The Wizard of the Fed

Everyone remembers that scene at the end of the Wizard of Oz, where the curtain is pulled back and we see the wizard without all the surrounding hocus-pocus.  What a disappointment!  I had that feeling reading Alan Greenspan’s new piece on the recession.  After just two sentences I was about ready to throw my shoe against the screen:

The US recovery from the 2008 financial and economic crisis has been disappointingly tepid. What is most notable in sifting through the variables that might conceivably account for the lacklustre rebound in GDP growth and the persistence of high unemployment is the unusually low level of corporate illiquid long-term fixed asset investment.

No.  The reason for the lackluster rebound in what Greenspan mistakenly calls “GDP growth” (which should correctly be called “real GDP growth,” as nominal should always be the default in economics) is very simple.  As I showed in this post, real GDP growth is very slow because NGDP growth is very slow.  And of course it’s the Fed’s job to control NGDP growth.

Then Greenspan suggests the problem is over-regulation:

As a share of corporate liquid cash flow, it is at its lowest level since 1940.  This contrasts starkly with the robust recovery in the markets for liquid corporate securities. What, then, accounts for this exceptionally elevated level of illiquidity aversion? I break down the broad potential sources, and analyse them with standard regression techniques. I infer that a minimum of half and possibly as much as three-fourths of the effect can be explained by the shock of vastly greater uncertainties embedded in the competitive, regulatory and financial environments faced by businesses since the collapse of Lehman Brothers, deriving from the surge in government activism. This explanation is buttressed by comparison with similar conundrums experienced during the 1930s.

Greenspan’s right about the 1930s, or at least the NIRA, but he’s wrong about the current policy environment.  None of the recent changes can explain the slow NGDP growth, and if that’s not persuasive enough then consider that the economy boomed in 1963-73, when government activism was far more aggressive than today.  Furthermore, a large share of corporate profits are now earned in booming overseas markets, so there is no mystery to be explained.

I found the following to be particularly dismaying, coming from a supposed libertarian:

But human nature being what it is, markets often also reflect these fears and exuberances that are not anchored to reality. A large number, perhaps a majority, of economists and policy makers see the shortfalls of faulty, human-nature-driven markets as requiring significant direction and correction by government.

Oh yes, those irrational market participants need to be herded like sheep by us hyper-rational academics and policymakers.  You know; the academics who almost universally failed to predict the crisis, and the policymakers who were acting as cheerleaders for the housing boom—complaining that banks weren’t doing enough sub-prime lending.  The policymakers who reacted to the gigantic sub-prime fiasco by finally getting around to banning sub-prime mortgages.  Oops, I mean by having the FHA subsidize even more sub-prime mortgages.

Here’s what Greenspan should have said:

Policymakers, particularly monetary policy makers, are subject to all sorts of fears that are not anchored in reality.  These include fear of unconventional monetary policy, once conventional policy is no longer possible.  Thus human-nature-driven policymakers require significant correction and direction by the markets.

HT:  Paul Krugman, who’s dismayed for slightly different reasons.



27 Responses to “The Wizard of the Fed”

  1. Gravatar of marcus nunes marcus nunes
    20. March 2011 at 18:57

    As I often say, Greenspan ended doing the right things during his tenure (Friedman acknowledged that much) from pure chance (what a lucky guy!). He confessed to that (unknowingly, of course) in the Conundrum – chapter 20 of his Age of Turbulance.
    In the end, everything for him is a “Conundrum”:
    “This explanation is buttressed by comparison with similar conundrums experienced during the 1930s”.

  2. Gravatar of Jon Jon
    20. March 2011 at 19:46

    Hmm. David Henderson linked to a recent recording on Greenspan on CNBC a couple weeks ago. Greenspan did make some interesting remarks, and many I thought were wrong, but what struck me most is how much he has aged.

    He appeared very much an old man, and so maybe you should be a little more forgiving and little less demeaning…

    Corporate balance sheets are a problem of regulation, or rather tax loopholes. The regulation in question, however, is tax law. When there is a 30% premium to repatriating those funds, there is a large barrier to domestic investment. Whether there would be domestic investment without that premium, who knows…

  3. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    20. March 2011 at 21:13

    Krugman’s really jealous because Greenspan will always be the Most Successful Fed Chairman Ever.

  4. Gravatar of Greg Ransom Greg Ransom
    20. March 2011 at 21:44

    Nice rant.

  5. Gravatar of DanC DanC
    20. March 2011 at 22:19

    The 1963-73 period saw very favorable demographics for the US. The civil rights movement should have increased productivity. And much of the LBJ spending was financed with deficits. (Deficit spending that was mostly financed by domestic borrowing i.e. one group of Americans borrowing from another group of Americans, ignoring misallocation, leaves all Americans about as well off.)

    So why do you thing this period was more aggressive? Spending as a percentage of GDP?

    Or how about the growth of unfunded mandates?

    Increased complexity of the tax code?

    While QE may have helped the economy, so to did a rather radical shift in power in Washington and many states. It eliminated the risk of even greater government interventions in the economy.

    I think you are far too quick to discount the impact of taxes and regulations on the economy

  6. Gravatar of Morgan Warstler Morgan Warstler
    20. March 2011 at 22:40

    Scott, you have to learn to play on one side of the fence.

    You can criticize Greenspan, but the ISSUE is what he didn’t do in 2004-2006.

    Using your time talking about 2008, feels good, but you’ll have so much more cred if you get to 2008 AFTER you have hit 2004-2006.

  7. Gravatar of Mike Sandifer Mike Sandifer
    20. March 2011 at 22:58

    Greenspan was calling for a gold standard or currency board recently: (it’s short)

    I put Greenspan in the same category now as Stiglitz. That is, their opinions may be increasingly more reflecting senility now than anything else.

    Unfortunately, I wonder at times now about Krugman, who’s my second favorite blogger and someone I almost always agree with politically. I consider his comments on China’s currency peg and it’s negative effects on the US, which I think he’s exactly wrong about, and his view on monetary policy and liquidity traps here:

    I responded with comment #8:

    “I have no idea where you’re coming from here. First, if fiscal expansion doesn’t create much in the way of stimulus expectations, then at the very least won’t the effects lag? And then, of course, there’s the little matter of running up the deficit, which certainly isn’t a problem now, but given the state of Washington it could be within a generation.

    And you lack confidence unconventional monetary policy? How do you interpret the temporal contiguity between QE1 and 2 and spikes in nominal and real GDP? How about the more or less instant asset market reactions? Are these just coincidences?”

  8. Gravatar of mbk mbk
    21. March 2011 at 00:34

    If you think about it, the example of Alan Greenspan shows how long it may appear that one’s models work until it turns out that they don’t, and never did. His example makes me extra careful about being certain, even when there are decades of apparent success as proof.

    This actually harks back to the “economics as science” debate. It does matter whether a model is closer to truth than another, as opposed to a model that just works better than another in a particular situation. In the latter case it may just suddenly stop working. The number of all possible models that fit a complex situation is infinite and curve fitting will always produce a better approximation to reality than a correct model – for a while.

  9. Gravatar of Doc Merlin Doc Merlin
    21. March 2011 at 03:32


    “I think you are far too quick to discount the impact of taxes and regulations on the economy”

    Agreed, I think regulatory impact far, far, far outweighs anything a central is likely to do in the short run.

  10. Gravatar of The Numeraire The Numeraire
    21. March 2011 at 04:02

    “The 1963-73 period saw very favorable demographics for the US.”

    Demographics were pretty god in recent decades with a large share of the population in their peak productive and earning years. Nonetheless, Scott’s thesis on 1963-73 is off-base. Most of the intrusions he cites occurred in the latter half of the 10-year period, when growth was much lower and inflation much higher.

    Even some of the intrusions are not nearly as awful as claimed when compared to similar government activity today. Are we to believe that establishing Medicare in 1965 with a modest payroll tax and the majority of health care cost still financed out-of-pocket is way worse than … establishing an individual and employer mandate to acquire/provide subsidised health insurance when the majority of all health care costs are third party and already subject to price controls and strict regulation of delivery. After 40 years of overegulating and abandoning free-market health care is further regulation and government oversight going to be more intrusive and distortive than what Medicare would have been in its infancy?

  11. Gravatar of sam sam
    21. March 2011 at 04:06


    In the end, everything for him is a “Conundrum”

    “Those of us who have looked to the self-interest of lending institutions to protect shareholder’s equity (myself especially) are in a state of shocked disbelief.”

    Greenspan Admits Errors to Hostile House Panel

    It might have been better for us if Mr. Greenspan had spent less time studying economics and more time, say, reading Shakespeare (I’d recommend close attention to MacBeth). Or any other great commenter on the mysteries of the human heart. He might have been spared the inconvenience of shocked disbelief.

  12. Gravatar of DanC DanC
    21. March 2011 at 05:03

    The 1963-73 period saw very favorable demographics for the US

    especially in terms of the number of people supporting the government Vs the number receiving benefits. The projected long term costs of LBJ programs were greatly underestimated and underfunded.

  13. Gravatar of Scott Sumner Scott Sumner
    21. March 2011 at 05:05

    Marcus, Yes, but pretty much all central bankers did the right thing after 1983–so why is Greenspan special?

    Jon, Those tax policies were in effect in 2007, when unemployment was low.

    Greenspan’s a public figure who is used to attacks. He doesn’t care at all about my mild criticisms, not when Krugman is referring to his “Rantings.”

    Patrick, He was a successful Fed chairman. He may go from being undeservedly praised to being undeservedly condemned. I certainly don’t blame him for the reasons that Krugman does. I think he was a good Fed chairman.

    Thanks Greg.

    DanC, I link to a post that explains why 1963-73 was so bad. Yes, there was some deficit spending (albeit not that much), but that’s far more true today. If deficit spending is expansionary, then we should be booming even more than in the earlier period. The key difference is that NGDP growth is much lower today, and that’s on the Fed.

    Morgan, But 2004-06 wasn’t really that bad. BTW, did you catch my earlier comment which praised your view of toilets?

    Mike, Gold standard? He’s living in the past.

    I also disagree with Krugman in those two areas.

    mbk, I would say that models with more robust theoretical underpinnings are likely to work better. “Closer to truth” is almost a tautology, as we define truth by what works.

    Dcoc Merlin, I think tax and regulatory policies are very important, but with a few exceptions they don’t much impact the business cycle. The facts are simple, NGDP (i.e. monetary policy) drives the business cycle. The rest is wishful thinking from people (like me) who don’t like taxes and regulation. Yes, they are bad, but not because they create business cycles. In 2002 a new Argentine government put in a whole raft of crazy left wing ideas, and the economy has been booming ever since. Before 2002 there was a neoliberal government, and it had been in depression for years. Please explain that to me.

    Numeraire, I never said Medicare was worse, I said the totality of regulation was worse. And yes 1968-73 was less good than 1963-68, but paradise compared to what we’ve observed recently. Unemployment averaged about 5%, I’d love to go back to those days.

    Yes, Obamacare is a burdensome regulation that I oppose, but we already have lots of burdensome regulations–one more doesn’t make all that much difference. The 99 week extended UI has a much bigger impact on the business cycle, and of course slow NGDP growth is the primary problem.

  14. Gravatar of Scott Sumner Scott Sumner
    21. March 2011 at 05:05

    DanC, Weren’t welfare roles rising fast during that period?

  15. Gravatar of DanC DanC
    21. March 2011 at 05:06

    I think the economy is a three legged stool. Fiscal policy, monetary policy, and regulations. Too often, for my taste, Scott argues that he can balance the economy with one good leg.

  16. Gravatar of DanC DanC
    21. March 2011 at 05:22

    DanC, Weren’t welfare roles rising fast during that period?

    I would assume so but I’m not as sure as a % of GDP

    I was once warned that Argentina government data is highly suspect.

  17. Gravatar of flow5 flow5
    21. March 2011 at 05:32

    Greenspan is an Keynesian economist that thinks that interest is the price of money – not the price of loan funds (i.e., someone that thinks the money supply can be managed thru the manipulation of interest rates). Greenspan guaged the volume & timing of open market operations in terms of the level of the federal funds rate instead of the desired rate of increase in the volume of costless legal reserves.

    I.e., Greenspan (at the height of the bubble), initiated a “tight” money policy for 31 out of 34 consecutive months. I.e., despite 11 reductions in the FFR Greenspan’s policy remained too tight.

    Then Greenspan wildly reversed his tight money policy & began an easy money policy for 41 consectutive months. I.e., despite 17 increases in the FFR, Greenspan NEVER tightened monetary policy.

    Greenspan’s record is dismal & gives all economists & economics a bad name.

  18. Gravatar of flow5 flow5
    21. March 2011 at 05:57

    But Volcker was even worse. On October 6, 1979 Paul Volcker, Chairman, Board of Governors of the Federal Reserve e System promised that the Fed was going to mend its ways. Hereafter the Fed would deemphasize the control of the federal funds rate and concentrate on holding the monetary aggregates in check. We were advised to “watch the money supply”.

    Paul Volcker’s version of monetarism (along with credit controls), was limited to Feb, Mar, & Apr of 1980. With the intro of the DIDMCA, total legal reserves increased at a 17% annual rate of change, & M1 exploded at a 20% annual rate (until 1980 year’s-end).

    Why did Volcker fail? This was due to Volcker’s operating procedure. Volcker targeted non-borrowed reserves when at times 10 percent of all reserves were borrowed. That’s before the discount rate was made a penalty rate. And the fed funds “bracket racket” was simply widened, not eliminated.

    Then came the “time bomb”, the widespread introduction of ATS, NOW, & MMMF accounts — which vastly accelerated the transactions velocity of money (all the demand drafts drawn on these accounts cleared thru demand deposits (DDs) – except those drawn on Mutual Savings Banks (MSBs), interbank, and the U.S. government).This propelled nominal gNp to 19.2% in the 1st qtr 1981, the FFR to 22%, & AAA Corporates to 15.49%.

    By the first qtr of 1981, the damage had already been done. But Volcker screwed up again (supplied an excess rate of legal reserves to the banking system), in late 1982-83. AAA corporates yields later hit 13.57% May 31st 1984.

    Monetarism has never been tried.

  19. Gravatar of marcus nunes marcus nunes
    21. March 2011 at 06:07

    Greenspan was special for several reasons:
    1. He was Fed Chairman (others follow)
    2. He was there for a very long time
    3. He was responsible for the creation of a new activity (that spread worldwide): The Fed (and other CB)watchers.
    4. He turned himself into an “oracle”.
    5. He was almost unanimously praised beyond praise.
    6. The “Great Moderation”

  20. Gravatar of W. Peden W. Peden
    21. March 2011 at 07:32


    I’ve always found American monetarism a little difficult to grasp. The focus on monetary base control is particularly alien for those of us in Britain, as is the contempt for para-fiscal policy like PSBR targeting.

    American monetarism was certainly never tried and American economists seem to be very uninterested in the experience of the more idiosyncratic versions in Britain, Germany and other countries. In fact, they tend to say that these forms aren’t Real Monetarism at all, which is fair enough but which is no reason to ignore some rather interesting episodes of money mischief e.g. the effect of supply-side reforms on the velocity of money in Britain during the early 1980s.

  21. Gravatar of flow5 flow5
    21. March 2011 at 07:58

    W. Peden

    The monetary base is not, nor has ever been, a base for the expansion of new money & credit, e.g., an expansion of currency is contractionary.

  22. Gravatar of Benjamin Cole Benjamin Cole
    21. March 2011 at 09:18

    Oh, P.U. to Greenspan. And yet another excelletn post by Sumner.

    There are new impediments in place now that frustrate recovery? Really? And what is happening in the 50 states, and hundreds of local governments, where there can be real impediments to business, such as zoning laws?

    And two ongoing overseas nation-occupations, and their attendant trillion-dollar pricetags–why are they never mentioned as a drag on growth? The impossible terrorist security apparatus and the new $200-billion-a-year anti-terrorism boondogglism–why are they never mentioned as drags on growth?

    Crikey, how did the USA economy ever grow in the 1960s, when the top federal income tax rate was 90 percent?

    Like everyone, I detest too-much government intrusion into the marketplace. Sumner’s recent post on OSHA was telling. We don’t need OSHA. Hell, we don’t need the entire Department of Labor.

    But for Greenspan to say that suddenly a magic line was crossed in the last two years is silly.

  23. Gravatar of Morgan Warstler Morgan Warstler
    21. March 2011 at 09:21

    I saw the toilets thing! Now if only Tyler will rewrite that damn digital pamphlet.

    Scott, I think you ought to model what level NGDP 5% from 2000 looks like, and show what would have happened – when would we have raised rates?

    It’d be a good blog post.

  24. Gravatar of bertusmaximus bertusmaximus
    21. March 2011 at 13:32

    any thoughts on the Treasury winding down its MBS portfolio or banks being allowed to pay dividends?

  25. Gravatar of Scott Sumner Scott Sumner
    22. March 2011 at 07:13

    DanC, I agree that taxes and regulation are the keys to long run growth, but money is quite important in the business cycle. RGDP usually falls because of a slowdown in NGDP.

    The Argentine inflation data is unreliable, but the growth data is at least in the ballpark.

    flow5, I agree that interest rates are a poor indicator of tightness, which aggregate do you use?

    Marcus, All true, but recall that other countries like Australia had an even Great Moderation, and never left it.

    Benjamin, I agree.

    Morgan, If you want to show money was too easy in 2004, you’d better start in 2002. If you start in 2000, money won’t look easy because we fell below trend in 2001-03.

    Bertusmaximus, I have a big problem with bank regulation in general. They should have required much larger down-payments on mortgages and construction loans, and left it at that. Oh, and sharply reduce the maximum deposit covered by FDIC. I don’t object to bank dividends, bonuses, etc. I heard the Treasury made a profit on its MBS purchases, but of course they will probably lose on bailing out the GSEs. That’s all I know.

  26. Gravatar of mbk mbk
    22. March 2011 at 16:14


    “The facts are simple, NGDP (i.e. monetary policy) drives the business cycle.”

    You realize that this is pretty much the central tenet of Austrians? This could have come straight from Mises, or Rothbard. (with some license as to the vocabulary). The only difference is that Austrians regard monetary policy as usually incompetent, because politically tempted. That’s also the only reason they like the gold standard. They’d rather have natural feedbacks do the regulation (along the lines of: Lots of savings – more money in the banks – easier money. Little savings – less money in the banks – tighter money). One could also reasonably say that the whole political opportunity for messing is created by reserve banking to begin with and its endless possibilities for tweaking the rules on creating credit.

    Your true innovation in this line of thought is to take the political bias out of policy by targeting expected NGDP through an actual impersonal market. But your recent “recession” post shows you also don’t trust politics to actually stick to this. Now we’ve come full circle (I am actually not so pessimistic).

  27. Gravatar of ssumner ssumner
    23. March 2011 at 17:02

    mbk, I didn’t mean to say I don’t trust politicians to do this. I meant that if they let thee deep slump happen, they have already pretty much signaled they don’t intend to do NGDP targeting, so I wouldn’t be optimistic at that point. Australia’s done well since 1991, so I have no reason to think modern economies can’t sharply reduce the business cycle, I think they can. If they are successful, it won’t look like they have done anything, it will look like “luck.”

    I agree that Hayek favored NGDP targeting.

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