Help me prepare for GMU

Next week I go to George Mason University  (which is suddenly my favorite economics department) to present two papers.  On Tuesday I will talk about the relationship between cultural values and neoliberal reforms.  I have already discussed part of that paper on this blog, and will try to do the Switzerland chapter in a few days.  On Wednesday I present a paper on the current crisis.  I had grand ambitions to write this paper in China, but it was a struggle to even keep the blog afloat.  So now I am under pressure to get something done quickly.

I think the best solution is to present a slightly modified version of my recent Cato paper.  This paper is to be discussed by three distinguished economists over the next week; first James Hamilton (of econbrowser.com), then George Selgin, and finally Jeffrey Hummel.  Then we will have a discussion.  It should be a lot of fun, and if I am not able to fully discuss their comments at Cato Unbound (I don’t know if there are space limits) I might add a few comments here.

But then it occurred to me that I really needed to do more than talk about my view of the crisis, I also needed to discuss why almost all other economists are wrong.  (I know that sounds ridiculously arrogant.  Obviously by “wrong” I simply mean “disagree with me.” )

Right now just about everyone seems to be doing attacks on the economics profession, or responses to those attacks.  So I decided to add a few appendices to my paper that briefly sketch out where I think others went wrong in the current crisis.  I have included these below.  I would appreciate any comments you might have (preferably by tomorrow, when I need to send this paper to GMU.)  I am especially interested in feedback from Austrians, because (according to Greg) I seem unable to understand the ABCT.  And it’s true that because I have a single-minded focus on NGDP, subtleties like misallocation of capital, or time-lengthening of production, or co-ordination failures have only a fuzzy meaning for me.  Since there are probably some Austrian economists at GMU, I don’t want to make a complete fool of myself.

BTW, your feedback on the democracy issue has forced me to rethink my views a bit, and as a result my argument won’t be demolished quite so thoroughly by Bryan Caplan.  So thanks for that.

Appendix A:  Why the monetarists are wrong:

Anna Schwartz has argued that monetary policy is very easy.  Her evidence is that:

It is standard practice for a central bank like the Federal Reserve to ease monetary policy to combat a recession, and then to tighten it as recovery gets under way. Mr. Bernanke so far has only had to do the first half, and has conducted a policy of extreme ease. The Fed’s Open Market Committee cut the federal funds rate in October to 1 percent from 1.5 percent, and then in December to a range of zero percent to 0.25 percent.

In contrast, Milton Friedman argued in 1998 that:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.  .  .  . After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead.  Apparently, old fallacies never die.

At least Friedman’s not around to see 99% of the profession equating low interest rates with easy money, the same mistake Joan Robinson made in 1938 when she denied easy money could have caused the German hyperinflation.

Alan Meltzer has argued that high inflation is almost inevitable in countries that see rapid increases in the money supply and massive budget deficits.  Paul Krugman pointed out that this hypothesis is contradicted by the recent case of Japan.  I agree, but also see a much more serious problem with monetarism.  The monetarists are generally free market economists who believe markets are relatively efficient.  They also place great weight on the importance of inflation expectations.  And yet in my research on the Great Depression I noticed that markets frequently failed to move in the appropriate direction following monetary “shocks” identified by Friedman and Schwartz.  I concluded that F&S had misidentified monetary shocks, relying on a theoretically dubious “long and variable lags” view of policy.  In fact, auction-style markets should respond immediately to monetary shocks that are expected to be permanent, and I found that these markets did respond appropriately to the international gold market shocks of 1929-33, and 1936-38, but often ignored the traditional monetary shocks identified by F&S (OMOs, discount rate changes, and reserve requirement changes.)

In the recent crisis the policy of paying interest on bank reserves has meant that the monetary base is a misleading indicator of monetary policy.  The broader aggregates are slightly better, but the demand for bank deposits is also distorted by a flight to quality during a financial crisis.  In the end, the only reliable indicator of the stance of monetary policy is the expected growth of the policy target, the price level or NGDP.  In the 1990s, Milton Friedman endorsed Robert Hetzel’s proposal for the Fed to target inflation expectations in the indexed bond market.

Appendix B:  Why Bernanke is wrong:

I only met Bernanke once, when he presented a seminar at Bentley on his 1983 paper claiming that that disintermediation played a big role in the Great Depression, independent of the contractionary monetary policy.  I asked just one question:  “What impact would the banking problems have had if the Fed had successfully targeted nominal GDP growth?”  It was many years ago, and I don’t recall his precise answer, but I am fairly certain that he hemmed and hawed a bit and then said something to the effect that the bank failures would still have had an impact on output, but that impact would be somewhat lessened.

Isn’t it presumptuous of me to report on an answer I don’t clearly recall?  Maybe, but any other answer would have been seared into my memory forever.  Bernanke is known for his strongly held view that monetary policy can still be highly effective when rates hit zero, so it would have been stunning if he claimed that nominal GDP targeting was not feasible, at least as a thought experiment.  And he is a conventional new Keynesian, who certainly wouldn’t argue that the collapse in NGDP had no impact on output.  So he had to admit that the Depression would have been milder.  At the same time he couldn’t argue that the Depression would never have occurred with NGDP targeting; or else his thesis that disintermediation was an independent shock would have been discredited.

In recent months I have often thought of how ironic it is that my only question for Ben Bernanke lies at the center of my current disagreement with Fed policy.  I think Bernanke was wrong about the Depression; NGDP targeting would have prevented a depression regardless of whether there were lots of bank failures.  And I believe this error led Bernanke to misdiagnose the current crisis, and to focus on bailing out banks rather than boosting NGDP growth expectations.

Appendix C:  Why the New Classical economists are wrong:

The Great Depression has always been a big stumbling block for ‘real business cycle’ (RBC) theories.  It is hard to believe that so much unemployment could represent the equilibrium condition in the labor market, hence the tendency of Keynesians to mock the RBC theory of “The Great Vacation.”  In recent years many RBC-types have accepted that there may be some nominal rigidities, and that severe nominal shocks can have some short run impact on real output.  But I sense that they’d like to believe that these nominal rigidities are relatively unimportant, unless accompanied by perverse government policy such as wage and price controls.  Lee Ohanian has argued that governmental policies to promote high wages did raise unemployment in the 1930s, and account for much of the difference between the sharp but brief 1921 depression, and the much longer and deeper downturn in the 1930s.

I think Ohanian’s view of the Great Depression is defensible, especially for the period after 1933.  But even the 1921 depression was severe, and I think he underestimates the amount of wage and price stickiness in even a free market economy.  In a recent debate I argued that the severe decline in NGDP growth (from a norm of roughly 5% to something closer to negative 4%) had a severe impact on employment.  Ohanian wasn’t convinced.  I believe he thought that inflation was a better indicator of nominal shocks than NGDP, and inflation had declined much less than NGDP.  He also argued that wages were now much more flexible than in the 1930s.  As far as the severe decline in real output, a RBC economist might admit that wage and price stickiness played some role, but would be more likely to emphasize some real factor; the Bernanke disintermediation story, the Austrian misallocation of capital story, or even higher minimum wages.  If so, then any attempt to boost NGDP growth back up to 5% might lead to much higher inflation.

This argument might be plausible if the severe financial crisis of late 2008 was an endogenous shock.  But it wasn’t.  The crisis was exactly what one would expect from a highly deflationary monetary policy that caused NGDP to fall sharply. If individuals and business are earning much lower nominal incomes, and have borrowed money at interest rates that factored in 5% expected nominal income growth, then one would expect loan defaults to soar, and the financial crisis to spread beyond the sub-prime mortgage sector into all sorts of less risky mortgages, as well as consumer, commercial and industrial loans.  And that is exactly what happened in late 2008, when an excessively tight monetary policy depressed NGDP.
So RBC economists made two mistakes.  Their ideological preference for equilibrium models led them to underestimate the problem of wage stickiness on employment, and because they assumed money was not “tight” then overlooked the possibility that an easier monetary policy could have reduced the size of the financial crisis.

(I recently debated Lee Ohanian on CBSMoneywatch.com.  Interested readers might want to look at this link, and also here and here, in case I have mischaracterized Ohanian’s views.)

Appendix D:  Why international macroeconomists are wrong;

Here I am referring to those international economists who have studied dozens of financial crises in foreign countries, and have that slightly superior attitude toward us closed economy macroeconomists.  They like to point out that this is nothing new, that there have been dozens of banking crisis in other countries and in every single case real output fell sharply.  Even worse, some of these recessions were associated with highly inflationary monetary policies.  “So what makes Sumner think that the Fed could have papered over the problem with easier money?”

The interesting question is how many of those crises occurred in countries where the currency rapidly appreciated right in the teeth of severe financial distress?  I can only think of two examples, although there may be a few others.  One occurred in 1930-33, when the US dollar (then pegged to gold) appreciated against a trade-weighted basket of currencies.  And the other occurred in Argentina in the late 1990s and early 2000s, when the Argentine peso (then pegged to the dollar) appreciated against most currencies.  And in both cases it is widely believed that tight money was to blame for causing deflation, which severely intensified the banking crisis.  So while I would agree that a policy of NGDP targeting would have been of limited value in many of the famous banking crises that have occurred in developing countries, a policy of NGDP targeting would have made a huge difference in the two cases that are most relevant to the US in late 2008.

Appendix E:  Why the Austrians are Wrong:

First an disclaimer.  I am not as knowledgeable about Austrian business cycle theory as many of my readers.  Nevertheless, I think I know enough to have a general sense of how Austrians tend to view the crisis:

1.  An excessively expansionary monetary policy led to overinvestment in housing, and perhaps some other areas as well during 2004-06.  After mid-2006 the housing bubble peaked and eventually prices started falling.  Labor and capital then needed to be re-allocated out of sectors such as housing, and into other sectors of the economy.  For a variety of reasons this re-allocation process requires a lengthy period of sub-normal economic activity.  Laid-off construction workers are not immediately re-employed in high tech, or in the service sector.  If I am not mistaken the bubble and the subsequent painful readjustment is often described as a sort of “co-ordination failure.”

2.  If the economic crisis following a burst bubble is severe enough, it may interact with the monetary system, producing a “secondary deflation.”  This shows up as falling NGDP, and can make the recession even worse.  Monetary policy should not try to prevent the needed re-allocation of resources after the bubble bursts; to do so would either lead to inflation, and/or further misallocation.  The only appropriate role for monetary policy would be to prevent a secondary deflation.

I don’t disagree with any of these assertions.  In my view the period from mid-2006 to mid-2008 represented the sort of painful adjustment that Austrians describe.  And the steep downturn that occurred in late 2008 was a perfect example of a secondary depression.   I do think people tend to somewhat overestimate the role of easy money in the housing bubble, but my primary objection to Austrian economics lies elsewhere.  I believe that Austrians tend to overestimate the misallocation of capital problem and underestimate the secondary deflation problem.  After the housing market peaked in mid-2006 there was a period of two years when resources were being re-allocated from housing to other sectors such as manufacturing and services.  During this adjustment period real GDP did not decline, but rather grew at a below trend rate.  Unemployment rose slightly.

The severe crisis that we now face was caused by the “secondary deflation,” or the severe monetary shock of late 2008.  My impression is that many Austrians misdiagnosed this problem, assuming we were experiencing “more of the same.”  Some Austrian (and non-Austrian) economists assumed that the severe nationwide housing downturn of late 2008 was simply an intensification of the earlier slump in sub-prime markets, whereas in fact it was an entirely different problem caused by falling NGDP.  In addition, as other sectors such as manufacturing (especially autos) began to decline, there was talk of “overcapacity” in those industries as well.  It began to seem as if the mere fact that sales fell short of capacity was, ipso facto, evidence that too much capacity had been built, rather than that there was too little aggregate demand in the economy.

Perhaps the most revealing example occurred in my blog, where I discussed the housing slump that occurred late last year in China.  Some commenters told me that this indicated that there had been a “bubble” in Chinese housing; that China had overinvested in housing.  I was a bit incredulous that in a country where real GDP had been growing at 10% for 30 years, and where average living space was barely over 100 square feet per capita could be said to have “too much housing,” but it is certainly possible.  What most bothered me, however, is that commenters didn’t seem to have any good reason for this assertion, other than that prices were now falling, or that there were unsold houses on the market.  But that could also occur under a secondary deflation, where the problem is monetary.  In any case the Chinese government stimulated AD and the economy is again booming.  And guess what?  The problem of “too much housing” in early 2009 has magically disappeared, as housing demand has risen along with the general recovery.

Let me be very clear that I don’t attribute all of the US housing slump to inadequate AD.  The Austrians are absolutely right that too much housing was built in the middle of the decade, and that a contraction of housing was needed.  But in my view the needed contraction was almost complete by mid-2008, and the subsequent decline in housing (which also occurred in markets not affected by the subprime lending-fueled speculative excesses) was an example of overshooting to the downside.  That is, an example of the secondary deflation causing a generalized decline in the demand for all goods.  Also keep in mind that virtually all business cycle theories predict that real investment should be especially cyclical, so it is not surprising that this secondary deflation hit housing, and even autos, much harder than services.

I also don’t think this Austrian misdiagnosis was a mere accident.  In the early 1930s Hayek made a similar mistake, assuming that the Great Contraction represented the needed reallocation of resources after the speculative excesses of the late 1920s.  As a result, he initially opposed monetary remedies to the Depression.  Later he admitted his mistake, after he realized that what had actually occurred was a secondary deflation, and that monetary policy should have been expansionary enough to prevent NGDP from falling.  But by that time the damage had been done.  In the 1930s the Austrians seemed to have no answers for what was perceived as crisis of capitalism, or at least no answers beyond “next time around don’t pump up a bubble with easy money.”  The world turned to an economist that did offer answers.  Unfortunately, he also misdiagnosed the problem.

Appendix F:  Why the old-style Keynesians are wrong.

Keynes argued that the Great Depression was caused by a decline in aggregate demand.  The implication was that if NGDP had risen slightly, rather than fallen nearly in half, there would have been no depression in the early 1930s.  To a modern economist this would suggest that Keynes thought the Depression was caused by a failure of monetary policy; either excessively tight money or at least a monetary policy that was insufficiently expansionary to offset non-monetary shocks to AD.  But that was not Keynes’ view.  Keynes developed a non-monetary theory of NGDP determination, which replaced the “quantity of money” approach (M*V) with an expenditure approach (C+I+G+NX.)  But this approach wasn’t able to deal with a world of changing inflation expectations, a weakness that eventually undermined his theory.

The so-called “classical economists” were well aware of the fact that all sorts of shocks such as changes in expectations could depress velocity, and also that because wages and prices were sticky a fall in NGDP would also reduce real GDP in the short run.  To build a new “General Theory” of NGDP, Keynes had to first discredit the quantity theorists’ answer to depressions, which was to keep NGDP stable by offsetting any decline in velocity with a corresponding rise in the money supply.  He did so by arguing that monetary policy would be ineffective in a deep slump.  Both Hicks and Friedman saw the liquidity trap as the key innovation of Keynes, the assumption that gave the General Theory is radically different perspective on monetary and fiscal policy and also the role of saving and investment.

Friedman and Schwartz showed that Keynes was wrong in assuming that monetary policy was ineffective in the 1930s.  Keynes had assumed that the low nominal interest rates of the early 1930s indicated that money was “easy” and thus had failed to boost AD.  F&S showed that M1 and M2 declined sharply, and argued that interest rates were a very poor indicator of the stance of monetary policy.  Krugman tried to rehabilitate Keynes by showing that the decline in M1 and M2 resulted not from “tight money” (i.e. a falling monetary base), but rather from the hoarding of cash and reserves, which led to a decline in the money multiplier.  Krugman also argued that the same problem had occurred in Japan during the late 1990s.  But it was too late, the Keynesian view of liquidity traps had already been fatally undermined by other developments in “new Keynesian” research, ironically including work by Krugman himself.

In 1998 Krugman showed that contrary to what Keynes had argued, monetary policy could still be highly effective in an economy with near zero rates and falling prices.  What was needed was a credible policy to inflate.  Because liquidity traps don’t last forever, the quantity theory prediction that more M will raise prices equiproportionately is still true in the long run.  Thus to depress real interest rates the central bank merely had promise to permanently raise the money supply (relative to demand.)  This would raise inflation expectations and lower real interest rates (assuming nominal rates were stuck at zero.)  This was essentially the “inflation targeting” approach that had already become the consensus policy of the new Keynesians.  Even better, new Keynesians like Lars Svensson and Gauti Eggertsson showed that FDR tried exactly this policy in 1933, when he devalued the dollar to boost prices, and it succeeded in dramatically raising NGDP despite near zero interest rates.

Even worse, the rehabilitation of monetary policy had the side effect of relegating fiscal policy to the sidelines.  If the monetary authority was already setting monetary policy at a level expected to produce on target demand growth, then what possible role could fiscal policy play?  The so-called “multiplier” would be precisely zero in a world where the Fed targeted inflation or NGDP, as the monetary authority would simply offset the expected impact of fiscal stimulus on the target variable.

I like to divide old-style Keynesians into two groups; Paul Krugman, and all the rest.  Most old-style Keynesians seem completely unaware that the Keynesian view of liquidity traps and monetary ineffectiveness has been fatally undermined by the developments that I just discussed.  They still talk of the ineffectiveness of exchanging cash for perfect substitutes such as zero-interest Treasury debt.  That is, they responded to the recent problem of the “zero rate bound” as if nothing had been learned in the past 70 years.

Krugman’s case is a bit more complex, as you would expect.  He did understand that inflation targeting offered a way out of the liquidity trap, and on occasion he even mentioned this possibility.  But when he did so it was mostly to lament that the world’s central bankers were just too conservative to promise to inflate, and that as a result any currency injections would be viewed as temporary, and hence would merely be hoarded.  Thus he suggested that massive fiscal stimulus was the only way to boost AD.  Sometimes Krugman would even forget to mention that a credible policy of targeting inflation could be highly effective, and simply asserted that monetary policy was ineffective once rates hit zero.

But Krugman’s view seems highly suspect—why would the Fed view a 2% inflation target (or 5% NGDP growth target) as excessive?  That rate of inflation would be slightly below the US average for the past 20 years.  Thus there is no reason why the Fed could not have adopted a much more expansionary policy.  Their failure to do so caused the sharp fall in NGDP and the accompanying recession.

Appendix G.  Why the New Keynesians are wrong.

Everything I have said so far suggests that the new Keynesians fixed the problem with Keynes’ original model.  They understood that monetary policy should target inflation and that if it did so it could still be highly effective, even in an economy with near zero nominal rates.  So why don’t most new Keynesians see the crisis the way I do?  I don’t have any single answer, but will offer several possibilities.

1.  New Keynesians misdiagnosed the problem as financial, not monetary.  But this isn’t a complete answer, because they understood that a sharp fall in NGDP would be extremely undesirable, whatever the root cause.  So why not adopt a monetary policy expansionary enough to keep the financial crisis from depressing NGDP?

2.  The new Keynesians tended to favor Taylor Rule-type monetary policies.  There are two problems with the Taylor Rule.

a.  It relies on a fed funds rate target, which becomes ineffective in a liquidity trap.

b.  It is a backward-looking policy.  This led some economists to (wrongly) suggest that a credible policy of inflation would require sharply negative nominal rates.  That view may be a prediction of the Taylor Rule, but it ignores the fact that any monetary policy expected to be expansionary would sharply raise both the expected inflation rate, and the Wicksellian equilibrium real rate.  From a forward-looking perspective the question isn’t: “What interest rate does the Taylor Rule call for?”  Rather the question is: “What nominal interest rate is consistent with on-target expected NGDP growth.”  Thus you had prominent economists like Krugman and Mankiw citing Fed research (and presumably agreeing with this research, although it’s hard to be sure) that suggested something like 6% expected inflation was needed to escape the liquidity trap.  But this was inconsistent with Krugman’s other claim that the SRAS is relatively flat in a deep slump.  For instance, think about the predicted effect of 6% NGDP growth in the new Keynesian model.  If you are in a deep slump, and wages and prices are sticky, then it is likely that 6% NGDP growth would result in only 1-2% inflation, and 4-5% real growth.  Thus not only is 6% expected inflation not needed to achieve the policy goals of Taylor Rule proponents, even 2% might be more than enough.  This is the sort of elementary error one can make if one approaches macro from a backward-looking perspective.

3.  Many new Keynesians focus on inflation targeting.  Because the core inflation rate is fairly stable I think many economists underestimated just how deflationary monetary policy had become in late 2008.  Because tight money initially impacts output, and prices respond with a lag, NGDP is a better short term indicator of the stance of monetary policy than inflation.  If your focus is on inflation it would have been easy to assume that monetary policy was not far off target in 2008.  (Of course that begs the question of why so many new Keynesians supported the massive fiscal stimulus.)

4.  As with the monetarists, new Keynesians put too much weight on policy lags and may have been intimidated by the Fed’s massive injections of liquidity, which roughly doubled the monetary base in just a few months.   Many economists did not seem to understand that the new policy of paying interest on reserves prevented these open market purchases from having any expansionary impact. In addition, new Keynesians such as Frederic Mishkin seemed to be content with a “wait and see” attitude, a willingness to give the Fed’s extraordinary efforts more time to work.  But there is no lag between monetary policy and expectations of future NGDP growth.  One new Keynesian who wasn’t lulled into a false sense of complacency about the stance of monetary policy was Lars Svensson.    In the next appendix I will discuss why he was the exception.

5.  And finally I think there is a tendency of economists to lack the courage of their convictions, and to revert back to a sort of crude Keynesianism when faced with an unfamiliar crisis.  In a recent paper John Cochrane made the following comment in his response to Krugman’s recent NYT critique of mainstream macro:

“Krugman is trying to say that a cabal of obvious crackpots bedazzled all of macroeconomics with the beauty of their mathematics, to the point of inducing policy paralysis.  Alas, that won’t stick. The sad fact is that few in Washington pay the slightest attention to modern macroeconomic research, in particular anything with a serious intertemporal dimension.  Paul’s simple Keynesianism has dominated policy analysis for decades and continues to do so. From the CEA to the Fed to the OMB and CBO, everyone just adds up consumer, investment and government “demand” to forecast output and uses simple Phillips curves to think about inflation.  If a failure of ideas caused bad policy, it’s a simpleminded Keynesianism that failed.”

Bryan Caplan quoted (and linked to) this passage in his blog, and then added:

“As far as I can tell, Cochrane’s right.  The only thing weirder than the sharp disconnect between undergraduate and Ph.D. macro is the fact that for practical purposes, Ph.D.s rely on what they learned as undergrads.”

I would add that for those with a backward-looking view of macroeconomics, which includes about 99% of the profession, an economic crisis can seem a bewildering and frightening event.  The simple Keynesian model with its common-sense view that government spending on infrastructure can “put people back to work” seems like a comforting security blanket–much more so than risky and unproven policies aimed at “targeting expectations.”  It’s not surprising that many new Keynesians heard the siren song of fiscal stimulus.

Appendix H:  Why the “forecast-targeting” economists were right.

In a recent blog post I discussed the striking similarity between the tiny group of economists who have written papers advocating policies that would effectively “target the forecast,” and the equally small group that believes monetary policy was too contractionary last fall.  Here are the two lists I came up with:

Did “targeting the            Viewed Fed policy as too                                                forecast” research           contractionary in late 2008

1.  Thompson                  1.   Thompson

2.  Hall                             2.  Hall

3.  Glasner                       3.  Glasner

4.  Me                              4.  Me

5.  Hetzel                         5.  Hetzel

6.  Woolsey                      6.  Woolsey

7.  Svensson                    7.  Svensson

8.  Jackson                      8.  Jackson

9.  Dowd                         9.  Congdon

A few caveats.  I inferred Hall’s views on policy from comments in his blog.  Svensson dissented from a recent decision of the Riksbank to cut rates to 0.25%; he favored a cut to zero.  In addition, Svensson is responsible for the Riksbank’s decision to start paying negative interest on reserves (an idea I have been promoting since last fall.)  So I inferred that he would not have supported the Fed’s decision to bribe banks to hoard reserves by paying positive interest, and also that he would have opposed the Fed’s attempt to hold rates above zero.  I recently came across two other economists who viewed money as being too tight last year, but who haven’t done targeting the forecast research.  So the correlation is not perfect, and there may be few other exceptions.  But the pattern is still striking, and calls for an explanation.

Because I believe in targeting the forecast, I always tend to judge the stance of monetary policy by trying to infer market expectations of NGDP growth.  That is not easy, as it involves looking at TIPS spreads, commodity prices, stock prices, real output, and a host of other factors.  But last October it became very easy; every single indicator was pointing toward a severe slowdown, and possible decline in NGDP.  I was so shocked by what I saw that I went down to Harvard to have lunch with Greg Mankiw and Larry Ball.  I asked “Does the Fed realize that over the next 12 months the nominal aggregates are going to come in far below any plausible Fed target?”  I seem to recall Mankiw saying something to the effect “Oh they certainly know this; they just don’t know what to do about it.”  That meeting radicalized me; it led me to wonder if I had misjudged the state of modern macro, whether I had wrongly assumed that the Fed knew what they were doing.

Svensson’s maxim that the stance of monetary policy should always be set at a level where policy is expected to succeed had just seemed like common sense.  I had assumed everyone thought that way.  Now I realized that almost nobody looked at policy that way.  Instead, almost everyone was still fixated on interest rates, a policy indicator that (I thought) had been thoroughly discredited by the late 1970s.

BTW, as far as I know there are only a handful of economists who have published papers criticizing a policy of targeting the forecast.  One of those economists was Ben Bernanke.

Appendix I. Why me?

The previous appendix discusses one reason why I ended up taking such a heterodox position on the current crisis.  But two other factors also played a role.  In addition to forward-looking monetary policy rules, I have also done extensive research on liquidity traps and on the Great Depression.  My research on the Japanese liquidity trap of the late 1990s and early 2000s convinced me that the idea of monetary policy ineffectiveness at the zero bound was a myth.   The term “trap” is highly misleading, as it suggests the Bank of Japan wanted to inflate, but was unable to.  In fact, they intentionally ran a mildly deflationary policy, twice even tightening monetary policy by raising rates in the midst of more than a decade of continual deflation in the GDP deflator.  In addition, at any time the BOJ could have depreciated the yen as sharply as they wished.  If this policy was prevented by political considerations such as pressure from the US and Europe, then that political pressure, not the zero rate bound, would have been the cause of Japan’s deflation.

My research on the Great Depression convinced me of the importance of changes in expectations of inflation and NGDP growth.  In late 1929 and again in late 1937 there was a sharp fall in expectations of NGDP growth going several years out into the future.  The onset of these deflationary expectations caused an immediate crash in stock and commodity prices, as well as industrial production.  Nominal interest rates also declined.  When I saw the same thing occur in late 2008, I immediately recognized the similarity to the earlier two crashes.

It was initially believed that financial turmoil caused the Great Depression, and that falling NGDP was a symptom.  Only later was it determined that this reversed the causation, that falling NGDP has caused the financial crisis of the early 1930s.  It was rather dismaying to see the profession making the same misdiagnosis in late 2008, simply assuming that the causation went from financial turmoil to falling NGDP, despite the fact that the sharp break in NGDP occurred a month before Lehman, and probably contributed to the worldwide banking crisis of late 2008.


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86 Responses to “Help me prepare for GMU”

  1. Gravatar of Tushar Saxena Tushar Saxena
    16. September 2009 at 11:45

    A nice omnibus post, Scott. I hope the monetarists, old-keynesians, new-keynesians, and austrians reply in-depth.

  2. Gravatar of Don the libertarian Democrat Don the libertarian Democrat
    16. September 2009 at 11:55

    “In 1998 Krugman showed that contrary to what Keynes had argued, monetary policy could still be highly effective in an economy with near zero rates and falling prices. What was needed was a credible policy to inflate. Because liquidity traps don’t last forever, the quantity theory prediction that more M will raise prices equiproportionately is still true in the long run. Thus to depress real interest rates the central bank merely had promise to permanently raise the money supply (relative to demand.) This would raise inflation expectations and lower real interest rates (assuming nominal rates were stuck at zero.)”

    If this is true, why wouldn’t Buiter’s plan work:

    http://www.nber.org/~wbuiter/helijpe.pdf

  3. Gravatar of Cameron Cameron
    16. September 2009 at 12:20

    I doubt I can help you much as I’m just a lowly undergraduate student at George Mason(and an avid reader of your blog) but I’m really looking forward to your presentation.

    Based on reading part of James Hamilton’s response to you I suggest you try to really emphasize how the immediate power of monetary policy lies in shaping future expectations. The fed can’t change nominal GDP to what it wants immediately by changing the money supply (increases in M tend to be associated with a decrease in V Hamilton points out), but if it can shift future expectations it can at least keep current NGDP from plunging. This seems hard for people to grasp.

    It’s also probably worth mentioning that no matter how well the fed could have handled the situation using the current system that it would have been much better handled using a CPI or NGDP futures targeting regime. If the fed truly was powerless in late 2008(as apparently Mankiw, Krugman and Hamilton believe) then a better system would be one which could avoid such a situation in the first place.

  4. Gravatar of George Selgin George Selgin
    16. September 2009 at 12:45

    Scott,

    You definitely aren’t ready to go to GMU yet: you have still to compose an appendix saying “Why the Public Choice Theorists are Wrong,” and another on “Why Tyler Cowen is Wrong” (Tyler has become his own school).

    Once you do that, I think you’ll be good to go.

  5. Gravatar of rob rob
    16. September 2009 at 12:55

    The paper is next week and this is all you have????!!!! What were you doing in China????

  6. Gravatar of Joe Calhoun Joe Calhoun
    16. September 2009 at 13:10

    Scott,

    I think the thing that is missing from the Austrian story is what Robert Higgs referred to as regime uncertainty. In the case of last year, the term actually has two applications in my mind. The obvious one is the uncertainty surrounding the interventions of the Fed and Treasury. It wasn’t that the market particularly feared the financial fallout from letting Lehman fail but rather that it introduced a whole new set of uncertainties. Up to that point, everyone kind of assumed that any large firm would be bailed out and after Lehman no one knew what to expect. The second application of the term concerns the election which, post McCain’s panic return to DC, meant trying to figure out what policies were likely out of the new Obama administration.

    Observing the market this year I think confirms the idea that the uncertainty surrounding Obama played a big role in the market selloff. As health care reform and cap and trade both stalled, the market improved. I don’t think that is a coincidence.

    So as someone who basically accepts the Austrian framework, I am faced with the question of what to do in this situation. Obviously, there are real world economic effects of market dislocations like the one of last year so I don’t think you can just ignore it. The problem I see with applying monetary policy as a way to get past the uncertainty is that the Fed is highly unlikely to get the exit right as confidence returns. That’s why I’ve come to view your NGDP targeting as a good alternative. It would provide a better exit from the monetary expansion needed to offset the consequences of the uncertainty period.

    I also felt the adjustment the Austrian narrative calls for was going just fine last year. Yes, the economy had slowed but I saw no reason we needed to have a deep recession to complete the readjustment. It wasn’t until September that I changed my mind based on what I was seeing in the market (as we’ve discussed on here before). Could better monetary policy have mitigated the consequences of the uncertainty? Yes, I think so, but not enough to prevent a larger recession than would have happened absent the uncertainties introduced by government intervention and the uncertainty of the election. I wonder if the dislocation would have been as large if it wasn’t a presidential election year?

    Anyway, just my two cents worth. Good luck at GMU.

  7. Gravatar of Thorfinn Thorfinn
    16. September 2009 at 13:35

    I think the biggest problem many people have with your thesis is that you don’t fully point out the counterfactual policies (Friedman and Schwartz were very good about that) beyond ‘target NGDP better’.

    The Fed cut interest rates to zero, started QE, and rapidly expanded the base. Maybe it should also have not paid out reserves and expanded QE better. But, as the Cato response argues, it’s hard to imagine that being enough to have stopped a massive panic.

    People across all real estate categories started defaulting because housing prices went down. What would housing prices have looked like under more accommodating monetary policy?

  8. Gravatar of Bill Woolsey Bill Woolsey
    16. September 2009 at 15:05

    Scott:

    It looks good.

    As you know, I have problems with your answer to Krugman. A credible commitment to 10% inflation would make real interest rates -10% and jump start aggregate demand. But we don’t want 10% inflation. Well, Krugman won’t mind, but those conservative central bankers (and nearly all free market economists) don’t want 10% inflation.

    I know that you have argued that the better approach is to instead create a level of base money that gets nominal income back to its previous growth path, without really worrying about whether higher inflation expectations and lower real interest rates or else, more real income growth and a higher natural interest rate is what stimulates the recovery in expenditures. Krugman hasn’t made that argument (as far as I know.) I just think you need to be more explicit about it in this context. Recognize that the Krugman position could be that very negative real inerest rates are needed, and so high expected inflation must be generated. In particular, 2% inflation and -2% real interest rates won’t cut it. And so, is it 4% expected inflation? 6%? 10%? Sure, some level will do it, but it starts getting politically unplatable. Well, even unplatable for me.

    I’ll look again. I think there was some other stuff, but still, both this and what you have on Cato Unbound was very good.

    I know you are busy, but I have a blog now.

    http://monetaryfreedom-billwoolsey.blogspot.com/

    P.S. On the Austrian business. How can you forget that there are some Austrians who oppose monetary expansion in the face of the secondary deflation? But, I don’t disagree that focus on Hayek and those modern Austrians who see it similarly is better. Personally, I disagree with the notion that the readjustments in the allocation of resources were done in the summer of 2008. That is, if we had beentargetting nominal GDP sucessfully, then it would have been a continuing problem–slightly high unemployment and slow real growth (and higher inflation too.) The current crises is superimposed. I don’t disagree that there is probably overshooting in housing right now (too little construction) and I also don’t think there is much reallocation in the sence of resources properly unemployed from housing going much of anywhere, but if we had a recovery in nominal expenditure, I think we would be left with high structural unemployment, a low level of real output compared to the long run trend, and a higher price level. Even now.

  9. Gravatar of Bill Woolsey Bill Woolsey
    16. September 2009 at 15:11

    George:

    And what about Klinganomics (Klingonanomics?)

    As for Cowen, I am sure Scott remembers Cowen and Krozner and abstract units of account from the old days. I doubt Scott understood it much better than the rest of us.

    Seriously, I come from the Public Choice school. Of course, I am out of touch, but back in the day, the basic view was.. we are microeconomists! This macro is bunk. Further, some old fashioned monetarism. A new friend of mine, a graduate of the UVA vintage Virginia School, was very concerned with the performance of M2 last fall. Also, some public choice economists really liked the Hayek of the Denationalization of Money–competing private “fiat” currencies. Of course, there is the idea of a Monetary Constitution. And Buchanan’s brick standard. Were you just joking, or is there a public choice view of money that msut be dealt with.

  10. Gravatar of Bob Murphy Bob Murphy
    16. September 2009 at 15:15

    Scott,

    I agree with George Selgin; you should devote a section to explaining why Cowen’s views on the crisis are wrong. Fortunately, you just need to scan his blog posts to find the opposite case being made. (Ohhhh! I’ll be here all week folks, remember to tip your waitresses.)

    I don’t have a problem with what you said about the Austrians. I personally don’t get too excited by the “secondary depression” stuff; I liked Hayek (and Lionel Robbins) in the thick of the Great Depression, rather than their wussy concessions decades later. But obviously, it’s not your fault if plenty of Austrians subscribe to that notion.

    I just want to reiterate that the Austrians are allowed to cite other things besides their business cycle theory when explaining the events of 2001-present. If Bernanke and Paulson had adopted a tough-love, liquidationist stance in 2006, then I think you would have seen a severe recession that would have lasted 18 months or so.

    But of course that isn’t what happened. Government officials held out hope for a bailout, which (I claim) prevented the truly insolvent banks from declaring bankruptcy. Instead they started stringing everybody along, investors weren’t sure which banks were solvent, etc. etc. My memory is failing but I think by August 2007 the Fed started its “rescue” operations, and it was all downhill from there.

    If you haven’t already read it, I highly recommend Cochrane and Zingales’ WSJ op ed where they argue that it wasn’t the Lehman failure, but Paulson’s saber rattling, that caused the financial panic.

    You might be right that if, given everything else, the Fed would have announced a specific inflation (or NGDP) target in the summer of 2007, that the crisis might have been postponed or “diluted.” But to me, that’s like saying it would have been a “good idea” to knock someone out with a baseball bat if you are already decided that you’re going to chop his arms off with a hacksaw. That way you provide a “soft landing” for the “shock” your original policy is going to give.

  11. Gravatar of ssumner ssumner
    16. September 2009 at 15:41

    Thanks Tushar.

    Don, I just skimmed the paper, so maybe I missed something, but I don’t quite follow your question. I think the Buiter plan would work. Indeed it even involves a bit of overkill, because it relies solely on the real balance effect, which in my view isn’t the main transmission mechanism. I think Buiter and Krugman would agree, but perhaps if I took a longer look I’d see something that conflicts.

    Cameron, I don’t believe you are a lowly undergraduate. The point you just made is absolutely correct, and indeed is something I should have emphasized in the Cato article. (Of course there are space limits.) I made a similar argument over at econbrowser.com, so you and I think alike. I hope you are able to come to the seminar. I should warn you that I am not the world’s best presenter, but I think I do a reasonable job answering questions.

    George, Don’t laugh, but my other paper (on culture and neoliberalism) is a sort of attack on the public choice model of politics.

    rob, I wrote up the appendices yesterday. And the Cato paper before I went to China. So I really did nothing there. (Yes, I know you are joking.)

    Joe, I agree that the election negatively impacted the market, but there is no way that I can come up with estimates of more than a few percentage points. The average hit from a Democrat being elected is less that 2%. And remember that we are talking about an election where it was always likely Obama would win, and all you saw in late September and early October was an increase in the odds. So during that period the impact on the markets should have been far less that 2%. Yes, Obama might have been worse than average, but I’m not convinced. And McCain was a closet liberal on domestic issues, I think he would have proposed a similar health bill to what we will end up with, as did Republican governor Romney in Massachusetts. I’m not happy about any of this, I just don’t see it as a big market factor. Especially when compared to the fear of a big drop in NGDP, which would devastate banking.

    Despite these reservations, I think you have good instincts. There have been some big market crashes before presidential elections, and during the “interregnums” (if that’s a word). I think the markets may have rightly worried about policy drift at a crucial time. I know this was true in 1932-33, and perhaps late 1920 as well (although I don’t have the figures, I just know the economy fell off a cliff when Wilson was a lame duck.)

    Thorfinn, You said;

    “The Fed cut interest rates to zero, started QE, and rapidly expanded the base. Maybe it should also have not paid out reserves and expanded QE better. But, as the Cato response argues, it’s hard to imagine that being enough to have stopped a massive panic.”

    The biggest panic in American history occurred in early March 1933. Yet within weeks NGDP was growing at the fastest rate in history. How did it happen? For the only time in US history the government adopted an explicit price level target, a plan to raise the price level. And they succeeded.

    The other point I would make is that zero plus zero plus zero is still zero. All these actions look impressive, but as Milton Friedman rightly said, low interest rates aren’t easy money, they are a sign of tight money. I don’t think they should have expanded the base even more. I think it should have expanded far less. But there should have been no interest paid on reserves, and there should have been an explicit CPI or NGDP target path, level targeting.

    But you are right, I need to make that argument more forcefully.

    BTW, I haven’t had time to look at James Hamilton’s comments yet. I don’t doubt he has some thoughtful and persuasive criticisms. But don’t worry, I will have some responses next week.

  12. Gravatar of Devin Finbarr Devin Finbarr
    16. September 2009 at 15:43

    Why do you focus NGDP as measure of monetary policy? I completely understand the problems with CPI. It makes sense to judge monetary policy by measuring national income/aggregate demand. But NGDP is not that number. It excludes income from asset sales, which is a critical oversight. Asset prices matter a lot, and they tend to be leading indicators. The best numbers to use for national income are the IRS income statistics. The only problem is that the full statistics do not come out very often. But I’m sure the Fed could pull together a stat that used weekly payroll stubs, reported quarterly profits, and changes in asset markets to approximate national income. That would be the number to use to judge monetary policy.

    Also, what is your opinion of the post-Keynesians like Warren Mossler?

  13. Gravatar of ssumner ssumner
    16. September 2009 at 16:01

    Bill, That’s great news about the blog–I will look at it after I return from GMU.

    I think you are right about housing, the adjustment wasn’t quite over. But the Economist had a great graph a few months back (I linked to it but can never find it as my blog’s so long now) that shows month over month changes in housing prices. There was a big dip, and then by the spring of 2008 it was leveling off, and then another big dip in late 2008. Even with the seasonality problem, it was very distinct.

    My point on the inflation targeting is that 10% isn’t needed, 2% would have been fine. If Krugman wants to argue 6% expected inflation was needed, he would have to abandon his argument that the SRAS is pretty flat in a steep slump. Or else some sort of weird model where the Fed and the markets have completely different inflation expectations. Maybe I misunderstood your argument, and we are talking past each other. But I definitely wasn’t suggesting that any radical inflationary policy was needed.

    Here’s another way of putting it. In the Keynesian model monetary policy boosts NGDP. The partitioning between real output and inflation is dependent on the SRAS. So if you have 6% NGDP growth you’d probably have mostly real growth. Now suppose Krugman argued that to get 6% NGDP growth you needed 6% inflation (to get negative 6% real rates). In that case you’d have 0% RGDP growth. I.e. the SRAS would be vertical. But that conflicts with the Keynesian model. His numbers don’t add up.

    Bob, Thanks for the comments on Austrian BCT. At least I’m not way off base. And I did read an except from the Cochrane and Zingales piece over on Econlog–it looked really good. I’ll have to read the whole thing. It actually compliments my view. I have argued that the Fed lost credibility in early October when they focused on banking bailouts and did nothing to prevent NGDP from falling sharply. They also tell a story about how the Fed and Paulson impacted expectations. Indeed their story might be more plausible than mine, but also might compliment my explanation.

  14. Gravatar of John Hall John Hall
    16. September 2009 at 16:13

    I think forward-looking policy rules are a good idea. Set the rate to the real equilibrium interest rate plus core PCE plus the 12 month ahead real GDP % change forecast plus the anticipated inflation rate over the next 12 months minus 2% minus the trend growth rate (3.5% or 4%). You can get the forecasts since 2007 for core PCE from SPF and longer back for real GDP (or GDP deflator if you don’t want to use core PCE). By this standard, policy was tight, but not that tight. I know Scott prefers another approach, but I think this is easy enough to compute that it could provide a guide. So I think that if there is to be a central bank, it should follow some policy rule that is forward looking if it can’t follow your own system.

    I don’t think you’re entirely wrong in your criticism of the Austrian story. However, this statement isn’t true: “The world turned to an economist that did offer answers. Unfortunately, he also misdiagnosed the problem.” Larry White wrote a paper criticizing this view.
    http://economics.sbs.ohio-state.edu/jmcb/jmcb/07056/07056.pdf
    Hayek suggests stabilizing nominal income, not so different from you. From above, the sum of the forecasts for real GDP and core PCE/GDP deflator did not dip below 3 or 4% until pretty late. So I think to much an extent you’re right about your diagnosis of a secondary deflation. However, I would note that the Austrian story doesn’t solely focus on the boom/bust story of Mises and Hayek. There are certainly other things going on. Like the above commenter (Calhoun) notes, regime uncertainty was a big factor, particularly in September 2008. There was a great chart in the WSJ the other day showing equity prices when the Lehman collapse happened and then also noting when Paulson testified. The regime uncertainty and straight up panic following the debate over what to do cannot be understated.

    I guess my biggest problem with your analysis is why did this secondary deflation happen. I would argue that the collapse of Fannie/Freddie/Lehman/AIG (largely due to bad bets that have x number of other explanations for why they happened) combined with the uncertainty with knowing what do was the problem. It seems like you’re downplaying the real factors that contributed to the decline in September and October 2008. Your argument about Fed policy being too tight makes sense, but it is hardly the reason why GDP declined so sharply. Forecasts were only revised lower AFTER the sharp declines from the failure of Fannie, etc. What you seem to be saying is that the Fed should have set policy so that the forecasts aren’t revised lower (target the forecast), but even in August no one thought GDP would decline nearly -6% annualized in Q4 2008 and Q1 2009. They were positioned well enough in August, but it wasn’t until September that those forecasts were revised lower. Was not cutting below 2% a mistake on August 5th or September 16th? Or should they have cut 1.5% on October 5th? Would it really have made that much of a difference? I don’t think so. There were factors outside of monetary policy that pushed down nominal GDP forecasts and nominal GDP.

  15. Gravatar of George Selgin George Selgin
    16. September 2009 at 16:46

    Concerning the ABCT, those self-styled Austrians (including a large share of the Mises-Institute crowd) who think that recovery from a malinvestment boom requires some contraction of MV, in order to get relative prices back on track, don’t understand the theory they are so anxious to defend. For the “bust” follows boom, according to that theory, is precisely because relative prices _inevitably_ get back on track, and would do so even in the face accelerating inflation. Were this not the case, central banks (or fiat money issuing ones, at any rate) could keep booms going indefinitely.

    So, there’s no need for MV, have risen excessively, to shrink to help relative prices back to their neutral values; and insisting otherwise is, to paraphrase Mises, like insisting that the only in which a cat can fully recover from being run over, is to put the responsible vehicle in reverse, and then back over it.

  16. Gravatar of Philo Philo
    16. September 2009 at 18:10

    You write: “I recently came across two other economists who viewed money as being too tight last year, but who haven’t done targeting the forecast research.” Is one of them James Hamilton? In *Cato Unbound* he writes (footnotes omitted):

    “I believe that once the nominal T-bill rate falls to zero, not much is achieved by further open market purchases of T-bills by the Federal Reserve. However, there is still an opportunity for monetary stimulus in such a situation through purchase of assets other than T-bills, and I believe that this was something the Fed should have tried in the fall of 2008.

    “Unfortunately, until the beginning of 2009, the Federal Reserve was doing everything it could to prevent its actions from stimulating the economy in the usual fashion. It was viewing the slowly unfolding credit problems as primarily a crisis in lending, in which the Fed felt it needed to step in as lender of last resort on what ultimately proved to be a massive scale. The Fed wanted to lend extensively, but did not want to see currency held by the public increase. For this reason, it sold off a significant portion of its holdings of T-bills through September 2008, in a paired set of actions, lending with one hand and selling T-bills with the other, that might be described as “sterilizing” the lending operations so as to prevent them from having an effect on the money supply. When the Fed ran out of T-bills to sell, it asked the Treasury to create some more for the Fed to use just for sterilization. More importantly, In October the Fed began paying interest on reserves, in effect borrowing directly from banks, and creating an incentive for banks to hold the newly created deposits as a staggering burgeoning of excess reserves, again preventing its actions from increasing the value of M1. Excess reserves amounted to $833 billion by August 2009, or more than the sum of all the currency issued by the Federal Reserve between its creation in 1913 and 2008.

    “I agree with Sumner that the Fed made an error in abandoning its traditional goal of monetary expansion. The sterilization efforts ultimately made it much harder for the Fed to do what I think they now understand would be desirable, namely, provide a more traditional stimulus to aggregate nominal GDP. In my opinion, the preferred policy in the fall of 2008 would have been to acknowledge more aggressively the losses financial institutions had absorbed on existing loans, impose those losses on stockholders, creditors, and taxpayers, and retain as the Fed’s first priority the stimulus of nominal GDP rather than trying to lend to everybody.”

    You have a convert! (But Hamilton doesn’t understand your ideas about how the Fed could effectively target NGDP.)

  17. Gravatar of marcus nunes marcus nunes
    16. September 2009 at 18:41

    Scott
    The appendices idea was a “masterstroke”. I had to do a quick reading since it´s late and I have an early morning call. For me (that has looked at all those pictures (and more)) your arguments are clear and to the point.
    Nevertheless you will get flack from all directions because this crisis is seen as the “mother of all the greed in the world”. Patently false because the weakness that came to pass in the housing market was 100% the government’s responsibility. If it was “greed”, it was of the political kind.
    You should stress that as late as the FOMC meeting in August 08, Dallas Fed President Fisher voted for an immediate rate increase! In the September meeting, 24 hours after Lehman, the official view was that inflation was still a risk and that the next rate move would probably be UP!
    What is the rest of us supposed to think? If others see that it is very likely that I will lose my job (income) tomorrow, I most surely won´t be able to borrow today. So if the Fed is indicating that they will likely tighten, the perception or expectation is that income will fall, so no one wants to lend, especially if they think that the borrower may already be a victim of mortgage delinquency (something that had started 2 years earlier).
    Bernanke “pursued” his beliefs. He is the most forceful proponent of the “credit channel”. What happened is that he missed the fact that by his monetary policy decisions he was in effect helping to block the “credit arteries”.
    Have a good time in GMU.
    Marcus

  18. Gravatar of Don the libertarian Democrat Don the libertarian Democrat
    16. September 2009 at 18:52

    Scott,

    I think that it would work as well. That’s why it was my plan for QE. I asked the question because I feel like I’m agreeing with you but coming at these problems from a slightly different angle. I also thought that it would add another person to your profile list who’s very interesting, if contentious. Once again, thanks for your help. Feel free to ignore my questions when they are idiotic. I’ll also try to not ask rhetorical questions when commenting. Have a good time at GMU.

    PS one of the great things about blogs is that people like you are getting noticed. You deserve it.

  19. Gravatar of Jon Jon
    16. September 2009 at 19:18

    Scott working through your claims section-by-section:

    I concluded that F&S had misidentified monetary shocks, relying on a theoretically dubious “long and variable lags” view of policy. In fact, auction-style markets should respond immediately to monetary shocks that are expected to be permanent, and I found that these markets did respond appropriately to the international gold market shocks of 1929-33, and 1936-38, but often ignored the traditional monetary shocks identified by F&S (OMOs, discount rate changes, and reserve requirement changes.)

    Your diagnosis seems wrong to me–I believe in the long and variables lags. I think you’re equating two pieces of information as having the same meaning when initially revealed to the public on the basis of your knowing what happened eventually.

    Moving the gold peg is an immediate and direct stroke of inflation. The markets react immediately because the implication is clear. OMOs and banking policy do not follow the same pattern. Recall for instance that the dominant policy view at the time was the Real Bills Doctrine. The very basis of that policy is that CB policy actions can cause inflation but not if its done “right”. The real bills qualifier being put forward then as the rule-of-thumb for what’s right. Indeed, we know this central idea to be true today as well even if we no longer believe it should be regulated by the volume of real-bills. Regardless, Bankers have claimed for several hundred years that should have the right to issue unlimited notes, and that this policy is harmless to inflation when handled appropriately.

    So when faced with an OMO, what does this mean for the price-level? The answer is not apparent at the time of the OMO. The market’s delayed reaction reflects the gradual ripples in the pond.

  20. Gravatar of Lorenzo (from downunder) Lorenzo (from downunder)
    16. September 2009 at 22:02

    Love reading your blog, but monetary economics still confuses me. I have a really basic question which may just show how much I do not understand.

    Economists say money has three functions: medium of exchange, unit of account, store of value. But then they seem to talk as if all those functions are absolutely and perfectly bundled together in a single thing. But if money has these different functions, is that a sensible way to proceed? And if that is not what they mean, should not they be clearer about that?

    It seems to me that if those functions were “separating” so as to be operating in different directions at the same time, that would be a problem. Maybe that is what people mean but, if so, would it not be better to be explicit about that, to avoid hidden failures of logic and/or identification of relevant factors? (It might also make it clearer to lay folk like me.)

    Part of my angst about this is I am aware that the stories monetary economists tell about barter and the origins of money do not seem to coincide with what archaeologists and anthropologists actually find. Since I am very much someone who believes social phenomena reveal themselves through history, this bothers me and makes me wonder if there are some base-level problems in economists understanding of money which leads to these disparate understandings of appropriate policy or even what monetary policy is about, as you have previously noted.

  21. Gravatar of Ben Ben
    16. September 2009 at 22:26

    Scott,
    your posts launched a lot of discussion with my friends and a passionate debate whether you are a damned monetarist, whether your ideas are not different from standard New keynesian economics …. Most people tend to dismiss you views as if you were coming toward old monetarism , with this obession of the MV=PQ equation…. Personnally, I tend to see beyond this , but I cannot see what really differentiates your work from an attempt to model “expected nominal demand”. Do I really understand you ? Do you mind that the Central bank can pilot expectations ? Do you want to focus on nominal expected GDP growth because we cannot get, due to nominal rigidities, the split between expected real growth and expected inflation ? Do I really get it if I summarize your view like this : let us create a future markets on expected demand, so that central bankers can target this ? Why not focus only on inflation expectations ? If so you can pilot the effective real interest rate isn’t it ? Why bother with nominal expected growth ???

  22. Gravatar of Greg Ransom Greg Ransom
    16. September 2009 at 22:50

    Scott, you nailed the Austrian stuff this time, and your weighting of relative causal significance here is a defensible position.

    Many Hayekians like Russ Roberts, Roger Garrison, Peter Schiff and Arnold Kling might put more weight on “too big to fail” moral hazard, the various pathologies of housing policy and Wall Street finance regulations, bandwagon effects, and the fuel mixture of combining these with Fed policy.

    Hayekian production/credit/money micro plays well with friends. Micro which includes choice over production processes of alternative time dimensions is an explanatory
    workhorse that can pull in team with other explanatory causes — and it does not exclude them.

    The dimensions of the economic crisis made inevitable simply due to housing policy, moral hazard & finacial regulations involved massive misallocations — and

    destructions — of production value and monetary wealth — and no Fed policy could have stopped it.

  23. Gravatar of Greg Ransom Greg Ransom
    16. September 2009 at 23:04

    Bob, Hayek was talking about secondary depressions and was praising Keynes ideas for dealing with it as early as late 1931 and early 1932.

    Go to my Taking Hayek Seriously blog for details.

    Bob writes:

    “I don’t have a problem with what you said about the Austrians. I personally don’t get too excited by the “secondary depression” stuff; I liked Hayek (and Lionel Robbins) in the thick of the Great Depression, rather than their wussy concessions decades later.”

  24. Gravatar of John Bailey John Bailey
    17. September 2009 at 04:20

    1. This perceived wealth/profit/income results in existing businesses and individuals failing to take the corrective actions that would have taken place in a “normal” economy. The normal reduction in production that accompanies changes in the employment of people, property and resources is put off. That creates even more perceived “wealth” during the boom as people, property and resources delay moving to sustainable employment. This delay magnifies the problems during the bust as these people, property and equipment adds to the unemployment.
    2. The money that is “lent” into existence necessarily become debt. Debt loads increase but appear to be supported by bubble induced increases in asset values and incomes. Eventually, resources with relatively inelastic supply, such as oil and other commodities, increase in price, putting pressure on both consumers and business. Combined with high debt loads, increases in prices and incomes can’t be sustained. Mistaken investments are exposed and a downturn begins. The downturn exposes more problems. When the bubble bursts asset values and incomes fall but the debt remains.
    3. The high debt load increases individual and business minimum income requirements. Since 80% of that minimum creates the same consequences as 0%, people delay action, searching for 100% of their minimum. That delays their re-employment, reducing production, and, for those who fail, making the consequences worse for the economy as a whole.
    4. All of the corrective actions that could/should have been taking place over time now take place in a relatively short time.
    5. Because wages, prices, and interest rates are “wrong,” new sustainable ones have to be “discovered” though a process of trial and error. These errors cost. In addition, people are correctly uncertain about wages, prices, and interest rates. Discovering sustainable wages, prices and interest rates takes time. Regaining certainty takes even more time.
    6. Safety Net Paradox – While normal unemployment insurance may have a positive effect during normal economic conditions, allowing people to make effective job changes, during a severe downturn, it delays re-employment and increases debt load.
    7. Government policies can contribute to recovery by incentivizing workers, businesses and property owners to re-employ resources through removing taxation on re-employed resources. This tax removal also helps workers make their minimum payments. Since the unemployed resources aren’t producing any income and may be costing, this tax removal is probably revenue neutral and may, through secondary effects, be revenue positive.
    8. Government can also help reduce the excessive debt load by allowing people to make debt payments and investments with pre-tax income. Secondary effects may well balance the revenue consequences of these provisions.

    I am interested in any criticisms comments at jbailey@sprintrome.com

  25. Gravatar of StatsGuy StatsGuy
    17. September 2009 at 04:32

    Scott, if you get the chance, you may want to familiarize yourself with Katzenstein’s argument on small states, since many of your examples (in the democracy argument) relate to them. It’s an ’85 book and much out of date, but some of the thoughts are relevant particularly for European small states. It may help you answer the riddle of why smaller states, even those with smaller government, seem to really like social safety nets.

    http://www.amazon.com/Small-States-World-Markets-Industrial/dp/0801493269#reader

    On public choice – I don’t know if this is a “theory of the money supply”, but the school does have something to say about money supply in general. It’s mostly in the context of principal-agent problems. There are a couple key conclusions that would come out:

    1) Since the General Public is short sighted/unsophisticated/unorganized, and elections run 2/4/6 years, politicians are strongly incented to create bubbles in the short term since the payback is after their election term. It’s the same argument for running up deficits (e.g. fiscal policy). I think the commonly cited examples are macroeconomics in Latin America in the 70s, etc.

    2) Creating an insulated monetary institution (e.g. central bank) helps.

    Public Choice also has comments on special interests (mostly from Mancur Olsen, via organizing costs) which are basically common sense. By extension, it has comments on capture of government institutions by those special interests, with a debate over whether capture occurs by design (via Congress) or by accident (over time, due to cooption or revolving door or intellectual paradigm, etc.). Terry Moe, etc. vs. old style capture theory. This debate has become relevant mostly in the context of the fiscal-policy (e.g. treasury) bailouts of financial institutions and the moral hazard problems of using central bank monetary policy to backstop excessive risk taking.

    (E.g. If we “target the forecast”, then – even if we don’t use treasury funds per se to bailout banks – the mere promise of using massive monetary policy (e.g. “inflation”) to keep NGDP stable could create moral hazard problems for banks/high risk investors.)

    As I said, the core (or at least, one of the cores) of Public Choice is principal agent problems in relation to the money supply.

    specifics about what you wrote:
    ——-

    “NGDP targeting would have prevented a depression regardless of whether there were lots of bank failures.”

    Choke. (Couldn’t you instead argue that there would not have been so many bank failures if NGDP targeting had been used??? It seems a reasonable middle ground is that “once it gets to the point where you have massive bank failures, those failures make things worse all by themselves”. If that’s Bernanke’s retort, it’s kind of hard to argue against that from a practical point of view. But the Gread D had multiple waves of bank failures; a lot were caused by asset contraction and overleverage. Many should have been avoided if there was an expectation of inflation…)

    The reason this is relevant to the modern debate is Lehman Brothers. The question is, did letting Lehman fail make things much worse than they would have been otherwise (independent of the overall monetary policy, which may have been more important)? It’s not a small question.

    I’ll go through the other half of your post later and see if there is anything useful to say that might help you…

  26. Gravatar of StatsGuy StatsGuy
    17. September 2009 at 04:34

    I wrote “As I said, the core (or at least, one of the cores) of Public Choice is principal agent problems in relation to the money supply.” … I meant the core of Public Choice in relation to the money supply is principal agent problems.

  27. Gravatar of Current Current
    17. September 2009 at 04:42

    Firstly, it great to see that so many other folks have blogs. In reading the comments on this post I’ve got links for ~5 other blogs that look well worth reading.

    Going back to the subject…. Others have covered most of the points I would have. One thing I would say is that I find your discussion of Krugman and “expected inflation” a bit inadequate. As you’ve said before there is a demand to hold money. If it increases and the monetary system accommodates the increase then there may be no change in the interest rate. Once the promise is there to meet the demand there doesn’t seem to be much of a need for extremely low or sub-zero interest rates.

    I think that the splits between different schools aren’t the same as they were in the past. The financial crisis and recession have changed them. Many people don’t look at either through the lens of normal economic theory, they see them as a particular expression of the problems of the institutions (public and private) of the time.

    Each economic school is digging up it’s ideas about financial institutions and how they fit into everything else, and into the “institution” of money. A large part of the argument is not between those who favour specific micro-economic causes, such as bad incentives in banks, and those who favour more traditional ideas.

  28. Gravatar of Current Current
    17. September 2009 at 04:43

    Also, regarding public choice, if your talk is good you will be insulted by Gordon Tullock….

    http://www.marginalrevolution.com/marginalrevolution/2006/08/insults_from_go.html

  29. Gravatar of Current Current
    17. September 2009 at 04:48

    Greg, remember you’re site is .org not .com.

  30. Gravatar of mbk mbk
    17. September 2009 at 07:09

    I find this bog impressive, though I would not dare commenting on the validity of the arguments, for this my background is not deep enough. I can follow the idea that interest rates do not by themselves say anything about whether money is tight or not, because they are a price (the rent for money) not the stock of the good itself (supply). And whether money was tight or not would depend on the value of demand vs. available (Hume!) supply, which determines the price, but which _is_ not the price itself. Naively at least I would imagine as well that officially fixed low prices (interest rates) may even destroy effective supply (availability of loans), like in an olden days communist supermarket where milk is cheap, except there isn’t any. So I can see how price (interest rate) is not availability (looseness/tightness).

    But why did the ratio of supply /demand fall off a cliff in such a sudden manner in Sept. 2008? Whatever the Fed may have missed to do afterwards, the sudden tightness was not due to any sudden Fed action, and somehow I mistrust purely psychological arguments (panic). There is such a thing as thermodynamics, the equilibrium seeking forces across a gradient etc. – if money exists that can be lent out, it will be lent out. At some price. So that leaves real procedural balance sheet requirements in the wake of Lehman as a possible cause for “tightness” – collateral on CDSs etc. Would this be enough to explain “sudden tightness” at such a scale? What was the analog then in the 30s?

  31. Gravatar of Current Current
    17. September 2009 at 07:38

    mbk. Remember what you said above about the demand for money. If the demand for money sharply increases then policy becomes “tight” (a very inappropriate word) if it doesn’t respond.

  32. Gravatar of Scott Sumner Scott Sumner
    17. September 2009 at 09:38

    Thanks everyone. I have made many changes. No time to respond now but I will respond. Marcus, I even quoted you in the paper I am presenting at GMU. Indeed the last sentence of the paper now reads “I wish Marcus had been on the FOMC.”

  33. Gravatar of StatsGuy StatsGuy
    17. September 2009 at 11:41

    Read everything, and it strikes me that there is one gaping hole here… all the above approaches are built using models of relatively closed financial systems, yet we have open financial markets – indeed, the financial markets are faster and more international than the goods/services markets (which operate at a relative lag).

    Thus, the expectation of a falling dollar (because the Fed will need to respond to the coming recession) causes the dollar to fall, commodity prices increase which increases the volatile components of inflation (which are “real” in the sense of hitting consumer wallets), and we get capital flight at the same time(investors demand higher return to offset expected fall in the dollar). All of this suppresses GDP, but the Fed is constrained because it thinks it needs to stop expectations of a dollar collapse. In short, the Fed faces constraints created by expectations of US insolvency (or, perhaps, expectations of debt monetization) in combination with relatively slower growth compared to trading partners.

    This theme – dollar weakening, US debt, dollar flight, and its impact – has dominated the financial markets for over 2-3 years. Continues to dominate them. Yet how many major macroeconomists have even raised this as an issue? The only folks touching it are the finance/business school professors. Roubini and crowd – the ones closest to the trenches.

    This is the elephant in the room.

  34. Gravatar of Current Current
    17. September 2009 at 12:04

    Statsguy, those are good points. The whole picture of international economics needs some refreshing too.

    In England there has been a lot of fall-out from the crisis because of London’s place as a financial centre. The government there have bad policies certainly, but they can’t be to blame for things like a drop in intermediation activity for foreign financial products sold to other foreigners.

  35. Gravatar of StatsGuy StatsGuy
    17. September 2009 at 12:07

    marcus:

    “You should stress that as late as the FOMC meeting in August 08, Dallas Fed President Fisher voted for an immediate rate increase! In the September meeting, 24 hours after Lehman, the official view was that inflation was still a risk and that the next rate move would probably be UP!”

    Yes… But to play devil’s advocate, in his defense we note that Fed dependence on lagging inflation indicators, and the pre-occupation with defending their anti-inflation legacy, are not entirely to blame. Consider that even going into August, the 10 year TIPS inflation expectation was still riding higher than 2%…

    http://economistsview.typepad.com/.a/6a00d83451b33869e201156ff56430970b-320wi

    Inflation expectations were slowing down only because they had been fluctuating between 2.25 and 2.5%, which is above the Fed’s target, since Jan 08.

    So why were they so obsessed with inflation? Possibly their own instutional legacy was at stake…

    “I’m acutely aware that the current FOMC has inherited the inflation policy credibility that was hard won by our predecessors. One thing that has impressed me since taking my position last year is the seriousness with which my colleagues approach the duty to protect that legacy. I am confident that the Federal Reserve’s institutional commitment to maintaining low and stable inflation will prevail.”

    — Dennis Lockhart, President Atlanta Fed, August 2008

    http://macroblog.typepad.com/macroblog/2008/08/index.html

    The OTHER reason is that oil hit 147 dollars a barrel in august. Price of oil was THE dominant feature in economic AND political/election discussions of the day, and many perceived the high price of oil/commodities as an implicit hedge/bubble/dollar flight… right until we started to see signs of “demand destruction” in late august.

  36. Gravatar of 123 123
    17. September 2009 at 13:35

    Scott,
    Your Cato paper should be a required reading for everyone.
    Some thoughts about appendices:
    Appendix A: Why the monetarists are wrong: – Was the market right in ignoring the reserver requirement change in 1936?

    Appendix B: Why Bernanke is wrong: If financial sector is a part of real productive capacity of the economy, then Bernanke is right – NGDP and credit channel are both important.

    Appendix D: Why international macroeconomists are wrong; International macroeconomists are right – run on a financial system reduces potential real output. On the other hand, last September there were no indications of a third world type crisis in America.

    Appendix F: Why the old-style Keynesians are wrong. You wrote, “But when he [Krugman] did so it was mostly to lament that the world’s central bankers were just too conservative to promise to inflate, and that as a result any currency injections would be viewed as temporary”. I think that this is a realistic assessment of curent central bankers (excl. Svenson), while you may be right about the ideal bankers, Krugman describes current bankers better.

  37. Gravatar of marcus nunes marcus nunes
    17. September 2009 at 13:53

    In his Cato discussion of yor essay, Hamiltons says: “I agree that faster growth of nominal GDP would have been a good thing, but argue that, particularly if you start the clock in the fall of 2008, the Fed lacked the tools to prevent a decline in nominal GDP”.
    The point is that by the fall of 2008, the Fed´s succesive mistakes had already brought NGDP down. It seems to me that if, mistakenly, the Fed can bring NGDP down, correcting the “mistake” would go at least some way in redressing the “problem”!

  38. Gravatar of marcus nunes marcus nunes
    17. September 2009 at 14:06

    Dennis
    I understand you perfecly, more so because in Brazil, over the last 14 years of “low” inflation, after more than a decade of hiperinflation, no Central Bank is more obssesed with the “beast” than the Brazilian CB.
    I think that is less understandable in the case of the US, especially after 25 years of “Great Moderation”. The links usually made of inflation with oil prices and such were carried over from the 70´s. The economic structure has been very different for a quarter century. This episode has shown how costly it can be to remain “attached” to “old correlations”.
    Marcus Nunes

  39. Gravatar of ssumner ssumner
    17. September 2009 at 15:39

    Devin, I prefer GDP because I care about production, not income. The point is to stabilize production, as that reduces the business cycle.

    I don’t care about the leading indicator aspect of asset prices, as I favor targeting expected future NGDP, not current NGDP.

    John, The Larry White paper is where I got my information. Check out his conclusion–he says the same thing I do.

    You said;

    “It seems like you’re downplaying the real factors that contributed to the decline in September and October 2008.”

    Real factors don’t explain sharp declines in nominal aggregates–that’s the Fed’s job. Here’s an analogy. Suppose after the Soviet empire collapsed there was a lot of hoarding of dollars in the old Soviet bloc. And suppose that caused the amount of the monetary base that circulated in the US to fall 10%. (I assume no change in the total MB, just an outflow of dollars from the US to Russia.) And suppose the Fed did nothing to offset this. So it’s like a really tight money policy in the US. Would you blame the resulting recession on Russian hoarding of cash? In a sense that would be the cause. But I think it would be crazy to look at things that way. It would be 100% the Fed’s fault. The Fed has to stop this “hope for the best” attitude. They have to insist that they will pour whatever amount of money in the economy that is necessary to get their own internal forecasts of NGDP growth up to 5%. Whatever it takes. And if they don’t do that they will be 100% at fault. And here’s the beauty of that sort of policy–it makes their job 10 times easier if the markets know this will happen. The financial panic didn’t just happened, it occurred because we were sliding into recession and bank balance sheets were getting much worse. And that happened because the markets lost all confidence in the Fed. Not in September but in October. The markets gave the Fed ample time, and the Fed’s response was pathetic.

    The forecasts got gradually worse over a period of several months. The Fed had ample time to react to those forecasts, and they didn’t. The had no excuse for not easing very aggressively in mid-September. A 100 basis point cut would have electrified the stock market, shored up asset prices, and improved bank balance sheets. But if you’re right, that just shows we need to replace Fed discretion with futures targeting.

    George, I completely agree, and have gradually (through this blog) become more aware of these different versions of Austrian econ.

    Thanks Philo, I wouldn’t call him a “convert” for several reasons. First, he was one of the first to criticize the Fed, so it’s not like he learned anything from me. And second, his critique differs in some ways from mine, for instance I seem to recall that he thought money was too easy in the first half of 2008. I believe that’s because he focuses more on commodity prices (especially energy) and I focus more on NGDP, which was rising at a below normal rate.

    But I do appreciate your point, and there is some truth in what you are saying. I had actually thought of including him in that list last month, but one or two of his blog posts made me think he wasn’t quite in the same group. On the other hand, I’m sure you could say the same thing about a few others I included, like Hall.

    Thanks Marcus, I quoted from your comment in my paper, to show the GMU people how informed my readers are.

    Don, Now I see your point. Yes, Buiter has some similarities to my views. He also discussed the negative interest idea (after Mankiw and I did.) My list was people highly critical of the Fed in 2008.

    Jon, It’s not just the gold price changes, I am also talking about changes in the demand for gold. They also had powerful and immediate impacts on the markets. My point is that some of the OMOs weren’t viewed as permanent changes, and had no effects. If they did turn out to be permanent, and the markets eventually reacted, they weren’t reacting with a lag to the initial OMO, they were reacting immediately to the realization that the money supply increase was permanent.

    Lorenzo, I have a different view of the “three roles” than many other economists. Lots of things can be media of exchange and even more so stores of value. The unit of account is the key role. And that’s because monetary theory is fundamentally a theory of nominal aggregates like the CPI and NGDP. It’s because we measure prices in terms of Federal Reserve Notes (cash) that they are so important. Stocks are a more important store of value, but we don’t measure the price level in terms of shares of Google (thank God) and wages are not sticky in term of shares of Google. They are sticky in terms of Federal Reserve Notes. That’s why cash matters, not because it is a store of value or because it is used in a modest fraction of transactions.

  40. Gravatar of ssumner ssumner
    17. September 2009 at 17:00

    Ben, The MV=PY equation plays zero role in my mecroeconomics. If your friends think so they misunderstand me. I am:

    25% monetarist (Friedman)
    15% ultra-new Keynesian (Woodford)
    30% “New Monetary Economics” (Irving Fisher to Robert Hall)
    5% Austrian (Hayek/Selgin version)
    0% Post-Keynesian
    25% my own ideas (futures targeting, gold market models, eclectic methodology, NGDP forecasts indicate stance of monetary policy, etc.)

    I should add that’s just on the monetary question. On the real side I am a moderate supply-sider, and a pragmatic libertarian. Does that help?

    As far as NGDP, it comes down to this: What would yield a higher social welfare? NGDP growing exactly 5% each year, or the CPI growing exactly 2% each year? I think both would yield the same average inflation. But NGDP gives you more stable output, whereas CPI targeting gives you more stable inflation. I think inflation fluctuating from minus 1% to 5% is far less costly than real output fluctuating the same amount (from 0% to 6%) That’s why I prefer NGDP.

    Thanks Greg, Do you disagree with Larry White’s paper in the JMCB? I thought he suggested Hayek’s conversion came later. Or was it a gradual change in mind? Perhaps I misunderstood White, I read the paper quickly.

    If he was praising Keynes in 1931, how did the conventional history of thought story get so far off base? I’m not saying you’re wrong, I just find it frustrating when economist’s statements seem to conflict with their generally understood views. Off topic, but didn’t Keynes say The Road to Serfdom was a great book and that he (Keynes) agreed with almost everything in it? I find that sort of thing frustrating, as Keynes surely wasn’t a Hayekian during most of his career.

    John, I’m not crazy about your monetary views, but some of your later points are good.

    Statsguy, Thanks for the tip on small states.

    I don’t think the public choice model has much to say about the Fed. The mistakes are mostly honest errors.

    I just added a sentence about how there’d be less failures. But remember that there were hundreds of bank failures each year even in the prosperous 1920s. They were mostly small banks and no big deal. If the Fed had maintained healthy NGDP growth then bank failures would have no more caused a recession that a corporate failure. The reason bank failures were actually devastating is because they led to cash hoarding, which effectively tightened monetary policy, which reduced NGDP. This is why they were so harmful. The direct effects were trivial. Perhaps our modern system is more interconnected and fragile. I don’t know. I have never argued that the government was wrong to worry about the banking system last year—I just don’t know enough. But as far as the run of the mill failures of the 1930s, they were no big deal except their effect on monetary policy.

    Current, It is very difficult to interpret a statement like “need for low rates.” This is because low rates can be an indication of easy money (the usual view) or an effect of tight money creating deflation expectations. Without knowing why rates were low, I can’t comment on whether they were “needed.”

    I look forward to a Tolluck insult.

    mbk, Good question. First you need to know that under interest rate pegging you have a very unstable equilibrium. If you start moving toward easy or tight money, and don’t adjust rates, the disequilibrium conditions accelerate fast. Suppose the rate is 2%, and the Wicksellian equilibrium rate is also 2%. Things are stable. Then the economy slows in August, and the Wicksellian rate falls. Now money is a little bit tight. This further slows the economy. If the fed doesn’t react things get still worse, and the Wicksellian rate is even lower. Now money is even tighter. And so on. I would never deny that Lehman was another factor weakening the credit markets. The Fed needed to respond to Lehman, and didn’t. Once the markets lost confidence the Wicksellian rate plunged. And even a zero fed funds target wasn’t enough to turn things around.

    Statsguy, I don’t think the value of the dollar plays much of a role in Fed thinking, nor do I think it should. The dollar will not collapse as long as NGDP growth is around 5% and core inflation is low and stable. There will be dollar fluctuations as there always have been. The dollar was soaring in value last summer and fall, so it did not inhibit the Fed in the key September/November period. They could have eased policy.

    you said;

    “The OTHER reason is that oil hit 147 dollars a barrel in august. Price of oil was THE dominant feature in economic AND political/election discussions of the day, and many perceived the high price of oil/commodities as an implicit hedge/bubble/dollar flight… right until we started to see signs of “demand destruction” in late august.”

    I think you are slightly off. I recall oil peaking in early July and falling sharply in August. But I agree that the Fed had reason to not ease in August (but not tighten, as NGDP growth was anemic.) But Marcus is right about September. By then there was no excuse.

    123, All very good questions:

    1. That’s a tough question. Based on what they knew at the time, they were right to brush it off. There was massive dehoarding of gold, and accelerating inflation. The policy seemed too weak to slow inflation. Later on when things turned around in late 1937 and gold started being hoarded again, then the RR increases turned out to be a mistake. So ex post the markets were wrong, but based on what they then knew, their lack of response was reasonable.

    2. See my comments above. It is a part of the real economy, as you say, but sectoral problems don’t cause recessions—unless they get entangled with monetary policy. Of course my proposed policy of NGDP targeting would have made the financial crisis much smaller. And although I am a libertarian I would say if there was some sort of systemic risk perhaps something needed to be done. It’s not my area of expertise. My point is that fixing the banks was not a substitute for monetary policy. In the 1930s I am very confident that NGDP targeting would have been more than enough. One, because it would have prevented the banking crises, and two, because even if some banks failed it would have caused no more problems than in the 1920s, when 100s of small banks failed each year and the economy boomed. There is always a lot of churning in the US economy. For instance, I once read that each year 30 million workers lose jobs, and 31 million gain jobs, for an average gain of 1 million. Banking is kind of like that–a bunch of failures is no big deal unless you let it affect NGDP.

    3, My point is that they were wrong in applying that argument to the US. I think we actually agree. I agree that they are right about Mexico, Thailand etc.; the countries whose currencies collapsed. But ours strengthened during the crisis, that is inexcusable.

    4. I understand your point, but that is to view monetary policy in a completely positive fashion, like you are examining an insect colony. Yet Krugman was trying to influence fiscal policy–which is equally deterministic, after all they refused to adopt his proposed 1.3 trillion stimulus. So why shouldn’t he also try to convince the Fed? Even worse, the reason he gave is based on a misunderstanding by the Fed. I am not trying to convince the Fed to do something that goes against their value system, I am trying to make them see that their own value system (2% inflation) called for much more aggressive steps. So in the end although Krugman correctly predicted the Fed’s lack of action, I strongly oppose the implication that this was due to the Fed adhering to some sort of principled conservatism, it was an example of Fed incompetence, of them not knowing what was in their own interest. And he did condemn the ECB, which is equally conservative (if not more so) and equally deterministic.

    Marcus, I don’t quite follow Hamilton’s argument. He seems to think that monetary ease was not needed, until it was too late for it to work. What about in the in between period? I have beefed up the paper to talk more about how a Fed commitment to boost future NGDP, also helps keep current NGDP from falling. I think that will be our biggest point of debate. There is very solid research suggesting that the most important determinant of current aggregate demand is expected future AD. Because the Fed can impact the latter, it can also impact the former.

    I agree with your second point. I lived through the 1970s, indeed was studying econ for 7 years. So I am as aware of the risks as anyone. And (sorry Bob) but this is nothing like the 1970s (except gold prices, and I think they are misleading.)

    I am in the new Reason magazine, and the cover is about the risk of 1970s inflation. Everyone on the right seems to be worried about inflation except me and the other like-minded people in this blog.

  41. Gravatar of Greg Ransom Greg Ransom
    17. September 2009 at 18:29

    Scott, here’s Hayek on the “secondary depression / deflation” writing in 1931, published in 1932, from my Taking Hayek Seriously blog last month:

    Just to set the record straight, I’d like to point out that Friedrich Hayek was well aware of the problem of the sort of “secondary” deflation which often occurs after the onset of an economic bust made inevitable by a prior credit induced artificial boom.  In part 2 of Hayek’s “Reflections on the Pure Theory of Money of Mr. J. M. Keynes”, written in 1931 and published Feb. 1932, Hayek writes:
    the very fact that processes of investment have been begun but have become unprofitable as a result of the rise in the price of factors and must therefore be discontinued, is, of itself, a sufficient cause to produce a decrease of general activity and employment .. without any new monetary cause (deflation).  In so far as deflation is brought about “” as it may well “” by this change in the prospects of investment, it is a secondary or induced phenomenon caused by the more fundamental, real, disequilibrium which cannot be removed by new inflation, but only by the slow and painful process of readjustment of the structure of production.
    And similarly:
    I do no deny that, during this process [of re-coordination across relative prices and the time structure of production], a tendency towards deflation will regularly arise; this will particularly be the case when the crisis leads to frequent failures and so increases the risks of lending.  It may become very serious if attempts artificially to “maintain purchasing power” delay the process of readjustment .. This deflation is, however, a secondary phenomenon in the sense that it is caused by the instability of the real situation; the tendency will persist so long as the real causes are not removed.
    In other words, the suggestion of some commentators that Hayek discovered the phenomena of the “secondary deflation” occurring during the bust phase of the the cycle only in old age, or only after the experience of the Great Depression, or only after the publication of Keynes’ General Theory, etc. is purely fictional.
    The two quoted passages are from pages 194 and 196-197 of F. A. Hayek’s Contra Keynes and Cambridge:  Essays, Correspondence.
    Hayek even indicates as early as 1931 that he has no problem with efforts to counter-act such post-bust problems as the “secondary deflation”, going so far to say that John Maynard Keynes in his 1930 book A Treatise on Money had “made valuable suggestions for treating these secondary complications [such as the secondary deflation].”
    Hayek didn’t oppose blocking the secondary deflation, he opposed going far beyond such a policy,  into the completely different realm of policies which by accident or design would block, jam, or delay the re-adjustment process working to bring the time structure of production and consumption closer to sustainable reality.

  42. Gravatar of mbk mbk
    17. September 2009 at 18:50

    Scott,

    the reason for my question are a couple disparate observations as the crisis unfolded. One feature was how all sorts of things fell off a cliff world wide, not just US NGDP. World industrial real output, trade volumes… all down by 10-40% within weeks and months, yet at the same time say actual US real retail for instance suffered far less, down maybe a few percent. So production cut down instantly before consumption, the cart before the horse (to the extent that here in Singapore I wanted to buy a monitor early 2009 and one large brand’s models were all out of stock, all models! For weeks! ).

    Anecdotally I remember the issues arising for businesses late 2008, quoted not as “can’t pay the high interest/went bankrupt” but as “can’t get loan at any condition”. This is what made me think of either, money being held so cheap that under prevailing risky conditions no one would lend it out (analogy: communist supermarket), or, soaring demand for reasons of balance sheet arcana, or, a qualitative imbalance in the various money instruments that prevented intermediation (analogy: heart attack through clogging). Maybe all three, who knows.

    Ad “plunging supply”, I did not think so much of the Wicksellian rate, again I am with you in that this must have been a nominal issue not a real one, because it happened to fast to be cause by a real imbalance (all of a sudden) – and as far as I understand it the natural rate relates to the real economy. So if the natural vs. money rate had been the cause the cause of the plunge then why did it happen so fast (even if the relation is unstable to begin with). I tried to conceptualize this at a more naive inductive level staying purely in the money markets – what if the heavily manipulated money “market rate” was not what a true money market rate would have been in a system where banks and individual could negotiate every lending act freely? What if the problem is one of sagging intermediation because the usually reasonable and factored in restrictions on intermediation are suddenly inappropriate for the new situation? So it could have been supply that suddenly sagged, or rather, supply of loans acceptable to potential lenders at the low interest rates. What I am saying is under the sudden rise of perceived risk, a naive mind would think at that point any measure for any kind of effective interest rate should have gone through the roof if interest truly reflected perceived risk and supply vs demand. But of course “interest rates were kept low”, so no milk in the communist store. Lenders would lend, maybe, but not at these prices.

    Ad “soaring demand”, alternatively if it was not supply that dried up but demand that soared (and not by consumers, see actual retail ca. end 08 US ex cars, down at worst a few percent, but trade finance, international productione etc). Why would businesses suddenly need more “money” than there was “supply” , why was there a sudden imbalance with supply? I can think of a spike in actual demand that was balance sheet related, say need for additional collateral for CDSs, this is truly ironic because collateral would really be Hume’s gold in a chest, and highly contractionary.

    Finally ad “qualitative imbalance”, this would truly be a failure of coordination, a collapse in supply caused by the wrong specific qualitative form of money (while other forms may have been available). So this would relate to the reported troubles GE had to find short term financing of their payroll which was done using credit lines that dried up; reported impossibility to get letters of credit for trade finance in late 2008 etc. These are not incompatible with the idea of prices or money beong too low of course, maybe at 35% monthly someone _would_ have lent to GE… Still this kind of coordination failure could have been created by internal mechanisms kicking in the various institutions that create positive feedback, say, institutional investors only allowed to invest in AAA rated securities, so a downgrade triggers a selloff which triggers the next downgrade, margin calls and total annihilation. In my interpretation btw most of what the Fed did was to really create a massive “bypass” to alleviate the financial clogging. (in case of clogging additional supply is irrelevant, you need to unclog, or use a bypass for a while).

    On a side note the entire finance world seems to make little formal use of stability and feedback analyses that are the staple of control theory, applied to dynamical systems, signals, or even pedestrian electrical circuits. Negative feedbacks turing into positive feedbacks through phase lag is a classic. And the spontaneous generation of clogging and the propagation of entire traffic jam waves on highway traffic, without an external trigger, has been studied half a century ago.

  43. Gravatar of Greg Ransom Greg Ransom
    17. September 2009 at 20:22

    Scott, it’s been a good while since I read Larry White’s JMCB paper.

    I’m guessing White’s focus was _not_ on Hayek’s scientific and theoretical views, but on Hayek’s weak / false knowledge of the empirics on the ground in the U.S., mistakes of empirical accessment acknowledged by Hayek himself.

    Note well that the very little that Hayek wrote the situation at hand in the early 1930s was mostly focused exclusively on the very different British situation dating back to
    1925, and there is no evidence that Hayek spent any time at all thinking about or researching the American situation.

    And yes, there has always been an agenda drivin the many unfair, false and misleading myths and slanders aimed at the economics of Hayek.

    No one has ever challenged the scientific pretentions, explanatory strategies and policy presciptions of the economics profession from within the tradition of the marginalist revoluion the way Hayek has — and many British and American economists have always resented it, especially the more scientistic, interventionist or “mathematical” among them — or those still dependent on pre-marginalist
    models of capital and interest theory ( e.g. Knight and the Chicago economists and Keynes and the Cambridge economists).

  44. Gravatar of mbk mbk
    17. September 2009 at 22:03

    Scott, since you replied in the other thread to my “price fixing” remark and I somehow repeated it in the above post, let me restate what I mean. I do understand that the Fed does not “fix” prices in the conventional sense, rather, the Fed’s open market operations aim at achieving a certain target market rate, and they do this by exchanging one monetary product for another.

    What puzzles me in the crisis situation we just had is that thusly achieved market prices for a sought-after commodity (money for rent) were low, quantity in circulation was high, and yet potential customers claimed that they could not find any on the market. To me this normally only occurs when the nominal market price is a price proclaimed by fiat, and the real (black) market rate is far higher. I have no specific idea how this situation comes about in money markets, but it puzzles me.

    If I had to guess I would say money markets between large financial players function differently than the interface of money market players with real world players (essentially it’s easier for financial institutions to make money shifting it around within the financial system, than lending it out to the risky real world. So they don’t).

    The “exchanging one monetary product for another” formulation that I chose above to characterize open market operations maybe hints at a possible connection with qualitative imbalances in monetary products. Maybe fixating in targeting interest rates for cash on demand is irrelevant when markets may care more for the behavior of non cash monetary products.

    [Note on the side, I grew up in a world of bank accounts, credit cards, cheques and electronic transfers. I hardly ever see cash. Monetary theory often talk about cash holdings by the public and banks, in my experience cash holdings by the public known to me, virtually don’t exist. Maybe 5% of my total monthly transactions is in my pocket at any given time and probably 80% never go through any cash stage].

  45. Gravatar of Current Current
    18. September 2009 at 01:54

    I also experienced the LCD screen shortage, from the point of view of someone who works for a large PC company.

    I can’t tell you much about it, except that there’s a bit more to it to what you write. Type “LCD shortage” into google and see what comes back.

  46. Gravatar of vimothy vimothy
    18. September 2009 at 02:14

    Was the spike in oil & agricultural commodity prices really a bubble? At what point do we say, “this is no longer driven by fundamentals”? At the time, I thought that it was due to demand growth (China et al) and biofuels, i.e. not a bubble at all. Was this wrong?

    Scott, great blog, BTW. Will you be recording/posting the talk?

  47. Gravatar of Current Current
    18. September 2009 at 03:15

    Greg, Scott,

    In that paper White writes in note 5:

    “After 1929 Hayek (1984 [1932]. p. 130) complained that Federal Reserve attempts to re-expand credit, ‘in complete accordance with the prescriptions of the stabilization theorists,’ in combination with interventionist measures undertaken by Hoover, were deepening and prolonging the crisis by ‘preventing or delaying the normal process of liquidation. Had contemporary data been available to him. Hayek-to be consistent with his own constant-MV norm-might have placed greater emphasis on the danger of allowing MV to continue shrinking. By 1933 United States nominal GNP had fallen well below even its lowest point of the 1920s (Greenfield 1994, p. 10).'”

    I don’t really know how to interpret this. White is writing about an article by Hayek I don’t have and haven’t read. I can’t even tell which article he is talking about.

    As I said earlier I don’t really find this discussion of what Hayek thought in the past very helpful.

    The article you mention is interesting and difficult. I think that one of the main things we need to understand about this “monetary equilibrium” business is exactly which flavour of it is best.

  48. Gravatar of Current Current
    18. September 2009 at 04:04

    The three properties of money are not equal.

    It is clear that the use of money as a store of value isn’t critical. In Germany in the hyperinflation of the 1920s money was still used until the quite late stages. People were still using money when the rate of depreciation per day was significant.

    Nor is money’s property as a unit of account so critical. In ancient history monetary systems occurred where there were sets of separate coins. The state did not setup official exchange ratios between them. As a result as many units of account as types of coin existed. It was also possible at many times to account in either gold or silver. Similarly debts could be made in various ways.

    What really distinguishes money in microeconomics is it’s use to facilitate indirect exchange. Money’s property of being the “most marketable good”.

    It may be true that for Scott’s monetary theories the unit-of-account part is more important. I don’t think though that the facility to make indirect exchange is unimportant though. There can be no demand for a unit of account in the economic sense of the word “demand”.

  49. Gravatar of Giedrius Giedrius
    18. September 2009 at 06:18

    I know then just from their blogs, but here goes:
    1. Be prepared to make bets. Better yet, propose them to bet on something you disagree about.
    2. Be prepared to defend your active personal portfolio management practices.
    3. They have this question about your most absurd belief (in other peoples eyes). But I guess NGDP futures targeting would do.

  50. Gravatar of happyjuggler0 happyjuggler0
    18. September 2009 at 09:10

    Scott,

    I am curious what you think of an idea of mine (noting that there is nothing new under the sun). Assume there is a situation similar, but not quite identical (the players have changed just a bit), to last Fall. Frame it any way you want to, soaring demand for money, plummeting velocity of money, a large drop in AD. Assume also that we are at zero interest rates (or virtually at, such as ~0.25%), and that the central bank, for whatever reason, stops trying to ease, and instead focuses on propping up both main street banks and wall street banks.

    Now assume that the Treasury Secretary came to you something like:
    I am at wits end. I’ve tried to persuade the Fed to engage in QE and at the same time target 5 or 6% NGDP, and to do so by targeting the forecast somehow, and to tell the world that that is going to be the “permanent” Fed policy from now til eternity.

    To make matters worse, Paul Krugman just won the Nobel Prize, and is loudly calling for “massive Keynesian fiscal stimulus” which I think will saddle the nation with massive debt that will hurt the economy in the long run, and which won’t do anything in my opinion to improve the economy in the short run, i.e. no multiplier. The President is about to take his advice.

    I have an alternative idea for the fiscal side, and want your thoughts. The basic idea is to soak up “mattress money” and recycle it back into the for-profit sphere of the economy. How about the US government issue huge amounts Treasuries in various maturities, such a 3 month, 1 year, 2 year, 5 year, 7 year, and 10 year paper. Then with the proceeds, sets up a Norwegian style (i.e. multiple outside managers) Sovereign Wealth Fund (SWF). The SWF will be managed by the private sector, namely by the top ten mutual fund families, on a for profit basis with a combination of set pay and incentive pay for the fund companies in question.

    Each of the ten funds will receive equal amounts of SWF money, and will be charged with buying corporate debt in maturities equivalent (mean average, it doesn’t have to be precise, indeed probably shouldn’t be precise) to the treasuries used to fund the SWF. The idea being to not speculate on the yield curve, but to in effect arbitrage between ultra-low Treasury interest rates and higher than “normal” corporates. The 10 individual funds will be free to buy any corporate debt under such maturity limits, regardless of what the idiotic rating agencies rate the debt at. They may not buy anything but general corporate paper, e.g. no CDO’s or muni’s. They must remain fully invested.

    The Treasury will continue issuing new Treasuries, and handing the cash to the SWF, until such time when (presumably not if!) the Treasury/corporate spread closes to historical norms. The ten funds that make up the SWF will then manage their funds until the individual debt matures, returning the proceeds to taxpayers (i.e. the government) along the way over the next ten years.

    Contrast what I want to do with the “Krugman plan”. “Keynesian stimulus” misdirects massive amounts of wealth to the inefficient public sector for an indefinitely large amount of time, saddles future taxpayers with massive amounts of debt, and does nothing in the short term to address the disintermediation in the corporate debt sector. My plan on the other hand directs idle money to currently “starved” businesses that those professional private sector fund managers think worthy, makes a large profit for the taxpayers, and by my reckoning deals substantially with the massive drop in money circulation that we have right now that is pummeling the economy.

    So what do you think, should I send my plan to the president? How would you amend it, noting that we can’t figure out how to get the Fed to adopt your plan? Finally, do we need the Fed to engage in QE at all under my plan?

  51. Gravatar of happyjuggler0 happyjuggler0
    18. September 2009 at 09:15

    By the way, if at all possible, could you amend your website to give posters a “preview submission” option, which is the norm for most blogs? Thanks.

    Once again, thanks for responding to posters here. You seem to be pretty unique in that regard. I for one have learned a lot over the past few months as a result of both your posts and your responses to various comments, and from other’s comments as well. Even if I don’t always agree with you, especially when you stray from monetary policy. 🙂

  52. Gravatar of StatsGuy StatsGuy
    18. September 2009 at 09:30

    ssumner:

    “I don’t think the value of the dollar plays much of a role in Fed thinking, nor do I think it should” and “dollar was soaring in value last summer and fall, so it did not inhibit the Fed in the key September/November period”

    It’s critical to separate July/August from September/October.

    Consider this chart (dollar vs. Euro, 5 years)…

    http://finance.yahoo.com/echarts?s=USDEUR=X#chart2:symbol=usdeur=x;range=5y;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=on;source=undefined

    two year:

    http://finance.yahoo.com/echarts?s=USDEUR=X#chart6:symbol=usdeur=x;range=2y;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=on;source=undefined

    We see a pretty steady downward trend, interrupted by a spike. The beginning of the spike is right around when the price of oil starts to implode, and the first month of that spike could be called an “adjustment” due to overshooting. Then observe what happens… Sept 10/11, dollar starts to plummet again, Sept 19th a sharp reversal as the dollar rises, which quickly becomes undone as the panic resides over the next 6 months…

    Given all this movement, it’s hard to expect the Fed was not cognizant (and worried about) the Dollar during that time period, and probably in the dark about what the “real” trend was. (We won’t know without transcripts, I suppose, although the inclusion of Paulson in so many discussions is an important data point.) Whether it SHOULD have been is another question.

    But the second thing this chart should call attention to is that the sudden increase in the dollar was unexpected. (If it was expected, the graph wouldn’t be sharp, right?). The going-in expectation was for the dollar to remain weak. The rise is widely attributed to sudden and massive and unexpected deleveraging, which created demand for dollars to settle debt. The deleveraging was thought to be triggered by the bank run (Lehman, and later WaMu on the 25th – although the 11th vs. 19th timing is weird), but certainly there was a massive increase in risk premia during that time as the government insisted on a 700 billion dollar backstop for AIG and the 3.6 trillion dollar short term paper (money market) market.

    After September 19th, when the dollar starts spiking and inflation expectations start to plummet, the Fed has zero excuses for its tight money policy. (Except to preserve its precious “hard won” reputation for low inflation.) Up until then, the picture is muddled – and as noted above, even the _expectation_ for inflation using TIPS remains at or above until the end of summer.

    This sort of movement also reinforces the notion that a bank run of sufficient scale can cause an independent shock. Movement as dramatic as we observe in the exchange rate over that month (from 0.68 Euro to 0.79 Euro in a month frame, over a 13% change between the world’s two largest currencies) speaks volumes about _something_ (if we believe the markets don’t lie). Perhaps it’s simply that investors’ beliefs about the Fed’s likely response was radically updated (I know mine were). Or perhaps it was the increase in risk premia/flighttosafety/deleveraging story. They co-occur, so causality is an issue.

    By the way, in terms of systemic stability and whether a banking shock could cause independent harm, take a look at figure 2.6 from here:

    http://www.imf.org/external/pubs/ft/gfsr/2009/01/pdf/chap2.pdf

    Chapter 1 is also good – great discussion of how wrong everyone was in the belief that contagion could be isolated.

    I don’t expect it will change anything you’re writing.

  53. Gravatar of azmyth azmyth
    18. September 2009 at 14:04

    Lorenzo – I’m no anthropologist, but I just went to the British Museum and they had an exhibit on ancient money systems. Carl Menger’s story seemed to line up quite nicely.

    Joe Calhoun – Austrian economists do address regime uncertainty, especially those at GMU. In fact, I would recommend to Scott to emphasize how using rule based, forward looking policy minimizes uncertainty.

    Larry White is one of the best economists on the issue of free banking. I think your idea of stabilizing MV is similar to what a free market in money would actually do, so I think you’ll find some sympathetic ears. Pete Boettke is also a good person to talk to. Alas, I won’t be there as I am studying abroad this semester. Have fun and good luck!

  54. Gravatar of Current Current
    18. September 2009 at 17:59

    azymth,

    Carl Menger’s story is very plausible. However the situation isn’t really so clear. It is quite possible that Menger’s story is true but political force stalled it in early history. Then politicians allowed money to appear when the time was right for them. Another explanation is the debt explanation (which came from another Austrian, Fetter) this says that debt arose first and a common way of repaying it rose afterwards. That could have happened too, particularly if Menger’s explanation were headed off by politics. So, theoretically speaking almost anyone could be right.

    The whole subject is very complicated. I’m afraid I don’t think that archeologists add much to it, because most know very little about economics.

    I agree with your other subjects. The uncertainty caused by politics on monetary factors is an old subject in Austrian economics.

  55. Gravatar of RebelEconomist RebelEconomist
    18. September 2009 at 23:18

    Scott,

    Sorry if this comment is too late to be helpful, but the long post and its thought-provoking comments took me some time to read!

    If you do not consider the Fed funds rate to be a good indicator of the tightness of monetary policy, what would you prefer (I dare say some would say that the Fed funds target is the measure of the tightness of monetary policy by definition, and think of other factors – eg demand for base money – as exogenous)? The fact that Fed policy is set in terms of the Fed funds rate means that the Fed should automatically accommodate an increase in demand for base money like the Russia shock you mention. As I recall, the Fed funds rate did stay close to the target in late 2008, but the problem was the supply of longer term and less well secured loans. The problem seemed to be not so much the setting or the target of monetary policy, but its method of implementation. And even if this could have been changed, I would question whether it should have been – ie real mistakes had been made (imprudent loans) that should have been dealt with by real solutions (orderly bankruptcy with government assistance to minimise actual closure of institutions). I suspect that some of the attention you are getting at present is because you are offering a relatively easy solution to recent problems; I think that NGDP targeting would be tough to sustain in a low inflation boom.

  56. Gravatar of ssumner ssumner
    19. September 2009 at 07:15

    Greg, You quote Hayek as saying:

    “I do no deny that, during this process [of re-coordination across relative prices and the time structure of production], a tendency towards deflation will regularly arise; this will particularly be the case when the crisis leads to frequent failures and so increases the risks of lending. It may become very serious if attempts artificially to “maintain purchasing power” delay the process of readjustment .. This deflation is, however, a secondary phenomenon in the sense that it is caused by the instability of the real situation; the tendency will persist so long as the real causes are not removed.”

    I would argue exactly the opposite, the tendency toward deflation will become much less serious if attempts to maintain purchasing power delay the process of readjustment. Indeed the appropriate policy is to attempt to maintain purchasing power at pre-depression levels.

    You should re-read White’s paper, as if you are right then White is wrong. He claims that Hayek later regretted his views on stimulus during the Depression. More specifically, Hayek later regretted opposing stimulus during the 1930s.

    mbk, you said;

    “the reason for my question are a couple disparate observations as the crisis unfolded. One feature was how all sorts of things fell off a cliff world wide, not just US NGDP. World industrial real output, trade volumes… all down by 10-40% within weeks and months, yet at the same time say actual US real retail for instance suffered far less, down maybe a few percent. So production cut down instantly before consumption, the cart before the horse”

    This isn’t that unusual. The same happened in 1929. The reason it seems unusual is that people have been brainwashed by Keynesian economics, which emphasizes expenditures. In the stick-wage model, deflation causes higher real wages, lower production, and then when workers lose jobs they scale back purchases. We saw sudden collapses in output in the fall of 1929 and 1937 that were as steep, or steeper, with no financial crisis, just a drop in expected future NGDP.

    Here is an analogy–a new additive that boosts gas mileage by 30% is discovered. It will take six months to get into gas stations. And yet oil production will plunge immediately, even with no change in current oil consumption. Inventories will be run down as companies expect lower future prices.

    There is a huge difference between a real shock that is expected to reduce output for just a few months, like Katrina, or like a temporary credit crunch, and a nominal shock that is expected to lower the path of NGDP for years to come. Only the later will lead to massive job losses. The former will lead to one bad GDP quarter. We are looking at 8-10% unemployment for years to come.

    mbk, You said;

    “What puzzles me in the crisis situation we just had is that thusly achieved market prices for a sought-after commodity (money for rent) were low, quantity in circulation was high, and yet potential customers claimed that they could not find any on the market.”

    This confuses money and credit. Credit was tight, but there was no shortage of money. ATM machines were doling it out to anyone who wanted any. The Fed controls money (cash) not credit.

    You said;

    “[Note on the side, I grew up in a world of bank accounts, credit cards, cheques and electronic transfers. I hardly ever see cash. Monetary theory often talk about cash holdings by the public and banks, in my experience cash holdings by the public known to me, virtually don’t exist. Maybe 5% of my total monthly transactions is in my pocket at any given time and probably 80% never go through any cash stage].”

    You are atypical. The amount of cash in circulation is over $2500 per capita. Even excluding foreign holdings it is well over $1000 per American.

    Current, Temporary product shortages occur during both booms and recessions. I never saw any articles suggesting the problem was dramatically worse last year, although I don’t rule out the possibility. But that would have been a Katrina-like blip, and couldn’t explain the sharp fall in NGDP over the past 12 months.

    vimothy, I don’t know of the talk is recorded. I agree that it is hard to determine bubbles, it’s even hard to define them.

    Current, Thanks for the quotation. Just to reiterate, I don’t think any of this reflects badly on Hayek’s theory. But I differ with Greg about how it reflects on Hayek as an economists. I see the ability to comment intelligently on current macro issues as being very important, even for a theorist. Macro is (or should be) a very applied field. Greg and I will just have to agree to disagree. I don’t at all disagree with his evaluation of Hayek as a pure theorist.

    Current. There is demand for cash as a medium of account. I.e. the “thing” that embodies the unit of account. Regarding ancient times, if there were multiple units of account then wage and price stickiness would only be a factor if measured in terms of a specific unit. If wages were denominated in terms of many different units, then business cycle theory would become much more complex. My hunch is that real factors mattered more in ancient times. But I have never studied the issue.

    Giedruis, Who is “they.”

    happyjuggler0, Surprisingly, it might work. Indeed if adopted in March the government probably would have made a profit. But I don’t like it as a general policy. Too risky, too open to abuse. But again, your logic is good, That might have been an indirect way of boosting velocity.

    Thanks for the compliment. I have also learned a lot from commenters. They have also led to new posts. I’ll look into the preview submission option, but it won’t be implemented right away. Things move slowly here.

    statsguy, You said;

    “But the second thing this chart should call attention to is that the sudden increase in the dollar was unexpected. (If it was expected, the graph wouldn’t be sharp, right?).”

    Virtually all changes in exchange rates on a daily basis are unexpected (due to the interest parity condition.) You may be right that the Fed worried about exchange rates–if so, they made a huge mistake.

    azmyth, Thanks. Are you a grad student at GMU?

    rebeleconomist, You said;

    “I dare say some would say that the Fed funds target is the measure of the tightness of monetary policy by definition,”

    I sure hope not. Otherwise money was really “tight” by definition during the German hyperinflation, and really easy during 1932 in the US. If that’s the conventional view, then it is 180 degrees off.

  57. Gravatar of rob rob
    19. September 2009 at 08:03

    Scott,

    Most of your theory draws on Great Depression data, but doesn’t the Great Depression offer only a few data points? How do you separate causation from correlation with so few data points? It seems that your hypothesis is untestable.

  58. Gravatar of mbk mbk
    19. September 2009 at 08:17

    Scott,

    thank you for responding in so much detail, as always. I still remain puzzled. You say:
    “There is a huge difference between a real shock that is expected to reduce output for just a few months, like Katrina, or like a temporary credit crunch, and a nominal shock that is expected to lower the path of NGDP for years to come. Only the later will lead to massive job losses. ”

    This assumes that real production collapsed because the real economy correctly and immediately recognized the nominal nature of the crisis (as opposed to previous real-natured crises) – something that economists are still debating as of now (sic!) – and anticipated its soon to follow real consequences. Analogy, it assumes that companies reduced production because they expected that due to their soon to be reduced production, their soon to be fired worker would not be able to buy products anymore. Somehow I still don’t understand the mechanism of propagation from the nominal to the real, unless it is through creating real issues such as, no letter of credit, no credit line, etc.

    When you say
    “This confuses money and credit. Credit was tight, but there was no shortage of money. ATM machines were doling it out to anyone who wanted any. The Fed controls money (cash) not credit.”

    Is not the entire point of targeting interest rates ultimately to control credit? By abuse of language we say “money was tight” but really is it not always credit that is meant? (nobody complained about ATMs). Is interest on money not pretty directly linked to interest for credit? And is money in deposits not linked to money available for credit (assuming constant reserve requirements etc)? And if this is so, then how can credit be tight but cheap at the same time, and remain so for months?

  59. Gravatar of JimP JimP
    19. September 2009 at 08:17

    Well Scott – best of luck – and I do mean it. The deflationists are still out there – in full cry. According to Meltzer et al we just have to suffer through – cause it will somehow be good for us. Bernanke will be with us in our pain – and China will cheer the strong dollar – them and the WSJ. What a mess.

    They simply do not understand the power of the FED – to pay either positive or negative amounts on excess reserves. It is the same simple platform as before – and you should just repeat it over and over. Charge interest on excess reserves – and set a clear price level target. Just do it, Mr Bernanke. Do it.

  60. Gravatar of Current Current
    19. September 2009 at 10:00

    Scott: “Temporary product shortages occur during both booms and recessions. I never saw any articles suggesting the problem was dramatically worse last year, although I don’t rule out the possibility.”

    Yes, the situation with LCDs was special.

    I agree with what you say about changes happening in advance of the problems spreading through society. This is an old point, it is most clearly seen with changes in monetary exchange rates. From the time when the exchange rate between the euro and pound changed until the time when Scots Whisky changed in price there was a long gap.

    I see what you mean about Hayek and his statements. I’ll read White’s paper properly when I get around to it.

    Scott: “There is demand for cash as a medium of account. I.e. the “thing” that embodies the unit of account.”

    No, not really. A unit of account is an abstract metric. We don’t store those. I don’t keep a box full of 30cm rulers, I only keep one or two. However, if a certain unit of account becomes standard then it becomes useful to keep a stock of them. Doing so removes the burden of agreeing on a price for some good in relation to the unit of account. Note though that this demand is a demand to hold a good that can readily be used for indirect exchange. Which brings us back to the last definition I gave. It’s not possible to demand an abstraction, that would be like “throwing Human Action on a scales to see how much Austrian Economics weighs” as Bob Murphy once wrote.

    Scott: “Regarding ancient times, if there were multiple units of account then wage and price stickiness would only be a factor if measured in terms of a specific unit. If wages were denominated in terms of many different units, then business cycle theory would become much more complex. My hunch is that real factors mattered more in ancient times. But I have never studied the issue.”

    Even in the relatively recent past there were several types of money. In England there were pounds and shillings that were made from silver, and sovereigns that were made from gold. In practice there was no tie between the value of sovereigns and guineas, and the value of pounds and shillings. They floated against each other. The gold coins were only used by the very rich. Also, until quite recently grain was still used as a form of currency for some purposes.

    It’s not clear how business cycle theory applies to economies before modern times.

  61. Gravatar of azmyth azmyth
    19. September 2009 at 10:07

    Current – Thanks for the comment. I’ll look into Fetter.

    Scott – Yes, I am.

  62. Gravatar of RebelEconomist RebelEconomist
    19. September 2009 at 13:17

    So, Scott, what is your measure of the tightness of monetary policy? I think you need to specify this if you are arguing that the cause of the sharp downturn in 2008 was excessively tight monetary policy.

  63. Gravatar of happyjuggler0 happyjuggler0
    19. September 2009 at 16:04

    Scott,

    It may be too late, but I think you should include the (seemingly?) sample of one country that chose to implement some form of NGDP expectations targeting, namely Australia, in your paper/presentation.

    Just a suggestion. 100% success ratios can sometimes open eyes, even if they aren’t statistically significant.

  64. Gravatar of Vangel Vangel
    19. September 2009 at 17:32

    “First an disclaimer. I am not as knowledgeable about Austrian business cycle theory as many of my readers.”

    I agree. You certainly do not seem to know much about the Austrian business cycle theory.

    First, the Austrians were right that the constant meddling in the economy as the Fed took action to prevent necessary economic contractions for more than two decades would end badly. (I do not believe that the expected end has come yet because the Fed stepped in once again and prevented the necessary liquidation of bad debts and malinvestments.) While few of the mainstream schools saw a problem, the Austrians knew that the housing sector would lead to a major contraction.

    Second, the Austrians understand that in the absence of the necessary contraction and liquidations there will be too much uncertainty for new capital investment to take place. Given the meddling by the Bush and Obama administrations I do not see how one would expect anything else but the confusion that has taken place. As long as economists and politicians refuse to let the markets work the Austrians expect the troubles to continue and for the fiat currency to keep losing purchasing power. From what I can see the incentives still favour distorting the economy and the markets for short term political gains. That suggests that the USD will have strong rallies but will continue to lose purchasing power much more rapidly than most economists imagine. Given the massive unfunded liabilities the end game includes a major devaluation and a significant decline in the standard of living for Americans. A prudent Austrian would buy gold and silver and would look to purchase shares in foreign companies that produce commodities and have reserves in politically safe areas of the globe.

  65. Gravatar of Current Current
    19. September 2009 at 19:01

    azymth: “Current – Thanks for the comment. I’ll look into Fetter.”

    On reflection, I’m not sure it was Fetter, it may have been someone else (Davenport?). I didn’t think anyone was really interested in that bit of the debate.

    Anyway, several plausible explanations of the origin of money exist. In practice Menger’s has occurred several times in recorded history in military prison camps and in prisons. So, Menger’s is plausible. But, we don’t know about the political environment of the time when money did evolve. It may have been suppressed, so the other theories are similarly quite plausible. Though I’m an amateur Austrian economist I must say that the chartalist theory may be correct in that the ancient states may have prevented the evolution of money until it benefited the rulers to allow it. The actual history is probably very complex.

    The argument Austrians try to make from it though is mostly about how money is dimished. The state can damage the “store of value” bit and money will continue to work. Similarly, the use as a unit of account can be confused and money will still be used. However, it is categorically impossible to use it except as a means on indirect exchange. In money crises in history this has been shown quite clearly. In the hyperinflation Germans quickly stopped relying on reichmarks as a store of value. Soon after they stopped believing accounts represented anything useful. Only after that though did they stop using marks.

  66. Gravatar of Greg Ransom Greg Ransom
    19. September 2009 at 19:40

    Scott, you’ve got the sense of Hayek’s remarks here all wrong because you are forgetting that Hayek is talking here about cutting off the artificial Fed induced bubble in say 2002, rather than in, say 2007 / 2008, or early 1927 rather than late 1929.

    If you delay ending the Fed generated artificial boom the bust will be
    worse — if you kill it in 2007 / 2008 the secondary deflation will be much worse
    than if you kill it in 2002.

    You need to remind yourself of Hayek’s causal model if you don’t want to misunderstand the meaning of his words.

    I quoted Hayek saying:

    It may become very serious if attempts artificially to “maintain purchasing power” delay the process of readjustment ..

  67. Gravatar of Greg Ransom Greg Ransom
    19. September 2009 at 19:44

    Scott, this doesn’t make any sense to me. Somehow I’m not following you:

    you write:

    You should re-read White’s paper, as if you are right then White is wrong. He claims that Hayek later regretted his views on stimulus during the Depression. More specifically, Hayek later regretted opposing stimulus during the 1930s.

  68. Gravatar of Greg Ransom Greg Ransom
    19. September 2009 at 19:53

    Scott, as I explained before, Hayek did his applied work in the 1920s — he set up and ran one of the first business cycle statistical reseach institutes in the world, and he used his research findings to call the bust of 1929.

    Did you do that this decade?

    And Hayek was the first economist from the continent to study he Federal Reserve and work on American macro data and statistics.

    But as I explained before, Hayek had much larger fish to fry in the 1930s than applied grunt work.

  69. Gravatar of Greg Ransom Greg Ransom
    19. September 2009 at 20:06

    Scott, have you followed through the logic of Fed action to
    maintain the continually accelerating “purchasing power” needed to keep
    the housing and car bubbles going and the finance companies making money — and paying their bonuses, creditors, and owners?

    I’m not seeing much evidence that you have.

  70. Gravatar of Giedrius Giedrius
    20. September 2009 at 01:39

    By “they” I meant “the people you will be talking to”. GMU economics department. By the way, Tyler Cowen uses the question about your absurd beliefs to determine your cognitive profile 😉

  71. Gravatar of Current Current
    20. September 2009 at 03:35

    This discussion about Hayek has gone beyond my understanding of the subject. After reading some of White’s paper I’m not sure that my previous view was correct. I’ve never got around to reading the more obscure books by Hayek that White mentions.

  72. Gravatar of bill woolsey bill woolsey
    20. September 2009 at 05:05

    Scott:

    The word is “currency,” not “cash.”

    The money multiplier includes the currency deposit ratio. Yes, the currency held by the banks is called “vault cash,” and used to be a key part of reserves. But that is it.

    The “cash” in the “Cash-balance approach” is money measured somehow or other and usually not as currency. Transactions deposits are always included–well, since some point in the 19th century.

  73. Gravatar of bill woolsey bill woolsey
    20. September 2009 at 05:14

    Ransom:

    I didn’t quite agree with Scott’s argument, but I do think that nominal income targeting would very plausibly slow the liquidation of actual malinvestments, and that this is not a bad thing at all.

    It is about a reallocation of resources. Reallocations take time. It is easier to cut back the production of the wrong things than it is to expand the production of anything, right or not. To the degree that exceptionally low nominal interest rates in a recession allow what will unltimately turn out to be malinvestments to hold on a bit longer, this isn’t really a bad thing if bottlenecks mean that the real opportunity cost is less because the alternative is idle resources. If prices were perfectly felixible, then this phenomenon would involve overshooting of resource prices in contracting sectors (that is, their relative prices temporarily fall by more than what is needed in the long run, so that they may be employed now producing scarce goods, but goods less valuable than their opportuntity costs. As resources can be redeployed to alternative sectors, resource prices in the sectors that should shrink rise back to long term values, production falls as it should, and so on.

    Interest rates that are too long for the long run during the recession have a similar impact. The key point (and perhaps the major error of Mises and Hayek in this context) is to assume myopia. That everyone figures that depression level interest rates are permanent.

    Anyway, Scotts point that falling nominal income by itself makes many good invetments appear to be malinvestments is the more important point.

  74. Gravatar of Thruth Thruth
    20. September 2009 at 05:42

    Scott: Interesting post, essay and as usual some great comments from readers. During your talk, you are probably going to need to qualify the statement that the “subprime crisis was a fluke”, especially in light of Hamilton’s reply. Your regular readers probably understand what you mean (there will always be shocks that have obvious explanations ex post) but certainly not outsiders. Some people point to the unsustainable build-up of aggregate debt as if they know what sustainable is. Others (more correctly) point to the bad incentives built into the system the encouraged the private sector to take on debt without having to bear the full consequences. Perhaps that makes the economy more vulnerable to large shocks than it should be, especially in light of imperfect monetary policy.

    Anyway, I’d love to come to your Wednesday talk if it is open to the public… (I’d come Tuesday too, but can’t spare both days)

  75. Gravatar of StatsGuy StatsGuy
    20. September 2009 at 07:24

    Bill:

    “To the degree that exceptionally low nominal interest rates in a recession allow what will unltimately turn out to be malinvestments to hold on a bit longer, this isn’t really a bad thing if bottlenecks mean that the real opportunity cost is less because the alternative is idle resources.”

    Add that, in practice, it’s very hard to distinguish between what will ultimately turn out to be malinvestments vs. good investments. Again, turning to practical debates, this is exactly the argument raised by banks in arguing that they should be allowed to use hold-to-maturity valuations instead of mark-to-market valuations. EVEN IF we accept EMH works in one of its stronger forms, we also have to consider endogeneity… that is, the market’s determination of whether a firm with financial assets (or even a firm with production assets that are highly leveraged against future sales revenue) is solvent may very well depend on expectations of NGDP. This is the vicious cycle argument – that excessively rapid liquidation is self-reinforcing. Firms will die that _should not_ die, and rather than seeing resource reallocation we’ll just see resource churning as resources are taken out and then put back into the same activities under new ownership (but after substantial redistribution of wealth and lots of social pain).

    Arguably, an NGDP stabilization regime might make it _easier_ to sort out good/bad, by making the market less noisy by coordinating NGDP expecations. Much of the volatility of October through March was because of uncertainty over what the Fed/Treasury would do… That uncertainty alone massively heightens the risk premia. Thus, the dominant trading characteristics of the securities markets from September of last year through this year was a move OUT of beta, and then back INTO beta. The market is now where it was a year ago. The dominant feature in the real economy? High unemployment.

  76. Gravatar of scott p scott p
    23. September 2009 at 17:05

    Scott- I applaud your approach to blogging. it is direct, dense and unpolished. perfect- good work.

    However, your view that the price of money (high rates in 2008) was a significant cause of the current recession (second dip) is misguided. Interest rates may determine the pace of investment at the margin, during normal times. But during the summer of 2008, credit costs soared- almost to infinity for many companies and Higgs “regime uncertainty” caused companies and individuals to stop risk-taking enterprises. Monetary policy would have no effect when people are scared and the normal rules of commerce are at whimsical determination of gov’t actors. NGPD was negative in 4Q08-2Q09 because people were uncertain, not because money was expensive.

    My second criticism is the practicality of Fed officials focused on anything at market speed. I agree that a focus on NGDP is better than inflation or unemployment, but they are still human beings with a ‘fatal conceit’ that they can manage something: price stability, Taylor rule, expectations or something else. Even if they were superhuman, that fact that they meet once a month is not fast enough for the pace of changing expectations when congress is debating TARP. If the price of money is really as important as you think, then why leave it to the discretion of Fed officials, it would be better determined by a basket of real commodities.

  77. Gravatar of Current Current
    25. September 2009 at 00:55

    The “regime uncertainty” comes in three parts. Firstly there is uncertainty over government policy, secondly uncertainty around general economic conditions and the state of private business, thirdly there is uncertainty around what the Fed will do next. An NGDP or MV=PQ target of some sort would help with the last sort of uncertainty.

  78. Gravatar of Current Current
    25. September 2009 at 05:26

    The food critic has replied to Scott on his blog….

    http://www.marginalrevolution.com/marginalrevolution/2009/09/meeting-scott-sumner.html#comments

    I think he makes some good points.

  79. Gravatar of Current Current
    25. September 2009 at 07:13

    As has a gambling Austrian….

    http://austrianeconomists.typepad.com/weblog/2009/09/a-vist-some-talks-and-a-bet.html#more

  80. Gravatar of rob rob
    25. September 2009 at 11:29

    The Austrian isnt a very smart gambler to bet $100 on hyperinflation. If he is right he stands to win much less than he will lose if he is wrong. Proving again that economists dont think like speculators.

  81. Gravatar of Current Current
    25. September 2009 at 17:45

    Rob, I thought that myself reading the post. The point has been raised on the Austrian Economists blog.

  82. Gravatar of ssumner ssumner
    26. September 2009 at 10:54

    rob, The Great Depression offers more data points than you’d think, and some of the best. For instance, there were 5 big wage shocks in the 1930s, and several of them were far bigger than any other in American history. So it is the best place to examine wage shocks. It also includes some of the biggest monetary shocks. But I also look at recessions like 1921 and 1982, and 2009, which are also consistent with my theory.

    mbk, Perhaps economists don’t buy my cause of the crisis, but I don’t agree that there is much disagreement among economists about the consequences of a sharp fall in NGDP. Almost all agree it would have a severely negative effect on current NGDP. And I think investors also know this, as every time NGDP fell in the past output also declined. So I am not saying anything controversial here. The standard macro model says if NGDP is expected to suddenly fall sharply, it will immediately depress real output.

    Regarding interest on money, until last October the Fed did not pay any interest on the money it created. So monetary policy is not credit policy; money and credit are two very different things. And tight money often makes interest rates fall, as in December 2007.

    Thanks JimP, I thought the talk went well.

    Current, The unit of account is an abstraction, but not the medium of account, which is dollar bills. If England had floating rates (and I thought the guinea/pound rate was fixed) then what would be important would be the unit used to measure wages and prices.

    Rebeleconomist, Money is tight when the expected growth rate of the Fed’s target variable is lower than their target. Thus if they target 5% NGDP growth, money is tight any time expected NGDP growth is less than 5%.

    happyjuggler0, Thanks, but do you have any evidence that they actually targeted NGDP? I thought they just had a slightly higher inflation target? If you have any evidence (even indirect) you can share I would be very interested.

    Vangel, I have no idea what you mean by the Fed’s “meddling.” I certainly don’t think they have meddled to prevent necessary corrections. When markets over-expanded the Fed let them correct.

    Greg, I don’t think there was an artifically created bubble by the Fed in the late 1920s. I think the economy was doing fine in mid-1929. Too bad the policy of mild deflation during 1928-29 wasn’t continued. Instead of mild deflation as people like George Selgin propose, the Fed shifted to severe deflation.

    Greg, You asked;

    “Did you do that this decade?”

    Good economists don’t make predictions, they infer market predictions. When I saw the markets predicting a severe downturn last October I ran around like Paul Revere raising an alarm. In retrospect wasn’t I right and the Fed wrong? Shouldn’t policy have been more expansionary last fall? Shouldn’t we have refrained from bribing banks to hoard reserves?

    You said;

    “But as I explained before, Hayek had much larger fish to fry in the 1930s than applied grunt work.”

    So he left the “grunt work” of offering solutions to the Great Depression to people like Keynes. And as a result Keynes won many more converts than the Austrians.

    You said;

    “Scott, have you followed through the logic of Fed action to
    maintain the continually accelerating “purchasing power” needed to keep
    the housing and car bubbles going and the finance companies making money “” and paying their bonuses, creditors, and owners?”

    That’s an idiotic statement. I have consistently said exactly the opposite. i have always said that it was appropriate to let the housing bubble burst in 2007.

    Current, I am glad to hear that after reading White’s article you have come around to my view. I can’t understand why Greg doesn’t see that White’s article shows that Hayak admitted he was wrong about the Great Depression. And that is pretty important if you are trying to convince others to adopt your macro model.

    Bill, In most texts “cash” is currency and coins held outside banks.

  83. Gravatar of ssumner ssumner
    26. September 2009 at 12:07

    scott p, You said;

    “However, your view that the price of money (high rates in 2008) was a significant cause of the current recession (second dip) is misguided.”

    I don’t view high rates as the cause of the current recession. Indeed I don’t think interest rates played any role in the recession. I blame it on falling NGDP.

    You said;

    “My second criticism is the practicality of Fed officials focused on anything at market speed. I agree that a focus on NGDP is better than inflation or unemployment, but they are still human beings with a ‘fatal conceit’ that they can manage something: price stability, Taylor rule, expectations or something else. Even if they were superhuman, that fact that they meet once a month is not fast enough for the pace of changing expectations when congress is debating TARP. If the price of money is really as important as you think, then why leave it to the discretion of Fed officials, it would be better determined by a basket of real commodities.”

    This is why I oppose the current discretionary regime, and favor a market-oriented regime. Instead of a basket of commodities, however, I’d link the dollar to NGDP futures. But even with there current regime, they could do much better. They made horrible decisions when they did meet.

    Current; you said:

    “The “regime uncertainty” comes in three parts. Firstly there is uncertainty over government policy, secondly uncertainty around general economic conditions and the state of private business, thirdly there is uncertainty around what the Fed will do next. An NGDP or MV=PQ target of some sort would help with the last sort of uncertainty.”

    Don’t you think a sudden decline in NGDP would have a significant impact on “general economic conditions.”

    Check out my reply to Tyler.

    I appreciate the kind words from Peter, he was very nice to me on the visit. But I strongly disagree with the Joan Robinson/Anna Schwartz view that low interest rates mean easy money. I think Milton Friedman is right, low interest rates mean money has been tight.

    I look forward to saying “I told you so” to a lot of conservatives who predicted high inflation. It will start this January, when my bet with Bob Murphy is completed. Bob bet that we’d have double digit inflation in the second half of 2009. Then there is Art Laffer, Anna Schwartz, Alan Meltzer, and on and on.

  84. Gravatar of Current Current
    28. September 2009 at 02:10

    Scott: “The unit of account is an abstraction, but not the medium of account, which is dollar bills. If England had floating rates (and I thought the guinea/pound rate was fixed) then what would be important would be the unit used to measure wages and prices.”

    I don’t think we really disagree about this much.

    The exchange rate between English gold and silver coinage was sometimes fixed and sometimes floating. Sometimes a de jure fixed rate was not obeyed in practice.

    As I understand it both were used as mediums of exchange and units of account. But the gold coinage was only used by the very rich.

    It’s not such an unusual situation. Quite often during periods of inflation two types of money have coexisted in one country. After the great hyperinflation in Germany it became clear that many people had been hoarding currencies of other countries, which were used towards the end of that period rather than marks.

    Scott: “I am glad to hear that after reading White’s article you have come around to my view. I can’t understand why Greg doesn’t see that White’s article shows that Hayak admitted he was wrong about the Great Depression. And that is pretty important if you are trying to convince others to adopt your macro model.”

    Well, I haven’t quite come around to your view. After reading that I see that the issue is more complicated than I thought. I don’t think I know enough about it to comment either way.

    Current: “The “regime uncertainty” comes in three parts. Firstly there is uncertainty over government policy, secondly uncertainty around general economic conditions and the state of private business, thirdly there is uncertainty around what the Fed will do next. An NGDP or MV=PQ target of some sort would help with the last sort of uncertainty.”

    Scott: “Don’t you think a sudden decline in NGDP would have a significant impact on ‘general economic conditions.'”

    I agree with you there. The regime uncertainty over government policy would be reduced were the regime uncertainty over fed policy reduced. The governmental regime uncertainty can’t be eliminated though.

    I agree with you in you’re reply to Tyler and Kling that the NGDP and RGDP are not unrelated. (Isn’t this obvious).

  85. Gravatar of ssumner ssumner
    28. September 2009 at 06:45

    Current, The German hyperinflation is a good example of what I was talking about. There was more than one currency, but since most wages and prices were denominated in mark terms, the German mark was the important medium of account.

  86. Gravatar of Current Current
    28. September 2009 at 14:07

    Scott,

    I see, the “medium of account” is the medium of exchange that is used as the most widespread unit of account. That makes sense.

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