In early March 2008 I wrote an open letter to the President:

President Obama: You need to talk to Christy

I pointed out that Christine Romer understood the importance of monetary stimulus in the Great Depression, and predicted that she would recommend aggressive monetary stimulus in this crisis as well.  I doubt he ever talked with her, as he didn’t even bother filling empty Fed seats.  At the time most progressives were ignoring monetary stimulus, and focusing almost entirely on fiscal stimulus.

Now we know I was right, Christine Romer does think that monetary stimulus is crucial:

“We need to realize that there is still a lot of devastation out there,” Romer said, calling the 8.9% unemployment rate “an absolute crisis.”

“If I have a complaint about policy these days, it’s that we’re not doing enough,” she said. “That goes all the way up to the Federal Reserve, [which] could be taking more aggressive action. It goes to the Congress and the Administration – there are fiscal policy actions they could be taking.”

“And don’t tell me you can’t [take those actions] because of the deficit because I think there are fiscally responsible ways,” she said.

Romer suggested that extending the payroll tax break to the employer side of the payroll tax could spur the economy;

The employer-side payroll tax cut is a good way of offsetting wage stickiness, and is an idea I have often advocated.  Monetary stimulus combined with an employer payroll tax cut would be a powerful one-two punch.

Why didn’t he talk to Romer?  I suspect that Larry Summers blocked access.

HT:  Matt Yglesias

PS.  Replies to comments may be delayed.

Update 3/25/11:  Alex Tabarrok sent me an even better quotation from Romer:

One thing I had the class read was Ben Bernanke’s 2002 paper on self-induced paralysis in Japan and all the things they should’ve been doing. My reaction to it was, ‘I wish Ben would read this again.’ It was a shame to do a round of quantitative easing and put a number on it. Why not just do it until it helped the economy? That’s how you get the real expectations effect. So I would’ve made the quantitative easing bigger. If you look at the Fed futures market, people are expecting them to raise interest rates sooner than I think the Fed is likely to raise them. So I think something is going wrong with their communications policy. They could say we’re not going to raise the rate until X date. Those would be two concrete things that wouldn’t be difficult for them to do. More radically, they could go to a price-level target, which would allow inflation to be higher than the target for a few years in order to compensate for the past few years, when it’s been lower than the target.

Milton Friedman helped revive capitalism when he showed that the Great Depression didn’t show capitalism was unstable, but rather that monetary policy had been unstable.  Some critics argue he actually was a closet interventionist, as he thought capitalism required active stabilization policy.  Perhaps, but one could also argue that he was saying “as long as the government runs our monetary regime, they need to do it well.”  Sort of like a libertarian arguing that if governments build our bridges, they should build them so that they don’t collapse.

In any case, conservatives later started to drift away from the Friedman/Schwartz view of the Great Depression, and became increasingly disdainful of “demand shock” explanations of the business cycle.  This created a huge problem in 2008, as conservatives had great difficulty defending the free market, which seemed to have once again failed us.

To be sure, they did find some important policy failures; from the GSEs to deposit insurance to the regulation of the ratings agencies to the moral hazard created by “Too-Big-to-Fail.”  Nevertheless, given all the bad loans that were made without government pressure, by private banks, to middle class borrowers, it was pretty hard to completely absolve the private sector.

I believe that abandoning the Friedman/Schwartz view of the business cycle was a big mistake.  It’s not that this view would have magically absolved the private sector from any role in the sub-prime fiasco, I’m somewhere in the middle on this issue, believing both regulators and private actors made huge mistakes.  Rather the F/S view would have absolved the financial crash from being the primary cause of the Great Recession.  It would be much easier to live with the occasional financial fiasco if it didn’t lead to a Great Recession.  Remember 1987?

If RGDP hadn’t fallen sharply in 2009 then the banking crisis would have been resolved much more easily, with far less public money.  For that to have happened we would have needed to prevent NGDP growth from turning negative.  And that would have required that conservatives accept the F/S view of the Great Depression, instead of drifting toward “real” theories of business cycles.

Why focus on conservatives, weren’t liberals also clueless about monetary stimulus?  If people like Fisher, Plosser, and Hoenig had warned that aggressive monetary stimulus was needed to prevent a severe slump; does anyone really believe the doves at the Fed would have stood in the way?

In 1930-33 the policies advocated by Friedman and Schwartz would have been viewed as being highly progressive.  Later Friedman moved away from steady monetary growth toward policies that would offset velocity shocks—even more progressive.  It’s a pity that so few liberal and conservative economists picked up the torch when Friedman died in 2006.  What is “the torch?”

1.  Demand shocks drive the business cycle.

2.  Monetary policy is the best tool for demand stabilization.

3.  Monetary policy is very powerful at the zero bound.

How many economists believed all three in October 2008?

Marcus Nunes sent me what might be the first mainstream media article to correctly describe what went wrong in 2008.  It appears in the National Review, one of those conservative magazines that Paul Krugman thinks only publishes articles written by gold bugs and austerians.

Ramesh Ponnuru relies heavily on the views of quasi-monetarists like David Beckworth, Josh Hendrickson and myself.  And he gets it right.  (I hope this doesn’t sound condescending, but the MSM often doesn’t quite understand monetary economics, as the field is full of counter-intuitive arguments and subtle distinctions that are hard to grasp.)

Josh Hendrickson””an economist at the University of Toledo, and like Beckworth a right-leaning blogger””has shown that the Fed did a pretty good job of stabilizing the growth of nominal income at roughly 5 percent per year during the “great moderation” that lasted from the mid-1980s until the current recession. (Although Beckworth notes that growth was slightly above trend during the housing boom, for which he faults the Fed.) Most debts””notably, most mortgage debts””are contracted in nominal terms, with no inflation adjustment. If people are used to 5 percent growth in nominal incomes each year and make their arrangements accordingly, then an unexpected drop will make their debt burdens heavier and also make them reluctant to make plans for a suddenly uncertain future.

That’s what happened during the recent crisis. Scott Sumner””yet another right-of-center econoblogger, this one based at Bentley University””often notes that in late 2008 and early 2009, we saw the sharpest fall in nominal income since 1938.  In his view, much of what we think we know about the recession of 2007-09 is wrong. Not only has money not been loose since the crisis began, but tight money is the fundamental reason the recession was so severe and the recovery has been so halting. He argues that it was more fundamental than the housing bust, since residential-construction employment started falling long before the crisis hit.

The article is entitled “Not Enough Money: Why QE2 Worked.”  Sorry, I can’t find a link.

Karl Smith should be much more famous.  Here he criticizes Paul Krugman’s defense of the liquidity trap.

I wrote an article for the Adam Smith Institute called “The Case for NGDP Targeting.”  I can’t find it online, but they have paper copies.

My colleague told me that the job market site for economists has an entire thread devoted to this question:

Do you think Scott Sumner is batshit insane?(14 posts)

And here is the comment on top:

His blog is usually pretty good when he isn’t talking about how monetary policy was contractionary in 08-09. (Lol…)

my vote is not-quite-batshit-insane-but-still-insane

Commenter d4bb (notice how they don’t use their names) is actually about right; insane, but not batshit insane.  BTW, I’d actually be more inclined to hire someone who called me insane—let’s have some fun debates in the faculty dining room.

I agree that back in late 2008 I was just about the only one claiming that monetary policy was very contractionary.  That’s a pretty good definition of insanity–looking at the world in a way that others find preposterous.  But let’s see who gets the last “Lol.”

Bruce Bartlett recently sent me a very interesting paper by Lars Svensson.  At least I think it’s very interesting, as I don’t read math.  In any case, here’s what Svensson thinks about easy and tight money:

We see that there is a substantial difference between restrictions on the nominal and the real policy rate, since inflation is quite sensitive to the real policy rate in Ramses. In the top middle panel, we see that a restriction on the nominal policy-rate projection to equal 25 basis points for quarters 0–3 corresponds to a very high and falling real policy-rate projection. In the top right panel we see that the restriction on the real policy rate to equal 25 basis points for quarters 0–3 corresponds to a nominal policy-rate projection quite a bit below the real policy rate. . . .

If restrictions are imposed on the nominal policy rate for many periods, unusual equilibria can occur. We can illustrate this for Ramses in Figure 4.4, where in panel b the nominal policy rate is restricted to equal 25 basis points for 9 quarters, quarters 0–8. This is a very contractionary policy, which shows in inflation and inflation expectations falling very much and the real policy rate becoming very high.  (Italics added.)

A policy rate set at 0.25% for a long period of time.  A real interest rate that actually rose well above the nominal interest rate.  Sharply falling inflation expectations.  Does that sound a little bit like late 2008?  Looks like I’m not the only one calling that “contractionary.”

LOL

Those who can read math might want to tell me whether I misunderstood the paper.  After all, it’s well known that I’m delusional.

BTW, you have to wonder about people who have time to do these long threads at “Economics Job Market Rumors,” picking on an obscure professor at Bentley.  Don’t they have better things to do with their time?

I know what you are thinking—“What does that say about you Sumner.”

Here’s a more interesting comment by “8aea”:

When Sumner tries to get into the details of monetary policy, however, he gets a little lost. It is far, far more coherent to discuss these issues in Woodfordian “expected path of interest rates” language, but he instead insists on talking in terms of quantities. This causes problems during discussion of QE2, because from a “quantity” perspective it seems that QE is clearly beneficial, whereas from a modern (correct) perspective it doesn’t do anything at all unless it provides a signal about the future path of the Fed’s policy instrument. The funny part is that Sumner actually seems to acknowledge this (the fact that QE only matters as a signaling device, except for perhaps some slight portfolio balance effects) when pressed, but then declines into rambling about NGDP targeting and whatnot.

Woodford says the way to get out of the liquidity trap is to promise to hold rates at zero for a really long time.  If I wanted to be sarcastic like these guys, I’d say “How’s that working out for the BOJ?”  I do respect Woodford’s view, but I’m not sure that I’d characterize someone like Bennett McCallum as “a little lost,” and yet he also thinks the quantity of money approach is useful.  Woodford thinks of the transmission mechanism in terms of interest rates; I think of it in terms of asset prices.  Look at how interest rates and asset prices responded to QE2, and tell me which view seems more plausible.  Or how about the Fed announcement of December 2007, which caused a sharp stock market decline, and also caused nominal rates to fall across maturities from 3 months to 30 years.

BTW, the “signaling” that I am supposedly confused about is a signal for a higher future path of the supply of base money relative to demand—sending future prices (and NGDP) higher through the excess cash balance mechanism, once we are no longer at the zero bound.  Not sure why that’s viewed as “rambling.”

But commenter “d018” clearly nails me:

His obsession with nominal GDP borders on the sociopathic.

PS.  Responses will be very slow for the next few months.

PPS.  If DeLong, Yglesais, Svensson, etc, are saying the same thing as me, I might as well quit blogging.  It’s only fun if you can be a contrarian.

PPPS.  9.8%, 9.4%. 9.0%, 8.9%.  Why couldn’t my fellow economists have demanded QE2 in 2008?   Why did we have to throw nearly 2 years away on a futile and expensive fiscal stimulus, before getting serious?  Haven’t we been teaching our grad students for two decades that fiscal stabilization policy doesn’t work very well?  Did we not believe what we were teaching?

I don’t know how to directly post Youtube videos yet, so please play along and click on the link below.  Before watching the one minute video, please pay close attention to the instructions—you are to count only the number of times the three people wearing white pass the ball.  Ignore the three people wearing black.  Pay close attention, as the action moves along at a good pace.

http://viscog.beckman.illinois.edu/grafs/demos/15.html

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If you have watched the video, you may be wondering what it has to do with monetary policy.  The three people in white represent the banking crisis, and also the efforts by Congress, the adminstration and the Fed to solve the problem during September-December 2008.

The other visitor who wanders into the picture represents the Fed’s passivity in the face of sharply falling NGDP expectations during late 2008.  I’d guess 99% of economists focused on he banking crisis and overlooked this important event.  Only the very few who are singlemindledly obsessed with looking for gor . . ., I mean looking at NGDP growth expectations as an indicator of the stance of monetary policy, actually noticed the problem.  By 2010, however, many economists noticed the “800 pound gorilla in the room.”

HT:  Lorne Smith