OK, the title’s not as dynamic as Camille Paglia’s Break, Blow, Burn, but I’m only an economist.  Recently I’ve been trying to figure out several questions; including what do we mean by the stance of monetary policy, and what do we mean by a monetary shock?  I suspect that at some deep level these are actually the same question, much as I suspect, “Does free will exist” and, “Is there such a thing as personal identity?” are the same question.  This post is a reaction to some good comments I’ve received, and also an excellent new post by Nick Rowe.  Don’t expect any final answers here, go to Nick’s post for specifics on VAR models.

Let’s work backwards from “cause.”  Perhaps a monetary shock is a change in monetary policy that causes something or many things to happen.  But that forces us to examine the thorny issue of what do we mean by “cause?”  In a sense, monetary policy could be said to cause all nominal changes in the economy, and many real changes.  After all, under a fiat money regime there is always some alternative monetary policy that would have prevented a nominal variable from changing.  Thus if the price of zinc rises from $1.30 to $1.35 a pound, you could say the cause of the increase was the Fed’s refusal to use OMOs to peg the price of zinc at $1.30/oz.  I think we can all agree that this is not a very useful view of causation.  But this problem will creep in to some extent no matter how hard we try to pin down ’cause’.

Now let’s look at ‘stance’ and ‘shock’.  By now you are sick of me telling you that interest rates don’t measure the stance of monetary policy.  But why not?  And why can’t I provide a definitive definition, if I’m so sure interest rates are wrong? Let’s consider three groups of possible indicators:

1.  Interest rates and the monetary base

2.  Exchange rates and the monetary aggregates

3.  Inflation, NGDP growth and zinc prices

I’d like an indicator that always moves in one direction in response to a given change in the stance of monetary policy. That’s why I hate interest rates; tight money sometimes makes them rise, and sometimes makes them fall.  So we can’t look at interest rates and identify the stance of policy.  Ditto for the base, which might rise because we are monetizing the debt Zimbabwe style, or it might rise because we are accommodating a high demand for reserves at the zero bound, a la Japan since the late 1990s.  That’s not to say that we can’t assume a given nudge in rates or the base leaves policy predictably tighter than a few minutes earlier.  The problem is that we can’t look at rates or the base and tell whether policy is looser or tighter than 3 months ago, which makes it useless for projects like VAR studies.  Nor does it help to look at rates relative to the natural rate, as the natural rate is highly unstable, and hard to estimate.

The second group is better.  In general, tight money will appreciate the exchange rate and reduce M2.  But I’m not 100% sure that’s always true.  Is it possible that tight money could lead to expectations of depression, and that expectations of depression could lead to lower future expected exchange rates, and that this would reduce the current value of the currency?  Is it possible that tight money could lead to such uncertainty that people want to hold more M2, relative to other assets?

The last group seems safest, and the first two items in group #3 are also the indicators chosen by Ben Bernanke back in 2003.  I can’t imagine a case where tight money raises either inflation, NGDP, or zinc prices.  So at least in terms of direction of change, they seem completely reliable.  One can think of the CPI as measuring the (inverse of the) value of money.  That’s a nice definition of easy or tight money—changes in its purchasing power.  NGDP is slightly more ungainly, the (inverse of the) share of national income that can be bought with a dollar bill.

Unfortunately I’ve engaged in circular reasoning.  I’ve defined easy and tight money in terms of inflation and NGDP growth, because I believe they are reliably related to the stance of monetary policy.  But how do I know that the thing that causes NGDP to rise is easy money?  Here I don’t think we can escape the necessity of relying on theory.  Theory says that an unexpected injection of new money will have all the effects associated with easy money, such as temporarily lower interest rates, a depreciated currency, more inflation and NGDP growth.

If we define the stance of monetary policy in terms of inflation or NGDP growth, then it seems to me that it makes sense to think of “shocks” as policy actions that change the stance of monetary policy.  Thus if Fed actions moved expected GDP growth from 4% to 6%, you could say that monetary policy eased and a positive monetary “shock” occurred.  Vice versa if expected NGDP growth fell from 4% to 2%.

But lots of people aren’t going to like the implications of all this, or any of this, as there are deep cognitive illusions about distinctions between “errors of omission” and “errors of commission” that seem important (but in my view are not.) For instance, VAR studies could no longer disentangle monetary and demand-side fiscal shocks—-all changes in NGDP would be monetary shocks, by assumption.  There would be no difference between a change in M and a change in V, both would be monetary shocks.

If you try to flee back to your comforting notions of causality, they will fall apart under close inspections.  Suppose Russians hoard 5% of the US monetary base in 1991, and the Fed does not accommodate that increase, even though they easily could have done so.  Interest rates soar, V falls, and the US goes into recession.  What do the “concrete steppes” people say? Unfortunately they’d start arguing with each other.  The monetary base concrete steppes people would insist the Fed did not cause the recession, it was caused by Russian currency hoarding.  The base didn’t change.  The interest rate concrete steppes people would insist the Fed did an error of commission; they increased interest rates sharply and caused the recession.

Nor is it possible to fall back on “unexpected changes in interest rates.”  Suppose that prior to the Sept. 2008 FOMC meeting, markets had expected a huge negative monetary shock, which would occur because the Fed foolishly kept interest rates at 2%.  But instead (suppose) the Fed surprised us and avoided a negative monetary shock by cutting rates to zero and switching to NGDP level targeting.  There would be a huge negative surprise to interest rates, but no change in the stance of monetary policy, by the NGDP criterion.

Macroeconomics is riddled with unexamined assumptions about stances of policy, shocks, and causation.  It’s ironic that we use the term ‘stance’ as there’s no stable ground here to stand upon.  It’s like we’ve moved from a classical Newtonian world to a relativistic universe.  What’s is the stance of policy?  It depends where you are standing, how fast you are moving, what variables you are interested in, etc., etc.

People are constantly telling me that my “tight money” theory of the 2008 recession is loony.  But I am never provided with any good reasons for this criticism.  I have no doubt that there are hundreds of macroeconomists who are much smarter than I am, but I do occasionally wonder if my profession is somewhat lacking in imagination.

PS.  Going back to the opening paragraph, the answers are no and no.

Here’s Ben Bernanke on the idea of using monetary policy to address financial imbalances:

Let there be no mistake: In light of our recent experience, threats to financial stability must be taken extremely seriously. However, as a means of addressing those threats, monetary policy is far from ideal. First, it is a blunt tool. Because monetary policy has a broad impact on the economy and financial markets, attempts to use it to “pop” an asset price bubble, for example, would likely have many unintended side effects. Second, monetary policy can only do so much. To the extent that it is diverted to the task of reducing risks to financial stability, monetary policy is not available to help the Fed attain its near-term objectives of full employment and price stability.

For these reasons, I have argued that it’s better to rely on targeted measures to promote financial stability, such as financial regulation and supervision, rather than on monetary policy.

One of the “unintended side effects” of the Fed’s 1928-29 attempt to pop the stock market bubble was the Great Contraction of 1929-33.  Another was Hitler taking power in Germany.  And another was WWII.  So if anything, Bernanke is being too polite to those who favor using monetary policy to prevent financial imbalances.

Now of course they’d insist that they also favored macroeconomic stabilization, and merely wish to use monetary policy at the margin.  But even those more reasonable proposals are highly questionable.  Bernanke cites one study (links further down) that does find that monetary policy might play a role, but not a very large one:

Although, in principle, the authors’ framework could justify giving a substantial role to monetary policy in fostering financial stability, they generally find that, when costs and benefits are fully taken into account, there is little case for doing so. In their baseline analysis, they find that incorporating financial stability concerns might justify the Fed holding the short-term interest rate 3 basis points higher than it otherwise would be, a tiny amount (a basis point is one-hundredth of a percentage point). They show that a larger response would not meet the cost-benefit test in their estimated model. The intuition is that, based on historical relationships, higher rates do not much reduce the already low probability of a financial crisis in the future, but they have considerable costs in terms of higher unemployment and dangerously low inflation in the near- to intermediate terms.

And even this is doubtful, as it depends on the very dubious assumption that low interest rates imply easier money:

A new paper by Andrea Ajello, Thomas Laubach, David López-Salido, and Taisuke Nakata, recently presented at a conference at the San Francisco Fed, is among the first to evaluate this policy tradeoff quantitatively. The paper makes use of a model of the economy similar to those regularly employed for policy analysis at the Fed. In this model, monetary policy not only influences near-term job creation and inflation, but it also affects the probability of a future, job-destroying financial crisis. (Specifically, in the model, low interest rates are assumed to stimulate rapid credit growth, which makes a crisis more likely.)

Indeed a tighter monetary policy during the famous housing bubble of 2005-06 would have probably been associated with lower interest rates, not higher.  Thus in a counterfactual where in 2001-03 the Fed had cut rates to 3%, not 1%, the level of interest rates in the 2005-06 bubble would have had to be lower than the actual path of rates, as the economy would have been in depression.

What most caught my attention is that Bernanke comes down strongly in support of his former colleague Lars Svensson, who quit the Riksbank in disgust over its tightening of monetary policy around 2010-11:

Lars Svensson, who discussed the paper at the conference, explained, based on his own experience, why cost-benefit analysis of monetary policy decisions is important. Lars (who was also my colleague for a time at Princeton) served as a deputy governor of the Swedish central bank, the Sveriges Riksbank. In that role, Lars dissented against the Riksbank’s decisions to raise its policy rate in 2010 and 2011, from 25 basis points ultimately to 2 percent, even though inflation was forecast to remain below the Riksbank’s target and unemployment was forecast to remain well above the bank’s estimate of its long-run sustainable rate. Supporters justified the interest-rate increases as a response to financial stability concerns, particularly increased household borrowing and rising house prices. Lars argued at the time that the likely benefits of such actions were far less than the costs. (More recently, using estimates of the effects of monetary policy on the economy published by the Riksbank itself, he showed that the expected benefits of the increases were less than 1 percent of the expected costs). But Lars found little support for his position at the Riksbank and ultimately resigned. In the event, however, the rate increases were followed by declines in inflation and growth in Sweden, as well as continued high unemployment, which forced the Riksbank to bring rates back down. Recently, deflationary pressures have led the Swedish central bank to cut its policy rate to minus 0.25 percent and to begin purchasing small amounts of securities (quantitative easing). Ironically, the policies of the Swedish central bank did not even achieve the goal of reducing real household debt burdens.

When someone leaves an important policy position, where a person is not really free to speak their mind, to blogging, which is all about speaking one’s mind, you quickly learn a great deal about their views on controversial issues. Anyone want to wager with me on what Bernanke and Svensson think of the ECB’s decision to twice raise rates in 2011?

I was only disappointed by one aspect of the post—Bernanke continues to (implicitly) use a conventional measure for the stance of monetary policy.

Despite the substantial improvement in the economy, the Fed’s easy-money policies have been controversial. Initially, detractors focused on the supposed inflation risks of such policies. As time has passed with no sign of inflation, that critique now looks rather threadbare. More recently, opposition to accommodative monetary policy has mostly coalesced around the argument that persistently low nominal interest rates create risks to financial stability, for example, by promoting bubbles in asset prices or stimulating excessive credit creation.  (emphasis added)

In 2003, Bernanke correctly pointed out that conventional measures such as interest rates are highly flawed:

The imperfect reliability of money growth as an indicator of monetary policy is unfortunate, because we don’t really have anything satisfactory to replace it. As emphasized by Friedman (in his eleventh proposition) and by Allan Meltzer, nominal interest rates are not good indicators of the stance of policy, as a high nominal interest rate can indicate either monetary tightness or ease, depending on the state of inflation expectations. Indeed, confusing low nominal interest rates with monetary ease was the source of major problems in the 1930s, and it has perhaps been a problem in Japan in recent years as well. The real short-term interest rate, another candidate measure of policy stance, is also imperfect, because it mixes monetary and real influences, such as the rate of productivity growth. In addition, the value of specific policy indicators can be affected by the nature of the operating regime employed by the central bank, as shown for example in empirical work of mine with Ilian Mihov.

.  .  .

Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation. On this criterion it appears that modern central bankers have taken Milton Friedman’s advice to heart.

Of course by that criterion (averaging inflation and NGDP growth), money was tighter in 2008-2013 than in any 5 year period since Herbert Hoover was president.

Here’s commenter Philo, quoting me and then responding:

“It’s hard to evaluate current policy without knowing where the Fed wants to go, and they refuse to tell us where they want to be in 10 years, either in terms of the price level or NGDP. If they would tell us, I’d recommend they go there in the straightest path possible.” But why accept the Fed’s objective, whatever it may be, as valid? If they wanted to take us to hell, would you recommend that they do so as efficiently as possible? I think the Fed needs your advice about *what objective to aim for*, as well as about how to achieve that objective.

I do give the Fed both kinds of advice, but it’s very important not to mix them up. Suppose while living in Madison I get into an argument with friends about whether to vacation in Florida or California.  I lose the argument and we decide on Florida.  I’m in charge of directions.  Do I have the car head SW on highway 151, or southeast on I-90? If I suggest southwest, because I want to go to California, then when the vegetation starts getting sparse they’ll realize we are going the wrong way, and lots of needless extra driving will occur—the travel equivalent of a business cycle.

Now suppose I favor 5% NGDP growth and the Fed favors something closer to 3% in the long run.  In that case I may suggest they change their target to 5%, but it’s silly for me to give them tactical advice consistent with a 5% target.  After a few years of that we’d plunge to 1%, to create the 3% long run average.  Again we’d get a needless business cycle.  Whichever way they want to go, I’d like them to go STRAIGHT.

Tyler Cowen has a post that links to a FT story warning of a possible repeat of 1937. They should have warned of a possible repeat of 1937 and 2000 and 2006 and 2011, when various central banks tightened prematurely at the zero bound.  Did they ever tighten too late?  Yes, in 1951, in circumstances totally unlike today.  So yes, I’m worried about a repeat of 1937.  I currently think the odds are at least 4 to 1 against a double dip recession next year, but I’d like to see the Fed make those odds smaller still.

Tyler also links to a Martin Wolf piece that starts out very sensibly; pointing out that low rates do not mean money has been easy.  But then Wolf slips up:

The explosions in private credit seen before the crisis were how central banks sustained demand in a demand-deficient world. Without them, we would have seen something similar to today’s malaise sooner.

I see his point, and it’s true in a certain way.  But it’s also a bit misleading.  It would be much more accurate to say that central banks sustained demand by printing enough money to keep NGDP growing at 5%, and could have continued doing so if they had wished to.  It so happens that bad regulatory policies pushed much of that extra demand into credit financed housing purchases, instead of restaurant meals, vacations, cars, etc.  But that has nothing to do with monetary policy, which is supposed to determine AD.

Tyler comments on the debate:

I see a few possibilities:

1. Stock and bond markets are at all-time highs, and we Americans are not so far away from full employment, so if we don’t tighten now, when?  Monetary policy is most of all national monetary policy.

I’d say we tighten when doing so is necessary to hit the Fed’s dual mandate.  And how are stock and bond prices related to that mandate?  And what does Tyler mean by “tighten?”  Does he mean higher interest rates?  Or slower NGDP growth (as I prefer to define tighten)?

I do agree that the Fed should focus on national factors, but otherwise I think Tyler needs to be more specific.  Is he giving advice about tactics or strategy?  Does he believe this advice would help the Fed meet its 2% PCE inflation target?  If so, then why?  Notice that the inflation rate is not mentioned in his discussion of what the Fed should do, even though the Fed has recently adopted a 2% inflation target (2.35% if using the CPI), and is widely expected to undershoot that target for years to come.

2. It’s all about sliding along the Phillips Curve.  Where are we?  Who knows?  But risks are asymmetric, so we shouldn’t tighten prematurely.  In any case we can address this problem by focusing only on the dimension of labor markets and that which fits inside the traditional AD-AS model.

I agree with this, although I think the first and last parts of it are poorly worded.  I think he’s saying that we don’t know where we are relative to the natural rate of unemployment, which is true.  But the term ‘Phillips Curve’ is way too vague, unless you are already thinking along the lines I suggested.  Yes, the risk of premature tightening is important.  Even worse, the risks facing the Fed are somewhat asymmetric, due to their reluctance to target the forecast at the zero interest rate bound.  So excessively tight money will cost much more than excessively easy money, in the short run.  But what about the long run?  Again, that depends on the Fed’s long run policy goals, and they simply won’t tell us.  For instance, if the policy was something like level targeting, then the risks would again become symmetric–overshoots are just as destabilizing as undershoots under level targeting.  That’s one more reason to switch to level targeting.

I also find the last part to be rather vague (although maybe that just reflects my peculiar way of looking at things.)  I certainly think the labor market and AS/AD are the key to monetary policy analysis, but those terms can mean different things to different people. I think Tyler sometimes overestimates the ability of his readers (including me) to follow his train of thought.  “Labor market” might mean nominal wage path or U-3 unemployment.  Those are actually radically different concepts, as the first is a nominal variable and the other a real variables.

Tyler continues:

3. The Fed’s monetary policies have created systemic imbalances, most of all internationally by creating or encouraging screwy forms of the carry trade, often implicit forms.  A portfolio manager gains a lot from risky upside profit, but does not face comparable downside risk from trades which explode in his or her face.  The market response to the “taper talk” of May 2013 (egads, was it so long ago?) was just an inkling of what is yet to come.

Which “policies?”  Is he referring to excessively easy or excessively tight money?  No way for me to tell.  I think policy has created imbalances by being too tight.  I think an easy policy would have led to fewer imbalances.  But most people believe exactly the opposite.  Given that Tyler wants to be understood, it’s probably better to assume he’s addressing “most people.”

How has the Fed’s monetary policy contributed to the carry trade?  At this point I know that some people will want to jump in and insist that it’s all about interest rates.  But interest rates are very different from monetary policy.  And even if you think low rates are the issue, you’d have to decide whether the low rates were caused by easy money or tight money.  As I just mentioned, even sensible non-MMs like Martin Wolf are now skeptical of the idea that they reflect easy money.  So if low rates are the problem, should money have been even easier?  Easy enough to produce positive nominal interest rates such as what we see in Australia?  But wait, Australia’s having the mother of all housing “bubbles,” “despite” the fact that their interest rates are higher than in other countries.  (Sorry for two consecutive scare quotes; I’m getting so contrarian that I’ve almost moved beyond the capabilities of the English language.  Maybe that’s a sign I should stop here.)

No, I’m not done yet.  Why does 2013 suggest that Fed policy has a big effect on emerging markets?  As I recall, the unexpected delay in tapering in late 2013 had a very minor impact, suggesting the earlier EM turmoil mostly reflected other issues, not taper fears.

4. The Fed’s monetary policies have created systemic imbalances, most of all internationally by creating or encouraging screwy forms of the carry trade, often implicit forms.  Fortunately, we have the option of continuing this for another year or more, at which point most relevant parties will be readier for a withdrawal of the stimulus.  That is what patience is for, after all.  To get people ready.

OK, now I see.  I misread what Tyler was doing—these are “possibilities” not his actual views.  Yes, the Fed should be patient here, but certainly not in order to bail out speculators.

5. We should continue current Fed policies more or less forever.  Why not?  The notion of systemic imbalances is Austrian metaphysics, so why pull the pillars out from under the temple?  Let’s charge straight ahead, because at least we know the world has not blown up today.

Forever?  If “Fed policies” means the relatively steady 4% to 4.5% NGDP growth over the past 6 years then yes, by all means let’s continue them forever.  If it means zero interest rates, then no.

Of course now that I know that these are not necessarily Tyler’s views, I can see some sarcasm in the last sentence.  Once again, it all comes down to how we define monetary policy, how we define “straight ahead.”

At least physicists know the difference between up and down. It’s a pity that economists continue to debate the proper stance of monetary policy without having a clue as to what the phrase “stance of monetary policy” means.  As we saw in 2008, that confusion is unlikely to end well.

Alternatively, once we all agree to go straight ahead, we need to find some way to agree on what “straight” means.

PS.  The old man in The Straight Story (who reminded me of my dad) went the opposite way from what I proposed–northeast towards Wisconsin.

In all of the discussion about how wrong the right has been about monetary issues over the past 7 years, it’s also worth pointing out some flaws on the other side.  But first let’s start with the good news.  To put the following Paul Krugman quote into context, he’s responding to a Ambrose Evans-Pritchard story (exposé?) that the Fed sees falling long term rates as a sign of monetary ease, calling for a bit tighter policy stance.  Here’s Krugman making the observation that a contractionary demand shock can actually lead to lower long term interest rates over time:

A first-pass way to think about this is surely to suppose that the Fed sets U.S. interest rates, so that an increased willingness of foreigners to hold our bonds shows up initially as a rise in the dollar rather than a fall in rates. This may then induce a fall in rates because the stronger dollar weakens both growth and inflation, affecting Fed policy – but this means that the rate effect occurs because the capital inflow is contractionary, and is by no means a reason to tighten policy.

It’s only one step from there to Milton’s Friedman observation that low interest rates mean that money has been tight.

Some of my liberal commenters make a big deal of the fact that Krugman, and other liberals bloggers (DeLong, Thoma, Duy, Yglesias, Wren-Lewis, etc.) have favored monetary stimulus, and that lots of silly right wing Congressmen have opposed these policies.

On the other hand the left has not exactly covered itself in glory.  President Obama has done essentially nothing over the past 6 years to promote monetary stimulus.  Ditto for European social democrats.  Elizabeth Warren suggested that ultra-hawk Paul Volcker would be a dream candidate for  Fed chairman (no, I’m not joking.)  And now we have the Finance Minister of Greece, a country fanatically opposed to any sort of meaningful supply-side reform, denigrating Greece’s only hope for a demand-side economic recovery:

The European Central Bank’s bond purchases will create an unsustainable stock market rally and are unlikely to boost euro zone investments, Greek Finance Minister Yanis Varoufakis warned on Saturday.

The ECB began a program of buying sovereign bonds, or quantitative easing, on Monday with a view to supporting growth and lifting euro zone inflation from below zero up towards its target of just under 2 percent.

Bond yields in the currency bloc have collapsed, but record low interest rates so far have not spurred investments that would support growth in recession-hit countries like Italy or Spain.

“QE is all around us and optimism is in the air,” Varoufakis told a business audience in Italy. “At the risk to sound the party pooper … I find it hard to understand how the broadening of the monetary base in our fragmented and fragmenting monetary union will transform itself into a substantial increase in productive investments.

“The result of this is going to be an equity run boost that will prove unsustainable,” he said.

I don’t know whether to laugh or cry.  As Tyler Cowen keeps saying, these are not serious people.

PS.  In the right column of this blog I’ve had a pathetically inadequate and useless set of “categories.”  I’m in the process of vastly expanding that list, although I’m still struggling with how to categorize monetary policy posts—there are too many.  This post will go into the new category “praising Krugman,” among others.  This revision process will take a long time, I’ve only recategorized about the first 100 posts, out of over 2800. So for quite a while these new categories will only include a tiny fraction of the relevant posts.  It’s actually part of a project to turn my blog into a book.

HT:  Luis Pedro Coelho

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

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

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

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

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

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

1.  Liquidity effect; tight money raises rates

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

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

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

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

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

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