The mindset that led to the crisis

Last year I spent a lot of time emphasizing that the real problem was the profession, not the Fed.  The Fed represents the consensus of opinion among economists.  Unless we can change that consensus, it is unlikely that we can change Fed policy.

Paul Krugman is also pulling his hair out over attitudes toward monetary stimulus.  He recently linked to a 2008 post that criticized Ken Rogoff for advocating tight money to slow the commodity price boom of 2008.  Krugman responded (in 2008):

Um, why? Basically, the world is employing rapidly growing amounts of labor and capital, but faces limited supplies of oil and other resources. Naturally enough, the relative prices of those resources have risen “” which is the way markets are supposed to work. Since when does economic analysis say that the way to deal with limited supplies of one resource is to reduce employment of other resources, so that the relative price of the limited resource returns to “trend”?

Presumably there’s some implicit argument in the background about why a sharp rise in the relative price of oil is more damaging than leaving labor and capital underemployed. But that argument isn’t there in Ken’s recent pieces. Model, please?

I agree that

“Dollar bloc countries have slavishly mimicked expansionary US monetary policy”

and that’s a real issue: the Fed is pursuing very loose policy to deal with a US financial crisis, and that’s inflationary in countries that are pegged to the dollar without facing our problems. But that’s an argument for breaking up Bretton Woods II; it’s not an argument for tighter Fed policy.

Several points.  If the CPI is a much worse indicator than NGDP, then the price of oil and other commodities are far worse than even the CPI.  Krugman’s also right about the exchange rate issue.  BTW, China sharply revalued the yuan between 2005-08, and thus avoided high inflation.

On July 29, 2008, the very same day that Rogoff penned his infamous call for tighter money, I received a rejection letter for a paper I had submitted to Contemporary Economic Policy.  (Please don’t take this as a criticism of that journal, two other journals didn’t even think my paper was worth evaluating.)  Here is one of the two referees who didn’t like the paper (a third loved it):

The author assumes that the Fed will not repeat the mistakes of 1979-80.  The current environment looks very much like 1980.  The monthly CPI rose 14 a.r. in June and expectations in the Michigan survey rose from 4 to 7% for the year inflation with the June report.  The dollar is at all time lows and commodity prices are soaring to record heights.  With the fed funds rate negative the New Keynesian model is predicting a rapid rise in inflation.

Hey Mr. Anonymous referee; how’s that New Keynesian model prediction working out for yah?

So that’s where we were on July 29th, 2008, on the eve of the Fed’s Great Mistake.  With mindsets like those being the norm, is it really at all surprising that we ended up where we did?  If you are wondering what they should have been focusing on in 2008, my answer is NGDP forecasts for the US inferred from various real output indicators plus TIPS spreads.  This might not have called for easier money yet, but certainly not tighter money.

Part 2.  Krugman and Thoma vs. Rajan.

Krugman (and Mark Thoma) also criticize Raghuram Rajan’s recent article calling for tighter money.  Although I agreed with Rajan in his recent dispute with Krugman about Fannie and Freddie (and prefer his more polite writing style to Krugman’s), I’m afraid I find this column even more discouraging than do Krugman and Thoma.  Here is Rajan:

Regardless of the true explanation, the US is singularly unprepared for jobless recoveries. Typically, unemployment benefits last only six months. Moreover, because health-care benefits are often tied to jobs, an unemployed worker also risks losing access to affordable health care.

Short-duration benefits may have been appropriate when recoveries were fast and jobs plentiful, because the fear of losing benefits before finding a job may have given workers an incentive to look harder. But, with few jobs being created, a positive incentive has turned into a source of great anxiety. Even those who have jobs fear that they could lose them and be cast adrift.

Then he criticizes fiscal stimulus, before turning to monetary policy:

Equally deleterious to economic health is the recent vogue of cutting interest rates to near zero and holding them there for a sustained period. It is far from clear that near-zero short-term interest rates (as compared to just low interest rates) have much additional effect in encouraging firms to create jobs when powerful economic forces make them reluctant to hire. But prolonged near-zero rates can foster the wrong kinds of activities.

For example, households and investment managers, reluctant to keep money in safe money-market funds, instead seek to invest in securities with longer maturities and higher credit risk, so long as they offer extra yield. Likewise, money fleeing low US interest rates (and, more generally, industrial countries) has pushed up emerging-market equity and real-estate prices, setting them up for a fall (as we witnessed recently with the flight to safety following Europe’s financial turmoil).

Moreover, even if corporations in the US are not hiring, corporations elsewhere are. Brazil’s unemployment rate, for example, is at lows not seen for decades. If the Fed were to accept the responsibilities of its de facto role as the world’s central banker, it would have to admit that its policy rates are not conducive to stable world growth.

Policy would still be accommodative if the Fed maintained low interest rates rather than the zero level that was appropriate for a panic. And this would give savers less of an incentive to search for yield, thus avoiding financial instability.

Politicians will not sit quietly, however, if the Fed attempts to raise rates. Their thinking – and the Fed’s – follows the misguided calculus that if low rates are good for jobs, ultra-low rates must be even better.

Emerging studies on the risk-taking and asset-price inflation engendered by ultra-low policy rates will eventually convince Fed policymakers to change their stance. But, if politicians are to become less anxious about jobs, perhaps we need to start discussing whether jobless recoveries are here to stay, and whether the US safety net, devised for a different era, needs to be modified.

Another even more famous University of Chicago professor (Milton Friedman) pointed out that low interest rates are usually a sign of tight money, not easy money.  Tight money produces a weak economy and disinflation.  That drives nominal and real rates to very low levels.  Second, Brazil is not even in the dollar bloc.  So I don’t see how one can imply that easy money in the US is making economies like Brazil overheat.  They can revalue.  And the proposal to extend unemployment benefits seems puzzling for two reasons.  First, I thought it had already been done.  Maybe Rajan thinks even the extended benefits are not enough.  But second, studies show that this sort of policy creates more unemployment.

Hoover’s Fed raised interest rates from very low levels to somewhat less low levels in 1931.  FDR made labor markets much more rigid.  Between the two of them they produced a 12 year depression.  Rajan’s proposals obviously wouldn’t be anywhere near as harmful, but I still think it would be a step in the wrong direction.

Part 3:  Paging Banksy and Fairey

Maybe we need some sort of guerrilla street art campaign to change attitudes through subliminal indoctrination.  Outside of every economics conference, FOMC meeting, G-20 meeting, etc, we need street artists to plaster enigmatic images like this one, but with ‘obey’ replaced by 9/08+2%.  Then people might start asking what it means.

(I.e., target the core price level on a 2% growth track from Sept. 2008.)



16 Responses to “The mindset that led to the crisis”

  1. Gravatar of Doc Merlin Doc Merlin
    9. June 2010 at 08:06

    Re: Part 1.

    A keynesian making a supply side argument? Color me shocked.

  2. Gravatar of thruth thruth
    9. June 2010 at 08:48

    re Rajan. You can see the logic underlying his article in his paper with Doug Diamond here: (first link)

    “Indeed, the current financial turmoil in the United States could be thought of as being partially caused by lenders, anticipating a continued environment of low interest rates following the implosion of the “tech bubble” in early 2000 and the subsequent collapse of corporate investment, choosing to take on more illiquid financial assets financed with short term debt. Anticipation of low interest rates may have been strengthened by the so-called Greenspan Put, whereby the financial sector believed that if it ever
    came under strain because of excessive expansion, the Federal Reserve would cut interest rates. If shortterm
    interest rates are driven to a low level due to one aspect of policy, and solvency and financial stability constraints on future policy rule out future high short-term rates, then financing illiquid assets with short-term debt will be profitable and safe.”

    Make of that what you will.

    PS: I’ve been seeing this argument that all recent Fed policy, including interest rate policy, is a subsidy to the banks quite a bit lately. That’s why I asked your opinion about it in one of my previous comments.

  3. Gravatar of Dan Carroll Dan Carroll
    9. June 2010 at 09:39

    I would be interested in your take on the accuracy of the inflation indices – not just the CPI (which is easy to criticize), but the PCE (which I am less familiar with), among others. Implicit is a debate between transaction prices in an auction market (such as housing, not in the CPI directly), contracted prices, and smoothed prices, and which should be given more weight in decision-making.

    I know you prefer NGDP targeting, but if the Fed is using inflation-targeting, but uses indices that omitted, say, the deflation of housing prices over the last few years, it seems that could lead to bad decisions.

  4. Gravatar of mbk mbk
    9. June 2010 at 09:58

    “…we need street artists to plaster enigmatic images like this one…”

    I’ve seen a much better version of that famous poster. The text goes:


  5. Gravatar of mbk mbk
    9. June 2010 at 10:21


    random irony, the “Obey” series of posters you quote in the link were started by the same Shepard Fairey who designed the Obama campaign “Hope” poster.

  6. Gravatar of Don the libertarian Democrat Don the libertarian Democrat
    9. June 2010 at 13:52

    “But second, studies show that this sort of policy creates more unemployment.”

    Color me dubious. In some recent stories about this topic, the real problem was people gaming the system. If people think that they might soon be destitute, they will severely cut back on spending. Is that a good thing in Debt-Deflation? ( I’m tempted to keep asking questions.) The reason a Negative Income Tax would be a great Automatic Stabilizer, especially in a Saving/Hoarding Spree Environment, is that is will lessen the cutback on spending by lessening uncertainty. Although only some people lose their jobs, a lot more people fear that they might.

    I don’t doubt some small number of people choose not to work, but I think the fear of being laid off is a bigger concern, especially in a ‘recovery’ like the one we’re having. Other than that, I basically agree with you.

  7. Gravatar of Steve Steve
    10. June 2010 at 03:14

    Would be great if you could comment on this.

  8. Gravatar of Ryberg Ryberg
    10. June 2010 at 03:52

    I appreciate this discussion on multiple mindsets. Let me add another one. Not all money is the same and we need to be looking at its various forms.

    The Fed is believed to control short term rates on short term money to influence long term expectations. Helicoper Ben also believes he can simply print short term money with some impact on long term expectations. What is being overlooked are measures of long term money.

    This link shows that the rate of growth of M1 has been declining since before the beginning of the year; the M2 rate of growth has been declining for more than a year; and M3 has been been declining in absolute terms for at least 6 months. The money supply is deflating and the trend is for accellerated deflation of the money supply.

    The Fed tried to stem this flow by printing M1 money without effect. They have shot their wad and even M1 may decline soon. Money multipliers are working against them. They also work against fiscal policy stimulus.

    M3 money is comprised largely of private sector debt. As the economy weakens, debtors will be reluctant to add debt and will affirmatively try to reduce debt. This causes the money supply to stop growing at best and begin declining at worst. The result is a further weakening of the economy.

    Hence, the debt trap. And if the Fed isn’t powerless, it must address M3, which it doesn’t even publish any more.

  9. Gravatar of ssumner ssumner
    10. June 2010 at 05:21

    Doc Merlin, Krugman’s always been pretty reasonable on oil prices.

    thruth, I don’t know if the last sentence in the quotation is their view or the market’s view, but either way it is wrong. Borrowing short and lending long is not safe, even if short rates stay low. There is still default risk, as we have recently discovered.

    But the bigger problem is that he seems to confuse low interest rates with monetary ease.

    I think the current low rates reflect the weak economy. So I don’t see them as a subsidy to banks. One possible exception is the 1/4% interest on reserves.

    Dan Carroll, Good question. I frequently criticize these indices as being very inaccurate. They showed housing prices rising during the historic collapse of 2007-09.

    mbk, Yes, I recall that Obama poster. I’m surprised the conspiracy buffs haven’t picked up on all the subliminal messages being sent. 🙂

    If street art interests you, the film “Exit Through the Gift Shop” is a must see. It is very clever.

    Don the Libertarian Democrat, You said;

    “I don’t doubt some small number of people choose not to work,”

    I think this is a very misleading way of looking at things. I don’t doubt that almost everyone prefers to have a job rather than be unemployment. But that’s not the issue. The question is which job? UI increases what is called “search unemployment” which is people actively looking for work. It also makes nominal wages much more sticky.

    In my view AD is driven by monetary policy, not by whether people are cautious and don’t want to spend money.

    Ryberyg, I did a post a few weeks back on the big slowdown in M3 growth. I think the best indicators of Fed policy are expectations of NGDP growth, not the various monetary aggregates. But I do agree that the drop in M3 is probably one indication of tight money.

  10. Gravatar of ssumner ssumner
    10. June 2010 at 05:26

    Steve, I disagree with virtually everything until the last paragraph. The last thing Europe needs is for one of its sensible countries to follow the reckless fiscal expansion of places like Greece and Portugal. And Germany’s trade surplus is certainly not the problem. In the last paragraph Rodrik finally gets to the main point—the ECB needs a higher price level target.

  11. Gravatar of Jeff Jeff
    10. June 2010 at 11:22

    There are those who blame the Greenspan Fed for the housing bubble. They maintain that interest rates were held too low for too long after the tech bubble burst. Apparently Rajan thinks they may do it again.

    If you admit the possibility of including some asset prices in the price index that you target, then there is a continuum. At one end the asset-price weight is zero and the result is conventional inflation targeting. At the other end Scott sets up an NGDP futures market, gives that asset a weight of 1 and assigns everything else a weight of zero. I guess Rajan is somewhere in between and uses some other asset price, but I don’t know what it is.

    The other dimension of targeting is levels versus rates. Inflation targeters usually prefer rates, Scott prefers levels.

    Scott, if there had been an NGDP futures market back in 2003 – 2005, what do you think it would have indicated? Is there any evidence you can cite to support your view?

  12. Gravatar of Kaleberg Kaleberg
    10. June 2010 at 19:41

    This all ignores the real problem of rising productivity and stagnant wages. That nailed us in the 30s and it is nailing us now. Business won’t grow without customers. You can’t get customers unless people have money.

  13. Gravatar of Doc Merlin Doc Merlin
    11. June 2010 at 02:42


    That suggests we could fix the problem through loosening employment markets. Doing things like removing state requirements that employees are provided health insurance, removing minimum wage laws, etc.

  14. Gravatar of scott sumner scott sumner
    11. June 2010 at 04:57

    Jeff, Easy money didn’t cause the housing bubble, because money wasn’t particularly easy in 2003-05. Remember that low interest rates don’t mean easy money. Second, if asset prices should be a part of the target, then that provides even more reason to ease, as asset prices are quite low (especially real estate.)

    NGDP targeting would have prevented the recession we have just experienced. It might have modestly reduced the housing bubble in 2005, but I doubt it would have had much effect. Monetary policy can’t do everything, and it certainly shouldn’t be targeting a specific sector of the economy like housing. If we want to reduce housing bubbles, the only way is through better regulation of the banking system, not monetary policy.

    Kaleburg, I disagree. There was no sudden fall in real wages that caused the economy to collapse in late 2008. Instead it was a much tighter monetary policy. There was a fall in NGDP, which is the responsibility of the Fed, not business. The problem in the 1930s was that NGDP fell in half, unequal wages were not a factor.

    Doc Merlin, Those are good ideas, and would boost total wages earned.

  15. Gravatar of Jeff Jeff
    11. June 2010 at 07:15

    Scott, I don’t disagree. I was only pointing out a possible reason for Rajan to say what he says.

    I also agree that monetary policy can’t do everything. In particular, it can’t prevent bubbles. Only appropriate regulation can do that.

    If the government guarantees any liabilities of an institution, it must also limit that institutions leverage. Greater leverage increases the expected value of the guarantee, so hard limits are a necessity. Experience also shows that risk-adjusted capital requirements are mostly a bad idea, as they invite gaming the system. The only exception I would allow is a de minimis requirement for holdings of short-term Treasuries and deposits at a Federal Reserve Bank. A simple rule that said everything else had to be funded at least 20 percent by equity or convertible debt would prevent almost all financial crises. Banking would be less profitable, and bankers would be paid less, but as they say in the software business “That’s not a bug, it’s a feature!”

  16. Gravatar of ssumner ssumner
    12. June 2010 at 06:46

    Jeff, I agree. I favor abolishing FDIC, or reforming it greatly. If we can’t do that, I’d limit leverage by requiring 20% downpayments on mortgages and similar loans.

    We’d have less housing, but as you say “that’s not a bug, it’s a feature.”

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