Reply to Arnold Kling
Arnold Kling recently had this to say:
I will excerpt from the Meltzer paper. But first, let me quote from the media release of Macdonald-Laurier.
“In a period of runaway monetary stimulus by the industrialized world…”
I do not think that Scott Sumner would characterize the monetary situation that way.
I use the Bernanke criterion from 2003, discussed in my previous post. According to the Bernanke metric, monetary policy since mid-2008 has been tighter than any time since Herbert Hoover was President. Kling continues:
In fact, while we are talking about non-monetary factors in economic performance, I might mention the much-discussed Fed study suggesting a 40 percent decline in median household wealth between 2007 and 2010. Timothy Taylor has the link and some helpful analysis.
I think that economists who believe that aggregate demand was a big factor in the recession (which means most economists, just not necessarily including me) are inclined to view this wealth decline as the cause, rather than taking Scott Sumner’s view that this was a monetary contraction. To rescue a role for money, you could try to argue that the wealth decline was the result of monetary austerity (impossible to disprove, but I do not believe it) or, more plausibly, that a vigorous monetary expansion could have maintained nominal GDP in the face of the huge decline in the relative price of houses and bank stocks.
Not surprisingly, I have all sorts of problems here. Start with the decline in wealth. It seems clear to me that something on the order of 70% of the decline was due to tight money. That’s just a ball park estimate, but the exact percentage isn’t critical for my argument. I base this on 60% of the wealth decline being residential housing, and 40% being other assets like commercial RE and stocks. I also estimate that the first half of the housing price decline was mostly autonomous, and the second half mostly reflected falling NGDP–i.e. tight money.
But let’s say I’m wrong about tight money causing the fall in wealth, even though previous big falls like 1929-33 were also due to tight money. Say that Kling is right. There is no reason why a big fall in wealth should have any impact on AD, as long as the central bank is following some sort of stable monetary policy: inflation targeting, NGDP targeting, whatever.
In late 1987 there was a stock market crash as big as 1929. I’m not arguing that it was identical to the recent wealth crash; it was much smaller, and more concentrated among the wealthy. Nonetheless because the Fed was targeting NGDP or inflation, there wasn’t even a tiny fall in AD. Not even a minuscule fall in AD, following a 1929-style stock market calamity. I mention that because I think a lot of average people have the 1929 crash in the back of their minds, and think it somehow contributed to the Great Depression. That false impression, which we got from believing what we were taught in our economics and history classes, has led many to be way too easily accepting of wealth explanations for the current recession.
I can’t emphasize enough that we need to purge from our minds almost everything we learned about economic history. Our teachers had flawed models, and never updated them when the 1987 crash showed the standard model of the Great Depression was completely bogus.
There is a way to test whether I am right. If we do the policy that Arnold and I favor:
I presume Meltzer would prefer a rule fixing the growth rate of a monetary aggregate (the monetary base seems to be his choice). On this issue, I tend to side with the market monetarists, but for non-monetarist reasons. A nominal GDP target will be imperfect because of forecasting errors. A monetary aggregate target will be imperfect because of velocity instability. I think I would rather take my chances on the forecasting errors.
then I claim future wealth crashes would not cause serious recessions–at least not through a demand side channel. (No one would dispute that a huge supply shock such as an asteroid impact would reduce both wealth and RGDP.)
HT: Saturos
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15. June 2012 at 09:28
Arnold is worried about forecasting errors. He doesn’t understand that you want to target the forecast of NGDP–the market’s expectation–not actual NGDP. The market’s expectation for (say) next year’s NGDP is pretty accurately discernible now, and would be almost exactly discernible with the NGDP futures market you desire.
15. June 2012 at 09:35
It’s not just the Fed who get to decide ‘monetary policy’ …
When the Fed ties itself to an unsustainable fake ‘gold’ standard, is pumping up an unsustainable stock & industrial boom & then sees investors/speculators voting against that unwise decision, the Fed at some point has lost control of ‘monetary policy’.
When the Fed pumps up an unsustainable mortgage security, CDS, housing & transportion bubble, the Fed at some point has lost control of ‘monetary policy’ as the markets make their own choice — to crash housing & transportation & the whole structure of production associated with them, to massively crash the stock of liquid ‘shadow money’, etc.
If ignoring all of this is required to do ‘science’, maybe it isn’t ‘science’ that is being done.
15. June 2012 at 09:49
Something no one one seems to see is that the government sector / government worker boom & crash is directly related to the housing et al boom & crash — in CA the massive expansion of government worker compensation went hand in had with the tax windfalls being showered on government from the housing and related booms. When the private economy boom went bust, the massive unsustainable government worker compensation packages led to government worker hiring freezes and layoffs across California.
15. June 2012 at 09:50
Yup, that is *exactly* what I thought you’d say.
15. June 2012 at 10:39
One of the things that has driven me nuts over the past 3 ½ years is how many people say the deep recession and weak recovery is a result of “deleveraging” (PMICO, Bridgewater, Richard Koo, ect). But when you press them on why deleveraging matters they tell you a story about households needing to pay down debt (as if the money used to pay down debt simply disappears into thin air) and therefore need to spend less. And they fail to realize that this collapses into a story about weak AD which, if the central bank has any kind of nominal target, must be the responsibility of monetary policy. It’s the central bank’s job to exactly offset any and all shocks to that can affect AD (including bursting asset bubbles and fiscal policy shocks) else it will not hit its target.
15. June 2012 at 11:33
Philo, I tend to agree.
Greg, I ignore side issues of tangential importance. Isn’t that “good science?”
Saturos, I’m too predictable.
Gregor, I share your frustration. Why should debt problems make workers want to take long vacations?
15. June 2012 at 14:51
What do you mean when you use the word “autonomous”?
15. June 2012 at 16:06
Scott — I calculate about a $20 trillion decline in real household net worth from 2007-2009. About 10 trillion of that occurred from 2007-mid-2008, the other half corresponded to the NGDP crash. Interestingly, iceland’s stock market fell 90%+ despite steady NGDP thus only a ‘real’ shock, albeit an insanely, insanely large one.
15. June 2012 at 22:14
“I ignore side issues of tangential importance. Isn’t that “good science?””
The field of electricity had 3 or 4 theoretical frameworks prior to Franklin’s progressive program that eventually brought explanatory unity to the field. Each of these rival frameworks tried to make sense of a small slice of electrical phenomena, and pretended that the other aspects of electrical phenomena essentially didn’t exist. (See T. Kuhn)
This is the sort of thing that goes on in macroeconomics. Several rival frameworks that pretend to master one thin slice or another of the problem raising patterns before us, and ignoring all the rest.
16. June 2012 at 06:43
[…] one of yesterday’s posts I pointed out that we can’t trust any of the economic history that we learned in […]
16. June 2012 at 07:36
JoeMac, Autonomous means some change not generated by the factor I am considering. If I’m looking at monetary policy, it would be a change in the economy not caused by monetary policy.
Tommy, Thanks, but how does household net worth relate to total national wealth (which is what I’m interested in.)
Greg, I’m sure there are many examples in science where exactly the opposite is true. Thus someone explaining tides might create a model that ignores the impact of rivers flowing into the ocean.
18. June 2012 at 07:13
Wealth is sum of asset prices minus sum of liability prices.
Tight money depresses asset prices.
Why is it at all controversial that tight money caused a precipitous decline in wealth?
18. June 2012 at 07:15
Greg, those simple models of electricity and magnetism are often much more useful than the big unified models. When I want to figure out whether adding an appliance to my kitchen will blow the circuit breakers, I don’t bust out Feynman diagrams and computational QED.