Easy Virtue: Did a bashful Fed create the Great Recession?
For more than two years I’ve been wrestling with the question of why monetary policy is so tight, despite very low NGDP relative to trend (or low inflation and high unemployment, as most people look at it.). Brad DeLong made this observation:
Right now the Federal Reserve appears to think:
- fiscal policy is about to become inappropriately tight.
- monetary policy is appropriately loose.
This, to me, does not make sense. If the Federal Reserve knows that the Congress is about to make a mistake, it should act to offset the consequences of that mistake and neutralize the damage.
I’m going to give Matt Yglesias what I think is his strongest argument against me. As you know, I think fiscal policy is very costly. There may or may not be wasteful spending, but at a minimum the huge deficits will force higher future taxes, which are distortionary. In contrast, monetary stimulus is costless, like turning a steering wheel in one direction or another. Even better, monetary stimulus reduces the budget deficit, at least in the short run. So why don’t we do it? Consider this Yves Smith comment, quoted by Brad DeLong:
[Update: That’s Edward Harrison, not Yves Smith–my apologies.]
I have consistently warned for the past few months that the Fed would pause before rushing into QE3. I reiterated this yesterday. Yet, somehow people came away from Ben Bernanke’s testimony before Congress yesterday thinking the Fed was going to crank up the QE3 keyboard strokes. It’s not going to happen…. If economic growth in the U.S. does not falter in the second half of 2011, the Fed will look to drain excess reserves from the system as preparation for an interest rate hike at some unforeseeable future date.
There is immense pressure on the Fed from within as well as politically to refrain from more unconventional policy. The economy will weaken significantly before the Fed moves against it – and only then because of vocal outcries for more policy stimulus.
This suggests the Fed’s previous actions have given her a “loose” reputation. She’s willing to be easy, but not that easy. Of course you and I know that monetary policy has been very tight. But what matters in questions of virtue are perceptions. And there are few areas of life more permeated by Victorian morality that monetary policy.
If this is the problem, then fiscal stimulus might just work. The Fed cares about the perceived stance of policy. It wants more NGDP, but isn’t willing to put out.
Unfortunately, the Japanese case suggests that the Fed may be taking the wrong approach to protecting its reputation. The BOJ has had deflationary monetary policy for 17 years, and yet policy looks “looser” that ever. So my suggestion to the Fed is “Go ahead, sleep around try some stimulus, you’re going to be called a s*** either way. So you might as well kick back and enjoy it.”
PS. Brad’s post is entitled “The Peculiar Position of the Federal Reserve on the Stance of Macro Policy” Hmmm, let’s keep it PG13 in the comment section.
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15. July 2011 at 11:48
Is President Obama’s inability to get more governors elected to the Fed (and the Congresses refusal to make such appoints) an important factor here politically? Would it be possible for Obama to repopulate the Fed with easy money advocates? Would he do it? Would Republicans let him?
I really enjoy this blog, and I find that the monetary answer makes a lot of sense (I am an undergrad econ student), but if it is this obvious why isn’t Bernanke pushing this to the President/Treasury secretary/ other governors. He spent much time studying the Japanese lost decade, and yet it seems like he is resigned to make this same mistakes… Is this really pure amnesia on his part, or is there some evidence not being considered that makes monetary policy not seem like the silver bullet to all the economic problems?
15. July 2011 at 11:54
It’s interesting that taxes are distortionary but pumping trillions of dollars into the banking system and pushing real interest rates into negative territory-why that’s not distortionary at all.
15. July 2011 at 12:30
[…] as I start to sound more like Yglesias on fiscal policy, he starts to sound more like me on monetary policy. When I saw the title of his […]
15. July 2011 at 12:37
Marcelo, The problem is not Obama’s inability to get people on to the Fed, it’s that he hasn’t tried. He let three seats sit empty for more than a year without even appointing anyone. Then he failed to do a recess appointment when the Senate didn’t want to vote on Diamond. The Senate has not voted down any of his candidates, as the Dems have a majority.
John, I’m not in favor of the Fed’s current policy, which you seem to object to. But yes, it’s not distortionary to exchange near-zero interest rate reserves for near-zero interest Treasuries. What is distortionary is to allow NGDP growth rates to gyrate all over the place. We need stable money.
15. July 2011 at 12:43
Scott,
Why are those reserves and interest rates near zero in the first place if not for federal reserve policy. I’m pretty convinced that negative real rates do not reflect the Wicksellian “natural” rate of interest. As an Austrian, it’s the difference between the natural rate and the money rate of interest that I believe to be distortionary.
15. July 2011 at 12:46
Scott,
The author of the piece above is actually Edward Harrison from Credit Writedowns. He has interesting things to say, including this piece where he mentions you:
http://www.creditwritedowns.com/2011/07/political-federal-reserve.html
15. July 2011 at 13:36
One of the issues here is that the Fed ended up going with the wrong tool: QE instead of eliminating IOR or even doing a negative IOR.
The basic problem with QE is that over the course of the business cycle, it needs to be unwound. The knowledge that most of it will be unwound makes it less effective (its a temporary increase in M). Moreover, the interest-rate risk makes the tool unstable. If yields jump–which they easily could given that S&P’s announcement yesterday:
there is going to be massive scramble to unwind quickly.
On top of this, the Fed backed itself into a corner justifying QE. It was very strenuous in insisting on the need for positive IOR. That really foreclosed the policy options.
The Fed feels trapped.
15. July 2011 at 13:52
Once again, the Fed is FAR MORE likely to support tax cut fiscal stimulus, then they are government spending.
The folks against goosing AD in the the most politically acceptable way are the progressives who don’t really care about AD.
15. July 2011 at 13:59
No one at the FED understands money & central banking. Bernanke initiated a “tight’ money policy as soon as he was inducted. He reduced the rate-of-change in long-term monetary flows (Mvt)for 29 consecutive months, or at first, sufficient to wring inflation out of the economy, but persisting until the economy plunged into a depression.
The FOMC continued to drain liquidity despite its 7 reductions in the FFR (which began on 9/18/07). I.e., despite Bear Sterns two hedge funds that collapsed, the FED maintained its “tight” money policy (i.e., credit easing, not quantitative easing).
I.e., Bernanke didn’t initiate an “easy” money policy until Lehman Brothers filed for bankruptcy protection.
I’ll take on all bets that I can get Bernanke fired.
15. July 2011 at 14:20
John,
“I’m pretty convinced that negative real rates do not reflect the Wicksellian “natural” rate of interest.”
What makes you so sure? The real 5-year rate has been below zero for a year now and has been below 1% for almost two years. If rates have been “artificially” held far below the “Wicksellian” rate, Austrian theory tells us that nominal spending should be growing rapidly and so should credit. But neither of those things is happening. Nominal spending and credit growth have been remarkably weak. So by what criteria do you judge monetary policy too be too loose? Is it simply because real interest rates are below zero?
15. July 2011 at 14:38
Flow5,
If making loads of terrible decisions was enough to get Fed chairmen fired, then who would have finished their full term? Paul Volcker, I suppose. Alan Greenspan, if one is charitable?
15. July 2011 at 15:37
What this post is desperately calling for is a little “Loose Lucy”:
“Loose Lucy is my delight, she come runnin’ and we ball all night,
round and round and round and round and round and round and round,
don’t take much to get me on the ground.
She’s my yo-yo, I’m her string, listen to the birds on the hot wire sing,
yeh-yeh yeh-yeh yeh-yeh yeh, singing, “Thank you, for a real good time!”
I got jumped coming home last night,
Shadow in the alley turned out all my lights,
round and round and round and round and round and round and round,
don’t take much to get me on the ground.
Loose Lucy, she was sore, says I know you don’t want my love no more,
yeh-yeh yeh-yeh yeh-yeh yeh, singing, “Thank you, for a real good time!”
Be-bop baby how can this be? I know you been out a’ cheating on me,
round and round and round and round and round and round and round,
don’t take much to get the word around.
Cross my heart and hope to die, I was just hanging out with the other guys,
yeh-yeh yeh-yeh yeh-yeh yeh, singing, “Thank you, for a real good time!”
Went back home with two black eyes, you know I’ll love ya till the day I die,
round and round and round and round and round and round and round,
don’t take much to get the word around.
I like your smile but I ain’t your type,
don’t shake the tree when its fruit ain’t ripe,
yeh-yeh yeh-yeh yeh-yeh yeh, singing yeh-yeh yeh-yeh yeh-yeh yeh,
singing yeh-yeh yeh-yeh yeh-yeh yeh,
singing, “Thank you, for a real good time!”‘
http://www.youtube.com/watch?v=sUwC6tDJD1o&feature=player_embedded
Thank you, for a real good time!
15. July 2011 at 15:44
Gregor Bush,
The Wicksellian rate reflects the supply of savings and capital goods that correspond to those savings. During a credit crunch, following a period of low savings, or any other time banks are capital constrained, this natural interest rate rises. In contrast the Fed, which controls the money rate of interest to a large extent, follows a counter cyclical policy of pushing rates down. In 2007-9 interest rates would have risen under a hard money system to reflect the scarcity of capital and encourage savings.
Second, Austrian theory doesn’t necessarily say that there are “high levels” of spending and credit growth, only more spending and credit expansion than would have been the case otherwise. An increase in interest rates and savings along with a decrease in credit expansion were the natural antidote to the negative savings rates
and unsustainable spending of the housing boom years.
Third, these negative real rates your talking about are a fantasy and will require a painful correction somewhere down the road or they’ll be paid for with a decade or more of paralysis.
15. July 2011 at 16:12
Gregor,
I should say what I wrote above more concisely. How do I know negative real rates aren’t natural? Because no one would want to make loans when they are going to lose money in real terms. It would be more intelligent to spend the money or invest it in more promising avenues like stocks. Therefore, it’s very unlikely that anyone would voluntarily charge their customers a negative real rate on the loan, it might even be a better option to hold onto cash. Maybe that’s why banks and businesses are sitting on so much money.
15. July 2011 at 16:15
Scott,
Ok, I understand that then it may be a policy decision by the white house not to appoint, but then I wonder why they wouldn’t want to. Once again, I’d like to think there isn’t some total lack of competence in the White House, and that the staff there must feel that expansionary monetary policy would at best, lower unemployment, or at worst (If they assume that loose money is bad for the economy) take pressure from them and onto the Fed. I suppose my question is more pertaining the politics of the appointment. Do you have any thoughts as to why Obama wouldn’t push for more Fed governor appointees? My best guess is that the risk of a drawn out filibuster episode over monetary policy may present to the white house more political costs than benefit in their eyes…
15. July 2011 at 16:45
“She’s willing to be easy, but not that easy.”
“It wants more NGDP, but isn’t willing to put out.”
What we need is more “Loose Lucy.” Loose Lucy always willing to be easy, and to put out.
May 17th 1974 Vancouver, B.C. Canada:
http://www.youtube.com/watch?v=bZC16XYv9CQ&NR=1
15. July 2011 at 17:31
At the risk of sounding like a whiner, I contend these endless reviews of the Great Depression are not convincing, from any angle. The economy, and flows of capital across borders, and labor markets, and just about everything was much different then.
Add to that, one must wonder about the quality of data back then, and the size of the off-the-books economy in a much more agrarian era. These are not reflections in a distant mirror, but dimly lit scenes from old but contentious play.
I prefer analysis of what is happening, and ongoing, in Japan.
Japan was a nation vibrant until 20 years ago, and has slumped since. The very strong and compelling case can be made that the slump was and is induced by tight money–the proof is in the exchange rate of the yen in the last 20 years. They are dead in the water.
PR-wise, the Japan story is an easier sell–when discussing economic policy of the USA everything inevitably becomes entangled in politics, and battle lines drawn based on ancient tiffs, imagined insults and the like.
But saying the Japan have bungled it badly–no one in the USA takes umbrage at that. Calling the Japanese central bank “ineffectual” and “weak” –again that does not raise hackles in the USA, yet still makes the point. It even appeals to American pride, that we are not a bunch of little sissies like those Japanese (although our central bankers are).
Well, that is my rant of the day.
15. July 2011 at 17:40
Hi Benjamin,
By the way hi Morgan, David, flow 5, Gregor Bush, W. Peden and whoever else I may have missed. I’ve been reading Scott’s recent posts but I’m busy trying to stay alive and further my career right now. It’s hard juggling multiple things but on the other hand it’s exciting. I’ll be more visible (opinionative) when I have more time.
15. July 2011 at 18:10
Scott – you mentioned an excess demand for gold as the cause of the 1937-38 recession. Do you not subscribe to the F&S argument that it was the Fed’s doubling of reserve requirements in 36-37 and the plunge in high-powered money and NGDP that ensued? Wehave a real-time replay 75 years hence in the eurozone, and it ain’t working out so well.
15. July 2011 at 18:22
John, When tight money drives the economy into a deep slump, the real interest rate falls sharply. It happened in the US in the 1930s, in Japan in the late 1990s, and again in the US.
Interest rates are a notoriously unreliable indicator of monetary policy. They are the price of credit, not the price of money.
David, Thanks, I just did an update. I’m going to blame DeLong.
Jon, You might be right.
Morgan, I doubt the Fed has much influence on the type of fiscal stimulus.
flow5, I have mixed feeling on his first year or two. There was some real inflation concern, but on the other hand he should have cut rates more sharply in December 2007. They got behind the curve, and then found themselves against the zero bound.
Gregor, Good point.
Mark, A deadhead–well that explains a lot. Have you been consuming the shrooms again? 🙂
John You are asking the Fed to do the impossible. No one knows where rates should be. No one knows the Wicksellian real rate. They shouldn’t be targeting rates, they should be targeting NGDP. And NGDP fell in 2009, so Hayek would have said money was too tight.
Marcelo, I think he doesn’t know what’s going on (which isn’t surprising, as most economists don’t either.) Romer would have given him good advice, but he probably listened to Larry Summers.
Benjamin, Actually the data’s pretty good, but I see your point–Japan seems more relevant to the average 21st century person.
Mark, Glad to have you back.
15. July 2011 at 18:28
MTD, I don’t think there was a plunge in high powered money. The higher reserve requirements created more demand for high powered money. Perhaps the growth in the MB stopped for about 12 months, I’d have to check. That was because gold hoarding stopped the growth in the domestic monetary gold stock for about 12 months, which then stopped the increase in the MB.
I think the RR increases was a factor, but much less important than gold hoarding and the big wage shock following unionization drives.
I haven’t talked much about Europe, as I don’t know what will happen there. It looks like the crisis will continue for quite some time. But I don’t know enough to predict the endgame for Greece, or how many countries will default. The ECB rate hikes aren’t helping.
15. July 2011 at 19:02
Scott,
man you get short sighted when it isn’t your thinking.
the Fed OBVIOUSLY can have an influence… they get to choose to neuter fiscal. How do you miss this?
If it is government spending, that’s MORE government, that’s bad, so they neuter it.
If it is tax cuts, that’s less long term government (by your own previous admission), that’s good, so they don’t neuter it.
—-
Alan Greenspan proves my point.
15. July 2011 at 19:06
Howdy mark.
15. July 2011 at 19:08
Scott,
Can Bernake’s continued calls for more fiscal stimulus mean he doesn’t think the Fed will offset it? Why else would he call for it?
15. July 2011 at 19:43
Mark-
Good luck with your career, and I look forward to your posts.
15. July 2011 at 19:44
so…whats the holdup then with putting the foot on the gas? credibility is not one-sided: just as the Fed needs to prove it keep inflation tame, it also needs to prove it can act and not get behind the curve. the “recovery” has not achieved liftoff mainly because the Fed has been overly cautious, seeing nonexistent inflation and nonexistent growth just around the corner.
if one consistently overpredicts growth, ones credibility ought to already be in question.
15. July 2011 at 19:47
Scott Sumner-Not just more relevant, but an easier sell–you say “Great Depression,” and hackles and war-chants start. The ideological battle lines have been drawn, if however poorly, and people do not stray from those lines.
You say” the Bank of Japan is run by ineffectual effete snobs more concerned with teeny inflation rates than getting the factories humming”–well, no one in the USA lifts his shield before you can even make an argument.
Japan, Japan, Japan. Plus is is current, to this day.
15. July 2011 at 22:36
In response to Scott, of course I’m asking the fed to do the impossible by targeting the Wicksellian natural rate. I don’t think the Fed should be targeting rates at all, or even exist for that matter. They’re a disruptive and intrusive force in the market economy.
Second, in an unmanipulated banking system, tight money would correspond to rising interest rates because bankers, with limited funds to make loans, would charge a higher price for the scarcer money. In the Austrian view, the fact that rates have fallen during tight money recessions is a policy failure by the Federal Reserve which prevents an economy from regaining solid footing.
Could you maybe do a post one day about how NGDP tageting would avoid the pitfalls of all the other types of central planning? I’m fairly confident it would fail like all the other Keynesian ideas to keep a semipermanent boom in effect.
16. July 2011 at 04:36
Okay, never mind. I see you addressed my question with a new post.
16. July 2011 at 06:20
John:
The natural interest rate is the real interest rate where saving equals investment.
Saving is that part of income not spent on consumption.
Investment is purchases of capital goods by firms.
All of this must be evaluated at the full-employment levels of output.
At the same time that the natural interest rate coordinates saving and investment, it generated sufficient real expenditure (consumption and investment) to purchase the full employment level of output.
When you make claims about people buying stock or holding money, then you are discussing two alternative means of saving.
16. July 2011 at 06:21
With sufficiently depressed views about future production, it seems to me that the natural interest rate can be negative.
Why not?
It is driven by expecations.
16. July 2011 at 08:58
Morgan, I recall Bernanke calling for “big government” in late 2008.
Mike, He’s not really calling for more fiscal stimulus. He’s saying don’t pull it back in the “very short run.” But he does want them to reduce spending.
dwb, That seems logical to me, but Fed officials keep insisting they are under tremendous political pressure to end the “ultra-easy money.”
John, You said;
“Second, in an unmanipulated banking system, tight money would correspond to rising interest rates because bankers, with limited funds to make loans, would charge a higher price for the scarcer money. In the Austrian view, the fact that rates have fallen during tight money recessions is a policy failure by the Federal Reserve which prevents an economy from regaining solid footing.”
The first sentence makes no sense as you confuse money and credit. Second, as Milton Friedman pointed out, tight money leads to low interest rates, not high rates. Third if the Fed tried to stop rates from falling in a recession (remember they fell in recessions even before we had a Fed) then we would have had a Great Depression.
I’ve done many posts on NGDP targeting.
Bill, Good explanation.
16. July 2011 at 17:18
I have just read Nathan Lewis’ book on gold as future money. He promotes a world with the dollar linked to gold via a currency board, low taxes and a Fed whose only job is to provide liquidity in emergencies.
Do you folks think this would be good for our economy?
17. July 2011 at 01:45
Ha! What a great way of framing the issue. I wish I could explain to my leftist friends that echoing the Paulistas in their irrational critiques is actually a surreptitious form of Victorian moralism.
17. July 2011 at 16:23
Bob, It would be a disaster. The deflation would discredit supply side economics, (which I support.)
Thanks Shane.