OK, the title’s not as dynamic as Camille Paglia’s Break, Blow, Burn, but I’m only an economist. Recently I’ve been trying to figure out several questions; including what do we mean by the stance of monetary policy, and what do we mean by a monetary shock? I suspect that at some deep level these are actually the same question, much as I suspect, “Does free will exist” and, “Is there such a thing as personal identity?” are the same question. This post is a reaction to some good comments I’ve received, and also an excellent new post by Nick Rowe. Don’t expect any final answers here, go to Nick’s post for specifics on VAR models.
Let’s work backwards from “cause.” Perhaps a monetary shock is a change in monetary policy that causes something or many things to happen. But that forces us to examine the thorny issue of what do we mean by “cause?” In a sense, monetary policy could be said to cause all nominal changes in the economy, and many real changes. After all, under a fiat money regime there is always some alternative monetary policy that would have prevented a nominal variable from changing. Thus if the price of zinc rises from $1.30 to $1.35 a pound, you could say the cause of the increase was the Fed’s refusal to use OMOs to peg the price of zinc at $1.30/oz. I think we can all agree that this is not a very useful view of causation. But this problem will creep in to some extent no matter how hard we try to pin down ’cause’.
Now let’s look at ‘stance’ and ‘shock’. By now you are sick of me telling you that interest rates don’t measure the stance of monetary policy. But why not? And why can’t I provide a definitive definition, if I’m so sure interest rates are wrong? Let’s consider three groups of possible indicators:
1. Interest rates and the monetary base
2. Exchange rates and the monetary aggregates
3. Inflation, NGDP growth and zinc prices
I’d like an indicator that always moves in one direction in response to a given change in the stance of monetary policy. That’s why I hate interest rates; tight money sometimes makes them rise, and sometimes makes them fall. So we can’t look at interest rates and identify the stance of policy. Ditto for the base, which might rise because we are monetizing the debt Zimbabwe style, or it might rise because we are accommodating a high demand for reserves at the zero bound, a la Japan since the late 1990s. That’s not to say that we can’t assume a given nudge in rates or the base leaves policy predictably tighter than a few minutes earlier. The problem is that we can’t look at rates or the base and tell whether policy is looser or tighter than 3 months ago, which makes it useless for projects like VAR studies. Nor does it help to look at rates relative to the natural rate, as the natural rate is highly unstable, and hard to estimate.
The second group is better. In general, tight money will appreciate the exchange rate and reduce M2. But I’m not 100% sure that’s always true. Is it possible that tight money could lead to expectations of depression, and that expectations of depression could lead to lower future expected exchange rates, and that this would reduce the current value of the currency? Is it possible that tight money could lead to such uncertainty that people want to hold more M2, relative to other assets?
The last group seems safest, and the first two items in group #3 are also the indicators chosen by Ben Bernanke back in 2003. I can’t imagine a case where tight money raises either inflation, NGDP, or zinc prices. So at least in terms of direction of change, they seem completely reliable. One can think of the CPI as measuring the (inverse of the) value of money. That’s a nice definition of easy or tight money—changes in its purchasing power. NGDP is slightly more ungainly, the (inverse of the) share of national income that can be bought with a dollar bill.
Unfortunately I’ve engaged in circular reasoning. I’ve defined easy and tight money in terms of inflation and NGDP growth, because I believe they are reliably related to the stance of monetary policy. But how do I know that the thing that causes NGDP to rise is easy money? Here I don’t think we can escape the necessity of relying on theory. Theory says that an unexpected injection of new money will have all the effects associated with easy money, such as temporarily lower interest rates, a depreciated currency, more inflation and NGDP growth.
If we define the stance of monetary policy in terms of inflation or NGDP growth, then it seems to me that it makes sense to think of “shocks” as policy actions that change the stance of monetary policy. Thus if Fed actions moved expected GDP growth from 4% to 6%, you could say that monetary policy eased and a positive monetary “shock” occurred. Vice versa if expected NGDP growth fell from 4% to 2%.
But lots of people aren’t going to like the implications of all this, or any of this, as there are deep cognitive illusions about distinctions between “errors of omission” and “errors of commission” that seem important (but in my view are not.) For instance, VAR studies could no longer disentangle monetary and demand-side fiscal shocks—-all changes in NGDP would be monetary shocks, by assumption. There would be no difference between a change in M and a change in V, both would be monetary shocks.
If you try to flee back to your comforting notions of causality, they will fall apart under close inspections. Suppose Russians hoard 5% of the US monetary base in 1991, and the Fed does not accommodate that increase, even though they easily could have done so. Interest rates soar, V falls, and the US goes into recession. What do the “concrete steppes” people say? Unfortunately they’d start arguing with each other. The monetary base concrete steppes people would insist the Fed did not cause the recession, it was caused by Russian currency hoarding. The base didn’t change. The interest rate concrete steppes people would insist the Fed did an error of commission; they increased interest rates sharply and caused the recession.
Nor is it possible to fall back on “unexpected changes in interest rates.” Suppose that prior to the Sept. 2008 FOMC meeting, markets had expected a huge negative monetary shock, which would occur because the Fed foolishly kept interest rates at 2%. But instead (suppose) the Fed surprised us and avoided a negative monetary shock by cutting rates to zero and switching to NGDP level targeting. There would be a huge negative surprise to interest rates, but no change in the stance of monetary policy, by the NGDP criterion.
Macroeconomics is riddled with unexamined assumptions about stances of policy, shocks, and causation. It’s ironic that we use the term ‘stance’ as there’s no stable ground here to stand upon. It’s like we’ve moved from a classical Newtonian world to a relativistic universe. What’s is the stance of policy? It depends where you are standing, how fast you are moving, what variables you are interested in, etc., etc.
People are constantly telling me that my “tight money” theory of the 2008 recession is loony. But I am never provided with any good reasons for this criticism. I have no doubt that there are hundreds of macroeconomists who are much smarter than I am, but I do occasionally wonder if my profession is somewhat lacking in imagination.
PS. Going back to the opening paragraph, the answers are no and no.