How do we know that the problem is too little NGDP?

Ever since late 2008 I’ve been arguing that we misdiagnosed the crisis.  The main problem was not sub-prime mortgages and banking distress, but rather falling NGDP.  Indeed I’ve suggested that perhaps 2/3 of the banking crisis was due to falling NGDP expectations.

What about the other third?  That’s the obvious part—the subprime loans, the Greek debt, etc.  Now Matt Yglesias has a post that suggest 2/3rds may be an underestimate—we may rapidly be approaching a point where the global debt crisis is 75% or 80% NGDP shortfall:

Robin Wigglesworth covers capital markets for the FT and has a rundown of the ensuing carnage, which I shall summarize for you in bullet points:

“” Italian 10-year yields jumped 32 basis points to 7.02 per cent, which is the level that prompted Berlusconi’s ouster.
“” In Spain a new 12-month bond yielded 5.02 percent (up from 3.6) and 18-month yieled 5.15 percent (up from 3.8).
“” “France’s 10-year notes jumped 20 bps to yield 3.59 per cent – a record 188 basis points above comparable German Bunds.”
“” “The FTSE Eurofirst 300 index tumbled 1.5 per cent, led by the French, Italian and Spanish markets, and have now given up all of last Friday’s gains.”
“” “Belgium, Austria, and Finland’s 10-year benchmark bonds also widened markedly in early trading.”

Now Belgium and Finland aren’t really important countries in the scheme of things but this is a sign that you’ve moved into Total Chaos And Market Panic Mode. You don’t lose faith in Finland’s ability to repay debts based on shady budgeting in Greece or political dysfunction in Italy. You lose faith in Finland’s ability to repay debts when you wake up one day and realize that all European sovereigns no matter how well-run are in a third world fiscal position where they lack a lender of last resort.

It would be nice if the ECB became lender of last resort.  But even that isn’t really essential, and I’m not sure it would be enough.   What we really need is faster NGDP growth in the eurozone, even if the ECB does so by monetizing German debt.  Given the choice of boosting the NGDP growth rate by 5% while purchasing German debt, and acting as lender of last resort to Italy but sterilizing any effects on the monetary base, I’d take the higher NGDP growth.

The great irony of the Depression period is that by 1936 things had gotten so bad that even the French had to devalue.  The French had helped cause the Depression by their obsessive hoarding of gold, and their refusal to help out the weaker countries.  In other words, in monetary terms France was the Germany of the 1930s.  When you see doubts raised about countries like Finland and Austria, you really have to wonder if even the German debt is truly safe.

I still think the policy elite are slightly less pigheaded than in the 1930s, so I doubt things will go that far.  But it would be a lot simpler if they recognized reality right now, instead of dragging out the pain.

Three years ago I argued that falling NGDP was causing the debt crisis to get dramatically larger.  I’d be interesting in hearing whether you think that argument seems more plausible today, November 15, 2011, given the evidence provided by Matt Yglesias.  Or would you prefer to believe that the rising yields on Finnish and Austrian debt represents the market’s sudden realization that Finland and Austria are also run by corrupt governments?



36 Responses to “How do we know that the problem is too little NGDP?”

  1. Gravatar of John John
    15. November 2011 at 14:59

    To say that most of the problem was falling expectations seems disingenuous. What caused the falling expectations in the first place? It wasn’t as if the Fed suddenly did some kind of tightening; if some measure says they did then it was a de facto tightening or tightening by default. By the conventional measures, the Fed has never been more activist in its history. Ben Bernanke is the Franklin Roosevelt of the Federal Reserve.

    The destruction of wealth came from falling real estate values and the collapse of the financial assets which had pyramided on top of rising real estate prices. This wealth destruction shrank the supply of money and credit, putting downward pressure on spending and NGDP. The government’s activist response prevented market mechanisms from working to create a recovery and sowed great uncertainty about the future of the regulatory and monetary environment.

    If you want to blame our recession on NGDP, you have to have a story about why NGDP fell. It isn’t enough to blame the Fed for not pursuing loose enough policies when their money creation over the past 3 years has absolutely no precedent in American history. Why would you blame Fed tightness when they’re giving money away like candy on Halloween? Why look for more stimulus we’ve gotten more than we’ve ever had before and this is the second worst recession in US history?

  2. Gravatar of Britmouse Britmouse
    15. November 2011 at 15:31

    The link to the Spiegel article from the first commenter on Matt’s article says it all. Jens Weidmann is saving Germany from hyperinflation. That is all that is happening now.

    It might look like the gradual disintegration of functioning society in southern European, but hyperinflation is the threat. Hard to imagine that policymakers were worse than this in the 1930’s. Hard to imagine that having made those mistakes, we’d do it all over again.

  3. Gravatar of Don Geddis Don Geddis
    15. November 2011 at 15:37

    John: “What caused the falling expectations in the first place? … If you want to blame our recession on NGDP, you have to have a story about why NGDP fell.”

    Sure, there had to be a spark. And the obvious one was the housing run-up, and the subprime mortgage collapse.

    But consider: you’re at the edge of a field, and someone lights a match and tosses it into the brush. A huge wildfire ensues and destroys forests and towns. Meanwhile, right next to you, is a professional firefighting team with trucks and hoses and plenty of water. But they just sit and watch as the match gets tossed, and the grasses catch, and the flames spread. And they do nothing.

    In the end, is the match really to blame? Especially when we’ve seen many matches previously (1987 stock market crash, 2000 dot-com crash) which were easily contained. The difference this time is that the paid and trained professionals who were watching, chose not to act.

    Don’t blame the tiny match. It was only a spark. Blame the people who had the power to prevent the spread, but instead chose to stay on the sidelines.

  4. Gravatar of Bob Murphy Bob Murphy
    15. November 2011 at 15:56

    Don Geddis, but for your analogy to work, the fire department pumped as much water in four months as all previous Fire Chiefs had pumped since 1913. They didn’t “do nothing” as you claim. Scott’s argument for tight money isn’t based on the evidence of their actions, but the evidence of the results. It would be like judging water pumping by the size of the fire, instead of how many gallons left the hose per minute.

  5. Gravatar of Bob Murphy Bob Murphy
    15. November 2011 at 16:05

    Scott, I guess I’m OK if you start running victory laps if Germany itself goes down. But do you agree with me that that would pose a problem for Krugman? I thought he was saying that the problem in Europe was that Greece’s wages needed to fall, in order to make them competitive again, but that the stingy Germans weren’t going to allow that. So Greece’s problem wasn’t their big debt, it was that an economic shock left them with a need to lower real wages, and then they were stuck with a pseudo-gold standard and so have to rely on painful internal devaluation.

    So if all of a sudden Germany is in the same boat, doesn’t that make Krugman’s story go out the window? Or will German workers’ wages all of a sudden be too high, when they weren’t last month?

  6. Gravatar of Don Geddis Don Geddis
    15. November 2011 at 16:40

    Bob Murphy: “the fire department pumped as much water in four months as all previous Fire Chiefs had pumped since 1913. They didn’t “do nothing” as you claim.”

    Granted. But: expectations of the future matter a lot too.

    To continue the fire analogy: they said, “we have this limited quantity of water, and we’re going to dump it all in this spot, and then stop.” The problem is, the fire didn’t completely go out, and eventually it spread again.

    What you would like to hear is: “we’re going to keep pouring water on the fire until it is out.” But the Fed was unwilling to say that.

  7. Gravatar of Brett Sheckler Brett Sheckler
    15. November 2011 at 16:50


    I don’t think I disagree with you, at least not head on, but I have a different take on Matt’s points.

    At it’s core, unease about France, Belgium, Finland, Austria (and even Germany) springs from unease about any nation that is trapped in a monetary union that is not workable in its current form.

    A better ECB would reduce the likelihood of catastrophe in the near-term, but it would not resolve the core challenges at play.

  8. Gravatar of ssumner ssumner
    15. November 2011 at 16:58

    John, You said;

    “What caused the falling expectations in the first place? It wasn’t as if the Fed suddenly did some kind of tightening;”

    Yes it did. Your mistake is to assume that steady interest rates mean a steady monetary policy. Not so, if the Wicksellian equilibrium interest rate is falling, as it was between April and October 2008, then the steady nominal interest rate meant that the Fed was effectively tightening policy sharply. The falling NGDP expectations were an INDICATOR of progressively tightening policy.

    Britmouse, Yes. They also warned about hyperinflation in the 1930s, even as prices were falling. Generals fighting the last war.

    Bob, Not at all, just as France going down in 1936 didn’t contradict the view that the gold standard was a deflationary disaster. But just to be clear, I’m not predicting Germany will go down, just suggesting it’s not beyond the realm of possibility.

    And the Fed didn’t pump any water. Pumping water is costly, requires effort. Nothing the Fed does costs a cent. So there is no “effort.” The right metaphor is adjusting a steering wheel, and all that matters is whether they set the steering wheel in the right position.

    They pumped up the base because money was tight so NGDP fell so interest rates fell to zero so the demand for base money soared.

  9. Gravatar of John John
    15. November 2011 at 16:58

    Don Geddis,

    No the match wouldn’t be to blame but the person who threw it would be to blame not the match or the firefighters. In your metaphor, the cause was still the match thrower which correlates to the people who pyramided our economy on rising house prices.

    PS. I think the cluster of entreprenurial errors came from Fed policy in the first place. That’s where the metaphor breaks down.

  10. Gravatar of John John
    15. November 2011 at 17:01


    That’s exactly what I meant by a de facto tightening. Your basically blaming the Fed with a sin of omission but there where much worse sins committed to get us into this mess. Chief among those I’d list the Federal Reserve’s commitment to shield banks against market forces.

  11. Gravatar of ssumner ssumner
    15. November 2011 at 17:02

    Brett, I’m all for the view that the euro is deeply flawed. But I still think the current problem is tight money. As long as money stays tight, bailing out Italy and Greece doesn’t solve the problem. The two countries still have to decide between 20 years of austerity and/or devaluation. Neither option is appealing, even if they avoid default. Only more NGDP gets you to a better equilibrium by boosting growth.

  12. Gravatar of John John
    15. November 2011 at 17:02

    PS. You seem to condone this slippery protectionism as well. I’m not necessarily just talking about bailouts either but also the commitment to keeping stock prices high.

  13. Gravatar of ssumner ssumner
    15. November 2011 at 17:04

    John, The Fed’s job isn’t to keep rates stable, it’s to prevent deflation and high unemployment. In 2009 we had deflation and high unemployment. You can call it what you like, I call it a sin of commission, not ommision.

  14. Gravatar of ssumner ssumner
    15. November 2011 at 17:05

    John, False. I oppose targeting stock prices, I oppose bailouts, and I oppose protectionism.

    Don’t ever say I “seem to” If I don’t say it explicitly, it’s not my view.

  15. Gravatar of Benjamin Cole Benjamin Cole
    15. November 2011 at 17:18

    Right, right, right. If you own the printing press, then you can always honor your debts. Yes, inflation, but it also assures that sovereign debt is gilt.

    No more for the euro “nations.”

    What kind of nation foregoes its own printing press?

    The risk premium for a nation without its own prating press must be multiplied.

    If these nations could print a lot more money, the NGDP would be higher and debt loads (reactive to NGDP) lower.

    Of course, it is better not to run up huge national debts. But here we are now.

  16. Gravatar of Morgan Warstler Morgan Warstler
    15. November 2011 at 17:29

    Scott, the interesting thought experiment is why Matty would hate 4% level targeted, that answers your question.

    What we ARE talking about is FORCING every European country to behave as if:

    1. They are as productive as the Germans.
    2. They are as homogeneous as the Swedish.

    We’re talking about the whole dismantling of Southern European culture and proto-bureaucratic socialist thinking.

    Sure you can provide a nice safety net, but only if you convince (force) everyone to work for civic pride, and government employees seek to maintain the state by making personal sacrifices themselves (no graft).

    The point here is that NGDP target as a “winner” will be adopted when it works to the benefit of the winners, nothing is going to buy the losers more power in the future.

    This is your fundamental mis-understanding of Matty’s desire to promote NGDP, he’s smart enough to know it works, but dumb enough to think if he adopts it, it won’t be used to crush his dreams.

    And that’s what the folks that run Germany/ECB/Fed/Mundell/WSJ etc all are going to make sure happens.

    Look, just say OUTLOUD, the Greeks aren’t gong to get to be Greek anymore, and the French, well they too are going to have to step up their game.

    Beat that drum. Relentlessly. Because its only with the promise of fundamental losers lose, and to the cultrual victors go the spoils, will your ideas corss into the promise land.

    Mundell ran the ball down the field, you are just kicking an extra point, but you are BOTH on the same team.

  17. Gravatar of Becky Hargrove Becky Hargrove
    15. November 2011 at 17:40

    It still seems that if they don’t take the pains to create a fiscal union now that everyone, even Germany, will get a run on the banks. And Germany for all its strength is not hoarding gold as France did the last time. Would not it be easier to target NGDP with a fiscal union?

  18. Gravatar of Bob Murphy Bob Murphy
    15. November 2011 at 18:54

    Scott, if you’ll allow me one more pass at this, I’d appreciate it. I am 90% sure that Krugman in the past has said that the reason the ECB is causing Europe to suffer, is that Greek wages are too high *relative to prices and wages in Germany* (and elsewhere). So, one solution is to have low continent-wide inflation, with Greek wages falling in absolute terms. That is awful, leads to debt problems, and the euro collapses.

    The other solution, Krugman said (I think), is for the ECB to adopt a higher inflation target. Then Greek wages can stay flat while prices all over go up. Then Greece easily regains competitiveness, its tax receipts go up, and the bond vigilantes can start using babysitters again.

    Doesn’t that sound like a decent rendition of Krugman’s analysis of Europe, a la one month ago?

    OK, so if that’s right, then how the heck can Germany all of a sudden fall victim to the bond vigilantes? It can’t be that German and Greek wages have to both fall relative to each other.

    (I think I see how he might explain the transition, but I’d like to hear your take on it.)

  19. Gravatar of flow5 flow5
    15. November 2011 at 19:17

    Aggregate monetary purchasing power is equal to nominal gDp. I.e., nominal gDp is a function of money flows MVt. The rate-of-change in MVt fell for 29 consecutive months. Then predictably, MVt completely collapsed in the 4th qtr of 2008.

    The FED controls MVt. Statistically you can measure MVt (& project its path). So it is a foregone conclusion that as MVt fell, so did nominal gDp. I.e., Bernanke literally drove the economy into the ground. Nominal gDp fell as a direct result of the FED tighening MVt. Nominal gDp has been thus obviously been suppressed.

  20. Gravatar of John John
    15. November 2011 at 19:17

    Scott, the Fed did prevent deflation except for a brief period at the end of 2008. It’s open for debate whether they really have the power to prevent unemployment. The short answer is they really don’t since monetary policy doesn’t work forever. The long story short is that they embarked on their most active policy phase ever beginning at the end of 2008 and we still got a depression. You hanging on to the Friedman-Schwartz theory of depressions is pure dogma.

  21. Gravatar of John John
    15. November 2011 at 19:17

    Scott, the Fed did prevent deflation except for a brief period at the end of 2008. It’s open for debate whether they really have the power to prevent unemployment. The short answer is they really don’t since monetary policy doesn’t work forever. The long story short is that they embarked on their most active policy phase ever beginning at the end of 2008 and we still got a depression. You hanging on to the Friedman-Schwartz theory of depressions is pure dogma.

  22. Gravatar of Steve Steve
    15. November 2011 at 22:21

    God help me, I feel brain damaged after reading the last several comments!

    There are three scenarios for German debt:

    (1) German Bund yields fall, as austerity programs increase the likelihood of pan-European deflation, just as US treasury yields fell in 2008.

    (2) German Bund yields rise, as it becomes clear the ECB will be forced to adopt unsterilized QE and raise NGDP, just as US Treasury yields rose during both QE programs.

    (3) German Bund yields rise, if it becomes clear that the Germans are willing to haircut their own sovereign debt before they are willing to accept price increases. This is unlike anything the US has experienced or is likely to experience, but it is possible fallout of the Greek haircut. Normally sovereign credit has exactly one risk, that of inflation. But in Europe, we now know sovereigns are at risk of loss from haircuts as well loss from inflation.

    Option 3 is highly unlikely, at least for Germany. We will likely get some combination of 1 and 2, which will allow all the crackpot economists to claim whatever cause and effect their prejudices dictate.

    Actually, there is an option 4. If it becomes clear the EMU will split up, and debt will get redenominated in local currencies. In this case, Bunds could get a negative yield due to expected appreciation once they are “Deutsche marked”. I predicted that possibility on these very pages back in July. This is a perilous option because of the likelihood of bank runs in the periphery.

  23. Gravatar of Steve Steve
    15. November 2011 at 22:35

    I should add that a combination of 1 and 2 is consistent with the BundesECB following a rigid inflation targeting mandate in the core. If deflation appears contained to the periphery, 1 will be the preferred policy. If deflation becomes contagious 2 will be preferred. Unfortunately for Europe, deflation is difficult to contain with gradualist and incremental monetary policy. It’s like using a box fan to contain a level 4 infectious disease.

  24. Gravatar of Jason Odegaard Jason Odegaard
    16. November 2011 at 05:36

    Hi Scott,

    This raises a question I’ve been meaning to ask for a while – what importance do you place on the lender-of-last-resort function of central banks? During the financial crisis, the Fed provided several trillions of dollars in short-term lending to financial entities as well as larger businesses, often times just overnight or loans of a few days. Is this important? Wasn’t lender of last resort the original reason for founding the Federal Reserve?

    Hi John,

    Once deflation starts, this is where the whole liquidity trap Keynes made famous appears – that dramatic alteration of expectations such that the vast majority of economic participants prefer to hold liquid money savings, and pull out of all investments. It is this flight to cash that the Fed can help arrest by providing the cash balances the market suddenly wants to hold.

    Longer-term, this is why NGDP targeting is better than inflation targeting, since it commits the Fed to providing the type of monetary easing or tightening that guarantees a more stable rate of economic growth. The amount of monetary easing during 2008 would have continued rapidly and would have avoided the passive tightening that occurred instead.

    If I look at the NGDP, inflation, and core inflation that I can get from FRED ( it looks like core inflation (what the Fed could control long-term) actually didn’t plunge that significantly during the depth of the recession. But NGDP did plunge, and since that is a proximate measure of national incomes, we run up against the other part of nominal rigidity – declines in income. Even more than a decline in prices, people resist declines in wages. And that’s just human nature – humans have a general loss-aversion to numbers.

    That’s why driver’s licensing points systems that *subtract* from your total points are more effective than programs that *add* points due to traffic offenses.

  25. Gravatar of ssumner ssumner
    16. November 2011 at 09:47

    Ben, That’s right.

    Morgan, Lots of great metaphors, but the same old liquidate, liquidate, liquidate ideology.

    I feel confident that the Greeks will have to learn to live within their means no matter what is done, even with faster NGDP growth.

    Bob, Yes, that was Krugman’s story, but I don’t think he’d ever rule out the possibility that NGDP could fall so low that even German wages would be too high. That wasn’t the case a month ago, it’s still probably not the case, but it could be in the future. Falling NGDP can make everyone uncompetitive, it’s not just wages in one country relative to another that matter.

    John, The entire collapse in RGDP in this recession occurred between June and December 2008, that “brief” period when they allowed deflation. It was a very costly mistake.

    I don’t see it as an open question as to whether they can boost employment, but I’d favor 5% NGDP targeting even if they couldn’t.

    Yeah they were “active” — actively contractionary (remember IOR?)

    Steve, Good analysis.

    Jason, It was the original reason, but I don’t see it as being particularly important. Control over NGDP is the key.

  26. Gravatar of John John
    16. November 2011 at 10:38


    You’re right that core inflation didn’t fall AT ALL and neither did wages. Headline CPI fell because the Saudis agreed to pump out a bunch of oil to ease economic conditions. Because prices didn’t fall and monetary aggregates (again look over at FRED) never contracted year over year, the idea that the Fed drove the recession in a similar way to the Great Depression seems weird.


    Actively contractionary? Because of a 0.25 IOR? It stuff like that which thinks maybe you belong in a straightjacket like an inflationary Hannibal Lector. Look at what the Fed controls, the monetary base. Here’s a series of graphs that make my case.

    Currency component of M1

    M1 Money Stock

    Total Checkable Deposits

    M2 Money Stock


    All of these graphs show that the last 4 years have seen the fastest money growth in the history of the United States.

  27. Gravatar of Morgan Warstler Morgan Warstler
    16. November 2011 at 12:20

    No Scott!! I want to level target NGDP!!!

    How can you possibly call that liquidation????

  28. Gravatar of Bob O’Brien Bob O'Brien
    16. November 2011 at 17:38

    I have read a lot about what people think happened in Q3 & Q4 2008. For example from Scott:

    “The entire collapse in RGDP in this recession occurred between June and December 2008, that “brief” period when they allowed deflation.”

    Does anyone have some nice graph’s of data that illustrate what happened in this time period.

  29. Gravatar of Jason Odegaard Jason Odegaard
    17. November 2011 at 03:24


    I guess I didn’t make my point very well. I was noting that NGDP fell, so incomes also fell. And there was a period of time, as Scott noted, that the Fed was passively tightening (holding Fed Funds Rate at 2%) even while NGDP (and incomes) were falling.

    Bob O’Brien,

    Here is a graph I pulled from FRED that shows what Scott is talking about. It is just for 2008 so it zooms in on the time period he mentions:

    You can see the orange line go flat during the period the Fed held rates at 2%, despite declining RGDP and NGDP.

  30. Gravatar of ssumner ssumner
    17. November 2011 at 18:35

    John, IOR was considerably more than 0.25% in 2008, when the big mistakes were made.

    In any case, the MB soared in the 1930s. Are you going to claim we had “easy money” during 1930-33?

    Thanks Jason. Macroeconomics Advisers has monthly estimates that are even more interesting.

  31. Gravatar of ssumner ssumner
    17. November 2011 at 18:36

    John, BTW, Since when are the broader aggregates informative? People stopped looking at those in 1982.

  32. Gravatar of marcus nunes marcus nunes
    17. November 2011 at 18:48

    Glenn Hubbard was saying in late July 2008 that MP was accomodative with 2% FF rate. Look at the picture of what was happening to monthly NGDP (from Macroeconomic Advisors) at the time:

  33. Gravatar of John John
    17. November 2011 at 23:25


    I included broad and narrow aggregates. They all say the same thing. Money is growing faster than it ever has in US history while the backbone of your argument is that money is too tight.


    The monetarist and quasi-monetarist theory of the business cycle says that recessions result from the Fed letting money contract. Money didn’t really contract outside of a very brief period and has grown at the fastest rate in history since then according to numerous measures of money supply. Despite the expansion of money, we still got a severe depression. It seems like the facts support the Austrian story of misallocated resources due to incorrect relative prices and non-market interest rates.

  34. Gravatar of ssumner ssumner
    18. November 2011 at 18:55

    Marcus, Remind me not to listen to his forecasts.

    John. You said;

    “The monetarist and quasi-monetarist theory of the business cycle says that recessions result from the Fed letting money contract.”

    Then I’m not a monetarist of quasi-monetarist. I’m a market monetarist–markets tell me if money is too loose or too tight.

  35. Gravatar of Mikko Mikko
    20. November 2011 at 02:20

    John: you are conveniently forgetting the size of excess reserves sitting at Fed in your “monetary aggregates”. Those are not part of the real money supply, as long as they sit there doing nothing.

    What Fed did in 2008 was that it pushed lots of money into the market with one hand and then vacuumed approximately the same amount of money away with another hand (into excess reserves).

  36. Gravatar of TheMoneyIllusion » Is it 1936 already?!?!? TheMoneyIllusion » Is it 1936 already?!?!?
    23. November 2011 at 09:10

    […] that didn’t take long.  I have to admit that when I made this prediction eight days ago I didn’t really expect it to happen so fast: The great irony of the Depression period is that […]

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