Everyone seems to be giving the last rites to orthodox macro.  Here’s Nick Rowe:

I think we are witnessing the biggest silent shift in macroeconomic thought since the Second World War. For 70 years we have taught, and believed, that we would never again need to suffer a persistent shortage of demand. We promised ourselves the 1930’s were behind us. We knew how to increase demand, and would do it if we needed to.

The orthodox have lost faith in that promise; only the heterodox still believe it.

I have certainly lost faith in the promise that we “would do it if we needed to.”  But I still believe it can and should have been done.  Arnold Kling makes this observation:

The only thing I will add to Nick’s post is that the exponents of the orthodox view were contemptuous of dissenters when they held their views of three years ago, and they are just as intolerant of dissenters to the new consensus.

A few years ago, pretty much everyone said that monetary policy could correct any aggregate demand shortfall coming from the collapse of a bubble. Now, pretty much no one, other than you know who, says so. The new consensus is that banks matter, and bailing out banks was a key policy move to prevent calamity.

This sounds similar to Nick, but is actually a radically different proposition.  When Bernanke was asked why he didn’t follow the advice he gave Japan—shoot for 3% inflation—he didn’t say the Fed couldn’t create inflation, he said it would be a bad idea to have higher inflation.  Krugman doesn’t think a higher inflation target won’t work, he thinks the Fed is too conservative to do it.  Woodford doesn’t say OMOs won’t work at zero rates, he says OMOs won’t work at zero rates unless the Fed has a price level target.  Which is what he said before the crisis.  Mishkin revised his text in light of the economic crisis, and kept the part about monetary policy being highly effective when nominal rates are zero. 
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I should probably stick to monetary economics, but I can’t resist commenting on a couple Yglesias posts.  Not because I disagree with Yglesias (I mostly agree), but rather because I think I have something to add that puts things in a bit more perspective.
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Date            S&P500       WTI oil     5-year TIPS spread

May 3        1202.26         86.19         2.00%

May 4        1173.60        82.74          1.94%

May 5        1165.87        79.97          1.89%

May 6        1128.15        77.11          1.79%

May 7       1110.88         75.11          1.75%

May 10    1159.73         76.80          1.85%

May 11     1159.75        76.37          1.86%

May 12    1171.67        75.65           1.92%

May 13    1157.44        74.40           1.89%

May 14    1135.68        71.61           1.83%

May 17   1136.94        70.08           1.81%

May 18   1120.80        69.41           1.77%

May 19   1115.05        69.87           1.70%

May 20   1071.59        68.01           1.60%

May 21   1072.58                            1.56%    (as of 10:30am)

The oil and stock prices (plus falling metals prices) are telling us that real growth expectations are probably falling.  TIPS spreads are telling us that inflation expectations are probably falling.  Anyone want to guess what is happening to NGDP growth expectations?  We can’t know for sure, but I’d wager that if we had an NGDP futures market, NGDP futures prices would have fallen significantly since May 3.  BTW, it is a disgrace that the government hasn’t created one.  It isn’t just me, Robert Shiller has been calling for an NGDP futures market as well.  We are flying half-blind, when we could have extremely valuable market data on NGDP expectations at a trivial cost to the Federal Reserve.  I wish more macroeconomists would speak out on this issue.

Last time we had a severe AD shock it was easy to misdiagnose the problem.  It coincided with a severe banking panic.  Although I believe that the subsequent recession was caused much more by falling NGDP, than banking problems, I can understand how others might have reached different conclusions.

This time there are no excuses.  No one in their right mind thinks the stocks of US manufacturing corporations with no loans to Greece or Spain are plunging because of debt problems in Europe.  Stocks crashed 4% today because people are increasingly worried about the macroeconomy.  Yes, there are real aspects to the Greek crisis.  Greece will need to engage in austerity over the next few weeks.  But Greece, Portugal, and Spain are not big enough countries to knock 25% off the price of oil in one month.  Oil prices are plunging for the same reason as US equity prices are plummeting—fear of a sharp fall in AD (and hence economic activity) all over the world.

Problems in Greece don’t cause 5-year US inflation expectations to suddenly plummet from over 2% to 1.6% in just a few weeks.  Falling AD does.

Just as in 2008, the monetary policy screw-up was triggered by a combination of a real shock (banking then, Greece now) and a dysfunctional monetary regime (interest rate targeting.)  In 2008 a reasonable person could have attributed all the damage to the real shock.  They would have been wrong in my view, but it was a plausible argument.  Now there are no more excuses.  Money is too tight.  The falling asset prices are not directly caused by Greece, that country is much too small.  The asset price declines are caused by monetary policy errors triggered by central banks that remained passive in the face of a debt crisis in Europe.

In 2008 people pointed to rapid growth in M2.  I don’t think the monetary aggregates are reliable indicators; but even if they were, M2 has actually fallen thus far in 2010.

I don’t doubt there are other explanations.  Maybe US stock investors suddenly realized that a new round of “recalculation” was necessary.  But why would this need for extra recalculation in America have been triggered by problems in Greece?

In 2008 there were no bloggers pointing to tight money as the problem (although Earl Thompson did publish one article.)  Today we have bloggers on the right (me), bloggers in the center (Ryan Avent), and bloggers on the left (Matt Yglesias) all pointing to the need for easier money.

Surely the central banks see the problem—will they have the courage to act?

Update 5/21/10:  Tim Duy also has an excellent piece.

HT:  Marcus

It’s worth thinking about where we are in the Great Recession, relative to the same time period in the Great Depression:

1.a  October 1929, stocks crash on sharply falling expectations of NGDP growth.

1.b  October 2008, stocks crash on sharply falling expectations of NGDP growth.

2.a   Early 1931, stocks rise on signs of recovery

2.b  Early 2010, stocks rise on signs of recovery

3.a   May 1931, stocks fall as European banking/sovereign debt crisis begins

3.b  May 2010,  stocks fall, as European banking/sovereign debt crisis begins
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