Archive for the Category Great Recession


We all know how it developed.

Matt Yglesias has a post describing how Hjalmar Schacht cleaned up after not one but two monetary policy disasters:

I was reading recently in Hjalmar Schacht’s biography Confessions of the Old Wizard (thanks to Brad DeLong for getting me a copy) and part of what’s so incredible about it are that Schacht’s two great achievements””the Weimar-era whipping of hyperinflation and the Nazi-era whipping of deflation””were both so easy. The both involved, in essence, simply deciding that the central bank actually wanted to solve the problem.

.   .   .

The institutional and psychological problem here turns out to be really severe. If the Federal Reserve Open Market Committee were to take strong action at its next meeting and put the United States on a path to rapid catch-up growth, all that would do is serve to vindicate the position of the Fed’s critics that it’s been screwing up for years now. Rather than looking like geniuses for solving the problem, they would look like idiots for having let it fester so long. By contrast, if you were to appoint an entirely new team then their reputational incentives would point in the direction of fixing the problem as soon as possible.

This reminded me 1936-37, when the Fed made the mistake of doubling reserve requirements.  Late in the year the economy slumped badly, and it was clear that the decision had been a mistake.  At the November FOMC meeting they discussed the possibility of reversing the decision:

“We all know how it developed. There was a feeling last spring that things were going pretty fast … we had about six months of incipient boom conditions with rapid rise of prices, price and wage spirals and forward buying and you will recall that last spring there were dangers of a run-away situation which would bring the recovery prematurely to a close. We all felt, as a result of that, that some recession was desirable … We have had continued ease of money all through the depression. We have never had a recovery like that. It follows from that that we can’t count upon a policy of monetary ease as a major corrective. …  In response to an inquiry by Mr. Davis as to how the increase in reserve requirements has been in the picture, Mr. Williams stated that it was not the cause but rather the occasion for the change. … It is a coincidence in time. … If action is taken now it will be rationalized that, in the event of recovery, the action was what was needed and the System was the cause of the downturn. It makes a bad record and confused thinking. I am convinced that the thing is primarily non-monetary and I would like to see it through on that ground. There is no good reason now for a major depression and that being the case there is a good chance of a non-monetary program working out and I would rather not muddy the record with action that might be misinterpreted. (FOMC Meeting, November 29, 1937. Transcript of notes taken on the statement by Mr. Williams.)”

This is one of the most chilling statements I have ever read.  The opening sentence is the sort of thing juvenile delinquents say to each other when their prank has gone horribly awry, and they are nervously working on a joint alibi.  An incredible effort at denial runs all through the piece.  First he admits that they raised reserve requirements because “some recession was desirable.”  Then he claims it was just a “coincidence in time” that the downturn followed the reserve requirement increase, even though the express purpose of the increase was to cause a “recession.”  Then he claims that if they reverse their decision it will look like the previous decision had caused the recession.  Then he said that a depression can’t be happening, because there is no good reason for a depression.  Well it was happening, unemployment rose to almost 20% in 1938.  In the end, they decided to stick with the high reserve requirements throughout the rest of 1937.  Reading that quotation one can almost see the perspiration on Mr. Williams’ forehead.

In a recent comment section a Fed employee named Claudia Sahm took me to task for some intemperate remarks I made about the Fed.  I think her criticism was valid.  I should not throw around terms like “criminally negligent.”  I don’t doubt that the vast majority of Fed employees are well-meaning.  Maybe all of them are.  But Matt’s piece reminds me that human psychology is very complex.  We often don’t know why we do things.  Why am I blogging?  Is it the valiant crusade I’d like to believe I’m engaged in, or am I just fooling myself?   (As Robin Hanson would presumably argue.)  Suppose Ben Bernanke had been at Princeton for the past 5 years.  Now suddenly the Fed chairman is “promoted” to Secretary of the Treasury, and replaced with Bernanke.  (As G. William Miller was replaced mid-term with Volcker.)  What would happen next?  My guess is that Bernanke would immediately set out implementing some of the bold policies that he recommended the Japanese adopt back in 2003.

In 2008 the Fed did what the consensus of economists thought they should be doing.  If we could go back in time to the meeting right after Lehman failed, most economists would now say the Fed should slash interest rates sharply (they actually left them unchanged.)  If John Taylor is appointed Fed chairman in 2014, and if aggregate demand is still quite depressed, I very much doubt he’d adopt the tightening of monetary policy that many on the right are now calling for.

Update: Speaking of Robin Hanson, his new post relates to his very issue.  And I also enjoyed this recent post:

For example, to impose punishments bigger than lifetime exile, beat them a bit first.

Some worry about variation in how much people dislike exile. But there is also variation in how much people dislike fines, prison, torture, and public humiliation. The best way to reduce punishment variation is probably to bundle together many kinds of punishment. Maybe fine them some, beat them a little, humiliate them a bit, and then exile them for a while.

In 2006 the US spent $69 billion on corrections, and 2.3 million adults were incarcerated at year-end 2009. A state prisoner cost an average of $24,000 per year in 2005 (source). Why waste all that money?!

Not so much the ideas, but the way they are expressed.  Only an economist can write like that!

Don’t think we don’t see what’s going on here

The Fed is clearly ignoring its dual mandate.  After the last meeting they basically admitted as much:

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect a moderate pace of economic growth over coming quarters and consequently anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee’s dual mandate. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.

In a previous post, this is how I responded:

We expect to fail, but we’ll keep a close watch on things just to make sure.

Yet the inflation rate is close enough to their informal target that lots of average people are being fooled into thinking the Fed is “doing its job.”  But not the experts.  Here is James Hamilton’s reaction:

In almost identical language that it used November 2, the Fed is saying that it expects unemployment will remain higher than it wants, inflation will likely be lower than it wants, and that it has significant concerns about where events in Europe might lead. In normal times, that trio would surely signal that policy would become more expansionary.

But the Fed opted instead to keep things more or less on hold, again using almost identical language as in its previous statement:

I vaguely recall similar statements made at various times by progressives like Krugman, DeLong, Yglesias, etc.  It’s very clear what’s going on here.

Unfortunately there is a long delay in releasing the minutes from Fed meetings.  When the minutes for the November 1937 meeting were released, we learned that the Fed was almost criminally negligent.  They had doubled reserve requirements earlier in the year.  Now the economy was clearly sliding into a deep slump.  But they did not reverse course.  One governor indicated that if they cut reserve requirements the Fed would be embarrassed, as its previous decision would look incorrect–thus putting his “feelings” ahead of the welfare of millions of cold, hungry and unemployed men and women.

I expect similar revelations from the minutes of the past four years.  Just consider the slump in NGDP between June and December 2008.  There was the August meeting where Fisher voted for tighter money.  The meeting after Lehman failed in mid-September, where the Fed refused to cut rates out of fear of inflation, even as TIPS spreads (correctly) showed 1.23% inflation over the next five years.  The decision to raise the interest rate on reserves to roughly 1% in November 2008, in a successful attempt to keep excess reserves bottled up in the banking system.  All the various decisions not to use their ammunition, despite the obvious need for more demand.

Some will argue the Fed’s doing a good job; that it’s all about low inflation.  Unfortunately, the Fed itself does not agree.  Frequent commenter Benjamin Cole has an eloquent post over at Lars Christensen’s blog.  Here he points out that there’s never been anything magical about 2% inflation:

The United States economy flourished from 1982 to 2007″”industrial production, for example, doubled, while per capita rose by more than one-third””while inflation (as measured by the CPI) almost invariably ranged between 2 percent and 6 percent. That is not an ideology speaking, that is not a theoretical construct.  It is irrefutably the historical record.  If that is the historical record, why the current hysterical insistence that inflation of more than 2 percent is dangerous or even catastrophic?

The Fed has frequently eased monetary policy when inflation was well above 2%, most recently in late 2007 and early 2008.  You might argue that those easings were done in response to fear of a banking crisis.  That’s right, they’re willing to ease to help the banks, but not to help the unemployed.  BTW, employment is part of their dual mandate, banks aren’t.

You might wonder how I can be so sure that the Fed minutes will expose all sorts of embarrassing admissions.  It’s not hard at all, just look at what Fed officials are saying publiclyMarcus Nunes directs us to a recent speech by Richard Fisher.  Here’s a passage he didn’t quote:

My colleague Sarah Bloom Raskin””one of the newest Fed governors, and a woman possessed with a disarming ability to speak in non-quadratic-equation English””recently used the example of the common kitchen sink to illustrate a point. I am going to purloin her metaphor for my description of our present predicament. You give a dinner party. The guests leave and you are washing the dishes. When you are done, you notice the remnants of the party are clogging the sink: bits of food, coffee grinds, a hair or two and the like. You have two choices. You can reach down and scoop up the gunk, a distinctly unpleasant task. Or you can turn the water on full blast, washing the gunk down the drain, providing immediate relief from both the eyesore and the distasteful job of handling the mess. You look over your shoulder to make sure your kids aren’t looking, and, voilà, you turn the faucet on full blast, washing your immediate troubles away.

From my standpoint, resorting to further monetary accommodation to clean out the sink, clogged by the flotsam and jetsam of a jolly, drunken fiscal and financial party that has gone on far too long, is the wrong path to follow. It may provide immediate relief but risks destroying the plumbing of the entire house.

Fisher would have been quite at home on the Herbert Hoover Fed.

Fisher’s speech produces two reactions.  First, how could he be so clueless about monetary policy.  But when you stand back and start to think about what it all means, a second question begins to emerge.  Why are such fools allowed on the FOMC?  How is it that the world’s greatest economic policy institution, the central bank that tends to set the tune for world aggregate demand, is managed by people who are so obviously incompetent?  Let’s see where we can connect the dots:

1.  Stiglitz develops a theory that unemployment is caused by rapid technological change, which makes workers redundant.  This in some mysterious way reduces aggregate demand.

2.  Stiglitz meets with Obama, to offer a Nobel Prize winner’s expert advice on our predicament.

3.  Christy Romer and Larry Summers are horrified to find Obama spouting theories that the unemployment problem isn’t lack of demand, rather it’s ATM machines stealing  jobs.  Christy Romer can’t convince Obama that the Fed still has ammunition.

4.  Obama never pays any serious attention to the Fed.  When the Dems had a filibuster-proof majority in the Senate, he fails to even nominate people for several positions for a period of 18 months.  Even today he is ignoring the problem, several seats remain empty.

The following quotation is from Fisher, but it might just as well have been Stiglitz:

My reluctance to support greater monetary accommodation has been based on efficacy: With businesses’ cash flow””driven by record high profits and bonus depreciation””at an all-time high, both absolutely and as a percentage of GDP; with every survey, including those of small businesses, indicating that access to capital is widely available and attractively priced;[6] with balance sheets having been amply reconfigured; and with bankers and nondepository financial institutions sitting on copious amounts of excess liquidity, I have argued that further accommodation was unlikely to motivate the private sector to put people back to work. It might even prove counterproductive should it give rise to fears the Fed is so hidebound by academic theory as to be blind to the practical consequences of harboring an ever-expanding balance sheet. This inevitably raises concerns we are creating distortions in the fixed income markets that inhibit proper market functioning, or concerns that””despite our protestations to the contrary””we are given to monetizing the government’s debt, an impulse that ultimately destroys a central bank’s credibility.

I have argued that other, nonmonetary factors are inhibiting the robust job creation we all seek.

Monetary policy is one of those areas where the fringe right and the fringe left meet and shake hands.  And right now they are influential enough to prevent the Fed from doing what it knows needs to be done.  Not powerful enough to prevent all action—the Fed will prevent deflation, I have no doubt about that.  But powerful enough to prevent the Fed from fulfilling their dual mandate.  History will see all this very clearly, and judge the Fed harshly.  How ironic after Bernanke promised Milton Friedman that the Fed would never repeat the errors of the Great Depression.  How ironic after Bernanke eloquently spoke out against the passivity of the Bank of Japan (an institution that also cut rates to zero and did massive QE.)

On a positive note, Fisher will be off the FOMC in January.

HT:  Morgan Warstler

Robert Hetzel on liquidity traps and NGDP targeting

Here is Robert Hetzel discussing a Tim Congdon essay on liquidity traps:

If the public is sufficiently pessimistic about the future so that asset prices are low and the demand for money is high, the central bank might have to create a significant amount of money to influence the expenditure of the public. The institutional fact that makes a liquidity trap an irrelevant academic construct is the unlimited ability of the central bank to create money. One can make this point in an irrefutable manner by noting that the logical conclusion to unlimited open-market purchases is that the central bank would end up with all the assets in the economy including interest-bearing government debt, and the public would hold nothing but non-interest-bearing money. Because that situation is untenable, individuals would work backward from that endpoint and begin to run down their money balances and stimulate expenditure in the current period.

What drives the conclusion that the central bank can control the dollar expenditure of the public is that the central bank can conduct monetary policy as a strategy, say, by altering the monetary base and the money stock by whatever amount necessary to maintain nominal expenditure on track. Historically, however, the FOMC has never been willing to communicate its behavior as a “policy” in the sense of systematic procedures designed to achieve an articulated, quantifiable objective (a reaction function). Instead, it communicates individual policy actions such as changes in the funds rate or, since December 2008, changes in the size and composition of its asset portfolio. Just as importantly, it explains those individual policy actions using the language of discretion.

The FOMC Minutes released after each meeting package the current policy action as optimal taken in the context of the contemporaneous state of the economy. As a matter of political economy, the FOMC can then attribute adverse outcomes to powerful real shocks originating in the private sector. In the event of inflation, as in the 1970s, it can blame the greed of powerful corporations. In the event of recession, as in the Great Depression and now with the Great Recession, it can blame the greed of bankers who made excessively risky, speculative bets. From this political-economy perspective, a “policy,” which requires a numerical objective, say, steady nominal expenditure, and an articulated strategy, say, a feedback rule running from a path for nominal expenditure to money creation, suffers two defects.

First, the explicitness of an objective communicates to the political system that the FOMC can take care of a problem that the FOMC considers to have been not of its making. A problem arising as a real shock should possess a solution coming from the political system, for example, through expansionary fiscal policy. Second, an explicit objective, by its nature, highlights misses. As a matter of accountability, however, that is the point. The FOMC must then explain rather than rationalize the miss by defending the miss as a real shock originating in the private sector rather than as arising from faulty policy based on a misunderstanding of the economy.

Hetzel has a new book coming out that will revolutionize the way economists look at the Great Recession, much as Friedman and Schwartz changed the way we look at the Great Depression.  Here is the title:

Hetzel, Robert L. The Great Recession: Market Failure or Policy Failure? Cambridge: Cambridge University Press, 2012.

HT:  David Levey

How macroeconomists ruined the world economy

I first became radicalized about 3 years ago when I realized that my fellow economists did not see the seemingly obvious need for greater monetary stimulus.  Here are a few facts:

1.  The number one monetary textbook tells us that monetary policy is still highly effective at boosting nominal spending at the zero bound.

2.  There are many prestigious academic papers discussing how the Fed can boost nominal spending at the zero bound.

3.  American economists were highly critical of Japan’s refusal to boost NGDP growth in the 1990s and 2000s.

4.  I’ve never met a right-of-center economist who worried about “liquidity traps.”

5.  Lots of progressives (Romer/Krugman/DeLong/Yglesias, etc) favor more Fed stimulus.

6.  Ben Bernanke keeps insisting that the Fed is not out of ammunition, a view he’s held from the beginning.

OK, there are some economists who worry about the Fed running out of ammunition.  But rates weren’t even at zero in the fall of 2008, and there was still no pressure on the Fed to ease.  None at all.  And nothing’s changed in the subsequent 3 years.

Clare Zempel sent me a new survey from the National Association of Business Economists:

Given a budget of 10 points, what are the major factors holding back the recovery?  You may allocate all 10 points to one factor or divide the points among them.

16.9% Uncertainty about future economic policies
13.7% Low consumer and business confidence
13.5% Financial headwinds caused by tight credit conditions and balance sheet restructuring
11.0% A tepid housing market
7.4% State and local government spending cutbacks and tax increases
7.3% Uncertainty about economic prospects in the rest of the world.
6.5% The burden of new regulations
6.3% Structural imbalances requiring the reallocation of labor and capital across sectors
6.1% Lack of progress in reducing long-term fiscal imbalances
4.9% The removal of near-term fiscal stimulus
3.1% High and rising commodity prices
1.6% Inadequate monetary stimulus.
1.2% Nothing is holding back the recovery. The economy is poised for a strong rebound.
0.4% Ongoing supply disruptions associated with the earthquake and tsunami in Japan

Just three of the 49 respondents selected “inadequate monetary stimulus” — and just one considered it to be quite important (by allotting 5/10 points to it).

So my fellow economists don’t think we need more monetary stimulus.  And I have no doubt that this is why the Fed isn’t doing more.  If the monetary stimulus choice was 98.4% rather than 1.6%, you can be sure the Fed would be doing all sorts of aggressive stimulus right now.

Here’s the big puzzle; do my fellow economists oppose more monetary stimulus because they don’t think it will work, or because they fear it will work?  In other words, do they want more AD or not?

When I look at all the responses, I see at least a half dozen that implicitly point to AD being a problem.  But in that case why wouldn’t they favor more monetary stimulus?  Is it really possible that 46 out of 49 economists think the Fed is out of ammo?  Or is there some sort of third possibility, which I miss because the model is completely off my radar screen?  I.e. do they think monetary stimulus creates inflation and fiscal stimulus creates real growth?  God only knows.  All I can say is that I am part of a profession that I know nothing about.  I can’t even fathom what is going on in the minds of my fellow economists.

Of course it’s very possible that this whole blog is wrong, and that we don’t have a demand shortfall.  Or that we do, but a more expansionary monetary policy can’t boost nominal spending.  But if I am right then there can be no doubt as to who is to blame for the current crisis (in both America and Europe.)  It’s not politicians.  It’s not bankers.  It’s not voters.  It’s macroeconomists.

PS.  In my view the top 4 choices are mostly a consequence of tight money, of low NGDP.

PPS.  Maybe I should look at the bright side.  Four times as many point to monetary policy being the problem, as compared to the tsunami in Japan.

Christina Romer on fiscal policy

Marcus Nunes sent me a new Christina Romer paper, which claims that fiscal stimulus is effective.  I’ll argue that she has some good evidence, but also that there are weaknesses in her argument.

Her best evidence is a study that she did with David Romer, which examined two types of tax cuts; those done to boost the economy, and those done for other reasons, which can be viewed as “exogenous.”

What David and I did was to bring in information on the motivation for tax changes. For every legislative tax change, up or down, there is a huge narrative record about why it was passed. This narrative record is contained in Congressional reports, presidential speeches, the Economic Report of the President put out by the Council of Economic Advisers each year, and other documents.

We read all of those documents and classified tax changes into those taken in response to other factors affecting output and those taken for more independent reasons. We identified a number of tax cuts taken because the economy was slipping into a recession. We also found a number of tax increases taken because government spending was rising; for example, policymakers raised taxes dramatically during the Korean War. This is important because spending increases will tend to increase output, while tax increases will tend to reduce it. So in cases where the tax increase is caused by the spending increase, there are systematically factors going in opposite directions.

At the same time, we also found a number of tax changes taken not in response to current or forecasted economic conditions, but for more ideological or long-term reasons. For example, Ronald Reagan cut taxes in the early 1980s because he believed lower tax rates were good for long-term growth. Bill Clinton raised taxes in 1993 because he thought dealing with the deficit would be good for the long-term health of the economy.

We argued that to estimate the impact of tax changes, we should look at the behavior of output following these tax changes made for more ideological reasons. In other words, we dealt with some of the omitted variable bias problem by excluding from the empirical analysis the tax changes taken in response to economic conditions.

They found that the endogenous tax changes had a modest (but positive) effect on output, while the exogenous changes had a large impact on output.

I favor a pragmatic approach to research, so I applaud the Romers for using the narrative approach.  However what’s being tested here isn’t really “stimulus,” it’s tax cuts.  The traditional Keynesian model says fiscal stimulus will boost NGDP, and will also boost RGDP if there is slack in the economy.  Otherwise you get higher prices.  So there are actually two interesting questions worth testing; does Keynesian stimulus boost NGDP (i.e. spending) and does the higher spending lead to more real output.

To make things even more complicated, supply-siders have suggested an alternative channel through which tax cuts might boost RGDP; increasing the incentive to work, save and invest.  The basic supply-side model doesn’t predict claim any impact of tax cuts on NGDP, indeed it was sold in the late 1970s as a tool for boosting output without boosting inflation.  Even so, if the central bank is targeting interest rates, then supply-side effects could easily lead to more NGDP as well.

So let’s accept Romer’s argument that tax cuts boost RGDP.  Is it a problem that we don’t know exactly how or why?  It could be, because if it is due to supply-side effects then lump sum tax rebates and government spending increases wouldn’t necessarily work.

Romer discusses one such event that occurred in the spring of 2008, when the Bush administration issued tax rebates to boost consumption.  John Taylor later pointed out that consumption did not seem to respond to these tax rebates, despite the temporary spike in disposable income.  Romer replied:

The trouble with this analysis is, Professor Taylor wasn’t thinking about what else was going on at the time. Democrats and Republicans didn’t come together to pass the tax rebate for no reason. This was the heart of the subprime mortgage crisis. House prices were tumbling. Mortgage lenders like Countrywide Financial were in deep trouble.

Economists were worried that consumption was about to plummet. For most families, their home is their main asset. When house prices fall, people are poorer, and so tend to cut back on their spending.

Against that background, the fact that consumption held steady around the time of the tax rebate may in fact be a sign of just how well it was working. It kept consumption up for a while, despite the strong downdraft of falling house prices.

Romer’s right that without the rebates aggregate spending and output might have been somewhat lower during mid-2008.  But Romer doesn’t consider whether that might have led the Fed to move much more aggressively in September 2008.  As it is the Fed met two days after Lehman failed and did nothing (which effectively tightened policy sharply as the Wicksellian natural rate was plunging rapidly during this period.)

The Fed cited an equal risk of recession and inflation (i.e. economic overheating) when it left interest rates unchanged at 2% in September.  It seems highly unlikely that the Fed would have been so passive if Romer’s counterfactual had come to pass.  If so, then John Taylor might be right, but for the wrong reason.  The real problem is that the Fed sabotaged Bush’s tax rebate.  The real problem is that in new Keynesian models the fiscal multiplier is precisely zero if the central bank targets either inflation or NGDP.

This is the biggest weakness in Romer’s paper.  When discussing Taylor’s critique she rightfully talks about the omitted variable problem.  But then she basically ignores the problem of monetary policy counterfactuals when considering what would have happened without the Obama stimulus.  The basic problem here is that she seems to hold three contradictory views:

1.  She agrees with Bernanke that the Fed is not out of ammunition.

2.  Elsewhere she praises Bernanke for acting aggressively in 2008-09, making the recession less severe.

3.  Her three million “jobs created or saved” estimate for the Obama stimulus implicitly assumes that if Obama’s stimulus had not passed, then the Fed would have responded to the deeper downturn with almost criminal negligence.

Now I’m perfectly willing to concede that it’s unlikely a counterfactual monetary policy would have exactly offset any fiscal stimulus reductions.  But I would also insist that monetary policy counterfactuals must be addressed in any multiplier estimates.  And I see one Keynesian study after another completely ignoring this problem.

She also cites the study by Nakamura and Steinsson that looked at the cross-sectional effects of defense spending in various regions.  But as I’ve pointed out many times, these multiplier estimates are completely consistent with the national multiplier being zero.  In other words, models that assume no aggregate multiplier effect (such as the monetary policy offset model) would nonetheless predict that regional defense expenditures would impact regional GDP.

She also cites a study of how individual reactions to rebate checks depend on the date they were received (Jonathan Parker, et al.)   This approach is somewhat better, but still fails to fully address the monetary offset problem.  Stimulus might boost NGDP in Q2, and the Fed might take it all back in Q3.

On a more positive note let me acknowledge that the Romers’ tax cut study is very important.  It suggests that we do know, at a minimum, that cuts in marginal tax rates boost RGDP.  I’m willing to support that sort of fiscal stimulus.  But at this point I’d have to say that’s all we know.  In a world where central banks are targeting inflation (and by implication AD), then all multiplier estimates for demand-side stimulus will be highly uncertain, little more that estimates of monetary policy incompetence in the specific period being examined.