Could we have had a severe recession without the 2008 financial crisis?

Paul Krugman argues that it would have taken a dramatically different set of policies back in 2007 to prevent the Great Recession, and Brad DeLong argues that a much more modest set of initiatives might have sufficed.  There is much to agree with in both posts.  First here’s Krugman, quoted by DeLong:

What It Would Have Taken: “Think of it this way: what would a really effective set of policies be right now? First… aggressively reverse the fiscal austerity of the last few years…. Monetary policy should accommodate that boost; interest rates should not go up even if inflation goes somewhat above 2 percent. In fact, there’s an overwhelming prudential case for raising the inflation target…. Say for the sake of argument that the right policy is two years of fiscal expansion amounting to 3 percent of GDP each year, plus a permanent rise in the inflation target to 4 percent. These wouldn’t be radical moves in terms of Econ 101 “” they are in fact pretty much what textbook models would suggest make sense given what we have learned about macroeconomic vulnerabilities. But they are completely outside the bounds of respectable discussion. That’s the sense in which we are “doomed” to long-term stagnation. We have met the enemy, and it’s not the economic fundamentals, it’s us.

And here’s DeLong’s reply (or more precisely the response of Brad’s Greek friends):

Thrasymakhos: Oh, Krugman’s 100% right about today…

Khremistokles: He is indeed. We are totally tracked…

Thrasymakhos: Very few members of congress or FOMC participants seem to spend any significant time talking to anybody who is not a plutocrat…

Khremistokles: But he is wrong about how aggressive and radical the needed policies back in 2007 were. As a share of GDP, the bad shopping-mall and office-tour debts of Houston, etc, in 1989 were as large as the bad mortgages of 2007…

Thrasymakhos: But back in 1989 the political power of the princes of finance was much less than in 2007…

That’s probably right, but I have trouble with DeLong’s implicit assumption is that the financial crisis caused the Great Recession.  DeLong points out that the recession of 1990-91 was far milder, despite equivalent bad debt (as a share of GDP.)  And that the 1990 crisis was handled better. Krugman’s comment points to one overlooked factor.  In 1990 we did have a de facto 4% inflation target.  The years leading up to 1990 saw Australian-level NGDP growth, if not more.  So even if lending standards tightened sharply in the wake of the 1989-90 crisis, there still would have been no possibility of hitting the zero bound.  Rates fell to about 3% in the recession, still a bit higher than in Australia this time around.  With no zero bound in prospect, there’d be no reason for markets to expect an NGDP collapse.  Elsewhere I’ve argued that growing realization of plunging NGDP tanked the asset markets in the second half of 2008.

Even if we had managed the 2007-08 subprime crisis very well from a regulatory/resolution perspective, there is no question that banks would have tightened lending standards sharply.  That effectively reduces the demand for credit. And of course house prices were plunging even before Lehman, and then we got a “secondary deflation” of house prices when NGDP plunged.  It’s quite plausible that the Wicksellian equilibrium natural rate would have fallen to zero in late 2008, even with a better resolution of the banks.  On the other hand if we’d gone into 2007 with Paul Volcker’s de facto 4% inflation target (a policy he now opposes), then the Great Recession would have been a 1990-style mild recession.

One area where I slightly disagree with Krugman is his focus on inflation.  A 5% NGDPLT target path would have been enough; we didn’t need 4% trend inflation.  Nor do we need fiscal stimulus. On the other hand the supply side fundamentals of the economy were so poor after 2008 (for reason I don’t fully understand) that 5% NGDP growth would have led to some unpleasant stagflation. So we might have gotten Krugman’s 4% inflation anyway.  Indeed if my preferred policy had been adopted, it would have been widely judged a failure, partly because (as DeLong correctly pointed out) almost nobody back in 2007 envisioned a recession as severe as the one we got.

People see bad outcomes, and have trouble envisioning it could have been much worse.  That’s one reason why my preferred policy was not politically feasible in 2008.  But thanks to the NGDP targeting boomlet, it will be somewhat more feasible next time around.  Next time people will be able to envision a worse alternative.

All stabilization policies eventually fail, just as all presidents are judged failures in their 6th year in office.  The trick is to have a modest failure like Clinton or Obama, not a serious failure like FDR or Nixon.  NGDPLT would have given us just that in 2008-09.

PS.  I have a new post on Jeremy Stein over at Econlog.

HT:  TravisV


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83 Responses to “Could we have had a severe recession without the 2008 financial crisis?”

  1. Gravatar of John Becker John Becker
    26. March 2014 at 05:41

    If banks tighten lending standards, isn’t that a change in the supply of credit? After all banks are the ones supplying credit (actually individual savers supply the raw capital but banks reduce transactions costs) and borrowers are the ones demanding it, right? Do you use supply and demand interchangeably in macro?

  2. Gravatar of TravisV TravisV
    26. March 2014 at 05:56

    Hmmmm…..this is the post I originally linked to:

    http://equitablegrowth.org/2014/03/24/2351/no-i-really-do-not-think-that-we-were-doomed-to-the-lesser-depression-plus-the-greater-stagnation-i-think-paul-krugman-gets-one-wrong-here-monday-focus-march-24-2014

    Headline is more provocative.

  3. Gravatar of babar babar
    26. March 2014 at 05:57

    the financial crisis caused people not to know with any certainty what the price of assets was, and that caused people to liquidate assets. some of that was just plain fear, some of it was logic (many assets showed up as being worth zero or less given leverage) and some of it was leveraged holders being forced to liquidate.

    liquidating assets => increased demand for money.

  4. Gravatar of TallDave TallDave
    26. March 2014 at 06:16

    there is no question that banks would have tightened lending standards sharply

    Indeed, they were required to, because taxpayers were getting shellacked over at Fannie and Freddie.

    Krugman and BDL don’t like to hear it, but decades of incremental policy changes through 2003 (yes, including to CRA!) designed to foster homeownership set up a situation in which massive numbers of new and refinanced mortgages were being mispriced because the risk factors were being minimized or ignored — indeed the Feds were basically forcing banks to do so. And when that failed, they promptly started forcing them to do the opposite.

    That’s why the whole “plutocrats” line of argument is such nonsense — Wall Street is utterly obeisant to Washington and their social justice agenda. How many armored divisions does Goldman Sachs have?

  5. Gravatar of TallDave TallDave
    26. March 2014 at 06:19

    BTW virtually every objection to that line of reasoning is addressed here. Regulators absolutely created this problem, in a thousand little steps.

    http://www.businessinsider.com/the-cra-debate-a-users-guide-2009-6

    Note that nothing like this happened in Canada, which barely noticed the financial crisis.

  6. Gravatar of benjamin cole benjamin cole
    26. March 2014 at 07:00

    Great blogging.
    For sure, NGDP targeting…but the important take-away is that a 2 percent inflation target is actually dangerous…easy to slip into ZLB or monetary asphyxiation.
    Krugman is right, a higher inflation target is needed…and there was a day in the not-long ago but evidently forgotten past when 4 percent inflation was fine and dandy…

  7. Gravatar of benjamin cole benjamin cole
    26. March 2014 at 07:05

    Add on: Suppose the Fed said, “For the next three years, we are targeting 3.5 percent inflation.”

    1. Markets? I think we see rallies.
    2. Real growth? I think it would be highrt.

    Downsides? Does anyone really believe the higher target rate would crimp investment, as sometimes claimed?

  8. Gravatar of Major_Freedom Major_Freedom
    26. March 2014 at 07:59

    TravisV:

    Notice this comment from Sumner:

    “All stabilization policies eventually fail”

    That is exactly what I have been saying about NGDPLT. Indeed, it is true for statism as well.

    And you believed that saying the exact same thing made me unwisely “pessimistic.” Well, what do you think about NGDPLT now that Sumner has said it will eventually fail? Is it still wise to think the way you have been?

  9. Gravatar of Tom Brown Tom Brown
    26. March 2014 at 08:06

    Mark O/T: You posted a link to one of Sumner’s articles on base money for me once: it had a photograph of a very large denomination bill in it. I can’t recall the title, do you?

  10. Gravatar of Major_Freedom Major_Freedom
    26. March 2014 at 08:08

    “On the other hand if we’d gone into 2007 with Paul Volcker’s de facto 4% inflation target (a policy he now opposes), then the Great Recession would have been a 1990-style mild recession.”

    That was the very policy prescription the Fed used after the 2000-2001 bust. The Fed loosened monetary policy which staved off a deep correction and as one result, we only had a mild recession. But another result is that the Fed blew up a financial and real estate bubble.

    2008 was worse than it otherwise would have been had the Fed allowed the corrections from 2000-2001 to take place.

    Are we getting it yet?

  11. Gravatar of Mark A. Sadowski Mark A. Sadowski
    26. March 2014 at 08:50

    Tom Brown,
    “The Monetary Base is Special”:

    http://www.themoneyillusion.com/?p=17357

    http://www.themoneyillusion.com/wp-content/uploads/2012/10/Screen-Shot-2012-10-28-at-9.28.30-AM.png

  12. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    26. March 2014 at 09:04

    What Tall Dave said;

    http://www.voxeu.org/vox-talks/puzzling-pervasiveness-dysfunctional-banking

    Also, I love this disingenuousness from DeLong;

    ‘But back in 1989 the political power of the princes of finance was much less than in 2007…’

    Not mentioned is that they became ‘princes’ in the 1990s, thanks largely to decisions in the Clinton Administration, in which J. Bradford served as a Deputy Ass’t Treasury Sec’y.

    Though to be fair, they couldn’t have done it without substantial help from Newt Gingrich.

  13. Gravatar of flow5 flow5
    26. March 2014 at 09:08

    The 2008 recession was already “baked in” by the FOMC’s policy actions in Dec 2007 (the trajectory for the roc in the 10 month proxy for real-output would inevitably prove contractionary).

    Paying interest on excess reserve balances was its coup de grace. Dr. Henry C.K. Liu predicted this “Repo Time Bomb”:

    http://www.atimes.com/atimes/Global_Economy/GI29Dj01.html

    And any institution whose liabilities can be transferred on demand, without notice, & without income penalty, via negotiable credit instruments, or data pathways, & whose deposits are regarded by the public as money, can create new money, provided that the institution is not encountering a negative cash flow.

    So the investment banks needed some type of gov’t backstopping when they rolled-over huge volumes of short-term wholesale money market funding on a day-to-day basis (repurchase agreements & commercial paper, etc.), in their borrow-short to lend at higher: risks/rewards business’ plans.

    I.e., Bankrupt you Bernanke destroyed the savings->investment process, or non-bank lending/investing (which, pre-Great-Recession, represented 82% of the pooling & lending markets) – see: Z.1 release, sectors, e.g., MMMFs, commercial paper, GSEs, etc.

  14. Gravatar of bill bill
    26. March 2014 at 09:09

    Krugman’s a smart guy. Why can’t he see that a 5% NGDP target has the benefit of being a 5% inflation target if real growth falls to zero combined with being a 2% inflation target if we’re humming along at 3% real growth?

  15. Gravatar of Tom Brown Tom Brown
    26. March 2014 at 09:12

    Mark, thanks!

  16. Gravatar of flow5 flow5
    26. March 2014 at 09:24

    At the height of the Doc.com stock market bubble, Dr. Alan Greenspan initiated a “tight” monetary policy (for 31 out of 34 months).

    A “tight” money policy is defined as one where the rate-of-change in monetary flows (our means-of-payment money times its transactions rate of turnover) is no greater than 2-3% above the rate-of-change in the real output of goods & services.

    Greenspan then wildly reversed his “tight” money policy (at that point Greenspan was well behind the employment curve), & reverted to a very “easy” monetary policy — for 41 consecutive months (i.e., despite 17 FOMC policy rate increases in the target FFR (June 30, 2004 until June 29, 2006), – every single rate increase was “behind the inflationary curve”). I.e., Greenspan NEVER tightened monetary policy.

    Then, as soon as Bankrupt you Bernanke was appointed to the Chairman of the Federal Reserve, he initiated a “tight” (actually contractionary or roc’s less than zero), money policy (ending the housing bubble in Feb 2006), for 29 consecutive months, or at first, sufficient to wring inflation out of the economy, but persisting until the economy plunged into a depression). I.e., Bankrupt you Bernanke CAUSED THE GREAT RECESSION.

    The FOMC continued to drain liquidity despite its 7 reductions in the FFR (which began on 9/18/07 until 4/30/08). I.e., despite Bear Sterns two hedge funds that collapsed on July 16, 2007, & immediately thereafter filed for bankruptcy protection on July 31, 2007 — as they had lost nearly all of their value), the FED maintained its “tight” money policy (i.e., credit easing, not quantitative easing).

    I.e., Bernanke didn’t initiate an “easy” money policy until Lehman Brothers later filed for bankruptcy protection (& it was one the Federal Reserve Bank of New York’s primary dealers in the Treasury Market), on September 15, 2008.

    And Greenspan didn’t start “easing” on January 3, 2000, when the FFR was first lowered by 1/2, to 6%. Greenspan didn’t change from a “tight” monetary policy, to an “easier” monetary policy, until after 11 reductions in the FFR, ending just before the reduction on November 6, 2002 @ 1 & 1/4% (approximately coinciding with the bottom in equity prices).

    I.e., Greenspan was responsible for both high employment (June 2003, @ 6.3%), & high inflation (rampant real-estate speculation, followed by widespread commodity speculation).

    Bankrupt you Bernanke then relentlessly drove the economy into the ground, creating a protracted un-employment, & under-employment rate, nightmare.

  17. Gravatar of flow5 flow5
    26. March 2014 at 09:38

    David Stockman fingers the crony capitalists in his book: “The Great Deformation” (i.e., regulatory malfeasance).

  18. Gravatar of Scott Sumner Scott Sumner
    26. March 2014 at 10:00

    John, It has the effect of reduced demand for credit (becasue it lowers the cost of credit.)

    Travis, Thanks, I’ll take a look at that one too.

  19. Gravatar of Mark A. Sadowski Mark A. Sadowski
    26. March 2014 at 10:32

    Scott on Stein at Econlog:
    “Because low rates can reflect either easy money (liquidity effect) or tight money (income, price level, expected inflation effects) the stance of monetary policy is often misidentified in empirical studies. This gives me little confidence that we can accurately estimate the impact of monetary policy on risk premiums—a key precondition for Stein’s proposed policy.”

    Interestingly, I’ve been doing some estimates which seem to be highly relevant to this observation.

    I recently came across the following paper by Daniel Thornton:

    http://research.stlouisfed.org/publications/review/2014/q1/thornton.pdf

    Thornton estimates the effect of long term one year or greater) Treasury supply on the term premium and seems to be largely an attempt to disprove prior estimates by Gagnon, Remache, Raskin and Sack (2010):

    http://www.ijcb.org/journal/ijcb11q1a1.pdf

    Gagnon et al regress the Kim-Wright measure of the term premium (one of the two measures discussed by Stein) on various measures of long-term Treasury supply and some control variables and conclude that Treasury supply is significantly correlated with the term premium. The implication is that QE reduces the term premium since it reduces the supply of long term Treasuries.

    Thornton’s main contribution is to show that the addition of trend variables renders these results statistically insignificant.

    Both Gagnon et al and Thornton work with the same time period: January 1985 through June 2008. Personally I thought that it was odd that they used these results to form conclusions about the effects of QE. I wondered what the results might look like if we re-estimated them over the time period when there had actually been QE.

    I use the same Kim-Wright measure of the term premium as used in both studies. I also use four control variables that both Gagnon et al and Thornton use: 1) the unemployment gap, 2) the year on year core CPI inflation rate, 3) the University of Michigan inflation expectations disagreement, and 4) the 6-month 10-year T-Note realized daily volatility.

    I constructed several measures of long-term Treasury supply: 1) outstanding long term Treasuries less Fed holdings, 2) outstanding long term Treasuries less Fed holdings and less foreign official holdings, 3) outstanding long term Treasuries less Fed holdings of long term Treasuries and long term Agencies (one year or longer) and less foreign offical holdings of Treasuries, and 4) outstanding long term Treasuries less Fed and foreign official holdings of long term Treasuries and Agencies.

    Consistent with Gagnon et al all supply measures were as a percent of GDP (I interpolated monthly GDP). The only thing I did different from Gagnon et al is that I did not subtract foreign official holdings of corporate bonds, which seemed minor, as well as irrelevant.

    I included a trend variable like Thornton in alternate specifications. Consequently I estimated a total of eight specifications of the equation.

    The period I looked at was December 2008 to August 2013.

    In all of my estimates inflation disagreement and realized volatility failed to be statistically significant, in contrast to Gagnon et al and Thornton ‘s results. Core CPI was highly significant (at the 1% level) but was of the opposite sign as Gagnon et al and Thornton. Thus higher core inflation correlated with a lower term premium. The unemployment gap was not statistically significant in measures of Treasury supply that subtracted Fed or foreign official holdings of Agencies.

    But the most interesting result was effect of the measures of supply themselves. All but one were statistically significant at the 1% level (one of the specifications including a trend variable was at the 5% level). But all were of the opposite sign as Gagnon et al. That is, a higher Treasury supply was correlated with a lower term premium.

    The only specification in which the trend variable was statistically significant (at the 1% level) was in the measure of Treasury supply that only subtracted Fed holdings of long term Treasuries. Furthermore, the sign was positive, which was the opposite of Thornton’s results.

    The fact that Thornton’s trend variable turned out not to be robust to choice of time period didn’t surprise me at all. But the fact that the effect of Treasury supply on term premium is the complete opposite of Gagnon et al was a huge surprise.

    Based on Granger causality tests I have previously conducted, QE raises 10-year T-Note yields. Obviously the term premium is not the same as the actual yield, but this did suggest to me that Gagnon at al’s results concerning the effect of Treasury supply on the term premium might not be robust under actual QE conditions. But to obtain results that were statistically significantly and of the opposite sign was startling.

    Consequently I am now very curious why no studies of the effect of QE on term premium seem to have been done during the time there has actually been QE.

  20. Gravatar of TravisV TravisV
    26. March 2014 at 10:39

    Major_Freedom,

    Apologize for your dishonesty.

    Here is the full context of what Sumner said:

    “All stabilization policies eventually fail, just as all presidents are judged failures in their 6th year in office. The trick is to have a modest failure like Clinton or Obama, not a serious failure like FDR or Nixon.”

    I’m very very confident that the next ten years will be more stable than the last ten years.

  21. Gravatar of TravisV TravisV
    26. March 2014 at 10:43

    Dear Commenters,

    I think the next ten years will be far more stable than the last ten years. What do you rest of you think?

    At least Ben Cole agrees with me! See here:

    http://www.themoneyillusion.com/?p=26442&cpage=2#comment-325432

  22. Gravatar of Rajat Rajat
    26. March 2014 at 12:17

    But, Scott, you’ve often said that the US was above the ZLB in September 2008 and the Fed refused to cut rates in the meeting after Lehman despite what markets were telling them. Yet here you make it sound like it was the ZLB itself that was the difference between 2008 and 1989. If you are saying that it was the proximity of the ZLB that contributed to the Fed’s timidity when the FF rate was about 2%, then I would agree. But surely another factor that you’ve mentioned before is the rise in oil prices in 2008, which generated high CPI figures and was probably mainly responsible for staying the Fed’s hand.

  23. Gravatar of TravisV TravisV
    26. March 2014 at 12:47

    Warren Buffett: It would surprise me if stock prices drop 50%

    http://www.cnbc.com/id/101494538

    he believes “this country will come through anything.”

    Even if the U.S. hadn’t guaranteed money market funds, preventing a total shutdown of the economy, “the United States would still come back. We would come back if we had some massive attack from abroad. … The farms don’t go away, the productive capacity doesn’t go away, human ingenuity doesn’t go away, the desire of people to live better in the future and for their kids doesn’t go away.”

  24. Gravatar of Tommy Dorsett Tommy Dorsett
    26. March 2014 at 15:18

    Scott, Lars did a post a while back subtracting the CBO’s estimate for potential rgdp growth from a 5% ngdp constant. Here’s what it looks like:

    https://research.stlouisfed.org/fred2/graph/?graph_id=91841&category_id=

    So we wouldn’t have ended up with Krugman’s 4% inflation but close to it. Yes, it would be judged a failure (absent the Great Recession counterfactual), but then Congress would be forced to enact good supply side policies to change the P/Y split. Something they are not doing now.

  25. Gravatar of Mark A. Sadowski Mark A. Sadowski
    26. March 2014 at 15:57

    Off Topic.

    There’s been an interesting back and forth between Cullen Roche and Nick Rowe recently.

    I want to focus on one particular claim by Cullen Roche which he repeats three times in various forms at two different posts.

    http://pragcap.com/of-course-all-economists-already-understood-the-money-multiplier-not/comment-page-1#comment-171007

    Cullen Roche
    “Depends on the banking system and the “money” you’re referring to. “Federal Reserve Notes” are not actually issued by the CB even though they’re a liability of the CB. They are purchased by the CB and printed up by the Bureau of Engraving. Reserve Banks purchase coin at face value from the US Mint (who is determining your “conversion” rate there – a branch of the US Tsy or the Fed?). So, in a strange sort of way, the Treasury acts as a banker to its own bank and charges that bank quite a bundle in fees to deal in “legal tender”. There is this circuitous/hybrid relationship here that I think gets bungled by a lot of people.

    So, when Scott Sumner refers to reserve notes as “paper gold” he’s really not referencing the power of a Central Bank. He’s actually referring to the issuer, the US Treasury which makes Sumner an ironic/funny kind of way. And this is the problem with parts of Market Monetarism. If you don’t respect specific institutional arrangements you end up saying things that make no sense when you consider the actual design of the system.”

    http://pragcap.com/who-is-the-alpha-bank/comment-page-1#comment-171180

    Cullen Roche:
    “…1) I think you overstate the exchange rate concept given that the Fed buys coin and currency from the US Tsy and the fact that there’s deposit insurance via FDIC. US bank deposits are at a very low risk of ever trading below par. The “value” of commercial bank money has been backstopped for all intents and purposes and the Fed is far from the only cause of this effect…”

    http://pragcap.com/who-is-the-alpha-bank/comment-page-1#comment-171181

    Cullen Roche
    “I understand Nick’s point. The thing is, the “unit of account” in Sumner’s theory is not even created by the CB. It’s created by the Bureau of Engraving. All cash and coin is sold to the Fed at face value by the Bureau, a department of the US Tsy. The alpha bank, if we’re going to use such a term, is actually the US Treasury in the Market Monetarist model and they don’t know it because they don’t actually describe the reality of how money is created. Sumner’s “paper gold” is a creation of the US govt, not the Fed…”

    In a word, this is wrong.

    (continued)

  26. Gravatar of Mark A. Sadowski Mark A. Sadowski
    26. March 2014 at 15:59

    (continued)

    http://www.newyorkfed.org/aboutthefed/fedpoint/fed01.html

    “The distribution of coins differs from that of currency in some respects. First, when the Fed receives currency from the Treasury, it pays only for the cost of printing the notes. However, coins are a direct obligation of the Treasury, so the Reserve Banks pay the Treasury the face value of the coins…”

    The cost of printing the notes has averaged approximately 0.325% of their face value in the past 11 years:

    https://research.stlouisfed.org/fred2/graph/?graph_id=169160#

    Of course the Federal Reserve pays 100% of the face value for coins. What proportion of the value of the currency in circulation consists of coins?

    http://www.federalreserve.gov/newsevents/testimony/roseman20100720a.htm

    “…The value of U.S. coins in circulation as of May 31, 2010, was approximately $40.4 billion, or about 4.3 percent of total currency and coin in circulation.”

    So the Treasury only gets paid about 4.6% of the face value of the nation’s currency in circulation by the Federal Reserve, which is appropriate if the Treasury is really in the role of performing a service for the Fed.

    As Cullen says:
    “If you don’t respect specific institutional arrangements you end up saying things that make no sense when you consider the actual design of the system.”

    Kind of “ironic/funny”, eh?

  27. Gravatar of Mark A. Sadowski Mark A. Sadowski
    26. March 2014 at 16:50

    Off Topic.

    This whole alpha/central bank versus beta/commercial bank fracas between Nick and Cullen reminds me of how perverted Monetary Realism’s “scale of moneyness” is:

    http://pragcap.com/wp-content/uploads/2013/03/moneyness1.png

    Poor thing. It reminds me of one of these at the carnival freakshow:

    http://blog.allanellenberger.com/wp-content/uploads/freaks-olga.jpg

    Fortunately virtually the rest of the monetary universe has the head where the head should be, and the torso where the torso should be, and so on and so forth.

    And lest you think I’m only speaking for the monetarists, here’s what Post Keynesianish heterodox economist Perry Mehrling has to say about the whole matter (Page 10):

    http://ieor.columbia.edu/files/seasdepts/industrial-engineering-operations-research/pdf-files/Mehrling_P_FESeminar_Sp12-02.pdf

    “Returning to our simple hierarchy of money, the point is that there is a simple hierarchy of market makers to go along with the hierarchy of instruments. And for each market maker, there is an associated price of money. The prices in the simple hierarchy are three: the exchange rate (the price of currency in terms of gold), par (the price of deposits in terms of currency), and the rate of interest (the price of securities in terms of deposits or currency, assuming par). These prices are the quantitative link between layers of qualitatively differentiated assets. The market markets who quote these prices in effect straddle the layers of the hierarchy, using their own balance sheets to knit those differentiated layers into a coherent whole.”

    Be sure and look at Figure 3 on page 19. (Yep, head and torso are in the right spots.)

  28. Gravatar of wufwugy wufwugy
    26. March 2014 at 16:51

    TallDave, thanks so much for posting the CRA article. I had no luck googling for an explanation of the moral hazard role in the housing crisis. The mainstream view that the problem was just greedy bankers instead of moral hazards and monetary policy is overwhelming. I’ve been trying to bring what I learn here to a very liberal board that I’ve posted on for a while, but the inability to back things up due to difficulty in finding sources is sometimes insurmountable

  29. Gravatar of Tom Brown Tom Brown
    26. March 2014 at 16:51

    Mark, I used an argument similar to that (in jest) to argue that coins are the only true money. Reserve notes and electronic reserve balances are just promises to pay coins. That’s why notes and Fed deposits are liabilities to the Fed: to remind the Fed of the coins they owe. Those notes and Fed deposits are then truly IOUs: What does the Fed owe the bearer? Coins.

    The funny thing is, that’s the way the accounting makes it appear.

  30. Gravatar of Tom Brown Tom Brown
    26. March 2014 at 17:23

    … and actually, if you dig a little deeper you find that nickles are actually the only true money in the US:
    http://web.hbr.org/email/archive/dailystat.php?date=022712

  31. Gravatar of Philippe Philippe
    26. March 2014 at 17:25

    Mark,

    you may have noticed that ‘monetary realism’ is whatever Cullen Roche happens to think on any given day. He just made up his nonsensical ‘scale of moneyness’ one day and pronounced it to be the absolute truth, his followers obediently praised his awesome genius and anyone who bothered to point out it didn’t make much sense was subjected to a barrage of incoherent verbal abuse. He has of course repeatedly contradicted himself on the matter since, but he does this on most things anyway.

  32. Gravatar of TravisV TravisV
    26. March 2014 at 17:42

    Warren Buffett: Wow!

    http://www.cnbc.com/id/101494538

    “Buffett told 58-year-old host Joe Kernen that he will live to see the Dow at 100,000. “I won’t, but you will”

    As John Hempton has noted:

    http://brontecapital.blogspot.com/2012/02/stocks-you-can-fondle-them-and-they.html

    “Though unstated you can tell Buffett does not predict a Japanese outcome. Twenty years of deflation would make bonds a fantastic investment by Buffett’s criteria. That is a possibility he does not even entertain”

  33. Gravatar of Mark A. Sadowski Mark A. Sadowski
    26. March 2014 at 17:49

    Off Topic.

    And this back in forth between Cullen Roche and JP Koning had me in stiches. It starts here:

    http://pragcap.com/of-course-all-economists-already-understood-the-money-multiplier-not/comment-page-1#comment-170835

    Cullen Roche:
    “…When you understand endogenous money you have to basically throw out the old concepts of the central bank controlling inflation…”

    JP Koning
    “Not necessarily. Go read David Glasner. He thinks in terms of endogenous money, and he also explains how a central bank controls inflation”

    Cullen Roche:
    Not sure I agree with the underlying point he’s making. For instance, [David Glasner] says:

    “…the underlying confusion here is that the authors seem to think that the amount of money created by the banking system actually matters. In fact, it doesn’t matter, because (at least in the theoretical framework being described) the banks create no more and no less money that the amount that the public willingly holds. Thus the amount of bank money created has zero macroeconomic significance.”

    This is just a different version of the idea that banks are intermediaries who just allocate funds to the public. It downplays the actual importance of their role in the economy by creating the illusion that commercial banks are interdependent on the central bank when they create money. In this case, he’s saying that banks just supply some level of deposits that the public “wants to hold” without considering the stock/flow consistency of this concept.

    For instance, the public, as a whole, would rather not own any money that comes with an interest cost. The public would rather hold non-interest charging notes. But that is obviously not how the monetary system is designed. The public cannot simply reflux its holdings back to the banking system because it is largely contingent on the flow of income that comes from other loans that have created deposits. The fact that money IS credit is central to this understanding and the ability to see the monetary system in a stock/flow consistent framework….Therefore, in the long-run and in the aggregate, the idea that “any unwanted bank deposits are returned to the banking system” is a concept that is misleading at best and void of value at worst…”

    JP Koning:
    “How are Glasner’s ideas about reflux any different from Marc Lavoie’s ideas about reflux?”

    Cullen Roche:
    “Correct me if I am wrong, but Glasner is not a true endogenous money proponent. That is, he doesn’t think bank money matters to the macroeconomy whereas someone like Lavoie would never claim such a thing (or I assume he wouldn’t). So the point is that they’re utilizing different models of the economy. PKE is an endogenous money view whereas most neoclassical economists are exogenous money proponents. Or, if they understand endogenous money it is still a supply side driven element. So, there’s a difference between understanding endogenous money and using this understanding in what a Post-Keynesian would call an endogenous money perspective…”

    (At this point Cullen’s babblings begin to remind me of one of Governor Rick Perry’s debate performances.)

    JP Koning:
    “Cullen, you said:

    “The public cannot simply reflux its holdings back to the banking system…So the idea that ‘any unwanted bank deposits are returned to the banking system’ is a concept that is misleading at best and void of value at worst.”

    Lavoie says:

    “The primary mechanism through which the supply and demand for deposits become equal is the generalised reflux principle.”

    …and goes on to describe how unwanted deposits can’t exist, only desired money can exist.

    http://www.scribd.com/doc/214350744/Lavoie-1999-The-Credit-Led-Supply-of-Deposits-and-the-Demand-for-Money-Kaldor-s-Reflux-Mechanism-as-Previously-Endorsed-by-Joan-Robinson

    So why does Lavoie, a PK’er and proponent of endogenous money, seem to be contradicting you?”

    Cullen Roche:
    “Hey JP. That was a sloppy comment on my part. Sorry. I should have been clearer.

    Borrowers can obviously pay back loans in the short-term. But in the aggregate, over the long-term, there is no reflux. Firms and households will demand more deposits because deposits are the dominant MOE. We are thrust into a monetary world in which the payment system is dominated by banks and obtaining some level of their liabilities is a must for engaging in this system. If we want to participate in the monetary economy we cannot, in the aggregate, “pay back” or reflux our deposits over the long-term without major changes in how the system is actually designed. Said differently, there is an inherent upside bias in bank liability demand due to the mere design of our system. Therefore, the supply of deposits is not only demand driven (primarily), but it is also function of the system’s institutional arrangement. Saying that demand deposits don’t matter or are just something we can choose to hold, is misleading in my view.”

    (continued)

  34. Gravatar of Mark A. Sadowski Mark A. Sadowski
    26. March 2014 at 17:50

    (continued)

    “JP Koning:
    “Sorry Cullen, I’m having problems grokking you here. As always, it’s a version of this problem.”

    http://pragcap.com/on-money-demand-qe/comment-page-1#comment-161453

    And the upshot of that link is that Cullen has no theory of price level determination and what determines the purchasing power of base money.

    This reminds me of the fact that this is one of Post Keynesian economist Thomas Palley’s key criticisms of MMT:

    http://www.thomaspalley.com/?p=393

    “…Among many failings, Tymoigne and Wray fail to provide an explanation of how MMT generates full employment with price stability; lack a credible theory of inflation; and fail to justify the claim that the natural rate of interest is zero…”

    Which when you combine it with the fact that Monetary Realism gets its moneyness scale completely disjointed, MR is even more screwed up than MMT if that’s possible.

  35. Gravatar of Mark A. Sadowski Mark A. Sadowski
    26. March 2014 at 18:43

    In my opinion the following was an important exchange, especially given the nature or Cullen Roche’s post. Starts here:

    http://pragcap.com/of-course-all-economists-already-understood-the-money-multiplier-not/comment-page-1#comment-170989

    Cullen Roche:
    “And no, the manner in which we are discussing the money multiplier has nothing to do with convertibility at par. It has to do with the way people think reserves “flow out” of the banking system…”

    Nick Rowe:
    “The whole point of the first year textbook example is to show that when reserves flow out of an *individual* bank, when its deposits get *converted* (at a fixed exchange rate) into deposits at another bank, those reserves do not flow out of the banking *system*. They flow into some other bank. The whole point of the first year textbook example is to show that the banking system creates money, and creates *more* money than the central bank creates (assuming less than 100% reserves). That’s why they call it a “multiplier”. And yes it will be inflationary, if the total supply of money increases more than the total demand to hold money. (And remember, when a bank creates a deposit by extending a loan, the person who borrows that money very probably wants to spend that money, and not hold extra money sitting in his bank account.)

    Cullen Roche:
    “The way you’re describing the multiplier is different from the way I am criticizing people for using it. The people who abuse the concept assume that reserves are something that “flow out” of the reserve system.”

    Nick Rowe:
    “An *individual* bank that makes a loan *does* lose reserves to other banks (unless it can increase its market share of deposits at the same time) when the money gets redeposited at a *different* bank. It is exactly as if the individual bank lent its reserves, or made the loan in currency. And that is what all the economists you quote above are saying. They know full well those reserves are not lost to the banking system as a whole (unless they result in a currency drain, and the central bank holds base money=currency+reserves constant. Despite what you seem to think, those guys aren’t complete idiots.”

    And actually, in my opinion, the Krugman quote that Cullen Roche took out of context, came from one of his best blog posts ever.

    http://krugman.blogs.nytimes.com/2012/03/30/banking-mysticism-continued/

    March 30, 2014

    Banking Mysticism, Continued
    By Paul Krugman

    “Update: It’s obvious that many commenters don’t get the distinction between the proposition that banks create money “” which every economics textbook, mine included, says they do (that’s what the money multiplier is all about) “” and the proposition that their ability to create money is not constrained by the monetary base. Sigh.

    A bit of a followup on my previous post.

    As I read various stuff on banking “” comments here, but also various writings here and there “” I often see the view that banks can create credit out of thin air. There are vehement denials of the proposition that banks’ lending is limited by their deposits, or that the monetary base plays any important role; banks, we’re told, hold hardly any reserves (which is true), so the Fed’s creation or destruction of reserves has no effect.

    This is all wrong, and if you think about how the people in your story are assumed to behave “” as opposed to getting bogged down in abstract algebra “” it should be obvious that it’s all wrong.

    First of all, any individual bank does, in fact, have to lend out the money it receives in deposits. Bank loan officers can’t just issue checks out of thin air; like employees of any financial intermediary, they must buy assets with funds they have on hand. I hope this isn’t controversial, although given what usually happens when we discuss banks, I assume that even this proposition will spur outrage.

    But the usual claim runs like this: sure, this is true of any individual bank, but the money banks lend just ends up being deposited in other banks, so there is no actual balance-sheet constraint on bank lending, and no reserve constraint worth mentioning either.

    That sounds more like it “” but it’s also all wrong.

    Yes, a loan normally gets deposited in another bank “” but the recipient of the loan can and sometimes does quickly withdraw the funds, not as a check, but in currency. And currency is in limited supply “” with the limit set by Fed decisions. So there is in fact no automatic process by which an increase in bank loans produces a sufficient rise in deposits to back those loans, and a key limiting factor in the size of bank balance sheets is the amount of monetary base the Fed creates “” even if banks hold no reserves.

    So how much currency does the public choose to hold, as opposed to stashing funds in bank deposits? Well, that’s an economic decision, which responds to things like income, prices, interest rates, etc.. In other words, we’re firmly back in the domain of ordinary economics, in which decisions get made at the margin and all that. Banks are important, but they don’t take us into an alternative economic universe…”

    Nope. Not a complete idiot.

  36. Gravatar of TallDave TallDave
    26. March 2014 at 18:52

    wufwugy — You’re more than welcome, I too spent a lot of frustrated time searching for an article like that one. Really a must-have on the genesis of the credit crisis.

  37. Gravatar of TallDave TallDave
    26. March 2014 at 19:01

    BTW you might point out that yes bankers are greedy, but bankers are supposed to be greedy, and in fact regulators leveraged that greed by creating incentives to make more loans. Unfortunately everyone involved mispriced the risk because as long as home values kept rising defaults remained low.

  38. Gravatar of Frances Coppola Frances Coppola
    26. March 2014 at 19:26

    Mark,

    Off topic (and not getting involved in the MR stuff):

    The post by David Glasner that JP Koning refers to has been bothering me for a while. It dismisses QE as irrelevant and ends with an indirect plug for negative interest rates on reserves:

    http://uneasymoney.com/2014/03/21/the-irrelevance-of-qe-as-explained-by-three-bank-of-england-economists/

    I fear Glasner has fallen into his own trap. He correctly says that banks can only create the amount of deposits the public is willing to hold, so the amount of money created by banks is itself of no macroeconomic significance – although that doesn’t mean that bank lending decisions don’t have macroeconomic effects. But he then suggests that spending would only increase if bank reserves are not willingly held:

    “The problem with the creation of new central-bank reserves by QE at the zero lower bound is that, central-bank reserves earn a higher return than alternative assets that might be held by banks, so any and all reserves created by the central bank are held willingly by the banking system. The demand of the banking [system] for central bank reserves is unbounded at the zero-lower bound when the central bank pays a higher rate of interest than the yield on the next best alternative asset the bank could hold. If the central bank wants to increase spending, it can only do so by creating reserves that are not willingly held.”

    This implies that private sector spending is driven by bank lending. Even I (a determined advocate of the macroeconomic significance of banks) don’t go that far. Just as throwing money at banks doesn’t make households and corporations borrow, so charging banks to hold that money doesn’t make households and corporations spend. It would make banks spend, but not necessarily allocate capital efficiently: I could imagine it resulting in all manner of stupid investments. Haven’t we had enough misallocation of capital already?
    Negative rates on reserves are a tax on deposits, so the increase in spending from the hot potato effect would have to be sufficient to offset the essentially contractionary nature of such a tax. It would be quite a gamble.

    I’m with him on the irrelevance of QE, though, except to support asset prices in a crisis. But then I have contrarian views on QE, as you probably know.

    Your findings on the term premium and Treasury supply are really interesting. How on earth do you find the time to do all this research?

  39. Gravatar of Tom Brown Tom Brown
    26. March 2014 at 20:10

    Frances, you think Glasner is arguing for the irrelevance of QE? … I’ll have to reread Glasner’s post. I know it says that in the title, but that’s what he’s saying the BoE paper does, right?

    I’ve asked Glasner before what he’d do, specifically, if he were in charge of the Fed, and he described a for-instance schedule of increasing asset purchases, complete with a for-instance test or threshold for stopping them. He gave specific numbers, like “buy $50 B a month, increasing by $50 B each month, until NGDP was such and such, and then continue at flat level of purchases another so and so months”

    I’m too lazy to look up his exact quote, but that was the nature of it. So I’d be very surprised if he’s arguing for the irrelevance of QE. I know he’s very much against an IOR > 0. Are you sure he’s not just saying it’s irrelevant when IOR is too high? I’ll re-read.

  40. Gravatar of TravisV TravisV
    26. March 2014 at 20:22

    Frances Coppola,

    (1) Glasner certainly does not believe QE has been ineffective, believe me. He was the first to identify the strong relationship between QE surprises, increases in expectations of inflation (therefore aggregate demand) and stock prices.

    (2) Many Market Monetarists have commented on that BOE report, including Sumner. You should google around for them.

    (3) QE surprises have done far more than just “support asset prices.” The key is understanding that QE is not working by decreasing interest rates. In fact, QE surprises tend to INCREASE long-term rates rather than decrease them. Take a good look at this excellent graph:

    http://gundlachonthemarkets.blogspot.com/2013/09/quantitative-easing-qe-bond-market.html

    And this post:

    http://scottgrannis.blogspot.com/2013/08/why-qe-was-successful-failure.html

    Yes, QE has increased stock prices a tremendous amount. See this graph:

    http://gundlachonthemarkets.blogspot.com/2013/09/quantitative-easing-stock-market.html

    But QE surprises do NOT tend to increase asset prices via interest rate decreases. Quite the contrary. QE surprises increase asset prices by increasing expectations of future demand (and therefore sales). Which has a HUGE positive impact on employment, NOT just asset prices!

    P.S.: Here is the strong relationship between stock prices and inflation (therefore aggregate demand) first discovered by Glasner:

    http://macromarketmusings.blogspot.com/2012/02/chart-of-day.html

  41. Gravatar of TravisV TravisV
    26. March 2014 at 20:45

    Frances Coppola,

    You might be interested in checking out Glasner and Sumner’s strong agreement on the “root causes” of the Great Depression. Here’s Sumner:

    http://www.themoneyillusion.com/?p=4220

    http://vimeo.com/11700175

    And here’s Glasner:

    http://uneasymoney.com/2013/08/21/why-hawtrey-and-cassel-trump-friedman-and-schwartz

    And here’s a great video where Sumner provides his detailed view of the 2008 Great Recession:

    http://vimeo.com/38915078

  42. Gravatar of Mark A. Sadowski Mark A. Sadowski
    26. March 2014 at 21:33

    Frances,
    I was a little perplexed by David Glasner’s most recent post as well. But it’s not clear to me that he is actually saying that QE is irrelevant.

    He qualifies his statements numerous times with such phrases as “…in the framework suggested by this article…”, “…in the theoretical framework being described…”, “…in the theoretical framework described by the authors…” etc. I read his post as being more a critique of the theoretical framework of the BOE paper than anything else.

    I loved the section of Glasner’s post that JP Koning and Cullen Roche discussed. I believe that the macroeconomic effect of commercial banks is strictly contingent on the conduct of monetary policy by the central bank, and that *by themselves* commercial banks have no macroeconomic significance.

    Just to be clear on my own views, I think there is quite a bit of empirical evidence that QE is functioning through a variety of channels. Furthermore Peter Ireland has done some theoretical work that suggests that monetary policy should still be effective even with interest on reserves and excess reserves.

    On the other hand I don’t think there is any doubt that interest on reserves is contractionary, as it increases the demand for base money. And we don’t have to guess what the effects of negative interest on reserves would be like, as it was successfully implemented by Sweden in 2009-10.

    “Your findings on the term premium and Treasury supply are really interesting.”

    Thanks!

    “How on earth do you find the time to do all this research?”

    Let’s just say I live very simply.

  43. Gravatar of Philippe Philippe
    26. March 2014 at 21:42

    Mark, do you have a link to research on the negative interest rate experience in Sweden? Thanks.

  44. Gravatar of Mark A. Sadowski Mark A. Sadowski
    26. March 2014 at 22:53

    Philippe,
    We did a post on Sweden vs Denmark in January:

    http://www.themoneyillusion.com/?p=25716

  45. Gravatar of Vaidas Urba Vaidas Urba
    27. March 2014 at 01:35

    Mark Sadowski,
    Regarding negative deposit rate in Sweden, my impression was that it did not impact the opportunity cost of reserves, so Swedish experience is not a good test of negative interest on reserves.

    I looked at the charts and it seems they were on the corridor, not floor system at that time. Some reports said there was a loophole to get zero rate from Riksbank, but I guess these reports are mistaken.

    In any case, Swedish experience is not a good test. It is possible we could get a good test from the ECB, if they combined negative rates with excess liquidity conditions.

  46. Gravatar of Vaidas Urba Vaidas Urba
    27. March 2014 at 01:39

    Mark Sadowski:
    “I believe that the macroeconomic effect of commercial banks is strictly contingent on the conduct of monetary policy by the central bank, and that *by themselves* commercial banks have no macroeconomic significance.”

    Nominal effect of commercial banks is strictly contingent on the monetary policy. But what about the real effect?

  47. Gravatar of Frances Coppola Frances Coppola
    27. March 2014 at 01:44

    Mark,

    QE undoubtedly has effects – in fact one of the interesting things about it is just how widespread its effects are. The question is what those effects are, and whether the NET effect is expansionary. I remain unconvinced, but this would be a long and detailed conversation!

    The presence of excess reserves and IOR certainly doesn’t make monetary policy ineffective. It just has to be conducted slightly differently, since IOR (or – now – the reverse repo rate, in the US) replaces the funds rate as the principal policy tool. The essential mechanism is still the same.

  48. Gravatar of Morgan Warstler Morgan Warstler
    27. March 2014 at 04:02

    Mark,

    “I believe that the macroeconomic effect of commercial banks is strictly contingent on the conduct of monetary policy by the central bank, and that *by themselves* commercial banks have no macroeconomic significance.”

    I view banks as basically pawn shops, each loan, brings with it collateral, sometime atoms themselves, sometimes from streams of revenue connected to atoms.

    Until recently almost all of the macroeconomy ran on atoms.

    Now in the winter of our discontent, we see each year more of the economy and in indeed the long run a total change to a non debt based, pure equity based economy based on the digital.

    There is far less collateral in the future, and far less opportunity to borrow. You consume the calories and the electricity you need to run full tilt. And yes there are atoms and yes there is atomic property law… but atomic scarcity sucks for most people, so they lovingly choose full digital immersion.

    So two questions:

    1. Apart from role of CB, Isn’t banks effect on the macro economy tied to the ability and willingness of people to use atoms as collateral, which is shrinking? If people bring less things into the bank to pawn, bc there are less things to bring in, that has to have some effect, no?

    2. If #1is right, what does CB do to ensure it doesn’t slow down the conversion to an equity based digital economy, instead of a miserable old atomic debt based one? What is the optimal approach rule set for speeding up the conversion?

  49. Gravatar of Willy2 Willy2
    27. March 2014 at 04:31

    Greg Mankiw boasted in late 2007 the FED had the dream team of economists and nothing could go wrong. But in spite of that there was the meltdown of 2008.

    Focussing on 5% NGDPLT is sheer nonsense. The public determines whether or not they want to borrow.

  50. Gravatar of ssumner ssumner
    27. March 2014 at 04:33

    Travis, I don’t claim to be able to forecast the economy, but given the recent recession was the worst since the 1930s, I think you are probably right about the next 10 years.

    Rajat, I agree that the supply shock was also a factor. But I believe in late 2008 markets became increasing pessimistic that the Fed had a backup plan for when rates eventually fell to zero. Partly because the Fed actually said (or implied) it had no backup plan when it called for fiscal stimulus. If I was a market participant I would have been horrified by their call for fiscal stimulus–it’s an admission they were out of ideas. IOR was also a huge mistake.

    Tommy, Thanks. Of course the trend rate of RGDP growth might have been a bit higher without the demand shock.

    Mark, You quoted Cullen as saying:

    “All cash and coin is sold to the Fed at face value by the Bureau, a department of the US Tsy. The alpha bank, if we’re going to use such a term, is actually the US Treasury in the Market Monetarist model and they don’t know it because they don’t actually describe the reality of how money is created. Sumner’s “paper gold” is a creation of the US govt, not the Fed…”

    He has said a lot of wacky things in the past, but that is especially crazy. How would the Fed earn seignorage?

    Tom, I have a post arguing that the Great Depression was caused by a drop in the supply of nickels.

    Vaidas, That’s my view, under a modern monetary system banking has real (supply side) effects but not nominal effects. Under the gold standard it affects both.

    Frances, There’s no question that QE is expansionary, the question is why.

  51. Gravatar of TravisV TravisV
    27. March 2014 at 06:34

    Prof. Sumner,

    Thanks! Now I can die in peace!

  52. Gravatar of TravisV TravisV
    27. March 2014 at 06:39

    Frances Coppola,

    I encourage you to further study the material of Glasner and Sumner. Two brilliant economic historians largely operating independently arriving at very very similar conclusions.

    Another thing: Glasner’s ideology might appeal to you more than Sumner’s.

    Sumner, Marcus Nunes and Morgan Warstler lean right with their ideologies while Glasner and Mark Sadowski lean left.

    I suspect that Glasner receives more love from Krugman, Noah Smith and John Aziz because he leans more left than Sumner does.

    However, Sumner is a very open-minded guy. If you dig a little deeper, you’ll see that he’s a utilitarian who actually agrees with numerous left-wing arguments.

  53. Gravatar of flow5 flow5
    27. March 2014 at 07:15

    Dusty school work. I cracked the code in July 1979. Rates-of-change in Mvt = roc’s in both real-output & nominal-gDp:

    “All eyes are opened, or opening, to the rights of man. The general spread of the light of science has already laid open to every view the palpable truth, that the mass of mankind has not been born with saddles on their backs, nor a favored few booted and spurred, ready to ride legitimately, by the grace of God.” – Thomas Jefferson
    ——

    QE induced dis-intermediation among the non-banks (as Henry C. K. Liu predicted in: The Wizard of Bubbleland’s “repo time bomb”).

    http://bit.ly/1idRtkx

    Rates fell as aggregate monetary purchasing power fell. AD fell because money flows fell. I.e., the FOMC inadvertently tightened monetary policy in a multiplicity of ways:

    1) roc’s in MVt fell (both short & long-term)
    2) the prudential reserve E-D market contracted as safe assets were bid up (this forced the dollar’s exchange rate higher)
    3) there was also a “flight to safety”
    4) interest on reserves destroyed the repo & commercial paper markets
    5) unless money expands at least at the rate prices are being pushed up, output can’t be sold & hence the work force will be cutback
    6) countercyclical increase in bank capital requirements

    See the impact on the dollar’s exchange rate:

    http://bit.ly/1mfzn6N

    http://bit.ly/1mfznDK
    ——-
    The science (long-run validity), is as repeatedly and accurately reproduced (predicted).

    That’s how I denigrated Nassim Taleb’s general theory of the “Black Swan” (the failure of circuit breakers and limits on high frequency trading) of May 6th 2010. I.e., I predicted the “flash crash” 6 months and within one day of the 1000 point swing.

    As one of my favorite economists, Dr. Richard Anderson, always emphasizes: “All analysis is a model” – Ken Arrow

  54. Gravatar of Vaidas Urba Vaidas Urba
    27. March 2014 at 07:18

    Scott:
    “That’s my view, under a modern monetary system banking has real (supply side) effects but not nominal effects.”
    I’ll just note that expected volatility of NGDP is a real variable

  55. Gravatar of Vaidas Urba Vaidas Urba
    27. March 2014 at 07:23

    …and that’s why it is important to do detailed studies that you and Hetzel do to determine which crisis (nominal vs real) is the primary one.

  56. Gravatar of Tom Brown Tom Brown
    27. March 2014 at 07:28

    Scott, re: nickles, I’ll look for that one. So does that mean that if the quantity of nickles -> 0, then P -> 0?

    😉

  57. Gravatar of Brian Donohue Brian Donohue
    27. March 2014 at 09:09

    Scott, the recession didn’t need to be as bad as it was, but there were a lot of bad habits people picked up that portended some kind of nasty correction. I always expected something worse than 1991 or 2001. In fact, the 2001 recession was short-circuited by 9/11, which institutionalized financial/fiscal irresponsibility, which, IMO, set the table.

    I live out here in middle America and, in 2005, almost everyone I knew was ‘stretched’. Overleverage seemed to me to be a serious problem. As Buffett said “When the tide goes out, you see who’s swimming naked.”

    Perhaps the tide didn’t need to go out so far or for so long, but overleverage, it seems to me, was a REAL THING .

    Wasn’t overleverage also a problem in 1929? Again, of course, it didn’t need to be so bad, and monetary policy made things a lot worse, but…

    Anyway, I thought Jeremy Stein’s take on monetary policy was very interesting. As he acknowledges, there may be practical measurement issues with leverage, but it feels to me like he’s looking in the right place.

    If the debate among thinking people has moved to one between you and Jeremy, I take this as an enormous step forward.

  58. Gravatar of Tom Brown Tom Brown
    27. March 2014 at 10:41

    “However, Sumner is a very open-minded guy. If you dig a little deeper, you’ll see that he’s a utilitarian who actually agrees with numerous left-wing arguments.”

    Hmmm, how can we ruin Scott with the right… What are your views on immigration Scott? Are you an “open borders” guy? 😀

  59. Gravatar of Frances Coppola Frances Coppola
    27. March 2014 at 11:16

    Brian,

    at the risk of stealing Scott’s thunder, I would say this….

    “Overleverage” is not an absolute. A sudden rise in interest rates creates what you call “overleverage” (by which you seem to mean struggling to afford to service debts) among actors who would not previously have regarded themselves as overleveraged.

    There are far too many absolutes floating around, and far too much demonization of debt going on. Debt itself is not the problem. Affordability is.

  60. Gravatar of Doug M Doug M
    27. March 2014 at 11:53

    There actually is an absolute criteria for “overleverage.”

    If you invest in something with a positive return and some level of risk there is some level of leverage at which increasing your leverage decreases your total return.

    Of course you can always misunderestimate the risks you are taking and have determined before hand what was a correct level of leverage and find your self insolvent after the fact, and everyone will tell you what an idiot you were for overleveraging.

  61. Gravatar of ssumner ssumner
    27. March 2014 at 12:25

    Vaidas, Of course I believe you minimize NGDP volatility with NGDPLT.

    Tom, Yes, toward zero, assuming there is no shortage of nickels. I discuss the idea in this post, which is my personal favorite:

    http://www.themoneyillusion.com/?p=2219

    If I ever die in a plane crash, that’s the post I want to be judged by.

    Brian, Yes, but borrowing too much causes people to work more. In fact, they worked less. So over-borrowing didn’t cause the recession.

    Tom, My views tend to lean left on social issues, foreign policy, immigration (more is better), and carbon taxes. I’m a moderate on inequality and monetary policy. I’m on the right on free markets and fiscal policy.

  62. Gravatar of Vaidas Urba Vaidas Urba
    27. March 2014 at 12:36

    Scott, other steps might be needed to minimize NGDP volatility when economy adjusts to NGDPLT.

  63. Gravatar of Frances Coppola Frances Coppola
    27. March 2014 at 12:50

    Doug,

    No, that is not an absolute criterion. The rate of return on an investment can vary, as can the value of an asset. Just ask the owners of underwater properties.

  64. Gravatar of Mark A. Sadowski Mark A. Sadowski
    27. March 2014 at 12:58

    Vaidas Urba,
    “Nominal effect of commercial banks is strictly contingent on the monetary policy. But what about the real effect?”

    It depends on what you mean by “real effect”.

    RGDP growth volatility induced by NGDP volatility is a “real effect” which is attributable poor monetary policy, not to any particular industry.

    The “real effect” which may be attributable to particular industries is a matter of long run growth. Since money is neutral in the long run (albeit not superneutral) the “real effect” attributable to any particular industry is probably not contingent on the conduct of monetary policy.

    Incidentally, to put this is some perspective, in 2012, credit intermediation (NAICS Code 521CI), which is comprised predominantly of depository institutions, was the 11th largest out of 69 industry groups in the U.S. as a percent of GDP. It was 2.7% of GDP, just behind administrative and support activities, and just ahead of insurance carriers. So the “real effect” of banking is no doubt very important to the nation’s economy as a whole.

    But in my opinion, it is the real effect of the toaster manufacturers that is truely underappreciated. :)

  65. Gravatar of Mark A. Sadowski Mark A. Sadowski
    27. March 2014 at 13:48

    Morgan Warstler,
    “1. Apart from role of CB, Isn’t banks effect on the macro economy tied to the ability and willingness of people to use atoms as collateral, which is shrinking? If people bring less things into the bank to pawn, bc there are less things to bring in, that has to have some effect, no?”

    It’s hard to find historical data specific to depository institutions that gives us an idea of their relative importance to the economy. The closest I can come to is employee compensation. In 1929 compensation of employees in depository institutions was about 1.5% of total employee compensation. As of 2000 (the most recent year) it was 1.7% of GDP.

    Credit intermediation (NAICS Code 521CI) was 2.7% of GDP in 1997 and it was still 2.7% of GDP in 2012.

    So my sense is there is no trend either up or down in the relative inmportance of banking to the U.S. economy.

    “2. If #1 is right, what does CB do to ensure it doesn’t slow down the conversion to an equity based digital economy, instead of a miserable old atomic debt based one? What is the optimal approach rule set for speeding up the conversion?”

    In my opinion any positive real change in the economy will be enhanced by a policy of stabilizing aggregate demand or NGDPLT.

  66. Gravatar of Vaidas Urba Vaidas Urba
    27. March 2014 at 14:12

    Mark Sadowski,

    financial industry will expand if we get NGDPLT.

  67. Gravatar of Morgan Warstler Morgan Warstler
    27. March 2014 at 17:49

    Mark, mine too. NGDPLT for sure.

    What I’m angling at though is the actual level, if what we have going on is not a shock, but a polarity reversal. If the economy is moving from an atomic debt based system to an digital / equity based system.

    If in 20 years half of DJIA are 25 different What’sApp and they each have only 10000 employees. and there is no government debt:

    Does a 4% NGDPLT delay that change more than a 1% NGDPLT does? Can there be so much digital price deflation (think of it as invisible real growth), that adding in more inflation to get to 4%, when we need a ton just to stay at 1% – if we have had a polarity change, does holding on to 3% RGDP and 2% Inflation make sense? Does it delay our digital future? Speed it up? Why?

  68. Gravatar of Mark A. Sadowski Mark A. Sadowski
    27. March 2014 at 19:08

    Morgan,
    I believe Akerlof, Dickens, and Perry (1996):

    http://www.brookings.edu/~/media/Files/Programs/ES/BPEA/1996_1_bpea_papers/1996a_bpea_akerlof_dickens_perry_gordon_mankiw.pdf

    To have microeconomic labor market efficiency with changes in real relative wages, one must have on average about 2% inflation to allow for some nominal wages to rise faster than others.

    In other words the future will get here faster with 5% NGDPLT than with 3% or 1%.

  69. Gravatar of Brian Donohue Brian Donohue
    27. March 2014 at 22:16

    Frances,

    I’m not thinking about ‘overleverage’ as an absolute. I’m talking about household balance sheets.

    On one side are assets, on the other are liabilities and net worth.

    Home equity has historically comprised the bulk of net worth for the bulk of household balance sheets.

    Buying a bigger house increases assets- you feel richer. Look around. But it increases liabilities too (bigger mortgage), so you’re not really richer. This is risky. I’m not thinking of a tipping point so much as a gradient of riskiness. There was a lot of this going on in the oughts.

    Worse, the unprecedented rush to cash in home equity to prop up consumption decreases net worth. Much more leverage, much more fragility in the system. There was a lot of this going on in the oughts.

    More leverage means less ability to withstand any shocks- it’s a dangerous strategy, as millions of people found out the hard way.

    And over the past six years household leverage has decreased a lot. Less fragility. These are the lessons people learn, and they are behaving more responsibly now.

    As far as the ‘demonization of debt’- I can only laugh. The above discussion ignores household’s share of incurred government debt. As households have been repairing balance sheets, Uncle Sam has been upping the credit limit on the nation’s credit card at an astonishing pace. How bad is government debt? Well, clever economists tell us it’s nothing at all because ‘governments aren’t households’ is a magical incantation, but I assure you that $18 trillion in debt is $12 trillion worse than $6 trillion in debt, and the risk is perfectly analogous to household leverage risk- ask the Greeks. And a country where leading geniuses howl at the savage austerity that is $600 billion deficits four years after the recession ends is hardly a land where debt is demonized.

  70. Gravatar of Brian Donohue Brian Donohue
    27. March 2014 at 22:23

    Scott, I can’t tell you how much I appreciate your attention to your commenters, but I feel a bit slighted by this:

    “Brian, Yes, but borrowing too much causes people to work more. In fact, they worked less. So over-borrowing didn’t cause the recession.”

    I feel like you’re applying a KKR LBO “pile on the debt, lean and mean, make ’em sweat” approach to households. The strategy is risky, but it may make sense for a portfolio of companies, some of whom blow up while others make outsize returns because leverage.

    But what happens when a family blows up?

  71. Gravatar of Frances Coppola Frances Coppola
    28. March 2014 at 01:05

    Brian,

    A couple of points.

    Firstly, “overleverage” is a meaningless term even for a household. If I borrow to buy a house, I am careful to borrow an amount that I can comfortably afford on my present salary. I am not “overleveraged”, whatever the size of the house or the mortgage. Then we have a recession and I lose my job. I am unable to find another job at the same salary level and am forced to work in Walmart. Suddenly I am seriously overleveraged and likely to default. The amount I have borrowed has not changed, but my circumstances have. This is what has happened to a lot of people in both the US and Europe since 2008. You can talk about fragility, if you like – but “overleverage” is a function of circumstances, not an absolute.

    Secondly, the US is nothing – absolutely nothing – like Greece. Greece is locked into the equivalent of a very badly designed gold standard. It does not issue its own currency and has no functioning central bank. It therefore has no control of monetary policy. It’s the Eurozone equivalent of Detroit.

    Moreover, Greece was a fiscal basket case even when it joined the Euro and it lied about its true financial position in order to be accepted – though I reckon EU policymakers knew perfectly well the Greek government was fudging its balance sheet but let them in anyway for political reasons. It was the equivalent of a household deliberately concealing massive credit card debts when applying for a mortgage, and the mortgage lender being so keen to lend to them that it turned a blind eye to the concealment even though it knew about it. When it finally admitted its true financial position, not surprisingly borrowers rejected its debt and its bond yields headed for the moon. Greece is a “Ninja” in household terms. Highly-indebted though it is, the US is not.

  72. Gravatar of Morgan Warstler Morgan Warstler
    28. March 2014 at 05:23

    You are kind of talking past each other. But in one important way the US was very much like Greece.

    What happened in 2003-2006, wasn’t anyone making a careful choice about what they could comfortably afford.

    Taxi drivers in south Florida with no provable income not only got credit to buy a house, the value of the house was overpriced on paper, and LTV was high enough, they actually took out cash, and lived fat on it, and as the price of that home went up, they used it to buy more houses.

    Ads were run on craigslist looking for lower middle class with good credit who wanted to be paid for putting their name on a mortgage.

    It was endemic, the buyers were not naive, and the neither were the bankers, but this was the best time they ever had in their lives, they NEVER expected to have this kind of life. And they never should have been given it.

    The fact is under NGDPLT, this wouldn’t / couldn’t happen. The very first month the market started to get overheated (in 2004), rates would go up, and just like any other kind of shortage (say gas in in 1970’s), very quickly the weakest least stable deals on the table would get nuked. We’d see right away who was naked. Fight t and next month, the machine raises rates 3x as much, keep fighting it? next month 6x – it is ruthless and brutal.

    It is true that homes are assets, but the rental value of the homes determines its worth. Being able to live off home price appreciation? Silly.

  73. Gravatar of Morgan Warstler Morgan Warstler
    28. March 2014 at 05:30

    Mark, I’m with you… in 1996.

    What I’m talking about is IF there is >2% “invisible” real growth YOY (meaning digital deflation is happening, bc we aren’t able to measure free consumption), why not have NGDPLT at 3%?

  74. Gravatar of Mark A. Sadowski Mark A. Sadowski
    28. March 2014 at 06:43

    Morgan,
    If actual RGDP growth were higher than measured RGDP growth this would imply that actual labor productivity is higher that measured labor productivity. If that were the case I would have no problems at all with lowering the proposed NGDP growth rate target, as it would not lead to high rates of unemployment. This would lead to “good” deflation, as is theoretically possible, but of which I have yet to see a single authentic historical example.

    However, we *do* have relatively high rates of unemployment, so this suggests to me that labor productivity is in fact as bad as measured estimates show it to be.

  75. Gravatar of Tom G Tom G
    28. March 2014 at 09:02

    Scott, ” On the other hand the supply side fundamentals of the economy were so poor after 2008 (for reason I don’t fully understand) that 5% NGDP growth would have led to some unpleasant stagflation.”

    The reasons are two: a) you don’t fully incorporate Home Equity Wealth and its huge change over the 2005 – 2008 from a peak to the “realization” that the money in the home “bank” was gone, which affected and changed many econ decisions and especially the trends, plus

    b) the huge internal loss of illegals’ cash activity which was often not part of the “official” rates of unemployment or other econ statistics, but were real for landlords and many small cash businesses. You like to claim that the 2006-2008 growth contradicts but I’m convinced the lags of wealth change and lags of reduced illegal econ activity caused the numbers to be much further from the true reality than usual.

  76. Gravatar of Frances Coppola Frances Coppola
    28. March 2014 at 09:34

    Morgan,

    The US is nothing at all like Greece. Greece’s debt problem was not caused by a property & credit bubble.

  77. Gravatar of ssumner ssumner
    28. March 2014 at 11:16

    Brian, When family “blows up” I’d expect them to work even harder. What would you expect?

    Tom, Those are not supply side factors—but the exodus of illegals certainly reduced AS, an issue I’ve discussed elsewhere.

  78. Gravatar of Brian Donohue Brian Donohue
    28. March 2014 at 12:57

    Frances and Morgan,

    Thanks for your thoughts. I’d like to rope back to the theme of the post: what was the best case for the 2008 recession given optimal monetary policy? If one concedes that even under optimal monetary policy, there would have been some kind of recession, what is the basis for this belief?

    I’m not an Austrian, but I do believe the (fiscal, not monetary) excesses of the early oughts (tax cuts for all, trillion dollar wars, unfunded Medicare Part D, “compassionate conservatism”, the “ownership society” push for increased homeownership with no regard to prudence, home equity as ATM) in the wake of 9/11 produced the fragility. Way too many people swimming naked.

    The increasing leverage I’m talking about is easy to understand and well-documented. Gubmint was mostly concerned with keeping capital C up, cuz consumption “drives” the economy according to upside-down worldviews, and the best laid plans of gubmint were counting on this growth and had already figured it in.

    Greece is actually an interesting case and to me it bears on the topic of the post: is their suffering primarily due to ceding monetary levers to the EU? I don’t think so, although a drachma devaluation might have softened the blow somewhat in a parallel universe. Just like US homeowners, the Greeks feasted on debt, in their case as a result of the convergence of borrowing rates that attended the Euro (presumably, under the mistaken belief that the EU would stand behind such debts cuz Euro.)

    The way I see it, the single currency was responsible not so much in tying Greece’s monetary hands as facilitating the run-up in debt/leverage. Lack of monetary autonomy was a supplemental and secondary factor.

    OK, I think I’m repeating myself now. Morgan, I have to meditate on this NGDPLT brake you mention. Under the circumstances, I don’t see the Fed taking the punch bowl away, but maybe that’s your point- their hands need to be tied.

  79. Gravatar of Tom Brown Tom Brown
    30. March 2014 at 22:23

    Scott I read your “autistic” post. By chance, do you sometimes have an urge to jump over things?

    http://www.ttbook.org/book/transcript/transcript-david-and-kristen-finch-asperger-diagnosis

  80. Gravatar of Major_Freedom Major_Freedom
    30. March 2014 at 23:37

    “Brian, When family “blows up” I’d expect them to work even harder. What would you expect?”

    Are we talking about what you would do, or what you believe they ought to do, or what they will actually do?

    If the third, then it is possible for them to seek the dole and “give up”. Over 40 million people in the country on food stamps today. Over half the country dependent on government handouts in some respect.

    It is not reasonable to expect only one type of response, of “working harder.”

  81. Gravatar of ssumner ssumner
    31. March 2014 at 05:54

    Tom, No, but I did enjoy that book.

  82. Gravatar of Tom Brown Tom Brown
    31. March 2014 at 06:14

    Scott,
    “Tom, No, but I did enjoy that book.”
    Finch’s book?

    This one’s a (short) work of fiction, but you might like it too:
    http://en.wikipedia.org/wiki/The_Curious_Incident_of_the_Dog_in_the_Night-Time

    (I was proud of myself for working out the correct solution to the “Monte Hall” problem he presents in there before the protagonist goes over the solution)

  83. Gravatar of ssumner ssumner
    1. April 2014 at 10:07

    Tom, I forget the author’s name–the boy was Japanese. Thanks for the tip.

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