A few weeks back Tyler Cowen made this observation about my approach to monetary crisis:
Recently Scott Sumner visited us and I pondered the following.
Let’s say that at the peak of a financial crisis, the central bank announces a firm intention to target a path or a level of nominal GDP, as Scott suggests. If everyone is scrambling for liquidity, and panic is present or recent, and M2 is falling, I wonder if the central bank’s announcement will be much heeded. The announcement simply isn’t very focal, relative to the panic. A similar announcement, however, is more likely to work in calmer times, as the recent QEII announcement has boosted equity markets about seventeen percent. But for the pronouncement to focus people on the more positive path, perhaps their expectations have to be somewhat close to that path, or open to that path, to begin with.
(Aside: there is always a way to commit to a higher NGDP path through currency inflation, a’la Zimbabwe. But can the central bank get everyone to expect that the broader monetary aggregates will expand?)
The question is when literal talk, from the central bank, will be interpreted literally.
I’ve already taken one stab at addressing Tyler’s post, today I’ll take a couple more. BTW, you should read his entire post, as my excerpt doesn’t present the full argument.
Part 1. The root problem isn’t the Fed, it’s macroeconomists.
Most people think of my blog as a critique of the Fed, and in one sense they are right. But if anyone was crazy enough to read the entire nearly 2000 page blog, they’d notice another theme—a critique of the economics profession. In previous posts I observed that the Fed policy was usually close to the consensus of macroeconomists. That’s probably why the consensus of economists almost never blames the Fed for recessions, in real time. Instead, they say “most recessions are caused by drops in aggregate demand, but this one’s different because of blah blah blah.” After a few decades pass by, macroeconomists look at the time series data on output, prices and NGDP, and come to the conclusion that it wasn’t different after all. Most recessions (with the notable expectation of 1974) are now at least partly blamed on a demand shortfall. The Great Depression is obviously the best example of this sort of re-evaluation, but I am quite confident that future generations of macroeconomists will feel the same way about the big decline in NGDP during 2008-09. They’ll scratch they heads and ask why economists weren’t demanding easier money in the second half of 2008.
So on one level my blog is a critique of Fed policy, suggesting they should have behaved differently in 2008. But at a deeper level I am trying to grab the economics profession by the shoulder and shake them up: “You guys need to think about monetary policy in a different way, the current approach is what caused this crisis.”
You might ask why focus on economists, do they have that much influence? After all, economists believe in free trade but almost all countries have trade barriers. But monetary policy is different. Over time the policy apparatus has been increasingly turned over to economists, as non-economists find it hard to critique, or even to understand, concepts like the Taylor Rule. (Do you think Pelosi and Barney Frank knew IOR was contractionary when Congress gave Bernanke that tool in late 2008?) The best example of this phenomenon is the widespread adoption of inflation targeting by central banks all over the world after the debacle of the Great Inflation. Another example is the Taylor Principle.
Obviously I can’t claim that central banks precisely implement the preferred policy of macroeconomists, after all they don’t even agree among themselves. John Taylor thought money was too easy in 2003 and Paul Krugman did not. But my hypothesis does fit the current debacle fairly well. During the second half of 2008 there was relatively little criticism of the Fed for being too tight. Indeed at the time I couldn’t find any, although later I did discover a few other like-minded critics, mostly quasi-monetarists like myself.
So here’s one reply to Tyler Cowen’s argument. If the Fed promises to do what a majority of economists think it should do, then the markets will find that policy credible—even in the midst of a financial panic. The root cause of the problem in 2008 wasn’t Ben Bernanke’s passivity, it was that the economics profession did not see any problem with the Fed deviating from what I had assumed was their implicit policy—targeting the forecast.
Recall that almost everyone agreed that AD was likely to fall much more sharply than was desirable. So the problem was not that economists thought that the economy did not need more AD. They most assuredly thought it did, at least by October 2008. And the problem was not that interest rates were stuck at zero, they were 2% during the first week of October, and 1.5% throughout most of the remainder of the month. No, the economics profession knew the economy needed more AD and they knew the Fed had the ability to ease policy further. Why didn’t they march on Washington and demand easier money? I can’t say. I tossed around many theories but in the end I can’t think of anything more satisfactory than the “boo-boo” theory. Macroeconomists focused on the banking problem, and simply took their eye off the ball. They can’t walk and chew gum at the same time. They think that stabbing someone in the gut who also has pneumonia doesn’t make them worse off, because “the real problem is pneumonia.” And they thought that the Fed letting NGDP fall sharply during a banking panic wouldn’t make things worse because “the real problem was the banking panic.”
Part 2. Was the crisis really an exogenous shock?
Tyler’s comment uses the fairly widely held assumption that the crash of late 2008 was an exogenous shock, and the issue the Fed faced was what to do about it. I have two problems with this view. First, I believe there were two quite distinct shocks in late 2008, one of which was actually caused by the Fed. Second, I believe that even the other shock, (the banking panic) was partly caused by the Fed’s tight money policy (although not entirely.)
The commenter Cameron has been sending me a lot of quite interesting information recently, and I plan to do a post discussing his work in the near future. He has uncovered evidence that the stock market was being strongly impacted by monetary policy decisions during late 2008. For instance, check out his post here first, and then here. For now I’ll just repeat that while the banking crisis during September 2008 did depress stock prices, the severe stock market crash occurred in early October, during a period of little financial news but strong indications that NGDP was falling sharply and that the Fed did not intend to do anything about it.
I can’t prove this hypothesis, but I believe the most likely explanation for the October crash is that as of September 30, 2008, markets thought the Fed would not allow NGDP to fall at the fastest rate since 1938, and that as of October 10 2008 they realized that they were wrong. Yes, I know that here I am committing the cardinal sin of attributing my beliefs to the market. Actually, I am saying the markets were a bit ahead of me because if the market hadn’t crashed, then even on October 10th I probably wouldn’t have realized quite how severe the recession was becoming. (I suffer from data lags, but the stock market as a whole sees all macro data in real time, even if individual traders do not.)
1. If the economic consensus had been that the Fed should target NGDP, or even do price level targeting during a financial crisis, the Fed would have done exactly that.
2. If the consensus was that the Fed should do level targeting in a crisis, and the Fed in fact did level targeting in a crisis, then the markets would have believed the Fed would carry through with level targeting in a crisis.
3. With level targeting, monetary policy is able to greatly cushion the blow of a financial shock, even if monetary policy is completely impotent in the short run in a purely technical sense. Thus even if the Fed is unable to raise current M2 or lower current short term rates, level targeting will greatly reduce the fall in NGDP, and thus make the recession much less severe. There are two reasons for this, one general and one specific to the 2008 crisis. The general reason is that current AD is strongly affected by future expected AD, and asset prices are one important transmission mechanism linking the two. And the 2008-specific reason is that because level targeting would have made the asset price crash much smaller, it would also have made the financial crisis much smaller. Contrary to the conventional wisdom it wasn’t all about sub-prime mortgages, when NGDP expectations plunged in the second half of 2008 the crisis got several times worse, even though the sub-prime fiasco was already fully priced into the markets by mid-2008.
Thus when Tyler Cowen asks whether an aggressive Fed policy would have been credible in the midst of a crisis, my response is that if the Fed had the right policy regime, the crisis they would have been in the midst of would have been much smaller.
I’m trying to change the conventional wisdom on what the Fed should do in the crisis, much as Friedman and Schwartz changed the conventional wisdom about the Depression. Ideas matter, and this time the Fed did take steps to prevent a repeat of the Great Depression. With the lessons learned from this crisis we’ll eventually have a new conventional wisdom, and the macroeconomic fallout from the next financial panic will be even smaller.
Does a more stable macroeconomic environment cause the financial sector to take bigger risks? Yes, but the solution to that problem is not to create recessions, but rather to better regulate the financial industry. Creating more recessions doesn’t just encourage banks to take fewer risks; it also makes it much more likely that any given level of risk will result in a financial crisis. As we’ve just seen. With stable 5% expected NGDP growth the recent sub-prime crisis would have been a footnote in the history books, roughly like the 1980s S&L crisis. If you don’t believe me go back and read the news from late 2007 and early 2008, when the sub-prime fiasco was well understood. Only when the Fed let NGDP fall sharply in the second half of 2008 did the banking problem turn into the extraordinary, huge, gigantic, vast, enormous, mammoth, tremendous, titanic, humongous, immense, colossal, gargantuan, stupendous financial crisis of late 2008.
Tags: Taylor rule