A slightly off-center perspective on monetary problems.
I’ve already argued that the current depression was caused by an excessively tight monetary policy. But why did policymakers get it so wrong? I don’t think it’s just the Fed, there is a deeper problem in way the profession as a whole approaches these issues.
A few years ago it was difficult to find many elite macroeconomists who put much faith in fiscal stimulus. Now suddenly it is all the rage. What happened? The only explanation I can think of is that as soon as nominal interest rates fell close to zero, and aggregate demand seemed to be spiraling downward, much of the profession assumed that we had entered a “liquidity trap.” I haven’t seen much evidence that very many economists actually know anything about liquidity traps, but perhaps they have a vague memory of the concept being mentioned in their undergraduate macro classes. Unfortunately, what they learned is almost certainly wrong.
I plan to reread parts of the General Theory in the near future, but before doing so I thought I’d sketch out why I’ve never been able to take the book seriously (unlike the Tract on Monetary Reform, which is a fine book.) It seems clear to me that in the GT Keynes was focusing almost entirely on aggregate demand. That is, he was primarily concerned with nominal income determination, not how nominal income gets partitioned between prices and real output. Unfortunately, he doesn’t seem to have any model of nominal income. If you search the GT for an explanation of why U.S. nominal GDP is roughly $15 trillion, rather than $15 billion or $15 quadrillion, you won’t find any explanation beyond a perfunctory nod to the long run role of the classical model (MV=PY.)
I’m certainly no expert on Austrian economics, but I have always viewed Friedman and Schwartz’s Monetary History as a sustained attack on both the Austrian and Keynesian views of the Great Depression. Now we have a revival of the Austrian view from an extremely unlikely source. Before considering her arguments, let’s first look at the F&S analysis of monetary policy during an asset price bubble.
One thing that the current crisis has done is to expose just how much economists differ in their mental models of the macroeconomy. It seems as if we often talk right past each other, not really understanding the points the other side is trying to make. And I don’t think this is an inevitable part of academic discourse. In microeconomics, for instance, Chicago economists may differ from salt water economists about just how competitive most markets are, but at least they can debate the issue using a commonly understood language. Not so in macro.
