What my lunch conversation tells me about the state of economics

I recently had lunch with a guy who is very bright, and pretty well-informed about economics.  He had seen Inside Job and immediately spotted the flaws.  He started lunch by asking me what I thought about the crisis.  I said; “do you want to talk about the financial crisis that took place three years ago, or the current problem of recession and 9.2% unemployment?”  He responded that most people see the two as related, that one led to the other.

I asked why a financial crisis in 2008 would cause high unemployment in 2011.  He talked about the loss of wealth, that people were cutting back on their spending—basically an AD-side explanation of the recession. 

I pointed out that he was confusing “spending” (i.e. consumption), with aggregate demand, which involves all types of output.  It’s not immediately clear that less consumption means less AD.  After all, savings equals investment, and investment is part of AD.  Less consumption is more saving, which means more investment.  At this point the Keynesian readers will be throwing bricks at the computer screen, we will go through a long fruitless discussion of planned and unplanned, and end up with the conclusion that more saving depresses interest rates, which lowers velocity, which lowers AD.  Fair enough.

But that would be equally true if the collapse of the Soviet Union led Russians to hoard $100 billion in US base money.  Yet I doubt you’d find a single economist arguing that that action would cause a recession.  The reason is that if the Fed were targeting interest rates, rather than the money supply, the Russian hoarding would be smoothly accommodated by the Fed, and NGDP would remain unchanged.  In contrast, the financial crisis led to velocity falling at a given interest rate, and thus the Fed might have needed to drive real interest rates much lower in order to prevent the rush for savings from lowering AD and NGDP.

Even so, they did have the power to prevent NGDP from falling 10% below trend in 2011, Ben Bernanke just reiterated that point yesterday.  So why does the banking crisis in 2008 cause low NGDP in 2011?  And then it hit me.  The intelligent but uninformed analysis of my non-economist friend had become the OFFICIAL DOGMA of the economics profession.  To deny that the banking crisis of 2008 causes the low NGDP of 2011 makes you a heterodox economist.  Out on the fringes.

And here’s what’s even more interesting.  I’m simply doing mainstream economics, right out of all the textbooks.  The rest of the profession is making it up as they go along.  Go back and look at your economics textbooks, and see where is says a banking crisis will cause NGDP three years later to be far below the level the Fed wants it to be at.  You won’t find it.  You’ll find 100s of models explaining how the Fed determines the path of NGDP.  But nothing about how banking crises make it impossible for the Fed to determine NGDP three years later.

You might be thinking; “But didn’t Bernanke argue the banking crises made the Great Depression worse?”  Yes he did, but he was also very critical of the Fed.  He argued that once the US cut the tie to gold, they had essentially unlimited ability to raise NGDP.  And of course in this crisis Bernanke has never once argued that the banking crisis prevents the Fed from raising NGDP three years after the crisis—just the opposite. 

But that’s where we are.  The common sense view of AD, that when America suffers great losses, it is important for millions of Americans to go on 99 week “vacations” in order to “rebalance” the economy, has become official dogma. 

You might argue that the recession is structural.  Yes, that’s possible, but nevertheless the official dogma is that demand is low because Americans are broke.  That’s not structural, that’s AD.  We have way too many houses, with no one to move into them.  No one except the millions of 20-somethings that are doubling up in their parent’s house.  And why are they doing that?  Because they are broke, they have no jobs.  And why do they have no jobs?  Because there’s no AD, because Americans are broke.  And why are Americans broke?  Because we built too many houses, so their value fell.  No one to live in those houses.  No one except all the young people who can’t afford houses because they have no jobs because there’s not enough AD.  And we all know the official dogma says there’s nothing the Fed can do about that lack of AD.  That’s how the banking crisis of 2008 mysteriously causes low NGDP in 2011.

In the future we should just let non-economists write our textbooks; at least if we plan on adopting seat-of-the-pants, common sense views as the OFFICIAL DOGMA of macroeconomics.

BTW, during the decade of 2001-11 housing construction in America was well below normal.  Too many houses or too little income?

PS.  Hang in there for just a couple more days and I promise my onslaught of posts will end, I’ll return to my normal one-a-day.


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56 Responses to “What my lunch conversation tells me about the state of economics”

  1. Gravatar of foosion foosion
    14. July 2011 at 05:53

    >>Even so, they did have the power to prevent NGDP from falling 10% below trend in 2011, Ben Bernanke just reiterated that point yesterday. So why does the banking crisis in 2008 cause low NGDP in 2011?>>

    It causes low NGDP because even though they may have the power to fix it, they are not exercising that power.

    I’m not sure if I’m agreeing with you or not.

    Isn’t the common sense view that we’re suffering from a lack of AD and therefore we need more AD, such as the govt propping up AD or possibly the Fed easing by further lowering rates (5 year TIPS are at -0.5% real) or raising inflation expectations? It’s so hard to tell what’s common sense any more.

    If I pay off a loan and the lending bank holds the money in reserves, has investment increased in a useful manner?

  2. Gravatar of Steve Steve
    14. July 2011 at 06:37

    My impression is that the non-economist explanation depends on political party.

    The democrats believe, as you stated, that the banking crisis has caused NGDP to fall 10% below trend, as you stated. This is the evil capitalist banker argument.

    Republican believe Obama’s policies have caused NGDP to fall 10% below trend. This is the evil socialist politician argument.

    http://online.wsj.com/article/SB10001424052702304911104576443953024891120.html

    From Robert Lucas in the WSJ:

    The persistence of growth 10 percentage points below its long-term trend line is troubling.

    He credits the current Federal Reserve with avoiding the mistakes of the Depression, properly acting this time as the lender of last resort. With the financial side essentially in order and the recovery stalled, Prof. Lucas sees public-policy analogies to the 1930s: “The likelihood of much higher taxes, focused on ‘the rich’; medical legislation that promises a large increase in the role of government; financial legislation that assigns vast, poorly defined responsibilities to the Fed and others.”

  3. Gravatar of Steve Steve
    14. July 2011 at 06:40

    Here’s how I would explain it:

    If the NGDP shortfall is caused by monetary policy, then nobody in Washington wins. Ergo, the NGDP shortfall is not caused by monetary policy.

  4. Gravatar of effem effem
    14. July 2011 at 06:41

    Scott,
    I’m confused on one major point. What exactly is the transmission mechanism between AD and jobs? The most intuitive would seem to be that higher AD = higher corporate profits = more jobs. However, corporate profits (and margins) are already at record highs and we have little hiring.

    Put another way – which environment would be better for job creation: 1) Higher AD but lower corporate profits, or 2) lower AD but higher corporate profits?

  5. Gravatar of Rien Huizer Rien Huizer
    14. July 2011 at 06:44

    Bless you!

  6. Gravatar of David Pearson David Pearson
    14. July 2011 at 06:47

    Scott,

    Imagine a model of home purchases. In period 1, the 25-35 cohort rents while they save up the down-payment for a house, while the 35-45 cohort buys a house. In period 2, the 25-35 cohort needs no downpayment and buys houses along with the 35-45 cohort. In period 3, the 25-35 cohort goes back to renting and saving.

    We are in period 3. All else equal in the model, demand for housing doubles in period 2, halves in period 3. Is this structural, or AD-related?

    Those “millions of 20-somethings” are renters, not homebuyers. If they are living with Mom and Dad, its because they don’t have a job that pays enough to make rent. That could be AD related, and it could also be a consequence of rents outstripping wages for more than a decade.

  7. Gravatar of Scott Sumner Scott Sumner
    14. July 2011 at 06:47

    Foosion, You said;

    “It causes low NGDP because even though they may have the power to fix it, they are not exercising that power.’

    But go back to my Russians hoarding currency example. If the Fed was passive, not one economist in the entire country would blame Russia for the recession.

    The common sense view is that the Fed has nothing to do with the recession. I’ve haven’t heard a single average person argue that tight money caused the recession.

    In your final example there was no change in aggregate saving, as both loans and deposits declined.

    Steve, No, the GOP (and Lucas) is blaming the fall in RGDP on structural problems, not the fall in NGDP. But that’s not the standard view. The standard view is that AD is low because Americans are poorer and are spending less, which of course makes no sense in terms of economic theory.

  8. Gravatar of Richard W Richard W
    14. July 2011 at 06:53

    Great post, Prof. Sumner. Underpinning our inability to act is the endemic almost quasi-puritan religious belief that somehow people need to be punished after a period of excess. This ‘ common sense ‘ moralising is implicit in so many of the made up economic reasons why so many economies are operating below potential. When nations current account surpluses and deficits are described in terms of virtue and sinners, it is obvious that we have lost the plot. As Adam Smith should have said too much moralising will lead to a great deal of ruin in a nation.

  9. Gravatar of Scott Sumner Scott Sumner
    14. July 2011 at 06:54

    effem, That’s a false choice, as the Fed has no control over corporate profits, much of which are earned overseas. The transmission mechanism is relative wages. If you boost NGDP, it lowers the ratio of nominal hourly wages to NGDP, and encourages firms to hire more workers.

    Thank you Rien!

    David, I don’t follow your argument. I am talking about the doubling up, which did not occur (as much) before this crisis. The renting is a side issue, my focus is the number of housing units being “consumed.” That is lower than either period one or two, and causes low new housing construction.

    I accept your assumption that some people who bought in period two should have rented. But if millions more rented today, wouldn’t that spur construction of new apartment buildings?

  10. Gravatar of Scott Sumner Scott Sumner
    14. July 2011 at 06:56

    Richard, Excellent point. Go back to February 2009 and you’d find one of my very first posts was on the puritan mindset in policy during this slump.

  11. Gravatar of Gregor Bush Gregor Bush
    14. July 2011 at 07:02

    Thank you once again Scott for putting my frustration into words. The consensus view among economists is that the economy is operating far below its capacity but there’s nothing the Fed can do about it. This of course makes absolutely no sense but it is the opinion of the overwhelming majority.

    “You’ll find 100s of models explaining how the Fed determines the path of NGDP. But nothing about how banking crises make it impossible for the Fed to determine NGDP three years later.”

    A big part of the problem is that most economists 9and here I’m taling about Wall St. economists who make up the majority of those in the Yahoo finance article you linked to previously)don’t think about NGDP. They think only in terms of RGDP and inflation. So they don’t ask the question “was this a real or nominal shock” where an AD shock is nominal and an AS shock is real. To them, AD is C+I+G+X-M all in REAL terms so shocks to AD ARE real shocks.

    That’s how they can hold the incoherant position that there is a large “output gap” but the central bank cannot and should not do anything about it.

  12. Gravatar of Andy Harless Andy Harless
    14. July 2011 at 07:19

    Even if one were to concede that monetary policy becomes ineffective when the short term interest rate goes to zero, it doesn’t justify blaming today’s problems on the 2008 financial crisis. People seem to forget that the federal funds rate was down to 1% in 2003. That’s only 75 basis points above the top of the current target range. And that was with the housing boom already in progress and with a budget deficit that was quite large by the standards of the time. What do people think would have happened if there had been no housing boom (and thus no financial crisis) and no wars and no tax cuts?

  13. Gravatar of David Pearson David Pearson
    14. July 2011 at 07:20

    Scott,

    I agree the millions renting should spur investor home purchases. However, we have structural mis-match in housing right now. Mulifamily (what renters want) is in short supply, whereas large single family has a glut. Multifamily starts are rising nicely, as one would expect, but it will take a few years of this to satisfy the excess demand.

    The other problem is house prices are still no bargain on a price to rent basis in bubble geographies. The supply of distressed properties is driving down this price-to-rent, but again, not fast enough. This is because Fed and federal government policies are propping up home prices (through ZIRP, FHA lending, regulatory forbearnce for banks, etc).

  14. Gravatar of Gabe Gabe
    14. July 2011 at 07:27

    Scott says: “The common sense view is that the Fed has nothing to do with the recession. I’ve haven’t heard a single average person argue that tight money caused the recession.”

    I apologize if I have been obtuse and overly confrontational in the past. I have a straight forward real question related to this comment:

    Do you consider it possible that the housing bubble as measured by the metric (Median House Price/Median Income) was very high and was bound to snap back to more normal levels at some point assuring a painful period was coming? In agreement with you, I 100% acknoweledge that the painful period may have been delayed for and indefinite period of time if the Fed had maintained an expansionary monetary policy for a longer time period, and so YES we agree that the Fed’s tight policy DID cause the painful correction. The continued downward pressure on house prices is still to blame on tight monetary policy IMO….but given the extremely high Price/Income metric(that fed policies helped create) this was going to happen at some point. Why did the Fed pop the housing bubble with tight policy? isn’t it true that the bubble was starting to spill over into gold/silver/$150 oil/copper/corn/ etc? and those pressures would have continued to build…this popping was going to come at some point…whether it was $150 oil or $250 oil or $20 corn.

    Do you see what I am saying?

  15. Gravatar of Scott Sumner Scott Sumner
    14. July 2011 at 07:28

    Andy, I agree, and in this recent post I discussed how we (including me) should have paid more attention to what 2003 was telling us.

    http://www.themoneyillusion.com/?p=9820

    David, I agree with much of what you say, I’d just add that “rising nicely” is nice, but twice that many being built would be twice as nice.

    But I certainly agree we can’t rely on residential construction for a robust recovery, we need many more sectors to be involved.

  16. Gravatar of Scott Sumner Scott Sumner
    14. July 2011 at 07:31

    Gabe, Yes, but the painful period was January 2006 to April 2008, when 70% of the decline in housing construction occurred. But housing is way too small a percentage of GDP for that to cause major problems, as a result unemployment only rose from 4.7% to 4.9% over those 27 months. The big rise in unemployment was caused by the tight money policy that drove NGDP much lower after June 2008, and cost millions of service and manufacturing jobs.

  17. Gravatar of Scott Sumner Scott Sumner
    14. July 2011 at 07:32

    Gregor, Good point.

  18. Gravatar of Joe Joe
    14. July 2011 at 07:34

    Isn’t this just a critique of the paradox of thrift?

  19. Gravatar of foosion foosion
    14. July 2011 at 07:47

    Scott

    “In your final example there was no change in aggregate saving, as both loans and deposits declined.”

    Agreed. We have a decrease in consumption and no increase in investment, so a decrease in AD as consumers deleverage in response to our recent crises .

  20. Gravatar of foosion foosion
    14. July 2011 at 07:54

    Steve,

    >>The democrats believe, as you stated, that the banking crisis has caused NGDP to fall 10% below trend, as you stated. This is the evil capitalist banker argument.>>

    As far as I can tell, the democrats believe the collapse of the housing bubble caused the problem. The evil capitalist bankers contributed to this problem, but the main issue is that the loss of perceived wealth and the need to deleverage have caused AD to drop. Businesses aren’t hiring due to a lack of customers purchasing their goods and services, raising unemployment and exacerbating the problem.

  21. Gravatar of effem effem
    14. July 2011 at 08:14

    Scott,
    The NIPA data breaks out domestic and overseas profits – both are at or near records.

    I think you are way to quick to assume.. “The transmission mechanism is relative wages. If you boost NGDP, it lowers the ratio of nominal hourly wages to NGDP, and encourages firms to hire more workers.”

    Let’s get specific…to me the transmission mechanism between lower wages and job creation is that lower wages = higher profits = greater ability to hire (and invest). Businesses are clearly not concluding that excess returns should be spent on new workers. If margins are already at record highs I dont see why pushing them to higher-than-record-highs (via cheaper wages) would matter.

    Perhaps you’ll like this choice better – which environment would be better for job creation: 1) higher wages and higher domestic corporate profits or 2) lower wages and lower domestic corporate profits?

  22. Gravatar of Steve Roth Steve Roth
    14. July 2011 at 09:05

    effem: “higher AD = higher corporate profits”

    No: higher corporate *revenues*

  23. Gravatar of effem effem
    14. July 2011 at 09:13

    Steve Roth:

    So then tell me – which environment would be better for job creation:
    1) higher corporate revenue & lower profits or 2) lower revenue and higher profits?

    Said another way, if you were running a business what would entice you more to hire – a revenue boost or a profit boost?

  24. Gravatar of Morgan Warstler Morgan Warstler
    14. July 2011 at 10:05

    Of course if we just take the growth path from 2000-2003, we’re right on target.

    Which simply means that 2004-2008, money was too loose and we grew too fast.

    Imagine 2004-2008 without everyone building selling and flipping houses – take all that fake unsustainable / fraudulent growth and lose it – that’s the new normal, baby.

  25. Gravatar of Morgan Warstler Morgan Warstler
    14. July 2011 at 10:08

    Also, this is not about puritan punishment, this is about risk reward!

    We are supposed to REWARD the smart money that got out early by letting them buy up all the hard assets when the music stops.

    That’s the game, until the hard assets switch hands – we won’t get people to play again.

  26. Gravatar of Floccina Floccina
    14. July 2011 at 10:19

    If economists cannot keep monetary policy straight in their heads how can we expect the median voter to understand monetary policy. If the median voter cannot be expected to understand monetary policy the federal reserve system cannot work as well it could in theory. Free banking would be one solution. IMO people have far too much faith in greenbacks and T-bills and perhaps too little faith in KO stock.

  27. Gravatar of Benjamin Cole Benjamin Cole
    14. July 2011 at 10:26

    It is very aggravating to read Scott Sumner and consider what are the actual policies of the Fed.

    Bernanke: Please let it rip. What are your afraid of? They could run you out of town on a rail, and you will still get a comfy teaching job somewhere and a great book deal.

    On the other hand, if you bore down, and do what Sumner says, and the economy revives, they will call you “Bernanke: the Merlin of Money.”

    Bernanke, you got one shot. Take it.

  28. Gravatar of Gabe Gabe
    14. July 2011 at 10:53

    Cole:
    Bernanke doesn’t work for us and he is not afraid of us.

    Extract from Woodrow Wilson’s The New Freedom (1913):

    “Since I entered politics, I have chiefly had men’s views confided to me privately. Some of the biggest men in the United States, in the field of commerce and manufacture, are afraid of somebody, are afraid of something. They know that there is a power somewhere so organized, so subtle, so watchful, so interlocked, so complete, so pervasive, that they had better not speak above their breath when they speak in condemnation of it.”

  29. Gravatar of marcus nunes marcus nunes
    14. July 2011 at 10:59

    Gabe
    A great (and frightening) quote!

  30. Gravatar of Gabe Gabe
    14. July 2011 at 11:06

    Scott:”…The big rise in unemployment was caused by the tight money policy that drove NGDP much lower after June 2008, and cost millions of service and manufacturing jobs.”

    and who benefitted from the “accidental” crisis the Fed created with it’s tight policies in the fall/summer of 2008?

    Who eliminated key competitors? who was able to buy up distressed assets cheaply? who helped write the “emergency” plans that “fixed” things afterwards?

    either it was intentional or the monetary policy decision makers are completely incompetant. In either case it is clearly dangerous to entrust these people with the amazing Lord-Of-The-Rings level of power with which they have been blessed.

    Coincidentally these same people claim the Fed “accidentally” caused the Great Depresion as well! Really?! these genius billionaires had no idea that tight money causes a lot of problems in a economy built on pyramids of debt?! You really think these people are dummies?

  31. Gravatar of Gabe Gabe
    14. July 2011 at 11:13

    Has there been ANY indication during the 2008 crisis that Bernanke/Paulson/Geithner have the median income american as their first priority in thinking about who bears the burden/benefits of their policies?

    People still honestly believe Bernanke is concerned about the well being of the average American as his first priority? You have the naivity to sit hear and wonder if Bernanke has ever thought of the idea of targeting NGDP in a systematic transparent like fashion? It’s like a 10 year old alter boy wondering why the preist is hanging aroung the changing room…kinda sickening.

  32. Gravatar of Floccina Floccina
    14. July 2011 at 11:26

    effem wrote:
    “Let’s get specific…to me the transmission mechanism between lower wages and job creation is that lower wages = higher profits = greater ability to hire (and invest). Businesses are clearly not concluding that excess returns should be spent on new workers. If margins are already at record highs I dont see why pushing them to higher-than-record-highs (via cheaper wages) would matter.”

    There are always firms struggling. If they survive by paying lower wages they keep supply up pushing prices down.

  33. Gravatar of effem effem
    14. July 2011 at 12:46

    Floccina…that seems a very minor point to me. The MUCH bigger point is that people here are arguing that revenues are a bigger driver of hiring decisions than profits. Anyone who has even run a business knows that’s not true.

    Record business profits (US and ex-US) along with very high unemployment means there is not necessarily a transmission mechanism between AD and employment.

  34. Gravatar of Staunch Staunch
    14. July 2011 at 13:59

    Effem,

    I don’t think one is more important than another. Both are important during the business cycle of a company. You can maintain or even increase profits, despite decreasing revenue, by reducing expenditures, via less labor, less R&D, less capex. But you cannot do that forever, or you’ll destroy your capabilities down the road. Things depreciate.

    In bad times, business will try to hold off expenses as long as possible, but eventually, they have to make those expenditures. The goal is to make those expenditures when revenue is increasing. Even if your profit margin is decreasing, your overall profit can stay the same or increase, because overall revenue is growing.

    The point is, revenue growth provides the leeway to make additional expenditures without reducing short run earnings.

    This is why (I think) growing revenue is still very important, if not the more important metric here vis a vis employment.

  35. Gravatar of malavel malavel
    14. July 2011 at 14:34

    “But that would be equally true if the collapse of the Soviet Union led Russians to hoard $100 billion in US base money. Yet I doubt you’d find a single economist arguing that that action would cause a recession.”

    If this caused zero interest rates and a recession due to Fed errors, I wouldn’t be surprised if lots of economists blamed Russia instead of the Fed. Didn’t lots of economists blame China for the Yuan exchange rate and their current account deficit?

  36. Gravatar of Mike Sandifer Mike Sandifer
    14. July 2011 at 15:34

    Scott,

    Obviously, Krugman often has similar complaints, but then goes on to argue China is begging they neighbor given that we’re in a liquidity trap, which strikes me as making up theory on the fly too.

    I’ve been thinking lately about macroeconomics curricula and wondering whether it might be a good idea to have some form of standardized testing on basic concepts before one earns each level of degree.

  37. Gravatar of Scott Sumner Scott Sumner
    14. July 2011 at 17:30

    Joe, No, it’s a critique of the state of modern macro. How we seem to just drift into “Pop-macroeconomics” (to borrow Krugman’s “Pop Internationalism” label)

    Macro theory doesn’t say a big loss of wealth will depress NGDP three years later, we’re just making it up as we go along.

    foosion, Whether AD changes depends on Fed policy, not whether someone pays back a loan.

    effem, You said;

    “Let’s get specific…to me the transmission mechanism between lower wages and job creation is that lower wages = higher profits = greater ability to hire (and invest). Businesses are clearly not concluding that excess returns should be spent on new workers.”

    I must have misunderstood you, as you seem to be directly contradicting yourself here. Do lower wages cause more hiring through higher profits, or not?

    You said;

    “Perhaps you’ll like this choice better – which environment would be better for job creation: 1) higher wages and higher domestic corporate profits or 2) lower wages and lower domestic corporate profits?”

    Obviously number one, but in that case I’d argue that relative wages would fall, even though absolute wages rose.

    Let me be clear, I think it was a mistake for the Fed to let nominal wage growth slow sharply–I’m not arguing for lower nominal wages.

    Morgan, You said;

    “Of course if we just take the growth path from 2000-2003, we’re right on target.”

    Drawing a line through a business cycle peak, and a trough (or soon after) doesn’t establish a trend line.

    Floccina, We can’t expect the median voter to understand monetary policy, just as I don’t understand how to fly a jet fighter. The Federal government’s duties do require expertise. But I’d like the market, not the Fed, to be setting interest rates.

    Benjamin, I’m afraid he’s already missed his chance.

    Gabe, I don’t think many people benefited–certainly not the banks.

    I think Bernanke is well-intentioned. I’ve met him, and he certainly seemed like a good guy. I can usually tell.

    effem, You said;

    “Record business profits (US and ex-US) along with very high unemployment means there is not necessarily a transmission mechanism between AD and employment.”

    I flat out guarantee that if AD grew at 7% in 2012, we’d get lots more jobs.

    Malavel, You said;

    “If this caused zero interest rates and a recession due to Fed errors, I wouldn’t be surprised if lots of economists blamed Russia instead of the Fed.”

    If the Fed did nothing, short term rates would initially rise. But that doesn’t happen because the Fed targets rates. It wasn’t a hypothetical, BTW, it did happen and had no effect on the US economy. Have you ever heard an economist complain that interest rates were high because Colombian drug lords were holding lots of US currency? I never have.

    Mike, I agree on Krugman and China, but economists could never agree on a standardized test.

  38. Gravatar of Bonnie Bonnie
    14. July 2011 at 18:14

    “The common sense view is that the Fed has nothing to do with the recession. I’ve haven’t heard a single average person argue that tight money caused the recession.”

    We’ve never met, but if we were acquainted, you might have heard me argue that persistent tight money caused the recession to become severe and lengthy. I don’t get very far being a classical liberal who hangs out in a circle with mostly Rothbardian conservatives. While there are many points on which we have a meeting of the minds, economics isn’t one of them.

    I finally gave the Austrian school a look over. I get their point about the price fixing of credit and what it does to the business cycle. In my view they don’t spend a whole lot of time thinking about how to fix the monetary system we have because they hate it. With that in mind, one would think that taking the argument that tight money, a Fed blunder, is at the heart of this mess in which we find ourselves and screaming it from the rooftops would only bolster their hopes of getting enough public support for stripping the Fed of most of its power, if not completely eliminating it. Most of them are already in such hysteria about the coming inflation and are so focused on trying to pin every price change in the positive direction on the Fed that the perfect argument to serve their purposes goes unnoticed. If you ask me, Jane Average, what the Fed did (or didn’t do) in the fall of 2008 was derelict, at best, but probably hovers in the territory of criminal negligence. And I’m sure other “average” people would be quite angry about it if they only knew what really happened; and they would probably more angry about that than some bout of inflation that might or might not happen in the future.

    I am not taking a swipe at the Austrians here at all. In fact, I mostly agree with them on what the ideal monetary system might look like. But that isn’t the world we live in at the present. And so what I would like to see happen is fix what we have and then have a plan about how to get to where they think we should go so the least amount of harm is caused in the transition. I haven’t heard any details, only something about the sky falling.

    And by the way, the book “Rollback” by Thomas E. Woods, Jr. does a pretty good job of explaining the basics of the Austrian school; at least I came away with the feeling that I understand that point of view more clearly, if anyone doesn’t know about it and is curious.

  39. Gravatar of Declan Trott Declan Trott
    14. July 2011 at 18:28

    Hi Scott,

    Welcome back. You once asked Bernanke if we needed to worry about financial stability as long as NGDP was steady. I’ve been reading his Essays on the Great Depression, and I think his answer back then (1983 AER, reprinted 2000) was “no”, the banking crisis was a demand shock not a supply shock.

    “Unless it is believed that the outputs of large and of small businesses are not potentially substitutes, the aggregate supply effect must be regarded as not of great quantitative importance. The reluctance of even cash rich corporations to expand production during the depression suggests that consideration of the aggregate demand channel for credit market effects on output may be more fruitful.”

    The problem with disintermediation is simply that it creates bigger risk premia, and therefore makes the zero lower bound on safe assets into an even higher rate for risky borrowers. (I think Woodford did a paper something like this too.)

    Logically, then, if we overcome the zero lower bound with level targeting, a financial crisis doesn’t matter. (Of course, if we do that there probably won’t be a financial crisis in the first place.)

    To me this destoys any remaining consistency between Bernanke’s academic views and the Fed’s actions. If he believed, like Stiglitz, that financial disintermediation has big supply side effects, then it would make sense to take drasic bailout action at the same time you are trying to contain inflation (by implication, NGDP) with IOR. But if the goal is simply to keep people spending . . . then it is merely what it looks like, an ugly, incoherent mess.

  40. Gravatar of Greg Ransom Greg Ransom
    14. July 2011 at 23:44

    “And why do they have no jobs?”

    Because they can’t produce enough value to consumers in the world economy to cover their overpriced demand for compensation.

    They can’t produce the value because America has the wrong capital and workers have the wrong skills, and there are too many alternatives to laboring.

  41. Gravatar of Greg Ransom Greg Ransom
    15. July 2011 at 00:01

    Scott now reveals himself to be something of an old fashioned left wing secular stagnation / general glut economist.

    We can’t have a distorted production structure with massive overstocks of extremely long term & still over-priced production processes (e.g. housing) — no, the problem is we aren’t giving people enough money (without any trade for value output from them) to buy all of these extremely long period production processes.

    Do we expect a second dumping of money into extremely long term production processes (i.e. housing) to be any more sustainable the 2nd time we do this, than it was the first time?

    If the buyers are not creating enough value from their labor to sustain it, inflationary money creation will certainly not be capable of sustaining it — without, that is, an ever geometrically increasing inflation.

  42. Gravatar of Greg Ransom Greg Ransom
    15. July 2011 at 00:10

    The relative structure of alternative production processes is re-configuring — this HAS to happen to shorten the time structure (FEWER extremely long term production processes like housing — most houses produce output for more than a hundred years). Workers have to reconfigure themselves into this reconfiguration as well — finding new jobs and groping to find what their work is actually now worth in a completeky new relative price & interdependent production structure.

    Into this re-configuration process the government & the Fed throw monkey wrenches.

    And we wonder why the reconfiguration process is JAMMED?

  43. Gravatar of Greg Ransom Greg Ransom
    15. July 2011 at 00:19

    2000-2006 saw new home sales far beyond anything ever seen in the nation’s history — and new home sizes were far larger than ever before seen in the nation’s history.

    See this chart:

    http://cr4re.com/charts/charts.html?New-Home#category=New-Home

  44. Gravatar of Greg Ransom Greg Ransom
    15. July 2011 at 00:22

    We also need to look at new home started and new homes completed — record levels far beyond anything ever seen throughout most all of the last decade:

    http://cr4re.com/charts/charts.html?New-Home#category=New-Home&chart=NHSInventoryMay2011.jpg

  45. Gravatar of Scott Sumner Scott Sumner
    15. July 2011 at 09:40

    Bonnie, But would you agree that most people didn’t see tight money as the problem?

    Declan, Thanks so much, I’ll do a post on that.

    Greg, You said;

    “Scott now reveals himself to be something of an old fashioned left wing secular stagnation / general glut economist.”

    Huh?!? I suppose Milton Friedman was too.

    The housing sector is far too small to cause this severe unemployment in 2011. As you know, 70% of the decline in housing occurred between January 2006 and April 2008. And yet unemployment merely edged up from 4.7% to 4.9%. So much for the Austrian story. Those graphs greatly exaggerate the recent construction, as the country was much smaller in population the 1960s. Plus they exclude apartments, they only look at single family homes.

  46. Gravatar of Cahal Cahal
    15. July 2011 at 11:16

    Scott, small part of your article, but I am confused by your dismissal of well researched and made movies like Inside Job. Do you not believe on *some* level that banks are engaging in huge rent seeking, extracting money from their economies (witness: EZ, stagnant median incomes), and think that Yves Smith, Michael Hudson, Steve Keen and whoever else are completely wrong?

    Don’t get me wrong, there are no lizard people here – just a series of opportunistic attacks that have culminated in something far greater than the sum of their parts. It just confuses me that you don’t agree financial institutions in their current form are a massive problem.

  47. Gravatar of Mike Sandifer Mike Sandifer
    15. July 2011 at 14:15

    Cahal, I stopped watching Inside Job early. It was substanceless.

  48. Gravatar of A E Pasquino A E Pasquino
    15. July 2011 at 21:25

    I see a lot of tail-chasing in the piece you’ve written. There weren’t too many houses when working people had sufficient income, when incomes kept pace with rising costs of fuel, healthcare, tuition, food, etc. Incomes for most people have been flat for forty years. They didn’t believe it because they were told it was Morning in America, and banks gave them credit on their homes to cover the gap. Do we call this a Ponzi scheme? And who’s culpable in such schemes? The ones running it or the ones fleeced? It’s the same with the budget deficit: if average incomes had kept pace, fewer would need government programs and more people would be paying more taxes on better incomes. It’s the top few who do the best job of evading taxes. Who are the culprits and who are the victims? Sensible people should be able to look at trends these past few decades and see that George Bush Sr. was right. It was Voodoo, and it killed a very strong economy.

  49. Gravatar of Greg Ransom Greg Ransom
    15. July 2011 at 23:01

    Scott, you continue to fail to comprehend the difference between houses started, houses complete, and houses sold.

    See particularly this chart:

    http://cr4re.com/charts/charts.html?New-Home#category=New-Home&chart=NHSInventoryMay2011.jpg

    Also, it is a Turing Test fail to characterize the Hayek boom / bust construct as being isolated in exclusively the job site of houses being built.

    I actually can’t comprehend how you can pretend to yourself that Hayek’s construct isn’t an economy wide construct taking in ALL links in the economy. It’s an “I, Pencil” wolrd, and essay inspired by Hayek’s famed 1945 essay, and essay inspired as much by Hayek’s boom-bust construct as anything else.

    I’ve driven past 30miles of moth balled lumber hauling rail cars — just one of dozens of work intensive industries touched by just the housing part of the story.

    The Hayek story isn’t and can’t be a housing only story. And it’s preposterous to suggest otherwise — and doing so is punting, it’s not a counter argument related to anything. It’s dueling with phantoms. To what purpose I can’t imagine.

    “The housing sector is far too small to cause this severe unemployment in 2011. As you know, 70% of the decline in housing occurred between January 2006 and April 2008. And yet unemployment merely edged up from 4.7% to 4.9%. So much for the Austrian story.”

  50. Gravatar of Scott Sumner Scott Sumner
    16. July 2011 at 09:56

    Cahal, I haven’t seen Inside Job, But here’s my problems:

    1. I read some reviews.
    2. I saw excepts like the set up job on Mishkin (which was inaccurate.)
    3. They use Barney Frank as a friendly witness, not a villain.
    4. They don’t blame tight money for the crisis.

    People I trust have told me it’s awful

    I saw other excepts that made it look like 60 Minutes, or a Michael Moore documentary.

    Maybe I’m wrong, but life’s short and there’s a million other things I’d like to read and see even more, which I lack time for. We all have to pick and choose.

    Yes, I think evil banks do engage in rent seeking.

    AE, It wasn’t voodoo, it was tight money that caused the crisis.

    Greg, You said;

    “Scott, you continue to fail to comprehend the difference between houses started, houses complete, and houses sold.”

    This came up a few months ago, I wasted lots of time digging up the data, and the results were essentially the same for housing completions.

    The Austrians keep obsessing about housing, and when I dig up data showing housing isn’t the problem, they suddenly say it’s about other mysterious industries. I don’t buy it. Capitalism always has industries going up and down.

    You used to tell me that housing prices in OC had collapsed. I checked on the internet, and housing is really expensive in OC. Not just Newport Beach, but inland cities like Irvine. There’s plenty of land in the Southern half of OC, why not build houses? Is it zoning rules?

  51. Gravatar of Greg Ransom Greg Ransom
    16. July 2011 at 11:56

    Scott — this is a lie or, more charitably, it’s false BS.

    Build into the Hayek construct is the “I, Pencil” world. You don’t get that, you are tilting with phantoms, which may be your preferred scholarly style. Every “Austrian” assumes it. They aren’t changing the story, that IS their story. Not to get that is to not get it. Which is frequently a preferred “scholarly” approach to scientific conceptions that counter one’s own.

    “The Austrians keep obsessing about housing, and when I dig up data showing housing isn’t the problem, they suddenly say it’s about other mysterious industries.”

  52. Gravatar of Greg Ransom Greg Ransom
    16. July 2011 at 12:05

    Two things. Housing prices are down 30% – 50%. The exact same model in my division sold for $1,000,000 several years ago, and then later for $500,000. Prices are down now even on the coast.

    Read to OC Register for the story, easy to search the history of all this. Their coverage of housing, the mortgage industry, etc. has been better than most papers in the country.

    Most all the land available here is public land, parks and dedicated “green belt” areas. The deal is, if you develop, you give land to the county. Also, the giant land owning families are enviromentalists, and they believe in large green zones as a matter of family policy.

    Land is massively expensive.

    Also, most all open land is owned by large landowners, legacy of Spanish rule.

    There is a HUGE backlog of foreclosures here, and no one is building, mostly due to that fact.

    “You used to tell me that housing prices in OC had collapsed. I checked on the internet, and housing is really expensive in OC. Not just Newport Beach, but inland cities like Irvine. There’s plenty of land in the Southern half of OC, why not build houses? Is it zoning rules?”

  53. Gravatar of Greg Ransom Greg Ransom
    16. July 2011 at 12:16

    Scott, I don’t know a single Hayekian who has a “single product” story, unconnected with any other product in the economy. That’s not how the Hayekian boom/bust causal mechanisms works.

    And the big guns, Selgin, White, Horwitz, all see a straight out of Hayek role the downturn in post bust Fed policy.

    Don’t be distracted by Robert Murphy, Murphy is not a Hayekian, he’s a _Rothbard_ interpreted Misesian — he’s not even a straight Misesian.

    Finally, you are less than persuasive even in your story using you’re strange “house building unconnected to _ANYTHING_ else in the economy” model.

    Construction unemployment numbers remain percentage wise vastly more distorted than any other category in the economy.

  54. Gravatar of Greg Ransom Greg Ransom
    16. July 2011 at 12:23

    There are many parts to any Hayekian story, depending on the historical contingencies at play.

    The idea that a Hayek boom – bust story is restricted to house building in isolation from and utterly unconnected to _ANY_ other production or consumption part of the economy is not credible as an explication of Hayek’s science.

    And Hayek’s macro involves also changes in money stocks, near money values, velocity, etc. E.g. there is nothing “unHayekian” about looking at how interest on reserves effected the Fed money market, or about how the bust helped to collapse near monies & shadow money — as a number of contemporary financial analysts point out, this is actually STRAIGHT OUT of Hayek.

  55. Gravatar of Greg Ransom Greg Ransom
    16. July 2011 at 12:30

    I’ve always said it is about more than housing, and I’ve always said even _housing_ is more than about houses or the building of houses.

    Again, this is Hayekian macro i.e.

    From the beginning — and BEFORE — I’ve said it is about the car industry, the luxury goods industry, and the WHOLE time structure of the economy.

    As I’ve learned more, and as the facts have changed and revealed themselves over the unfolding of the boom / bust, I’ve added additional elements to the story, including the collapse of shadow money, the problems caused by Fed policy, esp. paying interest on reserves & the NGDP problem, etc.

    What have you added, Scott. What elements of the causal structure of inter-connected economic structure to you even acknowledge exist besides NGDP?

    “The Austrians keep obsessing about housing, and when I dig up data showing housing isn’t the problem, they suddenly say it’s about other mysterious industries.”

  56. Gravatar of Scott Sumner Scott Sumner
    17. July 2011 at 16:49

    Greg, You said;

    “Land is massively expensive.”

    That’s my point. Housing prices are basically land prices. That’s why houses are so expensive in OC. The lack of construction is regulation, not lack of demand. In Irvine people will pay a million dollars for a home that can be constructed for half that.

    Well if housing is just one part of a bigger picture, and falling NGDP is a key, then we agree on most things.

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