Is the free market economy “stable”?

Last month I had the privilege of finally meeting one of my very favorite economists—Robert Hetzel, who works at the Richmond Fed.  When I read his work on monetary economics I see a kindred spirit, almost a doppelgänger.  We both studied at the University of Chicago, we were both deeply influenced by Milton Friedman, and in 1989 we both published papers discussing how asset prices could help guide monetary policy (he used TIPS spreads, I used NGDP futures).  Of course he’s had a more distinguished career.  And the other major difference is that he seems like a much better person that I am.  A real gentleman.

Over the next few months I plan to do a number of posts on his work.  Today I’ll look at a key paper from early 2009, which correctly diagnosed the mistakes the Fed had made in 2008.  As far as I know he was the only economist within the Fed who understood (in 2008) the mistakes that we now know were being made.  But I’d like to start earlier, with his basic approach to monetary economics.

Very broadly, I place explanations of cyclical fluctuations in economic activity into two categories. The first category comprises explanations in which real forces overwhelm the working of the price system. According to the credit cycle, or “psychological factors,” explanation of the business cycle, waves of optimism arise and then inevitably give way to waves of pessimism. These swings in the psychology of investors overwhelm the stabilizing behavior of the price system. “High” interest rates fail to restrain speculative excess while R. L. Hetzel: Monetary Policy 203 “low” interest rates fail to offset the depressing effects of the liquidation of bad debt. In the real-bills variant, central banks initiate the phase driven by investor optimism through “cheap” credit (Hetzel 2008a, 12–3 and 34).  Speculation in the boom phase drives both asset prices and leveraging through debt to unsustainable levels. The inevitable correction requires a period of deflation and recession to eliminate the prior speculative excesses. At present, this view appears in the belief that Wall Street bankers driven by greed took excessive risks and, in reaction, became excessively risk-averse (Hetzel 2009b).

Within this tradition, Keynesianism emerged in response to the pessimistic implication of real bills about the necessity of recession and deflation as foreordained because of the required liquidation of the excessive debts incurred in the boom period. As with psychological-factors explanations of the business cycle, investor “animal spirits” drove the cycle. The failure of the price system to allocate resources efficiently, either across markets or over time, produced an underemployment equilibrium in which, in response to shocks, real output adjusted, not prices. In a way given by the multiplier, real output would adjust to the variations in investment driven by animal spirits. The Keynesian model rationalized the policy prescription that, in recession, government deficit spending (amplified by the multiplier) should make up for the difference between the full employment and actual spending of the public. Monetary policy became impotent because banks and the public would simply hold on to the money balances created from central bank open market purchases (a liquidity trap).

Another variant of the view that periodically powerful real forces overwhelm the stabilizing properties of the price system is that imbalances create overproduction in particular sectors because of entrepreneurial miscalculation.

I think that most people hold one of these views, even if they differ on the desirability of the Fed “rescuing” the economy when it gets into trouble.  But not monetarists:

In the second class of explanations of cyclical fluctuations, the price system generally works well to maintain output at its full employment level. In the real-business-cycle tradition, the price system works well without exception. In the quantity-theory tradition, it does so apart from episodes of monetary disorder that prevent the price system from offsetting cyclical fluctuations.  Milton Friedman (1960, 9) exposited the latter tradition:

The Great Depression did much to instill and reinforce the now widely held view that inherent instability of a private market economy has been responsible for the major periods of economic distress experienced by the United States. . . .As I read the historical record, I draw almost the opposite conclusion. In almost every instance, major instability in the United States has been produced or, at the very least, greatly intensified by monetary instability.

Friedman, Hetzel, and I all share the view that the private economy is basically stable, unless disturbed by monetary shocks.  Paul Krugman has criticized this view, and indeed accused Friedman of intellectual dishonesty, for claiming that the Fed caused the Great Depression.  In Krugman’s view, the account in Friedman and Schwartz’s Monetary History suggests that the Depression was caused by an unstable private economy, which the Fed failed to rescue because of insufficiently interventionist monetary policies.  He thinks Friedman was subtly distorting the message to make his broader libertarian ideology seem more appealing.

I’d like to first ask a basic question: Is this a distinction without a meaningful difference? There are actually two issues here.  First, does the Fed always have the ability to stabilize the economy, or does the zero bound sometimes render their policies impotent?  In that case the two views clearly do differ.  But the more interesting philosophical question occurs when not at the zero bound, which has been the case for all but one postwar recession.  In that case, does it make more sense to say the Fed caused a recession, or failed to prevent it?

Here’s an analogy.  Someone might claim that LeBron James is a very weak and frail life form, whose legs will cramp up during basketball games without frequent consumption of fluids.  Another might suggest that James is a healthy and powerful athlete, who needs to drink plenty of fluids to perform at his best during basketball games. In a sense, both are describing the same underlying reality, albeit with very different framing techniques.

Nonetheless, I think the second description is better.  It is a more informative description of LeBron James’s physical condition, relative to average people.  By analogy, I believe the private economy in the US is far more likely to be stable with decent monetary policy than is the economy of Venezuela (which can fall into depression even with sufficiently expansionary monetary policy, or indeed overly expansionary policies.)

Just to be clear, I do understand Krugman’s point, and it is a defensible argument.  But in the end I side with Friedman and Hetzel, for two pragmatic reasons:

1.  I think that most non-monetarists underestimate the extent to which seemingly “real” or “psychological” shocks are actually caused by monetary shocks that were misidentified.  I hope I don’t need to remind readers about how often easy and tight money are confused, due to excessive focus on interest rates as an indicator of the stance of monetary policy. Thus I believe that the Great Recession was triggered by tight money in late 2007 and early 2008, and that the onset of the recession made the economy seem unstable, and in need of what Krugman would regard as a “rescue” from the Fed, and then later from fiscal stimulus, once the Fed (supposedly) ran out of ammo.  If you insist on a “concrete steppe”, then use the sudden stop in the growth of the monetary base, but I’d prefer not to focus on concrete steps at all, as they are unreliable indicators. Note that Krugman specifically points to the growth in the monetary base during the early 1930s, to refute Friedman’s claim that the Fed caused the Great Depression.  But does anyone recall Krugman complaining (in the spring of 2008) about the sudden stop in base growth during August 2007 – May 2008?

2.  Second, I worry that Krugman’s way of thinking will make the public insufficiently demanding of sound monetary policy.  We will expect too little of the Fed, as we clearly did in 2008, when rates were still above zero.  I’m not surprised that the public, the Congress, the President, and the media failed to blame the Fed for excessively tight money in 2008-09, monetary economics is deeply counterintuitive.  But even our best and brightest macroeconomists failed us.  Go back to late 2008 and look for op eds blaming the recession on insufficiently expansionary monetary policy.  You wont find them.

If LeBron James had leg cramps in a game where his trainer had forgotten to bring the Gatorade, we would quite rightly blame the trainer, not the fact that James’s body is “naturally unstable”, unable to do well unless “rescued” by an injection of fluids.  We need to have equally high expectations of the Fed.  Any major shortfall (or overshoot) of NGDP is the Fed’s fault, and all eyes should be focused on the Fed when those problems develop.  In the 1930s, people looked elsewhere. Even Bernanke now admits that the Depression was the Fed’s fault.  In the 1970s, people looked elsewhere.  Even Ben Bernanke now admits that the high inflation was the Fed’s fault.  In September 2008, people looked elsewhere.  Even Ben Bernanke now admits the Fed should have cut rates.

The more we demand from central banks, the better the policy that we will get.  When expectations are especially low (as in the 1930s, or during 2008-13 in the eurozone), the performance will be especially poor.

When NGDP is unstable, it’s ALWAYS the Fed’s fault. Even if my underlying philosophical interpretation of causality is wrong, or not to your taste, it’s a useful fiction to believe in.

PS.  For non-basketball fans, James does occasionally have a problem with leg cramps.  Perhaps because he is among the most athletic “big men” in the history of sports, and puts huge demands on his body.

PPS.  George Selgin has a very good post on interest on reserves.  He knows more about banking than I do, and gets deeper into that issue than I’ve done in my critiques of IOR.  He also has a podcast explaining his views.


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62 Responses to “Is the free market economy “stable”?”

  1. Gravatar of Justin Justin
    18. December 2015 at 12:35

    Can you explain how tight money could lead to the wildly inaccurate pricing of CDOs and CDSs that seemed to lower in price even as price increased?

    I’m not challenging you, I genuinely want to understand this better.

  2. Gravatar of ssumner ssumner
    18. December 2015 at 12:52

    Justin, That’s not my claim, Even with sound money there might have been sizable problems in the CDO market. I do think the fall in NGDP made those problems worse, but I’m not claiming that there were no mistakes unrelated to monetary policy. Markets are not perfect.

    But there’s a lot of ruin in a nation. I think the experience of January 2006 to April 2008 shows that housing construction can fall in half without much impact on unemployment. As long as NGDP was kept growing at 5%/year, the financial distress (which was real, and began before the tight money) would not have had such a catastrophic effect.

  3. Gravatar of marcus nunes marcus nunes
    18. December 2015 at 13:17

    Scott, and there are those who think the GR was due to “modelling error”
    https://thefaintofheart.wordpress.com/2014/09/10/many-still-believe-the-great-recession-was-the-result-of-a-modeling-error/

  4. Gravatar of marcus nunes marcus nunes
    18. December 2015 at 13:22

    And those who think the economy was jolted into a “dark corner”
    https://thefaintofheart.wordpress.com/2014/08/31/the-great-recession-was-the-bastard-child-of-the-great-moderation/

  5. Gravatar of Brian Donohue Brian Donohue
    18. December 2015 at 13:39

    Excellent post, Scott.

    The link to Selgin was great. Very good sentence:

    “…[A] collapse in aggregate demand means, among other things, a collapse in the nominal demand for all sorts of credit, and a corresponding decline in market-clearing nominal interest rates.”

  6. Gravatar of marcus nunes marcus nunes
    18. December 2015 at 14:14

    While Larry Summers believes “it will lead to more emphasis on fiscal rather than monetary actions in depressed economies.”
    https://thefaintofheart.wordpress.com/2015/11/02/larry-summers-discusses-the-great-stagnation/

  7. Gravatar of Gordon Gordon
    18. December 2015 at 14:26

    I love the LeBron James analogy. I think that both liberal and conservative politicians do the “naturally unstable” human framing. The liberals say that with their wise coaching they’ll get LeBron back to health quickly when his legs cramp up and they’ll make certain to constrain his activity so that he doesn’t cramp up in the future. The conservatives say that pregame hydration efforts and post cramp rehydration efforts just encourage LeBron to overdo it and cause cramps. Given that Krugman is now a political pundit, I suspect he does the “naturally unstable” framing to help the politicians who position themselves as wise coaches.

  8. Gravatar of End. End.
    18. December 2015 at 15:01

    “Friedman, Hetzel, and I all share the view that the private economy is basically stable, unless disturbed by monetary shocks. Paul Krugman has criticized this view, and indeed accused Friedman of intellectual dishonesty, for claiming that the Fed caused the Great Depression.”

    What does it mean for the private economy to be basically stable? If Friedman’s k-rule is implemented, will the economy be stable?

  9. Gravatar of W. Peden W. Peden
    18. December 2015 at 15:19

    Bob Hetzel is great.

    IIRC, this debate can be traced right back to Adam Smith and David Hume, with Smith viewing the banking as having a tendency to over-expansion and Hume of course having essentially the quantity theory view you describe.

  10. Gravatar of W. Peden W. Peden
    18. December 2015 at 15:20

    * the banking industry.

  11. Gravatar of Justin Justin
    18. December 2015 at 15:51

    Okay, I understand what you’re saying now. I guess I was seeing the cause of the recession as the “animal spirits” in the financial sector, but you’re suggesting the fallout from the subprime crisis wouldn’t have been as severe with adequate NGDP growth. Thanks for the response!

    Fwiw, I took a Money and Banking class last semester because of this blog. I was disappointed that we spent most of the class talking about how markets for debt securities (and how they respond to changes in expected inflation and taxation) and the investment practices of firms. We only spent a day or two on monetary policy and unfortunately it didn’t greatly improve my grasp on it which was my motivation for taking the class, haha.

  12. Gravatar of Carl Carl
    18. December 2015 at 16:26

    Austrians might say the Fed is watering down the Gatorade and tricking Lebron into over-exerting himself.

  13. Gravatar of Gary Anderson Gary Anderson
    18. December 2015 at 16:30

    Artificially raised asset prices is a form of stealing. But I guess credit is necessary in society, so, at least it should be credit that is not toxic in nature. Underwriters should determine that people who borrow have a reasonable chance of paying back the loan. By the way, it is the law: 1989 FIRREA ACT.

    Scott, you made a reasonable statement here: “As long as NGDP was kept growing at 5%/year, the financial distress (which was real, and began before the tight money) would not have had such a catastrophic effect.”

    However, someone could have told the nation that securitization was a fraud back in late 2004 and the bubble would not have exploded as it did. No one responsible, Tim Geithner in particular, said anything to warn America.

  14. Gravatar of Benjamin Cole Benjamin Cole
    18. December 2015 at 17:34

    Robert Hetzel is a gem in the Fed. It is a pity he is not utilized by the FOMC. And even more importantly, Hetzel is a nice guy.

    In my humble opinion a free enterprise economy is mostly stable. But, when I hear recent political debates about how everyone is terrified about terrorism (a minute threat in the US), I wonder if the US business and investing class can also be easily frightened.

    Additionally, if the system is so stable, why is there emphasis on guidance from the Fed?

    In the end, the answer is always the same: print more money. Print money until we see Full Tilt Boogie Boom Times in Fat City, then print money for a few more years, then think about what to do next.

    Please, no more sanctimonious sermonettes about inflation from little boys in short pants.

    PS outlaw property zoning by local governments, and legalize push-cart vending. Then get rid of the minimum wage— but only after unemployment is driven down below 3%.

  15. Gravatar of ssumner ssumner
    18. December 2015 at 17:54

    Marcus, Thanks for the links.

    Thanks Brian.

    Gordon, Good analogies.

    End, It’s hard to say how stable the economy would have been with a 4% rule–I’m a bit skeptical. In my view you need NGDP targeting.

    The key parts of my post are points #1 and #2.

    W. Peden, Good observation.

    Ben, I agree that terrorism is probably the most overrated problem in American, it’s not even in the top twenty on any reasonable list. I recall you mentioned the 180,000 killed by drunk drivers since 9/11. How about drug resistant bacteria? That must be 1000 times more of a threat than terrorism. Politics is for morons.

  16. Gravatar of Jared Jared
    18. December 2015 at 18:11

    I think you’re right that it’s the framing that differentiates your view from Krugman’s. Ironically, I think Krugman draws a sharp distinction between private markets and the activities of government (including central banking). Your framing, on the other hand, dissolves the distinction and implies that well-tuned government intervention is a necessary condition for well-functioning markets, just as proper hydration is a necessary condition for a well-functioning human body; the two cannot be understood apart from one another. I think you’re right, but it seems counter-intuitive coming from a conservative.

    Another counter-intuitive aspect of your framework is your understanding of “stable monetary policy”. You define stability in terms of the Fed hitting its target. Others look to the activities conducted by the Fed. If the Fed maintained NGDP growth in 2007-008, they might have had to conduct huge OMOs adding billions of excess reserves into the system (although nowhere near the scale they actually ended up doing). If those actions managed to maintain NGDP growth, you would have described that as stable monetary policy, whereas just about every other economic commentator would be screaming about or commending a runaway, activist Fed.

    In the end, I think your framework has the advantage of focusing our attention on what truly matters, but it requires a Gestalt switch for many.

  17. Gravatar of Major.Freedom Major.Freedom
    18. December 2015 at 19:43

    The free market is neither stable nor unstable. In a free market we view the entirety of all activity as individual actions.

    It is quite possible for one individual to accumulate substantial wealth through saving and reinvestment, and then live a “stable” life as an indivosual, while another individual would have a very erratic lifestyle, rag to riches and riches to rags, and live an “unstable” life as an individual.

    It is meaningless to name both individual actions together as some aggregate conceptualization of “stable” or “unstable”.

    Google “Methodological Individualism” and then start to understand what is actually going on in the world around you.

  18. Gravatar of Ray Lopez Ray Lopez
    18. December 2015 at 22:32

    Let’s summarize Sumner’s ramblings:

    1) Some guy in the Richmond Fed, home of inflation hawks, is more of a gentleman than Sumner (obviously) yet is a doppelganger (evil twin, harbinger of luck).

    2) LaBron James pushes his body to the max and needs fluids. Somehow this supports the axiom (assumed): “When NGDP is unstable, it’s ALWAYS the Fed’s fault.” To avoid recession, drink more Gatorade?

    3) Sumner, like Krugman, like Friedman, like Bernanke, but unlike Major Freedom, and unlike me, and unlike the pre-1913 people who correctly blamed animal spirits for non-linear free markets, believes the Fed can steer the private economy, which is inherently unstable. Sumner is in good company. Besides the distinguished gentleman mentioned above, a certain K. Marx and V. Lenin believed the same thing, along with some non-gentlemen like Stalin, Hit ler, and Mao.

    The only part of the post I found useful was Selgin’s logical comments–though I don’t agree with his assumption of money non-neutrality–that the Fed paid banks a form of corporate welfare to repair their balance sheets, with Interest on Reserves (IOR), and this, at the margin, cut down on lending after the immediate 2008 crash. Whether this decrease in lending was significant or not is debatable, but it’s a fact.

  19. Gravatar of flow5 flow5
    19. December 2015 at 11:04

    “we were both deeply influenced by Milton Friedman”
    ———-

    MF was one of the worst thinkers to matriculate at Chicago.

  20. Gravatar of flow5 flow5
    19. December 2015 at 11:07

    “When NGDP is unstable, it’s ALWAYS the Fed’s fault.”
    ——-

    Indeed correct. Here’s who caused our recessions since the Great-Depression:

    Period …………….. Chairman

    Nov 1948 – Oct 1949… Thomas B. McCabe
    July 1953 – May 1954… William M. Martin
    Aug 1957 – Apr 1958… William M. Martin
    Apr 1960 – Feb 1961… William M. Martin
    Dec 1969 – Nov 1970… William M. Martin
    Nov 1973 – Mar 1975… Arthur Burns
    Jan 1980 – July 1980… Paul Volcker
    July 1981– Nov 1982… Paul Volcker
    July 1990 – Mar 1991… Alan Greenspan
    Mar 2001 – Nov 2001… Alan Greenspan
    Dec 2007 – Jun 2009… Ben Bernanke

    I.e., all these recessions were both predictable and preventable.

    Notice that no excessive volume of excess reserves were ever injected to combat recessions prior to remunerating reserves in Oct 2008 (big policy errors).

    http://bit.ly/1LXTqkM

  21. Gravatar of CA CA
    19. December 2015 at 11:44

    “MF was one of the worst thinkers to matriculate at Chicago.”

    Why do you think that?

  22. Gravatar of bill bill
    19. December 2015 at 12:02

    The post by Selgin is excellent. So is an earlier post of his on sterilization. He makes an excellent step by step argument laying out concrete mistakes made by the Fed in 2008. It’s not just that the Fed passively tightened. The Fed made active mistakes that greatly worsened the economy in 2008 and 2009.

  23. Gravatar of E. Harding E. Harding
    19. December 2015 at 14:12

    Test. The Marginal Counterrevolution site is being marked as spam at Econlog and at Bob Murphy’s blog.

    Test finished. The Marginal Counterrevolution is, indeed, being marked as spam on this blog, too. Scott, check the spam filter to make Aksimet stop seeing the Counterrevolution as a sign of spam.

  24. Gravatar of marcus nunes marcus nunes
    19. December 2015 at 16:06

    One day, present history will be revised!
    https://thefaintofheart.wordpress.com/2015/05/31/much-later-the-great-inflation-was-pinned-on-poor-monetary-policy-how-long-will-it-take-to-blame-monetary-policy-for-the-repressed-economy-since-2008/

  25. Gravatar of Major.Freedom Major.Freedom
    19. December 2015 at 16:28

    Ray Lopez,

    If money were neutral, then world productivity would not drop one iota if we eliminated money, the common denominator of exchange, and moved to trading on barter instead.

    But we know that having a common denominator against which to compare gains and losses, dramatically boosts productivity in a division of labor, because unlike barter we can directly compare the gains and losses of different investment opportunities.

    Most importantly, money neutrality is a contradiction in terms. It is an impossibility. We seek money precisely because of the gains that can be made on its non-neutrality.

    You yourself don’t even act in accordance with money neutrality. The fact that you have the choice to engage in barter, and yet you still choose to engage in indirect exchange using money, proves that you gain more by using money than you do in barter.

    Your content of your actions, therefore, contradicts your professed theoretical belief. In other words, you are just spewing empty rhetoric.

  26. Gravatar of Ray Lopez Ray Lopez
    19. December 2015 at 17:21

    @flow5 – nice parody, though on the internet it’s hard to tell if you’re serious.

    @marcus nunes – no need to click on your links when you can read the URL for the message, thanks!

    @MF – money neutrality does not mean money has no ‘unit of account’ functions, but anyway, in theory we can rely on a form of barter, it’s called Bitcoin. The value of Bitcoin would fluctuate (no ‘unit of account’ as in traditional money) but with modern communications you can in principle link the BTC price to say gold, or a basket of goods, or your labor costs. I say bring it on, wouldn’t change things much.

  27. Gravatar of Major.Freedom Major.Freedom
    19. December 2015 at 18:35

    Ray,

    “@MF – money neutrality does not mean money has no ‘unit of account’ functions”

    False. Money neutrality means money has no additional use value above barter. That means money would have to have no unit of account value, nor unit of exchange value, not any other specific to money value.

    “but anyway, in theory we can rely on a form of barter”

    Irrelevant. What is relevant is whether barter facilitates less or more or unchanged productivity as compared to trading for money as an indirect means to acquire goods.

    To argue money is not neutral and that it allows for greater productivity as compared to barter does not require characterizing barter as completely untenable.

    Obviously the world was on barter in the distant past, so obviously it had some use. However, and this is key to the theory of money neutrality versus non-neutrality, the onset of money and money trading must not facilitate any additional value or productivity IF money really were neutral.

    But given the fact that you choose to trade for money as opposed to bartering, means that you are an example of proof positive evidence that money allows for acquiring greater value. If money were in fact neutral as you claim, then it would not bring you any additional value as compared to barter, and you would be totally indifferent between accepting an income in goods as you would in money.

    “it’s called Bitcoin.”

    Bitcoin is a proto-money. It is widely accepted, but it is not universal!y accepted. But even so, telling me an example of what you believe to be a pure barter good does not stand as proof that money is equally valued as Bitcoins. That is what would have to be the case if dollars were neutral. You would have to be indifferent between receiving an income in a definite quantity of Bitcoins, or a definite quantity of dollars, or a definite quantity of real goods.

    “The value of Bitcoin would fluctuate (no ‘unit of account’ as in traditional money) but with modern communications you can in principle link the BTC price to say gold, or a basket of goods, or your labor costs. I say bring it on, wouldn’t change things much.”

    Ray, you do realize this is totally and completely irrelevant to the very specific claim you made that money is neutral? Telling me that there are limited examples of people trading goods for goods, which you did not mention was significantly dwarfed by the instances of people trading goods for money, and which you did not mention was itself an example of proof that a good that starts to acquire money like qualities allows for greater value seeking than without (that is why it was invented in the first place, as an intentional competition as money), is evidence that money AND goods that acquire money like characteristics, allows people to gain more than they could by pure barter alone.

    Bitcoins are not neutral either. If they were, they would never have been invented and they would never have been used. People would have been perfectly content with barter alone, and not only that, but the wealth of the world would have been exactly the same as compared to if no goods ever acquired money like characteristics.

    Both money and Bitcoins have unit of exchange value and unit of account value precisely because both are not neutral with respect to pure barter.

    Money solves the double coincidence of wants problem. The solution to this problem allowed for greater productivity overall. Instead of having to find the specific goods you want by convincing the producers of those specific goods to accept the specific goods and services you are personally able to produce, which is extremely time consuming and incurs significant search costs, you only need to find ANYONE who is willing to accept your specific goods. It doesn’t matter if they themselves only produce economics textbooks that you don’t want. They only need to pay you money, and then with that money you can go out and buy the specific goods you want from ANYONE who is producing them, and those producers don’t even have to value your specific output and supply of goods.

    The introduction of money represented a gigantic increase in the number of possible trades, and with more trading, there is more opportunity for people to specialize and dedicate all their efforts to a specific set of skills and knowledge, and with everyone trading for money, that specialization could be extended beyond anyone’s expectations as compared to barter.

    That specialization allowed for total productivity to increase so substantially that it is so easy to take it for granted. In your case, you have taken it for granted to such a degree that you don’t even realize the fact that it is precisely on account of money non neutrality that you seek and accept money rather than chickens and bear pelts without even realizing what it represents.

  28. Gravatar of Benjamin Cole Benjamin Cole
    19. December 2015 at 21:51

    I will answer Scott Sumner’s inquiry about deaths due to antibiotic-resistant bacteria, as it may frighten us Market Monetarists and free marketeers.

    “Antibiotic / Antimicrobial Resistance | CDC
    http://www.cdc.gov/drugresistance/‎
    12 Nov 2015 … … least 2 million people become infected with bacteria that are resistant to antibiotics and at least 23,000 people die each year as a direct result …”

    Okay, if we take that number on faith, that is 345,000 people in the U.S. who have died from exposure to antibiotic-resistant bacteria since 9/11. (I wonder if some of these people were old and enfeebled and might have died anyway, or if some hospitals chalk up to an uncontrollable when they botched care, but let that go).

    So about 180,000 since 9/11 have died in drunk driving accidents, and 345,000 due to antibiotic-resistant bacteria. Just from these two causes, then 525,000 since 9/11, or more than half a million.

    Since 9/11, I guess you have the 14 people in San Bernardino who were killed by an American and his Pakistan-born wife, a pair who may or may not been simply demented, but who by a stretch can be considered terrorists. Maybe you can say the Army psychiatrist lunatic was a terrorist, since he was Islamic. But really, we are down to scant handfuls of people killed by terrorists in the U.S., even by liberal definitions of what is terrorism.

    So…are markets rational? Can markets be spooked? So, do we need the backstop of the Fed, and a lender of last resort? FDIC insurance? Circuit-breakers on Wall Street?

    Seems to me there is NOT wisdom in crowds.

    Gadzooks, Americans are frightened of terrorists. This may be because of fearmongering by the GOP, which is aligned with military outlays, and they want those budgets as large as possible to funnel money to their constituent groups. So they relentlessly fearmonger, as a signal to some groups, “We will boost your federal budgets and benefits.”

    But then, somebody in the future might successfully fearmonger about the safety of banks, or that Wall Street is corrupt and will crash, or that gold is worth a bundle etc.

    Maybe free-market stability is an illusion.

    Maybe free markets need Big Mommy at the Fed and in Washington DC. It ain’t pretty, but maybe it is the truth.

  29. Gravatar of Ray Lopez Ray Lopez
    19. December 2015 at 22:16

    @MF – we are talking past each other. I don’t think money neutrality means money has no unit of account value. It only means changes in the money supply do not change any real values much.

    @B. Cole – most people who die of drug-resistant bacteria are either old, immuno-compromised, very young, and therefore would have died anyway or their economic value is less than that of a healthy adult, so, no, we can’t ‘let that go’ as you say. Cole: “Maybe free-market stability is an illusion” – you’re in good company: Marx, Keynes, Friedman, Krugman, Sumner… the sad list goes on.

  30. Gravatar of James Alexander James Alexander
    19. December 2015 at 23:02

    Ben
    But people aren’t frightened of drug-resistant bacteria or drink-related road accident death. Why not? Because in the real world they don’t spend all their time in a panic of fear and loathing. Politics is a wickedly twisted entertainment show and Islamic terrorists the celebrity contestants that everyone hates.

  31. Gravatar of James Alexander James Alexander
    19. December 2015 at 23:29

    Scott
    A problem with the LeBron James analogy is that he sound like a freak of nature to start with. Inherently unstable even if capable of performing great feats. On might argue that he is more like the subprime credit market and it’s funding “structure”, needing huge doses of Gatorade/”Greenspan put” to keep it going while at the same time (performing the great feat of) spreading house ownership to the masses.

    However, all I have seen and learnt since 2009 fits with Market Monetarism, For instance, the US subprime crash/house price crash wasn’t replicated in other countries with similar house price booms but better monetary policy.

  32. Gravatar of Gene Frenkle Gene Frenkle
    19. December 2015 at 23:36

    I always find it baffling that in the 2000s we were at war in the nation with the largest and most unproductive oil reserves while the oil price was increasing…and people assume the war was innocuous with regard to the global economy. The 1970s actually happened and the US was subject to the same dynamics during the 2000s. Our economy is extremely dependent on cheap energy and we did not have cheap energy in the 2000s.

  33. Gravatar of Ray Lopez Ray Lopez
    20. December 2015 at 01:23

    @James Alexander – do you always read those that you agree with? Self-selection, living in your own little world. Very common of closed minds. Google Ben S. Bernanke FAVAR and you might learn something new.

    “When the facts change, I change my mind. What do you do, sir?” – J. M. Keynes

  34. Gravatar of Postkey Postkey
    20. December 2015 at 03:22

    @Gary Anderson

    “However, someone could have told the nation that securitization was a fraud back in late 2004 and the bubble would not have exploded as it did. No one responsible, Tim Geithner in particular, said anything to warn America.”

    Someone did?

    “We didn’t truly know the dangers of the market, because it was a dark market,” says Brooksley Born, the head of an obscure federal regulatory agency — the Commodity Futures Trading Commission (CFTC) — who not only warned of the potential for economic meltdown in the late 1990s, but also tried to convince the country’s key economic power brokers to take actions that could have helped avert the crisis. “They were totally opposed to it,” Born says. “That puzzled me. What was it that was in this market that had to be hidden?”
    Levitt explains how the other principals of the Working Group — former Fed Chairman Alan Greenspan and former Treasury Secretary Robert Rubin —  convinced him that Born’s attempt to regulate the risky derivatives market could lead to financial turmoil, a conclusion he now believes was “clearly a mistake.”
    http://www.seniorwomen.com/news/index.php/the-woman-who-warned-about-the-financial-meltdown-ahead

  35. Gravatar of ssumner ssumner
    20. December 2015 at 06:26

    Ray, You said:

    “Sumner, like Krugman, like Friedman, like Bernanke, but unlike Major Freedom, and unlike me, and unlike the pre-1913 people who correctly blamed animal spirits for non-linear free markets, believes the Fed can steer the private economy, which is inherently unstable.”

    I hope that’s a typo, as my post argued it was inherently stable.

    E. Harding, I would not even know how to do that.

  36. Gravatar of Brian Donohue Brian Donohue
    20. December 2015 at 07:07

    @ E Harding, sounds like a feature, not a bug.

    Look, you already drag all of your thoughts into the comment section of all kinds of blogs as it is.

    Which is quite enough. Nobody is interested in your dumb blog.

  37. Gravatar of Ray Lopez Ray Lopez
    20. December 2015 at 08:04

    @Sumner who said: “Friedman, Hetzel, and I all share the view that the private economy is basically stable, unless disturbed by monetary shocks.”

    Unless. A qualifier you can drive an elephant through. Why not accept that the Great Depression was a one-off event that is unlikely to reoccur? Surely you don’t believe: (1) the Great Recession would have turned into another Great Depression unless Geither/Paulson/Bernanke etc rode to the rescue? or, (2) the weak NRA make-work of FDR and the US going off the gold standard somehow brought the US out of depression in the 1930s?

    In short, the economy heals itself and is stable, everywhere and always.

  38. Gravatar of Carl Carl
    20. December 2015 at 13:40

    “The economy always heals itself and is stable everywhere and always.”

    That’s true except for the period of human history.

  39. Gravatar of Major.Freedom Major.Freedom
    20. December 2015 at 17:01

    Ray,

    “MF – we are talking past each other. I don’t think money neutrality means money has no unit of account value. It only means changes in the money supply do not change any real values much.”

    No, money neutrality means zero changes to real variables. If there are any changes, money is not neutral.

    Also, the former implies the latter. It is because money is uniquely valued for specific activities such as unut of account that changes in money being about real changes.

    If money is given a unit of account value, or unit of exchange value, or any other specific to money value, that in itself is sufficient and necessary proof that the onset of money, and changes in money, do indeed allow people to change real values.

    You are able to observe a plethora of real changes in the world, but because your theory is flawed, you are unable to understand the extent to which those changes are caused by changes in money.

    You are able to observe for example the gigantic increase in the size and scope of the financial sector over the last 40 years, including the government debt market, which not only represents, but itself causes and brings about further, real changes, but you are unable to understand the inflationary causes.

    You are able to observe the increase in the size and scope of government activity, which is also representative of real changes and itself a factor in further changes to real activity, but you are unable to understand the inflationary causes.

    It would be absurd to believe that money non neutrality would require changes in money to have any greater change to real variables than what exists.

    The originators of the theory of money neutrality never had in mind an extent of real changes that were anywhere even remotely close to the kind of “not much” that you keep claiming here. They never intended for neutrality to mean “small” changes to real variables, or “pretty much zero” changes. They had in mind NO changes whatever.

    If you admit the changes are non-zero, then you have absolutely rejected the theory of money neutrality.

    You cannot redefine neutral to mean “pretty much neutral” just because it suits youur quest of the absurd.

  40. Gravatar of TallDave TallDave
    20. December 2015 at 21:20

    I always picture future ages looking back and chuckling at the Age of Not Understanding What Central Banks Are For.

  41. Gravatar of Saturos Saturos
    21. December 2015 at 02:00

    Nick Rowe just retweeted (yes he has Twitter now, heads up Scott) this interesting review of Sumnerian economics by Roger Farmer of UCLA: http://rogerfarmerblog.blogspot.com.au/2015/12/scott-sumner-and-musical-chairs.html

  42. Gravatar of Saturos Saturos
    21. December 2015 at 02:00

    It reads like a response to this post, as well.

  43. Gravatar of ChrisA ChrisA
    21. December 2015 at 05:37

    Scott – of course the debate about whether capitalist economies are stable or not goes back a long way, I think even Marx argued this. Mostly of course because they favoured some kind of socialism (or “intelligent guidance” of the economy). The argument made more sense when people thought of money (or the medium of exchange) and gold (or some other precious metal) as synonymous, like back in the 1930’s. In such an environment, it is hard to imagine that you can stimulate through monetary expansion, especially if you take on faith you cannot devalue your currency versus gold. So you are left with fiscal types of stimulation, a-la-Keynes. If you think like that, then yes “capitalism” is unstable. Of course in reality it is not capitalism but the gold standard that makes an economy unstable. Nowadays, with fiat currencies this problem doesn’t exist, but many people still haven’t really moved on from these money=gold days.

    I do think it is interesting how humanity has stumbled on fiat currency – I guess I would not have thought such a system would work ahead of time. Wouldn’t people just refuse to take fiat currency as payment? But it works. A lot of people are skeptical of Bitcoin for the same reason – but it seems to be establishing itself. The thing about Bitcoin is that it is more like gold – there is only a fixed supply I understand. So if it really does become the international currency – will we be back on a quasi gold standard?

  44. Gravatar of Dan W. Dan W.
    21. December 2015 at 05:45

    “When NGDP is unstable, it’s ALWAYS the Fed’s fault.”

    Scott, for this to be true there must exist a lever the Central Bank can pull to instantaneously correct any deviation from the desired course. For if the correction is not instantaneous then the existence of control lag in what is a non-linear, indeterminate system will be the source of instability.

    Instantaneous monetary control does not exist, except in theory. All policy responses to monetary shocks will lag. Consequently, both the presence and absence of central bank inputs can result in NBDP instability.

    If you wish to defend your ideal of an all-powerful central bank you need to be able to defend each and every contingency of it. Your theory of instantaneous response is one such contingency. What you insist to be true does not exist.

  45. Gravatar of ssumner ssumner
    21. December 2015 at 05:56

    Ray, That’s right, I don’t believe #2.

    Thanks Saturos, I’ll take a look.

    Chris, Good comment. If Bitcoin ever becomes the medium of account, then it would almost certainly no longer have a quasi fixed supply.

  46. Gravatar of Mike Rulle Mike Rulle
    21. December 2015 at 07:01

    Scott

    “Politics is for morans”

    I think you mean, or should mean, many morans engage in politics as they do in all walks of life (including those who respond to blogs :-)).

    How do you suppose one can change the world’s monetary policy without politics? Impossible

    One of the most absurd concepts is “death counting” by cause to determine its relevance. Have you forgotten the concept of opportunity costs? Yes, many people die from diseases. But look at all the people who do not die from diseases because mankind tries to prevent

    Yes,in America few have died from terrorism. Not so in Syria however. In July 2014, you would have been a “moron” if you feared cataclysmic war due to the inherently unstable cross treaties among the various European nations.

    I assume that quote was an afterthought as some politician you cannot stand crossed your mind.

  47. Gravatar of Mike Rulle Mike Rulle
    21. December 2015 at 07:02

    I meantJuly 1914 of course

  48. Gravatar of Doug M Doug M
    21. December 2015 at 15:47

    Forward looking expectations drive present investment spending. And today’s economy drives the outlook for tomorrow. The system has feedback loops. And dynamic systems with feedback loops are prone to chaotic behavior.

    The math says that the market should have periods of instability.

  49. Gravatar of ssumner ssumner
    21. December 2015 at 17:36

    Mike, I meant that political discussions tend to be very stupid. Not sure how that relates to 1914.

    Doug, There’s also the law of large numbers.

  50. Gravatar of Floccina Floccina
    21. December 2015 at 18:01

    Wouldn’t the relevant comparison be to an economy without Government money or a central bank.

  51. Gravatar of Doug M Doug M
    21. December 2015 at 18:27

    The Law of Large Numbers doesn’t mean what most people think it means.
    The Law of Large Numbers says that if you repeat the same trial repeatedly the average of those results will converge to the expected result.

    If there are 100,000 parallel universes, if we sample 1,000. We will have a better estimate of of the population average of whatever statistic we are measuring, than if we sample only 100, or 10.

    But, we can’t sample 1000 parallel universes, we can only sample one.

    What people thinks it means…. that the long-term is more predictable than the short-term. The up-and-down vagueries of the market cancel out over time. But this has repeatedly shown to be false. The longer the horizon, the greater the deviations from forecast.

  52. Gravatar of Doug M Doug M
    21. December 2015 at 18:44

    Law of Large numbers incorrect interpretation part ii.

    People say “If I flip a coin you have a 50% chance of guessing whether it is heads or tails. If I flip a coin 100 times I can be sure that it will come up 50 heads.”

    But, it is not true. There is an only an 8% chance of you being correct. Far smaller than the 50% chance of being correct on one flip. You can say that there is a 95% chance of there being 40-60 heads. Vs. a 100% certainty of 0-1 heads on one flip.

    And, the more you flip the wider your interval must be!

    If you are averaging errors, yes, your average error goes to 0.

    If you are accumulating… growing your money, or output or similar measure important to economists, the bigger the number the bigger the deviation.

  53. Gravatar of Engineer Engineer
    22. December 2015 at 06:01

    “I recall you mentioned the 180,000 killed by drunk drivers since 9/11. How about drug resistant bacteria? That must be 1000 times more of a threat than terrorism. Politics is for morons.”

    You can bring this argument to it’s logical conclusion…old man time and mother nature is responsible for 1000+ times more deaths than drunk driving and bacteria…so why worry about them…after all are we not all going to die eventually?

    Humans naturally rank life and death according to different criteria. A single innocent human life taken at the hands of another human in the name of advancing some dilutional ideology or belief system is naturally going to outrage people more than a death caused by a tornado touching down on someone’s house. While both are equally sad for the loved ones left behind, one is an attack on civilization and human decency, the other is just sad.

    I would argue that failing to make that distinction is a slippery slope philosophically.

  54. Gravatar of ssumner ssumner
    23. December 2015 at 13:31

    Doug, Yeah, I know what the law of large numbers means.

    Engineer, We should rank problems in terms of how easy it is to avoid needless pain and suffering and death. That’s what I’m doing. Far easier to stop people being killed by drunks or bacteria than by terrorists. Maybe 100 times easier.

  55. Gravatar of George H. Blackford George H. Blackford
    25. December 2015 at 21:50

    Re: “There are actually two issues here. First, does the Fed always have the ability to stabilize the economy, or does the zero bound sometimes render their policies impotent? In that case the two views clearly do differ. But the more interesting philosophical question occurs when not at the zero bound, which has been the case for all but one postwar recession. In that case, does it make more sense to say the Fed caused a recession, or failed to prevent it?”

    It seems to me that this misses the point. Of course the Fed caused the recession when it increased rates leading up to the crash. How can anyone deny that obvious fact? The real question is whether or not there is anything the Fed could have done to avoid a recession once non-federal debt had increase to 318% of GDP in a situation in which that debt had been created in the midst of a massive mortgage fraud that led to there being $11 trillion worth of mortgages at the heart of the $46 trillion worth of non-federal debt that existed in 2007—mortgages on properties the prices of which had been inflated by the housing bubble that the subprime mortgage fraud had helped to create. ( http://www.rweconomics.com/htm/WDCh10e.htm ) This begs the question: Is there anything the Fed could have done to have kept this sort of thing from happening?

    Twice during the past one hundred years the world economy has been driven to the zero lower bound: once following the Crash of 1929 and again following the Crash of 2008. The economic, social, and political upheaval created by the Great Depression following the Crash of 1929 eventually led to World War II, and the fallout from the current economic slump is in the midst of playing itself out in a way that does not seem to hold much promise for the future.

    It may be an interesting philosophical question to discuss if it makes more sense to say the fed caused a recession, or failed to prevent it, but this is of no practical importance. The substantive questions that come to the fore when faced with the kind of situation we face today are those concerned with how to contain the economic, social, and political upheavals created by the fallout from the kind of catastrophe we are in the midst of, and how to avoid this kind of catastrophe in the future. ( http://www.rweconomics.com/LTLGAD.htm ) It is only after we have answered these kinds of questions that the question as to whether the Fed causes or fails to prevent a recession becomes relevant.

  56. Gravatar of ssumner ssumner
    26. December 2015 at 07:55

    George, You said:

    “It seems to me that this misses the point. Of course the Fed caused the recession when it increased rates leading up to the crash.”

    I totally disagree. Your “of course” makes me think that you think I agree. It’s clear you haven’t done your homework, google one of my papers, like “The real problem was Nominal”

  57. Gravatar of George H. Blackford George H. Blackford
    27. December 2015 at 14:04

    Scott,

    You are, of course, right that I have not done my homework. I apologize for that and for anything I have said that seems to impute any false belief to you or to anyone else. That was not my intention. I only wish to bring attention to the issues, as I see them, that I feel most strongly about.

  58. Gravatar of ssumner ssumner
    27. December 2015 at 17:23

    Thanks George, Sorry if I was impolite. I do think that paper would give you a sense of where I’m coming from.

  59. Gravatar of George H. Blackford George H. Blackford
    30. December 2015 at 11:51

    Scott,

    I have read through “The real problem was Nominal” a couple of times now, and while there is much that I agree with in that paper I don’t think it addresses the point I try to raise in my comment above.

    Deregulation of the financial system in the 1970s through the early 2000s led to a series of epidemics of fraud that accompanied the Junk Bond Bubble, the Savings and Loan Crisis, and the Dotcom and Telecom Bubbles leading up to the massive Subprime Mortgage Fraud of the early 2000s.

    Housing prices increased in every quarter from 1998-1 through 2006-1 and had increased 61% by 2004 when the Fed began to tighten and by 79% when the bubble burst in 2006. At the same time total non-federal debt had increased to 280% of GDP by 2004, 299% of GDP by 2006, and peaked at 321% of GDP in 2008. As can be seen in Figure 10.1 in http://rweconomics.com/htm/WDCh10e.htm and Figure 12.1 in http://www.rweconomics.com/LTLGAD.htm these were historic highs.

    By 2007 there was $11 trillion worth of mortgages at the heart of the $46 trillion worth of non-federal debt that existed—mortgages on properties the prices of which had been inflated by the housing bubble that the Subprime Mortgage Fraud had helped to create. In addition, there were some $500 trillion worth of derivative contracts outstanding in 2007 that had been created in the absence of any kind of government regulation that would ensured the viability of these contracts, and leverage in financial institution had reached historic levels as well.

    It seems obvious to me that the Fed did, in fact, bring on the recession that began in 2007 in the United States as it tightened credit from 2004 through 2007 in an attempt to put a break on the housing market, but the question I raise is whether or not there is anything the Fed could have done to have avoided, as opposed to have simply postponed a recession in this situation? I raise this question because it seems to me that the imbalances in the system were so great by 2004 that a financial collapse and concomitant recession were inevitable whatever the Fed did with its monetary policy. The only question, as I see it, was when would it occur and how bad would it be.

    You seem to argue in “The real problem was Nominal” that the Fed could have avoided the ensuing recession if it had targeted NGDP rather than whatever it was in fact targeting during the lead up to the crisis in 2008. It’s not at all clear to me that the Fed can, in fact, achieve the kind of control over NGDP that you seem to think it can achieve, but, in any event, I just don’t see how that is supposed to work with the insanity, fraud, leverage, and lack of regulation in the derivative markets that existed in the financial system leading up to the crisis in 2008. I believe that if the Fed had continued to loosened credit leading up to 2008 the insanity in the financial markets would have gotten worse as non-federal debt relative to GDP, leverage in the financial system, and unsound financial derivatives grew to even greater astronomical levels than actually occurred. How was this supposed to end if the Fed had continued to feed the financial system with looser credit?

    You seem to be arguing in “The real problem was Nominal” (I’m not saying that you do argue this only that you seem to be arguing) that the inflation that would have resulted from the Fed’s feeding the financial system would have solved the problem. Relying on continual or possibly accelerating inflation to solve economic stability problems seems oxymoronic to me since inflation can be as destabilizing as recessions. This would seem to be trading one kind of economic instability (recession) for another (inflation), and there is no guarantee that, in the end, the resulting inflation won’t lead to an even worse recession than if the financial insanity had been nipped in the bud through tighter monetary policy.

    I would think that the only way to provide true economic stability is to avoid the kind of financial insanity that has existed since we began to deregulate the financial system in the 1970s, and the way to do this is through strict government reregulation with regard to leverage, reserve and margin requirements, clearing houses, etc.

    I just don’t get it. What am I missing here?

  60. Gravatar of Alex Alex
    31. December 2015 at 00:50

    The LeBron James analogy is flawed because (from the Keynesian perspective) what’s really happening is like this:

    Billy is an up-and-coming basketball player. He seems to do quite well, but every now and again he gets kinda lazy and would just prefer to stay in and play video games. His friend, Diane, sees Billy’s promise, but hates it when he refuses to budge. Often time she has to drag him to his private gym, and force him on the treadmill for his own good, or else he’ll get out of training. And on some occasions, Billy even refuses to give Diane the keys to his gym room, so poor Diane struggles to help him train but physically can’t do so.

    Now, if Billy doesn’t train, is that Diane’s fault, or does the main fault lie with Billy?

    Note, yes the two stories are very different – that’s my point. One can’t assert that what a Keynesian is saying and what a market monetarist are saying are just two slightly philosophically different ways of looking at the same problem. They’re actually quite different views.

  61. Gravatar of ssumner ssumner
    31. December 2015 at 10:26

    George, Your mistake is to confuse different types of problems, which have different causes, different effects and require different solutions. Problems with the financial sector require a better regulatory regime (not necessarily more regulation, better regulation). The business cycle is an entirely different and unrelated problem, which requires sound monetary policy. I’ve never claimed that stabilizing the business cycle solves the “insanity” you refer to, nor do I claim that sound money will cure cancer.

    Alex, I don’t agree. When not at the zero bound they are two different ways of describing the same underlying reality. At least Krugman’s version of Keynesianism, which is very different from Keynes’s version.

  62. Gravatar of George H. Blackford George H. Blackford
    4. January 2016 at 13:33

    Scott, I’m not sure how to draw a distinction between more and better regulation in a situation in which over-the-counter derivatives and shadow banks were unregulated, large investment banks were allowed to regulate themselves, regulatory agencies were understaffed and underfunded, the Fed refused to exercise its responsibility under HOEPA to regulate the mortgage market, and the Treasury used the courts to bar states from enforcing laws against predatory lending practices in the mortgage markets.

    I would think that one of the clearest lessons of history is that it is impossible for monetary policy to avoid an economic catastrophe in the face of the kinds of financial excesses that inevitably occur when the financial system is allowed to run amuck in the way it was allowed to run amuck leading up to the Crash of 2008, and I don’t see how the Fed could have done anything leading up to 2008 that would have avoided the catastrophe that ensued short of stepping in to enforce strict loan-to-value ratios for mortgages; placing margin requirements on repurchase agreements; setting capital requirements for hedge funds, investment banks, and SPVs; forcing derivatives onto exchanges with clearing houses when practical, and setting reserve and capital requirements when not practical; and strictly enforcing all laws against fraud and other forms of predatory lending practices before the situation got out of hand.

    It seems to me that once the financial situation is allowed to get out of hand in the way it was allowed to do leading up to the Crash of 2008 a crisis is inevitable no matter what the monetary authority chooses to do and that monetary policy is impotent in its ability to stabilize the economic system in the absence of the kinds of regulations on the financial system listed above.

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