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?

Matt Yglesias recently made this remark in a post criticizing Tyler Cowen’s assertion that the GSEs significantly worsened the US housing/banking crisis:

The part where unwise public policies to subsidize homeownership would seem to come into this is step (1), but we in fact see this happening in many markets (Spain, commercial real estate) where Fannie and Freddie weren’t players.

I’m not sure what Matt means by “many markets.”  According to the interactive housing price graph constructed by The Economist, only the US and Ireland experienced major housing bubbles.  Spain had a smaller one (although I suspect more accurate figures would show a more serious price decline in Spain.)  Japan and German also saw price declines after 2006, but they had had zero price run-up before 2006–so no bubbles there.  The vast majority of industrial countries saw big increases in real housing prices between 2001 and 2006, just like the US.  But unlike the US, prices tended to move sideways after 2006, even in real terms.  (Of course you can find some brief price dips in the severe 2008 recession, but nothing like the long collapse in the US, which pre-dated the recession.)

But let’s take a look at Spain.  It’s true that Spain does not have a single institution called “Fannie Mae.”  But do they have a similar problem of governments deeply involved in promoting real estate lending?  I’m no expert (and I welcome critiques) but my initial impression is that the answer is yes.  Here’s The Economist:

Another duality lies in the banking system. Observers fret that the Spanish state may have to pump a lot more money into the banks than the roughly €25 billion ($36 billion), or 2.5% of GDP, it currently reckons will be the total bill from Spain’s epic housing boom and bust (Ireland’s bank bail-out bill is over 40% of GDP).

The problem is concentrated in the cajas, local savings banks that make up around half the domestic banking system, rather than big Spanish banks like BBVA and Santander, which are protected by big international businesses. Not before time the government is overhauling the cajas. Their ranks are being slimmed””the number has fallen from 45 to 18″”and they are being reorganised as joint-stock companies that can raise equity capital. José Maria Roldan, director-general of banking regulation at the Bank of Spain, says that the reform is “a huge step forward, replacing the caja model with a standard banking template that is more secure and comprehensible to international investors.”

So I decided to further investigate the cajas, and this is what I found (also from The Economist):

IN THE end CajaSur trusted in God. On May 22nd the small savings bank (or caja), which is controlled by the Roman Catholic church in Córdoba, was seized by the Bank of Spain after failing to agree on a merger with Unicaja, a larger Andalusian rival. The move shocked investors and prompted other savings banks to hasten consolidation. But mergers between wobblier cajas, which are unlisted and make up close to half of Spain’s financial system by assets, are merely a first step in a longer process.

CajaSur is tiny, holding just 0.6% of Spain’s financial assets. Yet its seizure unsettled investors for two reasons. First, it was a reminder that politics often trumps rationality.

.   .   .

The politicians who control the cajas like this virtual structure because it allows the banks to keep their own brands, governing bodies and local retail operations while combining treasury and risk-management functions.

.   .   .

Encouragingly, both the government and the opposition have agreed to reform the law governing savings banks.Attracting private capital requires other changes, too, such as a reduction in the influence of politicians, something caja managers would relish. Greater openness about banks’ balance-sheets would also help: on May 26th the Bank of Spain moved in this direction by announcing plans for tougher provisioning rules.

“The politicians who control the cajas”?  I thought banks were supposed to be controlled by businessmen, not politicians.  I’m still no expert on Spanish banking.  But I’d wager that further investigation would turn up the same incestuous relationship between politicians and the cajas that we saw between politicians and the GSEs.

So we observed clear-cut housing bubbles and busts in just two countries with more than 5 million people; the US and Spain.  And both suffered from the same problem—politicized institutions that will require massive transfers from the public.  Both also had large private banks that made mistakes, but at least they didn’t impose huge burdens on the taxpayers.

Matt also mentioned commercial real estate in the US, but I don’t think that proves what he wants it to prove.  As you know, the profession has not accepted my argument that lack of AD, not the banking crisis is responsible for our macroeconomic problems.  But the one weakness in my argument is that the subprime bubble blew up well before the recession.  This leads Matt to draw a connection between the financial crisis and the recession.

Banking activities need to be regulated or else asset price fluctuations will lead to macroeconomic instability.

That’s why the stakes in this debate between progressives and libertarians are seen as being so high.  If it was just the TARP bailout, I’m not sure people would care that much.  The big banks are repaying the loans.  Indeed I’ve seem progressives praise the auto bailout, even though GM may never pay back all the money.  No, the reason this is so important is that it’s seen as a crisis that led to 9.2% unemployment three years later.  Fair enough.

But in that case Matt can’t use commercial real estate, as that was clearly a symptom of the recession.  Indeed commercial RE was still booming in mid-2008, and only turned south toward the end of the year.  Now in fairness to Yglesias, the fall in commercial RE did bring down lots of smaller regional banks, and this resulted in costly FDIC bailouts of depositors.  If we insist on having FDIC (a big mistake in my mind), and insist on not reforming it by placing $25,000 caps on insured deposits (and even bigger mistake), then yes, we need to regulate banking.  We tried to re-regulate after the 1990 S&L debacle, and it didn’t work.  We tried again with Dodd-Frank, and again failed to deliver an effective set of regulations (like, umm, banning subprime loans, for instance.)  But I would agree that in the presence of FDIC, a completely unregulated banking system will take far too many risks.  I don’t consider that the failure of “laissez-faire”, I view it as the failure of a banking system where much of the liabilities are essentially nationalized.

PS.  Interested readers may want to play around with the Economist’s interactive graph at this link:

It’s a bit hard to read the graph below, so a few comments.  The steady drop (orange line) is Japan.  The only other two countries down in real terms from 2001 are the US (grey) and Ireland (green, of course.)  Spain is a rather dark line that rises steadily to almost 180, then slips back to 140.  As I see the graph, most other countries had substantial real price run-ups, like the US, but then real prices trended sideways.  This shows that not everything that goes up must come down.  I see lots of commenters patting themselves on the back about how they predicted the bubble would burst.  Count yourself lucky that you live in America; otherwise you probably would have been wrong.  Germany is not listed because of incomplete data, but it had no bubble in the first place.

Also note that the default option is nominal prices, which is actually more supportive of my “very few bubbles” claim.  I converted to real for the graph below, which puts more of a downward bias on prices after 2007.

I recently had lunch with a guy who is very bright, and pretty well-informed about economics.  He had seen Inside Job and immediately spotted the flaws.  He started lunch by asking me what I thought about the crisis.  I said; “do you want to talk about the financial crisis that took place three years ago, or the current problem of recession and 9.2% unemployment?”  He responded that most people see the two as related, that one led to the other.

I asked why a financial crisis in 2008 would cause high unemployment in 2011.  He talked about the loss of wealth, that people were cutting back on their spending—basically an AD-side explanation of the recession.

I pointed out that he was confusing “spending” (i.e. consumption), with aggregate demand, which involves all types of output.  It’s not immediately clear that less consumption means less AD.  After all, savings equals investment, and investment is part of AD.  Less consumption is more saving, which means more investment.  At this point the Keynesian readers will be throwing bricks at the computer screen, we will go through a long fruitless discussion of planned and unplanned, and end up with the conclusion that more saving depresses interest rates, which lowers velocity, which lowers AD.  Fair enough.

But that would be equally true if the collapse of the Soviet Union led Russians to hoard $100 billion in US base money.  Yet I doubt you’d find a single economist arguing that that action would cause a recession.  The reason is that if the Fed were targeting interest rates, rather than the money supply, the Russian hoarding would be smoothly accommodated by the Fed, and NGDP would remain unchanged.  In contrast, the financial crisis led to velocity falling at a given interest rate, and thus the Fed might have needed to drive real interest rates much lower in order to prevent the rush for savings from lowering AD and NGDP.

Even so, they did have the power to prevent NGDP from falling 10% below trend in 2011, Ben Bernanke just reiterated that point yesterday.  So why does the banking crisis in 2008 cause low NGDP in 2011?  And then it hit me.  The intelligent but uninformed analysis of my non-economist friend had become the OFFICIAL DOGMA of the economics profession.  To deny that the banking crisis of 2008 causes the low NGDP of 2011 makes you a heterodox economist.  Out on the fringes.

And here’s what’s even more interesting.  I’m simply doing mainstream economics, right out of all the textbooks.  The rest of the profession is making it up as they go along.  Go back and look at your economics textbooks, and see where is says a banking crisis will cause NGDP three years later to be far below the level the Fed wants it to be at.  You won’t find it.  You’ll find 100s of models explaining how the Fed determines the path of NGDP.  But nothing about how banking crises make it impossible for the Fed to determine NGDP three years later.

You might be thinking; “But didn’t Bernanke argue the banking crises made the Great Depression worse?”  Yes he did, but he was also very critical of the Fed.  He argued that once the US cut the tie to gold, they had essentially unlimited ability to raise NGDP.  And of course in this crisis Bernanke has never once argued that the banking crisis prevents the Fed from raising NGDP three years after the crisis—just the opposite.

But that’s where we are.  The common sense view of AD, that when America suffers great losses, it is important for millions of Americans to go on 99 week “vacations” in order to “rebalance” the economy, has become official dogma.

You might argue that the recession is structural.  Yes, that’s possible, but nevertheless the official dogma is that demand is low because Americans are broke.  That’s not structural, that’s AD.  We have way too many houses, with no one to move into them.  No one except the millions of 20-somethings that are doubling up in their parent’s house.  And why are they doing that?  Because they are broke, they have no jobs.  And why do they have no jobs?  Because there’s no AD, because Americans are broke.  And why are Americans broke?  Because we built too many houses, so their value fell.  No one to live in those houses.  No one except all the young people who can’t afford houses because they have no jobs because there’s not enough AD.  And we all know the official dogma says there’s nothing the Fed can do about that lack of AD.  That’s how the banking crisis of 2008 mysteriously causes low NGDP in 2011.

In the future we should just let non-economists write our textbooks; at least if we plan on adopting seat-of-the-pants, common sense views as the OFFICIAL DOGMA of macroeconomics.

BTW, during the decade of 2001-11 housing construction in America was well below normal.  Too many houses or too little income?

PS.  Hang in there for just a couple more days and I promise my onslaught of posts will end, I’ll return to my normal one-a-day.

When visiting GMU in 2009, I was asked for my most outrageous belief.  I tried to use my view of the crisis; that tight money, not the financial crisis, caused the Great Recession.  But they wouldn’t accept that example.  Later I tried to satisfy them with a post claiming that India would have the world’s largest economy within 100 years.  I thought that was a fairly outrageous prediction, as most people think of India as a poor country.  Later I learned that it’s not really that outrageous, and moved the date up to 70 years out in order to be more provocative.  Now I’m going to move it to 50 years.  That’s right, in less than 50 years India will have the world’s largest economy.  Maybe 40.

A recent paper by Willem Buiter and Ebrahim Rahbari contains the following table:

By 2050, India’s per capita GDP will be almost 75% of China’s per capita GDP, and India’s will be rising faster.  That’s just 39 years out.

Meanwhile the UN says that by 2050 China will only have 76.5% of India’s population.  That means the total GDP of India will be almost as large as the total GDP of China by 2050, just 39 years from now.  And India will have a much faster growing population (China’s will be shrinking by then), and somewhat faster growth in GDP/capita.  India will become number one sometime in the 2050s, and that means my younger readers will live long enough to see this blessed event.  Alas, I’ll be gone by then.

I’m increasing resentful of the GMU people for rejecting my outrageous claim that tight money by the Fed caused the Great Recession.  No lowly professor at Bentley should be expected to come up with more than one such idea in a lifetime.  I’ll die a happy man if my gravestone reads:

Scott Sumner:  Devoted his life to blogging on Hetzelian ideas.

(Robert Hetzel has a great new book coming out, which may revolutionize how the profession thinks about the crisis of 2008.)

In several recent posts Tyler Cowen has tried to draw a distinction between how much wealth we believed we had, and how much wealth we really had.  I was somewhat skeptical of his argument, but also thought it had some merit.  Indeed in an earlier post (not posted yet!) I tried to distinguish between wealth we correctly thought we had, which was later lost due to bad policy (1929), and wealth we thought we had, that we never really had (2006.)  Now I have doubts about my argument, indeed I think we might both be wrong.  But I’m not sure.

Consider the following 5 scenarios:

1.  The bank makes a typo, which leads you to believe you have more money than you actually have.  The typo is eventually corrected.

2.  Your family believes it owns 10 1933 $20 gold pieces, worth $80 million.  Later you find out the government has a different view.

3.  The public believes it has lots of housing wealth in 2006, but there was never any prospect that these values could be maintained.

4.  The public believes it has lots of housing wealth in 2006, but later an immigration crackdown followed by tight money reduces housing prices.

5.  The public believes it is very wealthy in 1929, but later the Fed cuts NGDP in half and caused mass unemployment.

A few days ago I thought there was a clear distinction between case 1 and case 5.  Now I don’t know where to draw the line.  Indeed I don’t know if there is a line to be drawn.

I’d like to say the public really was wealthy in 1929, and that later decisions by the Fed destroyed that wealth.  But is that a scientific way of looking at things?  At levels about subatomic particles, we tend to assume that things follow deterministic laws.  Why couldn’t someone argue:  “That national wealth in 1929 was never real, because the Fed is a part of our economy.  It was a dysfunctional institution in 1929, so it was only a matter of time before they screwed up.  We just didn’t know it yet.”

Rorty argued that when people say “Most people think X is true, but I believe Y is true,” they actually mean “most people think X is true, but I predict that in the future people will come to believe Y is true.”  Rorty saw no distinction between what is true, and what we believe is true.

Rorty also believed; “That which has no practical implications, has no philosophical implications.”  So what are the practical implications of the distinction between believing one is wealthy, and actually being wealthy?  Obviously society acts on the basis of beliefs.  So for most people it is a distinction without any significance.  Like the difference between saying I believe X, and I believe X is true.   On the other hand the skeptic who believes the wealth is phony (i.e. predicts it will later be seen as phony), would obviously see practical implications for his belief.  Indeed policy implications.

Imagine I’m debating Tyler Cowen on the question of whether the 2006 wealth was real in 2006.  What’s at stake?  I might argue that the wealth was 100% real, but later policies like immigration crackdown and tight money reduced the wealth later on.  The practical implication is that we might want to reconsider those policies.  Or, one could argue that the extra wealth was only 40% real and the other 60% was irrational exuberance.  In that case the policy implication might shift slightly.  It doesn’t mean easier money couldn’t have helped a bit, but you’d also want to put in place banking regulations robust enough to prevent housing bubbles from damaging the banking system.  Indeed you might also want to do that if the problem was 100% the Fed’s fault, but the necessity would be greater if optimal monetary policy couldn’t solve the problem.

Are we rich if we believe we are rich?  I can’t answer that question.  Rorty would say beliefs are all we have.  Yet he also allows for dissenting voices.  Just because most people get swept up in the housing bubble, and believe ranch houses in San Bernardino are worth $500,000, doesn’t mean Shiller, Krugman, Baker and Roubini have to believe that.  One the other hand, current market values have a very practical implication, they’re what we can sell things for.  In that sense they are real.

Each day that goes by we find out that the previous day’s value of the S&P 500 was wrong, as new information comes in.  Or maybe it was right; maybe it was “true,” based on what we knew at the time.  What’s the TRUE value of the S&P 500?  God only knows.

PS.  I just noticed an interesting shift in wording between the first and second posts that I linked to above.  First post:

We were not as wealthy as we thought we were.

And second post:

We are not as wealthy as we thought we were

See the difference?  If applied to someone in 1933 talking about 1929, I’d have once said the first was false, and the second was true.  Now I don’t know what to think.  I wish Rorty was still alive to help me out.  Now I feel alone in the universe, with no one to provide true answers.

PS.  The second Cowen post that I linked to above didn’t make sense to me.  I left a comment over there—maybe someone can explain the connection to AD.