie Bonnie
    20. September 2010 at 21:09

    Criticism is generally a good thing, but it seems like everyone these days is a pundit, with very little beneficial information as to how to get from where we are to some general sense of being better off. If one likes the condition in which we find ourselves, then it is probably better to state it directly and be prepared to defend it rather than attacking Sumner as some kind of inflation addict who would rather rip off old ladies to cover up inefficiencies in the economy than live though one day of reckoning.
    I don’t believe him to be such (of course my opinion is probably no better than the housewife from Nebraska), but then again I cut my economic baby teeth on Friedman who advocated rational and reasonable growth in money generally and to meet changes in demand, whatever the cause. Some take him to be some kind of god of economics, but I think of it more like common sense.
    Some part of the fundamental question being presented here is: Should the Fed respond to nominal shocks in order to smooth out the road of real effects or should those on the FOMC just sit there with their mouths gaping open as the giant vacuum in the sky sucks all the money out of the financial sector, vaporizing it and our savings along with it? If one goes back to debates regarding the original Federal Reserve Act, it is not difficult to determine what the answer to that question is supposed to be. Yet here we are, nearly 100 years later acting like we haven’t quite figured out the legislative intent or real consequence of veering off course, and attempt to take any and all opportunity to bend public resources to our mob mentality regardless of law, intended purpose or consequence. It’s interesting that I hear many complain of uncertainty being major factor inhibiting growth while at the same time lauding the Fed’s mysterious new enlightenment as a good thing. It’s puzzling, at the very least.
    Abuse of power (or dereliction of duty) by anyone vested with it is exactly that. It does not matter which group benefits or which suffers, because in that case it is merely arbitrage out there in the territory of moral hazard. Everyone seems to have an opinion about who should be the ones to suffer and it generally does not include a group to which they belong. They advocate policies, not based in law and without regard to any kind of fairness to the future, that induce suffering somewhere and then it insist it better not be them. Is that really what we’ve become or am I just misunderstanding the Sumner pundits who can’t seem to square their individual theories with the facts as we know them. Since when it is just fine and dandy for everyone to take huge hits in their net worth and leave the economy staggering with little possibility of gaining it back so someone else can get the rich feeling?
    We are not only presented with the possibility of a Japanese style “Lost Decade”, we are also faced with the possibility of a lost generation as more and more new college graduates cannot find jobs with which to start their careers. Poverty and illicit drug use are soaring, but who really cares about that as long as the proverbial old lady who retired at 65 and is expected to live until 90 doesn’t have to give up an additional 1% per annum in her savings account and won’t hear of any reduction in SSI. Now just who is going to be working in order to deliver that monthly payout is anyone’s guess… Maybe they can devise another way to bilk the financial system to pay for that too?

  24. Gravatar of Morgan Warstler Morgan Warstler
    20. September 2010 at 21:18

    Scott, is so much fun to see your arguments shift:

    “This problem can be fixed without firing up the printing presses, we already have plenty of money in the system if the Fed would take steps to boost velocity.”

    In the last month you specifically told me you didn’t care about V. Learning as you go, huh?

    Ryan: This is of course the key question to Scott…

    “How many goods and services will be produced, new technologies developed, and human needs met, if we are perpetually being coerced into a choice of spend-now-or-lose-it-all?”

    Scott, isn’t an entrepreneur or small businessman, he doesn’t get that its all about the toilets.

    http://thecomingprosperity.blogspot.com/2010/08/its-toilets.html

    Josh,

    “Unexpected inflation (deflation) is redistributive.”

    Untrue, and that makes you a liberal. The tacit agreement is that the Fed will continuously step towards opportunistic dis-inflation. A dollar saved will be a dollar for as long as we can make it last… change your assumptions if you don’t know this already. We favor capital formation, it is who we are.

    Anything else is you lying to yourself or others for devious ends.

  25. Gravatar of Thomas Barton, JD Thomas Barton, JD
    20. September 2010 at 21:31

    Your knife wound/pneumonia metaphor puts me in mind of just how many bags of plasma will the banking world demand be pumped into the living corpse that is Allied Irish Bank ? I am not an economist but with more than a few Eurozone institutions bleeding out at accelerating rates how does this impact the efficacy of any substantial increase in monetary policy ?

  26. Gravatar of Ryan Ryan
    21. September 2010 at 04:30

    Prof. Sumner –

    “I’ve never seen a shred of evidence that easy money caused the housing bubble.”

    This is shocking to me. Maybe you just didn’t know how we were making money from 1990-2007? We would take out a HELOC and invest the money in an income trust. The monthly dividend would more than pay for the interest on the HELOC, so it was literally free money. We would fully leverage the invested amount, i.e. double-leveraged. Why not? It was literally free money. To hear someone suggest that this was somehow “tight money” over any period of time just blows my mind. The same bank that issued the HELOC would also allow us to invest on the margin.

    This isn’t a “regulation” problem, and it’s certainly not “tight money.” There were no derivatives involved. All the usual suspects were left untouched. What put a stop to it was not the “burst of the housing bubble,” but rather the fall in the prices of commodities. As soon as that happened, everyone had to cover their margins.

    …And *THAT* is what made the housing bubble burst. The HELOCs driving all of this economic “activity” were like a golden ticket. That’s why everyone wanted a house. That’s why everyone bought unaffordable homes. They weren’t unaffordable at all if you could pay your mortgage down with an investment in oil or natural gas.

    Maybe economists just didn’t know that that’s how people have been investing ever since the price of gold became irrelevant to the interest rate?

    As for the aggregate demand, GDP thing… Arnold Kling wrote the following on his blog this morning, about why he doesn’t think the recession has ended, and I think it conveys a very useful idea [emphasis mine]:

    I have gotten so used to not thinking of economic activity as spending that I am totally blowing off the fact that GDP has been increasing for the past year. Instead, I focus on patterns of sustainable specialization and trade, which I think are better indicated by employment. We are still seeing employment growth that is below the trend rate of increase in the labor force, so the way that I think about it, we are still in a recession.”

  27. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    21. September 2010 at 05:50

    @greg ransom

    “By what criteria could NGDP be too high?:

    NGDP could be too high according to the simple arithmetic criteria when comparing actual data to preannounced trend path of NGDP, this trend path should never change.

    “What underlying real capital structure would assure a stable and sustainable trend line?”
    It is the opposite. If malinvestment bubble creates excess nominal output (as compared to preannounced trend), central banks should tighten conditions until nominal output is expected to return to previous trend. If excess pessimism causes too low investment in real capital, conditions would be eased, encouraging the increased level of investment that is consistent with the nominal output catching up with the trend.

  28. Gravatar of scott sumner scott sumner
    21. September 2010 at 07:22

    David Stinson, I agree,

    Silas; You said;

    “There can be full employment with at any level of GDP; the only question is how much of a real pay cut people are going to take. Forcing people to consume or invest (else their money evaporate) doesn’t avoid the necessary cut in real per-person output; it just re-arranges it. When policy makes people engage in purchases (of whatever) that they don’t want, that’s simply a different way to absorb the cut, because they had to be prodded to make the purchase.”

    I have no idea why it is necessary to cut per person output. Are you advocating that we follow the Bangladesh strategy for full employment—produce so little per worker that everyone has to work? The point is to maximize per worker output, not reduce it.

    Lord, Did free market fundamentalism lead to FDIC, Fannie, Freddie, FHA, CRA, etc, etc? Housing was about as free a market as health care.

    David, No, Krugman thinks it was caused by the financial crisis, but rejects the notion that it was caused by malinvestments.

    Honeyoak;

    “I cannot seem to find an example of any country that has had a severe banking crisis and subsequently had robust growth due to expansionary monetary policy.”

    The US in March to July 1933 is a perfect example, before the recovery was aborted by FDR’s high wage policy.

    Britain had a much bigger real shock than we did; as you say banking is a much bigger part of their economy. Trade is also much bigger–another real shock. I don’t know enough about Britain to comment further.

    I am still an inflation hawk, in the sense that my preferred policy would result in a long run inflation rate of 2%

    123, You said;

    “I think you define tight money as monetary policy that is expected to cause too low AD, and I think Krugman would agree. In September/October 2008 he wrote that Bernanke will have trouble achieving normal levels of AD.”

    I think the Fed could have prevented a big fall in NGDP after September 2008, Krugman doesn’t seem to think so (based on what I read from him at the time.) He said because rates were zero there is nothing the Fed could do to stop the collapse. BTW, rates weren’t zero at that time, he just assumed they were.

    Regarding Bear Stearns; actually, I recall Krugman wanted to nationalize the banking system.

    Greg, You asked;

    “By what criteria could NGDP be too high?”

    Hayek said the government should set the target path for NGDP, and then use monetary policy to keep NGDP close to the target path.

    Bonnie, Well put. I especially liked this comment you made:

    “It’s interesting that I hear many complain of uncertainty being major factor inhibiting growth while at the same time lauding the Fed’s mysterious new enlightenment as a good thing. It’s puzzling, at the very least.”

    Morgan, My arguments don’t shift, just your understanding of them.

    Thomas, The banking problem is partly a result of tight money, and partly a separate problem. Monetary stimulus can only do so much.

    Ryan, You are confusing easy money with easy credit.

    Easy credit is low real interest rates, easy money is fast NGDP growth. NGDP growth may have been a tad high in the past decade, but nothing really out of the ordinary.

  29. Gravatar of Josh Josh
    21. September 2010 at 07:23

    Silas,

    You wrote, “certain *economists* are trying to force people into making exchanges they otherwise wouldn’t make.”

    What you are ignoring here is that the Fed controls the monetary base. If the demand for money is greater than the supply of money, aggregate demand declines as people try to accumulate larger cash balances. Thus, if one’s view is that the money supply isn’t large enough to satisfy demand, which Scott is implicitly arguing, it would follow that “certain *central banks* are trying to force people into NOT making exchanges they otherwise would make.”

    This is a fundamental proposition of most monetary theory. You are welcome to disagree with it. However, in the context of Scott’s argument, you are essentially saying, “you are wrong, therefore you are wrong.”

    Similarly, you wrote, “There can be full employment with at any level of GDP; the only question is how much of a real pay cut people are going to take.”

    Why aren’t these wage cuts happening? Are you advocating lower wages? If so, aren’t you advocating that we force people to engage in exchanges that they otherwise wouldn’t? Wouldn’t an increase in the price level also reduce real wages?

  30. Gravatar of Silas Barta Silas Barta
    21. September 2010 at 07:49

    @scott_sumner: I have no idea why it is necessary to cut per person output.

    I didn’t say it needs to be cut; I said it’s already fallen (by any measure we actually care about). The only question is how you want it to show up. When you jawbone people into spending when they don’t want to, that is simply shifting how the per person output shows up: as lower consumer surplus on purchases, as people are buying things only because their money is shriveling up. This can’t be counted as being as welfare-enhancing as if the item were worth buying in the absence of “spoiling money”.

    @Josh: This is a fundamental proposition of most monetary theory.

    I’m sorry, what’s the actual proposition there? That “if X is too low, then upping X is good”? The proposition would need to give an account of how X is upped, why X changes in value, and how that all interacts with the rest of the economy. Imagine if I argued that:

    “If the demand for _wheat_ is greater than the supply of _wheat_, aggregate _wheat demand_ [I know, loose terminology, but it’s just ported over mainstream monetary economics] declines as people try to _stop draining their wheat stocks_. This, if one’s view is that the _wheat supply_ isn’t large enough to satisfy demand, it would follow that the government should _increase wheat supply_.”

    Same argument, just swapped out terms. What implicit assumption does my version rely on? Well, that’s what scott_sumner’s (and mainstream monetary economics) relys on: the assumption that the higher price of money does not reflect a fundamental scarcity and can be eliminated without shifting the cost somewhere else.

    Money is valuable because it has certain functions. When you ignore these functions, you miss why its value goes up or down, and you end up advocating policies that make no sense, and are unable to integrate your economic model into a broader understanding of the world, or understand when a metric (like NGDP) ceases to positive correlate with what we want.

    Are you advocating lower wages? If so, aren’t you advocating that we force people to engage in exchanges that they otherwise wouldn’t?

    I’m sorry, are you really seeing no difference between someone’s wage falling because their work is worth less, vs. someone’s savings going away because the government is engineering a lower value for it?

  31. Gravatar of Ryan Ryan
    21. September 2010 at 09:48

    Prof Sumner –

    Oops, my mistake – but how does it fundamentally alter the point? If “easy money” didn’t cause the bubble but “easy credit” did, aren’t we really just differing over which level of M we’re implicating?

    With regard to the past decade, I agree with you. My own example covered the past two decades and suggested that it’s likely been going on for at least the last four.

  32. Gravatar of OGT OGT
    21. September 2010 at 09:54

    How did the CRA, Fannie and Freddie or Countrywide, for that matter, cause the housing bubble in Ireland? Or Spain? Or Britain? Or Latvia? Or Iceland?

    They did not, obviously. So one could put it down to a coincidence, but that seems more than a bit far fetched.

    Truth be told, Bernanke’s ‘Savings Glut’ argument holds up better than Rajan’s or Krugman’s, at least his theory accounts for the global nature of the crashes.

    Alternatively, David Beckworth’s the Fed Super Power argument has something to it, though Real Estate economist Ed Glaeser’s investigations generally exonerated interest rates.

    Minsky’s evolutionary finance approach is also plausible across countries (Minsky, btw, claims that prolonged periods of economic calm will tend to lead both private entities and public regulators to lower their risk estimates and encourage untested financial innovations to spread at an accellerated rate).

    But At any rate, anyone arguing Fannie did it, or Lehman or WaMu did it, can safely be ignored in my opinion.

  33. Gravatar of greg ransom greg ransom
    21. September 2010 at 10:20

    Scott, how does your model compare with Friedman’s plucking model.

    I really distrust the impulse to reify an aggregated “trend line”, esp in real terms.

  34. Gravatar of Josh Josh
    21. September 2010 at 11:26

    Silas,

    “I’m sorry, what’s the actual proposition there?”

    Suppose that you take the market for wheat. When there is excess demand for wheat what happens? The price rises. Problem solved.

    Money is different because money is the medium of exchange and therefore trades in all markets. When monetary disequilibrium exists, this effects all other markets. For example, if there is an excess demand for money, there is a corresponding excess supply of goods. This is the central proposition of monetary theory.

    How do you alleviate an excess demand for money? You increase supply. Under a free banking system with competitive note issuance, market forces could eliminate deviations between the supply and demand for money. We do not live in such a world. The monetary base is determined exogenously. Thus, it requires action of the central bank to increase the money supply to eliminate the excess demand for money. What’s more, this does not require inflation. In fact, if the money supply was always and everywhere equal to money demand, the price level would fall. (A result that I would advocate.)

    “Money is valuable because it has certain functions. When you ignore these functions, you miss why its value goes up or down, and you end up advocating policies that make no sense, and are unable to integrate your economic model into a broader understanding of the world, or understand when a metric (like NGDP) ceases to positive correlate with what we want.”

    It is precisely due to the unique properties of money that the supply and demand for money matters. The simplest and most useful equation in monetary theory is the equation of exchange:

    MV = Py

    M is the money supply, V is the velocity of circulation, Py is nominal income. When the money supply is equal to money demand MV is constant and therefore so is nominal income. Of course, we live in a growing economy, which is abstracted in that static model. Thus, I favor a nominal income target equal to the average real rate of growth for the economy.

    In the case of an excess demand for money, MV falls and therefore so does nominal income. We don’t care about nominal income because we like pretty, statistical correlations. We care about nominal income because it provides an indication about monetary equilibrium.

    “I’m sorry, are you really seeing no difference between someone’s wage falling because their work is worth less, vs. someone’s savings going away because the government is engineering a lower value for it?”

    My point about a rising price level and real wages was facetious. My real question, which you didn’t address, is whether or not you are advocating that people take lower wages. If so, you need to explain why it is okay to force people to take lower wages (that they clearly don’t want), but not to advocate increasing the money supply.

    What’s more, as I stated above, unexpected inflation (deflation) is redistributive. In other words, it erodes one person’s savings and it erodes another person’s debt. Note that I am not justifying inflation on these grounds, but rather pointing out that it is a transfer.

  35. Gravatar of Silas Barta Silas Barta
    21. September 2010 at 11:57

    @Josh: Since I’m having this exact discussion with John Salvatier, so I’ll just link my last reply there.

    Summary: When money trades at a premium, that reflects a real scarcity: people’s desire for a store of value has increased, which in turn indicates greater uncertainty about the ability of current structures of production to satisfy demand. It makes no more sense to suppress this signal than it does to suppress higher wheat prices after a crop failure. Your reply (and the monetary theory you endorse) complete ignores money’s fluctuating importance as a store of value — as something that allows you to trade away your production without knowing what you will trade it for. This leads it to break down in cases of such fluctuations.

    My real question, which you didn’t address, is whether or not you are advocating that people take lower wages.

    I didn’t answer directly, but the answer was implicit in the rest of the post: a) people are *already* taking lower average wages, and b) they are only being “forced” in the sense that people are forced to pay more for wheat during a crop failure: that higher price reflects a real scarcity, just like, I claim, the current higher price of money reflects a real scarcity, and not one that can be eliminated by printing new money.

  36. Gravatar of Lorenzo from Oz Lorenzo from Oz
    21. September 2010 at 20:14

    Silas: Part of my problem is I live in a country which avoided the GFC and Great Recession, so I lack a sense that massive downturns and increases in unemployment must be good for the soul of the economy, or something.
    but certain *economists* are trying to force people into making exchanges they otherwise [not] would make. No, I think they would like more people to be employed. If there is a lot of unused capacity out there — all those unemployed folk — there are probably a lot of useful welfare-enhancing exchanges to be made. Hence Josh’s point:
    For example, if there is an excess demand for money, there is a corresponding excess supply of goods. This is the central proposition of monetary theory. Really, it is about getting rid of massive unemployment.
    If your economic theory tells you that it would be a brilliant idea to print up new money and loan it at 0% to entrenched, incompetent big banks, then your economic theory sucks. Well, I happen to think injecting moral hazard into financial markets — as the IMF and other public bodies have been doing — is a really bad idea. But it is much better to be in a country where the unemployment rate is 5.2% than 9.6%. And I don’t think the difference is because Australians are being massively shanghaied into making exchanges they would prefer not to make.

  37. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    22. September 2010 at 05:11

    Scott, you said:
    “I think the Fed could have prevented a big fall in NGDP after September 2008, Krugman doesn’t seem to think so (based on what I read from him at the time.) He said because rates were zero there is nothing the Fed could do to stop the collapse. BTW, rates weren’t zero at that time, he just assumed they were.”
    In September/October 2008 Krugman was worried that Bernanke will not be responsive enough, and yes, he was right. Krugman was one of those few who understood that Lehman was such a huge shock to money demand that even ZIRP would not stop the collapse.

    If we are discussing Krugman, we should do it in terms of his 2001 model:
    http://www.princeton.edu/~pkrugman/next%20generation.pdf (chapter 4).
    In terms of that model, if Bernanke would be willing to do enough quasi-fiscal support combined with Svenssonian monetary targeting, crisis would be averted.

    “Regarding Bear Stearns; actually, I recall Krugman wanted to nationalize the banking system.”
    I believe this came later, after Lehman.

  38. Gravatar of Silas Barta Silas Barta
    22. September 2010 at 06:06

    @Lorenzo_from_Oz: There’s no need to caricature other’s positions as being that “massive downturns and increases in unemployment are good for the soul of the economy”. Nor to imply that I somehow disagree with the goal of decreasing unemployment — of course that would be good, the question is just how we are to achieve that.

    My position is that we should sustainably decrease unemployment, not just create fake, unsustainable employment by jawboning people into buying stuff they don’t want. Instead, the economy sould adapt to making stuff people do want, and would be glad to buy without jawboning, and which therefore sustainably employs people.

    That is part of why I always think in terms of “are the desires of individuals being satisfied”, in (apparent) contrast to the sorta-related question of whether people are spending. Yes, the latter *tends* to go with the former, but we need to check when that relationship breaks down — which it most certainly does when you make “increase in NGDP to god-decreed 5% trend” the central goal of monetary policy.

    If people in Australia are spending without having to be jawboned into it, great! That means the economy is producing what people want, and workers are organized into sustainable lines of production.

    But the rest of the world should be focusing on how to ensure a transition to an economy that makes things people want to buy, and employs people for making those things, rather than trying to trick them into buying what stuff it currently produces.

  39. Gravatar of Josh Josh
    22. September 2010 at 08:14

    Silas,

    I do not ignore the store of value function of money. In fact, I agree with you that the reason the demand for money increases is because of uncertainty and a “flight to quality”. Economists from Hume to Keynes to Friedman and Schwartz to Brunner and Meltzer, etc. have all agreed on this point.

    The point is that a disequilibrium is created when the demand for money falls — just as with falling demand for any good or asset. However, unlike other assets, an increase in the demand for money cannot be solved by increasing its price. What’s more, the fact that it is a medium of exchange results in a reduction in the demand for other goods and services. There are potential exchanges that could be made, but are not being made simply because individuals want to hold larger cash balances (and there is no mechanism to get us pack to equilibrium).

    You make the argument that this is good because it will and should reduce investment. Thus, what you are effectively arguing is for deflation which will eventually bring real balances in line with equilibrium. My argument is that when individuals want to hold more cash, they are effectively given more cash. This restores equilibrium and we don’t have to wait for prices to adjust. It is not clear to me how this necessarily creates malinvestment. Indeed, Hayek — whose monetary theory is almost completely concerned with malinvestment and resource allocation — advocated the policy prescription that I am describing.

    This conversation is clouded by the existence of central banks. Suppose that we lived in a world of free banking and without central banks. How would a free banking system get us back to equilibrium in the case of excess money demand? They would lower their reserve ratio thereby increasing the money supply.

  40. Gravatar of Silas Barta Silas Barta
    22. September 2010 at 09:29

    @Josh:

    There are potential exchanges that could be made, but are not being made simply because individuals want to hold larger cash balances (and there is no mechanism to get us pack to equilibrium).

    No, it would be more correct to say: There are potential disequilibrating changes that could be made, but are not being made because there is uncertainty about which lines of production will work to sustainably satisfy consumer demand, which is _reflected_ in the desire to hold larger cash balances (and this signal promotes a return to real equilibrium by encouraging re-evaluation of lines of production, and shifting resources to those areas).

    You make the argument that this is good because it will and should reduce investment.

    No, I make the argument that it will and should reduce *questionable* investment, and it will and should pave the way for entrepreneurs to identify the new, sustainable lines of production.

    My argument is that when individuals want to hold more cash, they are effectively given more cash.

    In other words, just give free money to everyone and everything will be okay because they can continue as they were, irrespective of any new economic reality?

    This restores equilibrium and we don’t have to wait for prices to adjust.

    Unless, of course, the new equilibrium you’re targeting isn’t the _sustainable_ new equilibrium in light of new economic realities, in which case you’re just blurring valuable price signals.

    This conversation is clouded by the existence of central banks. Suppose that we lived in a world of free banking and without central banks. How would a free banking system get us back to equilibrium in the case of excess money demand? They would lower their reserve ratio thereby increasing the money supply.

    Not if their contract with customers prevented it.

    In any case, private banks wouldn’t be in the business of planning an entire (monetary aspect of the) economy. If people wanted to hold onto the currency and not lend it out, the bank wouldn’t say, “hah, screw you suckers for holding our banknotes, we’re going to print and loan a lot more *anyway*!” Rather, it would say, “Gosh, there’s sure a lot of uncertainty about the future. Probably not a good idea to count on a lot of these more speculative projects to produce value down the road. Guess I’m going to have to be extra cautious about what projects I bankroll, and warn customers that they’d probably be better off connecting more directly with counterparties for investment-type exchanges.”

  41. Gravatar of Silas Barta Silas Barta
    22. September 2010 at 09:42

    @Josh: I should also add: there’s a big difference between

    “I, an economist, ‘get’ that money’s role as a store of value is important.”

    vs.

    “My economic models actually appreciate this insight and correctly adjust for this phenomenon over wide variance in this role, leading to good policy advice.”

    You’re right that lots of economists meet the first, but I’m more concerned with the second — and more disappointed with what I see.

  42. Gravatar of Josh Josh
    22. September 2010 at 10:14

    Unless, of course, the new equilibrium you’re targeting isn’t the _sustainable_ new equilibrium in light of new economic realities, in which case you’re just blurring valuable price signals.

    How are you defining sustainable? Hayek defines sustainability in terms of the coordination of the structure of production and the demand for consumption goods. Within his framework an increase in the money supply that corresponds with an increase in the demand for money does not distort the structure of production and does not distort price signals.

    I don’t know what framework you are using, but the prevention of monetary disequilibrium is a core concept among Hayek-minded Austrians, Monetarists, and Keynesians — or, in other words, monetary theory in general.

    In any case, private banks wouldn’t be in the business of planning an entire (monetary aspect of the) economy. If people wanted to hold onto the currency and not lend it out, the bank wouldn’t say, “hah, screw you suckers for holding our banknotes, we’re going to print and loan a lot more *anyway*!” Rather, it would say, “Gosh, there’s sure a lot of uncertainty about the future. Probably not a good idea to count on a lot of these more speculative projects to produce value down the road. Guess I’m going to have to be extra cautious about what projects I bankroll, and warn customers that they’d probably be better off connecting more directly with counterparties for investment-type exchanges.”

    I never said that banks in a free banking system would be concerned with the entire supply of money. What I said was that if the demand for money increases, banks in general will lower their reserve ratios because they notice that their banknotes are not being redeemed. This effectively increases the money supply. None of these banks is concerned with the overall money supply. This is in Larry White and George Selgin’s “How Would the Invisible Hand Handle Money” and elsewhere.

    Not if their contract with customers prevented it.

    Why would their contracts prevent it? The evolution of free banking doesn’t suggest that these contracts would emerge. Free banks routinely fluctuated their supply of notes relative to reserves.

    You’re right that lots of economists meet the first, but I’m more concerned with the second “” and more disappointed with what I see.

    I am not sure why you think that the role of money as a store of value means that the money supply should always and everywhere be fixed.

  43. Gravatar of Silas Barta Silas Barta
    22. September 2010 at 10:57

    @Josh:

    How are you defining sustainable? Hayek defines sustainability in terms of the coordination of the structure of production and the demand for consumption goods. Within his framework an increase in the money supply that corresponds with an increase in the demand for money does not distort the structure of production and does not distort price signals.

    Yes, that’s the definition of sustainability I’m using, and yes, increase in the money supply as conducted by central banking monetary policy does distort price signals, because it goes to specific players and favors their projects even in the absence of the level of coordination necessary for those projects to succeed.

    A recession involves a real discoordination, which is the source of the monetary disequilibrium. (A real discoordination raises the value of resources closer to satisfying consumer demand, as the uncertainty of the viability of each stage of production has incrased. Money is very close to satisfying consumer demand, because it is so liquid, and so it will get the biggest hike in value.)

    In such a discoordination, relative prices need to change to funnel resources back into sustainable lines, which will likely look very different from what exists at the time of the recession. Making loans to favored players so as to maintain the same level of money availability destroys the signals that a discoordination will send, and artificially makes projects look sustainable when they’re not.

    What I said was that if the demand for money increases, banks in general will lower their reserve ratios because they notice that their banknotes are not being redeemed. This effectively increases the money supply. None of these banks is concerned with the overall money supply. This is in Larry White and George Selgin’s “How Would the Invisible Hand Handle Money” and elsewhere.

    So what’s the point to your question? You and Selgin think free banks would work one way, I think the results of counterbalancing such contractions would discourage this from being a stable policy. Unless you can advance the disagreement beyond this point, I don’t know why you bring it up.

    Why would their contracts prevent it?

    Because some customers would want something like this? If not, I discussed the case of the other kind of customers.

    Free banks routinely fluctuated their supply of notes relative to reserves.

    And they routinely crashed too as a result of doing this, and they were routinely required to do stupid things with their holdings, and the laws about warehousing changed over this period, making it rather uninformative.

    I am not sure why you think that the role of money as a store of value means that the money supply should always and everywhere be fixed.

    Which has a lot to do with why I never said that it should be (check for yourself!). What I said was that using countercyclical policy to squelch premiums on cash during recessions does not help end the recession, but permits the discoordination to persist. See my latest reply to John Salvatier about what kinds of money supply increase are okay.

    The fact that I disagree with trying to hide the signal given by increased desire to hold money, does not imply that I want a fixed supply of anything — except economists that lack a well-connected understanding of the world, and that should be kept at zero 😉

  44. Gravatar of scott sumner scott sumner
    22. September 2010 at 15:02

    Silas, What about the 8 million that lost jobs? How do they get back to work if you don’t want the country to produce more?

    Ryan, The Fed controls monetary policy, it doesn’t have any control over whether credit is easy or tight.

    OGT, You said;

    “How did the CRA, Fannie and Freddie or Countrywide, for that matter, cause the housing bubble in Ireland? Or Spain? Or Britain? Or Latvia? Or Iceland?”

    This argument proves too much, as it implies nothing caused the US housing crisis, because I don’t doubt that any factor cited wouldn’t apply to every country. I’ve argued FDIC played a big role in our crisis. Anyone want to argue deposit insurance wasn’t the number one problem in Iceland?

    BTW, if you want to look at factors that affected every country, how about the big drop in NGDP? True, it didn’t fall sharply in Australia, but come to think of it Australia didn’t have a housing crash. Interesting coincidence.

    If Fannie and Freddie weren’t involved in the orgy of bad loans, perhaps you can explain why it will eventually cost the taxpayers zero to bail out the big banks, but $165,000,000,000 to bail out F&F.

    Greg, I don’t reify a trend line. I want the Fed to set an explicit target, if they don’t then I agree that there can be honest differences of opinion as to were we should be going from here. That’s why they need an explicit target.

    Sorry, I’ve forgotten Friedman’s plucking model.

    123, I don’t see your comment as contradicting me. I agree his earlier papers viewed monetary policy as being potentially quite potent, but he was clearly focusing on different issues by 2008. I also agree that Krugman thought a combined fiscal monetary stimulus could work, but I thought monetary policy alone could get the job done. For whatever reason, he didn’t think that was possible.

    BTW, I predicted fiscal policy would fail, I doubt Krugman would count that as a refutation of the view that fiscal policy was the way to go. He’d just say we didn’t do enough. That’s what I said about monetary policy.

  45. Gravatar of Morgan Warstler Morgan Warstler
    22. September 2010 at 22:18

    Scott, does it ever occur to you, that its pretty easy to pay people less money and hire the 8M back at less pay?

  46. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    23. September 2010 at 05:34

    “I don’t see your comment as contradicting me. I agree his earlier papers viewed monetary policy as being potentially quite potent, but he was clearly focusing on different issues by 2008. I also agree that Krugman thought a combined fiscal monetary stimulus could work, but I thought monetary policy alone could get the job done. For whatever reason, he didn’t think that was possible.

    BTW, I predicted fiscal policy would fail, I doubt Krugman would count that as a refutation of the view that fiscal policy was the way to go. He’d just say we didn’t do enough. That’s what I said about monetary policy.”

    His 2001 paper (he said it was prescient 2010) has two equilibria, and strong unconventional monetary or fiscal policy is needed to switch to a good equilibrium:
    “The general point is that intellectually consistent solutions to a domestic financial crisis of this type, like solutions to a third-generation currency crisis, are likely to seem too radical to be implemented in practice. And partial measures are likely to fail.”

    In 2008 he saw that unconventional monetary policy is too radical to be implemented in practice and supported fiscal policy. Now that there is no prospect for big further fiscal stimulus, he has explored monetary options again.

    Krugman’s 2001 model says financial crisis is only a trigger for low AD. High AD is all that it takes to solve the problem.

  47. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    23. September 2010 at 05:46

    On September 22, 2008 (one week after T-bills have reached the liquidity trap) Krugman said:
    ” Therefore, the reason changing the composition of the Fed’s balance sheet can move prices, to the extent it can, is because the Fed is taking on risk. This isn’t a role the central bank is meant to play; you’re sliding over into fiscal policy.”
    And well – credit easing was the main tool Bernanke has used to prevent the Great Depression II. And yet Bernanke should have done more credit easing, and he should have done it sooner.

  48. Gravatar of Josh Josh
    23. September 2010 at 07:16

    Silas,

    This conversation is never going to get us anywhere, so I leave you with the following response…

    Yes, that’s the definition of sustainability I’m using, and yes, increase in the money supply as conducted by central banking monetary policy does distort price signals, because it goes to specific players and favors their projects even in the absence of the level of coordination necessary for those projects to succeed.

    So, you say that you are using Hayek’s definition of sustainability, but you come to a different conclusion. Hayek favored a constant MV, or the equality of money demand and money supply. For more, see Larry White’s “Hayek’s Monetary Theory and Policy: A Critical Reconstruction.”

    So what’s the point to your question? You and Selgin think free banks would work one way, I think the results of counterbalancing such contractions would discourage this from being a stable policy. Unless you can advance the disagreement beyond this point, I don’t know why you bring it up.

    The point to my question is to show that in the absence of a central bank, the banking system as a whole would increase the money supply because of market forces and would not cause discoordination. George and I believe this based on historical evidence.

    And they routinely crashed too as a result of doing this, and they were routinely required to do stupid things with their holdings, and the laws about warehousing changed over this period, making it rather uninformative.

    A careful reading of banking history does not suggest that free banking led to crashes. When you state that they were “required to do stupid things”, this abstracts from free banking. See also Larry White’s Free Banking in Britain.

    The fact that I disagree with trying to hide the signal given by increased desire to hold money, does not imply that I want a fixed supply of anything

    Your examples are an increase in gold or a new common medium of exchange. Given that we don’t have a gold standard and there are legal restrictions on competitive currency, I would say that within the current institutional environment, you do want a fixed money supply.

  49. Gravatar of Silas Barta Silas Barta
    23. September 2010 at 08:46

    @Josh: You’re right, this isn’t going anywhere. And it doesn’t reassure me that you’re so assuredly arguing for your position despite your replies showing that you don’t have Level 2 understanding necessary to justify your economics. For example, when you rule out alternatives to US on the grounds that there are “legal restrictions on competitive currency” and we’re not in a gold standard, that shows that you weren’t even able to see the possibility of settling accounts using other assets, such as gold, or even foreign currencies.

    Similarly, you are non-responsive when you say this:

    A careful reading of banking history does not suggest that free banking led to crashes. When you state that they were “required to do stupid things”, this abstracts from free banking.

    Yes, these requirements are “noise” that keep us from being able to use the history of free banking as informative examples, as these other factors allow you to bend it toward any explanation you want. And I was referring to bank crashes, which they did — though again, this could be because of the requirements to hold stupid assets.

    When you’re so straightjacketed into thinking that so much of the economy must work exactly like it’s working now, you will be unable to see when your model has broken down. This is what I think has happened with mainstream monetary economists like Sumner and Krugman. Arnold Kling, by comparison, “get it”, as he is able to consistently identify when problems are due to things that such economists don’t talk about — like the consistent treatment of the economy as a homgenous “GDP factory”.

  50. Gravatar of Lorenzo from Oz Lorenzo from Oz
    23. September 2010 at 12:53

    Silas: Someone who ends a response to me with
    If your economic theory tells you that it would be a brilliant idea to print up new money and loan it at 0% to entrenched, incompetent big banks, then your economic theory sucks is not in a position to complain about caricaturing other people’s positions.

    you will be unable to see when your model has broken down.
    But Scott’s model seems to work quite fine in, for example, the Australian case. The US, and other countries, are having a nasty downturn. Downturns happen periodically (I do not believe the business cycle can be completely abolished, despite living in a country which has not technically had a recession since 1992/93). I am persuaded that the downturn happened because of poor monetary policy. I am also persuaded that the systematic injection of moral hazard into financial markets meant that some sort of financial crunch was likely. Whether the two had to happen together is another issue which strikes me as being about one level of counterfactual too far to examine easily.
    But I am not convinced that there is some huge structural adjustment needing to be made. It probably would be good if Americans saved more: it is useful to look at structural reasons why they do not. But that is about finding incentives created by processes with embedded negative externalities. And so on.
    But if the current downturn was created by poor monetary policy, it likely can be exited from more quickly by better monetary policy. That seems to me a good thing in itself.

  51. Gravatar of OGT OGT
    23. September 2010 at 13:21

    Sumner- I guess I’d rather prove too much than nothing. You’d be on much more solid ground developing a NGDP theory rather than chasing ideological ghosts involving Fannie May vs WaMu.

    Notice that I gave three plausible theories that could largely explain the international nature of the crash, including Beckworth’s which seems to boil down to the Fed being too loose then over tightening.

    I don’t mean to imply that financial governance is irrelevant, but it is not primary cause of the crisis. And any theory that says otherwise, from Krugman, Rajan, or Sumner, in my opinion can and should be safely ignored.

  52. Gravatar of Silas Barta Silas Barta
    23. September 2010 at 14:25

    @ Someone who ends a response to me with
    “If your economic theory tells you that it would be a brilliant idea to print up new money and loan it at 0% to entrenched, incompetent big banks, then your economic theory sucks” is not in a position to complain about caricaturing other people’s positions.

    If that’s not what you believe, then you’re not in agreement with scott_sumner either, and don’t fully appreciate what he’s advocating and why. You must have missed my earlier exchange with him (linked from the post), in which he really did agree with that caricature.

    Whatever policy you’re endorsing, it’s not scott_sumner’s favored one.

    But I am not convinced that there is some huge structural adjustment needing to be made. It probably would be good if Americans saved more:

    No, you don’t really believe that, because if they saved more, then the businesses scott_sumner is trying to prop up would have to shut down, and you would be endorsing my position that it is a *good* thing for those businesses to shut down and allow more competent entrepreneurs to repurpose their stuff to satisfy actual consumer desires — provide things that people would purchase *even if* the Fed didn’t threaten to erode their money right in their pockets if it weren’t spent soon enough.

  53. Gravatar of Silas Barta Silas Barta
    23. September 2010 at 14:26

    Oops, that should begin with “@Lorenzo_from_Oz”.

  54. Gravatar of scott sumner scott sumner
    23. September 2010 at 16:36

    Morgan, Inflation will reduce real wages. That’s waaaay easier.

    123, Read what Yglesias just wrote about the progressive movement. They were totally clueless that monetary policy could spur the economy in late 2008 and early 2009. Thought it was impossible at zero rates. And where does the progressive movement look for expertise on monetary issues?

    Yes, I agree that Krugman said all the things you said he did. But he also said 100 times more often that monetary policy can do nothing at the zero bound, and that’s all his readers remembered or understood.

    123, I disagree with him about taking on risk, that won’t do much at all. You must change expectations about future monetary policy, what he said in 1998.

    OGT, You said;

    “Sumner- I guess I’d rather prove too much than nothing. You’d be on much more solid ground developing a NGDP theory rather than chasing ideological ghosts involving Fannie May vs WaMu”

    The problem with people on the left is that they are trying to explain the housing bubble, but that’s not the problem. The problem is a mountain of bad loans. It makes no difference who made loans in which year. It’s funny that F&F need a $160,000,000,000 bailout, but somehow they are not responsible for the mountain of bad loans. Meanwhile the big banks are repaying all the TARP money, but it is all their fault.

    I’ve always argued that both the private and public sector are to blame, those who deny responsibility for the public sector have their heads in the sand.

    I’ve said from day one the crash was caused by tight money, not by banking problems. I have the theory that best fits the international nature of the crash. So I don’t understand how you can say my explanation tells us nothing about the international nature of the crash. I am not blaming F&F for the crash, I am blaming them for all the money they are taking from taxpayers. That’s what angers me. I’m also angry at the big banks, but at least they are repaying their loans. Surely that makes them slightly less objectionable than F&F. Regarding small banks I blame FDIC for weak oversight, letting them risk taxpayer money on excessively risky construction loans.

  55. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    24. September 2010 at 03:02

    Scott, you said:
    “Yes, I agree that Krugman said all the things you said he did. But he also said 100 times more often that monetary policy can do nothing at the zero bound, and that’s all his readers remembered or understood.”
    Yes, he made a colossal mistake by ignoring unconventional monetary policy in his propaganda pronouncements.

    You said:
    “123, I disagree with him about taking on risk, that won’t do much at all. You must change expectations about future monetary policy, what he said in 1998.”
    According to his 2001 model, central bank has to take on risk in order to credibly change expectations during financial crisis. Replacing short term bills with monetary base is just a cheap talk that achieves nothing. On September 29, 2008 Krugman was very worried, he wrote that three-month LIBOR was at 3.88. This of course meant that monetary conditions were tighter than was intended by FOMC, even though Bernanke had already done an unprecedented amount of unconventional stimulus. Only after October 6 and October 7 announcements that promised to do more unconventional stimulus and after October 13 announcement that promised unlimited amount of unconventional stimulus expectations stopped crashing.

  56. Gravatar of OGT OGT
    24. September 2010 at 04:53

    Sumner- If that’s what you’re saying then I think we’re in more agreement than I thought. Some commentator’s on the right have focused on Fannie and Freddie in order to absolve the mortgage brokers, rating agencies, banks and other private players. And yes, some on the left have done the opposite to try to prove the opposite. Both pretending that either was a proximate cause of the crisis.

    As you wrote above it was a mistake by liberls to defend FNMA and Freddie so vocifeously, as the article by Russel(?) you linked to a bit ago documented, the difference implied government backstops between the GSE’s and the big banks was never as bright as some have portrayed. They’re all GSE’s to an extent, and yes we got lucky that TARP didn’t cost much, but that wasn’t a given look at the UK, Ireland and Iceland.

  57. Gravatar of ssumner ssumner
    24. September 2010 at 16:18

    123, The “cheap talk” argument has zero empirical support. Even the slightest hint or whiff of inflation fro mthe Fed makes markets react strongly. Of course markets would believe the Fed if they set an explicit P-level target, level targeting. The Fed does not want to look like a complete fool. Krugman’s cheap talk theory comes from misinterpreting the BOJ. They promised no inflation, and they delivered no inflation. Promise kept.

    OGT, Yes, we are pretty close. Iceland is the most perfect example of deposit insurance run amok that I have ever seen. The Brits and Dutch thought the Icelandic people were backing up those deposits, and the Icelandic people were clueless about their exposure. The regulators should have never let them expand overseas, or if they did they should have gotten a promise from Britain that Iceland would not be responsible for losses.

  58. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    24. September 2010 at 16:48

    Scott, you are right about BOJ. BOJ promised zero rates and QE until deflation stops, and they delivered. But Krugman is right about September 2008. FOMC has promised 2% fed funds rate, but the Fed did not deliver – monetary conditions were much tighter. And the only way to restore credibility and ease monetary conditions was to take on risk (preferably while setting an explicit price level path target). Imagine if BOJ had promised zero rates until deflation stops, but the actual rates were 3.0% …

  59. Gravatar of Lorenzo from Oz Lorenzo from Oz
    24. September 2010 at 19:51

    Silas: I take Scott’s position to be that more money needs to be circulating/available for economic agents in general. I am not up enough on the specific mechanisms to say whether that has to be done via “entrenched, incompetent big banks”. But if they are entrenched and incompetent, that is not the consequence of monetary policy.

    If people’s incomes go up, their saving can go up without much (or perhaps any) decrease in income. Scott would like to see rising incomes. So would I. The saving question is a longer run, structural matter, surely.

    The problem with your “it clears out the deadwood” outlook to the downturn is (1) what determines “deadwood”? It is not as if firms do not go bankrupt in good times as well. The deeper the economic downturn, the lower the level of economic activity, the more businesses become unviable. But that does not prove that they should have gone. There are a lot of business which are perfectly viable in a prosperous economy but are not a goer in, say, Haiti. Viability is not independent of the level of economic activity. Pointing to businesses going bankrupt as the level of economic activity drops as “progress” is something with no bottom level, short of cessation of all economic activity.

    And (2) who bears the cost? All those unemployed Americans are not failed entrepreneurs, after all.

  60. Gravatar of David Tomlin David Tomlin
    25. September 2010 at 00:31

    Lorenzo from Oz:

    I am not up enough on the specific mechanisms to say whether that has to be done via “entrenched, incompetent big banks”.

    I think the Fed is authorized to buy just about anything it wants to. It could inject money via blasphemous bohemian artists by buying up the latest variants of ‘Piss Christ’.

  61. Gravatar of George Selgin George Selgin
    25. September 2010 at 04:32

    If Mr. Barta can supply so much as a speck of evidence supporting the following assertions I will eat my hat:

    “And they [free banks] routinely crashed too as a result of doing this, and they were routinely required to do stupid things with their holdings, and the laws about warehousing changed over this period, making it rather uninformative.”

  62. Gravatar of ssumner ssumner
    25. September 2010 at 06:11

    123, Again, I think a NGDP target, level targeting, would have been best. But even a price level target would have been much more effective–what he recommended the Japanese do in similar circumstances.

    George, I’m guessing he won’t be able to.

  63. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    25. September 2010 at 08:17

    Scott, I agree that NGDP path targeting would have been the best, and economy would eventually have returned to a desired equilibrium. The problem is the speed of the return. The Fed has lost credibility in September 2008 – monetary conditions were much tighter than 2% set by FOMC, and were getting tighter every day. This is why taking on risk by central bank a la Bagehot whould have been the necessary part of the solution.

  64. Gravatar of Lorenzo from Oz Lorenzo from Oz
    25. September 2010 at 14:18

    David: thank you.

  65. Gravatar of Lorenzo from Oz Lorenzo from Oz
    25. September 2010 at 15:20

    Apropos some of the conversation on this post, and Scott’s more general argument, this post has a link to a Reserve Bank of Australia research paper on monetary policy and asset bubbles. It is particularly good at showing up the very different policy settings in Australia.

    In particular, Australia does have a “four pillars” banking regime, where the big Australian banks of Westpac, the Commonwealth, NAB and ANZ are essentially protected against takeover. However, the other side of that is aggressive prudential regulation. It is a pragmatic policy trade-off that seems to work. In keeping with the very utilitarian Australian policy tradition.

  66. Gravatar of scott sumner scott sumner
    26. September 2010 at 06:47

    123, You may be right. I simply don’t know.

    Lorenzo, I love that term “pragmatic.” We’d do well to try to copy the Australian or Canadian banking systems.

    Still there is the question of how those banks would do if Australian home prices fell 30%. What do you think?

  67. Gravatar of Lorenzo from Oz Lorenzo from Oz
    26. September 2010 at 20:11

    They would certainly be under some strain, but there is nothing particularly odd about the mortgage products. In particular, if you default, the bank gets your house and pursues you for any other assets available. So any loss would be 30% less original deposit less amount paid back less other assets grabbed.

    So, their shareholders would take a real hit (as they did in the 1980s too), but I doubt very strongly the viability of the banking system would be at risk (but I am not basing this on careful analysis of the stats) though the Reserve Bank might have to intervene somewhat, even if only by reminding everyone of its lender-of-last-resort role.

  68. Gravatar of Lorenzo from Oz Lorenzo from Oz
    27. September 2010 at 13:58

    On the other hand, this post, full of revealing stats, suggests I might be being a little too sanguine. Australia does have a credit-fuelled housing price bubble (not that is any surprise to myself) whose collapse would strain the banking system.

  69. Gravatar of ssumner ssumner
    27. September 2010 at 20:12

    Lorenzo, Thanks for that info–I think we’ll all be watching closely. If the Australian market does not have a big collapse within 5 years, it will pretty much discredit the bubble theory of housing markets.

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