I was originally going to entitle this entire post “Why me?” But I thought that would be too self-indulgent, even by the standards of this blog. What I would like to do here is trace the development of my research into monetary economics since 1986, so that you can see things through my eyes. Almost no one accepts my view that a tight money policy by the Fed caused the crash that occurred in late 2008. I hope that if you better understand the development of market-based monetary policy proposals, you will come to see my hypothesis as natural, even inevitable. If you’ve ever read Murders in the Rue Morgue, you might recall a scene where the detective walks silently through the streets of Paris with a friend, observing all the things his friend notices along the way. Then he suddenly breaks into his friend’s (silent) internal monologue, as if they had been conversing all along. That’s what I hope to do here.
This plan may seem like wishful thinking, but when I started thinking about this post a week ago I realized that those economists whose research interests were closest to mine (Bill Woolsey, Aaron Jackson, etc) seemed to also have views of the current crisis that were closest to mine. More recently I found out that both Robert Hall and Earl Thompson (who is a fascinating character) share some of my views, and this further encouraged me to do this piece.
In the early 1980s a “New Monetary Economics” began to be developed by people like Black, Fama, Greenfield and Yeager. In my view the two key figures were Robert Hall and Earl Thompson. One key idea was that both the (Keynesian) interest rate approach and the (monetarist) money supply approach were deficient. Rather, monetary policy was about changes in the price of money. Unfortunately, other issues like laissez-faire monetary regimes got mixed up in the movement, insuring that mainstream macroeconomists would pay no attention. I should also mention that even before the early 1980s, supply-siders such as Robert Mundell and Art Laffer had begun taking a price of money approach.
I began doing research on monetary economics in 1986 (with no knowledge of Hall and Thompson), and within a few months developed a set of ideas that I subsequently refined over the years:
1. NGDP futures targeting, which I presented at the AEA conference in 1987.
2. The view that the Great Contraction was caused by gold hoarding (which led to 20 years of research on this issue.)
3. A countercyclical wage model of the Depression (with Steve Silver), which also led to a nominal wage targeting idea.
4. An AS/AD model of real wage cyclicality (also with Steve Silver.)
5. A view that the General Theory only made sense as a gold standard model.
David Galenson has argued that conceptual artists do all their best work when they are young, as that is when they are able to generate new ideas. I don’t know if that applies to economics, but I have basically spent 23 years coasting on ideas from 1986. Unfortunately, in the 1990s I discovered that almost all my “great ideas” had already been discovered by Earl Thompson, although I don’t know if he ever published them. I have never interacted with Thompson, but I later came across a very impressive book by David Glasner entitled Free Banking and Monetary Reform (1989). Glasner acknowledged that he had been influenced by Thompson’s ideas. There I discovered someone else with the view that gold hoarding caused the Great Contraction, and also that the monetary standard could be based on a sort of futures contract, linked to the policy goal.
Scott Lawton found a new article by Earl Thompson and noticed some important similarities to my view. As you will see, there are good reasons why we would have similar views. In the last paragraph there is a link to a paper modestly subtitled “The Perfect Monetary System.” Amazingly, he might be right. In just two pages Thompson comes up with not one but two ingenious ideas. One is for a “labor standard” where the medium of account is a contract able to buy a fixed amount of labor, say five minutes worth. Basically, Thompson is advocating a nominal wage rule. At first glance you might think that constant nominal wages are the last thing we’d want, aren’t sticky wages the cause of business cycles? But that’s exactly the point, cycles occur when aggregate nominal wage levels must adjust. Because nominal wages are sticky these adjustments are slow, creating employment fluctuations. If you set monetary policy at a level expected to produce a stable aggregate nominal wage level, then you have set it at a level where you believe workers will not (on average) need to adjust nominal wages to prevent suboptimal employment fluctuations. Employment would remain at its Walrasian equilibrium level (ignoring price stickiness–which I think is less of a problem.)
Then there is the problem of policy lags. We don’t even know the current average wage rate, so how can we make dollars convertible into units of labor? Here is where Thompson’s second innovation comes in; the dollar would convert into wage units at a level to be determined in the future. The speculators who sold dollars to the central bank (expecting wage inflation) would be paid $1.02 if the future wage announcement came in 2% above target. (I also did a version of futures targeting with nominal wages, but eventually settled on NGDP as a more practical alternative—Robert Hall also preferred targets that combined prices and real output.)
BTW, take a look at the link above if only to see the condition of Thompson’s paper. I don’t know the mysterious Mr. Thompson, but I can imagine that he is almost as computer-phobic as I am. The first page is smeared with black ink like an old mimeograph, and the second is tilted bizarrely to the side. One of the most significant monetary policy documents of the 20th century looks like a scrap of the Dead Sea scrolls.
I have already discussed Hall’s important 1983 paper on interest-bearing reserves in earlier posts, so perhaps I should say a word about what unites these divergent approaches to my own. We all look at monetary policy in terms of changes in the value of the monetary unit, not nominal interest rates. Macroeconomic stability can be achieved with suitable adjustments to either the supply or demand for base money. The most effective policy would involve stabilizing the value of a forward-looking contract that is indexed to the goal variable (prices, nominal wages, NGDP, etc.)
In Thompson’s recent article he indicated that he tried to sell his idea to the Fed, but was rebuffed. I have the impression that he lost interest in research on forward-looking monetary rules, and who can blame him? After all, he had solved the problem of policy lags and no one seemed to notice. In addition, the macro establishment was obsessed with defining monetary policy in terms of short term interest rates, which are merely an epiphenomenon to the more fundamental process, changes in the supply and demand for base money, which produce changes in all sorts of asset prices.
Of course there are some differences between Thompson’s work and Hall’s research. Thompson’s work is to Hall’s roughly what folk art is to academic art. Hall went on to have a distinguished career doing work in a variety of areas within macroeconomics. A commenter named Dilip told me that he sent Hall one of my earlier posts, and Hall replied that he had given up pursuing his idea since no one was paying attention. (I was.)
I find it sad that the profession overlooked the importance of these early pioneers of market-based monetary policies. Perhaps they were ahead of their time. The boom in prediction markets as policy guides occurred much later, led by people like Robin Hanson and Justin Wolfers, who are not macroeconomists. Only in the last few months, however, have I realized just how costly this oversight has been, as I strongly believe the current crisis never would have happened had the Fed been using a forward-looking monetary policy linked to market expectations.
[For those new to my blog, I should mention that by "the current crisis" I don't mean the sub-prime crisis of late 2007 and the very mild recession of the first half of 2008, but rather the severe fall in NGDP in late 2008 and 2009, as well as the resulting sharp increase in unemployment and severe intensification of the debt crisis.]
Part 2: Recent Events:
Over the past 20 years I have published many papers on futures targeting, attended many conferences, and spoken with many people about the idea. Most people are skeptical. If you respond to all the concerns they have over technical details, they often fall back on the line “the Fed already has some of the best forecasters, why rely on market expectations when there is no evidence that markets can predict business cycles better than the Fed?” And I have to admit that the macroeconomic performance of the U.S. between 1982 and 2007 was pretty good, so I felt no sense of urgency in promoting an idea that might merely offer a marginal improvement in the precision of inflation targeting.
In the first 10 days of October I suddenly realized that the relatively good performance of the U.S. economy in recent years was merely a stroke of luck, and that the mainstream macro model was seriously flawed. Like a true monetary crank I became convinced that I was right and the rest of the world was wrong, and that all our problems could be solved by printing money. But first let me describe the events which led to this epiphany.
When people assured me that the Fed was already forward-looking, already setting policy at a level expected to achieve the target inflation rate, I thought, “Fine, I’ll judge Fed policy against a benchmark of market expectations.” As long as expectations were reasonably close to the Fed target (using indicators such as the indexed/nominal bond yield spread), then there was no cause to complain about the discretionary policy regime.
In the fall of 2007 I noticed that the markets exhibited a high level of uncertainty, especially when the Fed cut rates less than expected in December (the first month of the recession.) Stocks immediately fell 2% (an implied 5% swing in stock prices between a .25% and .50% cut in the fed funds rate.) I also noticed that although this was a contractionary policy surprise, recession risks rose so sharply that Treasury yields actually fell from 3 month to 30 year maturities. This made me especially aware of just how unreliable market interest rates are as indicators of the stance of monetary policy. Rates were falling because of tight money, not easy money as many economists assumed.
In January the Fed realized its mistake and did 125 basis points of cuts in about 10 days, forestalling a severe recession in the first half of 2008. About this time I saw a headline “economists expect recession,” and sensing that couldn’t be right, took a closer look at the article. In fact, the headline was wrong, a consensus of economists were not predicting recession. Then I asked myself why I had instinctively felt the headline had to be wrong, and I realized that economists should never be able to predict a recession if monetary policy was forward-looking. I had read a lot of work by Lars Swensson, who suggested that the Fed should target the forecast, and also statements by Bernanke indicating that he agreed with Svensson, or sort of agreed. Then I started working on a paper arguing that economists would never again be able to predict a recession, even by chance, for reasons summarized in the following quotation from James Hamilton:
You could argue that if the Fed is doing its job properly, any recession should have been impossible to predict ahead of time.
The intuition is that if the Fed always targets the forecast, and if Fed forecasts are pretty close to the consensus private sector forecast, and if the Fed never targets an NGDP growth path which is expected to generate a recession, and if recessions are avoidable right up to the moment they begin, then recessions will never be predicted by the consensus forecast. It may seem implausible that recessions are avoidable right up to the last minute, but recall that the recession that began in December 2007 saw positive real GDP growth in the first two quarters of 2008. A highly expansionary monetary policy in mid-2008 might well have prevented a downturn in the second half, and the first half of 2008 might not have been retrospectively labeled a recession. Recessions are not just downturns, they are prolonged downturns, and hence are preventable even after they have started.
When stocks and commodities crashed in the first 10 days of October, and inflation expectations plummeted in the bond market, it became immediately obvious to me that 2009 was likely to be a very bad year. I spoke with a number of other prominent economists, and found it was immediately obvious to almost everyone that 2009 was going to be a very bad year. It wasn’t just me. In other words, the Fed was no longer targeting the forecast. The fed funds rate (set at 2% at that time), was for the first time in decades set at a level where it was obvious that nominal growth rates would be far below any reasonable Fed target. (Yes, I know the Fed doesn’t explicitly target NGDP growth, but to hit their ”dual mandate” NGDP needs to grow at about 4-5% per year.)
Being the egotistical monster that I am, my first reaction was “how dare they wreck my clever recession forecasting paper!” By setting policy at a non-optimal level, they had undercut my key assumption. Even though this turned out to be one more in a long line of recessions that economists failed to forecast, I no longer had a plausible model showing that future recessions would also be unforecastable—because the Fed clearly wasn’t targeting the forecast. My second reaction was “not only is my paper ruined, but they are wrecking the world economy, wrecking the stock market, dramatically worsening the debt crisis, and triggered all sorts of highly counterproductive statist policies (auto bailouts, bank bailouts, pork spending, etc.)
In other words, I thought: “Why isn’t monetary policy much more expansionary?” For a while I actually wondered if I was going crazy. Everything I thought I knew about monetary policy seemed to be thrown out the window. The Fed had set the fed funds target at 2% from late April well into October, when it was cut to 1.5%. But why wasn’t it zero? Why wasn’t the Fed already doing enough quantitative easing to raise the expected NGDP growth rate back up to a more reasonable level? By the way, when I started becoming a monetary crank I estimated the market forecast at roughly zero percent NGDP growth over the next year, a disastrous figure in the midst of a financial crisis. We now know it will be much worse than that. But the important point is that even then we knew that growth was going to be far below target. This seemed to contradict everything I thought I knew about monetary policy. The last 6 months have been a sobering experience. Here is what I have learned:
1. Despite that fact that we teach our students out of textbooks that suggest the zero lower bound doesn’t prevent highly effective monetary stimulus, and despite the many foolproof escapes from a liquidity trap put forward by Bennett McCallum, Lars Svensson, and even Ben Bernanke himself, there never in fact was any kind of consensus that the zero bound did not inhibit monetary stimulus. The profession as a whole is just as afraid of a liquidity trap as was Keynes, maybe even more so.
2. There never was any sort of consensus that monetary policy should be forward-looking, especially no consensus that policymakers should target the forecast. We are for the most part stuck in a backward-looking “let’s try some stimulus and see how it works” world, where policymakers blindly press ahead even as markets are screaming that their policy has already failed.
3. Despite many articles pointing out that interest rates are a poor indicator of monetary policy; most economists still seem to assume that zero interest rates mean “easy money.” I thought that Friedman and Schwartz had disposed of that myth with their Monetary History. I guess not.
4. Despite the fact that the monetary aggregates were discredited in the 1980s, and despite the fact that people seek liquidity in an financial crisis, and despite the fact that the monetary base soared in the early 1930s, many economists seemed to think the Fed had adopted a highly expansionary monetary policy merely because the base was increasing. “Just give it time; we’ll see high inflation soon.” And many of these were right wing economists who supposedly believe in efficient markets. Somehow they failed to notice that the markets were signaling deflation in late 2008, and then less than 1% inflation for the next 5 years. And somehow they failed to recall that after 14 years the Japanese are still waiting for that “hyperinflation” that is due to arrive any day now.
5. The last straw was when the Fed started paying interest on reserves in October, and issued a statement that explained their motive was to keep interest rates from falling. Hall (and Susan Woodward) called this a “confession” of contractionary intent. I noticed that James Hamilton, Nick Rowe and a few other lonely voices also questioned this move. I immediately recalled the 1936-37 doubling of reserve requirements, another deflationary Fed policy adopted in the midst of depression.
I know that almost everyone has trouble accepting my “errors of omission” argument that the Fed caused the crash of late 2008. But put yourself in my shoes. For years I had read and been told that the Fed was essentially doing what I wanted them to do–targeting the forecast. It’s just that they used internal forecasts, not market forecasts. In addition all the cutting edge macro by people like Woodford emphasized that markets reacted not to the current setting of the instrument, but the expected future path of the instrument. In that world there is only one monetary indicator to watch. It is not short term interest rates. It is not the money supply (however defined.) It is the expected growth path of the policy target. For 25 years expected NGDP growth was reasonably stable, now it was suddenly plunging. And (from my point of view) the Fed had plenty of ability to ease policy further. In October it could have cut rates from 2% to 0%, it could have stopped paying interest on reserves, it could have put a penalty rate on excess reserves, and it could have purchased trillions in government debt. But not only was the Fed not doing all of those things, it wasn’t doing any of them in October 2008. (And here I am giving the Fed a break on its September meeting, when it almost certainly made a mistake in standing pat.)
This is not a retrospective attempt to second guess the Fed for past decisions; my complaints were presented in October to a wide variety of audiences, both inside and outside of Bentley University. Nothing that has happened since has in the slightest changed my view that the Fed policy in late 2008 was far off course, and that it should have been obvious to the profession at the time.
But it wasn’t. During late 2008 very few economists criticized the Fed’s monetary policy. Instead they focused on the pros and cons of the various bank bailout proposals—failing to see that the rapidly falling NGDP was actually worsening the banking crisis. How could macroeconomists fail to understand that falling NGDP will dramatically weaken a banking system that is already very fragile due to the earlier sub-prime crisis? And yet most people I talked to, and even most articles I read written by economists, treated the late 2008 worsening of the financial crisis as an exogenous event—with causation running mostly from crisis to falling AD. At least (in his appearance on 60 minutes) Bernanke finally admitted the reverse causation theme I had been forcefully advocating since October—he admitted that the weakening economy had made the debt crisis much worse than originally anticipated.
I already mentioned that Hall saw the folly of the Fed’s interest on reserves policy, which is not surprising as his 1983 paper implies they should now be paying a negative interest rate on reserves. I was very pleased to see that Earl Thompson also singled out the interest on reserves mistake, as well as several others made by the Fed. I do not agree with all of the specifics in the Thompson piece I linked to, but at least he is one of the few economists who seems to understand the nature of the problem.
For those who have argued over the years that the Fed could do just as well as the market, consider the following question: What would have happened if the Fed had set up a 12-month NGDP futures targeting regime in September 2008? Assume the market set the monetary base at a level expected to produce 5% nominal GDP growth. How bad would the crisis have been? I don’t expect the Fed to suddenly adopt such a policy in the midst of a crisis, but if it is the optimal policy regime I do expect the Fed to try to target internal NGDP growth forecasts in a roughly analogous fashion. What is the alternative? Setting a policy stance expected to produce failure?
Within a few decades there will almost certainly be prediction markets in the CPI, NGDP and all sorts of other key variables. Then the Fed will have nowhere to hide. The public will no longer stand for bland assurances that (despite market pessimism) policy is on course to produce target growth. Like the moment at the end of The Wizard of Oz when the curtain is pulled back on the wizard, the mystique of the Fed’s superior forecasting prowess will be exposed as a myth. When that happens, a future Keynes will look back on people like Thompson and Hall as unjustly ignored innovators, just as Keynes rediscovered some earlier monetary cranks in his General Theory:
It is convenient at this point to mention the strange unduly neglected prophet Silvio Gesell (1862-1930), whose work contains flashes of deep insight . . . As is often the case with imperfectly analyzed intuitions, their significance only became apparent after I had reached my own conclusions in my own way. Meanwhile, like other academic economists, I treated his profoundly original strivings as being no better than those of a crank. (p. 353)
By the way, in an earlier post I mentioned how Greg Mankiw had recently discussed a clever idea from a Harvard grad student for escaping the liquidity trap—it was essentially the same idea as Silvio Gesell had proposed.
Part 3: Why me?
OK, here is where I get really self-indulgent and ask why I am just about the only one who believes the Fed caused the crisis. I want to assure you that I have not become a complete monetary crank. I do know about how humans tend to be overconfident in their beliefs, and that (looking at the situation objectively) the odds are very strongly against me having any great insight. But even so, we can’t go through life without at least a bit of self-delusion, so bear with me as I consider why I might have stumbled upon an important hypothesis that had somehow eluded even greater minds. At least you will be happy to learn that I mostly attribute it to luck, being in the right place at the right time.
Let’s consider three levels of enlightenment:
Level 1: The pragmatist. (Often people out in the real world, like bankers, who look at things from the perspective of credit markets.) For them, the cause of the crisis is very simple. Banks are not lending and that is reducing nominal GDP. But do Zimbabwe’s credit markets work well? Is its nominal GDP falling?
Level 2: Traditional Keynesians and monetarists. The Fed cut rates to near zero, and dramatically raised the monetary base, so policy is obviously expansionary. How can tight money have caused the fall in NGDP?
Level 3: Sophisticated Keynesians and monetarists. If you followed my blog at all you must know that I am thinking about someone like Krugman here. A relatively sophisticated monetarist analysis is the linked editorial by Robert Lucas. He basically takes the “let’s wait and see how Bernanke’s policy works out” attitude that I criticized elsewhere.
I am saying that even the level three economists have it wrong. How can I possible out-analyze two Nobel prize winners? It’s not as hard as you’d think. Even extremely smart people make small errors all the time. The world is complex and people can’t possible understand everything. To use a scientific analogy, even a mediocre scientist can understand Newton’s Laws, but it took a genius to discover those laws. When you apply those laws to particular situations, however, even the discoverer may have difficulty, and slip up on a tiny technical detail that the mediocre scientist notices.
I would never be able to do the sort of technical academic research that Krugman and Lucas do, but I do occasionally notice factual mistakes they make, which affects their analysis. So let me reiterate what I think these two got wrong, and then explain why I was well-placed to notice those errors.
1. Krugman erred in assuming that the U.S. was stuck in an expectations trap. He assumed that the Fed was trying to generate faster nominal growth, but was unable to because the policies lacked credibility in the eyes of the markets. He specifically pointed to the huge increase in the monetary base. Here are some reasons why I think Krugman got it wrong, each of which are linked to my own research interests:
a. He cited previous examples of expectations traps in the U.S. (1932) and in Japan (late 1990s and early 2000s). I have studied both cases and published papers on both episodes. Neither case was what Krugman assumed. In 1932 the Fed was constrained by the gold standard. As soon as they left it they had no trouble generating inflation. The Japanese central bank did not try to generate modest inflation and fail, they never tried. They have successfully targeted a deflation rate of roughly 1% per year on average ever since 1994. When price stability threatens, they tighten policy to maintain deflation. Krugman’s second error was to view the huge increase in the U.S. monetary base last fall as an expansionary policy that failed. It did fail (he is more correct than Lucas on this point), but it failed because the Fed sterilized it with a policy of interest on reserves. Many of the people who have spoken out against this policy (Thompson, Hall, Woolsey, Nick Rowe, myself) have done research on monetary policy from a supply and demand for base money perspective, rather than the traditional interest rate perspective. That made us more sensitive to this problem. In addition, I studied the contractionary reserve requirement increases of 1936-37, which also made me sensitive to this error.
2. Lucas was right that monetary policy is effective in zero interest rate conditions, and that quantitative easing can work. He also understood that velocity can fall sharply in a financial crisis. But he erred in assuming that the current Fed policy was sufficiently expansionary. Like most economists, Lucas takes a backward-looking approach to monetary policy, putting far too much weight on the mysterious “policy lags.” Once again, there are no lags between monetary policy shocks and market expectations of inflation and real growth. And those market expectations were signaling loud and clear that the current level of monetary stimulus (when the article was written in December, and even today) is woefully inadequate. Because people like Aaron Jackson, Bill Woolsey, Earl Thompson and myself, have done a lot of research on forward-looking monetary policies utilizing market expectations, we were especially sensitive to this issue.
So to conclude, even in the unlikely event that I am correct in my key hypothesis, I don’t claim that it shows me to be a superior economist; rather, it was more a question of being in the right place at the right time. Some people wonder why I cling to such a far-fetched theory, the idea that tight money, not financial panic, caused the severe downturn 6 months ago. Given what I know (or think I know) about monetary policy effectiveness in liquidity traps, and given what I know (or think I know) about the need for a forward-looking monetary policy that targets the forecast, how could I have reached any other conclusion? Tell me which research papers that I published in the past 20 years are wrong, and I’ll gladly change my mind. But for now my hypothesis, counterintuitive as it is, is simply the logical implication of that body of research.