I see lots of discussion in the press about how the housing bubble made Americans poorer, and that this explains the low level of AD.  Yet the conclusion doesn’t follow from the premise.

Every bone in my body tells me the conventional view is correct.  We built too many houses and got too deeply in debt.  Now we need to spend less, and that means we need to produce less (as trade is too small a share of GDP to make up the gap.)  Intuitively this seems true, but it’s actually false.  To see why, consider the following parable:

A pioneer family in the American Midwest has run into trouble.  Locusts ate their wheat crop, and now they can’t pay back the local moneylender for the loan they used to get started in farming.  He threatens to burn down their house if they don’t repay within another 12 months.  What do they do?  I’d argue they need to tighten their belts and consume less.  They also need to work much harder.  But in a closed economy (they are self-sufficient) how can this be?  They consume what they produce.  No, they consume part of what they produce.  They need to consume less consumer goods.  Since they are self-sufficient, money plays no role (and that means, THANK GOD, no NGDP shocks.)  They need to “spend” less on clothing and pots, by spending less time making clothing and pots.  And they need to spend more time clearing another 40 acres of land, by cutting down trees.  They need to actually work harder, and plant twice as many crops as the year before.

You may not like the exports of wheat that are implicit in this example.  Then assume the problem is poverty caused by locusts eating one half of their crops.  Now they need to clear twice as much land to feed themselves, knowing the locusts will eat half of whatever they produce.  Either way, they need to invest more.  In an open economy they also made need to export more (depending on the situation in other “countries.”)

What’s true of the pioneer family is also true of the modern US economy.  We need to tighten our belts by saving and investing more.  But the Keynesians are wrong in assuming that more saving means less GDP.  We need to have the Fed stabilize NGDP growth, so that more saving means more investment (and exports.)

A more sophisticated argument accepts this analysis as a long run proposition, but rejects it’s applicability for the US in 2008.  People like Tyler Cowen and Arnold Kling might argue that a modern sophisticated economy can’t easily switch from producing one type of good to producing another.  During the re-allocation of resources, and retraining of workers, there may be a good deal of unemployment.  I accept this in principle, but believe the effect is so tiny as to not have important cyclical implications.

Perhaps the most famous example of the US finding itself producing the wrong set of goods occurred in late 1941.  We had been producing lots of cars and other consumer products in our factories (the economy had mostly recovered from the Depression by December 1941.)  And suddenly in late 1941 we realized that we needed to entirely stop producing any cars, and start producing tanks, airplanes, etc.  And even worse, we had to do so with a largely untrained workforce, as a large share of our regular workforce was drafted into the military, and replaced by housewives, unskilled rural workers, etc.

So if re-allocation led to recession and high unemployment, then 1942 should have been the mother of all recessions.  Obviously it wasn’t.  And the reason is also obvious—NGDP rose sharply.  Some might argue that we knew the new products we needed in 1942, but not in 2008.  But I can’t see why that would be.  The price system gives us the signals telling us what to produce, even without the sort of central planning we had in 1942.  Keep NGDP growing at a steady rate, and booms will burst out in non-housing sectors.  I said booms, not bubbles.  This re-allocation is efficient, just like clearing land was efficient.

Another objection is that the Fed can’t prevent a fall in wealth from decreasing NGDP.  So even if reallocation is not a problem, falling AD is.  We had a near perfect laboratory test of this hypothesis in 1987.  But first a bit of history.  In 1929 there was a big stock market crash, and consumer spending fell sharply in 1930.  This led many Keynesians to hypothesize that the stock crash actually caused the fall in AD during 1930.  We now know that hypothesis is false, thanks to Alan Greenspan.  This is because the 1987 crash was almost identical is size to 1929; if you overlay the two graphs for September/October, they line up almost perfectly.  And because Greenspan kept NGDP growing at a steady rate, there was no collapse in consumer spending, and not even the teeniest slowdown in economic growth.  Thus 1988 and 1989 were the two most prosperous years of the entire decade.  Even the first half of 1990 saw very low unemployment.  So the Keynesians were wrong about the Great Contraction.

Many people will send in comments to the effect that 1987 was different due to blah, blah, blah.  And 1942 is not a good example of reallocation due to blah, blah, blah.  Maybe you are right.  But it won’t affect my views, because no one can point to a counterexample, that would disprove my “NGDP drives the cycle” hypothesis.

Someone needs to find a counterexample to the two following “it’s funnies”:

1.  It’s funny that big drops in wealth never seem to result in recessions, unless the Fed lets NGDP growth slow sharply.

2.  It’s funny that major episodes of re-allocation never seem to result in recessions, unless the Fed lets NGDP growth slow sharply.

For me, those two claims are the bottom line.  We know what classical economics says should happen; I say it will happen if NGDP growth is stable.  A commenter named Skip linked to an interview with Bob Lucas.  Skip made the following observation:

In his interview when asked about his thoughts on Real Business Cycle theory he essentially says that he thinks RBC theory is basically right WHEN MONETARY POLICY IS GOOD.

Yep.

PS.  Here’s the link Skip provided:

http://media.bloomberg.com/bb/avfile/Economics/On_Economy/vv9VRoc8DQl8.mp3

PPS.  This exercise has made me a bit more accepting of the Keynesian argument that it’s time for lots more infrastructure.  I was initially skeptical, as I assumed that good monetary policy would raise real rates back up to normal.  Now I think they’d only go part way back to normal, at least for a while.  Of course I’d hope we follow the Swedish lead and have the private sector build and operate as much of that infrastructure as possible.  (So don’t worry Morgan, I’m not going soft.)

A year ago I did a post called “Two untimely deaths.”  Here’s an excerpt:

Milton Friedman died on November 16, 2006, one year before the sub-prime crisis.  I’d like to suggest that his death was the closest equivalent to the death of Strong in 1928.  In 1998 Friedman pointed out that the ultra low interest rates were a sign that Japanese monetary policy was very contractionary, at a time when most people characterized the policy as highly expansionary.

There is little doubt that Friedman would have recognized the low interest rates of late 2008 were a sign of economic weakness, not easy money.  But what about the big increase in the monetary base?  First of all, the base also rose by a lot in Japan, and in the US during the Great Contraction.  Second, Friedman would have clearly understood the importance of the interest on reserves policy, which was very similar in impact to the Fed’s decision to double reserve requirements in 1936-37.  And in his later years he became more open to non-traditional policy approaches, for instance he endorsed Hetzel’s 1989 proposal to target inflation expectations via the TIPS spreads.  Note that the TIPS markets showed inflation expectations actually turning negative in late 2008.

Why was Friedman so important?  I see him as having played the same role among right-wing economists that Ronald Reagan did among conservatives.  Reagan was really the only conservative that all sides respected; social conservatives, economic conservatives, and foreign policy (or neo-) conservatives.  After he left the scene, the conservative movement cracked-up.

Friedman was respected by libertarians, monetarists, new classicals, etc.  Last year I criticized Anna Schwartzfor adopting the sort of neo-Austrian view that she and Friedman had strongly criticized in their Monetary History.  If Friedman was still alive, and strongly insisting that money was actually far too tight, then I doubt very much that Schwartz would have gone off in another direction.  It would be like Brad DeLongdisagreeing with Paul Krugman on macroeconomic policy.  Once in a blue moon.

Today there is no real leadership among right wing economists.

[BTW, I kind of regret the shot at DeLong—I’m increasingly impressed by his brilliance, despite the fact that we often disagree.]

Now this issue is resurfacing.  Here’s Will Wilkinson:

TIM LEE asks an important question: why are conservatives and libertarians so uniformly hawkish about inflation? Mr Lee (a friend and former colleague) notes that this regularity is far from inevitable. Milton Friedman, a revered figure in right-of-centre circles, famously pinned the severity of the Great Depression on contractionary monetary policy. Scott Sumner, a professor of economics at Bentley University who identifies himself as a “neo-monetarist”, has argued that Friedman would have supported monetary stimulus. And he has argued, on neo-Friedmanite grounds, that tight monetary policy both precipitated and exacerbated our recent recession. I happen to think Mr Sumner is correct, but his expansionary prescription remains anathema on the right. Why?

.   .   .

Milton Friedman was one of the 20th century’s great economists as well as one its most formidable debaters. This made him a powerful check on the influence of anarcho-capitalist Austrians, obviously much to the chagrin of Rothbard. “As in many other spheres,” Rothbard wrote, “[Friedman] has functioned not as an opponent of statism and advocate of the free market, but as a technician advising the State on how to be more efficient in going about its evil work.” Rothbard’s fulminations notwithstanding, Mr Friedman died a beloved figure of the free-market right. Yet it does seem that his influence on the subject of his greatest technical competence, monetary theory, immediately and significantly waned after his death. This suggests to me that Friedman’s monetary views were more tolerated than embraced by the free-market rank and file, and that his departure from the scene gave the longstanding suspicion that central banking is an essentially illegitimate criminal enterprise freer rein.

I’d add a couple points here.  During his period of greatest influence he was known as somewhat of an inflation hawk, as high inflation was the big problem and the old Keynesian model didn’t have good answers.  The right was happy with that monetarist critique of Keynesianism.  And second, the most important section of Friedman and Schwartz’s Monetary History of the United States was the chapter on the Depression, where they were highly critical of the Fed’s deflationary policies.  Even inflation hawks don’t think rapid deflation is a good idea.  But the subtext of their monetary history was even more important.  The Great Depression had discredited capitalism in the eyes of most intellectuals.  By showing that the problem was tight money, not laissez-faire policy, Friedman and Schwartz opened the door to the neoliberalrevolution.  The New Keynesian technocrats who ran the world economy from 1983 to 2007 are much more comfortable with laissez-faire than their old Keynesian predecessors.

And here’s Tim Lee:

This has gotten me thinking about the broader connection between peoples’ views on monetary policy and their broader ideological worldviews. With the lonely exception of Scott Sumner, virtually every libertarian or conservative who has expressed a strong opinion about monetary policy has come down on the side of the inflation hawks. Over the last three years, a wide variety of fiscally conservative Republican politicians have attacked the Federal Reserve for its unduly expansionary monetary policy. I can’t think of a single Republican on the other side.

Yet it’s not obvious why this should be. There’s a coherent ideological argument for abandoning central banking altogether in favor of a gold standard or free banking. In a nutshell, the argument is that no single institution will have the knowledge necessary to “steer” monetary policy, and so we should prefer a monetary system that decentralizes control over the supply of money.

But whether you like it or not, we do have a central bank and it’s important that it function effectively. Logically, it seems like libertarians should be equally worried about both the threat of too much inflation and the threat of too little. After all, one of Milton Friedman’s most famous books argued that the Depression was worsened by the Federal Reserve’s unduly contractionary monetary policy. Yet (again, aside from Sumner) no free-market thinkers or politicians made this argument even in the depths of the 2009 contraction.

So why is right-of-center opinion so lopsided? I can think of two possible explanations. One is that we’re still having the monetary policy debates of the 1970s, when right-of-center thinkers, following Milton Friedman, argued that the era’s persistently high inflation was the fault of unduly expansionary monetary policy. They were right about this, and a whole generation of free-market intellectuals has been on guard against the threat of inflation ever since. And this is obviously reinforced by the reciprocal trend on the left: because most of the inflation doves are on the left, people who are in the habit of disagreeing with left-wingers are discouraged from adopting their arguments on this issue.

Those are good points, but I’ll add a few more:

1. I t makes me uncomfortable to level this charge (as there is nothing I hate more than others questioning my motives) but it’s a bit awkward when you have conservative bastions like the Wall Street Journal bashing the Fed’s tight money policies in 1984, when inflation was 4% (and Reagan was in office) and making the opposite change when inflation is even lower, and Obama is in office.  I actually have a fairly positive view of the motives of most intellectuals on both the left and the right.  I assume they are well-intentioned.  But if a person strongly opposes a set of policies and hopes a new government will soon reverse them, it may at least subconsciously affect that person’s enthusiasm for monetary stimulus that would make the economy look much better, almost assuring the incumbents re-election.

2.  However I don’t believe even subconscious bias is the main issue.  The current policy stance looks much more expansionary than it really is (due to low rates and the hugely bloated monetary base.)  So there are certainly worrisome indicators that even the best macroeconomists could point to, especially given the (overrated) worry about “long and variable lags.”  It’s not all populism.  I was at a conference last year full of conservatives who knew just as much monetary economics as I do and they were almost all were opposed to QE2.  And conservatives weren’t criticizing the Fed in September 2008, when easier money might have helped McCain.

3.  I have very mixed feelings about seeing my name mentioned in both pieces.  Naturally I’m happy that people are paying attention to my ideas.  But I also worry about a world where I’m the name people mention when looking for someone who will carry on the tradition of Milton Friedman.  And this isn’t just false modesty.  No matter how highly I regard my own views, or those of similar bloggers like David Beckworth (who also could have been cited), the hard reality is that we don’t have the sort of credentials that carry a lot of weight among the elites.  (BTW, this doesn’t apply to Nick Rowe, who is probably has a much higher profile in Canada than we quasi-monetarists have in America.)

Cryptic prediction:  Before 12 moons have passed, a star will arise in the East to lead Milton’s scattered tribe into the promised land of respectability.

PS.  Thus far we’ve been called “quasi-monetarists.”  I would have preferred “new monetarists,” but Stephen Williamson’s already grabbed that name.  Will calls us neo-monetarists.  I’m growing increasing fond of ‘post-monetarist’—particularly for the futures targeting idea.  Weren’t post-modernists like Foucault skeptical of central authority?  And is it just me, or does “quasi” have a slightly negative connotation?

No, that’s not a typo.  In October 1929 the discount rate was 6%, and by October 1930 the discount rate was 2.5%.  So how can I say the Fed raised rates?  Because interest rates are the price of credit, determined in the market for credit.  And free market forces depressed the interest rate even more sharply than the 3.5% drop that actually occurred.  Thus in a sense the Fed had to raise rates with a tight money policy, in order to prevent them from being much lower than 2.5% in October 1930.

Of course the discount rate is actually a non-market rate set by the Fed.  But market rates such as T-bill yields fell by a similar amount in 1930.

A commenter of the Austrian persuasion recently argued that the Fed made a mistake by driving rates so low during the Great Contraction, and that if they hadn’t done so, market forces would have weeded out the weaker and less efficient firms, laying the groundwork for a more sustainable recovery (I hope I got that right John.)

But his entire argument is based on a misconception, that the Fed adopted an easy money policy in 1930.  In fact, the Fed did just the opposite.  In October 1929 the monetary base was $7.345 billion, and by October 1930 it was $6.817 billion.  That’s a drop of over 7%, one of the largest declines in the 20th century.  And the monetary base is the type of money directly controlled by the Fed.  When people talk about the government “printing money” they are generally referring to the monetary base.  So by that definition money was very tight.  If money was not tight in October 1930, then the low credit demand of the Great Depression would have meant even lower interest rates; perhaps the 1% we saw in 2003, which prevented another Great Depression.

Now for a curve ball.  So far I’ve assumed the Great Depression just happened for mysterious reasons, and that the Fed responded with tight money, thus preventing interest rates from falling as far as market forces would have taken them (assuming a stable monetary base.)

But why did the Depression happen in the first place?  It’s very likely that the Fed’s decision to reduce the monetary base by 7% was a major cause of the sharp contraction of 1929-30 (after October 1930 the base rose, as the Fed partially accommodated higher currency demand during the bank panics.)  So if tight money caused the Depression, why did rates fall?  First we need to recall that monetary policy affects rates in various ways:

1.  Liquidity effect; tight money raises rates

2.  Income effect; tight money reduces RGDP, investment, credit demand, and real interest rates

3.  Inflation effect; tight money reduces expected inflation and thus nominal interest rates

Note that the effect everyone focuses on (the liquidity effect) is actually the outlier, and is also a very short term effect.  Indeed I’ve seen the “long run” effects overwhelm the short run liquidity effect in a period less than three months!  Thus most of the movements in interest rates that we observe are not the Fed moving rates around via easy and tight money (as most people assume) but rather the market forces moving rates around.

Indeed 1929 is a great example.  The Fed only had raised rates to 6% for about three months in 1929, after which the economy started plunging so fast that the interest rates began falling sharply, even without any “easing,” without any increase in the monetary base.

Obviously all this has important implications for how 90% of our profession (and I’m being generous) badly misinterpreted the stance of monetary policy in 2008.

One final point.  I used the monetary base as the benchmark of policy, of the Fed “doing nothing.”  But of course a modern inflation targeting or dual mandate central bank is not instructed to target the monetary base or interest rates; they are instructed to produce stable macroeconomic conditions.  Under this regime, the only sensible way of thinking about whether money is easy or tight is relative to the goals of the central banks.  But that standard, monetary policy was disastrously tight in 2008-09.

There’s a lot of discussion now about the role of the GSEs in “the crisis.”  Unfortunately, not everyone is talking about the same crisis.  Some are talking about the housing bubble/crash, some are talking about the late 2008 financial crisis, and I believe both groups have the 2011 unemployment crisis in the backs of their minds (otherwise why is the debate seen as being so important?)  After all, there is no similarly high-charged debate over the auto crisis/bailout/sales slump.

Let’s start with the housing crisis.  A major theme of the Austrians is that too many houses were built in the mid-2000s, and the resulting slump has led to high unemployment.  Here are US housing starts per capita going back to 1960:

As you can see, housing starts over the last decade have been far below the level of previous decades.  We certainly don’t have a weak housing sector in 2011 because an extraordinarily large number of homes were built in the past decade.  Rather it seems the recession has caused many families to double up.  BTW, I will concede that we built too many homes in the mid-decade period, so I don’t completely deny the Austrian story.  I just don’t think too many houses is the huge “crisis” most people are talking about.

Instead, it seems to me that both sides of the GSE debate tacitly accept that lax lending standards due to either:

1.  deregulation and moral hazard causing banks to take excessive risks, or

2.  the GSEs and other federal housing rules, regulations, tax breaks, etc.,

caused a housing price bubble in the mid-2000s.  When this bubble collapsed, it created a severe banking crisis, which then led to a severe recession.

I believe this is mostly wrong.  I’ll concede that part of the housing bubble was due to the factors mentioned above (both banks and the GSEs played a big role.)  But the link between the housing bubble and the severe financial panic is much weaker than people realize.  And the link between the severe financial panic and high unemployment in 2011 is almost nonexistent.

The mistake both sides make is to look for monocausal explanations.  Here’s what the facts show:

1.  The economics profession almost entirely disagrees with me.  Yet in mid-2008 the consensus view of the economics profession was that we were NOT going to have a severe financial crisis and we were not going to have a severe recession.  Indeed growth was forecast for 2009, along with moderate unemployment.  And yet the scope of the subprime crisis was almost completely understood by that time.

After things blew up, Bernanke was mocked for early statements suggesting that likely subprime losses, even in the worst case, were not large enough to bring down the US banking system.  But of course he was right.  Here’s what actually happened:

1.  Between June and December 2008 both NGDP and RGDP fell sharply.

2.  The cause of the fall in RGDP was the fall in NGDP

3.  NGDP fell at the fastest rate since 1938 because the economy was already sluggish due to the housing slump, which reduced the Wicksellian equilibrium rate of interest.  Ditto for oil and auto sales.  Normally the Fed would cut rates enough to prevent a recession.  But this problem coincided with a severe commodity price shock, which drove up headline inflation and frightened the Fed.  They did not cut rates once between April and October, by which time the great NGDP and RGDP crash was nearly two thirds over.

4.  The big NGDP crash dramatically reduced almost all asset values in the second half of 2008.  About half way through this crash, the severe phase of the banking crisis started.  This doesn’t mean the earlier subprime fiasco played no role.  It did greatly weaken the system in 2007 and early 2008.  So the GDP crash was imposed on an already weakened banking system.  A cold turned into pneumonia.  GDP fell even faster.

5.  Estimated losses to the entire US banking system soared during this crash, and peaked in early 2009 at roughly $2.7 trillion, only a modest fraction of which were subprime mortgages.  Then expected growth rates recovered somewhat, asset values partially recovered, and estimated losses to US banking fell back under a trillion.  So the proximate cause of the financial crash was tight money which drove NGDP expectations much lower, although the earlier subprime fiasco certainly created an environment with a low Wicksellian equilibrium rate, making monetary errors much more likely.  And of course when rates hit the zero bound (which by the way didn’t occur until the great GDP crash had ended in December!!) the Fed had an even more difficult time steering the economy.

6.  To summarize, the severe financial crisis could not have caused the great GDP collapse, because monthly GDP estimates show it was half over before the post-Lehman crisis even began.  But even if this view is wrong, there is not a shred of theoretical or empirical evidence linking the current 9.2% unemployment with the 2008 financial crisis.  Theory suggests that if a central bank inflation targets, it drives NGDP.  The Fed says it has the economy where it wants it (in nominal terms), and doesn’t think we need more inflation.  When it did think we needed more inflation mid-2010 (when the core rate had fallen to 0.6%) it did QE2, which raised core inflation back up to roughly where the Fed wanted it.  Of course (just as in mid-2008) commodity price inflation is distorting Fed policy, but that’s a problem attributable to the Fed, not the financial crisis.

This graph shows how IMF estimates of total US banking losses are inversely correlated with expected total inflation and RGDP growth in 2009 and 2010.

I see three separate crises.  A “misallocation of resources into housing crisis,” a “federal bailout of banks crisis,” and a high unemployment crisis.  Who’s to blame for each?

1.  The private banking system and the GSEs both played a major role in causing too much housing to be built in the mid-2000s.  The errors of the private banking system were due to both misjudgment (they did lose money after all) and bad incentives (moral hazard due to various government backstops.)  Pretty much the same is true of the GSEs, although their role has always been a bit more politicized, and Congress must accept some blame for pushing them to boost the housing market.  But this was a modest problem, as the first graph shows.  It’s not the “real” issue that the left and right is debating so vigorously.

2.  The GSEs are far more to blame than the banks for the bailout problem.  And the banks most to blame are often smaller banks that made loans to developers, not the more famous subprime mortgages.  Last time I looked the estimated losses to the Treasury from the GSEs was a couple hundred billion, from the smaller banks (i.e. FDIC–which is financed by taxes, BTW) was over a hundred billion, and the big banks was near zero (depending on how much they lose on Bear Stearns.)  That’s all you need to know about where to apportion blame for the bailout crisis.

3.  As far as the high unemployment crisis, the proximate cause is low NGDP, which means the Fed is to blame.  Then we can apportion some blame to Obama for not putting more of his people on the Fed, and not doing it sooner.  But ultimately we macroeconomists are to blame, as both the Fed and Obama take their lead from us.  We were mostly silent on the need for vigorous monetary stimulus in the last half of 2008, and many have remained silent ever since.

The hero is the EMH, as markets warned the Fed that money was way too tight in September 2008.

In the history books it says the 1929 stock market crash triggered the Depression.  After an nearly identical crash in 1987 had zero effect on GDP, we learned that was false.  But it’s hard to blame historians for connecting a high profile financial collapse, with an economic collapse that was barely underway, and suddenly got much worse.   Economists should know better.

Here’s the GDP data I referred to (from Macroeconomics Advisers):

At least that’s how I read the passage sent me by Declan Trott, from Bernanke’s seminal 1983 paper on the impact of the banking crisis:

Did the financial crisis of the 1930s turn the United States into a “temporarily underdeveloped economy” (to use Bob Hall’s felicitous phrase)?  Although this possibility is intriguing, the answer to the question is probably no.  While many businesses did suffer drains of working capital and investment funds, most larger corporations entered the decade with sufficient cash and liquid reserves to finance operations and any desired expansion (see, for example, Friedrich Lutz, 1945).  Unless it is believed that the outputs of large and of small businesses are not potentially substitutes, the aggregate supply effect must be regarded as not of great quantitative importance.

The reluctance of even cash rich corporations to expand production during the depression suggests that consideration of the aggregate demand channel for credit market effects on output may be more fruitful.”

Many people read this paper as suggesting that the banking crisis was an important problem, even apart from the decline in AD.  And that’s probably how Bernanke intended it.  (You don’t get published in the AER by agreeing with previous studies.)  But in the end Bernanke has to acknowledge that the major contractionary effect worked through falling NGDP.  If the Fed doesn’t allow NGDP to fall in half, there is no Great Depression.

And if the Fed doesn’t allow NGDP to crash in 2008-09, and stay low in 2010-11?

PS.  It’s quite possible that in1929-33 the Fed wouldn’t have been able to prevent the crash in NGDP without leaving the gold standard—which it had no authority to do.  I have mixed feelings on that debate, but of course it is of no relevance to the current situation.