For decades the Fed has steered the economy along a path of two to three percent inflation.  The policy has not been controversial.  Sometimes they ease, and sometimes they tighten.

Recently inflation has run closer to 1%, and Bernanke has suggested pushing the rate back up to 2%.  Others at the Fed are more radical, calling for level targeting.  This would allow a bit above 2% inflation to offset periods of below 2% inflation.  Even those radical proposals are more conservative than the actual 2% to 3% average rate of recent years.  So how is the public reacting to monetary policy proposals that are more conservative that what actual occurred in recent decades?  According to Time magazine, they’re so angry it might lead to a civil war:

What is the most likely cause today of civil unrest? Immigration. Gay Marriage. Abortion. The Results of Election Day. The Mosque at Ground Zero. Nope.

Try the Federal Reserve. November 3rdis when the Federal Reserve’s next policy committee meeting ends, and if you thought this was just another boring money meeting you would be wrong. It could be the most important meeting in Fed history, maybe. The US central bank is expected to announce its next move to boost the faltering economic recovery. To say there has been considerable debate and anxiety among Fed watchers about what the central bank should do would be an understatement. Chairman Ben Bernanke has indicated in recent speeches that the central bank plans to try to drive down already low-interest rates by buying up long-term bonds. A number of people both inside the Fed and out believe this is the wrong move. But one website seems to believe that Ben’s plan might actually lead to armed conflict. Last week, the blog, Zerohedge wrote, paraphrasing a top economic forecaster David Rosenberg, that it believed the Fed’s plan is not only moronic, but “positions US society one step closer to civil war if not worse.” (See photos inside the world of Ben Bernanke)I’m not sure what “if not worse,” is supposed to mean. But, with the Tea Party gaining followers, the idea of civil war over economic issues doesn’t seem that far-fetched these days. And Ron Paul definitely thinks the Fed should be ended. In TIME’s recently cover story on the militia movement many said these groups are powder kegs looking for a catalyst. So why not a Fed policy committee meeting. Still, I’m not convinced we are headed for Fedamageddon. That being said, the Fed’s early November meeting is an important one. Here’s why:

Usually, there is generally a consensus about what the Federal Reserve should do. When the economy is weak, the Fed cuts short-term interest rates to spur borrowing and economic activity. When the economy is strong and inflation is rising, it does the opposite. But nearly two years after the Fed cut short-term interest rates to basically zero, more and more economists are questioning whether the US central bank is making the right moves. The economy is still very weak and unemployment seems stubbornly stuck near 10%.

In the past I’ve argued their mistake was to argue for more inflation, which sounds undesirable.  Contrast Fed policy with fiscal stimulus.  In early 2009 there was lots of criticism about the fiscal stimulus plan, but I don’t recall a single critic arguing that fiscal stimulus was a mistake, because it “might work.”  Instead, they argued it was a waste of money and would probably “fail,” which meant it wouldn’t boost AD.  It was taken as a given that more AD was desirable.  Now monetary policy has become so controversial that people are talking about civil war.  Why?  Because some of the more radical members of the Fed are proposing average inflation rates almost as high as what we have experienced over the last two decades.

What are some possible explanations:

1.  Higher inflation sounds bad–the Fed should have said it was trying to boost AD, or NGDP, or the average income of Americans.

2.  The monetary base has already exploded in size, so people are already worried that only “long and variable lags” separate us from Zimbabwe-style inflation—despite 2% bond yields and despite the fact that similar policies had no effect on long run inflation in Japan.

Today I’d like to suggest a different explanation.  Perhaps this crisis is a sort Waterloo for Keynesian interest rate targeting, analogous to the effects of 1982 on monetarism.  You may recall that in the early 1980s monetarist ideas were popular.  Slower money supply growth helped slow inflation.  But velocity seemed to decline sharply in 1982, so the Fed let the money supply rise above target, and went back to interest rate targeting.  (Indeed some claim they never really abandoned interest rate targets, but let’s put that aside.)

This crisis has put the economy into a position where the Fed’s normal interest rate mechanism doesn’t work.  It can’t steer the economy in the only way it feels comfortable steering the economy.  Maybe we need a new steering wheel.  And the search for a new steering wheel is what is so controversial.

If we had been doing NGDP futures target all along, nothing interesting would have happened in late 2008.   Expected NGDP growth would have stayed at 5%, nominal rates would have stayed above zero, and the monetary base might not have exploded (that is less clear.)  The severe financial crisis would have been far milder, if it occurred at all.  The Fed would have continued steering the economy in the same way it always had.  (BTW, the decline in house prices in bubble areas was already largely complete by late 2008—the second leg down was caused by falling NGDP.)

Instead, when rates hit zero the Fed stopped trying to steer the economy at all; it followed Stiglitz’s advice and stopped using monetary policy.  Of course they were still doing policy (and highly contractionary policy at that) but didn’t realize it, as their normal policy tool had jammed just as the wheels of the car were pointed toward a ditch called “recession.”  In the next post I’ll explain why it’s almost impossible to pry the Fed’s hands off the old steering wheel, even though it is now broken and not connected to the wheels.

A recent post by Bill Woolsey showed that Japan’s NGDP has been amazingly stable since the early 1990s (with just a dip in late 2008.)  This article in the NYT describes what happened after Japan adopted a stable NGDP monetary policy:

OSAKA, Japan “” Like many members of Japan’s middle class, Masato Y. enjoyed a level of affluence two decades ago that was the envy of the world. Masato, a small-business owner, bought a $500,000 condominium, vacationed in Hawaii and drove a late-model Mercedes.

But his living standards slowly crumbled along with Japan’s overall economy. First, he was forced to reduce trips abroad and then eliminate them. Then he traded the Mercedes for a cheaper domestic model. Last year, he sold his condo “” for a third of what he paid for it, and for less than what he still owed on the mortgage he took out 17 years ago.

“Japan used to be so flashy and upbeat, but now everyone must live in a dark and subdued way,” said Masato, 49, who asked that his full name not be used because he still cannot repay the $110,000 that he owes on the mortgage.

Few nations in recent history have seen such a striking reversal of economic fortune as Japan.

.   .   .

The downsizing of Japan’s ambitions can be seen on the streets of Tokyo, where concrete “microhouses” have become popular among younger Japanese who cannot afford even the famously cramped housing of their parents, or lack the job security to take out a traditional multidecade loan.

These matchbox-size homes stand on plots of land barely large enough to park a sport utility vehicle, yet have three stories of closet-size bedrooms, suitcase-size closets and a tiny kitchen that properly belongs on a submarine.

“This is how to own a house even when you are uneasy about the future,” said Kimiyo Kondo, general manager at Zaus, a Tokyo-based company that builds microhouses.

.   .   .

The decline has been painful for the Japanese, with companies and individuals like Masatohaving lost the equivalent of trillions of dollars in the stock market, which is now just a quarter of its value in 1989, and in real estate, where the average price of a home is the same as it was in 1983. And the future looks even bleaker, as Japan faces the world’s largest government debt “” around 200 percent of gross domestic product “” a shrinking population and rising rates of poverty and suicide.

But perhaps the most noticeable impact here has been Japan’s crisis of confidence. Just two decades ago, this was a vibrant nation filled with energy and ambition, proud to the point of arrogance and eager to create a new economic order in Asia based on the yen. Today, those high-flying ambitions have been shelved, replaced by weariness and fear of the future, and an almost stifling air of resignation. Japan seems to have pulled into a shell, content to accept its slow fade from the global stage.

.   .   .

The classic explanation of the evils of deflation is that it makes individuals and businesses less willing to use money, because the rational way to act when prices are falling is to hold onto cash, which gains in value. But in Japan, nearly a generation of deflation has had a much deeper effect, subconsciously coloring how the Japanese view the world. It has bred a deep pessimism about the future and a fear of taking risks that make people instinctively reluctant to spend or invest, driving down demand “” and prices “” even further.

.   .   .

A Deflated City

While the effects are felt across Japan’s economy, they are more apparent in regions like Osaka, the third-largest city, than in relatively prosperous Tokyo. In this proudly commercial city, merchants have gone to extremes to coax shell-shocked shoppers into spending again. But this often takes the shape of price wars that end up only feeding Japan’s deflationary spiral.

There are vending machines that sell canned drinks for 10 yen, or 12 cents; restaurants with 50-yen beer; apartments with the first month’s rent of just 100 yen, about $1.22. Even marriage ceremonies are on sale, with discount wedding halls offering weddings for $600 “” less than a tenth of what ceremonies typically cost here just a decade ago.

.   .   .

“It’s like Japanese have even lost the desire to look good,” said Akiko Oka, 63, who works part time in a small apparel shop, a job she has held since her own clothing store went bankrupt in 2002.

This loss of vigor is sometimes felt in unusual places. Kitashinchi is Osaka’s premier entertainment district, a three-centuries-old playground where the night is filled with neon signs and hostesses in tight dresses, where just taking a seat at a top club can cost $500.

But in the past 15 years, the number of fashionable clubs and lounges has shrunk to 480 from 1,200, replaced by discount bars and chain restaurants. Bartenders say the clientele these days is too cost-conscious to show the studied disregard for money that was long considered the height of refinement.

“A special culture might be vanishing,” said Takao Oda, who mixes perfectly crafted cocktails behind the glittering gold countertop at his Bar Oda.

After years of complacency, Japan appears to be waking up to its problems, as seen last year when disgruntled voters ended the virtual postwar monopoly on power of the Liberal Democratic Party. However, for many Japanese, it may be too late. Japan has already created an entire generation of young people who say they have given up on believing that they can ever enjoy the job stability or rising living standards that were once considered a birthright here.

Yukari Higaki, 24, said the only economic conditions she had ever known were ones in which prices and salaries seemed to be in permanent decline. She saves as much money as she can by buying her clothes at discount stores, making her own lunches and forgoing travel abroad. She said that while her generation still lived comfortably, she and her peers were always in a defensive crouch, ready for the worst.

“We are the survival generation,” said Ms. Higaki, who works part time at a furniture store.

Hisakazu Matsuda, president of Japan Consumer Marketing Research Institute, who has written several books on Japanese consumers, has a different name for Japanese in their 20s; he calls them the consumption-haters. He estimates that by the time this generation hits their 60s, their habits of frugality will have cost the Japanese economy $420 billion in lost consumption.

“There is no other generation like this in the world,” Mr. Matsuda said. “These guys think it’s stupid to spend.”

Deflation has also affected businesspeople by forcing them to invent new ways to survive in an economy where prices and profits only go down, not up.

Yoshinori Kaiami was a real estate agent in Osaka, where, like the rest of Japan, land prices have been falling for most of the past 19 years. Mr. Kaiami said business was tough. There were few buyers in a market that was virtually guaranteed to produce losses, and few sellers, because most homeowners were saddled with loans that were worth more than their homes.

Some years ago, he came up with an idea to break the gridlock. He created a company that guides homeowners through an elaborate legal subterfuge in which they erase the original loan by declaring personal bankruptcy, but continue to live in their home by “selling” it to a relative, who takes out a smaller loan to pay its greatly reduced price.

“If we only had inflation again, this sort of business would not be necessary,” said Mr. Kaiami, referring to the rising prices that are the opposite of deflation. “I feel like I’ve been waiting for 20 years for inflation to come back.”

One of his customers was Masato, the small-business owner, who sold his four-bedroom condo to a relative for about $185,000, 15 years after buying it for a bit more than $500,000. He said he was still deliberating about whether to expunge the $110,000 he still owed his bank by declaring personal bankruptcy.

Economists said one reason deflation became self-perpetuating was that it pushed companies and people like Masato to survive by cutting costs and selling what they already owned, instead of buying new goods or investing.

“Deflation destroys the risk-taking that capitalist economies need in order to grow,” said Shumpei Takemori, an economist at Keio University in Tokyo. “Creative destruction is replaced with what is just destructive destruction.”

Before commenters like Greg jump all over me, re-read the intro.  I never claimed the adoption of the 0% NGDP growth policy had anything to do with the dreary story described by the NYT.  And I’m not sure it does.  There’s nothing wrong with touting a country as a smashing success in one area, even if you disagree with its policies elsewhere.  I’m always praising Singapore’s fiscal policy, yet I detest many policies of the Singapore government.  It could well be that the bad performance of Japan’s economy was caused by supply-side factors unrelated to monetary policy.  Some bloggers even claim the Japanese haven’t done all that bad.

And yet . . . let’s be honest.  This is a big problem for the 0% NGDP growth fans.  Japan’s slide into stagnation co-incided almost exactly with the (de facto) adoption of a stable NGDP rule.  And it’s the only country I know that has adopted this policy.  And before the policy was adopted most mainstream economists thought deflation was a really bad idea.  Put that all together and I think “zero percenters” have got a massive PR problem.

Yes, the US grew rapidly in the late 1800s under deflation, but we had strong NGDP growth.  Japan doesn’t.  Are there any examples of countries doing well with stable NGDP?  I don’t know of any.  Unless someone can find plausible counterexamples, that makes Hayek’s argument a really hard sell.

Why is this important?  Because Hayek’s argument underlies the Austrian view that monetary policy was too “inflationary” during the 1920s, despite no rise in the price level.  He argued NGDP should have been kept stable, so prices could fall with productivity gains.  This argument also underlies some of the critique of Fed policy in the 2000s, as price inflation wasn’t all that high.  In fairness, some point to the rapid NGDP growth after 2003 as a problem, and I partly agree.  So the critique of the Fed in this case seems stronger from a NGDP targeting perspective.  But still nowhere near as strong as the critique of their policy of allowing NGDP growth to plummet in the midst of a financial crisis.

My research career often focused on offbeat topics that no one else seemed to be interested in.  Now it might be paying off.  One of those topics was Roosevelt’s “gold-buying program” of October-December 1933.  The only other article I’ve ever seen on this topic was published in an agricultural journal back in the 1950s.  This program was the last time (and perhaps only other time) that the US government explicitly tried to raise the price level.  Admittedly the entire April 1933-January 1934 dollar depreciation policy was aimed at reflation, but only during the gold-buying phase was the policy made explicit, and was a methodical policy followed to raise prices.

I did a long post on this in early 2009, and won’t repeat it all here.  Check out the post if you want to know more about how it was done.  Instead I’d like to discuss one very interesting aspect of the program that is relevant to what is going on right now.  (The policy involved raising the dollar price of gold to devalue the dollar.)  Here is a short passage from my Depression manuscript:

Then on November 20 and 21, the RFC price rose by a total of 20 cents and the London price of gold rose 49 cents.  On November 22 the NYT headline reported “SPRAGUE QUITS TREASURY TO ATTACK GOLD POLICY” and on page 2, “Administration, Realizing This, Vainly Tried to Persuade Him to Silence on Gold Policy”.  As with the Woodin resignation, Sprague’s resignation led to a temporary hiatus in the RFC gold price increases, this time lasting five days.

Over the next several days the controversy continued to increase in intensity.  The November 23 NYTreported “RESERVE’S ADVISORS URGE WE RETURN TO GOLD BASIS; PRESIDENT HITS AT FOES” other stories reported opposition by J.P. Warburg, and a debate between Warburg and Irving Fisher (a supporter of the plan).[1]  Another story was headlined “WARREN CALLED DICTATOR”.  The November 24 NYT headline suggested that “END OF DOLLAR UNCERTAINTY EXPECTED SOON IN CAPITAL; RFC GOLD PRICE UNCHANGED”.  Nevertheless, over the next few days the NYT headlines showed the battle raging back and forth:

“ROOSEVELT WON’T CHANGE GOVERNMENT’S GOLD POLICY, IGNORING ATTACK BY [former New York Governor Al] SMITH”  (11/25/33)

“SMITH SCORES POLICY . . . Says He Is in Favor of Sound Money and Not ‘Baloney’ Dollar . . . ASKS RETURN TO GOLD . . . Critical of Professors Who ‘Turn People Into Guinea Pigs’ in Experiments” (11/25/33)

“GOLD POLICY UPHELD AND ASSAILED HERE AT RIVAL RALLIES . . . 6,000 Cheer [Father] Coughlin as He Demands Roosevelt Be ‘Stopped From Being Stopped'” (11/28/33)

---

[1]  Fisher regarded Roosevelt’s policy as being essentially equivalent to his Compensated Dollar Plan.  Although there were important differences, the rhetoric used by Roosevelt to justify the policy was remarkably close to the rationale behind Fisher’s plan.

The Fed better fasten its seat-belt, as the previous price level raising policy was a bit controversial.  Several FDR advisers resigned in protest.

George Warren was the FDR advisor behind the plan.  Warren was to Irving Fisher roughly what I am to Milton Friedman—similar ideology but lacking the intellectual brilliance.   Here’s a more important passage:

“It is indeed difficult to find out exactly what are Wall Street’s views with regard to the monetary question.  When former Governor Smith made public his letter and stocks were going up, there seemed to be little doubt that Wall Street wanted sound money.  But yesterday, faced with the sharpest break of the month, opinion veered toward inflation again.  As one broker expressed it, it begins to appear as if Wall Street would like to see enough inflation to double the price of stocks and commodities, but little enough so that Liberty bonds can sell at a premium.” (NYT, 11/28/33, p.33.)

One explanation for this ambiguity is that investors distinguished between once and for all changes in the price level, and changes in the rate of inflation.  During the early stages of the dollar depreciation, long term interest rates held fairly steady, and the 3 month forward discount on the dollar (against the pound) remained below 1.5 percent.  The market apparently viewed the depreciation as a one-time monetary stimulus, which would not lead to persistent inflation.  Investor confidence was shaken during November, however, when persistent administration attempts to force down the dollar were associated with falling bond prices and an increase in the forward discount on the dollar.  Consistent with this interpretation, the Dow rose 4.6 percent in mid-January 1934, following the Administration’s announcement that a decision was imminent to raise, and then fix, the price of gold.  The NYT noted that:

“The satisfaction found by stock and commodity markets in the inflationary implications of the program was nearly matched by the bond market’s enthusiasm for the fact that the government had announced limitations to dollar devaluation.” (1/16/34, p. 1).

The takeaway from all this is that markets seem to really want higher prices, but not higher inflation.  You do that by switching from inflation targeting to level targeting, when inflation has recently run below target.  Yesterday when the Fed minutes suggested the Fed was about to do that, equity markets responded strongly all over the world.  I’d guess about $500 billion dollars in wealth was created worldwide in 24 hours by 13 words from the Fed’s minutes:

. . . targeting a path for the price level rather than the rate of inflation . . .

The markets already knew QE was likely, but now the Fed seems increasingly serious about level targeting.

In 1933, the markets were surprised when the gold buying program briefly pushed long term T-bond yields higher (Liberty bonds in the quotation.)  Under the gold standard, the expected rate of inflation was generally roughly zero.  Investors were used to a liquidity effect (easy money means low rates) but not a Fisher effect (easy money raises inflation expectations, and thus interest rates.)  Even Keynes was pretty much oblivious to the Fisher effect:

“If you are held back [i.e. reluctant to buy bonds], I cannot but suspect that this may be partly due to the thought of so many people in New York being influenced, as it seems to me, by sheer intellectual error.  The opinion seems to prevail that inflation is in its essential nature injurious to fixed income securities.  If this means an extreme inflation such as is not at all likely is more advantageous to equities than to fixed charges, that is of course true.  But people seem to me to overlook the fundamental point that attempts to bring about recovery through monetary or quasi-monetary methods operate solely or almost solely through the rate of interest and they do the trick, if they do it at all, by bringing the rate of interest down.” (J.M. Keynes, Vol. 21, pp. 319-20, March 1, 1934.)

Before we judge Keynes too harshly, recall that he lived in a time of near-zero inflation expectations, with the exception of clearly anomalous situations like the German hyperinflation.  So when FDR’s policy of reflation briefly seemed to be raising long term bond yields in November 1933, bond market participants were rather shocked.  And here’s what I find so fascinating; modern security markets are only now beginning to grapple with this distinction, which turns out to be pretty hard to wrap one’s mind around.  Here’s something from today’s news:

Neil MacKinnon, global macro strategist at VTB Capital, said the worry in the markets is that the Fed’s attempt to raise inflation may not be as manageable and as controllable as it thinks.

“The bond market is alert to the potential contradiction in Fed policy of buying U.S. Treasuries to keep bond yields down and ideas such as price-level targeting that are likely to raise bond yields,” he said.

That’s the conundrum; what counts as “success,” higher nominal bond yields or lower nominal bond yields?  Everyone seems to assume the Fed is trying to lower bond yields, but if the policy is expected to produce a robust recovery and higher inflation, how can bond yields not rise?  I can’t answer these questions, but my hunch is that it has something to do with the higher inflation/higher price level distinction.  If the Fed can convince markets that they can raise the price level without changing their 2% inflation target, it is likely that all markets will react positively.  If they are seen as raising inflation in a semi-permanent way, stocks may still rise (albeit by a smaller amount), but bonds will sell off.

This is such an unusual circumstance that I don’t have much confidence in my own opinion, nor anyone else’s.  I don’t even know of anyone else who bothered to study what happened the last time Uncle Sam tried to raise the price level.  Too busy doing those VAR studies and DSGE models.

PS:  Where did the $500 billion figure come from?  I guesstimated world stock market valuation at about $50 trillion, with a 1% bump from the Fed move.  The financial press reported that all the world’s stock markets were affected by the Fed action.  I noticed that European stocks rose about 2%, and the Fed move was cited as the primary factor.  So I think $500 billion is roughly the order of magnitude, although obviously the exact figure is unknowable.  BTW, sometimes it is possible to get semi-accurate estimates, as when a huge market reaction following immediately upon a 2:15 Fed announcement and we have relevant odds from the fed funds futures markets.  And in those cases the effect is often much bigger.  I can’t wait for November 3rd.

Why does stuff like this have to happen when I have no time to blog?  I promise commenters that I will eventually get to comments from recent posts.  Perhaps tomorrow night.  And then there is the backlog of posts I need to do.  But this one can’t wait.  I saw the following comment from someone whose byline is an apparent reference to Keynesian economics (“Obsolete Dogma“):

If it makes you feel any better, the latest FOMC minutes (http://read.bi/8Xejge) show the board considered implementing either a NGDP or price level target instead of targeting the rate of inflation.

The FOMC brings to mind Churchill’s quip about Americans: they always do the right thing “” after they have exhausted all other possibilities.

He or she is referring to this comment in the Fed minutes:

Participants noted a number of possible strategies for affecting short-term inflation expectations, including providing more detailed information about the rates of inflation the Committee considered consistent with its dual mandate, targeting a path for the price level rather than the rate of inflation, and targeting a path for the level of nominal GDP.

Like the hardy band of hobbits who brought the ring to Mordor, our little group of bloggers from schools like Texas State, Bentley, The Citadel, Wayne State University have finally succeeded in bringing NGDP targeting (level targeting no less!) into the formerly impregnable Federal Reserve System.  Kudos to Matt Yglesias as well.  And of course level targeting-advocate Michael Woodford, who in all seriousness does have influence at the Fed.

Here’s Yahoo’s explanation of why stocks turned around after Yellen’s scary statement depressed prices this morning:

 WASHINGTON (AP) — The Federal Reserve is leaning toward taking two steps to boost the economy: Buying more Treasury bonds to drive down loan rates, and signaling an openness to higher prices later to encourage more spending now.

And another Yahoo story explained the market reaction:

NEW YORK (AP) — Traders pushed shares higher Tuesday after minutes from the latest Federal Reserve meeting kept hope alive that the central bank would take more action to stimulate the economy.

The Fed had said after its Sept. 21 meeting that it was concerned that inflation was too low, and suggested it could step up its purchases of government bonds and take other action to encourage lending.

Minutes from the September meeting, released Tuesday afternoon, indicated that Fed Chairman Ben Bernanke and his colleagues were nearing a consensus on what steps to take. Traders are hoping for more concrete news from the Fed following its next meeting in early November.  (Emphasis added.)

Yes, I understand that the details will probably be underwhelming, and I shouldn’t get my hopes up.  But the fact that they are thinking along these lines may pay off in the next business cycle.  Imagine if these policies had been adopted in September/October 2008.  Remember, NGDP fell in 2009 at the fastest rate since 1938—level targeting would have made a huuuuuge difference in October 2008.

PS:  The post title is a reference to this Paul Krugman post.  In fairness to Krugman, any price level or NGDP target announced by the Fed is probably going to be too low to make a dramatic difference.  But I think he might underestimate the advantages of level targeting over “memory-less” growth rate targeting.  At least I don’t recall him discussing the topic.

If there is one thing almost every macro book agrees on, is that a large, sudden, and unexpected drop in nominal expenditure relative to trend is a really, really bad thing.   Aggregate demand shocks destabilize the economy, and lead to needless unemployment.  I don’t know about you, but I don’t recall reading; “Severe AD shocks are really, really bad, except when the economy is also suffering from some other structural problem.  Then they’re just dandy!”

As an analogy, suppose you had pneumonia, and then someone stabbed you in the gut.  You show up at the hospital, and the doctor says “there’s no need to patch up that knife wound, your real problem is pneumonia.”  I think you’d look for another doctor.  A severe AD shock causes lots of unemployment; that’s true whether you start from full employment, or whether you already have lots of unemployment from structural problems.

So when economists react to the sharpest fall in NGDP since 1938 by announcing that the economy really needs tighter money, I’m inclined to react as if a doctor ordered leeches for someone already bleeding from a knife wound.  I’m going to look for another economist.  In fairness, many proponents of structural causes of the recession do understand this point.  Tyler Cowen favors monetary stimulus, even though he thinks much of the problem is structural.  Even Arnold Kling thinks it’s worth a shot.

I was reminded of all this by a recent debate between Raghu Rajan and Paul Krugman.  Rajan has said elsewhere that we need tighter money.  Krugman strongly disagrees.  Here’s part of Rajan’s response to Krugman:

First, Krugman starts with a diatribe on why so many economists are “asking how we got into this mess rather than telling us how to get out of it.”  Krugman apparently believes that his standard response of more stimulus applies regardless of the reasons why we are in the economic downturn. Yet it is precisely because I think the policy response to the last crisis contributed to getting us into this one that it is worthwhile examining how we got into this mess, and to resist the unreflective policies that Krugman advocates.

I believe both Krugman and Rajan are wrong.  Rajan thinks the real problem is structural, and that more monetary stimulus might just blow up another housing bubble.  You already know what I think of that argument, so I’d like to focus on Krugman’s response.  Krugman rightly argues that we need much more AD and then suggests that it doesn’t matter why AD fell, we have the tools to boost it now.  I agree we need more AD, but I also think it does matter how we got here.

Both Rajan and Krugman believe the severe fall in NGDP in late 2008 was caused by the financial crisis.  Rajan thinks that means our dysfunctional financial system is the real problem, whereas Krugman thinks the current low level of AD is now the real problem.  In contrast, I think the sharp fall in NGDP during 2008-09 was caused by tight money, and that the solution is easier money.

But why does it make a difference that Krugman and I disagree as to how we got here, isn’t the important thing that we both agree that we need more monetary stimulus?  Yes and no.  Yes, in the sense that you need to patch that knife wound regardless of how you got it.  But if Krugman is right that tight money didn’t cause the fall in AD, then it creates doubt as to whether easy money can patch the wound.

Most economists disagree with my view that if the Fed had done 5% NGDP growth targeting, level targeting, from mid-2008 forward, we wouldn’t have had steep fall in NGDP.  The standard view is that the financial crisis was an exogenous shock, and a devastating shock, and the drop-off in lending would have caused aggregate demand to fall in any case.  Suppose my opponents are right, and the Fed couldn’t have prevented a severe decline in NGDP in late 2008.  Doesn’t that raise doubts as to whether the Fed could now fix the problem?  After all, even in 2010 banks continue to maintain a much more restrictive lending regime.  If that’s the “real problem” then arguably it is just as much a problem today as in 2008.

Of course I don’t think this would prevent easy money from triggering a robust recovery, and perhaps Krugman share’s my view.  But even if he does, it isn’t something you can just assume away.  I don’t face that problem because I believe the big fall in AD was caused by tight money—in September 2008 the Fed’s 2% target rate was way above the Wicksellian equilibrium rate.  But Krugman doesn’t believe that tight money caused the recession, he believes the financial crisis caused the big drop in NGDP.  So he faces a much bigger burden in showing that monetary stimulus can fix the problem.  He needs to show that monetary policy could not have prevented NGDP from falling in late 2008, but now the Fed can boost NGDP.  That’s certainly possible, but it’s not a given.

BTW, unless Rajan’s just making up facts, it seems to me that his response to Krugman is pretty persuasive on the issue of the financial crisis.  He has lots of evidence that Krugman is flat out wrong in asserting that government encouragement of low cost housing didn’t play a major role in the housing bubble.  Here’s just one example:

So Krugman shifted his emphasis. In his blog critique of a Financial Times op-ed I wrote in June 2010, Krugman no longer argued that Fannie and Freddie could not buy sub-prime mortgages.[v]  Instead, he emphasized the slightly falling share of Fannie and Freddie’s residential mortgage securitizations in the years 2004 to 2006 as the reason they were not responsible. Here again he presents a misleading picture. Not only did Fannie and Freddie purchase whole sub-prime loans that were not securitized (and are thus not counted in its share of securitizations), they also bought substantial amounts of private-label mortgage backed securities issued by others.[vi]  When these are taken into account, Fannie and Freddie’s share of the sub-prime market financing did increase even in those years.

In 2008 the left gleefully argued that the banking crisis represented a failure of laissez-faire.  As a result they over-reached, even defending the GSEs.  They would have been better off arguing that the GSEs were private (which isn’t really true, but is sort of plausible.)  By defending the GSEs, they implicitly acknowledged their public dimension.  Now more and more evidence is coming in that the problems with our financial system all start with the letter ‘F’.  (Fannie, Freddie, FDIC, FHA, etc.)  And what does ‘F’ stand for?

HT:  Patrick R. Sullivan