John Taylor has a new post criticizing NGDP targeting:

One change is that, in comparison with earlier proposals, the recent proposals tend to focus more on the level of NGDP rather than its growth rate. This removes some of the instability of NGDP growth rate targeting caused by the fact that NGDP growth should be higher than its long run target during the catch up period following a recession. But it introduces another problem: if an inflation shock takes the price level and thus NGDP above the target NGDP path, then the Fed will have to take sharp tightening action which would cause real GDP to fall much more than with inflation targeting and most likely result in abandoning the NGDP target.

I see lots of problems here, but in fairness this may reflect my particular vision of NGDP targeting, which is the “target the forecast” approach.  Under my plan, the Fed would constantly adjust policy so that expected future NGDP (12 or 24 months forward) remained right on target.  Ideally this would involve NGDP futures markets, more likely it would involve an internal Fed NGDP forecast, which also incorporated the consensus private NGDP forecast as well as various asset prices such as TIPS spreads.

Taylor is right that there might be inflation shocks under NGDP targeting, just like there are under inflation targeting.  For instance, the rise in oil prices in 2007-08 caused CPI inflation to rise far above the Fed’s implicit target.  But he’s wrong in assuming these inflation shocks would raise NGDP, indeed NGDP growth slowed to well under 5% during the 2007-08 oil shock.

The deeper problem with this criticism is that wages are not set on the basis of expected inflation, but rather the expected rate of NGDP growth.  That’s why wages in a country like China have been rising at double digit rates for years, despite much lower inflation rates.  It is why wages in the US remained well behaved in 2007-08, even as headline inflation rose to over 5% (as NGDP growth was slowing.)  As long as the Fed keeps targeting NGDP expectations, wage growth will remain anchored.  Workers and employers understand that wages cannot compensate for every spurt in prices at the gas pump.  If actual NGDP does change suddenly, it will be easy to reverse as long as expected future NGDP (and hence wages) remain on track.  (Note; this argument applies best if the Fed targets NGDP per capita, or per working age adult.)

If the Fed had been targeting inflation in 2008 the crisis would have been far worse, as monetary policy in mid-2008 would have been much tighter.  The Fed actually takes both inflation and real growth into account.  But an NGDP target would allow them to do so in a much more explicit fashion, and would have allowed them to ease much more aggressively in late 2008.

Taylor continues:

A more fundamental problem is that, as I said in 1985, “The actual instrument adjustments necessary to make a nominal GNP rule operational are not usually specified in the various proposals for nominal GNP targeting. This lack of specification makes the policies difficult to evaluate because the instrument adjustments affect the dynamics and thereby the influence of a nominal GNP rule on business-cycle fluctuations.” The same lack of specificity is found in recent proposals.

That may be true of Romer and Krugman, but they were basically endorsing the proposals of others.  And certainly no one can claim that my proposal lacks specificity—it is just as rule-based as Taylor’s famous policy rule.  It also has the advantage of being forward-looking, which is a huge plus in a fast moving financial crisis like 2008.  The Fed used Taylor Rule-like reasoning in deciding not to cut rates below 2% in their September 16, meeting, which occurred right after Lehman failed.  They cited a roughly equal risk of recession and inflation.  Incredibly, the risk they saw was excessively high inflation, not excessively low inflation.  How could the Fed have made such a bone-headed mistake?  They were looking in the rear view mirror, at nearly 5% headline inflation over the previous 12 months.  They should have looked down the road as Svensson suggests, as the TIPS spreads that day showed 1.23% inflation over the next 5 years.  Taylor Rule-type thinking caused the Fed to unintentionally leave money way too tight to hit their implicit inflation and employment targets.

I’m sure that today even Ben Bernanke would agree that they erred in not sharply cutting rates at the September 2008 meeting.  During the fall of 2008 the Fed needed to do enough stimulus so that forecasts of 2010 NGDP remained roughly 10% above actual 2008 levels.  They didn’t even come close, which is why the recession was so much worse than it needed to be.  The sub-prime fiasco made a mild recession almost inevitable, but the fall in NGDP (the biggest since the 1930s), made it far worse than it needed to be.  Sharply falling NGDP expectations in late 2008 led to sharply lower asset prices, which dramatically worsened bank balance sheets.  IMF estimates of expected US banking system losses nearly tripled in late 2008 and early 2009, even though the sub-prime fiasco was already well-understood by mid-2008.  What wasn’t predicted in mid-2008 was the catastrophic fall in NGDP over the next 12 months.

At first glance Taylor’s piece looks like a critique of NGDP targeting.  But on close inspection it is something different.  It is a discussion of tactics; level versus growth rate targeting.  Rules versus discretion.  I’ve added the issue of forward-looking versus backward-looking rules.  These are all interesting issues, and I actually agree with Taylor on the importance of policy rules.  He is well aware that some of the most distinguished proponents of NGDP targeting (such as Bennett McCallum) have proposed explicit NGDP policy rules.  He also knows that the dual mandate embedded in NGDP targeting is not that different from the dual mandate embedded in the Taylor Rule.  Readers of critiques by Taylor and Shlaes need to keep in mind that their real target isn’t NGDP targeting, it’s discretion.  I hope John Taylor will consider jumping on board and writing an explicit “Taylor Rule” for NGDP targeting, so that if the Fed does move in that direction they do so in a responsible way.

BTW,  What’s the non-discretionary Taylor Rule suggestion for Fed policy if rates fall to zero and further stimulus is needed?

HT:  Marcus Nunes

Here’s a comment from Andy Harless:

The question of whether monetary policy was tight in late 2008 is largely a matter of definition. How does one define “tight” monetary policy? If you define it by comparing the nominal policy interest rate to the latest reported 12-month inflation rate, then it wasn’t tight. If you define it by comparing forecast NGDP to the historical trend, then it was very tight.

I have to admit, when I first heard (second or third hand and incomplete, some time in early 2009 IIRC) about what you were saying, I dismissed it as some crackpot idea. But when (a year or so later) I actually started to read your blog, I became convinced that your definition of monetary tightness is as reasonable as any other. In monetarist terms, NGDP is just a velocity-adjusted monetary aggregate, so it’s a variation on a traditional way of measuring the ease of monetary policy. In New Keynesian terms, it’s a special case of a forward-looking Taylor rule, and it’s the most obvious special case “” a lot more obvious than Taylor’s original rule “” so it deserves some presumption. In October 2008, if the Fed had been following a forward-looking, equal-coefficient Taylor rule, the governors would have been tearing out their hair trying to find ways to simulate negative interest rates rather than dragging their feet about cutting rates while obsessing about providing liquidity.

I had similar thoughts swirling around in my mind, but he expresses the idea very clearly and elegantly.  He nails my approach to defining monetary policy, and my critique of policy in late 2008, all in one concise paragraph.  People need to pressure Andy to get back to blogging.

Here’s Mark Sadowski (from the same thread):

There’s a lack of interest in most economics departments in economic history primarily because most students are concerned about the job market and economic history only prepares you for academia and there aren’t many openings in economic history because students aren’t interested in studying it (and around and around we go). Other graduate students openly sneered at me whenever I mentioned I was taking a course in economic history. It’s a vicious downward spiral and unfortunately I think a major reason why economists were blindsided by the Financial Crisis and the Great Recession is the lack of knowledge of economic history by some otherwise very bright people.

Exactly.  Most economists have in the back of their mind the idea that Keynes showed monetary policy was ineffective at the zero bound during the Great Depression.  How many of these economists know that by the end of 1933 (with near 25% unemployment) Keynes was complaining that FDR’s monetary policy was too inflationary.  Or that when Roosevelt returned to the gold standard in January 1934, Keynes congratulated FDR for rejecting the advice of the “extreme inflationists.”  Or how many know that most banks didn’t take reckless risks in the late 1920s, but were actually very conservatively managed.  Or that the banking crisis happened because the nominal incomes of Americans fell in half.  Queue up that old George Santayana quotation.

I haven’t commented on the ECB’s latest blunder, but Paul Krugman, Matt Yglesias, David Beckworth, Kantoos, etc, have already said what needs to be said.

A commenter sent me a link to a video that I made for the Warwick Economic Summit in England.  (I wasn’t able to attend.)  I can’t bear to watch myself on TV, so I have no idea how it turned out.  I felt awkward standing in front of a black screen with no audience.  There are supposed to be PowerPoint slides interspersed.  I was limited to about 15 minutes, so the talk is sort of cut off at an awkward time.

Why do people hate watching themselves?  A reminder that others don’t see our beautiful minds, but rather our not-so-beautiful bodies?

A few weeks back Tyler Cowen made this observation about my approach to monetary crisis:

Recently Scott Sumner visited us and I pondered the following.

Let’s say that at the peak of a financial crisis, the central bank announces a firm intention to target a path or a level of nominal GDP, as Scott suggests.  If everyone is scrambling for liquidity, and panic is present or recent, and M2 is falling, I wonder if the central bank’s announcement will be much heeded.  The announcement simply isn’t very focal, relative to the panic.  A similar announcement, however, is more likely to work in calmer times, as the recent QEII announcement has boosted equity markets about seventeen percent.  But for the pronouncement to focus people on the more positive path, perhaps their expectations have to be somewhat close to that path, or open to that path, to begin with.

(Aside: there is always a way to commit to a higher NGDP path through currency inflation, a’la Zimbabwe.  But can the central bank get everyone to expect that the broader monetary aggregates will expand?)

The question is when literal talk, from the central bank, will be interpreted literally.

I’ve already taken one stab at addressing Tyler’s post, today I’ll take a couple more.  BTW, you should read his entire post, as my excerpt doesn’t present the full argument.

Part 1.  The root problem isn’t the Fed, it’s macroeconomists.

Most people think of my blog as a critique of the Fed, and in one sense they are right.  But if anyone was crazy enough to read the entire nearly 2000 page blog, they’d notice another theme—a critique of the economics profession.  In previous posts I observed that the Fed policy was usually close to the consensus of macroeconomists.  That’s probably why the consensus of economists almost never blames the Fed for recessions, in real time.  Instead, they say “most recessions are caused by drops in aggregate demand, but this one’s different because of blah blah blah.”  After a few decades pass by, macroeconomists look at the time series data on output, prices and NGDP, and come to the conclusion that it wasn’t different after all.  Most recessions (with the notable expectation of 1974) are now at least partly blamed on a demand shortfall.   The Great Depression is obviously the best example of this sort of re-evaluation, but I am quite confident that future generations of macroeconomists will feel the same way about the big decline in NGDP during 2008-09.  They’ll scratch they heads and ask why economists weren’t demanding easier money in the second half of 2008.

So on one level my blog is a critique of Fed policy, suggesting they should have behaved differently in 2008.  But at a deeper level I am trying to grab the economics profession by the shoulder and shake them up:  “You guys need to think about monetary policy in a different way, the current approach is what caused this crisis.”

You might ask why focus on economists, do they have that much influence?  After all, economists believe in free trade but almost all countries have trade barriers.  But monetary policy is different.  Over time the policy apparatus has been increasingly turned over to economists, as non-economists find it hard to critique, or even to understand, concepts like the Taylor Rule.  (Do you think Pelosi and Barney Frank knew IOR was contractionary when Congress gave Bernanke that tool in late 2008?)  The best example of this phenomenon is the widespread adoption of inflation targeting by central banks all over the world after the debacle of the Great Inflation.  Another example is the Taylor Principle.

Obviously I can’t claim that central banks precisely implement the preferred policy of macroeconomists, after all they don’t even agree among themselves.  John Taylor thought money was too easy in 2003 and Paul Krugman did not.  But my hypothesis does fit the current debacle fairly well.  During the second half of 2008 there was relatively little criticism of the Fed for being too tight.  Indeed at the time I couldn’t find any, although later I did discover a few other like-minded critics, mostly quasi-monetarists like myself.

So here’s one reply to Tyler Cowen’s argument.  If the Fed promises to do what a majority of economists think it should do, then the markets will find that policy credible—even in the midst of a financial panic.  The root cause of the problem in 2008 wasn’t Ben Bernanke’s passivity, it was that the economics profession did not see any problem with the Fed deviating from what I had assumed was their implicit policy—targeting the forecast.

Recall that almost everyone agreed that AD was likely to fall much more sharply than was desirable.  So the problem was not that economists thought that the economy did not need more AD.  They most assuredly thought it did, at least by October 2008.  And the problem was not that interest rates were stuck at zero, they were 2% during the first week of October, and 1.5% throughout most of the remainder of the month.  No, the economics profession knew the economy needed more AD and they knew the Fed had the ability to ease policy further.  Why didn’t they march on Washington and demand easier money?  I can’t say.  I tossed around many theories but in the end I can’t think of anything more satisfactory than the “boo-boo” theory.  Macroeconomists focused on the banking problem, and simply took their eye off the ball.  They can’t walk and chew gum at the same time.  They think that stabbing someone in the gut who also has pneumonia doesn’t make them worse off, because “the real problem is pneumonia.”  And they thought that the Fed letting NGDP fall sharply during a banking panic wouldn’t make things worse because “the real problem was the banking panic.”

Part 2.  Was the crisis really an exogenous shock?

Tyler’s comment uses the fairly widely held assumption that the crash of late 2008 was an exogenous shock, and the issue the Fed faced was what to do about it.  I have two problems with this view.  First, I believe there were two quite distinct shocks in late 2008, one of which was actually caused by the Fed.  Second, I believe that even the other shock, (the banking panic) was partly caused by the Fed’s tight money policy (although not entirely.)

The commenter Cameron has been sending me a lot of quite interesting information recently, and I plan to do a post discussing his work in the near future.  He has uncovered evidence that the stock market was being strongly impacted by monetary policy decisions during late 2008.  For instance, check out his post here first, and then here.  For now I’ll just repeat that while the banking crisis during September 2008 did depress stock prices, the severe stock market crash occurred in early October, during a period of little financial news but strong indications that NGDP was falling sharply and that the Fed did not intend to do anything about it.

I can’t prove this hypothesis, but I believe the most likely explanation for the October crash is that as of September 30, 2008, markets thought the Fed would not allow NGDP to fall at the fastest rate since 1938, and that as of October 10 2008 they realized that they were wrong.  Yes, I know that here I am committing the cardinal sin of attributing my beliefs to the market.  Actually, I am saying the markets were a bit ahead of me because if the market hadn’t crashed, then even on October 10th I probably wouldn’t have realized quite how severe the recession was becoming.  (I suffer from data lags, but the stock market as a whole sees all macro data in real time, even if individual traders do not.)

To conclude:

1.  If the economic consensus had been that the Fed should target NGDP, or even do price level targeting during a financial crisis, the Fed would have done exactly that.

2.  If the consensus was that the Fed should do level targeting in a crisis, and the Fed in fact did level targeting in a crisis, then the markets would have believed the Fed would carry through with level targeting in a crisis.

3.  With level targeting, monetary policy is able to greatly cushion the blow of a financial shock, even if monetary policy is completely impotent in the short run in a purely technical sense.  Thus even if the Fed is unable to raise current M2 or lower current short term rates, level targeting will greatly reduce the fall in NGDP, and thus make the recession much less severe.  There are two reasons for this, one general and one specific to the 2008 crisis.  The general reason is that current AD is strongly affected by future expected AD, and asset prices are one important transmission mechanism linking the two.  And the 2008-specific reason is that because level targeting would have made the asset price crash much smaller, it would also have made the financial crisis much smaller.  Contrary to the conventional wisdom it wasn’t all about sub-prime mortgages, when NGDP expectations plunged in the second half of 2008 the crisis got several times worse, even though the sub-prime fiasco was already fully priced into the markets by mid-2008.

Thus when Tyler Cowen asks whether an aggressive Fed policy would have been credible in the midst of a crisis, my response is that if the Fed had the right policy regime, the crisis they would have been in the midst of would have been much smaller.

I’m trying to change the conventional wisdom on what the Fed should do in the crisis, much as Friedman and Schwartz changed the conventional wisdom about the Depression.  Ideas matter, and this time the Fed did take steps to prevent a repeat of the Great Depression.  With the lessons learned from this crisis we’ll eventually have a new conventional wisdom, and the macroeconomic fallout from the next financial panic will be even smaller.

Does a more stable macroeconomic environment cause the financial sector to take bigger risks?  Yes, but the solution to that problem is not to create recessions, but rather to better regulate the financial industry.  Creating more recessions doesn’t just encourage banks to take fewer risks; it also makes it much more likely that any given level of risk will result in a financial crisis.  As we’ve just seen.  With stable 5% expected NGDP growth the recent sub-prime crisis would have been a footnote in the history books, roughly like the 1980s S&L crisis.  If you don’t believe me go back and read the news from late 2007 and early 2008, when the sub-prime fiasco was well understood.  Only when the Fed let NGDP fall sharply in the second half of 2008 did the banking problem turn into the extraordinary, huge, gigantic, vast, enormous, mammoth, tremendous, titanic, humongous, immense, colossal, gargantuan, stupendous financial crisis of late 2008.

Tyler Cowen and James Surowiecki have recently discussed why it is difficult for the Fed to set a higher inflation target.  They’re right.  All you need to do is read conservative press accounts of the recent Fed statement, which figuratively roll their eyes at the suggestion that we might need a little more inflation.  “Imagine that!  The Fed thinks we need more inflation.  Don’t they know inflation is a problem?”

Of course this is frustrating to macroeconomists, because if we are targeting inflation at say 2%, then it stands to reason that approximately one half of the time inflation will be too low, and one half of the time it will be too high.

But the articles that mock the Fed are not written to be read by macroeconomists, they’re to be read by the general public.  And the public does believe that inflation is a problem, for several very good reasons.  First, for any given nominal income, higher inflation will tend to hurt an individual worker.  And second, most of the major increases in inflation have been associated with bad times.  Think about 1974 or 1979, or the first half of 2008.  Of course all those were associated with adverse supply shocks.  You have to go back to the second half of the 1960s to find a major increase in inflation that was associated with good times.

On the other hand, if AD rises briskly and brings inflation from below normal back up to normal, most people feel better off.  So when the Fed says it would like to see higher inflation, what it is really saying is that it would like to see higher AD, which as a side effect will raise inflation somewhat.  For any given level of AD, higher inflation would be a bad thing, as it would represent an adverse supply shock.  So why not just call for higher AD?  We know that an increase in AD raises both prices and output, so it seems like what they really want is more NGDP, not higher prices.  Higher NGDP is definitely needed in a demand-side recession, whereas higher inflation might or might not be a good thing.

Consider the following 7 questions:

1.  Which target best measures what the Fed is directly trying to influence, NGDP or inflation?

Answer:  NGDP targeting.  For a given level of NGDP, higher inflation would actually be harmful.

2.  Which policy goal sounds better to the public, higher inflation or higher nominal NGDP?

Answer:  Hmmm, would you rather tell the public you are trying to boost their incomes back to prosperity levels, or that you are trying to raise their cost of living?

3.  Which policy is more consistent with the Fed’s dual mandate?

Answer:  NGDP targeting

4.  Which policy doesn’t force government bureaucrats to make high subjective estimates of quality changes in products?

Answer:  NGDP targeting

5.  Which policy is most like to prevent bubbles; NGDP or inflation targeting?

Answer:  NGDP targeting, which calls for lower inflation during booms.

6.  Which target best avoids liquidity traps, NGDP or inflation targeting?

Answer:  NGDP targeting, as 1% deflation may or may not result in a liquidity trap, depending on the trend real GDP growth rate.

7.  Which target is preferred by the Fed and most macroeconomists?

Answer:  Inflation targeting.

The public instinctively feels the Fed should be targeting NGDP.  And if they were, inflation really would be bad.  Always.  The public’s not stupid; they’re one step ahead of macroeconomic elite!  🙂

Update 9/27/10:  David Beckworth pointed out several advantages of NGDP targeting that I forgot to mention.  It is easier to implement than a Taylor Rule, and it has been advocated by a number of respected macroeconomists, both center-left and center-right.

Caroline Baum of Bloomberg recently suggested that Milton Friedman would have been appalled by the many top economists arguing the Fed is out of ammunition:

Milton Friedman, Nobel Laureate in Economics, died in 2006. Monetarism, the school of thought he founded, seems to have died with him, judging from recent comments.

Academics, such as Princeton’s Alan Blinder and Harvard’s Martin Feldstein, are claiming there’s very little the Federal Reserve can do to stimulate the U.S. economy. Newspaper headlines deliver the same message: the Fed is “Low on Ammo.” The public is feted with explanations — couched in technical terms, such as the “zero-bound” and a “liquidity trap” — as to why the Fed’s hands are tied.

What planet are these people on?

They’re clearly not on planet monetarism.  On the other hand John Taylor thinks Friedman’s message still resonates, but that he would have been opposed to additional monetary stimulus:

I see neither those ideas nor their adherents going to the grave. Indeed, the experience of this crisis is proving that Milton Friedman’s ideas were right all along, and I can see them gaining favor.

Two of Friedman’s most famous ideas in the macroeconomic sphere were (1) that monetary policy should follow a simple policy rule and (2) that discretionary fiscal policy is not useful for combating recessions, and indeed could make things worse. Both ideas have been reinforced by the facts during the recent crisis.

The first idea is reinforced by the evidence that the crisis was brought on by the failure of the Fed to keep following the rules-based monetary policy that had worked well for 20 years before the crisis. Instead, it deviated from such a policy by keeping interest rates too low for too long in 2002-2005. But Caroline Baum wonders whether the Fed should now just print a lot more money and buy more mortgages or other securities. That might sound like a monetarist solution, but Friedman did not believe in big discretionary changes the money supply. Rather, he advocated a constant growth rate rule for the money supply. I doubt that he would have approved of the rapid increase in the money supply last year, in part because he would have known that it would be followed by a decline in money growth this year. He always worried about monetary policy going from one extreme to the other and thereby harming the economy. That is why the Fed should be clear and careful as it brings back down the size of its balance sheet, which exploded during the crisis.

While Taylor’s argument is defensible (and I agree with him on fiscal policy), I believe the weight of evidence supports Baum’s interpretation.  Let’s look at what Milton Friedman had to say about Japan in December 1997.  The subtitle is as follows:

Nobel laureate and Hoover fellow Milton Friedman gives the Bank of Japan step-by-step instructions for resuscitating the Japanese economy. A monetary kiss of life.

And here’s Friedman’s argument:

The surest road to a healthy economic recovery is to increase the rate of monetary growth, to shift from tight money to easier money, to a rate of monetary growth closer to that which prevailed in the golden 1980s but without again overdoing it. That would make much-needed financial and economic reforms far easier to achieve.

Defenders of the Bank of Japan will say, “How? The bank has already cut its discount rate to 0.5 percent. What more can it do to increase the quantity of money?”

The answer is straightforward: The Bank of Japan can buy government bonds on the open market, paying for them with either currency or deposits at the Bank of Japan, what economists call high-powered money. Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand their liabilities by loans and open market purchases. But whether they do so or not, the money supply will increase.

There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately. A return to the conditions of the late 1980s would rejuvenate Japan and help shore up the rest of Asia.

The Interest Rate Fallacy

Initially, higher monetary growth would reduce short-term interest rates even further. As the economy revives, however, interest rates would start to rise. That is the standard pattern and explains why it is so misleading to judge monetary policy by interest rates. Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

In the article, Friedman presents data showing Japanese monetary growth slowing sharply in the 1990s.  He also notes that RGDP growth slowed from 3.3% during what he calls the “Golden Age” of 1982-87 to only 1.0% during 1992-97.  Inflation slowed from 1.7% to 0.2%.  From this we can infer:

1.  Friedman does not seem to agree with Fed hawks who think price stability is a good thing.  After all, Japanese prices were very stable during the 5 year period when he thinks money was far too tight.  Admittedly, some at the Fed define price stability as 2% inflation, but the hawks clearly don’t agree, as inflation is 1% and falling, yet the hawks still oppose stimulus.

2.  Friedman thinks near-zero interest rates are a sign that money has been too tight.  And he suggest that QE is the proper response.

3.  Friedman cites data showing that Japanese NGDP growth has slowed from 5% during the golden age to 1.3% in 1992-97.  Of course 5% NGDP growth is quite close to the US experience from 1992-2008, another “golden age.”  But then US NGDP fell 3% between mid-2008 and mid-2009, nearly 8% below trend.  And it continues to grow at well under trend during the “recovery.”  Friedman would have seen that as a warning sign.

4.  Friedman advocates raising money growth rates in Japan (M2) up much closer to the 8.2% of Japan’s Golden age.

5.  In the US monetarists tend to look at broader aggregates like M2 and MZM (although unfortunately we lack the ideal divisia index that monetarists like Mike Belongia say is needed.)  For what it’s worth, here are the growth rates of M2 and MZM from mid-2008 to mid-2009, and then from mid-2009 to mid-2010:

2008-09:   M2 grew 8.8%,  MZM grew 10.2%

2009-10:  M2 grew 2.1%, MZM fell 1.8%

So on average the aggregates grew around 9-10% during the financial turmoil, and then barely changed over the following 12 months.  It is difficult to know what Friedman would say about the increase in the money supply between 2008 and 2009.  Obviously the facts don’t exactly fit either my interpretation or Taylor’s.  But if we take a more expansive view of Friedman’s approach to macroeconomics, then I believe there is even more reason to believe that he would now favor monetary stimulus, just as in Japan:

1.  In the Monetary History, Friedman and Schwartz decided not to use the monetary base as their indicator of the stance of monetary policy.  In my view, this was partly because the base increased sharply between 1929 and 1933.  Friedman understood that NGDP had fallen in half during those four years, and thus monetary policy had obviously been too contractionary for the needs of the economy.  He also understood that the increase in the base reflected hoarding of cash and reserves during the banking panics.  Thus the most natural monetary indicator for a libertarian, the one directly controlled by the government, was not going to work.  Instead he and Anna Schwartz focused on broader aggregates, which declined sharply between 1929 and 1933.

2.  Now consider the 2008-09 increase in the broader aggregates.  Because we now have FDIC, people no longer hoard cash during a liquidity crisis; instead they hoard the very liquid and safe assets that make up MZM.  Friedman would have understood that the financial crisis was a special situation, and hence required economists to look past the temporary blip in MZM, just as he had overlooked the rise in the base during 1929-33.  He understood that money was actually tight during 1929-33, despite the increase in the base and the low interest rates.  (And he’d understand that the bloated base since 2008 largely reflects interest-bearing excess reserves, where yields exceed the rate on T-bills.)

3.  Friedman also understood that in uncertain times markets can provide an indication of whether money is too tight.  Recall his defense of speculators, and also floating exchange rates.  He clearly thought market signals were meaningful.  In 1992 [Money Mischief] he endorsed Robert Hetzel’s idea of having the Fed directly target expected inflation, by trying to peg the spread between nominal and indexed bonds.  Now recall that the TIPS spread briefly went negative in late 2008, and even today is only about 1% for one and two year T-bonds.  So if Friedman thought Hetzel’s proposal was a good idea, I think it unlikely he would brush off the message in the TIPS markets, as many conservatives seem to do.  The markets are clearly indicating both inflation and output will remain below the Fed’s implicit target for quite some time.  Friedman would have seen the importance of those market signals.

4.  There are some modern monetarists, such as Tim Congdon  (and this), who have made many of the same arguments that I’ve used in this post.

To summarize:

1.  In 2009 NGDP fell at the sharpest rate since 1938.  And NGDP growth is expected to remain very weak.   If M*V is that weak, something must be wrong.

2.  Friedman argued the low rates in Japan were actually evidence of tight money.

3.  Friedman would have been concerned by the abrupt slowdown in the growth rates of the monetary aggregates since mid-2009.

4.  Some modern monetarists like Tim Congdon think money is way too tight.

The burst of M2 and MZM in 2008-09 does point slightly in John Taylor’s favor, but overall I believe the evidence supports Baum’s view.

Of course neither John Taylor nor I hold identical views to Friedman.  He supports the Taylor Rule (why not, he invented it!)  I give him a lot of credit, as the Taylor principle is the primary factor behind the Great Moderation.  However I believe a Svenssonian “targeting the forecast” approach is even better.  In September 2008 the Fed failed to cut rates below 2%, looking backward at the high rates of headline inflation during the summer of 2008.  But forward-looking real growth and inflation indicators were already slowing rapidly, indeed the TIPS spread on 5 year bonds fell to 1.23% just before the post-Lehman Fed meeting.  I think almost everyone would now agree the Fed should have moved much more aggressively in September 2008, before rates had fallen to zero.  A forward-looking approach would have allowed them to do so, but instead they relied on historical data that seemed to suggest the risks of inflation and recession were equally balanced.  They did nothing.

I suppose the fight over Friedman’s legacy is related to the fact that he is the one right-wing macroeconomist who is almost universally respected by conservative/libertarian economists.  Even though I’m not a strict monetarist, I’d like to think he would support my view of the current crisis.  I’m guessing Taylor feels the same way.

HT:  DanC, Benjamin Cole, David Pearson, Richard W.

PS:  After 16 months of leisure frantic blogging activity, school starts tomorrow.  Unfortunately, posting and comment replies will have to slow down.