In the basic New Keynesian model the Fed is seen as something like a ship’s captain, which steers the economy between the twin dangers of recession and high inflation.  They do so by controlling aggregate demand.

It’s not  surprising that many people don’t see the Fed that way; after all, few people bother to follow monetary policy very closely, and indeed few even understand it very well.  But I’d like to argue that the problem is getting worse, that people who should understand have become confused.  And I’d like to suggest that fiscal stimulus played a role.

In my view the key mistake occurred in early 2008, when the Bush administration called for fiscal stimulus in the form of tax rebates.  Recall that lump sum tax rebates have no supply-side effect, so this was pure demand stimulus.

The Bush policy made no sense, and yet very few people pointed that out.  Some conservatives argued against it on “permanent income hypothesis” grounds.  That may or may not be correct (it’s probably partly correct) but in fact it was an extremely damaging argument.  The problem with the conservative argument against fiscal stimulus is that it created the impression that more demand was desirable, and that tax rebates were a bad idea for the reason that they’d fail to boost demand, not because no extra demand was needed.

Here’s the argument the conservatives should have made:

The Fed is responsible for controlling aggregate demand under our system.  They’ve been given to duty to set demand at a level most likely to hit the dual mandate.  If there’s a problem, we need to reform the Fed, or change the mandate.  Fiscal stimulus makes no sense, as the Fed will simply offset the policy with whatever monetary policy is most likely to hit their demand target.  Congress should never, ever, vote for fiscal stimulus, rather they should vote to change the Fed’s mandate.

However almost no one made this argument, and thus the damage was done.  Both sides of the debate implicitly acknowledged that if growth was needed; that “it sure would be nice if the fiscal authorities could provide some.”  Yes, they disagreed over the factual issue of whether fiscal stimulus worked, but that’s a side issue.

The effect of the debate over Bush’s fiscal stimulus was to marginalize the Fed in the minds of the People Who Matter.  Who are the People Who Matter?  They are a collection of academics, reporters, think tank people, politicians, Fed officials, big bankers, and various other groups that participate in the debate over monetary policy.  After the Bush tax rebate the Fed stopped being thought of as the institution that steers the economy, or at least that steers AD.  But the Fed must have some important role, so if they aren’t a ship’s captain, what are they?

Several years later progressives discovered to their dismay that the Fed had become a sort of firefighter.  If it’s not the Fed’s job to insure adequate AD, and they clearly have a major role to play, the most obvious alternative is firefighter—the agency that puts out inflationary fires.  Notice I don’t say “target inflation,” as that would imply they want to raise inflation 50% of the time and lower inflation 50% of the time.  No, they became an anti-inflation institution.

I think this occurred for two reasons.  First, in the Keynesian model inflation is caused by growth.  If it’s the fiscal authority’s job to spur growth through tax rebates, then the Fed would seem to have no role in raising the rate of inflation.  They sit back and wait for “inflation to become a problem” and then leap into action like firefighters.  Don’t believe me?  OK, do this test:  Count the number of times “inflation becoming a problem” is used in the press over the past few years, or even the past few decades.  Then count the number of times the reporter was referring to excessively high inflation and the number of times the reporter was referring to excessively low inflation.  I’d guess the numbers would be roughly 100 to 1.

Conservatives may pay lip service to “stable prices” but in practice they never want higher inflation, even when there is deflation.  Why is that?  Because when there is deflation (1930-33, and 2009) interest rates tend to fall to zero and people hoard lots of money.  To most conservatives that looks like easy money.  And that’s an “inflationary time bomb” waiting to explode (or course it isn’t really, as we see in Japan.)  So even though in principle some conservatives might favor easy money to prevent deflation, in practice they don’t.  The Fed is a firefighter, nothing more.  Hence if I propose 5% NGDP targeting, a policy roughly followed for several decades, they become apoplectic about “inflation.”

Why did I pick on the Bush stimulus; why not the bigger Obama stimulus?  I wanted to pick a time period when the economy was clearly not in any sort of liquidity trap, in order to show that the zero bound isn’t the real problem.  Everyone knows that if fiat money regimes really want to inflate, they can find a way (well perhaps everyone except MMTers.)  The zero bound isn’t the issue.  The real problem is that we stopped thinking about the Fed as a ship’s captain, and started thinking of it as a firefighter.  And now we are asking the Fed to stop being a firefighter.  And that a terrifying prospect for many people, even many of the People Who Matter.

In late 2008 it was frustrating to hear all the triumphal statements from leftists about the failure of neoliberalism, the failure or of market fundamentalism, the failure of deregulation.  Of course the real problem was the tight money policy of the Fed, which caused NGDP to fall rapidly.

Now the progressives are getting a taste of their own medicine.  Just as the 2008 crash did look (at first glance) like a failure of capitalism, the 2011 euro collapse looks (at first glance) like a failure of the European big government welfare state model.  Here’s Paul Krugman fighting a losing battle:

What a tragedy. A rich, productive continent, which has produced arguably the most decent societies in human history, is tearing itself apart because its elite insisted on embarking on a dubious monetary project, and now can’t bring itself to take the steps necessary to give that project a chance of working.

He may be right about the virtues of Europe.  But take it from me, trying to sell that argument at a time like this is like trying to hold back the tide.

In reality, the US banking model was flawed.  It made no sense to deregulate the asset side of bank balance sheets as we were backstopping the liability side.  And in reality, the Greek and Italian and Irish governments made a lot of poor choices.  But capitalism works pretty well, as does the Northern European welfare state.  In both cases tight money made some very real problems seem much worse than they actually were.

The majority view will always be the common sense view.  When that view is wrong, there’s not much you can do except keep plugging away, and hopefully convince historians to re-write the history books a couple decades later (as Friedman and Schwartz overturned the original view of the Great Depression)  That original view was that the Great Depression represented a failure of capitalism.  Now it’s understood to be a failure of monetary policy.

Plus ca change . . .

Most people agree that the Fed is a conservative institution. But conservative in what sense? Temperamentally, or ideologically? A temperamentally conservative Fed is reluctant to go out on a limb and try new techniques. An ideologically conservative Fed abhors greater than 2% inflation in much the same way that a vampire abhors sunlight. It turns out that it matters a lot whether the Fed is temperamentally conservative, ideologically conservative, or both.

In recent posts, Ryan Avent and Matt Yglesias have criticized the widespread view among Keynesians that the Fed is out of ammunition. People like Larry Summers are skeptical about whether the Fed could stimulate the economy, because doing so would require them to boost inflation. These Keynesians have tended to recommend fiscal stimulus as the only way to boost aggregate demand.

In my view there are two flaws with this argument. First, some Keynesians seem to believe that fiscal stimulus can work without raising inflation expectations, whereas monetary stimulus is only effective at the zero bound if the Fed succeeds in convincing the public that higher inflation is on the way.  But both fiscal and monetary policy work through higher AD.  And unless the SRAS curve is completely flat, higher AD means higher inflation. The markets know this; hence fiscal stimulus will be expected to work if and only if it boosts inflation expectations.  Yes, the early Keynesians believed the SRAS was flat when the economy had lots of slack, but after watching how sensitive oil prices are to growth expectations, I can’t imagine that anyone still believes in a flat SRAS curve.

So if fiscal stimulus is to work, it must boost inflation expectations. This is why we need to know the Fed’s motives. Will the Fed attempt to squash the higher inflation resulting from fiscal stimulus, or will they allow inflation expectations to rise?  Most Keynesians seem to have assumed the Fed was temperamentally conservative. That they were reluctant to make the sort of bold moves required to boost AD at the zero bound, but wouldn’t stand in the way of fiscal stimulus. And in fairness, there are statements by Bernanke that seems to support that assumption. But the actions of the Fed strongly suggest otherwise. Consider Fed policy since 2008:

1. The Fed started paying IOR for the first time in its history.

2. The Fed got involved in bailing out the banking system to an unprecedented extent.

3. The Fed got heavily involved in buying MBSs (QE1)

4. The Fed did QE2, with longer term bonds

5. The Fed did Operation Twist

That doesn’t seem like a timid or cautious Fed to me, that seems quite aggressive. Not at all temperamentally conservative. Now let’s consider evidence for ideological conservatism. Here’s Ryan Avent:

According to the Cleveland Fed’s estimates, 10-year inflation expectations haven’t risen above 2.1% since the end of 2008. At least three times during that span, the Fed has halted or reversed its easing, first by ending its initial asset purchases, then by allowing its balance sheet to contract naturally as securities matured, and then by ending the asset purchases known as QE2. Expectations have remained in check because the Fed has opted not to continue policies that would raise them. The myth of Fed helplessness is just that.

I think that’s exactly right. Ryan is describing a temperamentally ambitious Fed willing to try all sorts of unconventional policies, but which pulls back whenever inflation threatens to exceed 2%. My question to the Keynesians is:

How does fiscal stimulus overcome an ideologically conservative Fed?

I think they have in mind a scenario where the Fed won’t take affirmative moves to kill a recovery, such as raising interest rates. And that may be right. (We’ll see when we actually get a recovery—the FDR-era Fed, the BOJ, and the ECB all raised rates prematurely.) But that’s not the right question. The problem is that the Fed needs to do extraordinary things just to keep inflation from falling well below 2%. And it seems like when inflation rises to 2%, they stop doing those things. That’s ideological conservatism. It may be unintentional on the Fed’s part (I believe it is unintentional on Bernanke’s part) but it means the Fed is not just failing to do its part, it’s actually sabotaging fiscal stimulus.

PS. I’d also note that with an ideologically conservative Fed the most effective fiscal policies (for reducing unemployment) are not at all what progressives would like.  You’d need to lower employer-side payroll taxes, lower minimum wages, cut back on the maximum duration of UI benefits, in order to shift aggregate supply to the right. It’s interesting that a Fed dominated by Republicans does policies that make conservative fiscal policy the only effective option. Morgan Warstler’s fantasy.

Here’s a story on found on Tyler Cowen’s blog:

They are a cornerstone of Chrysler’s unlikely comeback: 900 employees turning out a Jeep Grand Cherokee sport utility vehicle every 48 seconds of the working day at an assembly plant here.

Nothing distinguishes them from other workers at the Jefferson North plant, except their paychecks. The newest workers earn about $14 an hour; longtime employees earn double that.

…the advent of a two-tier wage system in Detroit is spiking employment for one of the country’s most important manufacturing industries.

Here’s what we know for certain about the US business cycle:

1.  If nominal wages are highly sticky, then NGDP slowdowns will raise unemployment.

2.  Nominal wages are highly sticky for at least some workers.

3.  The period after mid-2008 saw the largest NGDP growth collapse since the Great Depression.

4.  The period after mid-2008 saw a huge rise in unemployment.

Here’s what we don’t know:

1.  Why didn’t Chrysler cut all wages to $14?  Fear of strikes?  Efficiency wages?

BTW, I do realize that long time employees are more skilled on average.  But that sort of huge pay gap didn’t exist in the 1960s or 1970s, and thus I think we can assume at least a big part of it is “artificial” in some sense.

Marxists would argue that further pay cuts for infra-marginal workers would merely raise profits.  I believe some of the money would go to extra employees.  And as Nick Rowe showed, in the public sector all of it could go to additional jobs.  I’d also note that health care is practically the public sector.

In an earlier post Tyler Cowen asks this question:

1. For how long “” in today’s America “” can an AD-driven recession last?  At what point do even the Keynesians toss in the towel and say “By now it is a growth and structural problem, not mainly AD”?  After all, the private sector had a chance to create more M2 and it failed.  How sharp is the distinction between the short run and long run?

Great question.  If I were forced to argue against my theory of the recession in an Oxford debate, my top three arguments would be:

1.  Natural rate hypothesis.

2.  Natural rate hypothesis.

3.  Natural rate hypothesis.

It’s a great model, I believe in it, and it suggests nominal shocks shouldn’t last for more than a few years.  I’ve already argued for the “entanglement theory” of this recession (between structural and AD factors), but let me provide three reasons why I think that monetary stimulus would help three years after the 2008 crash, but would not have helped (much) three years after the mid-1981 collapse in NGDP growth:

1.  The problem of 99 week extended UI benefits.  Powerful monetary stimulus would lead to a quick repeal.

2.  The problem of money illusion.  It’s much easier to slow the rate of increase in nominal wages, than to cut wages outright.  In 1982 we needed to slow the rate of increase in wages.  Now we need to actually cut many wages, which is far harder even if the consequences for real wages are exactly the same.  After I made this comment in a previous post lots of commenters wrote in trying to provide a rational explanation for worker reluctance to accept nominal wage cuts.  I thought all their arguments were bogus, and it just confirmed my view that money illusion exists.  My commenters are really smart.  If even they have money illusion I think it’s safe to assume the broader public does as well.

3.  The problem of reallocation out of fields like housing.  More NGDP would reduce the debt burden and raise real housing prices.  This would reduce unemployment caused by construction workers having a hard time finding other jobs.  Of course I’ve argued that housing is not the main problem with the recession, but it is a problem.

None of these applied to the 1983-84 recovery, which was the best example of the natural rate in action.  The UI wasn’t raised from 26 to 99 weeks, there was higher trend inflation, and hence less need to cut nominal wages, and there was no big housing/debt crisis.  Even the minimum wage situation was slightly different.

I would take Tyler Cowen’s challenge, and direct it at Keynesian fiscal policy advocates.  Originally fiscal policy was justified on the basis that NGDP was growing slower than Ben wanted, but Ben would not fix the problem on his own.  On the other hand, he wouldn’t stop fiscal stimulus from fixing it.  I never quite bought the argument, although I find it defensible.  But for how long?  After all, it is a fairly convoluted way of looking at monetary policy, isn’t it?  Is it still true?  Is monetary policy still not reacting at all to NGDP growth trends?

PS.  I don’t follow Tyler’s M2 comment.  I think he means NGDP.  But the private sector can’t create NGDP, only the Fed can.  And they haven’t created enough to support many jobs without massive wage cuts.  And it’s hard to cut wages, as we’ve seen at Chrysler.

When I began blogging in early 2009 I made a number of claims that seemed almost preposterous.  One of those was the claim that people had reversed causation; the housing crisis didn’t cause the recession, it was mostly a product of the recession.  This seemed crazy, as the housing crisis began well before the recession.

I distinguished between two phases of the housing crisis.  The first phase occurred during 2006-08, and was concentrated in the 4 subprime states.  It did lead to a modest slowdown in growth, and unemployment rose from 4.7% in January 2006 to 4.9% in April 2008.  But nothing severe.  The second phase of the housing collapse was much more severe.  When NGDP started falling rapidly due to tight money, housing prices fell all across America.  This triggered the severe banking crisis of late 2008, and was associated with a worsening of the recession—unemployment reached 10.1% by October 2009.

Day by day, month by month, opinion is imperceptably shifting in my direction.  Indeed so much so that a news article that basically proves my point seems to have elicited little surprise.  “Of course a severe recession would hurt the housing market.”

Let’s consider the original conventional wisdom, and then my heretical view of early 2009.

1.  The conventional wisdom was that we built way too many houses, and that the housing slump was a hangover from this effect.  If true, housing construction over the past 10 years ought to have been way above normal.  In fact, it has been way below normal.  Which leaves the puzzle of why we have so many empty houses.

2.  My view was that the severe recession greatly reduced the demand for housing.  Since very few Americans are homeless (in percentage terms), a reduction in demand for housing should imply an increase in average household size.  And that’s exactly what we’ve seen:

The number of people living under one roof is growing for the first time in more than a century, a fallout of the recession that could reduce demand for housing and slow the recovery.The Census Bureau had projected the average household size would continue to fall to 2.53 this year. Instead, the average is likely to hit 2.63, a small but significant increase because it is a turnabout.

“A funny thing happened on the way to the future” says Arthur C. Nelson, director of the Metropolitan Research Center at the University of Utah. “Household size increased.”

.  .  .

USA could end this decade with up to 4 million excess housing units because of the reversal in household size, he says.

A key factor: “The Great Recession has forced doubling up among both family and non-family members,” Nelson says.

Multi-generational households are on the rise: 49 million, or 16% of the population, live in a home that had at least two adult generations in 2008. In 1980, there were 28 million, or 12%.

According to a recent Pew Research Center report, the growth is due to demographics, cultural shifts and high unemployment.

“I think it’s the young adults,” says Dowell Myers, housing demographer at the University of Southern California. “Residential mobility has slowed down and when it slows down, they’re back in their parents’ houses or living with roommates.”

Household size began inching up in 2005, before the recession, a trend that might have been driven by the real estate boom that made housing unaffordable to many. Now, it’s more likely to be caused by the poor economy.

“There are a lot of trends going on,” Nelson says. Among them:

– Older Americans.They’re moving in with children and grandkids and vice versa. About 20% of people 65 and older live in multi-generational households

– High unemployment. It’s keeping young adults out of the job market and back home with their parents.

“Clearly, a lot of people are not forming households when they’re getting out of school,” says Karl Case, economics professor at Wellesley Collegewho helped create the Standard & Poor’s/Case-Shiller Home Price Index.

It’s not just that people are not buying homes. They’re not renting either, a sign that more people are squeezing into one unit.

“I can document this with my own students,” Case says. “Rental vacancy is the highest it’s ever been.”

– Immigrants. They have higher fertility rates and a cultural acceptance of extended families living together. Despite a decline in the influx of Hispanics since the economy soured, household size inched up.

“It’s going to have huge implications for the housing market,” Nelson says.

If it lasts. Many economists and demographers are convinced that as soon as the recession ends and jobs open up, Americans will return to their old ways. “I see it as temporary,” Myers says.

“The economy is the most important thing,” says Stephen Melman, director of economic services at the National Association of Home Builders. “Projecting lifestyles is a really tricky business.”

Hayek warned that if the Fed let NGDP fall you’d get a “secondary deflation.”  And that’s exactly what we got.   The first (small) part of the housing crash was a necessary adjustment.  The second much bigger part of the collapse was clearly the result of tight money reducing NGDP.  NGDP is the money people have to buy houses—it’s national income.  With less NGDP there will be less demand for housing.  You’ll have empty houses at the same time as people doubling up because they can’t afford houses.  Just as during the Great Depression you had farmers unable to sell their food, and hungry people who couldn’t afford to buy food.

We were a little poorer in 2008 than in 2006 because we misallocated resources into foolish housing construction.  We were a lot poorer in 2010 than 2008 because the Fed made us a lot poorer.

HT:  John Quiggin, Tyler Cowen.

PS.  The recession also reduced immigration, which reduced housing demand even further.

PPS.  Notice the headline of the USA Today article is still reversing causation.