The history of an idea

I was originally going to entitle this entire post “Why me?”  But I thought that would be too self-indulgent, even by the standards of this blog.  What I would like to do here is trace the development of my research into monetary economics since 1986, so that you can see things through my eyes.  Almost no one accepts my view that a tight money policy by the Fed caused the crash that occurred in late 2008.  I hope that if you better understand the development of market-based monetary policy proposals, you will come to see my hypothesis as natural, even inevitable.  If you’ve ever read Murders in the Rue Morgue, you might recall a scene where the detective walks silently through the streets of Paris with a friend, observing all the things his friend notices along the way.  Then he suddenly breaks into his friend’s (silent) internal monologue, as if they had been conversing all along.  That’s what I hope to do here.

This plan may seem like wishful thinking, but when I started thinking about this post a week ago I realized that those economists whose research interests were closest to mine (Bill Woolsey, Aaron Jackson, etc) seemed to also have views of the current crisis that were closest to mine.  More recently I found out that both Robert Hall and Earl Thompson (who is a fascinating character) share some of my views, and this further encouraged me to do this piece.

In the early 1980s a “New Monetary Economics” began to be developed by people like Black, Fama, Greenfield and Yeager.  In my view the two key figures were Robert Hall and Earl Thompson.  One key idea was that both the (Keynesian) interest rate approach and the (monetarist) money supply approach were deficient.  Rather, monetary policy was about changes in the price of money.  Unfortunately, other issues like laissez-faire monetary regimes got mixed up in the movement, insuring that mainstream macroeconomists would pay no attention.   I should also mention that even before the early 1980s, supply-siders such as Robert Mundell and Art Laffer had begun taking a price of money approach.

I began doing research on monetary economics in 1986 (with no knowledge of Hall and Thompson), and within a few months developed a set of ideas that I subsequently refined over the years:

1.  NGDP futures targeting, which I presented at the AEA conference in 1987.

2.  The view that the Great Contraction was caused by gold hoarding (which led to 20 years of research on this issue.)

3.  A countercyclical wage model of the Depression (with Steve Silver), which also led to a nominal wage targeting idea.

4.  An AS/AD model of real wage cyclicality (also with Steve Silver.)

5.  A view that the General Theory only made sense as a gold standard model.

David Galenson has argued that conceptual artists do all their best work when they are young, as that is when they are able to generate new ideas.  I don’t know if that applies to economics, but I have basically spent 23 years coasting on ideas from 1986.  Unfortunately, in the 1990s I discovered that almost all my “great ideas” had already been discovered by Earl Thompson, although I don’t know if he ever published them.  I have never interacted with Thompson, but I later came across a very impressive book by David Glasner entitled Free Banking and Monetary Reform (1989).  Glasner acknowledged that he had been influenced by Thompson’s ideas.  There I discovered someone else with the view that gold hoarding caused the Great Contraction, and also that the monetary standard could be based on a sort of futures contract, linked to the policy goal.

Scott Lawton found a new article by Earl Thompson and noticed some important similarities to my view.  As you will see, there are good reasons why we would have similar views.  In the last paragraph there is a link to a paper modestly subtitled “The Perfect Monetary System.”  Amazingly, he might be right.  In just two pages Thompson comes up with not one but two ingenious ideas.  One is for a “labor standard” where the medium of account is a contract able to buy a fixed amount of labor, say five minutes worth.  Basically, Thompson is advocating a nominal wage rule.  At first glance you might think that constant nominal wages are the last thing we’d want, aren’t sticky wages the cause of business cycles?  But that’s exactly the point, cycles occur when aggregate nominal wage levels must adjust.  Because nominal wages are sticky these adjustments are slow, creating employment fluctuations.  If you set monetary policy at a level expected to produce a stable aggregate nominal wage level, then you have set it at a level where you believe workers will not (on average) need to adjust nominal wages to prevent suboptimal employment fluctuations.  Employment would remain at its Walrasian equilibrium level (ignoring price stickiness–which I think is less of a problem.)

Then there is the problem of policy lags.  We don’t even know the current average wage rate, so how can we make dollars convertible into units of labor?  Here is where Thompson’s second innovation comes in; the dollar would convert into wage units at a level to be determined in the future.  The speculators who sold dollars to the central bank (expecting wage inflation) would be paid $1.02 if the future wage announcement came in 2% above target.  (I also did a version of futures targeting with nominal wages, but eventually settled on NGDP as a more practical alternative—Robert Hall also preferred targets that combined prices and real output.)

BTW, take a look at the link above if only to see the condition of Thompson’s paper.  I don’t know the mysterious Mr. Thompson, but I can imagine that he is almost as computer-phobic as I am.  The first page is smeared with black ink like an old mimeograph, and the second is tilted bizarrely to the side.  One of the most significant monetary policy documents of the 20th century looks like a scrap of the Dead Sea scrolls.

I have already discussed Hall’s important 1983 paper on interest-bearing reserves in earlier posts, so perhaps I should say a word about what unites these divergent approaches to my own.  We all look at monetary policy in terms of changes in the value of the monetary unit, not nominal interest rates.  Macroeconomic stability can be achieved with suitable adjustments to either the supply or demand for base money.  The most effective policy would involve stabilizing the value of a forward-looking contract that is indexed to the goal variable (prices, nominal wages, NGDP, etc.)

In Thompson’s recent article he indicated that he tried to sell his idea to the Fed, but was rebuffed.  I have the impression that he lost interest in research on forward-looking monetary rules, and who can blame him?  After all, he had solved the problem of policy lags and no one seemed to notice.   In addition, the macro establishment was obsessed with defining monetary policy in terms of short term interest rates, which are merely an epiphenomenon to the more fundamental process, changes in the supply and demand for base money, which produce changes in all sorts of asset prices.

Of course there are some differences between Thompson’s work and Hall’s research.  Thompson’s work is to Hall’s roughly what folk art is to academic art.  Hall went on to have a distinguished career doing work in a variety of areas within macroeconomics.  A commenter named Dilip told me that he sent Hall one of my earlier posts, and Hall replied that he had given up pursuing his idea since no one was paying attention.  (I was.)

I find it sad that the profession overlooked the importance of these early pioneers of market-based monetary policies.  Perhaps they were ahead of their time.  The boom in prediction markets as policy guides occurred much later, led by people like Robin Hanson and Justin Wolfers, who are not macroeconomists.  Only in the last few months, however, have I realized just how costly this oversight has been, as I strongly believe the current crisis never would have happened had the Fed been using a forward-looking monetary policy linked to market expectations.

[For those new to my blog, I should mention that by “the current crisis” I don’t mean the sub-prime crisis of late 2007 and the very mild recession of the first half of 2008, but rather the severe fall in NGDP in late 2008 and 2009, as well as the resulting sharp increase in unemployment and severe intensification of the debt crisis.]

Part 2:  Recent Events:

Over the past 20 years I have published many papers on futures targeting, attended many conferences, and spoken with many people about the idea.  Most people are skeptical.  If you respond to all the concerns they have over technical details, they often fall back on the line “the Fed already has some of the best forecasters, why rely on market expectations when there is no evidence that markets can predict business cycles better than the Fed?”  And I have to admit that the macroeconomic performance of the U.S. between 1982 and 2007 was pretty good, so I felt no sense of urgency in promoting an idea that might merely offer a marginal improvement in the precision of inflation targeting.

In the first 10 days of October I suddenly realized that the relatively good performance of the U.S. economy in recent years was merely a stroke of luck, and that the mainstream macro model was seriously flawed.  Like a true monetary crank I became convinced that I was right and the rest of the world was wrong, and that all our problems could be solved by printing money.  But first let me describe the events which led to this epiphany.

When people assured me that the Fed was already forward-looking, already setting policy at a level expected to achieve the target inflation rate, I thought, “Fine, I’ll judge Fed policy against a benchmark of market expectations.”  As long as expectations were reasonably close to the Fed target (using indicators such as the indexed/nominal bond yield spread), then there was no cause to complain about the discretionary policy regime.

In the fall of 2007 I noticed that the markets exhibited a high level of uncertainty, especially when the Fed cut rates less than expected in December (the first month of the recession.)  Stocks immediately fell 2% (an implied 5% swing in stock prices between a .25% and .50% cut in the fed funds rate.)  I also noticed that although this was a contractionary policy surprise, recession risks rose so sharply that Treasury yields actually fell from 3 month to 30 year maturities.  This made me especially aware of just how unreliable market interest rates are as indicators of the stance of monetary policy.  Rates were falling because of tight money, not easy money as many economists assumed.

In January the Fed realized its mistake and did 125 basis points of cuts in about 10 days, forestalling a severe recession in the first half of 2008.  About this time I saw a headline “economists expect recession,” and sensing that couldn’t be right, took a closer look at the article.  In fact, the headline was wrong, a consensus of economists were not predicting recession.  Then I asked myself why I had instinctively felt the headline had to be wrong, and I realized that economists should never be able to predict a recession if monetary policy was forward-looking.  I had read a lot of work by Lars Swensson, who suggested that the Fed should target the forecast, and also statements by Bernanke indicating that he agreed with Svensson, or sort of agreed.  Then I started working on a paper arguing that economists would never again be able to predict a recession, even by chance, for reasons summarized in the following quotation from James Hamilton:

You could argue that if the Fed is doing its job properly, any recession should have been impossible to predict ahead of time.

The intuition is that if the Fed always targets the forecast, and if Fed forecasts are pretty close to the consensus private sector forecast, and if the Fed never targets an NGDP growth path which is expected to generate a recession, and if recessions are avoidable right up to the moment they begin, then recessions will never be predicted by the consensus forecast.  It may seem implausible that recessions are avoidable right up to the last minute, but recall that the recession that began in December 2007 saw positive real GDP growth in the first two quarters of 2008.  A highly expansionary monetary policy in mid-2008 might well have prevented a downturn in the second half, and the first half of 2008 might not have been retrospectively labeled a recession.  Recessions are not just downturns, they are prolonged downturns, and hence are preventable even after they have started.

When stocks and commodities crashed in the first 10 days of October, and inflation expectations plummeted in the bond market, it became immediately obvious to me that 2009 was likely to be a very bad year.  I spoke with a number of other prominent economists, and found it was immediately obvious to almost everyone that 2009 was going to be a very bad year.  It wasn’t just me.  In other words, the Fed was no longer targeting the forecast.  The fed funds rate (set at 2% at that time), was for the first time in decades set at a level where it was obvious that nominal growth rates would be far below any reasonable Fed target.  (Yes, I know the Fed doesn’t explicitly target NGDP growth, but to hit their “dual mandate” NGDP needs to grow at about 4-5% per year.)

Being the egotistical monster that I am, my first reaction was “how dare they wreck my clever recession forecasting paper!”  By setting policy at a non-optimal level, they had undercut my key assumption.  Even though this turned out to be one more in a long line of recessions that economists failed to forecast, I no longer had a plausible model showing that future recessions would also be unforecastable—because the Fed clearly wasn’t targeting the forecast.  My second reaction was “not only is my paper ruined, but they are wrecking the world economy, wrecking the stock market, dramatically worsening the debt crisis, and triggered all sorts of highly counterproductive statist policies (auto bailouts, bank bailouts, pork spending, etc.)

In other words, I thought: “Why isn’t monetary policy much more expansionary?”  For a while I actually wondered if I was going crazy.  Everything I thought I knew about monetary policy seemed to be thrown out the window.  The Fed had set the fed funds target at 2% from late April well into October, when it was cut to 1.5%.  But why wasn’t it zero?  Why wasn’t the Fed already doing enough quantitative easing to raise the expected NGDP growth rate back up to a more reasonable level?  By the way, when I started becoming a monetary crank I estimated the market forecast at roughly zero percent NGDP growth over the next year, a disastrous figure in the midst of a financial crisis.  We now know it will be much worse than that.  But the important point is that even then we knew that growth was going to be far below target.  This seemed to contradict everything I thought I knew about monetary policy.  The last 6 months have been a sobering experience.  Here is what I have learned:

1.  Despite that fact that we teach our students out of textbooks that suggest the zero lower bound doesn’t prevent highly effective monetary stimulus, and despite the many foolproof escapes from a liquidity trap put forward by Bennett McCallum, Lars Svensson, and even Ben Bernanke himself, there never in fact was any kind of consensus that the zero bound did not inhibit monetary stimulus.  The profession as a whole is just as afraid of a liquidity trap as was Keynes, maybe even more so.

2.  There never was any sort of consensus that monetary policy should be forward-looking, especially no consensus that policymakers should target the forecast.  We are for the most part stuck in a backward-looking “let’s try some stimulus and see how it works” world, where policymakers blindly press ahead even as markets are screaming that their policy has already failed.

3.  Despite many articles pointing out that interest rates are a poor indicator of monetary policy; most economists still seem to assume that zero interest rates mean “easy money.”  I thought that Friedman and Schwartz had disposed of that myth with their Monetary History.  I guess not.

4.  Despite the fact that the monetary aggregates were discredited in the 1980s, and despite the fact that people seek liquidity in an financial crisis,  and despite the fact that the monetary base soared in the early 1930s, many economists seemed to think the Fed had adopted a highly expansionary monetary policy merely because the base was increasing.  “Just give it time; we’ll see high inflation soon.”  And many of these were right wing economists who supposedly believe in efficient markets.  Somehow they failed to notice that the markets were signaling deflation in late 2008, and then less than 1% inflation for the next 5 years.  And somehow they failed to recall that after 14 years the Japanese are still waiting for that “hyperinflation” that is due to arrive any day now.

5.  The last straw was when the Fed started paying interest on reserves in October, and issued a statement that explained their motive was to keep interest rates from falling.  Hall (and Susan Woodward) called this a “confession” of contractionary intent.  I noticed that James Hamilton, Nick Rowe and a few other lonely voices also questioned this move.  I immediately recalled the 1936-37 doubling of reserve requirements, another deflationary Fed policy adopted in the midst of depression.

I know that almost everyone has trouble accepting my “errors of omission” argument that the Fed caused the crash of late 2008.  But put yourself in my shoes.  For years I had read and been told that the Fed was essentially doing what I wanted them to do–targeting the forecast.  It’s just that they used internal forecasts, not market forecasts.  In addition all the cutting edge macro by people like Woodford emphasized that markets reacted not to the current setting of the instrument, but the expected future path of the instrument.  In that world there is only one monetary indicator to watch.  It is not short term interest rates.  It is not the money supply (however defined.)  It is the expected growth path of the policy target.  For 25 years expected NGDP growth was reasonably stable, now it was suddenly plunging.  And (from my point of view) the Fed had plenty of ability to ease policy further.  In October it could have cut rates from 2% to 0%, it could have stopped paying interest on reserves, it could have put a penalty rate on excess reserves, and it could have purchased trillions in government debt.  But not only was the Fed not doing all of those things, it wasn’t doing any of them in October 2008.  (And here I am giving the Fed a break on its September meeting, when it almost certainly made a mistake in standing pat.)

This is not a retrospective attempt to second guess the Fed for past decisions; my complaints were presented in October to a wide variety of audiences, both inside and outside of Bentley University.  Nothing that has happened since has in the slightest changed my view that the Fed policy in late 2008 was far off course, and that it should have been obvious to the profession at the time.

But it wasn’t.  During late 2008 very few economists criticized the Fed’s monetary policy.  Instead they focused on the pros and cons of the various bank bailout proposals—failing to see that the rapidly falling NGDP was actually worsening the banking crisis.  How could macroeconomists fail to understand that falling NGDP will dramatically weaken a banking system that is already very fragile due to the earlier sub-prime crisis?  And yet most people I talked to, and even most articles I read written by economists, treated the late 2008 worsening of the financial crisis as an exogenous event—with causation running mostly from crisis to falling AD.  At least (in his appearance on 60 minutes) Bernanke finally admitted the reverse causation theme I had been forcefully advocating since October—he admitted that the weakening economy had made the debt crisis much worse than originally anticipated.

I already mentioned that Hall saw the folly of the Fed’s interest on reserves policy, which is not surprising as his 1983 paper implies they should now be paying a negative interest rate on reserves.  I was very pleased to see that Earl Thompson also singled out the interest on reserves mistake, as well as several others made by the Fed.  I do not agree with all of the specifics in the Thompson piece I linked to, but at least he is one of the few economists who seems to understand the nature of the problem.

For those who have argued over the years that the Fed could do just as well as the market, consider the following question:  What would have happened if the Fed had set up a 12-month NGDP futures targeting regime in September 2008?  Assume the market set the monetary base at a level expected to produce 5% nominal GDP growth.  How bad would the crisis have been?  I don’t expect the Fed to suddenly adopt such a policy in the midst of a crisis, but if it is the optimal policy regime I do expect the Fed to try to target internal NGDP growth forecasts in a roughly analogous fashion.  What is the alternative?  Setting a policy stance expected to produce failure?

Within a few decades there will almost certainly be prediction markets in the CPI, NGDP and all sorts of other key variables.  Then the Fed will have nowhere to hide.  The public will no longer stand for bland assurances that (despite market pessimism) policy is on course to produce target growth.  Like the moment at the end of The Wizard of Oz when the curtain is pulled back on the wizard, the mystique of the Fed’s superior forecasting prowess will be exposed as a myth.  When that happens, a future Keynes will look back on people like Thompson and Hall as unjustly ignored innovators, just as Keynes rediscovered some earlier monetary cranks in his General Theory:

It is convenient at this point to mention the strange unduly neglected prophet Silvio Gesell (1862-1930), whose work contains flashes of deep insight . . .  As is often the case with imperfectly analyzed intuitions, their significance only became apparent after I had reached my own conclusions in my own way.  Meanwhile, like other academic economists, I treated his profoundly original strivings as being no better than those of a crank.  (p. 353)

By the way, in an earlier post I mentioned how Greg Mankiw had recently discussed a clever idea from a Harvard grad student for escaping the liquidity trap—it was essentially the same idea as Silvio Gesell had proposed.

Part 3:  Why me?

OK, here is where I get really self-indulgent and ask why I am just about the only one who believes the Fed caused the crisis.  I want to assure you that I have not become a complete monetary crank.  I do know about how humans tend to be overconfident in their beliefs, and that (looking at the situation objectively) the odds are very strongly against me having any great insight.  But even so, we can’t go through life without at least a bit of self-delusion, so bear with me as I consider why I might have stumbled upon an important hypothesis that had somehow eluded even greater minds.  At least you will be happy to learn that I mostly attribute it to luck, being in the right place at the right time.

Let’s consider three levels of enlightenment:

Level 1:  The pragmatist.  (Often people out in the real world, like bankers, who look at things from the perspective of credit markets.)  For them, the cause of the crisis is very simple.  Banks are not lending and that is reducing nominal GDP.  But do Zimbabwe’s credit markets work well?  Is its nominal GDP falling?

Level 2:  Traditional Keynesians and monetarists.  The Fed cut rates to near zero, and dramatically raised the monetary base, so policy is obviously expansionary.  How can tight money have caused the fall in NGDP?

Level 3:  Sophisticated Keynesians and monetarists.  If you followed my blog at all you must know that I am thinking about someone like Krugman here.  A relatively sophisticated monetarist analysis is the linked editorial by Robert Lucas.  He basically takes the “let’s wait and see how Bernanke’s policy works out” attitude that I criticized elsewhere.

I am saying that even the level three economists have it wrong.  How can I possible out-analyze two Nobel prize winners?  It’s not as hard as you’d think.  Even extremely smart people make small errors all the time.  The world is complex and people can’t possible understand everything.  To use a scientific analogy, even a mediocre scientist can understand Newton’s Laws, but it took a genius to discover those laws.  When you apply those laws to particular situations, however, even the discoverer may have difficulty, and slip up on a tiny technical detail that the mediocre scientist notices.

I would never be able to do the sort of technical academic research that Krugman and Lucas do, but I do occasionally notice factual mistakes they make, which affects their analysis.  So let me reiterate what I think these two got wrong, and then explain why I was well-placed to notice those errors.

1.  Krugman erred in assuming that the U.S. was stuck in an expectations trap.  He assumed that the Fed was trying to generate faster nominal growth, but was unable to because the policies lacked credibility in the eyes of the markets.  He specifically pointed to the huge increase in the monetary base.  Here are some reasons why I think Krugman got it wrong, each of which are linked to my own research interests:

a.   He cited previous examples of expectations traps in the U.S. (1932) and in Japan (late 1990s and early 2000s).  I have studied both cases and published papers on both episodes.  Neither case was what Krugman assumed.  In 1932 the Fed was constrained by the gold standard.  As soon as they left it they had no trouble generating inflation.  The Japanese central bank did not try to generate modest inflation and fail, they never tried.  They have successfully targeted a deflation rate of roughly 1% per year on average ever since 1994.  When price stability threatens, they tighten policy to maintain deflation.  Krugman’s second error was to view the huge increase in the U.S. monetary base last fall as an expansionary policy that failed.  It did fail (he is more correct than Lucas on this point), but it failed because the Fed sterilized it with a policy of interest on reserves.  Many of the people who have spoken out against this policy (Thompson, Hall, Woolsey, Nick Rowe, myself) have done research on monetary policy from a supply and demand for base money perspective, rather than the traditional interest rate perspective.  That made us more sensitive to this problem.  In addition, I studied the contractionary reserve requirement increases of 1936-37, which also made me sensitive to this error.

2.  Lucas was right that monetary policy is effective in zero interest rate conditions, and that quantitative easing can work.  He also understood that velocity can fall sharply in a financial crisis.  But he erred in assuming that the current Fed policy was sufficiently expansionary.  Like most economists, Lucas takes a backward-looking approach to monetary policy, putting far too much weight on the mysterious “policy lags.”  Once again, there are no lags between monetary policy shocks and market expectations of inflation and real growth.  And those market expectations were signaling loud and clear that the current level of monetary stimulus (when the article was written in December, and even today) is woefully inadequate.  Because people like Aaron Jackson, Bill Woolsey, Earl Thompson and myself, have done a lot of research on forward-looking monetary policies utilizing market expectations, we were especially sensitive to this issue.

So to conclude, even in the unlikely event that I am correct in my key hypothesis, I don’t claim that it shows me to be a superior economist; rather, it was more a question of being in the right place at the right time.  Some people wonder why I cling to such a far-fetched theory, the idea that tight money, not financial panic, caused the severe downturn 6 months ago.  Given what I know (or think I know) about monetary policy effectiveness in liquidity traps, and given what I know (or think I know) about the need for a forward-looking monetary policy that targets the forecast, how could I have reached any other conclusion?  Tell me which research papers that I published in the past 20 years are wrong, and I’ll gladly change my mind.  But for now my hypothesis, counterintuitive as it is, is simply the logical implication of that body of research.



63 Responses to “The history of an idea”

  1. Gravatar of travis travis
    26. March 2009 at 12:23

    What specific evidence would you point to that supports your hypothesis over the hypothesis that the banking crisis caused the downturn? The evidence that you have mentioned — collapsing stock prices — supports both hypotheses.

    The equity markets are currently acting as if the monetary policy is finally correct. An interesting consequence of your forward looking monetary policy is that given this situation, equity markets should rapidly recover to their September 2008 levels. Here’s hoping!

  2. Gravatar of Thofinn Thofinn
    26. March 2009 at 14:08

    This financial crisis looks, in many ways, like the various crises we have seen over the decades such as Japan in the 80s, the Asian Crisis in the 90s, Sweden in the 90s, Depression in the 30s, etc. Do you think each one of these could have been significantly improved by better monetary policy? The idea that banks became insolvent due to asset prices returning to earth, causing the crisis, seems a more parsimonious explanation. These countries all adopted wildly different monetary policies, but a common path to eventual recovery seems to have been a coherent banking solution.

  3. Gravatar of Jeremy Goodridge Jeremy Goodridge
    26. March 2009 at 14:19

    The graph below might be of use to you. It shows Fed funds rates, inflation-adjusted treasury interest rates (5 yr) and regular treasuries (5 yr). It shows that the market was signaling deflation expectations for nearly a month before the fed funds rate was dropped to near 0.

    See graph here:

    TIPS versus Nominal Treasuries Graph

    Here’s a detailed graph around the critical time when inflation expectations started to turn to deflation expectations:

    Zoomed in Graph

    On the issue of whether the banking crisis caused the depression or the aggregate demand contraction caused it, it’s a little bit of semantics. Maybe the banking crisis caused the aggregate demand contraction which in turn caused the depression. Yes, the Fed could have done more (and can still do more) to break the aggregate demand contraction, but it may have been the gradual depletion of housing value and debt overhang that finally broke the back of the consumer and triggered things. And I think that’s part of what’s so difficult for people to understand. While the trigger may have been the housing crisis, that does not at all mean that ‘fixing’ the mortgage or housing markets is the solution. The simpler solution is getting people money now that so that they can build of their savings faster and start to spend.

  4. Gravatar of JimP JimP
    26. March 2009 at 15:36


    Unfortunately – money is still too tight. We are still being suffocated by the deflationists.

    To quote from that article by Thompson:

    “President Obama should immediately call, just as President Bush should have called, Chairman Bernanke into his office to request his immediate resignation on the grounds that he significantly failed to do his job. No FOMC should ever allow commodity prices to plummet over 75 percent for half-a-year (see this) without resisting it with a significantly above-trend jump in an appropriate money supply. As an alternative Federal Reserve Chairman, I’d propose Dr. Jeffrey Lacker, the only FOMC member voting at their February meeting for an immediate FOMC purchase of government bonds. A responsive summer 2008 monetary policy would have prevented the wave of financial failures and resulting lock-up of our financial system as well as our current recession and associated foreclosure, bankruptcy, and bail-out nightmares.”

    Absolutely. Bernanke is giving us a depression – for no reason at all. Fire him.

  5. Gravatar of Bill Stepp Bill Stepp
    26. March 2009 at 16:26

    You are not the only one who thinks the Fed caused the downturn. I do too, and so do most of my fellow Austrians.
    The ECB had a hand in it too, as did the the BoE.

  6. Gravatar of The Ambrosini Critique » Blog Archive » Current History The Ambrosini Critique » Blog Archive » Current History
    26. March 2009 at 16:48

    […] long Sumner post is well worth it. My favorite part is all of it but bloggy customs require an excerpt: The […]

  7. Gravatar of ssumner ssumner
    26. March 2009 at 16:56

    I’m going to take Jeremy’s reply first, as it will help me answer travis (who raised a very good question that is not easy to answer.)
    Jeremy, Thanks for the very helpful graph and I also think your explanation is right on the mark. Since this issue is so important, allow me a long-winded analogy. A ship is steering out of a harbor between two rocky headlands–aiming for open ocean. The headlands on the left we’ll call falling NGDP, and on the right “high inflation.” The center channel is 5% NGDP growth. Now strong wind pushes the ship toward the left rocks. We’ll call this strong wind “banking crisis.” The ship hits the rocks. Who do we blame, the wind or the captain? Now let’s consider the captain’s situation. How much time did the captain have to respond to the strong wind? How much oomph did the engine give him, how sharply can the rudder turn? The ability to overcome the wind is like the power of monetary policy to affect NGDP. If Krugman is right, the engine or steering is broken. I say that monetary policy was still effective, for all the reasons you have heard me discuss earlier. Now let’s say I am right. Then the next question is whether the Fed was given sufficient warning. Jeremey’s data shows deflation risks soaring in late September and early October. The only thing the Fed did between it’s September 16 meeting (when it did nothing), and the belated 1/2 point cut on October 8th was the interest on reserves program, and that was CONTRACTIONARY. I say that they absolutely should have had their pedal to the medal by that time—with the target rate at 0%, not 2%, in early October. It was clear they were much more likely to hit the deflation rocks than the inflation rocks, and you should always set the steering for mid-channel–if you have enough engine power. Yes, I get why people instinctively feel the wind (banking crisis) caused the problem. There is a sense in which that is true. But if the captain did have enough engine power, and plenty of warning, but was drunk, don’t you think people would also be blaming the captain? That is my point. And Jeremy’s graph shows they did have enough warning. So then it comes down to whether you believe me (and financial markets who react strongly to Fed moves even in liquidity traps) or you believe Krugman, about the power of monetary policy to boost NGDP growth at low rates. And that’s a theoretical argument, which is difficult to resolve pointing to a single number. I can mention other examples of effective monetary policy in a depression, like FDR in 1933, but not everyone buys those arguments. And I can say the market reacted to QE as if it could boost the economy, but not everyone believes the EMH.

    One other point. In this whole analogy I was bending over backward to reflect my opponents’ point of view. I assumed the captain did nothing to cause the wind (here’s where my analogy would get silly.) But Jeremy’s graph also provides a bit of evidence for an even stronger assertion than my “errors of omission” argument. Inflation expectations were falling significant even before Lehman. Real interest rates were rising even before Lehman. Let’s not forget that the world economy probably peaked around mid-year, with commodity prices. But lots of indicators fell well before Lehman. The sharp fall in industrial production in August (the first big fall in the recession) occurred well before Lehman. So I might have an even stronger argument than “errors of omission.” The Fed may have actually helped trigger the banking crisis of September. And I am almost certain that the deflation in the last three months further worsened the crisis. So on that point the only issue is whether the Fed could have slowed or stopped the deflation.

    Thofinn, I hope my Depression book will show the Great Depression was 100% monetary failure. The banking crisis (which only began at the end of 1930, was caused by the tight money policy of late 1929, which triggered the Depression–that’s easy to show. Japan is some of each. Their deflation absolutely could have been ended with easier money. But Japan also has structural problems which probably would have led to slow growth, even if they had had 2% inflation. And the banking crisis was like a real (productivity) shock, which hurt the efficiency of the economy somewhat. So some of each. East Asia was mostly banking crisis. I recall that in HK and China tight money led to significant deflation (because of their dollar peg.) But I think in SE Asia it was mostly problems from the capital outflow–no monetary solution there. I don’t know Sweden, but in general look at the NGDP growth rate in developed economies. If it was normal in Sweden then any unemployment problems are 100% due to banking crisis. If NGDP grwoth falls sharply, then some of the unemployment is due to overly tight monetary policy which leads to high unemployment–because the equilibrium nominal wage must then fall, and nominal wages are downward sticky.

    JimP, I don’t feel I know enough about whether Bernanke is pushing for more, or whether this is his policy. All I can say is that it will be interesting to read his memoirs. My hunch is that I won’t be completely satisfied with his explanation for all of these “errors of omission.”

    Postscript to the long reply: I went down to Harvard in the fall and talked to three big names (with different ideologies.) They felt there was little question that we were more likely to hit the falling NGDP rocks. I thought I’d have to prove that to them. I was a bit shocked when I didn’t. Then the discussion focused almost exclusively on what to do about it. So I think Jeremy is on very strong ground in his interpretation of the graph.

  8. Gravatar of ssumner ssumner
    26. March 2009 at 16:58

    Bill, Thanks for the reply. I was writing my long reply when you posted it. I plan to look more closely at Austrian economics this summer.

  9. Gravatar of Nick Rowe Nick Rowe
    26. March 2009 at 17:39

    Scott: here’s the direct link to Earl Thompson’s paper:

    (To copy and paste links like that, you right-click the mouse, a menu appears, then click on “copy link location”. I only figured this out recently myself!)

    Whether or not people will agree with your view that monetary policy *caused* the problem (as opposed to *could have prevented it*) will depend on how they define “monetary policy” — as you say, as setting interest rates, setting the quantity of money, or setting a forecast. What does “holding monetary policy constant” mean, would be another way of putting it.

  10. Gravatar of ssumner ssumner
    26. March 2009 at 18:07

    Dear Nick, Thanks. Ironically, I said I was computer-phobic, and then proceeded to show how I don’t know how to attach a link. Do you know anything about the mysterious Mr. Thompson? I may send both he and Bob Hall this post tomorrow–I have to think they would like it as they both complain that nobody appreciates their work.

    You are right about the problem I face in getting people to think about monetary policy in a different way. In a sense people could say I am asking a lot. But in another sense all I’m saying is that we expect “Captain Bernanke” to do more than hold the steering wheel absolutely rigid, regardless of wind and waves. (This metaphor refers to my earlier reply.) So it’s all how you look at it.

    In general I’m not that much of a back street driver–in the previous 25 years I never had a strong feeling that policy was way off course, at most I had a hunch. So I think last October had a dramatic impact on me–I would have started this blog back then if I had thought I’d be capable of doing it. I didn’t know it was so easy.

  11. Gravatar of ssumner ssumner
    26. March 2009 at 18:27

    Ambrosini, One problem with being overwhelmed with work on the blog, and my classes, is that I haven’t had the time to look closely at other blogs. My readers might want to click on your blog (above) as you have an amusing take on my hypothesis–it’s all Krugman’s fault. I don’t know if you are half joking or half serious, but either way it’s pretty clever. A lot of people on the left look to Krugman for insight into difficult theoretical issues. And Krugman is an expert on liquidity traps. What if Krugman had said “The Fed has much more credibility to achieve 3% inflation than the BOJ. Set an explicit inflation target and do QE until you hit it. Otherwise the economy won’t be strong enough to fund Obama’s ambitious social programs.” Would the left have picked up this theme? If so, and given most right wing economists never really doubted that a fiat money regime was capable of debasing its currency, would the economics profession have been almost unanimous that QE would work? When economists are unanimous, the media has to take that view as official, so they would of started asking the Fed hard questions on monetary policy, instead of giving them a complete pass. The Fed would have had to do something if middle America was told that tight money was causing the crash. Oh for the days of leftists like William Jennings Bryan, who knew that the cure for deflation was easy money!

  12. Gravatar of Jeremy Goodridge Jeremy Goodridge
    26. March 2009 at 18:56


    Thanks so much for the lengthy reply.

    I think Krugman is more pessimistic than you about the capabilities of monetary policy, but, on the other hand, he hasn’t given up hope. He made clear his support for Bernanke’s recent move and probably would support more moves by him. In addition, he has been quite critical of the ECB for being too tight. If he really had given up hope all together, he wouldn’t even care what Bernanke or the ECB did. His views are a little confusing because he defines a liquidity trap in a narrow way — it’s when the Fed can no longer rely exclusively on ‘conventional’ monetary policy — i.e. the Fed can’t simply buy short-term Treasuries as its only policy tool to stimulate AD. But that’s not a very useful definition theoretically. And it makes it seem as if monetary policy IN PRINCIPLE has run out of steam. But that’s a much stronger claim, if one defines monetary policy simply as ‘printing money’ (increasing the ‘M’ in MV=PQ). So, I think it has led to some people misunderstanding him. Another confusing thing that you have pointed out is that he defines monetary policy as a temporary infusion of money. But that’s also based on the limitations of current, operating monetary policy. If monetary policy were instead about driving a constant rate of PQ growth, money would just be printed as needed, and would only cease when v picked up thus making monetary policy effective. Strangely (and I haven’t totally thought this through), it feels like a liquidity trap (in the broader sense of monetary policy being ineffective) could only occur if people stopped using the currency being printed. And that could only happen if the monetary authority had NO limitations (i.e. printed money beyond the fixed PQ growth target). In this case, the money would truly become worthless.

  13. Gravatar of Jeremy Goodridge Jeremy Goodridge
    26. March 2009 at 19:24


    I redid my graph — I used the ‘constant maturity’ TIPS graph rather than the 2010 — more comparable to the regular treasuries. It shows a similar pattern.

    Updated Graph

  14. Gravatar of Thruth Thruth
    27. March 2009 at 09:07

    Hi Scott,

    I like the fresh perspective your blog offers. This post is your best (and clearest) yet.

    Coming from more of a micro foundations background, I have some trouble connecting the various positions of other schools of thought. As I see it there are two fundamental problems driving the current crisis:

    1/ A long string of mal-investments dating as far back as the mid 90s, as evidenced by the bursting of two enormous bubbles, has resulted in the recognition of considerable wealth destruction. One would expect rational actors to start saving to accumulate new wealth and those savings would be directed to new productive activity. However,
    2/ The realization of the extent of those mal-investments has generated severe levels of risk-aversion and uncertainty about the state of the economy and the solvency of couterparties. That shows up as distrust of counterparties, retreat from all forms of risky activity and increased precautionary saving in safe assets. That means savings aren’t connecting with productive investments, exacerbating the wealth destruction effects of 1, possibly many times over.

    Most modern macro economists will describe the current crisis by combining 1 and 2 in different degrees.

    The Minesota crowd probably focus on 1 a lot more than 2 (viewing the past burst bubbles as revealed productivity shocks :)). It’s hard to build rational models where 2 has a big impact (financial accelerator models come to mind)

    My impression is that Austrian’s also focus on 1 almost exclusively then proceed to pound the pulpit on the untrustworthy Fed, the need for a gold standard yada yada

    Keynesians and Monetarists focus on 2 and treat it as a correctable demand shock. Clearly no amount of monetary or fiscal policy shenanigans can fix the direct fallout I described in point 1 (unless we consider finding a new bubble a fix).

    I have thought little about fiscal policy other than that under my description it seems clear that it will only help if at a minimum it (a) doesn’t crowd out other spending; or (b) actually finds its way to productive investment.

    On monetary policy, I suppose the forced deleveraging of the banks as trillions of dollars of subprime securitizations lost their funding source could be interpreted as a shock to the money supply. The fed actions to date have only shored up a fraction of the missing credit flow, so I can clearly see scope for more. My one concern is that some of the fed’s extraordinary interventions involve taking credit risk, which is more likely to involve picking winners and losers than a more neutral expansion of the money base. The other risk is that we simply find another bubble to reinflate in our haste to rebuild the lost wealth.

    How does this line up with your own thinking?

  15. Gravatar of Alex Alex
    27. March 2009 at 09:22


    Actually the first graph might be the correct one to use. In general it is true that you should use the constant maturity yield but apparently there was a change on how it is computed on 12/01/2008. See this post by Mankiw

    Scott do you have any idea if Mankiw is right on this one?


  16. Gravatar of Clayton Clayton
    27. March 2009 at 10:43

    Are you advocating the labor peg or just pointing to someone who suggests a futures-based approach?

    I’m having trouble processing the implication of a labor-peg in a high productivity environment. If productivity was increasing at 5% per year and the nominal risk free interest rate was 2%, certain investments would require a negative nominal interest rate.

    I don’t think this is inconsistent with the phenomenon that usually balance the return on investments. Specifically, if you have a commodity (basket) peg, it’s easy to carry a commodity forward in time — you produce and store it. This is how a commodity like oil can never have an expected return above its risk adjusted interest rate. People increase prices (to store it) today and sell it tomorrow when fundamentals demand the higher prices.

    Labor doesn’t behave in this way. You cannot “store” labor in the same way. You must use the labor today at today’s productivity (low value). Tomorrow, you get another round of labor at tomorrow’s productivity (high value).

    I believe this could turn the labor-index into a floor on interest rates with disasterous consequences. It’d be like locking expectations in a 5% deflationary environment (who wouldn’t hold cash).

    The redeemability issue is also suspect because the Fed could (and I believe would) be nearly instantly forced into insolvency. Since the assets in reserve, “gold or any noncurrency redemption asset” are storable, they could never appreciate at a faster rate than their risk adjusted interst rate. If the value of labor (via productivity) increased faster than the asset, the Fed would lose its ability to fully redeem the currency.

    Of course, the same could be true without the labor-specific productivity issues. If the currency is not redeemable *exclusively* in its peg, there’s the possibility that market forces drive the value of the peg higher than the redemption unit. A hard gold standard is free from this possibility because gold-backed certificates are redeemed in a fix ratio to the asset (gold) reserve.

    Am I missing something? Alternatively is your proposal still valid using a commodity (basket) peg?

  17. Gravatar of Thruth Thruth
    27. March 2009 at 11:00

    could you imagine the populist uproar over hedge funds shorting labor futures?

  18. Gravatar of saintsimon saintsimon
    27. March 2009 at 12:23

    as a civilian I’m not going to pretend to argue for or against your theory – it’s fascinating to read but I’m not sure how much of it I really understand. One question though: if you’re right, how would being right relate to all the things that are now perceived to be wrong with Wall Street? I mean, if you’re right and we could go back in time and do what you suggest, we’d I guess then be in the midst of a somewhat mild recession – but all the problems, all the flaws that have been laid bare in our financial institutions would still be there: they’d still be dangerously over leveraged, bizarre instruments would still be trundling along generating absurd profits for mysterious men, everyone would still be of the belief that America is the most remarkable economic engine ever conceived of etc etc – in short, we’d still be walking on thin ice but apparently saved from ever falling through by your theories? Logic dictates that things invariably fail – are you implying that your theories suggest that’s not true?

  19. Gravatar of ssumner ssumner
    27. March 2009 at 16:46

    Jeremy, You are right that some people misunderstand Krugman. But it’s not totally their fault. He makes some statements that I don’t think represent how nuanced his actual thinking is. I recall one sort of “Liquidity trap, End of story. Period.” type statement from him. But as you say, his expectations trap theory does allow for monetary policy to have an effect. I think if pushed, he would admit that a really aggressive monetary policy push, willing to take risks with unconventional OMOs, would almost certainly get the job done. But that’s just my hunch, and when I read him I sometimes don’t get the feeling that he is saying everything he really believes about the issue. He strongly favors fiscal expansion, partly because he thinks America needs a lot more federal spending in certain areas. So I think that subtly influences his statements about how effective monetary policy is likely to be.

    Jeremy#2, Thanks for the graph. That is the 5 year rate, so the swings are less dramatic than with your first graph showing one or two year yields. Is that right? Also see my response to Alex below.

    Thruth, I know this will seem counterintuitive to a micro-type, but you can’t look at monetary issues in the normal way. I believe about 1 trillion of the wealth destruction was from these bad (subprime) real estate investments. We knew that last June, when the stock market was only modestly below its all-time high. Since then we have had many more trillions in wealth destruction (even in Asian countries that had no banking bubble), in my view because investment that would have been sound with normal 5% nominal GDP growth became very unsound with sharply falling NGDP. So I think much of that loss was due to bad monetary policy. And some of it (not all) could be recouped with a vigorous expansion. In micro analysis we you take the macro environment as a given. Not in macro. Other than that, your analysis is good (i.e for things like the excess housing stock from the bad subprime loans.)
    BTW, this comment about monetary policy applies to both points one and two–both were made much worse by Fed policy. One analogy would be the 1929 bubble. Buildings like the Empire State Building and Chrysler building, which might have been very sound investments with good monetary policy, suddenly looked like “mistakes” in the completely unanticipated Great Depression.

    I wouldn’t worry about more bubbles now. We need to get the right policy. Even with perfect 5% steady NGDP growth there will be some bubbles, but they will do far less damage to the broader economy, than what we have seen recently.

    Alex, Mankiw is right. The almost vertical drop around early December was due to the switch to a different type of bond. It should actually be a more gradual decline in the real interest rate into 2009. Now it may be fairly accurate, as we have positive 5-year inflation expectations again.

    Clayton, You make a good point. I don’t know all the intricacies of his proposal, but let me say two things:

    1. The zero interest rate problem can be addressed by a 4% nominal wage increase rule (which is roughly comparable to a 5% NGDP rule.

    2. Any other issues you mention could be addressed by making it like my NGDP futures targeting proposal, but replacing the NGDP contracts with nominal wage contracts (rising at 4% a year.)

    Thruth, I agree that a wage rule is politically infeasible–that’s one reason I went with the NGDP rule, despite the beauty of Thompson’s idea.

    saintsimon, A lot of my views are counterintuitive, and here’s one. Let’s go back to the Great Depression. At the time everyone thought it had uncovered all sorts of Wall Street shenanigans. Like lifting up rocks and seeing worms underneath. Now we know that the initial Depression was 100% caused by bad monetary policy, and that “reforms” like the SEC, actually have done little or no good. Now a lot of people might be asking me about the bad old days before regulations. I can tell you that the American banking system circa 2007 was far worse than anything in our financial system pre-Depression (say back to the Civil War.) The bankers of that era would be totally shocked by the reckless risks our banks took in our (comparatively) highly regulated environment. Far worse than the risks taken in the pre-regulation era. Everyone seems to have blind faith in regulation. I remember after the S&L fiasco we were told regulation was needed to prevent a repeat. Well we didn’t get a repeat, we got far worse. And then we were told Sarbannes-Oxley was needed to prevent another Enron. And we got Madoff. I am actually not anti-regulation, we should probably encourage banks to take less risks through regulation. But I am beginning to lose hope that it will ever work.
    Sorry for the tirade. I am just as angry as you about the corruption. I am reacting to the theme that often underlies this analysis–which is that this is what laissez-faire produces. No, our “laissez-faire” 1920s banking system was far more responsibly managed.

  20. Gravatar of JimP JimP
    27. March 2009 at 17:37

    At last!

    A bit of criticism for Bernanke – for his timidity. And a sharp demand that he either change or be replaced. And from Forbes Magazine. Hope it spreads.

  21. Gravatar of saintsimon saintsimon
    28. March 2009 at 04:50

    oh, I’m not angry at the corruption and certainly feel no urge to embrace a naive socialism – I’ve been in business long enough to know that given a chance people will screw up, and that that chance always comes around. Much of what you say seems, from my untutored perspective, to make sense – but inherent in your theories is the paradox that they only become applicable once the damage is done and that, given the history of such things, they will fail to adequately predict the next crisis – which may just be a way of espousing creative destruction – still, the species does seem to be more adept and its true worth best expressed in responding to a crisis rather than predicting or stopping it altogether.

  22. Gravatar of Alex Alex
    28. March 2009 at 04:57


    Thanks for the reply. I didn’t reply to your post before because I had too much work. I’m not an expert in the type of monetary rules you are thinking of, and even though I do have a lot of education in economics I’m sad to admit that my knowledge on monetary economics comes mostly from what I lived as a kid and teenager in Argentina. Still I think you are being unfair with your judgement on Bernanke, after all

    * He increased the monetary base by 90% and no monetary aggregate fell.
    * Kept the banking system running with no fears of bank runs.
    * The economy did not collapse.

    This was done while:
    * The country had given all hope on monetary policy
    * Krugman, with his shinny new Nobel Prize, was claiming that there is no way out of a liquidity trap other than spend spend spend.
    * Congress was debating the fiscal stimulus plan.
    * 99% of academics are debating about the size of the multiplier effect (WTF?!).

    Did he do too little? He did more than anybody in the US has ever done, he was walking blindfolded, at night in unchartted territory. It is no surprise to me that a responsible economist would err on the side of doing to little. The last thing we want to do is have the 30’s plus the 70’s or Argentina in _____ (pick your favorite decade). Did he do it too late? Maybe, still he said from the very begining that the Fed was ready to purchase longer term securities if needed. My last point is that we have to judge him as a politician too, not as an economist. Can you think of any other economist who would have done a better job? You mentioned this guy Thompson who took his brillant idea to the Fed but they didn’t listened to him, well that person failed as a politician, if you can get people to buy your policy prescription no matter how good it is then you have failed. Bernanke succeeded in this sense, he did his thing in a conservative way (too conservative in your opinion) but in the end he even got Krugman to become a believer. Look at the big picture. Great Depression 25% UR, The second Great Depression UR 11%-12%(?). I think this is a great success. You think that the UR should have been 8%. I say lets wait another 80 years to find out.

  23. Gravatar of Bill Woolsey Bill Woolsey
    28. March 2009 at 05:59

    I was a teenage “Austrian.” Go the the Mises Institute or read comments of the many fans of
    Ron Paul in blog comments and you can see where I was coming
    from in the early seventies.

    While the story about inflation and malinvestment is an important aspect of Austrian “macroeconomics,” another element is that the purchasing power of money depends on the quanitity of money and the demand to hold that quantity of money. Any imbalance between the quantity of money and the demand to hold the quantity of money can, will, or should be corrected by an appropriate change in the purchasing power of money. On this view, Keynesian concerns about an imbalance between saving and investment and the impact on the nominal flow of spending in the economy involve failing to see that the real problem is an imbalance between the quantity of money and the demand to hold money, and that the solution is always an appropriate change in the price level, including nominal incomes like wages. With a properly adjusted purchasing power of money, the real flow of expeditures are always adequate to maintain full employment of resources.

    I woke from my dogmatic slumbers in about 1977. My undergraduate Money and Banking professor was David Friedman (yes, Milton’s son.) In truth, I mostly remember him exploding the rather arcane fallacy that fractional reserve banking is fraud. However, I also vaguely recollect him explaining that if bank supplied money is meeting an increased demand to hold money that this isn’t inflationary. And also, that I needed to be a bit clearer about the “can, will, or should” business regarding changes in the price level that will clear up an imbalance between the supply and demand to hold money.

    Much later, in 1982, I read an essay by David Friedman, Gold, Paper, or is there a better Money.

    I became an advocate of free banking combined with a commodity-bundle definition of the dollar. Reviewing that essay today, I think most of it is there. With a gold standard, the price level depends on the supply and demand for gold. And with a fiat standard, it is the supply and demand for the fiat currency. And, a stable price level is pretty much the goal. The quantity of money should adjust to accomodate changes in the demand to hold money at a constant purchasing power of money. (My own “contribution” was how commodity reserves could be reduced to zero using indirect convertibility.)

    Also, in 1982, Leland Yeager and Robert Greenfield published a paper called A Laissez-Faire Approach to Monetary Stability. This was inspired by papers by Fischer Black, Eugene Fama, and Robert Hall. They decribed it as the BFH payments system. A bundle of commodities defines the unit of account, and the media of exchange are money market mutual funds. (Indirect convertibility was included in their proposal)

    I wrote a dissertation on the subject with Yeager serving on my committee. Naturally, I became very aware of Yeager’s contributions to monetary theory, collected in The Fluttering Veil, Essays in Monetary Equilibrium. It was really through Yeager that I was introduced to Leijonhufvud. It was through him that I became more appreciative of a Wicksellian approach–that an imbalance between the quantity of money and the demand to hold money is closely related to a deviation between the market and natural interest rates. The sorts of “pure” inside money systems like the GY system I was studying clarify the matter. All “money” is related to bank lending. There is no base money that might drop from a heliocopter or be dug up from mines.

    During the early eighties, Larry White, then George Selgin, and then Steve Horwitz remained well within the Austrian tradition, but broke away from the fractional reserve banking is fraud notion. Further, that if the quantity of bank supplied money accomodates an increase in the demand to hold money, it isn’t destablizing. Also, the “free banking” Austrians became very insistent that stable nominal income is the proper goal.

    So, while there is nothing inconsistent about focusing on the market and natural interest rates, the unit of account is defined in terms of base money, and the supply and demand for base money is what provides the nominal anchor to the system. Nominal expenditures necessarily depend on the supply and demand for base money. But, as long as that is kept in mind, the reality that central banks operate as banks, makes market vs. natural rate thinking reasonable in undertanding the market process by which the price level remains anchored or changes in response to disequilibrium. Balancing the supply and demand for base money through changes in the price level is horribly disruptive. A stable growth path for nominal income is probably better in the face of productivity shocks than a stable price level.

    Sumner’s proposals in the mid-eighties regarding redeemability of base money with futures contracts on nominal income were naturally related to the issues with indirect convertibility that concerned me at the time. I was interested in combining index futures convertibility with free banking.

    When what I believe were (and are) solvency issues in the shadow banking and commercial banking system became obvious, because of lots of lending into a speculative bubble in real estate, there were many bailouts of politically powerful financial institutions. Claims were made that this was necessary to avoid another Great Depression. No. While there may well be a productivity shock due to a need to move resources out of housing production and difficulties in real intermediation, as long as the quantity of base money adjusts to accomodate the demand to hold base money, nominal expenditure can be maintained. Nothing like the Great Depression needs to happen.

    But the Federal Funds rate is nearly zero. What more can they do? As I heard that repeated over and over, I began to see that not everyone sees things as I do. Talk about quantitative easing by Fed officials made me feel a bit better, but then, this continued to be associated with targetting lending so as to revive loan securitization. Interest on reserves? Federal Reserve bonds? What are they doing?

    In my view, Yeager’s 1956 essay, “A Cash Balance Interpretation of Depression” and his 1986, “Money and Credit Confused,” should be required reading. And maybe the 1968 paper, “The Essential Qualities for the Medium of Exchange” would be helpful.

    As Scott mentioned, surely everyone understands that interest rate operating targets break down in the face of deflation. While I suppose rebuilding the house of cards that was the shadow banking system could correct monetary disequiligrium by lowering the demand for base money, it seems like a rather indirect approach.

    I must admit that this crisis has had an impact on my thinking. I believe that after Lehman Brothers there was a large increase in the demand to hold safe assets. Reserve balances at the Fed are one such asset. FDIC insured deposits are as well, and some of them create a derived demand for base money. As Yeager explains in the first paper cited above, an increase in the demand for bonds can easily be shunted over into a demand for money. And so, the loss of confidence in the shadow banking system created monetary disequilibrium.

    Because there is a demand for T-bills as well as base money, OMO using T-bills are going to exacerbate the shortage of T-bills. The yield on T-bills can’t drop much more and it will just be shifted over to money. While I think the Fed should buy them, it seems likely that the Fed will have to buy other assets.

    And so, the Fed is creating the safe assets people want to hold and instead holding some riskier assets (particularly interest rate risk with long term Treasuries.) The alternative solution is to clear up the shortage for the safe assets with negative yields. The “problem” with this is that zero interest hand-to-hand currency can’t have a negative yield. And so, while having the Fed buy up long term and riskier assets is sensible, the alternative is to return to the pre-Great Depression approach of a suspenion of currency payments from banks, and negative nominal yields on deposits, T-bills, and reserve deposits at the Fed.

    Of course, everyone who studies “free banking” knows about currency suspensions. That is how the banking system survived runs on the system before the Federal Reserve existed. When the Fed failed to do its duty in the thirties, and the pre-Fed policy of suspension was not instituted, disaster ensued.

    Still, having the Fed just purchase Treasury Bonds and then private securities is probably more realistic than a currency suspension. But penalty rates on exess reserves would be a move in the right direction. If this results in lower, or even negative yields on short T-bills, and FDIC insured deposits–good. That is the idea. It will help clear up the monetary disequilibrium and reduce the need for the Fed to choose which risky assets to hold.

    But, the Fed’s key _job_ is to keep nominal expenditures on their growth path. If they want to help maintain real productivity by promoting efficient real intermediation trough clever interventions in credit markets–well, I am a skeptic. But to try to use that method to avoid monetary disequilibrium seems–like Money and Credit still confused.

  24. Gravatar of Thruth Thruth
    28. March 2009 at 06:35

    Allow me to challenge a couple of points:

    >I believe about 1 trillion of the wealth destruction was
    >from these bad (subprime) real estate investments.

    The wealth destruction tied to real estate is more than just the subprime loan losses. The Case-Shiller futures were indicating 25-30% price declines from at least the start of 2007 and we’ve now experienced a good chunk of that. I don’t think that can be pinned on expectations of Fed failure at that point — clearly such expectations weren’t built into stock prices at that time.

    A 25% percent decline in housing values suggests a wealth shock on the order of $5 trillion. A shock of that order should have fairly serious macro implications even without being compounded by the fear/confidence issues affecting the credit channel (Only a fraction of the shock is being borne directly by the banking sector, but clearly enough to exhaust their capital). How many consumption and investment decisions were made based on faith in that now missing $5 trillion?

    >I wouldn’t worry about more bubbles now. We need to get the
    >right policy. Even with perfect 5% steady NGDP growth there
    >will be some bubbles, but they will do far less damage to
    >the broader economy, than what we have seen recently.

    It’s not clear to me what type of monetary mechanism will address the debt overhang problem facing the banks. Will simply expanding the money base get credit flowing again? With sufficiently aggressive monetary policy we could inflate the overhang problem away, but it isn’t obvious to me that this would be free of nasty side effects.

  25. Gravatar of Clayton Clayton
    28. March 2009 at 08:34


    The “monetary base”, as Scott has pointed out before, is not a good proxy for the tightness of policy. The accounting for monetary base makes assumptions that are poor at best.

    Somewhere in here (or one of the links) somebody correctly pointed out that “cash outside banks” is a better proxy for the actual effect of monetary policy.

    Even then… if someone tucks money inside a mattress, growth in “cash outside banks” is likely to overstate the growth in the actual amount of money being spent. This means that, at least with Scotts NGDP goals in mind, you would need to pump even more money into the system.



    I’ve mentioned risk as one source of real (and non-monetary) contraction. Certainly the wealth effect is another. I’m not convinced that an NGDP path eliminates cycles completely. As I’ve mentioned on other threads, you could easily inflate 15% in a 10% real decline and hit your 5% NGDP target. Since the policy is extremely transparent, everyone will rationally expect the inflation and behave accordingly… preventing even the effect of unanticipated inflationary pressure.


    If the Fed used inflation pathing (as Scott has alternatively mentioned), you would substantially reduce the possible real effects of monetary policy.

    You can see why if you make the (artificially) naive assumption that people expect 2% inflation all the time. During bubles, the Fed lets actual inflation slip as high as 4% or 5%. Temporarily, this will have an artificial, positive 2-3% real effect.

    During contractions, the Fed lets inflation fall to 0% or even negative (deflation). If people expect 2% inflation, this has a negative 2-3% real effect.

    At minimum, an inflation pathing commitment would largely eliminate the temporary real effects of these sorts of expectation gaps.

    In the real world, the effect is smaller because expectations change… but a real effect still exists as expectations lag policy.


    The wealth effect… risk tolerances… and anything in real business cycle theory (like technology) would still have real effects… but you’d essentially eliminate monetary sources of cycles.

  26. Gravatar of Rob Rob
    28. March 2009 at 08:47

    As a layman/non-economist also, I’d like to join the chorus of appreciation for the post. It’s very informative and thought provoking, and, although I may not fully understand why, I buy it.

    I should probably stop right there, but I do want to weigh in on the subtext in the comments regarding Bernanke (JimP). Has Bernanke been criminally slow? Should Bernanke be replaced?

    First of all, as Scott pointed out in his “let Bernanke be Bernanke” post, policy decisions result from intricate political dynamics that cannot be fully understood almost by definition. We know that. To cross the line from criticizing the behavior of the Fed to calling for the skin of its chairman seems to me to over-reach. Through what process will a better alternative emerge? Maybe there is no such thing. Let’s be careful what we wish for.

    Secondly, Scott’s metaphor of the ship in a gale is terrific, but it also may be unrealistic in one small respect. Those of us who sail, metaphorically or otherwise, know that winds seldom come up at a constant speed from a single direction. There are cross-winds and gusts. Similarly, while I don’t fully comprehend the complexities, it strikes me that we may be underestimating the uncertainties that are revealed to the Fed as events unfold. I understand the point that the barometers may be wrong, but I’d be surprised to learn that any of them have been so unambiguous that they couldn’t create the kinds of speed bumps we have seen.

    Following from the comment of saintsimon, I also can’t resist saying that the ship metaphor reminds me of Polybius account of the Roman navy being wiped out at sea on their return from one of the Punic wars (Book 1, Chapter 38 of The Histories). Polybius tells how the Roman generals were warned against venturing into certain waters, but they ignored the warnings because they believed “it (was) incumbent on them to carry out their projects in spite of all, and that nothing is impossible when they have once decided on it.” Polybius then points out that “(the Romans) owe their success in many cases to this spirit…. but when they come to encounter the sea and the atmosphere and choose to fight them by force they meet with signal defeats.”

    So, perhaps the final warning that we latter Romans should hear is Polybius’ conclusion: “It was so on this occasion and on many others, and it will always continue to be so, until they correct this fault of daring and violence which makes them think they can sail and travel where they will at no matter what season.” How do we learn to avoid these storms to begin with? While “regulation” is a false answer, I’d still contend that this question is as important as “how do we steer clear of the rocks.”

  27. Gravatar of JimP JimP
    28. March 2009 at 12:26


    As to the issue of the intentions and responsibility of Bernanke;

    Remember what Scott said about the bank of Japan. Whatever they may think and say about what they do – they act as if they desire 1% per year deflation, and they have been doing that for many years – and it is reasonable to therefore conclude that that is what they do desire – whatever they may think or say, even to themselves.

    Bernanke is a student of the depression – yet he is consciously acting as if he believes inflation, not deflation, is the main risk – so that must be what he believes.

    I don’t doubt that he is sincere, and sincerely believes that inflation is the main risk. Earl Thompson in that article linked above explains why he thinks Bernanke believes this. He is a banker – a creditor – and he acts in the interest of creditors – who are harmed by inflation and helped by deflation. Roosevelt came in on the votes of debtors – and sympathized with them. Neither Bernanke nor Obama do. But they sure should.

    This populist revolt that is around now would make it impossible to rescue the banks using Congressional resources. Debtors will simply never allow it. They should pay higher taxes to rescue the banks? That just won’t happen. It is very similar to the wave of revolt against the bankers that put Roosevelt into office. Obama can either ride that wave, or get buried by it. And I think that is why Bernanke has changed – even if only a bit. He should take the next step and do just what Scott suggests – drop the explicitly deflationary policy of paying interest on reserves – and announce an explicit and higher price level target. And then target the level and hit it.

    Inflationary expectations are now entirely unanchored. People are hording both currency and gold, being entirely uncertain if the ourcome of this will be inflationary or deflatioary. It is Bernanke’s clear and direct responsibility to anchor them – with a clear statement.

    He knows this. He has said this many times. He is not doing it. He should do this, and soon, or be fired, and be replaced by someone who will.

    That is certainly what I think at least. We need Roosevelt – a figure committed to the interests of the debtors. But what we have is our own version of the ECB or the Japanese central bank. That is just not good.

  28. Gravatar of JimP JimP
    28. March 2009 at 12:47

    An addition –

    As I have said before – I think it is well possible that Bernanke is not doing this because he fears he lacks the political support necessary to do so. It would be odd for a central banker to explicitly aim at inflation – and maybe he hesitates because he fears it could get out of control and then he and the Fed would be blamed.

    He needs Obama to act like Roosevelt. Obama must support the policy – explain it and support it. Maybe it is not Bernanke so much who has the slows – maybe it is Obama. It sure does feel like it.

  29. Gravatar of Alex Alex
    28. March 2009 at 12:48

    Another point I want to make which a lot of people do not think is important. We view the problem as an increase in the money demand alone the solution to which is for the Fed to buy bonds and increase liquidity. But the problem is that money demand increase as well as the demand for all government debt in which case substituting one government asset for another does not help. So in that aspect the Fed alone cannot do anything and we need the treasury to contribute by issuing more debt.

  30. Gravatar of Jeremy Goodridge Jeremy Goodridge
    28. March 2009 at 13:43


    The debt overhang problem at banks is real, but it’s also easy to resolve: bankruptcy (or receivership, nationalization — they are all the same thing in the end). It’s the method that’s been used for years to resolve excessive debt. But the Federal Govt believes that bankruptcy will disrupt the credit markets too much. So, they have instead chosen to give money to the banks. That way may work too — depends on how much debt there is and how much of a subsidy banks get.

    In the end, WHATEVER the reasons, a nominal AD shock is still the cause of most major recessions (including this one), and the solution is print enough money to minimize the AD shock. The debt overhang issue gets in the way and so does paying interest on reserves and guaranteeing more deposits at the banks who are hoarding money. But it just means that much more money needs to be be printed to resolve the situation. It feels like a free-banking system COMBINED with a fiat money system managed to minimize AD shocks is the most stable. The free-banking system allows the greatest institutional flexibility, so that money gets out of risky institutions into less risky institutions fast. This minimizes the amount of money in the hands of the ‘hoarders’. And the focus on AD allows dramatic changes in velocity not to cause major nominal disruptions.

  31. Gravatar of Rob Rob
    28. March 2009 at 13:44


    Getting called out on an econ blog is a new experience for me, but I suppose I did throw the first stone, so I’ll offer a couple of cautious responses.

    You make some very good points, if I may say, with some minor reservations on my part. Yes, the Bank of Japan comparison is compelling with respect to the gap between words and deeds, although I will point out that you personalize the actions of the Fed and generalize references to the ECB and BOJ. I also guess that the behavior of the Fed has changed because it has seen the Congress at work, as much as I’m not sure I want to attribute the change to a read of the Chairman’s psychology. The “debtors/creditors” thing is very interesting in spirit, although I cringe at use of the word “debtors,” “populist revolt,” and “policy” in close proximity. Finally, and maybe most importantly, the point about anchoring inflation expectations really does sound like job one. We have much to agree on.

    I just don’t remotely agree that any of this means that Bernanke should resign/be fired. I think more policy clarity to “anchor” would be great. Many readers of this blog would probably agree on an upping of the inflation target to 3% followed by a new policy to penalize excess reserves, for instance. However, I’d rather this be announced/accomplished through the normal course of business by “the man behind the curtain,” in much the same way as I prefer the safety demonstration on an airplane to come at the same time on every single flight, given by the lead flight attendant.

    In any event, I don’t really see how the central banker becoming Roosevelt really would anchor anything. It would strike me as quite unsettling. Maybe what we need is not louder statements but better hearing.

    Rather, the call to fire a central banker for perceived lack of leadership skills highlights for me one of the real political dynamics here that is problematic. It also seems there is a better solution to the problem you raise than firing Bernanke.

    Just who is/should be the spokesman for economic policy? I don’t want to divert the discussion to this very different point, but I do want to point out that there is a cast of characters to choose from who are all more likely than Bernanke. There is Summers, Geithner, Romer, etc., and some other names I’ve worked too hard to repress. The policy communication vacuum perhaps leaves us staring at the guy we know the best, but that doesn’t mean it is his job. Exposing Bernanke to the political hazards of this task strikes me as risking our last line of defense, and wishing removal because he doesn’t take it on smacks of throwing the baby out with the bath water.

    We don’t need Bernanke to step down. We need someone else to step forward.

    IF I understood you correctly…..

  32. Gravatar of Rob Rob
    28. March 2009 at 13:49


    I was carefully crafting my response and missed your addition. Thanks for the clarification, but I don’t think it needs to be Obama either. I don’t think the problem you are identifying communicating overall priorities and getting the country where it needs to go in the future. I think you are talking about making some nuts and bolts transparent – monetary policy and inflation expectations, no? That’s a strange message coming from either one of them, in my opinion. And, I think it is a message that would be undermined by a reactive personnel change.


  33. Gravatar of moldbug moldbug
    28. March 2009 at 14:15

    I find the tone of Professor Sumner’s essay, and of many of the comments, really admirable. It displays a kind of open-minded, open-ended curiosity that is in the highest tradition of science. Professor Sumner is not at all afraid to ask what he doesn’t know, and consider the possibility that the answer might be “everything.”

    But that said, I gotta say: “everything” is exactly the answer.

    None of you guys know anything about money. You are all a bunch of monetary cranks. And there is nothing worse than a monetary crank.

    Now, you might ask: who am I? Perhaps I’m a monetary crank myself. Perhaps I am the king-loon of all monetary cranks. Au contraire. I am the monetary crank’s worst nightmare: the orthodox economist.

    Of course, since monetary cranks conquered the world 75 years ago, I have to post this message from inside my cardboard box. However, I am encouraged by the Professor’s presentation of Dr. Thompson’s manuscript -clearly both composed and photocopied in the throes of a heavy ether jag. There is hope for us madmen yet.

    Like Bill Woolsey, I spent a while reading Mises and Rothbard, but I went off on a different trajectory. I became convinced that the Austrians were getting all the right answers, but not always for the right reasons. (For example: I think fractional-reserve banking is pathological, but not fraudulent per se.)

    I use the word “orthodox” in the exact same sense that Keynes and the early AEA economists used it. And in the opposite sense as the one in which Professor Sumner describes himself as a “crank.” To be orthodox is to believe the 19th century was generally right about money, and the 20th was generally wrong. A synonym is “reactionary.” An antonym is “progressive.”

    Obviously, from the orthodox or reactionary standpoint, Professor Sumner is indeed a crank. An inflationist crank, to be exact.

    So is everyone else posting here. So are almost all economists and bankers today, except a few of the most diehard Austrians. Most of whom have “von” in their names – so you know there must be something wrong with them. Probably, they are Nazis. You can never be too careful with Nazis.

    (BTW: I am delighted to see my second-favorite 20th-inflationist, Silvio Gesell, get a hat tip – but why no mention of Major Douglas, whose Social Credit movement was so lauded by Mr. Pound on the Italian radio?)

    For a good introduction to the orthodox perspective, read John Stuart Mill’s On An Inconvertible Paper Currency. Follow it up with Condy Raguet’s Treatise on Currency and Banking, and top that off with George Bancroft’s Plea for the Constitution.

    If you cannot answer the objections to inflationism raised in these tracts, you probably should not have imbibed the Kool-Aid in the first place. But in case you need any more brutal shots to the head, descend into the 20th century and read Garet Garrett’s Bubble That Broke the World, Henry Hazlitt’s Failure of the New Economics, and finally Rothbard’s comprehensive summation of the Austrian School, Man, Economy and State.

    I am not suggesting that any of the above works is a perfect source for the logic of money, or of anything else. Not even Mises is perfect, and he is about as close as it got. Rothbard is significantly less perfect – but still awesome, of course.

    However, if this treatment leaves you still a believer in the miraculous loaves and fishes of paper money, you are at the very least quite well-inoculated. Certainly it’s a solid introduction to the other side of the battle. And I personally feel these writers do a good job of conveying the attitude with which an orthodox economist should regard his natural enemy – the monetary crank.

    As Mill put it, over 150 years ago:

    Although no doctrine in political economy rests on more obvious grounds than the mischief of a paper currency not maintained at the same value with a metallic, either by convertibility, or by some principle of limitation equivalent to it; and although, accordingly, this doctrine has, though not till after the discussions of many years, been tolerably effectually drummed into the public mind; yet dissentients are still numerous, and projectors every now and then start up, with plans for curing all the economical evils of society by means of an unlimited issue of inconvertible paper. There is, in truth, a great charm in the idea.

    Basically, the 19th century had a decent if not perfect financial system, and the 20th went and ruined it. Thus the giant mountain of suck beneath which we now find ourselves, which may even be the penalty that the American people deserve for surrendering themselves so totally into the hands of monetary quacks and paper-money projectors.

    So, for example, Professor Sumner writes:

    I can tell you that the American banking system circa 2007 was far worse than anything in our financial system pre-Depression (say back to the Civil War.) The bankers of that era would be totally shocked by the reckless risks our banks took in our (comparatively) highly regulated environment.

    Yes. In fact, in my stale and reactionary orthodoxy, this strange fact – so often discussed of late in the New York Times – not only makes total and obvious sense, but even comes with a self-evident cause.

    And what would that cause be? I know the answer will surprise you: the gold standard! (Don’t miss Senator Raguet’s discussion of money and credit in Gibraltar and Havana.)

    Outside of Gibraltar and Havana, the only problem with the 19th-century monetary systems, most notably the London gold standard, was that they were not orthodox enough. The pre-WWI international gold standard was just not solid. It proved its lack of mettle (and metal) after the war, when the gold coverage (claims to present gold, divided by actual present gold) sank to levels last seen in the Napoleonic Wars. This time there was no escape, and Britain sank into the pit of democracy in which she remains.

    They still followed the practice of diluting metal with paper. The banks never held enough physical precious metals to pay their current claims – I don’t believe the Bank of England ever, since 1694, did.

    To find a true hard-currency system of major economic importance you have to go back to the giro banks of Amsterdam and Hamburg. And how’s that for reactionary? Indeed there is a direct economic analogy between the Amsterdamsche Wisselbank and the SPDR gold ETF, which now holds over a thousand metric tons of good old element 79. The institutions are centuries apart, and the former was vastly more flexible, useful and competent. But both serve essentially the same purpose.

    Anyway. This is enough history. Let me explain the basic theory of money. It’s really not complicated at all.

    A “market-oriented approach” to money must obviously note that money exists in societies which do not have central banks or monetary policy. Thus the problem of the origin of money, to which Carl Menger and Ludwig von Mises provided what is probably the first reasonable explanation.

    Anyone who has not read Menger and Mises on the problem of money has not even begun to approach the question. I am not completely satisfied by their answer, however, so I will insert my own.

    The problem of money is the anomalously high demand for it, which is noted both in fiat currencies and gold standards. Considering the actual utility of either Krugerrands or benjamins, which is small for the former and negligible for the latter, why are people willing to exchange such a quantity of tangible goods and services for either? This is just weird.

    For example, if gold was not subject to considerable (and clearly increasing) residual monetary demand, its price might be less like $1000 an ounce, and more like $100 an ounce. What is the industrial price for gold? We do not know, because we cannot observe or even define a world which is just like ours, but has no monetary demand for gold. But it is surely pretty low, by the standards of the present market.

    It is pretty clear that whatever good experiences this effect of anomalous demand is called, in the common language of the people, “money.” So if we can explain the microfoundations of said demand, we can explain money.

    The theory of Menger and Mises is that the origin of money is a kind of feedback loop. Money is a medium of exchange, so people demand it for purposes of exchange. This makes it more commonly available, and hence more desirable as a medium of exchange. Thus many people demand to hold money, and the price goes up. If Menger and Mises were writing today, they would probably describe this as a “coordination game.”

    My view (explained at more length in my newsletter, to which all must subscribe) is that money is a coordination game indeed – but the primary force behind the anomalous demand is not demand for money as a medium of exchange, but as a medium of saving. Ie, a “store of value.”

    To simplify wildly, the only subjective criterion for choosing between two stores of value, A and B, is the expected future price ratio A/B at the time when the saver expects to spend the holding. Now, clearly, the future price ratio A/B depends on whether A, B, both, or neither is chosen by the market as money. So we have a game-theory problem on our hands, all right.

    And basically, the goods that end up winning the coordination game, and forming a stable Nash equilibrium, are precious metals. These – and warehouse receipts for them – are the stable currencies of a normal society under a normal government. I’m afraid ours is none of the three (what it is is a longer discussion).

    If Thompson’s labor-index money (basically Marxist in inspiration, I think, and not at all an uncommon idea, whether in the era of Ezra Pound or today – eg, google “Ithaca Hours”) can even be related to any kind of storable and negotiable security, it should be equivalent to the axes in my example.

    Successful currencies have extremely inelastic supply. To see why that is, read the essay and look at what happens to Sven if he decides to save his fish in axes. Currencies which do not exhibit strong supply inelasticity are not free-market currencies, because they will not be selected as media of saving in a free market. An ideal currency would have a fixed supply.

    (I do agree with the conclusion that the Fed’s interest rate hikes triggered the crash, though – I just disagree with Professor Sumner’s inflationist way of getting there. But that’s a different conversation.)

  34. Gravatar of JimP JimP
    28. March 2009 at 14:53

    Rob –

    It just really gets to me – that we are having this stunning disaster – millions unemployed – families and companies and countries ruined – when we don’t have to. And it makes me so mad that I can hardly speak.

    I do personalize things – I guess that would be wrong – but Bernanke is a world expert on the depression! He is not Mr. No-one. What he is doing just really gets to me.

    And I do think Obama should be the voice of his own policy here. He is listening to the wrong people – when Roosevelt reflated he listened to one guy – everyone else disagreed. He went ahead anyway. He had a kind of both experience and self-confidence that Obama lacks – which I think is very much too bad. With Obama I just feel now that I have heard that same speech ten thousand times – and I am really tired of it.

  35. Gravatar of JimP JimP
    28. March 2009 at 15:17

    Rob –

    An addition -I always have second thoughts –

    I think everyone on this blog should wait till the next time Bernanke goes before Congress – and then send to all the Committee members the two questions from this blog:

    1. Mr. Bernanke -why are you paying interest on reserves? That is deflationary – it is the same mistake the Fed made during the depression when they raised reserve requirements. It is a radical departure from your previous policy. I, as a member of Congress and an elected representative of the American people, think you should stop doing that.

    2. Mr. Bernanke – what is your inflation target? Do you have one? Not your inflationary expectations – your target. We have the expectations – you set the target. What is it? Our inflationary expectations are entirely unanchored now. What is your target? And how will you hit it?

    We have every right to ask these questions – and he must answer them. If we can get a member to Congress to ask them, on TV, we will get the answers we need. Then we can judge – do we fire him or not. Just like Lincoln did with McClellan.

  36. Gravatar of Bill Woolsey Bill Woolsey
    29. March 2009 at 04:28

    I was reading about the “debt overhang” problem in a comment above. How can base money solve this problem? How many invetsment an consumption decisions were based upon trillions of dollars of wealth? How can the banks start to lend again when faced with this large debt overhang?

    Well, the first thing to remember is that when people repay their debts, those receiving the debt repayments now have funds to spend.

    The reasoning here is that the demand to hold money is a residual. People plan their exependitures and then any money left over is held. Why is that realistic?

    Apparently, the implicit model is that nominal income is found by adding up various elements of nominal expenditure, consumption, invesment, etc.

    People finance these elements of spending by borrowing. More borrowing and they spend more. Less borrowing and they spend less. But what if they don’t want to borrow? What if they are already indebted? What if the banks cannot lend?

    And so, we have banks. Banks do some lending. And the Federal Reserve impacts the banks.

    So, monetary policy impacts bank lending. Bank lending impacts credit financed expenditures of various sorts. And total spending is made up of all these diffierent sorts of spending.

    The monetary disequilibrium approach begins with the notion that most spending is financed out of the current flow of income.

    Credit markets shift funds between and among households and firms. Some households spend less, and others spend more. Repayment of debt does the same. It shifes funds back.

    So, debt overhang? Well, what do those who would have lent more do with the funds that are not being lent because the borrowers are already indebted? If those who are indebted want to pay down their debts, what do those receiving the debt repayments do with these funds?

    But, if people choose to increase the amount of money they want to hold, for any reason, including “debt overhand” then this will disrupt the flow of income and expenditure.

    If the quantity of money matches the amount of money people want to hold, then problems with debt overhand involve shifs in spending, not changes in aggregate spending.

    If there was no such thing as banks, nominal income could be maintained. If there were no credit markets, nominal income could be maintained. Credit markets shift funds between housheolds and firms in hopefully value enhancing ways. Financial intermediation, hopefully, helps with that process.

    In the end, if there are no credit markets, then everyone spends their own income. All investment is funded by retained earnings. Not very “efficienct” given the gains of trade, but not a problem of too little spending.

    The flow of spending is generally financed out of the flow of income.

    When people are increasing their spending by borrowing more and more, there are people that are lending more and more.

    Inflationary monetary disquilibrium is, of course possible. But the notion tha all credit is about creating excess money balances that people don’t want to hold is wrong.

    It is a disequilbrium situation. Once prices adjust so that real demand for money matches the real supply of money, then the real credit financed by that real demand for money involves a shift in resources between and among households and firms.

    We have learned that we can have a dynamic equilibrium with rising prices. And most of the credit markets aren’t about banks making loans by spending money into existence. Most credit markets are about selling securities to investors who
    no longer have the funds. Most debt repayments work in reverse. Those receiving payment now have the funds.

    For the most part, for every borrower there is a lender. For every debt repayment, there is a creditor collecting on loans.

    Anyway, “base money” solves the problem by meeting the demand to hold bank liabilities. The logic is that if there is a surplus of base money, base money will be spent. If the quantity of base money is such that it would be at equilibrium if nominal income is on target, then then there will be a surplus if nominal income is below target.

    If banks become institutions that just store currency and lend nothing, that won’t prevent monetary policy from increasing nominal expenditure. It just means that base money has to increase much more than it otherwise would.

  37. Gravatar of ssumner ssumner
    29. March 2009 at 06:46

    Be careful what you wish for. The first few weeks I was trying to get more people to read my blog, now it’s tough to keep up with all the comments. And the comments are very thoughtful, buy the way. Here are some brief reactions to each:

    JimP, Thanks, a reporter from Forbes just interviewed me Friday. I didn’t realize that his boss and I have similar views.

    saintsimon, I partly agree, but was confused by the phrase “only become apparent when the damage is done.” Early in October I called out the Fed, and if they had acted then as they should have, we would be recovering by now. And with NGDP futures targeting, there might not have been a recession at all.

    Alex, The MB is meaningless when interest is paid on reserves. The FDIC is the main factor preventing bank runs. And the economy didn’t collapse, but nominal spending is falling fast. Despite these reservations you make some good points, and I think your overall answer is reasonable. But let me emphasize that the purpose of my crusade is not to JUDGE Bernanke, but rather to get the Fed to change policy. A few other points:

    I hope the 99% figure is wrong, but I fear you might be close to being right. Also, I think it is Bernanke who has led us into uncharted territory with the unconventional alphabet soup of new facilities, and the interest on reserves. I wanted old-fashioned OMOs to target NGDP or inflation–I thought that’s what modern macro said they should be doing.

    Bill, A very good look at recent history from a slightly different perspective, it nicely compliments my analysis. Leland Yeager is someone I also need to read more of (I have read some of his work, and it is very good.)
    My only comment is that when the government goes off course it makes the monetary problem seem harder to solve than it really is. With good policy the hoarding problem will fade away quickly.

    Thruth, I did mean banking losses (and my number was a crude guess.) The honest answer is that nobody knows for sure. I don’t think a nominal fall in housing prices is a huge problem, if not associated with losses in other areas–that’s why I was thinking of banking losses. I don’t know whether we should rely on Case-Schiller for prediction–does it explain why prices are so high relative to income in the coastal markets? I think that people who take a very pragmatic look at the current crisis–focusing on the obvious problems–grossly underestimate how much of this is due to monetary policy. House prices fell, and then fell some more. Common sense says that whatever caused them to fall, caused them to fall some more. But I am saying the first fall (2007-mid 2008) was from the bursting bubble, and the more recent fall was from tight money. If you go outside the U.S. my point is even more true. I would guess that 90% of the damage in East Asia and some parts of Europe (like Germany) is from falling AD, not the U.S. subprime crisis. Even in the U.S. housing market, much of the recent worsening of the crisis is due to the difference between NGDP rising 5% and falling 6.5%. That swing has a HUGE impact on housing prices. Sometimes when people say they don’t see how 5% NGDP growth would solve such and such a problem, I wonder if they realize just how many other things would change if we had such growth. One can’t assume everything else would be the same, and just add 5% NGDP growth to the picture. On the debt overhang, also see Bill’s comment below.

    Clayton, I agree with much of what you say, but would make one comment. Although something like 15% nominal growth and minus 10% real growth is possible in an accounting sense, it would require a devastating AS shock. And the current crisis has AD shock written all over it. So I am not worried about that. Also, I hope people understand that while we often talk of wages being linked to inflation, they are actually linked to NGDP growth. So a devastating AS shock would sharply reduce real wages, (nominal wages wouldn’t rise much) and thus inflation would quickly fall back after the shock ended.

    Rob, I’ll let you and Jim debate the Bernanke question. My views on the Fed are clear, I have an open mind on the issue of whether Bernenke is quietly pushing for more. Regarding the wind metaphor, I appreciate your point. But I see the wind as pushing the boat steadily to the left. And I also see the captain as having had plenty of time to offset that (now predictable) left-pushing wind (sorry I don’t know the sailing term.)

    Alex, Negative interest on excess reserves is one thing they could do.

    Jeremy, I am an agnostic on the bailout/nationalization debate. But I strongly feel that NGDP target is far superior to both those options. I think your points are basically good, so allow me to go off on a slight tangent. Very few people have asked why I don’t propose 4-5% inflation, instead of 2%. If the only choice was between 4 or 5% inflation, which was considered relatively low in 1988-89 (at the end of the Reagan years) or socialism, I’d take 4 or 5% inflation. So although many on this blog think I am an inflationist, I think that partly reflects the conservative leanings of many commenters. But it also reflects the time. In late 1933 FDR was viewed as a wild inflationist, even by many of the left. This despite the fact that the price level was still far below the level of 1926-29.

    Speaking of conservative leanings, moldbug gives a very powerful defense of the old gold standard orthodoxy. I only have time for a few brief comments–when my book is published I will have much more to say.

    1. I have been an inflation hawk for most of my life. Like a broken clock that is right twice a day, the monetary cranks are right about twice a century. 1933 was one such time, 2008-09 is another.

    2. It is hard to evaluate the gold standard, because when you criticize it many proponents will (correctly) point out that it wasn’t a pure standard. Thus I don’t think the gold standard worked well in the 1890s or the early 1930s in the U.S., but then one could say the government made this or that mistake, and I might agree. But if we need to assume the government will manage the system well, why can’t we assume a well-managed fiat money system? The fiat money system has been managed increasing well until last year. 1982-2007 was far, far better than 1968-81, the first 13 years after we allowed gold prices to rise above $35. I don’t see why we can’t go back to doing that system, with some lessons learned from the recent fiasco. I feel that the free market vs. socialism issue is 10 times more important than monetary policy. I also think a fiat regime is inevitable. So I want to make that system work as well as I can, because when it fails, the left and the media blame capitalism, not monetary policy. Because they don’t understand monetary policy. So we get more socialism.

  38. Gravatar of moldbug moldbug
    29. March 2009 at 08:29

    Professor Sumner,

    There’s one graph that I feel tells the story of 1982-2007 quite well:

    This is not real prosperity. It is no “Great Moderation.” If you think of the economy as a firm, this is a money-losing firm. Apparent prosperity is no more than the result of increasing debt.

    As for a well-managed fiat money system, I agree. There’s a simple way to do it: fix the quantity of money. I recommend an even power of 2, such as 2^64.

    The problem is that there is no trivial way to return to hard currency without completely rebooting the financial system. M0 is still under $2 trillion. The total price of all financial assets is still something like $80 trillion. This price is based on future returns in dollars – M0 dollars. It don’t compute.

    It is a very useful exercise to think about what happens to financial asset prices if you fix M0 and throw away the key to your printing press. Perhaps the word “hyperdeflation” could be used.

    So, yes: my view is that the only complete way out of this fix is to monetize *all* financial assets, even homes, putting them on the Fed’s balance sheet, and then fix whatever quantity of money this produces. Then you can build a stable financial system in which for every private borrower of $X at term T, there is a private lender of $X at term T. You can also map this quantity to Fort Knox, which will yield a very high (but stable) gold price.

    The basic problem with monetary cranks is not that they favor diluting the currency. It’s that they believe in *continuous* dilution of the currency. If you do it once as part of a restructuring plan, this is something totally different. Fiat currency is essentially the sovereign version of corporate equity, and this is what we see in the private sector: new shares are issued for a specific transaction, never as a continuous hemorrhage.

    So if this is what you mean with your “broken clock,” you may very well be right. The difference, however, cannot be overemphasized.

  39. Gravatar of moldbug moldbug
    29. March 2009 at 08:35

    Also, I think it’s pretty clear that the right move in 1933 would have been staying on gold with a large devaluation, probably more like $50 or $100 than $35. This would have enabled some of those crazy debts to be paid – both WWI’s, and those of the ’20s.

    But there was no lobby for this policy. The progressives wanted their rubber dollar, their “elastic currency.” The conservatives clung to a gold valuation that their governments had long since trashed, and could not be defended.

    Blaming the gold standard for the Depression, as I see Krugman is doing again today, is like blaming a bus for hitting you, if you step in front of the bus. The gold standard took an incredible amount of abuse before it blew up. And even then, it was not the metal that was the problem – just the valuation of government promises of said metal.

  40. Gravatar of Jon Jon
    29. March 2009 at 14:28

    Bill writes “Still, having the Fed just purchase Treasury Bonds and then private securities is probably more realistic than a currency suspension.”

    Bill, purchases of treasury notes by the Fed is standard practice. The primary reason for the Fed to hold TBills is to have an easy (liquid) way of sterilizing sudden demand at the discount window.

    What is unusual is to buy 300B of such notes in a single year; the normal rate of note monetization is around 1/10 that amount.

    Incidentally, it was also about ten years ago that the Fed amended the OMO rules to allow purchases of private debt–the reason then being that the Treasury briefly suspended 30-yr auctions when we all (equally briefly) were under the delusion that persistent surpluses were on their way.

    It would be helpful to this entire debate, if people would stop focusing so much on the ‘means’ and focus more on the ‘amount’; certainly the ‘means’ is an interesting side-question so much as selective OMO create distortions because debt is not a commodity.

  41. Gravatar of Thruth Thruth
    30. March 2009 at 06:09

    >Common sense says that whatever caused them to fall, caused
    >them to fall some more. But I am saying the first fall
    >(2007-mid 2008) was from the bursting bubble, and the more
    >recent fall was from tight money.

    Don’t get me wrong, I’m largely on board with your view. BUT, we need to be careful about underestimating the severity of the wealth shock. Disentangling the initial shock from subsequent AD shocks due to failed monetary policy isn’t trivial. Even with first best monetary policy, I think a mild recession (at a minimum) was unavoidable due to the initial shock.

    We saw, for example, Brad de Long discount the impact of the initial shock with an essay along the lines of “how could a $2tn impulse turn into $20tn of wealth destruction”.

    I’m somewhat sympathetic to the Austrian view of the crisis, such as espoused most recently by Robert Murphy here:
    The basic idea here is that bubbles run deep: what may seem like just a $2 trillion (or $5 trillion) impulse, is a sequence of malinvestments that extend well beyond the housing market. How many other sectors were propped up by purchased and investment made on the premise of stored wealth in the home?

    However, I remain skeptical that the Austrians have even close to the full story because:
    * I don’t think you can pin the root cause of all this business on loose Fed monetary policy alone (rational actors can get things wrong in concert without federal intervention)
    * I’ve yet to see a concrete empirical or theoretical model from the Austrian camp (but maybe they exist and I just don’t know about them)
    * Why aren’t we seeing an investment boom to replace the missing wealth? This seems a prime candidate for AD type explanations.

    >don’t know whether we should rely on Case-Schiller for
    >prediction-does it explain why prices are so high relative
    >to income in the coastal markets?

    The futures are still market traded instruments and, hence, our best guide. There are many plausible explanation for high prices on the coastal markets that have no bearing on the validity of futures. You advocate a futures like market to control the currency, so wouldn’t it be inconsistent to argue for the reliability of one market and not another?

    Bill Woolsey said,
    >The monetary disequilibrium approach begins with the notion >that most spending is financed out of the current flow of

    Bill, interesting post. I wouldn’t mind some pointers to some of the models in this area.

    >If banks become institutions that just store currency and
    >lend nothing, that won’t prevent monetary policy from
    >increasing nominal expenditure. It just means that base
    >money has to increase much more than it otherwise would.

    The big question is how much does base money have to increase before the banks are in the clear? Are we talking about say $3 trillion or more?

  42. Gravatar of ssumner ssumner
    30. March 2009 at 12:56

    moldbug, The graph showing increased debt doesn’t bother me at all. It is exactly what one would expect during a period of falling inflation and falling tax rates on capital. Does that mean I approve of the subprime lending? Obviously not. But the general upward trend in debt is not a problem in and of itself. In your next post you start by talking about the Great Depression which followed the “crazy” debt levels of the 1920s. But if you look at your graph, you’ll see the 1920s debt levels were crazy low, not crazy high. So the graph you provided doesn’t seem to support your theory, unless I missed something.
    You say the gold standard took a beating, well our current fiat money system has also taken a beating. Government’s apparantly don’t know how to run either system very well. But it is easier to fix problems with a fiat system.

    Jon, I agree that the amount is the key, not the means. But I would add that we don’t need any more base money, if we put a penalty rate on reserves. That would eliminate the need to debate which assets should be purchased.

    Thruth, I did misunderstand your previous comment. The futures data is very relevant. But I have a new question–is it really true that the futures markets were showing 25-30% expected declines in early 2007, even before the subprime crisis. I find those numbers mind-boggling if true. Would you mind double-checking? Are you sure it wasn’t just for a regional market. Rembember that many markets in the heartland (like Texas) had almost no bubble. So the expected declines in bubble markets must have been close to 50%. But I don’t recall anyone predicting such a decline in early 2007.
    Regarding the Austrian model, I plan to study it more this summer. But I really don’t see why overinvestment should lead to a recession. As long as the Fed engages in NGDP targeting, then real output should keep growing, albeit at a slightly lower rate. i also wonder about the data issue you raised, but will defer judgment until later.

  43. Gravatar of TGGP TGGP
    30. March 2009 at 13:33

    Scott, though “subprime” is the big buzzword, perhaps “adjustable rate” should replace it. Stan Liebowitz provides evidence that it was the latter that was responsible for the unusually high (subprime is expected to be 10X prime and priced accordingly) rate of defaults.

  44. Gravatar of Jon Jon
    30. March 2009 at 17:31

    Scott: my comments were for Bill… needless to say I’ve said the same thing 100 times by now and I’m sure YOU’ve heard it…

  45. Gravatar of moldbug moldbug
    30. March 2009 at 18:40

    The graph showing increased debt doesn’t bother me at all. It is exactly what one would expect during a period of falling inflation and falling tax rates on capital.

    Again, consider “the economy” as a firm – GDP is its sales. If we see a firm continuously taking on debt over a period of 25 years, this could mean quite a few things. Basically, what we’re seeing is increased capitalization. This could mean the firm is financing factories, mines, buildings, etc, etc. That would be a healthy explanation.

    There are a number of reasons why capitalization could have increased. While “inflation” in the Chicago sense (CPI) is not one of them (unless you can explain the microfoundations of how CPI affects lending), lower capital taxes are. That would be another healthy explanation.

    There are also unhealthy explanations. Which reason is most plausible? Did these debts correspond to productive investments? Did America blossom between 1982 and 2007, or did it go to seed?

    At least to an old shell-backed literary economist such as myself, the question is a matter of aesthetic and qualitative assessment. If we were looking at a stable, hard-currency financial system in which there was no monetary dilution or maturity transformation, we could assess the answer quantitatively – did they lose money? But in the world of elastic currencies, asset/credit bubbles, Diamond-Dybvig multiple equilibria, etc, the EMH is a joke and we must rely on our old-fashioned, literary noses.

    In the US in the ’80s and ’90s, what did all that debt finance? Some new productive endeavors appeared. Some disappeared. There were certainly a lot of strip-malls and McMansions. But overall – especially in the light of the trade deficit – the hemorrhage explanation seems like the best to me.

    But if you look at your graph, you’ll see the 1920s debt levels were crazy low, not crazy high. So the graph you provided doesn’t seem to support your theory, unless I missed something.

    My impression is that most of the unsustainable increase in capitalization in the ’20s was not domestic debt. It was equity (ie, the stock market) and international debt (eg, loans to Germany, war loans, etc).

    Effect being the same: a large volume of bad debt in a system in which claims to current money are backed by long-term debt. Everywhere you find a financial crisis, you find this same pattern of “borrowing short and lending long” – maturity transformation. Can’t have a bank run without it.

    Now, it’s true that when you have a fiat currency, and you get into an MT crisis, it’s a lot easier to print yourself out of the hole than when you are backing present claims to gold by 30-year gold loans.

    It’s also true that if you fall off the Golden Gate Bridge, you’re more likely to survive if you’re wearing an inner tube. Does that mean we should all wear inner tubes? Or that we should figure out why we keep falling off the Golden Gate Bridge? Why on earth are we backing present claims with future money? Because we’ve always done it that way?

    The cool thing about an inelastic currency, whether gold or fiat, is that it precludes a lot of ways of making losses look like profits. What’s important is not the “intrinsic value” of the currency – just its bounded supply. Harder is always better. Gold would be a perfect currency if there was no such thing as a gold mine.

    It is easy to argue intuitively that social progress requires monetary dilution. It is also easy to construct models in which this relationship is tautological. It is quite a bit more difficult to construct microfoundations which explain why new money has to be created, and if so who should get it…

  46. Gravatar of Thruth Thruth
    30. March 2009 at 18:40

    >But I have a new question-is it really true that the futures
    >markets were showing 25-30% expected declines in early 2007, >even before the subprime crisis. I find those numbers
    >mind-boggling if true. Would you mind double-checking? Are
    >you sure it wasn’t just for a regional market. Rembember that
    >many markets in the heartland (like Texas) had almost no
    >bubble. So the expected declines in bubble markets must have
    >been close to 50%. But I don’t recall anyone predicting such
    >a decline in early 2007.

    whoops — big typo — I meant to type start of 2008 and was (in my mind at least) referring to peak-to-trough decline incorporating futures. If I recall correctly, long dated housing futures weren’t even traded until Sep 2007. As of Jan 2008, the index was down about 14% and the futures were showing a decline of another 16% (here’s one link to the futures curve at that time:

    This doesn’t change the substance of what I wrote: you’re arguing tightness in late-2008 caused a significant deterioration in the economy; I’m just saying a lot had already happened/was predicted to happen on the housing front before then. That doesn’t invalidate what you’re saying — things clearly got worse for both housing and stocks in late 2008.

    >Regarding the Austrian model, I plan to study it more this
    >summer. But I really don’t see why overinvestment should
    >lead to a recession. As long as the Fed engages in NGDP
    >targeting, then real output should keep growing, albeit at
    >a slightly lower rate. i also wonder about the data issue
    >you raised, but will defer judgment until later.

    I could well be wrong, but from what I can tell, the basic premise is analogous to the classic cake eating problem with an unanticipated negative shock to the value of the cake. Consumption/production plans were premised on a larger capital stock than actually existed. Once the shock hits, agents have less capital to work with (the capital is defunct) and hence production (and consumption) fall. I think you have to buy into the idea that the market values of assets are relied on by agents as a good proxy of productive value, a not altogether unreasonable premise. I assume that they believe that if you were to target positive nominal GDP growth that it will either cause stagflation or inflate new bubbles (i.e. you avoid recession with something more evil) — most of the little I’ve read seems to give AD shocks pretty short shrift.

  47. Gravatar of TGGP TGGP
    30. March 2009 at 19:32

    especially in the light of the trade deficit
    A trade deficit is the same thing as a capital account surplus. No “especially in light of” about it. America has had a trade deficit for most of its history. It had a trade surplus in the great depression.

    My impression is that most of the unsustainable increase in capitalization in the ’20s was not domestic debt. It was equity (ie, the stock market) and international debt (eg, loans to Germany, war loans, etc).
    It would be nice then if we had a graph that showed all forms of capitalization over time.

    asset/credit bubbles
    I believe those can happen in any system. Vernon Smith found that they emerged in lab experiments, even when participants were aware of the bubble problem. “Tulipmania” occurred in the Netherlands in 1637, and the Bank of Amsterdam was founded in 1609. Did their Golden Era you want to return to only last 28 years?

  48. Gravatar of ssumner ssumner
    31. March 2009 at 17:02

    TGGP, You may be right about the adjustable rate question. But I have always thought that defaults occurred not when people couldn’t pay their mortgages (they could sell the house) but when they had negative equity. So I sort of assumed the “zero down” was the big problem. Perhaps someone that knows more about real estate than me can tell me a rough percentage of the subprimes and Alt-As that were zero down or 5% down.

    moldbug, There’s too many differences between us to get into all the issues, but a few brief comments. I was thinking of the tax on nominal interest, but I forget the fact that interest can often be expensed, so it may not be a big issue. America seems much richer to me than in 1982, in all sorts of ways that go beyond strip malls. Do you remember what urban America was like in 1982? Where there were slums in 1982 there are now gentrified neighborhoods. I would never argue that “social progress requires monetary dilution.” You could have social progress with stable prices. My point is that it is foolish to go from 5% NGDP growth (on which contracts have been negotiated) to negative 7%, right in the middle of a debt crisis. That’s a very, very different argument.

    Thruth, Thanks for making me go look at the data, what I found supports my argument more strongly than I could have imagined. First of all, the C-S index only includes a few cities, heavily weighted toward the bubble regions. When I looked at some cities in non-bubble America (Cleveland, Dallas, Charlotte) I saw a very different pattern–very supportive of my argument. The housing decline leveled off in the spring of 2008, and then fell sharply in the fall. But I wanted national data, so here is what I found.

    Look at the national graph, I closely examined the line and estimated the following nationwide median prices:

    Jan. 2008 $200,000
    August 2008 $200,000
    Jan. 2009 $172,000

    That’s mind-boggling data. Someone tell me what I did wrong, because if this data is even close to being right it completely cinches my point. The first thing to do would be to get the actual numbers, not just the graph. And then the numbers for 2007 (I assume prices fell in late 2007.) If this holds up it seems to me to be the smoking gun that there were two shocks, and the second one is very closely correlated with the sharp decline in NGDP after August 2008. That data shows a 14% decline, not at an annual rate, but over just 5 months. Perhaps I made a mistake because if true why wouldn’t people be zeroing in on this pattern? It would be worth a post. Is there anyone who knows what the biases in the median home price numbers are? There might be a bit of seasonality, but nothing that could explain 14%.
    Update: I just found their February numbers: $165,400 ouch! (Down roughly 17% in 6 months)

  49. Gravatar of Thruth Thruth
    31. March 2009 at 19:42


    I tend to agree with the second shock assessment. However,

    1. I severely distrust the NAR data for this type of analysis. it doesn’t use repeat sales, which is a big problem. See discussion at, and fed paper comparing the indices:
    2. The OFHEO purchase only index is a widely cited national repeat sales index but only covers GSE housing (not jumbo/subprime) — it shows more steady decline over the course of the year, but accelerating in the second half.
    3. Although C-S concentrates on just 20 cities, it does pick up a big chunk of US housing wealth. It still shows the pattern you care about: accelerating decline in the second half of 08
    4. House prices have pronounced seasonality — spring/summer is buying season and, hence, tends to be when most of the gains appear

    Pushing back for the sake of geting you to develop your arguments: some might argue the poor summer sales confirmed the worst about housing, which painted a grim picture for the economy going forward. Also, many economist assert that aggressive monetary policy would not address the solvency of the banks without bestowing huge moral hazard inducing subsidies upon them.

  50. Gravatar of TGGP TGGP
    31. March 2009 at 20:05

    But I have always thought that defaults occurred not when people couldn’t pay their mortgages (they could sell the house)
    The paper says many of the people who got ARM’s were speculators who planned on selling the houses for an increased price before the rate ratcheted up. Selling your house for a high price became tough when prices stopped going up. Liebowitz did seem to agree that lack of downpayments were a big problem.

  51. Gravatar of ssumner ssumner
    1. April 2009 at 12:55

    Thruth, Your arguments “pushing back” as you put it have been very useful. We are not far apart, but I’ll just make a few observations:

    You are right about the NAR, but I see the C-S index as being perhaps a bit more biased than you do. One reason is that although median prices are biased toward the low-priced areas, I am not sure an index based on average prices is exactly right either. I believe that the foreclosures are heavily skewed to middle and lower priced homes (i.e. California’s inland empire, not its gold coast. If that’s right, then the damage to banks (my concern) is more in the middle and lower part of the market. In wealthy areas prices may decline, but wealthy homeowners may not default as much. My second concern is the regional bias–C-S definitely skews toward the bubble areas. Here is my hunch. The actual numbers relevant for my banking crisis analysis would fall about halfway between C-S and the NAR numbers. Here’s an anology for what I see happening: Suppose you had a huge energy shock that caused the CPI to rise 5% while most prices were stable, then the next year energy leveled off but you still had 5% inflation because monetary expansion drove price up across the board. I see something analogous here. The housing bubble was like a relative price shock, that strongly impacted 30-40% of the country (depending on how you measure it.) Just about the time things might have been levelling off, the sharp fall in nominal spending nationwide drove prices sharply lower in virtually all markets. This shows that it is no longer subprime related, but rather reflects a force affecting the entire economy, which would be AD, NGDP, or monetary policy (all are related.)

    One final thought, to address my lower/middle income housing issue, and the regional bias. One could construct C-S averages by region. Thus Charlotte/Atlanta/Dallas could represent the huge southern region (ex-Florida). Ditto for Cleveland/Chicago/Minneapolis for the midwest, even including upstate NY and western Penn. Then give these non-bubble areas a weight based on their fraction of the U.S. population–still using the superior C-S numbers. Something like that (done with other regions as well) would be my ideal index of prices relevant to the banking difficulties of the past 6 months. I think my hypothesis would really jump out. Not the 0% to minus 17% downshift I started with, but pretty significant.

    Regarding moral hazard, I have very clear views. Trying to get prices back to 2006 or even 2007 would be a big mistake. We shouldn’t target housing prices at all. But we should try to get NGDP growing 5% in the hope that housing will get back to mid-2008 levels–the levels after the subprime crash, but before NGDP crashed. There is no moral hazard in doing this, as it is unreasonable to expect people to anticipate NGDP falling sharply. So if that’s the only reason their home went into default, it is not their foolishness, but rather policy mistakes by the Fed. So that last bit of the crash SHOULD be “bailed out.” But no more.

    TGGP, I did 20% down on my house, and I’ve often thought of where we’d be if everyone had put that much down. I know that’s not realistic, but the thought experiment convinced me that the zero down mortgages might be a big factor. But I agree that the speculator/ARM issue was also very important.

  52. Gravatar of TGGP TGGP
    1. April 2009 at 14:29

    Liebowitz claims that even prime mortgages were sometimes effectively zero-down because a second, “piggyback”, mortgage was taken out to cover the cost of the first. He gets into why the studies showing the practice wasn’t too risky turned out to be wrong, but I don’t think there was much data about how many (prime or subprime) mortgages were piggybacked.

  53. Gravatar of TheMoneyIllusion » Evidence of Reverse Causality? TheMoneyIllusion » Evidence of Reverse Causality?
    1. April 2009 at 17:56

    […] the comment section of an earlier post here, there has been some interesting discussion of real estate prices, so I thought a new post would be […]

  54. Gravatar of moldbug moldbug
    2. April 2009 at 22:48

    America seems much richer to me than in 1982, in all sorts of ways that go beyond strip malls. Do you remember what urban America was like in 1982? Where there were slums in 1982 there are now gentrified neighborhoods.

    Yep. There’s your debt. That’ll buy a lot of granite countertops. Moreover, you see a general debt/equity increase in capitalization.

    If you put money into an unprofitable firm, you are still putting in money, and that money still gets spent.

    Moreover, the places that were slums in 1982 were not slums in 1932. Perhaps you’ve read Hazlitt’s Failure of the New Economics? You might enjoy it. You might also disagree with some of Hazlitt’s logic. But really, who can stand up and call the new economics a success?

    My point is that it is foolish to go from 5% NGDP growth (on which contracts have been negotiated) to negative 7%, right in the middle of a debt crisis. That’s a very, very different argument.

    With the exception of the rather Fisherine “on which contracts have been negotiated,” I agree. But it’s not clear what can be done about it.

    The Austrian point is that this is exactly what you’d expect to see happen when an overcapitalization bubble collapses.

    Your firm has been sucking in $2 trillion a year on the assumption that it is building $2 trillion worth of productive capital with the new debt it takes on. In fact, it has been building $500 billion of productive capital and spending the rest on cocaine. And the $1 trillion a year that the firm has been purportedly producing in reinvested profits from the factories built in previous years is actually $200 billion. This also was spent on cocaine.

    Therefore, when the debt inflow stops, the firm is expected to produce $1 trillion a year in profits. Instead it produces $2.1 trillion a year in losses, because its gross profit before cocaine is $200 billion and it spends $2.3 trillion on cocaine.

    Basically, what I’m saying here is that our financial markets are very, very far from any kind of stable asset-price equilibrium. To be more precise: they are very, very far *above* any kind of stable asset-price equilibrium. Because the markets are pricing the capital of our economy, and our economy is a blatantly unprofitable enterprise.

    This is why I favor shutting the markets down and building new ones. I don’t think there is any way back to the “Great Moderation.” Deflation is self-reinforcing, as you observe. And any hemorrhage of cash strong enough to overcome it is also strong enough to make itself permanent – you cannot distribute cash without creating interest groups. This gets you a nice start on the road to Weimar.

  55. Gravatar of ssumner ssumner
    3. April 2009 at 16:04

    TGGF, The piggyback mortgages are an interesting issue. If banks were worried about that issue, could they have a clause forbidding piggyback mortgages? It doesn’t seem like it would be possible, but then I really know nothing about mortgage law.

    moldbuy, Weimar survived the hyperinflation, what brought it down was deflation. The problem with things like your cocaine example, is they don’t really have much predictive power. By hard money standards, we have had lots of reckless decades. The 1960s didn’t end in a financial crisis, not did the 1970s. On the other hand the deflationary 1920s did end up with a financial crisis. I don’t think Fed policy can explain the subprime madness. I think Tyler Cowen has an example where he argues that if the government subsidizes bananas, and if you build your roof out of bananas because they are cheap, and if your roof collapses in a storm, it doesn’t mean you can blame the government banana subsidy for your flooded basement.

    One area we might agree somewhat is that I think Americans save too little, and that that low saving rate is partly due to the welfare state that has been created since 1932. I haven’t read the book you mention, but I might well agree with some of the ideas. I am a small government, free market economist.

    BTW, I wish I have gotten granite countertops, my Formica ones are already peeling off.

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