Reader requests

I have had several requests to comment on the euro crisis.  One person suggested discussing this post by Megan McArdle:

The Great Depression was composed of two separate panics.  As you can see from contemporary accounts–and I highly recommend that anyone who is interested in the Great Depression read the archives of that blog along with Benjamin Roth’s diary of the Great Depression–in 1930 people thought they’d seen the worst of things.

Unfortunately, the economic conditions created by the first panic were now eating away at the foundations of financial institutions and governments, notably the failure of Creditanstalt in Austria.  The Austrian government, mired in its own problems, couldn’t forestall bankruptcy; though the bank was ultimately bought by a Norwegian bank, the contagion had already spread.  To Germany.  Which was one of the reasons that the Nazis came to power.  It’s also, ultimately, one of the reasons that we had our second banking crisis, which pushed America to the bottom of the Great Depression, and brought FDR to power here.

Not that I think we’re going to get another Third Reich out of this, or even another Great Depression.  But it means we should be wary of the infamous “double dip” that a lot of economists have been expecting.  The United States is in comparatively good shape, but the euro is in crisis, and already-weak European banks seem to be massively exposed to Greece’s huge debt load.  They’re even more exposed to the debt of the other PIIGS, which is far too large for it all to be bailed out.  The size of the rescue package that Greece needs is already going to take a fairly substantial chunk of the IMF’s war chest.

I also found it hard to avoid comparisons to 1931.  I wish I could tell you the precise lessons of 1931, but it is surprisingly difficult.  The first question we need to consider is why some bad news from tiny Portugal seemed to knock 2.4% 0ff the S&P yesterday.  I always look at other markets for insights, and I noticed that the fall in stock prices was accompanied by lower 5 year inflation expectations, and a stronger dollar.  That looks like a contractionary monetary shock. 

In 1931 it was actually fairly easy to figure out how European debt problems caused deflation in the US.  It led to a scramble for liquidity, and in 1931 gold was the ultimate form of liquidity.  Even central banks hoarded gold.  A higher demand for gold was deflationary for countries still linked to gold (such as the US.)   The analogous asset today would obviously be dollars, which are a sort of safe haven in financial crises that are occurring overseas.  So the demand for dollars rose on Tuesday, which is deflationary.

But there is also an important difference; in 1931 the US could not print more gold, the only surefire way to avoid deflation was to devalue the dollar.  And that was politically very difficult.  In contrast, the Fed can print almost unlimited dollars, so an increased demand for dollars need not be deflationary.

On the other, other hand (by now you may share Harry Truman’s preference for one-handed economists), the markets seemed to indicate that they did not expect the Fed to fully accommodate any increase in demand for money.   I base this conclusion on the various asset price movements discussed above, which suggest that on Tuesday investors slightly scaled back their forecasts of medium term US NGDP growth.  And one can certainly understand why markets might be worried about the risk of slower NGDP growth, after all, the Fed failed to fully accommodate the demand for dollars associated with the 2008 banking crisis.

So as in many game theory situations almost anything is possible.  Even worse, the effects may not be linear, or even monotonic.  A small crisis in Europe might cause the Fed to do nothing, while a big crisis might cause such a large expansionary response by the Fed that US NGDP actually ended up higher.  But the truth is probably much simpler.  My hunch is that a bigger crisis in Europe would cause an even bigger fall in US stock prices and NGDP.

By now you may regret that I was asked to comment, as I haven’t come up with any definite answers.  As I keep saying, the markets are the best indicator of the likely effect of shocks; it’s our job to infer the best policy responses from the information embedded in asset prices.  If you want something much more interesting, from an economist who is actually comfortable with open economy macro, check out Nick Rowe’s recent post.

What should the Europeans do?  I don’t see any good options.  The ECB should be more expansionary, but for reasons unrelated to Greece.  And even that would probably not be enough to prevent a default in Greece.  It might, however, boost property markets on the Iberian peninsula enough to tip the balance in those two countries.  Just to be clear, if NGDP levels in the eurozone were adequate then I would not recommend using monetary policy to bail out debtors.  Even with this disclaimer I suppose many people will assume I am merely an inflationist who wants to paper over fiscal imbalances.  Of course what I am really saying is that a massive financial crisis is not the best time for the ECB to downshift to a much lower NGDP growth track, especially as NGDP is the variable that determines a country’s ability to service its nominal debt.  But the ECB moves in mysterious ways.

PS.  I just noticed that Nick Rowe also made the case for more monetary ease in this post.

HT:  Kyle Griffin

2.  Romer on monetary stimulus

Several commenters (Marcus Nunes and Daniel Carpenter) asked me to discuss this puzzling argument from Christina Romer:

The other fundamental source of the lingering shortfall of aggregate demand comes from the limits of monetary policy.  The recession we have just been through is different in character from almost every other postwar recession.  The usual postwar recession has a fairly simple narrative.  The groundwork is laid when for some reason policy is overly expansionary and so generates inflation.  The recession occurs when the Federal Reserve realizes that things have gone awry.  It raises interest rates, slows the economy, and so brings inflation down — at the cost of a recession.9

That type of recession is easy to end:  once the Federal Reserve is satisfied with the behavior of inflation, it can slash interest rates and provide the economy with a large jolt of stimulus.  The result is that the recoveries from severe recessions caused by tight monetary policy have been very strong.  For example, in the year following the trough of the 1981-82 recession, real GDP grew almost 8 percent and the unemployment rate fell 2.3 percentage points.

The recent recession was obviously not caused by tight monetary policy.  Interest rates were not especially high when it began, and so the Federal Reserve had only limited room to cut them.  It has brought short-term rates down to virtually zero, but it cannot push them below that.  The result is that we have not had the strong monetary stimulus that we would normally have in these economic circumstances.  One study found that given the Federal Reserve’s usual responses to inflation and unemployment, economic conditions would lead it to cut its target for the federal funds rate by an additional 5 percentage points if it were able to do so.10   That is, despite the very low level of interest rates and all the attention to the growth of the Federal Reserve’s balance sheet, current monetary policy is in fact unusually tight given the condition of the economy.”

This is a very strange comment.  Christine Romer did some very well known research on the role of gold flows in the Great Depression.  She argued that fears of war led Europeans to move gold to America.  This gold inflow boosted the US monetary base, and contributed to rapid economic recovery.  I don’t consider the recovery to have been all that rapid, partly because much of the enlarged MB was hoarded as excess reserves.  But nonetheless, that was her argument.  And keep in mind that nominal interest rates were near zero throughout the late 1930s.  So why is she now arguing that monetary policy can do nothing once rates hit zero?  And don’t say she only means conventional monetary policy.  People like Paul Krugman think that even OMOs (or QE) were ineffective during the late 1930s.  In contrast, Romer clearly argued that a higher MB was expansionary, even at near zero rates.  So while the conventional/unconventional distinction may work for Krugman, it doesn’t seem to explain Romer’s views at all.  What have I missed?

If I’m right, then it seems to me that Obama fans lose the excuse that he doesn’t control the Fed.  Rather it seems that his advisors are giving him bad advice, or perhaps they are being forced to toe the party line that only fiscal stimulus can save us now.



16 Responses to “Reader requests”

  1. Gravatar of rob rob
    28. April 2010 at 23:15

    i won’t pretend im so shallow as to look for investment advice here. and i realize that you never claim to offer that, that a good economist doesn’t make predictions. but what is the market saying now about inflation? there seems to be a case out there for inflation expectations, although i will admit to not understanding the 4D graphics:

  2. Gravatar of Mike Sandifer Mike Sandifer
    29. April 2010 at 03:47

    I’m progressive, but I didn’t vote for Obama. I have a libertarian streak and he isn’t libertarian enough.

    More relevant here though is that his economic policies have been disasterously ineffective. It’s even worse when coupled with his adminstration’s overly optimist original forecast for unemployment and recovery.

    I think Obama should be pressuring the Fed in every way possible to provide more liquidity. I’ve also thought that perhaps Fed independence should be formally conditioned upon whether it actually does enough to keep prices and unemployment constant.

  3. Gravatar of scott sumner scott sumner
    29. April 2010 at 05:15

    rob, According to that graph, the market expects very low inflation over the next two years, which is a bad sign.

    Mike, I strongly agree.

  4. Gravatar of Doc Merlin Doc Merlin
    29. April 2010 at 10:15

    Alternate explanation for S&P drop:

    News came out that republicans were going to cave on the financial regulation bill, and stop filibustering, on this news, Goldman shares rose and S&P fell.

  5. Gravatar of StatsGuy StatsGuy
    29. April 2010 at 11:09

    “Obama fans lose the excuse that he doesn’t control the Fed. Rather it seems that his advisors are giving him bad advice, or perhaps they are being forced to toe the party line that only fiscal stimulus can save us now.”

    I’m not sure how many economically literate Obama fans are defending his policies right now… It has been eminently clear that the Fed is pursuing policies consistent with Obama’s advisors’ opinions – notably Mr. Summers. Mr. Krugman’s arguments (on the limits of monetary policy) would be meaningful if the govt. were not running a massive deficit and didn’t have plenty of outstanding debt to monetize. But since they are, I fail to see the difference between additional fiscal spending (financed by debt) and having the Fed commit to buying large amounts of existing/newly issued debt and holding it as long as necessary.

    The clearest signal of Obama/Fed consistency was Mr. Obama’s reappointment of Bernanke.

    IF we were in a situation where the Fed was buying all available debt AND we still had low rates / an AD crisis, then there would be a legitimate argument for spending more just for the sake of spending more. (Arguments that govt. spending is delivering value are completely separable from stimulus for stimulus sake.)

    @ Doc Merlin – look at the intraday indexes – it’s quite clear that the crash followed immediately after the S&P downgrade. Moreover, the Republicans didn’t concede to floor debate on the senate bill until a couple days later (nor was it clear they would), and in doing so they won the removal of a 50 billion dollar fund that was to be financed by taxes – which is surely a win for the finance sector. Unless you were joking, I struggle to see any validity in the statement above.

  6. Gravatar of StatsGuy StatsGuy
    29. April 2010 at 11:36


    Not unexpected for Yellen. Peter Diamond is interesting – lately he’s done work on discount rates, and behavioral econ. He’s not averse to social engineering (aka, “nudging”), and is familiar with the law/econ movement. He used to teach class in flip-flops. I’m sure he and Summers know each other well. I’d put him in the Cass Sunstein camp.

    I wonder what Mankiw thinks… Although I can probably guess.

  7. Gravatar of Joe Joe
    29. April 2010 at 12:06

    Professor Sumner,

    Concerning Mundell’s four reasons for believing money was tight in 2008; the exchange rate, gold, oil, and inflation…. do you agree with him that these are examples of tight money? If so, technically, why would this not convince other economists, like Kling, what would cause doubt in their minds? Or, do you rather prefer to focus on NGDP?

    Your position, seems similar to me to that of Friedman, after 30 years, trying to convince the world of the Fed’s complicity in the great depression. You’re gonna need some intense statistical analysis to show what nobody else has noticed. No?



  8. Gravatar of Joe Joe
    29. April 2010 at 14:34

    I just realized I commented this under the wrong blog post…

  9. Gravatar of Mr. E Mr. E
    29. April 2010 at 15:13

    “In contrast, the Fed can print almost unlimited dollars, so an increased demand for dollars need not be deflationary.”

    The problem is that the fed has almost no control over inflation at this point. I know you keep pounding the table that they have all the tools they need, but possibly not the will to use them. I disagree. If the fed had this power, why hasn’t it used it? If they have and were able to precisely target the 2% we have now – with 0% core – why do we still have the unemployment at 10%? You would figure that with accuracy like that, they could do a little more for the poor working man. You know, run at like 3% for exactly 4.6 months and then dial it down to the 2.01% level or something.

    My point it that they got lucky.

  10. Gravatar of FU! I Mean, EU! « It Don't Mean Much, These Seats are Cheap. FU! I Mean, EU! « It Don't Mean Much, These Seats are Cheap.
    29. April 2010 at 19:33

    […] Scott Sumner […]

  11. Gravatar of scott sumner scott sumner
    30. April 2010 at 04:35

    Doc merlin, I have to agree with Statsguy here. I’m pretty sure it was Portugal.

    Statsguy, I am tempted to make a joke about the number of “economically literate Obama fans” but I won’t. (Of course there also weren’t many economically literate McCain fans.)

    Statsguy#2, I was very disappointed by the three names being mentioned. Two are not monetary economists, and the one that is doesn’t think monetary stimulus can work once rates hit zero. The only good thing is that with 4 of the 7 Board members being Obama people, they are less likely to prematurely tighten.

    We don’t need good regulation people at the Fed, their impact will be tiny. We need good monetary economists like Mishkin, Woodford, Svensson, McCallum, Mankiw, etc.

    Joe, Last year I provided 6 or 7 pieces of evidence that money became very tight in the last half of 2008. Falling TIPS spreads, falling stock prices, falling commodity prices, rising real interest rates, a rising dollar, falling non-subprime housing prices, falling commercial RE prices.

    Nor am I the only one who pointed this out. Hetzel had a major article in the Richmond Fed Quarterly. Earl Thompson had an article. Tim Congdon.

    Mr E. We have 10% unemployment because NGDP fell more than 8% below trend after July 2008, and isn’t bouncing back. And yes they do have all the tools required to boost inflation, indeed even Bernanke made the same claim about Japan once Japanese rates hit zero. I don’t think they should target the CPI, which is a flawed indicator, but rather NGDP.

  12. Gravatar of OGT OGT
    30. April 2010 at 05:10

    I agree that the ECB needs to loosen up, Nick Rowe’s piece on that was quite good. Krugman also has a line relating to Euro monetary policy in his column today in that the problem is a relative cost problem between Germany and southern Europe, Germany needs inflation and Greece deflation. It would be easier to make the necessary adjustments if they met in the middle.

    Since your taking reader requests, I can’t help thinking of one of the first pieces I read here. The primary point of it was about the long term rise of India, which I wholly agreed with.

    But you opened up with a bit about the narrative of hard working efficient Germans and idle Greeks being undermined by the closeness of their PPP GDP per capita. At the time I objected because I don’t trust PPP adjustments to compare relative economic strength (as opposed to living standard) because the PPP adjustments contain alot of noise and bleed through from land prices. So I think its better to look only at tradable goods production, goods that could potentially compete globally.

    In any case, do you take away anything about the relative value of ‘the narrative’ or in how to assess different countries’ economic strength?

  13. Gravatar of jsalvatier jsalvatier
    30. April 2010 at 05:45

    Sumner, I want to ask you to talk about “optimal currency areas” and the related idea that different areas in the same currency zone can need different monetary policies. People continue to talk about these ideas (example and I see people claim that some countries in the EU are having substantially larger recessions than other countries, but these ideas seem totally at odds with the idea of monetary disequilibrium (unless perhaps different areas had completely separate banking and money systems). Am I missing something important or do these ideas genuinely conflict with your understanding of monetary economics? I think you have made some comments about this topic before, but I didn’t find it very helpful.

  14. Gravatar of scott sumner scott sumner
    1. May 2010 at 09:51

    OGT, I still strongly believe that if you are comparing the size of economies (and the post was about the size of China’s and India’s economy) you want to do a PPP comparison. In my view the impact of China on the world economy is greater than non-PPP adjusted numbers would suggest. The nominal number is similar to Japan, but China has a vastly greater appetite for resources, and exports far more than Japan. If you look at output in volume terms (pounds of rice, number of haircuts, tons of steel, etc) China’s economy is much bigger than Japan’s.

    I do agree that the recent accounting scandals in Greece call into question my claim that in PPP per capita terms they were only 15% behind Germany. Perhaps land prices did distort things, as you say, and maybe the gap is bigger. But I still insist that in principle PPP is appropriate in evaluating the size of an economy in real terms. BTW, in another recent post I argued that India may end up with twice China’s population, strengthening my argument.

    Also note that the Germans don’t really work that hard (weekly hours are low) they work efficiently.

    Maybe my blog is like the Sports Illustrated jinx–as soon as I promote a country it falls into crisis.

    jsalvatier, I couldn’t open that link. I disagree with Krugman–both Germany and Greece need easier money. Krugman fixates on the German surplus in trade, which he sees as a problem, but I don’t.

    But mostly I agree with Krugman, we both think the ECB policy should be easier.

    There are two ways of thinking about the optimal currency area—the monetary policies that countries think they need, or those they actually need. Germany thinks it needs tighter money than Greece, but I think it is wrong, both countries need easier money. So from one perspective the problem is differences of opinion as to what sort of policy is needed, but from another perspective it isn’t a OCA problem, it’s a problem of money being too tight everywhere.

    I’ve always thought that the euro argument was strongest for the inner core (Germany, Denmark, France, Benelux, Austria) and after that it gets more doubtful. I thought Britain was wise to stay out. But I must admit that this crisis is worse than I expected.

  15. Gravatar of James James
    2. May 2010 at 08:59

    “Maybe my blog is like the Sports Illustrated jinx-as soon as I promote a country it falls into crisis.”

    I’ll be shorting Singapore and Australia.

  16. Gravatar of ssumner ssumner
    3. May 2010 at 05:54

    James, I don’t blame you. I sometimes feel that whenever a country seems to be doing well, there are problems dead ahead.

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