Archive for February 2009


I hate to say I told you so . . .

Since this past October I have been so alarmed about the worldwide collapse in demand that I have become something of a pest, badgering everyone who would listen about the urgent need for monetary stimulus.  At first the economics community seemed totally focused on the various bank bailout proposals.  The prevailing view was that the financial system was the fundamental problem and falling demand was a symptom.  I never understood this argument, as modern macro theory says falling AD is a symptom of monetary policy that isn’t expansive enough.  Now perhaps things are getting bad enough that people are beginning to understand that it does no good to bail water out of a boat if it is coming in even faster through a hole in the hull.

From a piece in Tuesday’s FT by Martin Wolf:

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Puritan attitudes toward monetary stimulus

Krugman has criticized people who view depressions as a necessary price to pay for our previous sins of profligate spending and borrowing, or as a way of purging excesses from the system.  I think he is right that this attitude exists, especially (although not exclusively) among those on the right.  I find that this mindset makes it especially hard to argue for monetary stimulus, even compared to fiscal stimulus.

When most people visualize the myriad economic crises that we face, it seems as if we carry an almost unbearable burden on our collective shoulders.  If someone comes along saying that we merely have to debase our currency, and the burden will be magically lifted, the solution seems incommensurate with the problem–it seems to good to be true.  Even fiscal stimulus, often called a politician’s dream, evokes thought of future sacrifice, as we eventually must repay the massive debts we incur.

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The Stimulus Muddle

An awful lot of words have been expended on whether the stimulus package will “work,” and yet we don’t seem to be getting any closer to a consensus.  Chinn used a textbook approach to clarify the debate, while McArdle and Sachs have questioned the value of the goods produced by the stimulus package.  But maybe we are all looking in the wrong place.  Perhaps even the more specific question “will it boost measured GDP?” is so ambiguous that no consensus is possible.

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What would really, really, really tight money look like?

We all know what tight money means, don’t we?  Some of us lived through the double-digit interest rates of 1979-81.  But what does it really mean?  What is the tightest money imaginable?

It seems obvious that the tightest conceivable monetary policy would cause deflation, or at least let’s say expectations of future deflation (as prices are sticky.)  So that rules out 1979-81.  One percent deflation is pretty tight, but why not try for 5% or 10%?  Beyond some point you run into a problem–the real return from holding cash would rise to implausible levels.  Perhaps with severe expected deflation price stickiness would evaporate from the sort of goods that are easily arbitraged.  So let’s just stop with a policy tight enough to generate 3% expected deflation.

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The “But wouldn’t that cause hyperinflation?” conversation.

Try this–it works almost every time (except with knowledgeable macroeconomists):

Someone asks your opinion on the economy.  You say the solution is a more expansionary monetary policy to boost nominal GDP.  They reply “But rates have already been cut to zero, we’re in a liquidity trap, businesses aren’t investing, ‘the problem’ is the financial system, etc.”  You reply with a really aggressive scenario that has the Fed buy up almost every asset on planet earth.  Make it sound dramatic enough and almost every single time you’ll hear “But wouldn’t that cause hyperinflation?”

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