More evidence the recession was not caused by the financial crisis

Last night I criticized a new Robert Hall article in the JEP, which argued that the financial crises of 1929 and late 2008 caused the Great Depression and the Great Recession.  I pointed out that there was no financial crisis in 1929, and that it was the Depression that caused the later banking panics.  I pointed out that the 2008 recession was well advanced before the banking crisis of late 2008 occurred.  Undoubtedly those crises worsened each slump by further depressing AD, but they weren’t the cause—tight money was.

Soon after I read a new article by Lee Ohanian from the same journal that supported my argument regarding the Great Depression, and provided lots of new evidence for the current recession.  Here he points out that the Great Depression could not have been caused by the financial crisis:

For example, many cite the fact that the number of U.S. banks declined by about 40 percent between 1929 and 1933 as a central reason why the Great Depression was “Great,” and draw inferences from this fact for the potential effect of financial crises more generically (for example, Reinhart and Rogoff, 2009). But most of the Depression-era banks that closed were either very small or merged, which indicates that the decline in banking capacity resulting from bank closings during the Depression was small. In fact, the share of deposits in banks that either closed or temporarily suspended operations for the four years from years 1930–1933 was 1.7 percent, 4.3 percent, 2 percent, and 11 percent, respectively (Cole and Ohanian, 2001).

Moreover, the Depression was indeed “Great” before any of the monetary contraction or banking crises identified by Friedman and Schwartz (1963) occurred.  Figure 2 shows that industrial hours worked had declined by 29 percent between January 1929 and October 1930, which is not only before the first Friedman and Schwartz–identified banking crisis (November 1930 to January 1931), but is also before the money stock fell.

I agree with Friedman and Schwartz that the 1930s banking crises were important, but only because they led to the hoarding of base money, not for Bernankean disintermediation reasons.  Indeed Ohanian misses his strongest argument here—the 1933 crisis was worse than all the others put together, yet 1933 was the first year of recovery, seeing brisk growth in industrial production and prices.  You might argue; “But that’s because dollar devaluation pushed up AD in 1933.”  Bingo—it’s all about AD, not disintermediation.  Then Ohanian turns his attention to the current crisis:

The corporate sector typically has nearly as much cash as they invest in plant and equipment, and cash is relatively high during the last few years.

One possible issue with Figure 3, however, is that perhaps the cash reserves displayed in the figure are only being held in certain sectors while other sectors have little or no cash. To address this issue, Chari and Kehoe (2009, in progress) examine firm-level data from Compustat to compare firms that use external finance to those that do not. These data indicate that on average about 84 percent of investment is financed internally. Indeed, about two-thirds of investment is undertaken by firms not using external funds, and slightly more than half of the investment undertaken by those using external funds is still financed internally.  .  .  .

Another assertion often made in the financial explanation is that small firms have much less access to capital markets, and thus small firms decline much more than large firms during crises. However, Cravino and Llosa (2010, in progress) show that there is virtually no change at all in the relative sales performance of small versus large firms during the 2007–2009 recession. They compare the share of sales accounted for by small, medium, and large firms during the fourth quarters of 2007, 2008, and 2009. The shares are virtually identical in these periods, indicating that firm sales growth was unrelated to firm size. This fact is thus inconsistent with a central assumption in the financial explanation.

The financial explanation also argues that the 2007–2009 recession became much worse because of a significant contraction of intermediation services. But some measures of intermediation have not declined substantially. .  .  .  bank credit relative to nominal GDP rose at the end of 2008 to an all-time high. And while this declined by the first quarter of 2010, bank credit was still at a higher level at this point than any time before 2008.6 Similarly, flow of funds data show that borrowing levels of households and of the nonfinancial businesses that households own, are virtually unchanged since 2007, and that the composition of those liabilities across mortgages and other liabilities are also unchanged. These data suggest that aggregate quantities of intermediation volumes have not declined markedly.  But perhaps the most challenging issue regarding the financial explanation is why economic weakness continued for so long after the worst of the financial crisis passed, which was around November 2008

I’ve consistently argued that if the AD was there then firms would have supplied the output, and I think most business people would tell you the same thing.  Many have pointed to a Rogoff-Reinhart study that shows financial crises are usually followed by severe recessions.  I have responded by asking “how many of those financial crises were associated with a sharp currency appreciation?”   I believe the answer is “damn few,” and I often cite the US in the early 1930s, Argentina in 1998-2002, and the US in the last half of 2008.  Note that in all three cases the financial crisis was caused by tight money, and in the first two cases rapid growth resumed almost immediately after the currency was devalued.  Here’s how Ohanian addresses the evidence:

From the perspective of the financial explanation, the continuation of recession long after the worst of the crisis passed raises an important puzzle about why employment did not recover sooner. This question is not resolved simply by noting that economies often remain below trend for years following a significant financial crisis (Cerra and Saxena, 2008; Blanchard, 2009). In many of these cases, output remains below trend because productivity is far below trend (Ho, McGrattan, and Ohanian, 2010, in progress). But as documented above, the productivity deviation during the 2007–2009 U.S. recession was very small, which means that low productivity is not the reason why U.S. macroeconomic weakness continued.

Ohanian explores whether the Great Recession can be explained in a “neoclassical” (i.e. real business cycle) framework.  He argues that the data on hours worked, productivity, etc, indicate that the marginal rate of substitution between labor and leisure had fallen far below the marginal productivity of labor.  He speculates that various government policies might have created an implicit tax wedge in the labor market that discouraged employment.  In my view this explanation suffers from some of the same problems as the financial disintermediation story—it doesn’t explain the sharp fall in NGDP and RGDP after June 2008.  But in making his argument he keeps scoring points that indirectly support my alternative wage/price stickiness story.  It’s like some alternative universe version of TheMoneyIllusion.  We both agree that the standard story is wrong.  We both agree on why it is wrong.  But we disagree on which alternative story is better.  I believe Ohanian has a very persuasive critique of the disintermediation story, and I very much want Ohanian to win in his attempt to discredit the mainstream story.  Then the dispute will be between my sticky wage/price transmission mechanism for falling AD, and his tax wedge argument that relies on the sort of explanation put forth by people like Casey Mulligan:

A policy explanation for the 2007–2009 recession is that economic policies, including the 2008 tax rebate, the Troubled Asset Relief Program (TARP), the American Recovery and Reinvestment Act (ARRA), Cash for Clunkers, Treasury mortgage modififi cation programs, and other policies signififi cantly contributed to the recession. The common argument here is that these policies distorted incentives through their deficient design and also increased uncertainty about the underlying economic environment. . . .

For example, Mulligan (2010a) studies the possible effect of U.S. Treasury mortgage modification programs on the low employment rate by evaluating how the eligibility requirements for these programs implicitly raised income tax rates on some households to levels of more than 100 percent.

I think I know which alternative explanation will win out among mainstream economists.   :)

PS.  I did find one flaw in the Ohanian article.  He seems to assume that US productivity did much better than German productivity during the recession.  But this may be because he was only able to find employment data for Germany (which did not decline) whereas hours worked data in Germany (which did decline) might have told a different story


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52 Responses to “More evidence the recession was not caused by the financial crisis”

  1. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    13. November 2010 at 07:14

    1. The problem is with the financing of personal consumption

    2. “bank credit relative to nominal GDP rose at the end of 2008 to an all-time high.” – this ignores that backup credit facilities were drawn after alternative sources of finance have dried up. Ohanian ignores the tightening of lending standards

    3. During the early stages of 2008 recession, the financial stocks fell most. 2008 recession before Lehman can be described as a housing and financial recession.

  2. Gravatar of David Pearson David Pearson
    13. November 2010 at 07:48

    “These data suggest that aggregate quantities of intermediation volumes have not declined markedly.”

    Shadow banking system liabilities — repo’s and ABCP — suffered a sharp contraction and have yet to recover.

  3. Gravatar of scott sumner scott sumner
    13. November 2010 at 07:56

    123, I don’t agree.

    1. I believe the financial story is completely unable to explain the sharp fall in NGDP between June and December 2008. Tight money triggered a sharp fall in NGDP after June 2008, I don’t think there was anything going on in the financial sector at that time that could explain the collapse in AD.

    2. The collapse in housing construction occurred between mid-2006 and mid-2008, and thus cannot explain the sharp fall in output after mid-2008. That’s why other economists turned to the business credit explanation for the severe stage of the recession, but that doens’t fit either, for all sorts of reasons. The severe stage showed up in mid-2008 before the financial crisis affected business borrowing. Also, large firms with huge cash hoards were equally affected by lower AD as small firms that depended on borrowing. All indications suggest it was a AD collapse, which is of course a monetary policy failure. I used to think that the financial crisis triggered the collapse in AD, before I looked closely at the data and realized AD feel first. For instance, the high oil prices in mid-2008 reduced the demand for credit to buy cars. That reduced the Wicksellian equilibrium real rate. The Fed didn’t cut nominal rates, and thus AD started falling fast.

  4. Gravatar of scott sumner scott sumner
    13. November 2010 at 07:57

    David, The timing is still all wrong–see my answer to 123.

  5. Gravatar of Bogdan Bogdan
    13. November 2010 at 08:02

    It’s not that easy to wholly discount the role of (a version of) the disintermediation story, at least with regard to 2008. What can explain better the world wide freeze and capital flight after the (unexpected) Lehman Brothers bankrupcy?

  6. Gravatar of Bill Woolsey Bill Woolsey
    13. November 2010 at 08:56

    I guess I need to read the article, but I say, money and credit confused.

    There is no shortage of money, firms have plenty of cash. They don’t need to borrow.

    Why don’t they understand it is the quantity of money relative to the demand to hold money.

  7. Gravatar of David Pearson David Pearson
    13. November 2010 at 09:09

    The panic in the shadow banking sector and its sharp contraction began in July of 2007 and peaked in the fall of 2008. It was not a discrete event. Instead, it was a process by which the AAA-rated collateral that backed shadow banking deposits came to be suspect. Essentially, concerns started at BBB- tranches in January of 2007 (the day that HSBC and New Century both warned on subprime delinquencies) and began affecting the perception of AAA-rated collateral by July/August, when BNP Paribas suspended withdrawals from a suite of subprime-backed money market funds over pricing difficulties.

    Very much unlike the GD, runs on (shadow) banking system liabilities began concurrent with a mild fall in output and while inflation expectations were stable or rising (into mid-2008). The two are simply not comparable in this sense.

    I would recommend looking at a graph of the ABX index (subprime CDS) for the BBB-, AA, and AAA tranches. You might find that the “inviolable” AAA tranche began to deteriorate while inflation expectations were still rising.

    Here’s an ABX snapshot:

    http://bigpicture.typepad.com/comments/2007/07/wtf-is-going-on.html

    And the evidence of central banks stepping in to stem a panic in money markets after BNP’s fund suspension. Note that the collateral backing those funds was 80% AAA-rated:

    http://www.telegraph.co.uk/finance/markets/2813759/ECB-injects-emergency-funds-for-first-time-since-911.html

  8. Gravatar of Ryan Ryan
    13. November 2010 at 09:47

    Call me the crazy libertarian in the room, but every alternative explanation for these events seems short-sighted to me having been through ABCT and capital theory explanations.

  9. Gravatar of Ted Ted
    13. November 2010 at 11:22

    I don’t doubt RBC-like mechanisms played some role in the recession (like 100%+ marginal tax rates from mortgage modification programs), but I don’t think such theories can adequately explain the recession.

    As a side note, an interesting non-monetary model is Beaudry and Lahiri’s model of the crisis, which isn’t exactly RBC, but can match the stylized facts of the 2000s and the current recession without invoking sticky wages, prices, or monetary policy. It’s really hard to describe the model with a quick summary, but essentially it ties financial markets to the real-side of the economy through a rise in the risk premium around a bad productivity shock. I only recently read the paper and I’m still trying to fully wrap my head around their argument, but it gives a story at least a bit more plausible than most RBC models (the paper can be found here: http://www.frbsf.org/economics/conferences/1003/beaudry_lahiri.pdf ) .

    I still don’t know why this recession is so mysterious though – in fact, I think the beginning looked like a “news-driven” real business cycle or Pigou Cycle with incorrect expectations about future growth and asset prices which led to a recession when the expectations were proven incorrect. However, mid to late 2008 looked pretty much like a nominal shock.

  10. Gravatar of Doc Merlin Doc Merlin
    13. November 2010 at 11:53

    ‘Last night I criticized a new Robert Hall article in the JEP, which argued that the financial crises of 1929 and late 2008 caused the Great Depression and the Great Recession. I pointed out that there was no financial crisis in 1929, and that it was the Depression that caused the later banking panics’

    I completely agree here, Scott. I think we had an adverse supply shock in 2007, the fed responded by tightening money to keep cost push inflation from the PPI rising from raising CPI. Because they tightened money when the problem wasn’t loose money, we had a massive NGDP shortfall. This caused the banking panic.

  11. Gravatar of Doc Merlin Doc Merlin
    13. November 2010 at 11:55

    @Ted

    Thanks, I’ll check out the link.

  12. Gravatar of Thomas Barton, JD Thomas Barton, JD
    13. November 2010 at 16:01

    As an interested layman, do any of you believe that the five major banks are effectively insolvent and if they are and have been what role does this play in your discussion ?

  13. Gravatar of Shane Shane
    13. November 2010 at 16:06

    Rbc people are praising what are basically the effects of labor regulation on Germany; Reich and Stiglitz have gone Austrian. The answer must be simple like prof Sumner says

  14. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    13. November 2010 at 16:38

    Scott, the financial crisis that started in August 2007 has affected expectations of growth of broad monetary aggregates, unless counteracted by the Fed, this depresses AD. The Fed was very successful in doing that in 2007, not very successful in the first half of 2008, and horrible from September 2008.

  15. Gravatar of Matt Young Matt Young
    13. November 2010 at 16:50

    I have a real money velocity slowdown in the second half of 2007 as oil prices reached $70. The decline in oil imports was orderly until something happened in Jan 2008 when oil imports became terribly erratic. Erratic oil flow drove up the price beyond $120 and we crashed.

    So, in my theory, the AD slowdown was consistent and orderly with increasing oil prices, and likely caused by them. Sort of the most obvious party until proven innocent.

    But why did oil imports suddenly become erratic in the first half of 2008?

  16. Gravatar of C C
    13. November 2010 at 17:17

    Yglesias has a post up on the Ohanian paper.

  17. Gravatar of Morgan Warstler Morgan Warstler
    13. November 2010 at 20:17

    WalMart Inflation runs at 4%… Drudge message matches Palin, Government is cooking books on CPI…

    “At that rate, prices would be close to four percent higher a year from now, double the Fed’s mandate.”

    The Federal Open Market Committee’s statement said, “Currently, the unemployment rate is elevated, and measures of underlying inflation are somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate.”

    But since that statement, interest rates have actually gone up, backfiring on a Fed chief who wants his quantitative easing to spark inflation of 2 percent annually. A moderate amount of inflation would be considered good for the economy. The problem is that inflation is already running well above a healthy level, investors said, Bernanke is just not looking in the right place, like a Walmart.

    “I suspect that when the Chairman thinks about reflation he has a difficult time seeing any other asset besides real estate,” said Jim Iuorio of TJM Institutional Services. “Somehow the Fed thinks that if its not ‘wage driven’ inflation that it is somehow unimportant. It’s not unimportant to people who see everything they own (homes) going down in value and everything they need (food and energy) going up in price.”

    Next week, the government is expected to say its official measure of inflation, the Consumer Price Index, increased at a 0.3 percent annual rate, according to economists’ consensus estimate. Core CPI, excluding food and energy, is expected to climb just 0.1 percent.

    http://www.cnbc.com/id/40135092

    —–

    So, Ben’s on record at a 2% target, and OMG! we’re going to be running over that.

    Over at ZeroHedge et al, guys are running their own informal inflation lists – build a basket of goods ping it weekly. Their finding out what Mom’s all know, the lower prices that all finally happened when gas prices fell, are headed back the other way.

  18. Gravatar of Mark A. Sadowski Mark A. Sadowski
    13. November 2010 at 20:21

    Scott wrote:
    “He speculates that various government policies might have created an implicit tax wedge in the labor market that discouraged employment. In my view this explanation suffers from some of the same problems as the financial disintermediation story—it doesn’t explain the sharp fall in NGDP and RGDP after June 2008.”

    Bingo. Enough said.

  19. Gravatar of scott sumner scott sumner
    14. November 2010 at 07:21

    Bogdan, No one is “wholly discounting” the disintermediation story. I have no doubt that it was a real shock that hurt the economy. My argument is that is NGDP growth expectations had stayed stable, the financial crisis would have been far milder and the recession would have been quite mild.

    Bill, When he says firms have plenty of money, he means plenty of loanable funds. He’s not defending monetary policy (or at least not necessarily) but rather arguing the banking crisis did not cause the plunge in GDP (which began well before the banking crisis.)

    David Pearson, We know that the banking problems of 2007 did not have a significant impact on RGDP growth–rather NGDP growth was the driving force. The Fed was still able to offset the drag of banking on the economy by cutting rates. Then after April 2008 they stopped cutting rates even as the Wicksellian equilibrium real rate began to fall. This caused monetary policy to effectively tighten, and GDP (real and nominal fell after June 2008. There was nothing going on in banking that can explain the June 2008 turning point.

    Your graphs about mid-2007 don’t help us understand the crash of late 2008. As late as 2008:Q2 the US economy was still growing, and economists had no idea a crash was on the way. Neither did markets. And yet they were fully aware of the banking stress of mid-2007, and the bailout of Bear Stearns of March 2008.

    Ryan, I going to call you the crazy libertarian in the room unless the specific ABCT you refer to is the “secondary deflation” of late 2008.

    Ted, I agree about the RBC theories not being able to explain the full story, and I agree about the nominal shock of late 2008.

    Doc Merlin, Yes, I think you are right. I’ve also occasionally talked about how the Fed was thrown off its game by the higher oil prices—the cost of not focusing on NGDP.

    Thomas, That’s a good question. I am no expert here, but my hunch is that it will depend on the speed of recovery. But others may be able to provide a better answer. In previous posts I argued that one reason we kept increasing estimates of the total banking losses in late 2008 (even as the subprime crisis had been well understood for over a year) was that other types of loans were also increasingly going bad, as the overall economy declined. It wasn’t just about mortgage loans.

    Shane, Great comment. Yes, in a world turned upside down, who’s to say a lowly Bentley professor might not be right?

    123, Even in the first half of 2008 the Fed did enough to prevent a severe recession. The cause of the recession was their passivity after June. Here’s an analogy. If Russians hoard lots of US currency after communism collapses, and if the Fed doesn’t accommodate that hoarding, and if real interest rates rise as a result, and if the economy goes into recession, EVERYONE will blame the Fed. NO ONE will blame the Russians. In fact foreigners often do hoard lots of currency, and the Fed accommodates those increases.

    If banking turmoil increases the demand for base money very modestly between April and November 2008, and the Fed doesn’t accommodate that modest increase, and if real interest rates rise sharply, and if we go into a severe recession as a result, who’s fault is that?

    Matt, Oil prices rose because of strong global demand–that’s pretty clear. But that was only indirectly a factor. It led the Fed to worry excessively about inflation, and it also may have reduced credit demand as auto sales dropped. The Fed needed to offset that drop in credit demand with easier money–and didn’t.

    C, Thanks, that last paragraph is pretty sarcastic, but also pretty accurate–many conservatives do overstate the fragility of the economy.

    Morgan, Yes, that’s right. Over one two month period one retailer who sells lots of imported goods reports total price rises (unannualized) of less than one percent while the dollar is plunging. Hyperinflation is on the way!

    Ben targets core inflation, not headline, and always has.

  20. Gravatar of scott sumner scott sumner
    14. November 2010 at 07:21

    Thanks Mark.

  21. Gravatar of Morgan Warstler Morgan Warstler
    14. November 2010 at 08:10

    Scott, would you like to place a small wager on the WalMart price index? In three months time?

  22. Gravatar of David Pearson David Pearson
    14. November 2010 at 09:52

    My point was directed at the idea that causality ran from a crash in NGDP expectations to the financial crisis. The graphs support the theory that the latter predated the former, unless you believe “post-Lehman” was the “financial crisis” in its entirety.

    The crisis was a series of classic runs on the liabilities of the shadow banking system. The runs begin well before the crash in NGDP, and while inflation expectations were rising. This is very different from GD1.

    In August of 2007, following the failure of German bank IKB, the German banking regulator said Germany faced the worse financial crisis since the 1931 failure of Creditanstalt. In 1931, NGDP had crashed. In 2007, it had suffered a mild downturn.

  23. Gravatar of David Pearson David Pearson
    14. November 2010 at 10:10

    One last point on the linked graph. Ex-post, its easy to say, “well, those crazy investors should have known AAA-rated ABS was junk.” But expectations are what matters. Investors thought AAA-rated paper was safe in all but a cataclysm. The fact that this paper fell below par during a mild recession was a complete surprise to the holders. More important, private label securitizations were the backbone of repo and ABCP collateral, and repo and ABCP were the principal financing vehicles for the shadow banking system.

    So a surprise downgrade to collateral values occurs, this leads to shadow bank runs, the runs cause the failure or rescue of several major institutions, and the broadening concerns over repo and ABCP collateral value ultimately produce a system-wide run on shadow banks that infects the traditional banking system as well. Again, this sequence of events is quite different from 1929-1933.

  24. Gravatar of Doc Merlin Doc Merlin
    14. November 2010 at 18:03

    @Matt Young
    “So, in my theory, the AD slowdown was consistent and orderly with increasing oil prices, and likely caused by them. Sort of the most obvious party until proven innocent.

    But why did oil imports suddenly become erratic in the first half of 2008?”

    Could the crisis in Mexico (they are having severe problems with their oil production) and Venezuela (the same), and Iran (yep also the same), have caused it? If so, you are talking about a supply shock in oil, not a demand shock.

  25. Gravatar of scott sumner scott sumner
    15. November 2010 at 06:19

    Morgan, For complicated reasons I don’t bet with individuals. In any case, I’m not interested in betting on the Walmart index because:

    1. I know little about it.
    2. Even if I cared about inflation I wouldn’t care about that index.
    3. I don’t care about inflation, I care about NGDP growth

    David Pearson, My Hall post was in response to his claim that the financial crisis in the “fall of 2008″ caused the recession. RGDP fell at an annual rate of 4% in the summer of 2008. I think most economists agree with Hall that only the fall of 2008 crisis was severe enough to causes a severe recession. Like other economists, I also think that the 2007 crisis was not bad enough to cause major problems. As late as 2008Q2 the economy was still growing. Many prominent economists were saying we would avoid recession as late as the summer of 2008 (including the Fed.) So again, I am criticizing the widespread view that Lehman caused the severe phase of the recession. I think people have reversed causality, although I agree the financial crisis made the recession worse, just as the 1930s banking crises made the GD worse.

    David#2. I agree the sequence of events was different from the 1930s. If the financial crisis had never happened, I agree the recession would have been far milder. But that’s a different question from whether monetary policy was to blame. Again my analogy of the Russians hoarding currency and causing a recession because the Fed is passive. If that occurred I’d still blame the Fed, even though the recession never would have occurred if the Russians hadn’t hoarded US currency.

    Doc Merlin, As I recall there was no drop in world oil output in 2008. Perhaps you could say output increased less than normal, as Chinese demand was soaring.

  26. Gravatar of Full Employment Hawk Full Employment Hawk
    15. November 2010 at 06:19

    What is your response to the “Open Letter to Bernanke” posted in the Wall Street Journal Today?

    See http://blogs.wsj.com/economics/2010/11/15/open-letter-to-ben-bernanke/

  27. Gravatar of Full Employment Hawk Full Employment Hawk
    15. November 2010 at 06:31

    And what do you think of Paul Krugman’s response?

    http://krugman.blogs.nytimes.com/2010/11/13/axis-of-deflation/

    It looks like Krugman is a lot closer to your position than people Boskin and Taylor.

  28. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    15. November 2010 at 06:38

    Scott, you said:
    “The cause of the recession was their passivity after June.”
    The cause was their passivity after Lehman.

    You said:
    “If banking turmoil increases the demand for base money very modestly between April and November 2008, and the Fed doesn’t accommodate that modest increase, and if real interest rates rise sharply, and if we go into a severe recession as a result, who’s fault is that?”
    I don’t agree that the demand for base money after Lehman was “modest”. It was enormous.

  29. Gravatar of James in London James in London
    15. November 2010 at 06:50

    Oh no. Empire State Manufacturing Survey really bad for November. Scott, I guess we need another round of QE. It’s got to work … or my monetary theory’s wrong, and that can’t be.

    But your theory is wrong, the US is not a lab. The US$ economy is a lot, lot, bigger than the the US economy. Or, in your terms, US$ nominal GDP is much bigger than US nominal GDP. And US$ nominal GDP is growing quite fast enough already. That is what you miss. That is why you get so frustrated.

    Monetarily, the US is not an island, it cannot these days act alone. As you said in an earlier reply “the Fed doesn’t even know where the monetary base is”, and neither do you. Merely stating that the US$ is not a unit of account overseas is not enough, it is a very widely used medium of exchange throughout the world, just where it is only a “unit of account” misses this bigger picture.

    You know the US economy is in deep (structural) trouble, but you can’t see that US$ are flowing to the non-US, less structurally-troubled US$ economies. The US needs structural reform to create confidence in its economy. Once the housing and shadow banking bubble burst it was revealed quite how much other parts of the US$ nominal GDP area were outcompeting the US economy nominal GDP area. The whole US economy is now the “rust belt” of the US$ economy. It needs to reinvent itself, not attempt to reflate itself.

    The UK economy got back onto some sort of track when the new government came in committed to doing something about the fiscal deficit. Whether it will succeed is another matter.

  30. Gravatar of marcus nunes marcus nunes
    15. November 2010 at 10:44

    The “vultures” come back!
    http://online.wsj.com/article/SB10001424052748704327704575614853274246916.html?mod=WSJ_hp_LEFTTopStories

  31. Gravatar of Full Employment Hawk Full Employment Hawk
    15. November 2010 at 11:28

    “Once the housing and shadow banking bubble burst it was revealed quite how much other parts of the US$ nominal GDP area were outcompeting the US economy nominal GDP area.”

    That is because the dollar is overvalued. To make U.S. goods competitive, the dollar has to depreciate. One of the benefits of quantitative easing is that it achieves this objective. Also a depreciating dollar will cause less of the dollars flow abroad.

  32. Gravatar of Full Employment Hawk Full Employment Hawk
    15. November 2010 at 11:33

    ” “Whether it will succeed is another matter.”

    Reducing a government deficit reduces NDGP growth. Whether it will succeed depends on whether or not the Bank of England is able and willing to offest the effect of the contractionary fiscal policy with a sufficiently expansionary monetary policy. The thing Britain has going for it is that it is not in the Euro system so that the Bank of England can engage in an independent monetary policy.

  33. Gravatar of Doc Merlin Doc Merlin
    15. November 2010 at 12:32

    @Full Employment Hawk
    “Reducing a government deficit reduces NDGP growth”
    Although thats what Keynesian theory says. The data hasn’t borne that out.

    No, No, No! Reducing deficit spending doesn’t necessairly reduce NGDP growth. The entire 90′s in the US contradict you strongly. Iirc the late ninties and 00′s in Canda also do.

    And the 50′s in the US also contradict you. We had largest cut in government spending and RGDP and NGDP growth rate coincide.

  34. Gravatar of Doc Merlin Doc Merlin
    15. November 2010 at 12:33

    I mean fastest increase in NGDP and RGDP growth rates for the 50′s.

  35. Gravatar of Doc Merlin Doc Merlin
    15. November 2010 at 12:35

    @Scott:

    “Doc Merlin, As I recall there was no drop in world oil output in 2008. Perhaps you could say output increased less than normal, as Chinese demand was soaring.”

    Yes, a foreign demand shock can in some circumstances (if we are a very heavy importer of that good) look like a supply shock to us, if supply doesn’t rise fast enough.

  36. Gravatar of Doc Merlin Doc Merlin
    15. November 2010 at 12:51

    @Full Employment Hawk
    “That is because the dollar is overvalued. To make U.S. goods competitive, the dollar has to depreciate. One of the benefits of quantitative easing is that it achieves this objective. Also a depreciating dollar will cause less of the dollars flow abroad.”

    Sigh, I am tired of hearing this BS argument.

    1. The US produces a whole lot of goods that are competitive around the world, they just aren’t measured by trade balances on the positive side.
    This includes investment products and capital goods. The US has the most liquid and deepest capital markets in the world, so the rest of the world invests their savings here.

    2. Goods prices aren’t fixed, US goods are quite competitive as we have an extremely high per cost productivity. We lead the world in exports of industrial goods, chemicals etc. Lots of european and japanese car companies do quite a lot of manufacturing here.

    3. We tend to import inferior goods. If the dollar depreciates americans will simply shift to buy more cheap goods from China. Sorry but thats the way it is, other than oil we mostly import inferior goods and export normal goods, so a dollar devaluation will just hurt us in the trade market.

  37. Gravatar of james in london james in london
    15. November 2010 at 13:20

    @Full Employment Hawk
    “To make U.S. goods competitive, the dollar has to depreciate.”

    You are still missing the main point I was making, and that rather messes up your US country lab model, quite apart from your and Scott’s Keynesian sticky income fallacy. The past success of the US economy has established the US$ as a world currency. Sure, local labour overseas is often (but not always) paid in local currency, much else is paid in US$ or US$-linked: energy, raw masterials, professional services, management, bribes. The US is just part of the US$ economy.

    The US economy cannot be considered as a standalone economy. That is why QE probably won’t work, in Scott’s terms, US$ wide-economy is already growing his beloved NGDP rapidly, it’s just the bit of the US$ wide-economy most of you US citizens live in that is growing slowly. Your humungous public sector deficit, over 30% of total public spending and your massively messed up, your nationalised, housing finance market and many other hubristic imperialist statist ambitions (as Scott sometimes acknowedges, and sometimes seems not to).

  38. Gravatar of Full Employment Hawk Full Employment Hawk
    15. November 2010 at 13:37

    “US$ wide-economy is already growing his beloved NGDP rapidly”

    Growth in the dollar economy abroad does not create jobs in the U.S. and that is what it is all about. We need faster DOMESTIC GDP growth.

    Floating exchange rates make it possible for the United States to conduct an independent monetary policy and provide stimulus for DOMESTIC NGDP growth. The resulting deprecisation of the dollar will make U.S. goods more competitive and contribute to the stimulus.

    “other than oil we mostly import inferior goods and export normal goods, so a dollar devaluation will just hurt us in the trade market.”
    An decrease in the price of the goods we export and an incrase in the price of the goods we import will hurt us in the trade market?

  39. Gravatar of Full Employment Hawk Full Employment Hawk
    15. November 2010 at 13:40

    Bradfor DeLong in his latest post is sounding a lot like you.

    Keynesians like Krugman and DeLong have finally reconciled themselves to the reality that in the current political situation they are not going to get the second stimulus they have wanted and realize that if anything is going to be done to bring the unemployment rate down, monetary policy is going to have to do it.

  40. Gravatar of Full Employment Hawk Full Employment Hawk
    15. November 2010 at 13:48

    “Oh no. Empire State Manufacturing Survey really bad for November. Scott, I guess we need another round of QE. It’s got to work”

    On the other hand, “A government report released before the market’s open revealed good news for retailers heading into the holiday shopping season. Retail sales increased 1.2% in October — a far better number than the 0.6% gain expected by analysts. … There is a lot of demand out there and people feel better. Those who have money are spending it, said Harry Clark, founder and CEO of Clark Capital Management Group.”

    The problem for the manufacturing sector is that the dollar is overvalued, and cannot sufficiently compete at the current exchange rate.

  41. Gravatar of Full Employment Hawk Full Employment Hawk
    15. November 2010 at 13:52

    “Sigh, I am tired of hearing this BS argument…. The US produces a whole lot of goods that are competitive around the world … We lead the world in exports of industrial goods, chemicals etc.”

    Versus:

    “Oh no. Empire State Manufacturing Survey really bad for November.”

  42. Gravatar of Doc Merlin Doc Merlin
    15. November 2010 at 14:23

    @Full Inflation Hawk.
    “Oh no. Empire State Manufacturing Survey really bad for November.”

    Thats more a problem with NY than anything else. Manufacturing is growing quickly in the South and in Texas. Also you didn’t address my more substantive points, or for that matter James in London’s.

  43. Gravatar of Richard W Richard W
    15. November 2010 at 14:46

    @ Full Employment Hawk

    Here is a good research note from Jonathon Anderson who is emerging markets economist at UBS. Some parts are a bit too emotive but he does not have much good to say about the Mundell savings fundamentalism. He does believe renminbi appreciation would help to rebalance.

    http://www.allroadsleadtochina.com/reports/Anderson_November.pdf

  44. Gravatar of scott sumner scott sumner
    15. November 2010 at 20:00

    Full Employment Hawk, I really don’t think the right is thinking clearly about this issue. But I do have a new post pointing out some on the right favor more stimulus.

    Krugman’s right about the need for monetary stimulus, but wrong in suggesting fiscal stimulus would work.

    123, You said;

    “Scott, you said:
    “The cause of the recession was their passivity after June.”
    The cause was their passivity after Lehman.”

    Look at the monthly RGDP numbers from MA, the recession was half over before the financial crisis of the fall of 2008 even started. How could it have been the cause of a recession that was already half over? But I agree it made the recession far worse.

    James, So what do you think the effect of higher NGDP in the US would be?

    Marcus, Yes, that’s depressing.

    FEH, Yes, I agree about the BOE–the independent monetary policy is a key advantage–ditto for Sweden.

    Richard, I don’t think “Mundellians” like me have ever denied that it is the government and corporate sectors of China (often intertwined) that are doing the bulk of the saving. Indeed I’ve emphasized that point.

  45. Gravatar of James in London James in London
    16. November 2010 at 00:29

    Scott
    Like all good right wing liberal I think “evil comsopolitan thoughts”. National boundaries are artificial constructs that usually do not contain their populations or innovations or economies or money (importantly for your thesis). Sometimes you can have “socialism in one country” experiments, but they don’t end happily, as you pointed out recently about China’s GLF. Right wing liberal states like the US (almost an oxymoron but not quite) do not have very meaningful national NGDPs. That is why you are “pushing on a string” by printing money in the US. Put your own (structural unsound) house in order and then trust the market. Conservatives (of the right and left wing varieties)don’t trust the market, and that’s why they fear deflation.

    I could point to numerous examples in Europe recently wherby the market has coped with sudden, increased, hoarding of money. German companies putting workers on half time, giving them one month off or reducing shifts. Italian SMEs (the bulk of their economy)just coping. The US is a little special in going to widespread and rapid lay-offs, but when the banks and corporates believe in the Federal Reserve/Greenspan/Bernanke/Sumner “put” they have faith in being bailed out no matter how egregious their malinvestments. Faith in the state doing the right thing is just that that, trusting the market is grounded in thousnds of years of human civilisation and economic growth despite the state.

  46. Gravatar of 123 123
    16. November 2010 at 03:12

    Scott,
    you said:
    “Look at the monthly RGDP numbers from MA, the recession was half over before the financial crisis of the fall of 2008 even started. How could it have been the cause of a recession that was already half over? But I agree it made the recession far worse.”

    Monthly NGDP numbers from MA are more useful, but I believe they have high levels of noise. Before Lehman, markets expected that NGDP decline will be quickly reversed.

  47. Gravatar of ssumner ssumner
    17. November 2010 at 18:35

    James, Here’s an analogy. Say China produces all the output of a certain rare earth metal. Just because those rare earth metals are exported all over the world, doesn’t mean the Chinese can’t control the price by changing output. Ditto for the Fed and the supply of dollars.

    123, I don’t agree about NGDP numbers. The recession is a fall in RGDP, not NGDP. NGDP rose fast in the 1974 recession.

    I do agree with the second half of your statmetn, so I think we may reach a common ground:

    1. You have a initial recession, which the markets expect to be reversed. That gradually hurts asset markets and then hurts banking balance sheets.

    2. As the banking problems leads to a severe financial crisis, things get worse in September.

    3. Then in October if becomes obvious to markets that “Helicopter Ben” has no solution for the liquidity trap (and they were right) so in October forward NGDP forecasts fall sharply.

    How is that?

  48. Gravatar of Das Lehman-Märchen « Kantoos Economics Das Lehman-Märchen « Kantoos Economics
    28. November 2010 at 15:09

    [...] Sumner (Bentley), Große Depression (2 [...]

  49. Gravatar of Das Lehman-Märchen « Kantoos Economics Das Lehman-Märchen « Kantoos Economics
    28. November 2010 at 15:09

    [...] Sumner (Bentley), Große Depression (2 [...]

  50. Gravatar of 123 123
    1. December 2010 at 14:22

    Scott, your three points are OK, although on the first point I would say “asset markets predict recession” instead of “recession gradually hurts asset markets”.

  51. Gravatar of ssumner ssumner
    2. December 2010 at 18:31

    123, Yes, I’m fine with that.

  52. Gravatar of Das Lehman-Märchen | Kantoos Economics Das Lehman-Märchen | Kantoos Economics
    28. March 2011 at 03:28

    [...] Sumner (Bentley), Große Depression (2 [...]

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