Archive for December 2010



This is a follow up to my previous post.

Part 1:  Capitalism later

When I was young I believed the GOP was more supportive of small government than the Dems.  I’m not sure why I believed this; when I came of age Nixon was president, and he was arguably the most anti-libertarian president of my lifetime (with the important exception of ending the draft.)

Supporters of the GOP always used to say that the president (Nixon, Ford, Reagan) wanted smaller government, but the Congress wouldn’t go along.  When the GOP finally took Congress in 1994, the alleged roadblock was President Clinton.  Finally, in 2001 nirvana arrived for us libertarians; the GOP took all branches of government, and we got . . . one of the biggest new entitlement programs in history, a massive increase in the National Security State, and a much greater Federal involvement in education.  The fastest growth in Federal spending since LBJ was president (for several years.)

That should have ended any illusions about the GOP being the party of small government, except to the most hopelessly deluded.  But with the rise of the Tea Party movement we are again hearing this meme—the GOP wants to trim the size of government.  For instance, the GOP has spent the last two years bashing Obama for not reining in Fannie and Freddie.  And now that they have taken Congress, the Wall Street Journal says they are ready to act:

Earlier this year, leading House Republicans proposed to privatize mortgage giants Fannie Mae and Freddie Mac or place them in receivership starting in two years.

Now, as Republicans prepare to assume control of the House next week, they aren’t in as big a rush, cautioning that withdrawing government support in the housing market should be gradual. . . .

Republicans were backing a bill by Rep. Jeb Hensarling (R., Texas) to start cutting the government’s ties to the mortgage giants or begin winding them down in two years; if they were deemed financially viable, they would become fully private within five years.

“Of all the dumb regulation that caused our economic crisis, none was dumber than that which created the (Fannie and Freddie) monopolies,” Mr. Hensarling said in March. . . .

Many Republicans now concede that a speedy exit may not be practical, because Fannie Mae and Freddie Mac have such a dominant position in the nation’s housing market. Mr. Garrett said he has “not established a specific timeframe for winding them down.”

[Insert obligatory Claude Rains exclamation here.]

Some might argue that the GOP is simply facing reality, the economy is weak and a drop in the housing market might further depress aggregate demand.  But since when is the GOP worried about AD?  They have been insisting that the Fed is making a mistake in trying to boost AD with a more expansionary policy—that this would merely bail out the Obama administration’s failed big government policies.  No, the GOP is not motivated by a desire to boost AD.  And neither are they opposed to more intervention in the free market.

The mostly like explanation is that the GOP’s paymasters in real estate and banking quietly had a word with them after the election.  I’d guess it went something like this:

“We greatly appreciate the help from the Tea Party in getting you guys back into a position of power.  But now these neophytes need to step aside and let the big boys take over.”

So which is it?  Is the GOP lying when they say we don’t need more AD, and that Fed policy is too easy?

Or are they lying when they say we need smaller government, and that the housing fiasco was caused by people like Barney Frank, who promoted the GSEs?

Part 2:  Regulation later

And then there’s the Dems.  They used the subprime fiasco to rail against unregulated free market capitalism, the so-called “market fundamentalism” of people like . . . well people like me.  Of course the true market fundamentalists were always opposed to the housing/banking system, which was riddled with moral hazard.  Unfortunately there were plenty of so-called market fundamentalists who cheer-leaded the “deregulation” of banking the the US, Ireland, Iceland, etc, thereby discrediting the entire movement.

In any case, the Dems did get around to “re-regulating” the housing mortgage system in the US.  More than a kilo-page of re-regulation.  There’s just one thing, they forgot to ban un-insured subprime mortgages.  That’s right, the alleged cause of the entire mess, which is already banned in many countries the Dems seem to hold up as models, was given a free pass.  There is no requirement that buyers put at least 20% down.  Indeed there is no requirement that they put even 5% down.  Nor are there any plans to phase in such a ban over a 5 or 10 year time frame.

So if regulation isn’t really the motivation of the Dems, what is?  The same WSJ article provides one answer:

Democrats tend to favor a more active role for the government in housing to ensure that underserved communities have access to mortgages.

So there you are.  The GOP doesn’t favor small government and the Dems don’t favor regulation.  Instead the GOP favors a bloc of people who vote for the GOP and contribute money to their campaigns, and the Dems favor a bloc of people who vote for the Dems and contribute money to their campaigns.

I’m not so cynical (yet) that I would deny there are some idealists in politics.  My hunch is that some politicians (even some I don’t like such as Barney Frank) are driven partly by idealistic motives.  After all, Frank recently mentioned abolishing Fannie and Freddie.  But whatever idealism exists is not strong enough to overcome the special interest groups.

Fortunately, good governance is not a zero-sum game, so once and a while the two parties come together and strike a deal that is win-win (such as the 1978 deregulation bill, or the 1986 tax reform, or the 1996 welfare reform.)

The most one can hope for is that some creative politician will be able to cobble together another such compromise sometime in the next 10 years.   Of course it would be much easier to do if we were Switzerland, Denmark, or Singapore.  Heck, if we were even Canada or Australia.  But we are a nation of 310 million people with very diverse cultural values and perspectives on economics.

Happy New Year!

Bad arguments against libertarianism

I’m a pragmatist, and hence don’t ascribe to the sort of libertarianism advocated by the true believers—those who base their arguments on natural rights.  I’d like a government that intervenes much less than any real world government, but much more than members so the Libertarian Party would want.

But when I read criticism of libertarianism by outsiders, it almost makes me want to embrace the most dogmatic forms of libertarianism.  Consider a recent critique of libertarianism by Christopher Beam of New York magazine, which struck me as a series of knee jerk reactions to libertarian ideas that seem wacky at first glance, until one actually starts to think seriously about the issues:

There are all sorts of situations the private market isn’t good at managing, such as asymmetrical information (I know my doctor is qualified to treat me because he has a government license)

That’s good to know!  I had almost been brainwashed by some big government advocates into supporting medical malpractice suits.  They kept telling me there are “thousands” of incompetent doctors out there.

I currently have an excellent doctor, but in the past that wasn’t always the case.  How do I know?  Let’s just say that I didn’t evaluate their effectiveness on the basis of whether they are government certified.  Indeed, how many of us have even checked out our doctor’s certification?  (And yes, there are doctors who practice illegally, w/o certification.)

Of course not everyone will agree with me.  But that’s the beauty of libertarianism–if you really are stupid enough to believe that one can judge a doctor’s quality on the basis of certification, you are free to rely solely on doctors who have degrees from respected medical schools.

Beam also ignores the costs of certification—all the residents of poor neighborhoods who are deprived of medical services because the medical cartel has priced health care services at exorbitant levels.  Many ordinary procedures could be performed by people with nurse-level training, for instance.

Here is another critique of libertarianism:

[Penn] Jillette might choose his words differently today. Everyone knows going through airport security sucks, even without “porno- scanners.” But few dispute the need for some line of defense. More-efficient, less-intrusive security would be great. But none at all? Jillette’s tract is a good example of how libertarianism ventures down some fascinating paths but usually ends up deep in the wilderness.

Put aside the empirical question of whether airport security does more good than harm, which Beam doesn’t even consider.  The more serious problem is that Beam confuses libertarianism as a political philosophy with the personal preferences of individual libertarians.

I don’t know the optimal amount of airport security.  My hunch is that it is much less than we have now, but more that Jillette would prefer.  But all that’s irrelevant; the question is whether the market would provide the optimal amount of air security.  I’d guess the answer is no.  People are irrationally afraid of flying.  The data on the safety of flying are literally beyond human comprehension, like the time it would take to ride a bicycle to Pluto—even with terrorism.  But that means the market failure is probably too much security.  Adding the TSA just makes a small market failure into an even bigger government failure.

I’ll stop there, although the rest of the article is almost as bad.  It consists of the sort of counterarguments you’d get from someone who had heard about libertarianism in a bar, but had never actually bother to evaluate arguments showing the myriad ways in which seemingly well-intentioned regulations can actually do more harm than good.

More disappointing was the praise Beam received from normally level-headed Matt Yglesias:

I liked Chris Beam’s NY Mag article on libertarians, but I want to quibble with this:

“Yet libertarianism is more internally consistent than the Democratic or Republican platforms. There’s no inherent reason that free-marketers and social conservatives should be allied under the Republican umbrella, except that it makes for a powerful coalition.”

People, especially people who are libertarians, say this all the time. But we should consider the possibility that the market in political ideas works is that there’s a reason you typically find conservative and progressive political coalitions aligned in this particular way. And if you look at American history, you see that in 1964 when we had a libertarian presidential candidate the main constituency for his views turned out to be white supremacists in the deep south.

So Yglesias thinks the main problem was that Beam didn’t also tar libertarians with the brush of racism?  Why pick Barry Goldwater?  Wasn’t Calvin Coolidge even more libertarian?  He presided over a government that spent 4% of GDP.  Yet the deep south states were just about the only states that Coolidge lost in 1924.  And does Yglesias really believe that libertarianism would appeal to the sorts of people who favor Jim Crow laws?  Wouldn’t it make more sense to see where the votes came from for presidential candidates who actually were libertarian, rather than someone who was a hodgepodge of libertarian, conservative, and militarist views?  The best performance by a libertarian candidate occurred in 1980, when Ed Clark received nearly a million votes.  His strongest support came from socially liberal states like Alaska and California; he did relatively poorly in the south.

Of course any movement collects it share of undesirables.  One can find self-professed “socialists” spanning the spectrum of Nordic-style social democrats all the way to hard core totalitarian communists.  So in that sense Yglesias is correct, it is easy to find examples of unsavory libertarian individuals and unsavory libertarian arguments.  But surely he goes too far when he claims:

And this is generally how politics goes in most countries. You have a dominant socio-cultural group allied with the bulk of the business community, and you have a more diffuse “left” coalition of reformers associated with labor unions and minority groups. There’s nothing “inconsistent” about organizing politics this way.

There are two problems here.  First, there are many places, such as Eastern Europe and Russia, where politics split along libertarian/statist lines.  “Liberals” are socially liberal and free-market-oriented.  Conservatives are strongly religious, xenophobic, and anti-market   And even where the right is “pro-business” it often doesn’t favor free markets.  Italy is the classic case of a country that lacks a pro-market right, but to a lesser extent this is also true in Japan, France and Germany (excepting the Free Democrats in Germany.)  In Latin American the right has traditionally been very hostile to the free market, with the notable exception of Chile after 1975.  China also splits along statist/classical liberal lines.  In much of the world Yglesias would be voting for the more free market party.

Yglesias is partly right about the US, but less than he might think.  There have been only a few truly free market reforms in the US since 1975 (price and market entry deregulation, NAFTA, deep cuts in MTRs during the 1980s, welfare reform, immigration reform, banking deregulation, etc.)  All received extensive support from Democrats, often from liberal Democrats such as Ted Kennedy.  So there is actually very little evidence that the statism/free market divide is what separate American liberals and conservatives.   And on both social issues and foreign policy the libertarians are much closer to the Dems.

Yglesias frequently points out (correctly) that American conservatives don’t really act like they believe in small government.  So he’s previously bashed conservatives for not really being libertarian, and now he’s bashing libertarians for being too close to Southern conservatives.  Yes, Obama has pushed the libertarian movement further to the right, but they certainly didn’t feel they had a home in the big-government conservatism of George Bush.

Here’s how one might defend Yglesias’s argument.  A healthy libertarian movement is a sign of good governance in a country with lots of social conservatives.  Where you have bad governance (say lots of really stupid economic policies, and also laws that discriminate against various groups), the honorable opposition is called “liberal.”  When you have already achieved a free market economy and also eliminated most laws that discriminate against minorities, women, and gays, the remaining fight will be in a few areas;  income redistribution, environmental protection, and affirmative government intervention to help minorities.  In that policy environment the dogmatic conservatives will often line up with cultural conservatives who resent the “undeserving poor” getting handouts, and who have somewhat traditional or tribal views on cultural issues.  With enough infiltration from the right, you’ll even get some so-called “libertarians” rejecting libertarian policies like open borders.

The dogmatic and pragmatic libertarians should really be treated separately, as any generalizations directed at one group will be wholly inappropriate for the other.   It’s easy to make fun of the views of Ron and Rand Paul.  But I don’t recall Milton Friedman losing many debates over libertarianism.  Indeed I don’t recall him losing any.  If Christopher Beam tried to address the arguments of people like Friedman, Hayek, Brink Lindsey, or Will Wilkinson, he might have produced an article worth reading.

HT:  Tyler Cowen

From the comment section

In the spirit of giving, I’ll give my commenters a voice today.  Later I’ll comment on recent posts by Arnold Kling and Jim Hamilton.

Here is commenter Cameron:

I was actually able to find fed fund futures reaction to the December 2007 25 (rather than 50) basis point cut. The only problem : for some reason they only provide data on the January meeting outcome and not March (still, I’ll argue this data supports your point).

Here is a link to the data. You can download an excel file at the bottom for more detail.

Here are the probabilities for before and after the December meeting…
FF Rate – Probability on December 10 – Probability on December 11

3.50 – 18.7% – 6.5%
3.75 – 7.0% – 24.3%
4.00 – 40.8% – 40.1%
4.25 – 30.1% – 28.6%
4.50 – 3.4% – 0.5%

At first glance, it seems like after a disappointing 25 basis point cut markets simply swapped the chance of the FF rate being 3.5% in January to 3.75%. But the average expected FF rate actually stood still (fell very slightly actually). That should be surprising given that the Fed cut by less than expected. I think the markets thought that even though the Fed screwed up, they wouldn’t be willing to cut 100 basis points in one meeting. Beyond that though, they actually saw less of a chance of rates being 4.00-4.5% in January even though the rate cut was less than expected.

(In the end the rate ended up being 3% after the January meeting FYI!)

In another comment he pointed out that the Fed funds futures markets responded to the recent tax cut by signaling that policy tightening was more likely in 2011 (a fact that Paul Krugman war rightly annoyed by.)  This is one more  piece of evidence that one cannot estimate the fiscal multiplier without forecasting the central bank reaction.  Of course that doesn’t stop Keynesians from doing exactly that.

Here’s another Cameron comment, in response to a recent post where I discussed Tyler Cowen’s suggestion that the markets might not have taken seriously a Fed promise to target NGDP in the middle of a financial panic:

Reading this reminded me of this calculated risk post in December 2008 titled “What if the Fed had a meeting and no one cared?”

To this day I don’t think I ever remember people caring less about a Fed meeting. Of course it may have been because people were too focused on financial matters, but when the Fed surprised markets and cut to 0.00-0.25% rates (and also hinted at QE) the S&P rallied nearly 5%!

It’s hard for Avent and Cowen to imagine the Fed mattering because the Fed made it look like it didn’t matter. When the Fed actually started getting “aggressive”, markets pretty clearly did react, even to relatively standard policies. Imagine what would have happened if the Fed promised to target an NGDP growth path.

In my study of the 1930s I noticed that economists often overlooked important policy developments, but markets almost invariably did notice.  I guess things were the same in 2008.  Economists didn’t think Fed policy was important because their instincts told them it wasn’t important.  Markets understood that monetary policy can be important even during a financial crisis.

And here is a comment by Gregor Bush, also after my reply to Tyler Cowen and Ryan Avent:

I think you left out an important aspect of Sumnerism from this post, which is that the Fed rarely or never deviates from the Consensus of the profession. And the consensus of the profession was, and, amazingly, STILL is, that the Fed was a relatively unimportant factor in the downturn and that there is little that it can do now. An article on Bloomberg the other day showed that most Wall St. economists STILL thought that QEII had minimal effect (and others though it was a net negative) – despite the fact that these forecasters all were frantically marking up their forecasts due to a mysterious and completely unexplainable uptick in the economic data in the fall.

Again, just like the 1930s.

And here is fellow blogger Marcus Nunes quoting from a recent paper by Zingales:

This must surely qualify as one of the great ironies in recent economic history. The quote is from Zingales essay on EMH:

“In a 1999 article with fellow economist Mark Gertler, Bernanke analyzed the impact of monetary policy when prices move away from fundamentals. That this contingency was the object of their analysis illustrates how the EMH was losing ground. Their conclusion, however, was that the Fed should not intervene, not only because it is difficult to identify the bubbles but also because “our reading of history is that asset price crashes have done sustained damage to the economy only in cases when monetary policy remained unresponsive or actively reinforced deflationary pressures.”

He´s surely “The man who knew too much” but when the time came to apply his knowledge…he failed!

Yes, Bernanke and Gertler were exactly right; financial crises are only harmful to the macroeconomy when monetary policy fails, i.e. when it allows NGDP to fall at the fastest rate since 1938.

Arnold Kling recently criticized monetarists who focus on the equation of exchange:

1. Why did money and velocity move in opposite directions for the most part from 1980 – 2007? Beckworth’s answer is that the Fed did a great job of offsetting shocks to velocity. The answer that I would give (and I suppose James Hamilton is with me, although I do not want to put words in his mouth) is that nominal GDP was doing its own thing, so that when the money supply changed, velocity moved in the opposite direction. I would say that velocity was able to offset monetary shocks.

My first reaction was that I can’t imagine any plausible money demand function where NGDP “does its own thing” at positive interest rates, and I’d be utterly shocked if Jim Hamilton agreed with Kling (for the 1980-2007 period.   He might well agree for the period after the Fed started paying interest on reserves.)  And when I went over to Hamilton’s blog, I found my hunch was exactly right:

Now, I think it is true that, in normal times, nominal GDP is one of the most important determinants of the demand for M1 or the monetary base. In the absence of other factors changing these demands, there certainly is a connection between money growth and inflation, and you do find a correlation if you look at much longer horizons than the quarterly changes plotted above.

But conditions at the moment are far from normal. In particular, something quite remarkable has happened to the demand for the monetary base.  (Italics added.)

Kling linked to this post, so he must have read the passage I just quoted.  This raises the question of why Kling thought Hamilton would agree with him.  Perhaps I am mistaken, but whatever the truth it’s clear to me that Kling and I see this issue very differently, as I would have thought Hamilton made it quite clear he did not think NGDP did its own thing during normal times (i.e. when rates are above zero.)  Did I misread Hamilton?

Merry Christmas to my readers, and Happy New Year to those who don’t celebrate Christmas.  By the way, here’s an interesting fact:  In China, Christmas is a fun holiday where you go out and party.  New Year’s is a family holiday where you get together and exchange gifts.

It’s complicated

With all the grading I have to do I shouldn’t be posting.  But life doesn’t provide many opportunities, and my National Review piece has led a number of very smart bloggers to mull over my ideas, including Brad DeLong, Tyler Cowen and Ryan Avent.  So grading will have to wait.

I’ve noticed is that it’s easier to see flaws in others than to see one’s own flaws.  For instance, I think I can see flaws in Paul Krugman’s analysis of China’s predatory trade policy, or his analysis of why Japan got stuck in a liquidity trap.  But strangely enough, I have trouble find major flaws in my own arguments (although I certainly see some modest weaknesses.)

If I try to crawl out of my own ego and look at things dispassionately, then I need to take seriously an issue raised by not one but two highly respected bloggers.  I’m referring to a recent Ryan Avent post that favorably quoted a question Tyler Cowen recently asked me.   Here’s Ryan Avent, followed by the Tyler Cowen question:

At a recent dinner here in Washington, Mr Sumner discussed his views and took questions. One, from Tyler Cowen, struck me as more psychological than economic, and also as one of the most potent criticisms of the Sumnerian approach:

“Let’s say that at the peak of a financial crisis, the central bank announces a firm intention to target a path or a level of nominal GDP, as Scott suggests.  If everyone is scrambling for liquidity, and panic is present or recent, and M2 is falling, I wonder if the central bank’s announcement will be much heeded.  The announcement simply isn’t very focal, relative to the panic.  A similar announcement, however, is more likely to work in calmer times, as the recent QEII announcement has boosted equity markets about seventeen percent.  But for the pronoucement to focus people on the more positive path, perhaps their expectations have to be somewhat close to that path, or open to that path, to begin with.

(Aside: there is always a way to commit to a higher NGDP path through currency inflation, a’la Zimbabwe.  But can the central bank get everyone to expect that the broader monetary aggregates will expand?)

The question is when literal talk, from the central bank, will be interpreted literally.”

And here’s what Ryan Avent said immediate after the quotation:

Had the Fed said, in the thick of the financial crisis, that it would maintain NGDP growth at 5%, who would have listened? There was a palpable sense at the time that the economy was in need, first and foremost, of serious repair to the banking system. A bit later, op-ed pages rang with calls for fiscal stimulus, as pundits explained that in an atmosphere of panic monetary policy was impotent since no one would borrow at any interest rate.

After that, Avent becomes supportive of my critique of Fed policy.  And Tyler Cowen has also said some good things.  Nevertheless, I need to address an issue that two sympathetic critics see as one of the least persuasive parts of my message.  How can I overcome the fact that others see our flaws more clearly?  By relying on the fact that others also see our models less clearly.  My argument is sort of like a jigsaw puzzle, with many interconnected pieces in areas such as monetary theory, efficient markets, economic history, policy constraints, monetary transmission mechanisms, unconventional monetary instruments, reverse causation, etc, etc.  An outsider will usually fixate on a few notable aspects of the argument, and may not see the entire picture as a unified whole.  OK enough navel gazing, so how do I respond?  Let’s assemble some pieces:

1.  The NGDP and RGDP collapse, (at estimated monthly frequencies) occurred almost entirely between June and December 2008.  I argue that NGDP targeting could have prevented that collapse.

2.  I argue that the dramatic worsening of the banking crisis after Lehman was mostly endogenous, as sharply falling NGDP expectations one, two, and three years out reduced current asset prices, and made bank balance sheets deteriorate sharply.

3.  I argue that NGDP growth targeting might not have been able to arrest the sharp fall in forward estimates of NGDP, but that NGDP level targeting could have done so.

4.  I argue that the crucial errors were made before we were in a liquidity trap (i.e. when rates were still 2% in September and early October.)

5.  I argue that the financial crisis of September 2008 did not cause a stock market crash, as the markets expected the Fed to continue its multi-decade policy of keeping NGDP growing at about 5%/year.  If the markets had given up on the Fed in September 2008, they wouldn’t have waited until October to crash.

6. I argue that stocks crashed 23% in early October on little financial news.  Instead, there were ominous reports of rapidly falling orders all over the industrial world.  Markets then sniffed out Fed passivity, a failure of the Fed to do what it takes to maintain the Great Moderation.  They became demoralized.

7.  I argue that the only significant Fed policy during the October crash was the IOR program, which was termed contractionary by leading monetary economists such as Robert Hall and Jim Hamilton.

8.  I argue that the Fed has many powerful tools even when rates hit zero, and even when the banking system is near collapse.  I cited FDR’s 1933 policies as a precedent.

9.  I argued that the recent market response to QE2 shows that monetary policies are powerful at the zero bound, and work through expectations channels.

10.  I argued that the failures of Fed policy in September 2008 were a clear example of the superiority of forward-looking monetary policy over backward-looking monetary policy.

11.  I argued that the Fed could have prevent the extraordinary increase in real interest rates on 5-year TIPS during July to November 2008 (from 0.6% to 4.2%) if it had moved aggressively.  This would have also prevented the sharp increase in the foreign exchange value of the dollar, something almost unprecedented in a financial crisis.

12.  I noted that many contemporaneous observers felt the Fed was powerless to arrest the 50% fall in NGDP during the early 1930s, because of financial panic.  Today much of the profession (including Bernanke) has accepted Friedman and Schwartz’s revisionist view that it was possible for the Fed to arrest that decline in NGDP.  But they don’t think the Fed could have done much in late 2008, under very similar circumstance.

13.  I’ve pointed out that cutting edge research in macro (i.e. Woodford) suggests that the most powerful determinant of current movements in AD is future expected movements in AD.  So if the Fed could credibly commit to boost AD when the banking crisis was over, it would have sharply boosted AD while the banking crisis was still going on.

14.  I’ve argued that even if banking problems are a real problem, and could not be papered over with more money; falling NGDP was also most certainly something that would reduce RGDP, above and beyond any decline due to banking.  Sharp declines in NGDP don’t suddenly become harmless when the economy has other problems, just as a knife wound doesn’t become harmless just because the patient also has pneumonia.

15.  I’ve argued that the banking problems of 2007 morphed to a NGDP crisis (needing different treatment) without the profession knowing it.  Just as my cold of last week morphed into bronchitis this week (again needing different treatment.)

16.  I’ve argued the Fed can tell right away if its policy has worked (in the TIPS markets) or if more is needed.  Contrary to what 99.9% of economists believe, there is no “we need to wait and see if it’s working” problem in monetary and fiscal stimulus.

I guess 16 is enough for now.  Now let’s see how this relates to Tyler’s argument.  Tyler asks how we can realistically expect markets to be convinced by aggressive Fed action in the midst of the banking crisis.  One response is that the banking crisis was caused by tight money.  Another response is that markets didn’t need to be convinced in the midst of the banking crisis (when stocks weren’t falling that sharply), but rather in the first 10 days of October, when the stock market did crash.  And I am arguing that the stock market crashed in part because of a growing realization that policymakers would not do anything to arrest the decline.  This does not mean each trader has a fully formed model of monetary policy in his or her head, much less my model.  That’s not how markets aggregate information.

Here’s an analogy.  I’ll bet you’d find more people on Wall Street who disagree with my views on the miraculous ability of QE2 to boost asset prices, than you would people who agree with my views (if you interviewed them.)  But in September and October the markets acted as if I am right.  FDR was hated by Wall Street, and all the business press thought the 1933 dollar devaluation was a horrible idea.  But asset markets soared on the news.  Money talks, and very loudly.

It’s hard to emphasize enough how un-radical the Fed’s QE2 policy really is.  It’s ultra-cautious.  They are buying some T-notes, with modest price risk.  That’s an open market operation.  They deliberately passed over all sorts of “nuclear options,” including a higher inflation target, or level targeting, or negative IOR.  And yet the markets still became totally obsessed with Fed rumors during September and October of this year.  Admittedly the news backdrop was more intense in late 2008, but not all the time.  Here’s Ryan Avent:

People remember the sharp decline in share prices in September and October of 2008, but from the end of 2008 until March of 2009, the Dow fell by a third. Ben Bernanke didn’t need to get everyone’s attention on September 15, 2008, or even that particular week.

I’d go further, there were plenty of slow news days in October when the Fed could have electrified the markets.  I know I’m going to be ridiculed for this, but what the heck.  I recall seeing Jim Cramer on TV one morning (in October 2008 I believe) and he was utterly despondent.  Why?  Because the Brits had cut rates sharply, initially leading to hopes on Wall Street that the ECB would do the same later in the morning.  But then the ECB made  a weak move, and US markets fell sharply on dashed hopes.  Cramer seemed forlorn, and berated the ECB.  If even Jim Cramer is grasping for straws from ECB rate decisions on national TV, just imagine the reaction to the United States Federal Reserve doing something bold.

If I were to critique my argument it would be as follows.  The Fed is what it is, a large bureaucratic institution.  I naively thought they could handle this sort of crisis.  Krugman correctly predicted they could not.  So there is a sense in which Tyler in right.  I may have been asking for something that the Fed simply wasn’t set up to do.

My response would be to go back and look at the 1930s.  You could argue that the Fed of the early 1930s wasn’t institutionally set up to prevent the sort of fiasco that we actually observed.  But we learned from that mistake.  And the Fed changed in ways that make another 50% fall in NGDP almost inconceivable.  So that’s progress, and we have Friedman and Schwartz to thank for that progress.

So maybe I was wrong that the Fed was implicitly targeting NGDP during the Great Moderation at roughly 5% growth.  And maybe Tyler’s right that it would not have been credible for them to suddenly start doing so in the midst of the banking crisis.  I’m still not convinced, but maybe he’s right.  Then my fallback is that I’m already fighting the next battle, we need to learn lessons from this fiasco that are analogous to the lessons we learned from the 1930s.  So that next time we’re near the zero bound everyone knows the Fed plans to immediately shift to NGDP targeting, level targeting, with a catch up for any near term undershoot.  Even better, let’s shift before the next crisis.  If we can learn that lesson from this crisis, we can make the next crisis even smaller.  (All battles over economic history are disguised battles over current and future policy.)

PS.  When I saw Jim Cramer I said to myself; “Even he gets it.  He understands the need for more monetary stimulus.  Why can’t Bernanke and all the other elite macroeconomists see the same thing?”  (I hope the term ‘even’ didn’t come across as condescending, but you know how academics look down on the shouters and the showman.)

PPS.  I still plan to say something more about Tyler Cowen’s longer critique, when I have more time.

HT:  Marcus Nunes

How did Don Luskin get so smart?

Josh Hendrickson sent me this Youtube video on Don Luskin defending QE2.  I won’t say; “I couldn’t have put it better myself,” the fact is that I couldn’t even have put it as well myself.  If you are not interested in his defense of supply-side economics, skip ahead to the 5 minute point.

Luskin nails one point after another:

1.  QE2 was needed as the economy showed all sorts of signs of sluggishness in the summer.

2.  QE2 is working because asset prices (stocks, TIPS spreads) responded strongly to rumors of QE2 that began in late summer.

3.  The rise is interest rates is actually a good sign, indicating that inflation expectations are moving closer to an appropriate level, and real growth expectations are increasing.

4.  Money was actually too tight during the summer, despite near zero rates.

5.  Milton Friedman pointed out that nominal rates were an unreliable indicator of the stance of monetary policy.

6.  Luskin said you must look at other indicators, and they all showed money was too tight.

7.  QE2 is very consistent with laissez-faire economics, as we don’t want the Fed to maintain a steady interest rate or money supply, but rather to provide enough money to generate a stable macro environment (dare I say NGDP) for companies to operate in.

Back in late 2008 I never heard that sort of talk on TV.  Indeed that’s the main reason I got into blogging; frustration over the conversation of pundits, which seemed to be ignoring the elephant in the room.  If I knew pundits were going to get so smart I might have stayed out of blogging.  It turns out I wasn’t needed.

PS.  It took me one year to figure out how to post graphs on my blog.  Perhaps in another year I’ll learn how to directly post YouTube videos.

PPS.  Tyler Cowen has a very generous post on my NGDP targeting talk.  I will definitely comment at some point, but am too busy with grading right now to give it the attention it deserves.  Meanwhile, help me think up titles;  “Wittgenstein and me”?  I will also eventually comment on his recent inequality article, but that may take even longer.

PPPS.  Luskin also supports the “tax cut.”  I get annoyed by progressives always talking about how the Clinton-era top rate (39.6%) was fine.  Maybe so, but then why don’t they support this “tax cut,” which will return the top rate to 38.8%, once the health care tax kicks in?