As you know, I have relentlessly argued that the Fed made a huge mistake in mid-2008 by not targeting NGDP at about a 5% growth trajectory, level targeting.  If they had done so, NGDP almost certainly would not have fallen last year, and the recession would have been far milder.  But 5% NGDP growth, which implies about 2% trend inflation, almost certainly is not the optimal monetary target in the long run.  I picked it because the Fed had been implicitly targeting NGDP at around 5% for several decades, and since all sorts of wage and debt contracts in 2008 had been negotiated under the reasonable assumption that we would continue to have roughly 5% NGDP growth, it didn’t seem like a good idea to enact a highly deflationary policy in the midst of a financial crisis.  But I’m not running the Fed.

In fact, the optimal inflation rate is probably either lower or higher than 2%.  If we were to assume the Fed adopted NGDP forecast targeting, level targeting, then we would not have to worry about “liquidity traps,” i.e. the zero-rate bound on conventional monetary policy.  In that case we’d be better off with a lower inflation rate.  Neither Bill Woolsey or George Selgin advocate inflation targeting; their proposals are somewhat closer to my NGDP idea, but Woolsey’s plan would likely lead to near-zero inflation in the long run, and Selgin’s plan would probably lead to slight deflation on average.  These are sensible ideas if we have sound monetary policy, as inflation is a tax on capital, and lowers the rate of economic growth.

On the other hand if we don’t have a sensible monetary policy regime, then low inflation makes an economy more susceptible to bumping against the zero-rate bound.  Nick Rowe compares the problem to balancing a tall pole in one hand.  If you want to make the top of the pole go left, you move your hand to the right.  If the Fed wants inflation to rise, it lowers the fed funds rate.  But suppose while balancing the pole you bump up against a wall, then you can’t move your hand further to the right, and thus can’t move the top of the pole to the left.  That’s a liquidity trap.  Of course both Nick and I realize that you aren’t really stuck, you can climb a ladder and directly pull the top of the pole in whatever direction you like.  But many central bankers are afraid of heights.

So let’s suppose you have a central bank full of meek, timid souls.  What sort of inflation rate is optimal?  I’ve mentioned that you’d probably be better off with an inflation rate even higher than 2%.  But I never really developed the idea, as I didn’t want people to associate my 5% NGDP rule with a policy of printing money to get out from under our debt burden.  I am not an “inflationist” or a monetary policy “dove.”  Still, I should have done a post and let the chips fall where they would. Fortunately, Andy Harless has done so, and much more elegantly than I could have.

In the 1980s we brought inflation down from double-digits to about 4%.  Should we have declared victory and stayed at that level?  In retrospect, we probably should have.  We did get inflation down to about 3% in the 1990s, and only 1.8% in terms of the GDP deflator from mid-2000 to mid-2008.  At the time I thought this was good, because it lowers the real tax rate on capital.  But in retrospect it was a big mistake, as the cost of the liquidity trap we stumbled into in late 2008 will vastly exceed the gains from 1% or 2% lower inflation.  Indeed one of the costs will be a massive increase in our national debt, which will almost certainly lead to much higher tax rates on saving and investment.

Interestingly, I know of only one country that stayed away from the ever lower inflation obsession of the major central banks.  The Bank of Australia.  Australia had about 4% inflation in their GDP deflator and 7.4% NGDP growth between 2000:2 and 2008:2.  With a much higher inflation and NGDP trend rate going into the crisis, they we able to avoid the zero interest rate bound.  And by the way, for those who think nominal shocks don’t explain real events like the recent recession, Australia was the only major developed economy to avoid a recession last year.  Indeed they haven’t had one since 1991.  They are called ‘the lucky country,” but I have argued that their culture lacks our puritanical obsession with inflation.  Perhaps each member of our FOMC should drink a 6-pack of Fosters before their policy meetings.

PS.  Matt Yglesias quoted Harless and then asked:

I would like to see more commentary on this matter from smart and informed people before I say I’m taking this account to the bank. But it seems to me to be an obvious enough question to ask especially since there are a variety of other reasons to think that something like a 3-4 percent inflation rate would be more desirable than a 2 percent inflation rate.

I don’t know if I am smart, but I think I am reasonably well-informed, so I’ll take a stab at the question.  If we ever get to NGDP targeting, a lower than 2% rate would be optimal.  Under our current far from perfect system, I’d say Yglesias and Harless are about right.

PPS.  Economic development is a much more important issue than monetary policy.  About the time he switched from money to development, Robert Lucas said that “once you start thinking about economic growth, it is hard to think about anything else.”  I sometimes feel guilty talking about these comparatively minor issues at a time when there is such a horrible tragedy in Haiti.  But I really don’t know enough about that issue to provide any useful ideas, and other bloggers like Tyler Cowen are covering the topic far better than I could.

Arnold Kling raises some very good questions regarding my recent post on James Tobin.  I had said:

I wish Tobin had lived long enough to have something to say about the role of money in the current financial crisis. As you know I am one of the few people who think tight money, defined as a policy of suddenly driving NGDP growth 8% below trend, was the most important factor in the financial crisis,

And Kling replied:

I strongly doubt that Tobin would say that Ben Bernanke carried out a policy of “suddenly driving nominal GDP growth 8 percent below trend.” I don’t think Sumner really wants to say that, either. At the risk of putting words in his mouth, I think that what Sumner wants to say is that there was a shock to velocity in 2008 that was going to drive expected nominal GDP growth 8 percent below trend, and the Fed, instead of doing something to offset that shock, mindlessly decided that with nominal interest rates already low there was nothing it could do.

Kling is being very polite in trying to give me another chance to recant my absurd argument, but I remain as stubborn as when Jimmy Carter gave Ford another chance, and Ford kept insisting that Poland wasn’t under Soviet domination.  I do really want to say the Fed drove NGDP 8% below trend with tight money.  Of course they didn’t actually want NGDP to fall, but they certainly could have taken any number of actions to prevent it, and decided that the risks of inflation were greater than the potential benefits of more aggressive rate cuts in September, October, and November 2008.  They also decided to pay interest on reserves in order to prevent a breakout in inflation (according to James Hamilton.)  Even the Fed admitted that the program’s intent was contractionary.  So one can hardly argue that the Fed didn’t do more in late 2008 because they thought there was no more that they could do.  Whether additional steps would have worked is of course an open question.

Kling then states:

I doubt that Tobin would have embraced recalculation, but I doubt that he would have said that the Fed could have done something about nominal GDP in the very short run (two or three quarters).

I have no idea what Tobin would have said.  However, it is well understood that if monetary policy affects AD in the long run, then, ipso facto, it also has an effect on near-term AD.  This is because near-term shifts in AD are (according to Woodford) strongly influenced by changes in future expected AD.

Kling then quotes from my discussion of sticky wages:

It’s like musical chairs; when the music stopped there weren’t enough dollars of NGDP out there to pay the debts and salaries that had been contracted under much different expectations.

And he doesn’t find my metaphor very convincing:

As to salaries, I just don’t think that the rise in real wages (less than 2 percent) is enough to explain 10 percent unemployment. When you say that debts were contracted under much different expectations, you make it sound like we had farmers taking out loans to plan crops when prices are 100, and then by the time the crops are harvested the prices are at 80, due to general deflation. That just does not seem like the story of the last year.

There are a couple problems here.  I wasn’t talking about real wages.  This is because I don’t trust price indices, and in any case I think the relevant variable is the relationship between nominal wages and NGDP, not nominal wages and prices.  If NGDP falls 8% below trend, then nominal wages must also fall 8% below trend to maintain full employment, regardless of what is happening to real wages.  But I also disagree with his characterization of the current situation.  At my company we did not receive any pay cut in the period from mid-2008 to mid-2009.  But if our wages had been flexible, rather than negotiated once a year, I am pretty sure we would have had a pay cut.  Why do I say that?  Because the first opportunity for wage cuts after the crash of late 2008 occurred in April 2009, when our salaries were set for the period from July 2009 through July 2010.  And we got no pay increase, which was 4% below trend.  That was a pretty good indication that even before July 2009 our wages were above equilibrium, they simply had not yet had a chance to readjust them yet.  And even this 4% pay cut relative to trend wasn’t enough to offset the sharp fall in NGDP.  There is definitely some money illusion involved when it comes to nominal wage cuts, and this imparts even more rigidity to nominal wages.  Another zero bound!

Of course Arnold Kling is famous for his recalculation theory, and here he adds one additional factor that might explain the severity of the recession:

I’m still wrestling with the issue of what caused such a deep recession. Another thought is that the domestic auto industry took another ratchet down in what has been a long-term trend. Manufacturing employment in general continued to ratchet down.

There is just one problem with this argument, there is no long term downward trend in domestic auto sales, indeed according to a 2006 article in Business Week, just the opposite:

It’s easy to get the impression that domestic car manufacturing is headed toward the same inevitable extinction as American textile, apparel, and consumer-electronics production.

But the reality is more nuanced. Look past the trouble in Detroit, and the auto industry is anywhere but in decline. In a growing number of Southern hamlets such as Canton, Toyota (TM ), Honda (HMC ), Mercedes (DCX ), and other foreign car manufacturers are providing nonunionized jobs — 33,000 since 2000 — that pay almost as much as United Auto Workers earn farther north. Consumers are enjoying more choice than ever, while the market as a whole is humming. Car sales in the U.S. inched up last year, to 17 million vehicles, the third-highest ever.

GEARING UP
And get this: Even as Ford and GM cut production last year, North American plants built 15.8 million cars and trucks, the same as in 2004. That happened thanks to foreign carmakers producing 4.9 million vehicles, an increase of 500,000 from 2004. Overall production is expected to rise to 16.8 million by 2009, when an estimated 5.8 million vehicles will roll off foreign-owned assembly lines. Looking back, car and truck production in the U.S. has nearly doubled since Detroit’s heyday in the early 1960s. “The domestic auto industry is as healthy as it has ever been,” says Eric Noble, president of Car Lab, an industry consulting firm in Santa Ana, Calif. “The names on the plants are just changing.”   (Italics added.)

Of course the auto industry never reached its production goals of 16.8 million units in 2009.  It’s tough to produce that many cars when NGDP is falling at the fastest rate since 1938.  Kling may have been referring to the long run decline in auto employment, but if the current recession was due to long run trends in productivity, we should see more autos being produced with fewer workers, as that is the long run trend.  Instead we are seeing a sharp drop in auto production.

Some will argue that correlation doesn’t prove causation.  Sure NGDP and RGDP are correlated, but there could be some other reason.  The problem with that view is that when we have evidence that a monetary shock is exogenous, it seems to produce a real effect.  There are good reasons why the best and the brightest macroeconomists from David Hume to John Maynard Keynes to Milton Friedman to Robert Lucas to Michael Woodford have been convinced that falling NGDP will depress real GDP in the short run.  If anyone has a better explanation for the correlation, I’d love to hear it.

From The Economist:

Foreign hostility to China’s export dominance is growing. Paul Krugman, the winner of the 2008 Nobel economics prize, wrote recently in the New York Times that by holding down its currency to support exports, China “drains much-needed demand away from a depressed world economy”. He argued that countries that are victims of Chinese mercantilism may be right to take protectionist action.

From Beijing, things look rather different. China’s merchandise exports have collapsed from 36% of GDP in 2007 to around 24% last year. China’s current-account surplus has fallen from 11% to an estimated 6% of GDP. In 2007 net exports accounted for almost three percentage points of China’s GDP growth; last year they were a drag on its growth to the tune of three percentage points. In other words, rather than being a drain on global demand, China helped pull the world economy along during the course of last year.

Foreigners look at only one side of the coin. China’s imports have been stronger than its exports, rebounding by 27% in the year to November, when its exports were still falling. America’s exports to China (its third-largest export market) rose by 13% in the year to October, at the same time as its exports to Canada and Mexico (the two countries above China) fell by 14%.

Some forecasters, such as the IMF, expect China’s trade surplus to start widening again this year unless the government makes bold policy changes, such as revaluing the yuan. However, Chris Wood, an analyst at CLSA, a brokerage, argues that China is doing more for global rebalancing than America. Rebalancing requires that China spends more and America saves more. Mr Wood argues that China is doing more to boost domestic consumption (for example, through incentives to stimulate purchases of cars and consumer durables, and increased health-care spending) than America is doing to boost its saving. America’s total saving rate fell in the third quarter of last year to only 10% of GDP, barely half its level a decade ago. Households saved more, but this was more than offset by increased government “dissaving”.

We don’t need to go half way around the world to find a big country that isn’t pulling it’s weight. 

PS.  In some Keynesian models of “depression economics” (aka “incompetent monetary policy economics”) saving is a “bad thing.”  In fact, we need a fiscal policy that is much more pro-saving, and a monetary policy that sharply boosts NGDP.

For younger readers, or non-economists, I should point out that James Tobin was a famous Keynesian economist and Nobel laureate.  Indeed he was a sort of Keynesian’s Keynesian, one of the most respected Keynesian economists of the 1960s-70s.  Kevin Donoghue recently sent me a 1983 paper by Tobin that contradicted my argument that liberal economists don’t tend to support NGDP targeting.  In 1983 James Tobin did:

For two years ahead, the intermediate target should be nominal GNP growth, or as Robert Gordon has suggested, nominal final sales.  [So I’m Tobin and Bill is Gordon.]  This would indicate how the policymakers would allow price and productivity shocks to affect output and employment, while allowing complete freedom to offset velocity-of-money surprises with money supplies.  Indeed the Fed might advertise this target as a velocity-adjusted monetary aggregate, a concept toward which it has been groping in these last turbulent years .  .  .

A nominal GNP or final sales target implies for the duration of its tenure a one-for-one trade-off between price and quantity.  An upward supply price shock would mean commensurately smaller real GNP growth.  These terms of trade may not accord with national priorities.  Separate ranges for price and quantity would allow an extra degree of freedom.  But a nominal GNP target range is easier to explain and understand.  

.   .   .

I know that central bankers will object because explicit policymaking on these lines makes their responsibilities for important economic outcomes transparent.   They prefer to hide behind less meaningful descriptions of what they are doing.  But there is no reason for the rest of us to respect that preference.   (Italics added.)

Of course some people have argued that the Fed was not to blame for the recent fall in NGDP, after all interest rates weren’t raised in mid-2008, rather they were kept stable.  Here is what Tobin says in 1983:

However, as I have argued above, “doing nothing” is not well defined.  Mariners would not define a fixed rudder angle rather than a fixed compass heading as conservatively “doing nothing.”  [Suddenly I feel like a plagiarist.]  Monetary rules themselves require the authorities to adjust instruments to achieve intermediate targets.  How fast they should try to return to track when events beyond their control, like wind, waves, and currents, throw them off is a consequential problem.    Achieving intermediate targets, to whatever degree of precision, does not in any case achieve desired paths of macroeconomic variables that really matter. Your conclusion as to what is the minimum-risk strategy, or an optimal strategy, will depend on your model of the financial and economic system and on your objectives and priorities.  It is unlikely to coincide with holding constant any of the instruments or variables directly under central bank control or any intermediate policy targets.

I wish Tobin had lived long enough to have something to say about the role of money in the current financial crisis.  As you know I am one of the few people who think tight money, defined as a policy of suddenly driving NGDP growth 8% below trend, was the most important factor in the financial crisis, which became most destructive in late 2008.  Tobin wrote this paper as we were just emerging from an almost equally severe recession in 1981-82, when unemployment reached 10.7%.  I had forgotten that there was also an international debt crisis in 1982.  But now I remember, and I recall the crisis was blamed on banks making a lot of foolish loans to third world countries.  But Tobin has an interesting observation:

Last summer Chairman Volcker and his Federal Reserve colleagues suspended their monetarist targets, to almost universal relief.  The severity of the recession, the international debt crisis, and the pace of change in financial structure were all good reasons.  (Italics added.)

I don’t entirely share Tobin’s anti-monetarist sentiments, which are overdone at various points in the paper.  Indeed at one point he blames monetarists for the bad condition of the economy between 1973-79; a bizarre argument.  But the debt comment is interesting, so I decided to go back and look at the NGDP numbers.  Between 1971:3 and 1981:3, NGDP grew at about 10% to 11% a year, although the rate was volatile.  Then between 1981:3 and 1982:3, nominal growth dropped to a mere 3%.  Hmmm, NGDP growth suddenly dropped about 7.5% below trend–does that sound familiar?  And the drop led to an international debt crisis (many of the debts were dollar-denominated.)  There was also an S&L crisis. 

Under normal times, there would be nothing wrong with 3% NGDP growth, indeed it might be optimal.  But because wage contracts reflected expectations of more than 10% NGDP growth, as did loan contracts, employers ended up laying off lots of workers, and debtors ended up defaulting on lots of debts.  It’s like musical chairs; when the music stopped there weren’t enough dollars of NGDP out there to pay the debts and salaries that had been contracted under much different expectations.  And of course the same thing happened in 2008.

So to summarize, Tobin believes:

1.  We should target NGDP.

2.  Sneaky central bankers will try to dodge their responsibility for stabilizing NGDP growth, by refusing to be tied down by any specific policy goal.  But we shouldn’t let them.

3.  Some other trade-offs between prices and output are possible (an anticipation of the Taylor Rule?) but NGDP is easier to explain and understand.    

4.  Economists currently lack a good definition for a neutral monetary policy stance.

5.  Holding interest rates steady at 2% does not mean that the Fed is maintaining a policy of monetary ease.  Policy changes when the compass changes, not the rudder.  (The compass is expected NGDP, the rudder is the fed funds rate or the monetary base.)

6.  A financial crisis can result from excessively tight money.

And here is the weirdest thing of all; I have always thought I had nothing in common with James Tobin, who I always saw as an outdated Keynesian.  And yet there they are; all the important ideas from my blog, published in a Tobin paper in 1983.  Economics is not like the hard sciences, there is much to be gained from reading old texts.

1   Is the EMH true?

2.  Free will or determinism?

3.  Poor countries; is it bad policies or bad culture?

4.  Do we know the Truth about reality, or do we merely regard things as true?

5.  Would economic problem X have been prevented by better regulation?

6.  Are murder, rape and slavery objectively evil, or do we regard them as evil?

7.  Can improved foreign aid significantly affect long run economic growth?

8.  The universe’s deepest structure:  pure mathematics, or  . . .  turtles all the way down?

Here’s my theory.  These questions are not about the nature of our universe, they are about the nature of our minds, our temperaments.  They reflect that fact that different people think about things in different ways.  On one side are the sort of world-weary fatalists.  On the other are the optimistic Americans with the can-do spirit.  The guys that want their hands on the steering wheel, and don’t want to be in the passenger seat.  I’m happier in the passenger seat (unless my wife is driving.)

I recall a quotation by William Easterly to the effect that the economic crisis was a point in favor of modern economics.  After all, the EMH says we can’t predict financial crises, and we didn’t.  It didn’t go over well.

I wasn’t surprised that Easterly and I would share this view, although logically there is no relationship between his views on the EMH, and on the efficacy of foreign aid.  But I would be very surprised if an American with that can-do spirit (say Jeffrey Sachs) had the same attitude.  My hunch is that people with a “can-do”  frame of mind are more likely to all line up on the optimistic side of these 4 economics and 4 philosophical questions (actually 3, the last was a joke.)

Given my views on the EMH, can you guess my views on free will and determinism?  Hint:  I’ll present both sides:

Determinism:  All scientific theory suggests that at the macro level, events are caused by the laws of science interacting with the pre-existing states of the universe.  This allows no role for free will.  At the micro level some events seem to be random, but those also don’t seem to involve free will.

Free Will:  Come on!  If there is a salt and pepper shaker in front of me, obviously I can choose to pick up the salt shaker, or I can choose to pick up the pepper shaker.

Compare that with two views of the EMH:

Pro-EMH:  Economic theory suggests that if asset prices had obviously moved away from their equilibrium position, investors would take advantage of the situation by going long in undervalued markets and short in overvalued markets.  This would eliminate any obvious mis-pricing.

Anti-EMH:  Come on:  If house prices are far too high relative to income, or stock P/E s are way too high, then you obviously have a bubble.

Robin Hanson wants some sort of test to see if there is a magic formula that can beat the market.  But in my “alchemist” post I argued that such a formula would be worth billions of dollars if held privately, but the value of the formula would fall to zero if published in a scientific journal, just as would the formulas for turning lead into gold—and yes, alchemists do know how, but they are not so stupid as to publicize the formula. 🙂   So we will never see Robin’s proposal enacted in a way that is acceptable to all sides.  If something seems to work initially, arbitragers will quickly eliminate any easy profits, and the EMH guys like me will say the initial success was just luck.  It’s not about tests, it’s about how you think about reality.  It is about whether you see yourself as a passive observer of reality, or an active agent of change that can “just do it.”

BTW, these views are not necessarily reflected in the way that people behave, but rather how they think about things.  Everyone behaves as if free will exists, regardless of their philosophical orientation.  And I like the term ‘orientation’ better than beliefs, as these varying outlooks are analogous to one’s sexual orientation.

Part 2:  Did government cause the crisis?

Vernon Smith says yes:

And we got into the business of, particularly at the federal level, the Community Reinvestment Act in the 1990s became a means by which the federal government enabled, wished to enable people of modest means to buy a home and so as a result that act created scoring system for private lenders whereby if they got good scores by aggressively, more aggressively making loans to people whose incomes were below 80% of the median those scores helped them, gave them, enabled them to more easily get approval for making expansions in regional banks and these scores were used in helping to decide whether to approve mergers, this sort of thing.  Various devices were used to encourage private lenders to more aggressively make loans on homes to be purchased by people of modest income and what we got from that was a particularly strong demand for homes at the low end of the pricing tier.

Whereas Tyler Cowen and Paul Krugman say no:

This is actually a very broad problem with all accounts of the crisis that try to exonerate the private sector and place the blame on the government and/or the Fed: none of the proposed evil deeds of policy makers were remotely large enough to cause problems of this magnitude unless markets vastly overreacted. That is, you have to start by assuming wildly dysfunctional financial markets before you can blame the government for the crisis; and if markets are that dysfunctional, who needs the government to create a mess?

BTW, this is a Krugman quotation, which Cowen calls “excellent.”

I am inclined to agree with both quotations, at least partially.  I should clarify that Vernon Smith did not explicitly blame the government, I just assumed most people would infer that from his remarks (very similar to my commenter Patrick.)

Here’s my take.  The government thought it a good idea to encourage banks and also F&F to make more loans to lower income people.  And the government thought this would not lead to a financial crisis that devastated banking. Private banks were partly encouraged by the government, but mostly simply decided that they could make money on lots of sub-prime lending.  And they also thought these actions would not devastate the financial system.  Indeed, you’d really have to have strong ideological blinders to argue against either of these assertions.

If I am right then society simply made a big mistake.  But most people aren’t satisfied with that answer.  We want villains, and we want policy implications.  I’m not much interested in looking for villains in either the public or private sector (excluding my Congressman of course) but I am interested in policy implications.  So if we roll back the clock, what do we do if both the government and the private sector are suffering from the sort of mass delusions that used to affect medieval villages that had a crop of bad mushrooms?  Obviously there is nothing we could do to directly address the bubble, unless you bring in a deus ex machina solution.  If Republicans and Democrats and bankers all missed it, and all wanted to shovel more money to borrowers with no income and no down-payment, then we are stuck.

But maybe there are alternative economic systems that could make those episodes of mass hysteria do less harm.  If you are a Democrat, perhaps the way to encourage more home ownership (a goal I don’t share, BTW) is to give tax credits to first time low income home buyers.  This doesn’t put our financial system at as much risk.  If you are a Republican you might want to abolish F&F, other countries get by fine without them.  If you are a libertarian you might want to abolish FDIC and TBTF.

Vernon Smith tends to favor free markets, but worries about the fragility of the banking system.  I think it is much less fragile than he thinks, because he wrongly attributes the problems of the 1930s to bad banking, whereas they were actually caused by the Fed letting NGDP fall in half.  Banks were actually far more conservatively run in the 1920s than the 2000s.  But he’s not a macro-historian, so his view is understandable.  Let’s say he is right that the system is inherently unstable, and also assume we are stuck with FDIC and TBTF. What then?  Smith gives what seems to me to be the only plausible answer:

And so what is important is really to avoid these kind of crisis situations in the first place and because they’re so difficult to deal with once we get into them because if nothing else the politics of these situations will drive policy and the politics is not necessarily good long term economic policy and of course the way to have avoided this kind of a problem in the first place was to have better collateralization of the kinds of loans that we’re being made in the housing market and generally in consumer credit markets.  It’s not only the housing market, but it’s also credit card debt, student loan debt, automobile loans, all of those credit markets, which ended up being the kinds of private credit instruments that the Federal Reserve found itself necessary to make loans on in 2008.

.   .   .

Born is seen now as something of a hero because she wanted to reexamine the question of the exempt status of those instruments and I think actually a fairly simple regulatory change for those derivatives is all that is called for and that is simply require them, derivatives to be listed on exchanges.  If you did that the exchanges then would require them to be collateralized and that is to me the main problem in the derivatives market, particularly that was true in the housing mortgage derivatives market because those are essentially markets where people are making bets on whether a certain class of mortgage backed securities are going to suffer default and the providers of that, the seller of those contracts. You see that’s a form of insurance in the sense the person who buys those contracts sees that as a way of hedging their risk of default, but it’s not insurance if the sellers of those contracts are not required to collateralize the contract and generally those contracts were not required to be collateralized.  This is basically how AIG go into trouble.

.   .   .

So to me it’s what is needed here is not some kind of heavy handed regulation, but simply an application of principles that we’ve already learned a lot about in other markets.

Collateral, collateral, and more collateral.  That’s the only practical answer.

Krugman seems to think it is realistic to expect regulators to spot bubbles in real time, and then do something about them.  Smith is more skeptical:

Question: What is the proper role of regulation in these markets?

Vernon Smith:  I don’t think there is anything you can do to prevent bubbles.  I think we’ve had frequent stock market bubbles that have self corrected and the burden of those bubbles and the pain is basically borne by the investors in those markets and you do not have collateral damage to the economy from bubbles in stock markets like you have in bubbles with housing and generally with consumer durables and I think the solution in the housing and the consumer durables markets is the same as the solution that we’ve worked out institutionally in stock markets and that is require these purchases to be reserved, collateralized.  

We can’t stop the winds from blowing.  Let’s build a financial system that can survive strong winds, not one that collapses in a light breeze.

Then let’s build a monetary policy that stabilizes NGDP growth.  Arnold Kling seems to think there is something inexplicable about the severity of this recession.  I don’t quite understand his puzzlement.  Standard macro theory (as illustrated in the AS/AD graph in the new Cowen/Tabarrok textbook) says that if NGDP suddenly grows 8% below trend then there will be a sharp drop in RGDP.  The severity of the drop is exactly what one would expect in a world of sticky wages (sticky relative to the fall in NGDP, not relative to the also sticky prices.)  The only interesting question is why did NGDP suddenly start growing 8% below trend.  That’s what this blog is mostly all about, but I’ve already gone on way too long.

PS.  Kling also makes this cryptic comment:

 The Keynesian story at least has some microfoundations. Scott Sumner’s Y = expected MV/P story is just hand-waving.

I recall discussing expected NGDP, but never expected MV/P.  [Edit, Bill Woolsey pointed out that I originally had a typo here, and Kling might have as well.]   And I use changes in expected future NGDP to explain changes in current NGDP, as do all the modern new Keynesians as far as I can tell.  So I am not quite sure how to respond to Kling.  I suppose my microfoundations are a bit more sticky-wage and a bit less sticky-price than those of the average Keynesian, but you can get a severe recession under either assumption if NGDP falls.

In fairness to Kling, while the severity of the recession is easily explicable, I expect the recovery to be slower than predicted by natural rate models due to a 40% jump in the minimum wage, 73 week extended unemployment benefits, and other supply-side problems created by Congress.

PPS.  Sorry Philo, I just can’t stay away from pop philosophy.

PPPS.  The Vernon Smith interview is very good.  Despite the occasional stumbles in macro, at least he intuits that we’d be better off if the price level were currently 6% higher.  (Actually we need NGDP to be 6% higher right now, but close enough.)