Hamilton argues that we face an adverse technology shock
In a recent post, James Hamilton argues that even if a stimulus package were to substantially boost nominal spending, the paralysis in our financial system would prevent an increase in real output, and we would instead end up with stagflation. I do think there is a grain of truth in this argument, and more than a grain if considering fiscal projects that call for resources to be quickly reallocated. Hamilton may be too pessimistic about the potential of monetary policy, however. (Interestingly, we end up with similar views on stimulus policy–(3% inflation targeting in his case), but I am more optimistic about what that can achieve. Here’s two reasons why:
First, the financial crisis did not have a severe impact on output outside housing until last summer. The sharp break in industrial production began in August, before the financial crisis intensified in September with the failure of Lehman. The period from 2007.4 to 2008.2 saw 3.3% nominal growth, and slight real growth on average, despite a rather severe oil shock. Thus, before nominal spending started declining rapidly, there was no evidence that financial turmoil had a severe impact on the AS curve. Furthermore, much of the post-Lehman intensification of the crisis was itself caused by declining nominal spending, and more importantly, by expectations that nominal spending would decline sharply in late 2008 and throughout much of 2009. This drop in expectations is what hurt the balance sheet of big institutions that had come through the original sub-prime mortgage crisis in decent shape (such as Citibank.) Falling nominal spending has a catastrophic effect on the balance sheet of highly leveraged commercial and investment banks, regardless of whether those declines are in real GDP or prices.
My second argument is historical. The fastest 4-month period of industrial growth in US history occurred between March and July 1933, when industrial production rose 57% despite a banking system that was still partially shutdown (even after the official bank holiday was lifted, the government re-opened the banks very slowly.) The growth was triggered by the sharp devaluation of the dollar, which dramatically raised prices (and inflation expectations.) When businesses can find willing buyers at a profitable price, they will find the funds necessary to finance that output. Loans are now hard to come by precisely because we are facing deflation and a potentially severe recession of unknown duration.
Imagine real estate prices started rising again. Does anyone doubt that this would dramatically impact the number of housing starts? One might ask, why do I emphasize the ability of producers to get credit, what about home buyers? The answer is that a monetary policy that boosted the price level at 3% a year (including presumably the price of goods like housing–at least relative to the current trend) must be expansionary enough to overcome any difficulty in getting mortgages. Thus if housing prices start rising at three percent a year (and I obviously don’t favor targeting housing, but am just using it as an illustration) then the monetary policy that produced that inflation had to be expansionary enough so that the demand was there despite the tighter lending standards.
Again, this is not to deny Hamilton’s point that the financial crisis does adversely affect AS. (In a recent paper I’ve also argued that it has a small effect.) But evidence from both the pre-Lehman crisis period, and the Great Depression, leads me to conclude that a 5% nominal growth target should yield at least 1 to 2% real growth, and no more than 3-4% inflation, a far better outcome than we are likely to get. I’ve been making this argument since October, and at some point we might need even faster nominal growth, as we keep falling further behind potential.
[Note: In recent correspondence Hamilton emphasized that he thought more nominal spending would help, but that it could only do so much. He thinks the “potential” growth rate may be negative, my hunch is that it is slightly positive, but I think we both believe that there should be more focus on monetary policy.]
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10. February 2009 at 10:17
It’s hard for me to see how a 3% inflation target would have avoided the subprime lending boom, as actual inflation seldom went much above that.
Whether one targets P, or GDP, or M, or B, it won’t do much good, in my opinion, unless the target is such as to allow for productivity-driven deflation. So long as policymakers make a fetish of never letting the general output price level decline (much more of forcing it always to rise), we shall have policy-driven boom-bust cycles.
10. February 2009 at 10:39
Thanks for the comment George. My take on the business cycle is slightly different. In my view the instability isn’t caused by a gradual uptrend in the price level or NGDP, but rather the instability. So I’d be happy with 4 or 5% NGDP growth, as long as it was steady (which is not to say that 0% nominal growth might not offer some advantages.) Inflation targeting is inferior to NGDP targeting, partly for the reason you mention–it would not have called for tighter money during the housing boom. The problem we face right now isn’t so much that prices are falling (that happened in the late 1800s for decades), but that prices are falling in an environment where wage and loan contracts were based on the expectation of 2-3% inflation, or roughly 5% NGDP growth. This lower than expected nominal growth raises unemployment and increases debt defaults.
I want to emphasize that the debt crisis has two parts–the smaller subprime crisis of 2007 to mid-2008, which had only a modest impact on the overall economy, and may have been abbetted by easy money, and the much more severe banking crisis since September 2008, which is actually caused by the unexpected contraction in NGDP, i.e. tight money. Again it is the unexpected nature of the decline in nominal income that is so disruptive to the economy.
12. February 2009 at 10:02
I think Selgin’s concern is something that could be important with regime changes and under a given regime, is one small effect of errors.
For example, if we had a zero nominal growth regime, and moved to 3% nominal growth regime, there might well be a self-reversing boom. I don’t know why the reversal of such a boom would be worse than any of the other shifts that are part and parcel of the world of creative destruction, but adding a temporary shift to other desirable ones would be something that suggests changing regimes would be a bad idea.
Given a regime (even one of fixed nominal spending,) mistakes that involve excessive expansion (for example, monetary expantion to offset what turns out to be an nonexistent drop in velocity,) could well lead to self reversing malinvestment. As various critics of the Austrian trade cycle have suggested, there is no particular reason why entrepreneurs should be myopic and make long term plans based upon a mistake (say excessively low short term interest rates,) But then, perhaps they are making the same mistake as those maintaining the regime–the central banker generally, or free banks or index futures specultators under some reform proposal.
15. February 2009 at 06:23
Bill, I generally agree with your comment. Suddenly moving from a long term policy of 0% nominal growth, to 3% nominal growth could create a destabilizing boom. My criticism of the Fed is symmetrical–they were too easy in 2004-06, and now are too tight, given their implicit preference for 4-5% long term nominal growth (2% inflation plus 2-3% real growth). I also agree that the Austrian view that low interest rates fueled the sub-prime boom is too simple. Ex post, bankers made some foolish decisions, but it’s hard to see how 1% rates forced them to do this. (I doubt they’d do the same thing again in the same situation.) The Austrians may be right about the Fed’s easy money policy being destabilizing, but the analyses that I have read seem too simplistic.
25. February 2009 at 06:14
“The growth was triggered by the sharp devaluation of the dollar, which dramatically raised prices (and inflation expectations.) [1933] ”
How do we know that the devaluation of the dollar came after we had confidence that the technical constraints had been overcome. This is a cause effect, if the nation had the capacity to renew commerce, then the fed would devalue the dollar in confidence.
25. February 2009 at 18:49
Matt, You look at financial market responses to daily (unexpected) devaluations. If yield spreads narrow between AAA and Baa bonds (as they did) it shows that devaluation reduces the risk of corporate defaults. It also increased real stock prices (again using daily data.) There is lots more circumstantial evidence that couldn’t be explained with your technology argument.
26. February 2009 at 13:15
Scott, I’m really enjoying this, and the fact that George Selgin has chimed in here is perfect. I’m interested in your thoughts on free banking. I realize it’s no salve for our immediate problems, but would free banking ultimately provide for a more stable financial system. Particularly, as Selgin has argued, would free banks tend to adjust the money supply to offset velocity, and would they do it in a more precise and efficient manner than do central banks?
26. February 2009 at 18:05
Will, There is no short answer here. In my previous work I argued that the key is getting a stable “medium of account.” So if one were to go with my futures targeting idea then CPI futures, or preferably nominal GDP futures, could replace gold. Then you could have completely free banking along the lines of a free banking gold standard. The only difference is the the medium of account would not be a unit of gold, it would be a unit composed of a basket of goods and services, or more precisely a futures contract linked to such a basket. I haven’t thought about this in a while, and I probably won’t spend time on it here–as I want a pragmatic blog that might influence important economists, who are mostly pragmatists. But it’s a good question.
The person to check out here is Bill Woolsey–I think he did the most work in this area, and for some reason I have trouble explaining exactly how the concept works. But the basic intuition is that you replace gold with a broader asset, one that will provide more macroeconomic stability. I’m sure George Selgin would also be able to describe the system more effectively than I could. There was once a long debate about “indirect convertibility,” and right now I don’t recall the exact details of how it came out.