Archive for the Category Monetary History


Why macroeconomists need to study history

One of the ways that macro differs from micro is that macro is essentially a branch of history.  Micro is not.  And yet today’s macroeconomists often have not studied monetary history.  Marcus Nunes and Ramesh Ponnuru directed me to a paper by White House economics advisor Jason Furman:

A decade ago, the prevalent view about fiscal policy among academic economists could be summarized in four admittedly stylized principles:

1. Discretionary fiscal policy is dominated by monetary policy as a stabilization tool because of lags in the application, impact, and removal of discretionary fiscal stimulus.

2. Even if policymakers get the timing right, discretionary fiscal stimulus would be somewhere between completely ineffective (the Ricardian view) or somewhat ineffective with bad side effects (higher interest rates and crowding-out of private investment).

3. Moreover, fiscal stabilization needs to be undertaken with trepidation, if at all, because the biggest fiscal policy priority should be the long-run fiscal balance.

4. Policymakers foolish enough to ignore (1) through (3) should at least make sure that any fiscal stimulus is very short-run, including pulling demand forward, to support the economy before monetary policy stimulus fully kicks in while minimizing harmful side effects and long-run fiscal harm.

Today, the tide of expert opinion is shifting the other way from this “Old View,” to almost the opposite view on all four points.

I think this is right, but where Furman and I differ is on the desirability of this shift.

Furman refers to the view “a decade ago” but he might just as well have said 90 years ago.  The New Keynesian consensus is actually not all that far from the views of progressive economists back in the 1920s, which favored a price level target and were skeptical about fiscal policy.  After the 1930s, opinions moved in the old Keynesian direction.  It wasn’t until the 1960s that the tide started swinging away from the “vulgar Keynesian” view that fiscal policy was more important than monetary policy.  Friedman and Schwartz started he counterrevolution, and by the 1990s it was pretty much complete.  Stabilization policy should rely on monetary policy.

And now we have still another swing of the pendulum, back toward the old Keynesian views of the post-1936 period. Here’s Furman:

The New View of fiscal policy largely reverses the four principles of the Old View—and adds a bonus one. In stylized form, the five principles of this view are:

1. Fiscal policy is often beneficial for effective countercyclical policy as a complement to monetary policy.

2. Discretionary fiscal stimulus can be very effective and in some circumstances can even crowd in private investment. To the degree that it leads to higher interest rates, that may be a plus, not a minus.

3. Fiscal space is larger than generally appreciated because stimulus may pay for itself or may have a lower cost than headline estimates would suggest; countries have more space today than in the past; and stimulus can be combined with longer-term consolidation. 

4. More sustained stimulus, especially if it is in the form of effectively targeted investments that expand aggregate supply, may be desirable in many contexts.

5. There may be larger benefits to undertaking coordinated fiscal action across countries.

Those old Keynesian views of the late 1930s were rejected for lots of good reasons.

I’m not quite sure what is more humiliating for the profession of macroeconomics:

1.  That we keep making the same mistakes, over and over again.

2.  That we change our views of macro on “new information”, which in fact is not new to anyone with an even passing interest in macro history.  (I.e., who know that the temporary QE of 1932 had little impact, just as the more recent temporary QE had little effect.)

3.  That we don’t pay attention to the empirical studies that refute old Keynesianism.

4.  That many macroeconomists are not even aware of the cyclical nature of their field.

It’s not unusual to find this sort of cyclicality in the arts.  For instance, in the arts there are swings back and forth between a more “classic” style and a more “romantic” style.  But it’s kind of embarrassing to see this in a science.

(And don’t embarrass yourself by arguing macroeconomics is not a science.  Of course it’s a science.  It’s failed science, but then so are some of the other sciences, at least based on what I’ve read about the crisis in replication.  The term ‘science’ is not a compliment, it’s not some sort of award given to a field, like a Nobel Prize.  It’s simply a descriptive term for a field that builds models that try to explain how the world works.  Saying that science must be successful to be viewed as science is as silly as saying that a work of art must be good to be considered art.)

We need a “timeless” macro.  That is, theories should not be developed to meet the specific conditions in the economy, at that moment.  And yet that’s exactly what old Keynesianism is, which is why it goes in and out of style.  Instead, theories should be developed to explain the entire history of macroeconomics—the full data set.  If your model is not good at explaining hyperinflation, stagflation, liquidity traps and the Great Moderation, then it’s not a good theory.

Old Keynesianism is not a good theory.

PS. I’d like to congratulate Ben Klutsey for winning the Great Communicators Tournament in Washington DC on Wednesday night. Some of you may know that David Beckworth and I both participate in the Mercatus Center’s Program on Monetary Policy. Unfortunately we both live some distance from the headquarters in Arlington, VA. Ben is the program’s manager, and does a lot of the behind the scenes work that readers might not be aware of. I feel lucky to work with someone who is both a very nice guy and a highly talented manager.

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Also congratulations to runner-up Charles Blatz, another Mercatus employee.

It’s the 1970s, without the inflation

During the fourth quarter of 1980 and the first quarter of 1981, America’s NGDP soared at an annual rate of more than 19%.  And yet unemployment hardly budged, slipping from 7.5% in September 1980 to 7.4% in March 1981.  What went wrong?

I’d like to suggest that the past decade is basically the 1970s without the inflation, at least in one important respect.  Before explaining why, let’s first consider the differences.  The period from 1971 to 1981 saw roughly 11% NGDP growth, which included about 3% real growth and 8% inflation.  That’s a lot more real growth than today.  In addition, labor force participation was rising sharply, whereas in recent decades it has been falling.  On the unemployment front, however, we are doing better today.

Now let’s imagine a policy counterfactual where, beginning in 1965, the Fed keeps inflation close to 2%.  Here are my claims:

1.  Under that monetary policy, we would have had roughly 5% NGDP growth from 1971 to 1981.

2.  Real growth would have still been about 3%, with inflation about 2%.

3.  The unemployment rate in late 1980 and early 1981 would have still been about 7.5%.

All of these predictions are based on the assumption that money is roughly neutral in the long run, that the Natural Rate Hypothesis is roughly (not exactly) true when NGDP growth avoids deep declines.  And most importantly:

4.  In that counterfactual, I believe that economists would have misdiagnosed the unemployment problem, assuming it reflected a sort of secular stagnation, a lack of aggregate demand.

We now know that what actually happened is that the natural rate of unemployment rose by a couple points between the late 1960s and the early 1980s.  We don’t know exactly why (theories includes more women and minorities and young people in the labor force, oil shocks, deindustrialization, environmentalism, more generous benefits for not working, etc.), but clearly the natural rate was increasing.  If 19% NGDP growth isn’t enough to make a dent, it’s fair to say that the high unemployment is not due to a “demand shortfall”.

Today, America is not faced with a higher natural rate of unemployment—it’s probably back around 4.5% to 5%.  Instead, we are faced with a different structural problem—a decline in the labor force participation rate (LFPR). Among men, this rate has been trending lower for at least 5o years.  We don’t know all the causes, but it’s clearly not just the Great Recession.  And once again, people are assuming that a structural problem is due to a lack of demand.

I believe they will once again be disappointed.  Our problems are much deeper than a demand shortfall.  That’s not to say that monetary policy should not be more expansionary.  Perhaps the economy still has a bit of slack, and the inflation rate has recently undershot its 2% target.  I’m making a broader claim.  The broad outlines of the 2016 economy are not going to change substantially with monetary stimulus.  We might get unemployment down to 4.5%, and the LFPR might rise a bit more.  And those would be very good things.  But we are still going to be stuck with a trend rate of RGDP growth of barely over 1%, and a LFPR rate (for men) that is quite disappointing by historical standards.  And that’s not even factoring in the lousy supply-side policies of the next president.

In the 1970s, we discovered the structural nature of the problem more quickly than today, because we had such high NGDP growth.  Our current sub 2% inflation rate has indeed represented a modest demand shortfall, and that is a small part of the problem.  But it doesn’t really come close to explaining the extent to which growth has slowed.  Inflation also averaged about 1.5% during the first half of the 1960s, but growth was fine.  “Lowflation” is a problem because it means the Fed is not hitting its target.  But it explains at most only a small fraction of the very low RGDP growth rate since 2006, as well as the current very low LFPR.

PS.  I believe that the Great Inflation is best described in terms of NGDP growth, not price inflation.  That makes it easier to see that it was a 100% demand-side problem; RGDP growth was fine.  Today I was pleased to see the Financial Times also using that metric:

According to Bank of America Merrill Lynch, the current global recovery is the least inflationary of all time, with nominal GDP (growth plus inflation) growing just 11 per cent in the last seven years.

That’s total!  (Not the annual average.)

That was from an article discussing the new Chinese growth data.  At the same time, there are a few “green shoots” for the global nominal economy.  Chinese NGDP growth is up to 7.8%, from a low of (I think) about 5.8% at the end of last year.  Chinese PPI inflation turned positive for the first time since early 2012, and CPI inflation is up to 1.9%.  The overvaluation of the yuan seems to be ending. Eurozone inflation also has been rising, albeit from a very low level.  I’m most pessimistic about Japan; they need to sharply depreciate the yen if they are serious about their 2% inflation target.  Will they?

Chinese growth is expected to slow to 6% in 2017, as the housing boom cools.  That’s still an excellent figure for a middle-income country with near-zero population growth.  Consumption will lead the way next year, as housing construction slows.  But China is by no means out of the woods. They still face a very tricky transition from a housing construction economy to a services economy.  Lots could still go wrong–just not yet.


Was the so-called “monetarist experiment” ever tried?

Jim Glass left this response to my (italicized) claim:

1. The Fed said it would start targeting the money supply, but it did not do so …. 1979-82 told us essentially nothing about the long run effect of money supply targeting. It wasn’t even tried.

I don’t understand you here. Certainly money supply targeting wasn’t tried over a long run, so one can’t see any long-run effect of it. But why do you say money supply targeting wasn’t adopted at all?

Volcker in his 1992 memoir “Changing Fortunes” explained why the Fed in 1981 had to change policy to money supply targeting from interest rate targeting, and went into considerable detail about the political resistance from the Reagan Administration that he had to overcome to do it, and the political ploys he used to do so. I don’t see why he’d make up such a detailed story about something that never happened.

Plus, looking at the M1 numbers for the period from Fred, one sees that after rising steadily pretty much from beginning of time, M1 peaked at $429 billion on 4/20/81, three months before the start of the recession, then went down a little bit, then bounced down a tiny tad and back up again repeatedly to hit pretty much exactly $429b again on 7/6, 8/10, and 10/12 thru 10/26 without ever going at all over $429b (or going below $423b). So on the dates three months before the recession started and then three months after it started, M1 was $429b, exactly unchanged. If the money supply wasn’t being targeted during that period, all those $429b numbers are a heck of a coincidence.

It’s certainly possible that the Fed was paying more attention to M1 than before.  I agree with that claim.  But there can be no dispute that they did not adopt Friedman’s proposal of a steady 4% growth rate in the money supply.  Indeed money growth actually became much less stable during 1979-82, which shows that Volcker moved policy even further away from Friedman’s ideal.  Now of course in a different sense you could say monetarism was adopted, as he used a tight money policy to control inflation.  That policy was a success.

But a money growth rule?  It’s never even been tried.  (And I hope it never will be tried, as it’s probably a lousy idea.)



Over at Econlog I did a post discussing the austerity of 1946.  The Federal deficit swung from over 20% of GDP during fiscal 1945 (mid-1944 to mid-1945) to an outright surplus in fiscal 1947.  Policy doesn’t get much more austere than that! Even worse, the austerity was a reduction in government output, which Keynesians view as the most potent part of the fiscal mix.  I pointed out that employment did fine, with the unemployment rate fluctuating between 3% and 5% during 1946, 1947 and 1948, even as Keynesian economists had predicted a rise in unemployment to 25% or even 35%—i.e. worse than the low point of the Great Depression.  That’s a pretty big miss in your forecast, and made me wonder about the validity of the model they used.

One commenter pointed out that RGDP fell by over 12% between 1945 and 1946, and that lots of women left the labor force after WWII.  So does a shrinking labor force explain the disconnect between unemployment and GDP?  As far as I can tell it does not, which surprised even me.  But the data is patchy, so please offer suggestions as to how I could do better.

Let’s start with hours worked per week, the data that is most supportive of the Keynesian view:


Weekly hours worked dropped about 5% between 1945 and 1946. Does that help explain the huge drop in GDP?  Not as much as you’d think. Here’s the civilian labor force:


So the labor force grew by close to 9%, indicating that the labor force in terms of numbers of worker hours probably grew.  Indeed if you add in the 3% jump in the unemployment rate, it appears as if the total number of hours worked was little changed between 1945 and 1946 (9% – 5% – 3%).  Which is really weird given that RGDP fell by 22% from the 1945Q1 peak to the 1947Q1 trough–a decline closer to the 36% decline during the Great Contraction, than the 3% fall during the Great Recession.

That’s all accounting, which is interesting, but it doesn’t really tell us what caused the employment miracle.  I’d like to point to NGDP, which did grow very rapidly between 1946 and 1948, but even that doesn’t quite help, as it fell by about 10% between early 1945 and early 1946.

Here’s why I think that the NGDP (musical chairs) model did not work this time. Let’s go back to the hours worked, and think about why they were roughly unchanged.  You had two big factors pushing hard, but in opposite directions. Hours worked were pushed up by 10 million soldiers suddenly entering the workforce.  In the offsetting direction were three factors.  A smaller number of (mostly women) workers leaving the workforce, unemployment rising from 1% to 4%, and average weekly hours falling by about 5%.  All that netted out to roughly zero change in hours worked.

So why did RGDP fall so sharply?  Keep in mind that while those soldiers were fighting WWII, their pay was a part of GDP. They helped make the “G” part of GDP rise to extraordinary levels in the early 1940s.  But when the war ended, that military pay stopped.  Many then got jobs in the civilian economy.  Now they were counted as part of hours worked. (Soldiers aren’t counted as workers.)  That artificially depressed productivity.

It’s also worth noting that real hourly wages fell by nearly 10% between February 1945 and November 1946:


This data only applies to manufacturing workers. But keep in mind that the 1940s was the peak period of unionism, so I’d guess service workers did even worse.  So my theory is that the sudden drop in NGDP in 1946 was an artifact of the end of massive military spending, and the strong growth in NGDP during 1946-48, which reflected high inflation, helped to stabilize the labor market.  When the inflation ended in 1949, real wages rose and we had a brief recession.  By 1950, the economy was recovering, even before the Korean War broke out in late June.

Obviously 1946 was an unusual year, and it’s hard to draw any policy lessons.  At Econlog, I pointed out that the high inflation occurred without any “concrete steppes” by the Fed; T-bill yields stayed at 0.38% during 1945-47 and the monetary base was pretty flat.  Some of the inflation represented the removal of price controls, but I suspect some of it was purely (demand-side) monetary—a rise in velocity as fears of a post-war recession faded.

This era shows that you can have a lot of “reallocation” and a lot of austerity, without necessarily seeing a big rise in unemployment.  And if you are going to make excuses for the Keynesian model, you also have to recognize that most Keynesians got it spectacularly wrong at the time.  Keynesians often make of big deal of Milton Friedman’s false prediction that inflation would rise sharply after 1982, but tend to ignore another monetarist (William Barnett, pp. 22-23) who correctly forecast that it would not rise.  OK, then the same standards should apply to the flawed Keynesian predictions of 1946.

Tyler Cowen used to argue that 2009 showed that we weren’t as rich as we thought we were.  I think 1946 and 2013 (another failed Keynesian prediction) show that we aren’t as smart as we thought we were.

Update:  David Henderson has some more observations on this period.


Three views on Fed independence

While reading an excellent new book by Peter Conti-Brown, I came across this interesting observation:

Liberals like Tobin, Galbraith, and Harris weren’t the only ones who thought a policy separation problematic. Milton Friedman, the great monetary theorist on the right, thought central bank independence much less desirable than a straightforward monetary policy rule that increased the money supply at an agreed-on rate.

I’d never quite thought of things that way.  He suggests that back in the 1960s, many liberal economists favored a supportive Fed.  Let’s think about three ways the Fed could have interacted with the fiscal authorities during the Kennedy/Johnson fiscal expansion:

1.  The Fed could have supported the fiscal authorities by holding interest rates at a low level, despite the fiscal stimulus.

2.  The Fed could have maintained a neutral policy, with a 4% money supply growth rule.

3.  The Fed could have sabotaged fiscal stimulus with a 2% inflation target.

Policy #1 would be the most expansionary.  The second option would also be somewhat expansionary, as fiscal stimulus would push up nominal interest rates, and also velocity.

Under option #3, however, monetary policy would be not at all stimulative, and would essentially neutralize the impact of fiscal stimulus.  And I find that to be a rather odd way of looking at things.  In this framework, Milton Friedman’s monetarism is the “moderate” position.  (Quite a contrast to the rules vs. discretion debate, where Friedman took an extreme position.)  Even more surprisingly, you find Keynesians at each extreme.  The older 1960s Keynesians favored a supportive monetary policy, and the new Keynesians of the 1990s wanted monetary policy to sabotage fiscal policy, in order to keep inflation at 2%.

Once I started looking at things this way, I noticed an uncanny similarity to the three ways that one could categorize monetary policy interrelationships under an international gold standard.  In my book on the Great Depression, I did not look at the interaction of monetary and fiscal policy, but rather the way various central banks reacted to moves at the dominant central bank.  For instance, in the late 1800s the Bank of England was dominant.  Other central banks could be supportive, neutral, or sabotage discretionary actions by the BoE.  In 1930, Keynes argued that they tended to be supportive:

During the latter half of the nineteenth century the influence of London on credit conditions throughout the world was so predominant that the Bank of England could almost have claimed to be the conductor of the international orchestra. By modifying the terms on which she was prepared to lend, aided by her own readiness to vary the volume of her gold reserves and the unreadiness of other central banks to vary the volumes of theirs, she could to a large extent determine the credit conditions prevailing elsewhere. (1930 [1953], II, pp. 306–07, emphasis added)

Here’s how I interpreted this issue in my book on the Depression:

If Keynes were correct then the Bank of England would have had enormous leverage over the world’s money supply.[1] For example, assume the Bank of England doubled its gold reserve ratio. This would represent a contractionary policy, which would then lead to a gold inflow to Britain. If other countries wished to avoid an outflow of gold they would have had to adopt equally contractionary monetary policies. In that case the change in the Bank of England’s gold reserve ratio would have generated a proportional shift in the world gold reserve ratio.

Although it is unreasonable to assume that foreign gold stocks were not allowed to change at all, during the interwar period some countries did not allow significant fluctuations in their monetary gold stocks.[1] Other central banks may have varied their gold holdings, but not in response to discretionary policy decisions taken by the Bank of England. Thus it is quite possible that the estimates in Table 13.5 significantly understate the ability of central banks to engage in discretionary monetary policies.

An alternative form of interdependence occurs when countries refuse to allow gold flows to influence their domestic money supplies. If one country reduces its gold reserve ratio, other countries can offset or “sterilize” this policy by raising their own gold reserve ratios. Complete sterilization would occur if the other countries raised their gold reserve ratios enough to prevent any change in the world money supply.

If central bank policies are interdependent, then there are a variety of ways in which a change in one country’s gold reserve ratio might impact the world gold reserve ratio:

  1. d(ln r)/d(ln ri) = 0 (the complete sterilization case)
  2. d(ln r)/d(ln ri) = Gi/G (the policy independence case)
  3. d(ln r)/d(ln ri) = 1 (the extreme Keynesian case)

In Table 13.5 the estimated impact of central bank policy changes was computed under the “policy independence” assumption (i.e., that a change in one country’s gold reserve ratio had no impact on gold reserve ratios in other countries).

[1] There also may have been an asymmetrical response, with central banks being more reluctant to allow gold outflows than gold inflows. Note that the unwillingness of central banks to vary their gold holdings does not necessarily imply an unwillingness to freely exchange currency for gold. They could set their discount rate at a level to prevent gold flows.

[1] McCloskey and Zecher (1976) criticized Keynes’s assertion by noting that the Bank of England held a gold stock equal to only 0.5 percent of total world reserves. This would seem too small to allow the Bank of England any significant influence over the world money supply (or price level). There are several problems with their criticism. They have assumed that central banks were indifferent between holding gold or Bank of England notes as reserves. Yet many countries placed great importance on their gold stocks, and in some cases laws specified a minimum gold reserve ratio. Thus the relevant size variable is the ratio of England’s monetary gold stock to the world’s monetary gold stock, not the ratio of England’s gold stock to total world reserves. More importantly, McCloskey and Zecher ignored Keynes’s assumption that other central banks were unwilling to vary their reserves of gold (as the rules of the game required).

These three cases offer an interesting parallel to the three types of fiscal/monetary coordination discussed above.  The “extreme Keynesian case” (relying on his 1930 hypothesis) is equivalent to the supportive central bank preferred by 1960s Keynesians.  The policy independence case occurs if countries follow the “rules of the game”, i.e. they must allow their money supplies to move in proportion to their monetary gold stocks.  This case is obviously similar to Friedman’s money supply rule.  And the complete sterilization case is equivalent to a central bank that sabotages fiscal actions. Indeed another term I could have used for “monetary offset” is “monetary sterilization of fiscal policy”.

PS.  This post is rather tangential to the main thrust of the Conti-Brown book.  I also have a new post on his book at Econlog, which gives a better sense of the book’s focus.