For readers who don’t already know this, my new blog is over at Substack:

scottsumner.substack.com

This will be my final Money Illusion post. The blog began on February 2, 2009. But the events that led to the blog took place in late 2008. Indeed my life can be divided into two segments, before and after September 16, 2008. It was that specific Fed meeting that radicalized me, and which led me to create this blog.

Originally, I planned to go back and review my first few posts, to see how they compare to my current views. I’ve decided to do that on September 16th, over at my new blog. That’s the 16th anniversary of a Fed meeting that Ben Bernanke later described (in his memoir) as a mistake:

At the end of the discussion we modified our planned statement to note market developments but also agreed, unanimously, to leave the federal funds rate unchanged at 2 percent.

In retrospect, that decision was certainly a mistake. Part of the reason for our choice was lack of time—lack of time in the meeting itself, and insufficient time to judge the effects of Lehman’s collapse.

I’m not going to thank all the people that helped me along the way, as I’m so forgetful I’d leave out lots of names. The general categories include the other market monetarists, other bloggers, my commenters, my colleagues at Bentley, and my wife and daughter (who had to sacrifice when I devoted too much time to blogging.)

Special thanks to Joe Weisenthal, Derek Thompson, Matt Yglesias and of course Tyler Cowen, who made September 13, 2012 the high point of my life, at least from a career perspective. And yes, the praise was excessive. (Today, that era seems a bit unreal, like another life.)

And thank God we market monetarists were able to come out ahead in our debate with the Keynesians, who predicted that (due to fiscal austerity) spending would slow sharply in 2013. It accelerated.

I also have regrets; most notably that the blog’s tone has often been too critical of people with whom I disagree, including other bloggers and policymakers like Ben Bernanke.

This blog has obviously deteriorated over time. That’s partly because the world situation has become fairly bleak. My whole adult life, I’ve strongly opposed the twin evils of socialism and nationalism. Unfortunately, the world has seen a modest resurgence in socialism and a big increase in nationalism over the past 15 years. This may have contributed to my more pessimistic tone. Burn out. Note that in some of my early posts, I pointed to the fact that previous NGDP collapses such as 1929-33 had also had this effect.

In my new blog, I hope to make the tone more upbeat and I will try hard to improve the quality. I hope to see you all there.

In the mid-1990s, the consensus view was that central banks should target inflation at 2%. Then in the late 1990s, a light rain of “magic dust” descended on the islands of Japan. The dust made people passive and fatalistic, and the economists there suddenly forgot how to create inflation, a previously inconceivable development.

At the time, Western economists were stunned. “What’s wrong with the Japanese? Why don’t they just do X, Y and Z?”

A decade later, the same magic dust fell on North America and Europe (fortunately the southern hemisphere was spared.) Now Western economists forgot how to create inflation. They began to claim that it was impossible when interest rates were zero.

A few lonely economists had a genetic mutation that made them immune to the effects of the magic dust. They wondered why economists had changed their minds about the efficacy of monetary policy. After all, the Fed and ECB had also failed to do X, Y and Z.

Another decade went by, and the effects of the magic dust began to wear off. The next time deflation threatened in an environment of zero rates, central banks began doing some of the X, Y, and Z that they had recommended to the Japanese a few decades earlier, And it quickly created lots of inflation.

A recent Bloomberg article suggested that we may be moving toward a regime characterized by fiscal dominance, at least part of the time:

In their paper, three economists from New York University, Stanford and London Business School argue that the US is moving from a regime of “monetary dominance” to one of “fiscal dominance.” In the former, the Fed controls inflation by adjusting short-term nominal interest rates. The government supports these efforts by committing to increase future taxes, ensuring that other interest rates don’t change too much and debt doesn’t overwhelm markets. Under a monetary dominance regime, interest rates and inflation are low and relatively stable.

I don’t agree with the claim that monetary dominance implies low and stable interest rates or inflation. We clearly had monetary dominance in the 1960s and 1970s, when budget deficits were small as a share of GDP. And yet inflation was high and unstable. Both in the Great Inflation, and in the more recent bout of high inflation, the problem was the Fed’s misguided belief that easy money is a good way to create jobs.

The regime changed during and after the pandemic, when wartime-sized debt was issued with no care of paying it back. . . . Under such a [fiscal-dominance] regime, the Fed is less powerful.

I wouldn’t say the Fed “manages” bouts of inflation, as that term makes them seem like an innocent bystander. The Fed created the high inflation of 2021-22 with a highly expansionary monetary policy. And the Fed was no less powerful than before, as it had plenty of “ammunition” to adopt a tighter monetary policy if it had wished to.

Not only is its job harder, but its tools are less powerful — it has less influence over interest rates.

Its power doesn’t come from control of interest rates; it comes from control over the gap between the target rate and the natural rate. And it has just as much power over that gap as before deficits became large.

After spending moderated and monetary policy became more restrictive, the US returned to a monetary policy regime. But the nation’s debt trajectory risks a future turn to fiscal dominance.

It moderated only relative to the Covid period. In absolute terms, fiscal policy is currently highly irresponsible, especially if compared to the Great Inflation of 1966-81. If the fiscal dominance model were true, the US would currently be experiencing very high inflation. On the other hand, I agree that our current path does impose at least some risk of slipping into fiscal dominance. That’s what tends to happen in banana republics.

Fiscal policy, which has become more ambitious in recent years, is finally doing the job it’s supposed to do. Both parties have been vocal in supporting policies that aim to shift production from services to manufacturing, either through tariffs or with industrial policy. There are also goals related to improving infrastructure, lowering the cost of housing, and reforming the immigration system. These policies change the supply side of the economy . . .

In a recent Econlog post, I pointed out that tariffs might end up shifting output toward services, by increasing the relative price of manufactured goods. (Tariffs might reduce the trade deficit, but probably won’t.) And those three goals sound fine, but I don’t see much action.

Matt Yglesias directed me to this tweet:

If you looked at certain polls, you’d think the economy was doing poorly. On the other hand, if you looked at state economic performance polls, or polls asking about an individual’s personal financial situation, then things look far better. But one thing is clear—the US is outperforming the economies of other developed countries by a fairly wide margin. Why is that?

Let’s start with the macro. I think Pethokoukis somewhat overstates the supply shock and monetary headwinds. As you know, interest rates don’t matter. The thing that does matter (NGDP) has been a headwind, not a tailwind:

The growth rate has recently slowed, but remains well above the pre-Covid norm.

There were some supply shocks in 2022, but the energy situation is now pretty good, and many other supply line bottlenecks have been resolved. On the plus side, a big surge in immigration has added substantial labor force supply (even with the recent downward revision.)

At the micro level:

1. We have less regulation in some key industries like fracking, and this has boosted our GDP relative to Europe.

2. We have gains from agglomeration and network effects. When combined with an inflow of many highly talented individuals, this has led us to vastly outperform our rivals in high tech.

3. We have our Nimby problems, but in much of America it’s still pretty easy to build. Densely populated Japan and Europe (especially the UK) probably have more restrictions on building.

Note that all three of these micro factors are things that have become much more important over the past 10 or 20 years. And this roughly corresponds to the period when Europe stopped catching up to us and began falling further behind.

I’ve been amazed by the response to Russia’s invasion of Ukraine. The most militarily expansionist leader since Hitler and Stalin starts a war that threatens to spiral out of control. He leads a country with enough weapons to destroy most of the US population. He threatens to use nuclear weapons (and is scolded by China for doing so.) And in response we are told by our foreign policy establishment that “China is the real threat”.

A recent podcast provides some interesting historical parallels:

Jordan Schneider: Then in the 1980s, the concern was that Japan would overtake the US. David Halberstam — author of The Best and Brightest and Breaks of the Game — wrote in 1983 that Japan’s industrial ascent was America’s most difficult challenge for the rest of the century and a “more intense competition than the previous political-military competition with the Soviet Union.”

There was a deep consensus within the American body politic that America was losing the technological future and long-term productivity race to Japan. What didn’t Japan get right?

Jeffrey Ding: This was a very real threat in the eyes of the US. Henry Kissinger wrote an op-ed in The Washington Post saying that Japan’s economic strength and rise in high-tech sectors would eventually convert into military power and threaten the US. A poll in the late 1980s found that more Americans were worried about Japan than the Soviet threat to US national security.

The trend that I see so clearly with all these historical examples is the US overhyping other countries’ scientific and technological capabilities. One reason we do that is because we don’t pay as much attention to diffusion capacity.

Japan was the real threat, not the Soviet Union?? Americans seem to have a deep-seated need to see Asians as the “real threat”, not Europeans. Recall the ethnic group that FDR put in concentration camps back in 1942.

Later, Ding points out that it’s not easy to determine what strategy toward China is best, even if we accept the premise that it is a threat:

Jeffrey Ding: We have shifted so far in the direction of US national security interests and the need to beat China in all these different forms of competition. The biggest risk is if China overtakes us on something, whether militarily, economically, or by soft power.

I’m not sure where I stand on this, but why are we not considering that the biggest national security risk for the US is a weak China and a China that can’t sustain its growth? For the longest time that was US State Department policy. A strong China is good for peace.

All this self-flagellation that’s been coming out in terms of China’s AI sector has been overhyped. China could also suffer economic stagnation. What would the national security consequences be for the US? They might not be good.

It’s not even in the Overton window. We’re not even talking about it anymore in Washington.

To be clear, both Schneider and Ding see China as a serious threat. Please read the entire interview. But at least they seem to have some historical perspective that is lacking in most other commentary on the issue.