Three wacky theories

Traumatic events spawn wacky theories.  After 9/11 some claimed the government had planted explosives in the Twin Towers.  The Great Crash of 2008 spawned no less than three new theories on the internet:

1.  The boom caused the bust.  The Fed blew up the bubble, and the only solution is to abolish the Fed and go back to gold.

2.  The monetary base doesn’t matter.  The Fed can swap dollars for bonds without creating inflation, even in the long run.

3.  A sharp drop in AD (or NGDP) will cause a big fall in real GDP.  The Fed controls the path of NGDP.  Low interest rates don’t mean easy money.  Fed policy is highly effective even when rates are near zero.  Fiscal stabilization policy is unnecessary.

No one should be surprised by any of this.  What is surprising, indeed shocking, is that one of the three wacky theories was conventional wisdom just 5 years ago, taught to thousands of graduate students by hundreds of New Keynesian and monetarist macroeconomists in elite graduate schools. The theory was completely abandoned in 2008, then rediscovered in 2009—making it a new (and now heterodox) theory.

How strange is all this?  Imagine if the successful test of general relativity in 1919 (during the lunar eclipse) had caused Einstein to abandon his theoretical edifice.


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22 Responses to “Three wacky theories”

  1. Gravatar of Ryan Ryan
    5. April 2012 at 17:25

    I also think that people who disagree with me are wacky.

  2. Gravatar of Peter N Peter N
    5. April 2012 at 18:07

    “The boom caused the bust. The Fed blew up the bubble, and the only solution is to abolish the Fed and go back to gold.”

    This is a whole nest of ideas, not 1.

    1) Booms and busts

    a) Booms are often caused by busts.

    This is hardly heterodox, though the question is complicated by potential quibbles about what is meant by cause (immediate, ultimate, contributory, necessary…).

    b) This particular bust was caused by a boom.

    c) The real estate boom was a reflation of the internet boom, so there was a single boom that caused the bust. This is usually part of any theory that blames the Fed.

    2 “The monetary base doesn’t matter. The Fed can swap dollars for bonds without creating inflation, even in the long run.”

    You can accept or deny these independently and argue about the relationship. For instance, you may recall a bit of recent discussion about reserves.

    3 “A sharp drop in AD (or NGDP) will cause a big fall in real GDP. The Fed controls the path of NGDP. Low interest rates don’t mean easy money. Fed policy is highly effective even when rates are near zero. Fiscal stabilization policy is unnecessary.”

    a) “Low interest rates don’t mean easy money.”
    Not very heterodox.

    b) “Fed policy is highly effective even when rates are near zero.”
    More heterodox and subject to assumptions about what the accompanying fiscal policy is. I think most economists would say that monetizing a deficit is effective (inflationary), even if they thought it was bad policy.

    c) “The Fed controls the path of NGDP.”
    Certainly true, but disagreements about delays, side effects and political realities make this largely an empty tautology.

    d) “Fiscal stabilization policy is unnecessary.”
    Always? Usually, but now is a special case? Except when there is a guarantee of complementary monetary policy?

    e) “A sharp drop in AD (or NGDP) will cause a big fall in real GDP”

    Heterodox? You know people who will argue that demand affects supply only in nominal terms and not real ones? Where do they teach? Are they allowed visitors there?

    If you want to have discussion rather than flames, it’s better to open only one can of worms at a time. Advice I should take more to heart myself.

  3. Gravatar of Mark A. Sadowski Mark A. Sadowski
    5. April 2012 at 18:55

    Scott,

    I guess you mean

    “3. A sharp drop in AD (or NGDP) will cause a big fall in real GDP. The Fed controls the path of NGDP. Low interest rates don’t mean easy money. Fed policy is highly effective even when rates are near zero. Fiscal stabilization policy is unnecessary.”

    was orthodox until four years ago.

    Yes, I know that’s what I was taught but now if you claim that they call you a bloody radical!

  4. Gravatar of Dan Kervick Dan Kervick
    5. April 2012 at 21:10

    I assume you are kidding about the “successful test” idea. Theory three was pure conceit pre-2008 and pure conceit post-2008.

  5. Gravatar of Mark A. Sadowski Mark A. Sadowski
    5. April 2012 at 21:16

    Thursday night breakdown.

    http://www.youtube.com/watch?v=6QaAdT3zHLs&feature=player_embedded

    Libertarians let you hips move free.

  6. Gravatar of Greg Ransom Greg Ransom
    5. April 2012 at 22:00

    William White presented this theory in 2003 — in person — to Alan Greenspan & the Fed banking establishment:

    “The Great Crash of 2008 spawned no less than three new theories on the internet:

    1. The boom caused the bust.”

    White and the BIS economists were warning Greenspan, Bernanke & the profession what they were producing across the 2000s — you can go to the BIS research archive and read their papers for yourself.

    And this stuff was discussed in the blogs across the decade, as well.

    There is no reason anyone should have been so massively ignorant of this work as most macroeconomists were — and continue to be.

    The basic picture was awarded the Nobel Prize in Economics in 1974.

    There is no excuse for the incompetence of the profession in this area.

    None.

  7. Gravatar of Saturos Saturos
    5. April 2012 at 23:18

    “… one of the three wacky theories was conventional wisdom just 5 years ago, taught to thousands of graduate students by hundreds of New Keynesian and monetarist macroeconomists in elite graduate schools.”

    I think that was the problem: when a crisis comes, people don’t really think in terms of grad-school econ. It may have reached the right conclusions, but only through a lot of highly mathematical reasoning which does little to bolster people’s intuition. Krugman himself has said that he likes to run policy through an ISLM check first, and only then comes up with an ex post facto NK model justifying his desired conclusion. What really matters to the way the economics profession actually handles a crisis when it comes is the economics taught at undergraduate level. As has been (repeatedly) pointed up, Macro 101 is still stuck in an Old Keynesian timewarp – that’s what really determines the reaction of the opinion-makers. And when ISLM is properly introduced the following year, it still isn’t taught right – focus is taken away from the centrality of excess cash balances, and, “IS shifts in mysterious ways”. The IS is often derived from the Keynesian cross without mentioning loanable funds at all. Put on the spot, a Keynesian is hard pressed to explain to someone like Russ Roberts how it is that we increase G without full crowding out, holding the money supply constant. (Try asking your sophomores whether they understand this point). Of course, Keynesian cross should be derived from ISLM, not the other way around. But we can’t have Nick Rowe teaching in every university.

    I think this is the real answer to your central question on this blog: “Why does almost no one else see things that way?” If Milton Friedman were taught with more focus in the undergraduate syllabus, we’d be less obsessed with backward-looking, poorly communicated Taylor rules and more focused on stabilizing the path of nominal spending. The fact that this still isn’t obvious to most economists shows that they never really “got it”.

    Greg Ransom:

    I see Scott still hasn’t changed your views on the significance of recalculation. You seem to be even more resilient to abandoning this than John Cochrane and John Taylor are to abandoning their “financial” explanations.

  8. Gravatar of Steve Steve
    6. April 2012 at 03:25

    Scott, as usual I agree.

    One additional wacky theory I have is that low inflation actually caused the housing boom-bust (with tie-ins to the bad bank/mortgage regulation story).

    The idea is so incredibly simple. Credit is allocated based on nominal coverage variables: PITI/INCOME (or INTEREST/EBITDA or INTEREST/TAX REVENUE for corporate and government entities), so the system initially allows huge leveraging in response to low inflation.

    However, I believe that lots of prices eventually return to longer-term trends.

    1) House price trends will eventually return to a long-term growth trend in CPI and income growth as Shiller has shown.

    2) Interest rates will eventually return to a level near expected CPI.

    Notice that my argument superficially plays into the hands of the “too low for too long” crowd, as low interest rates fostered housing focused leverage among people maxing their PITI/INCOME ratio. The “too low for too long crowd” is completely wrong, however, because while they believe in (1), they completely ignored (2).

    The Fed attempted higher rates and a flat monetary base in 06-08 and got a massive bust. Ultimately we returned to the low rates of the late Greenspan era (and we will stay there no matter what the hawks think), but the bust produced the tighter credit underwriting we should have had then.

    As you know I agree with market monetarism, but we over-allocated to housing (or at least mis-allocated to people who couldn’t afford it) in the Greenspan period because the markets didn’t understand that credit metrics needed to *tighten* in a low inflation environment.

  9. Gravatar of ssumner ssumner
    6. April 2012 at 05:04

    Peter, I’ll skip over points one and two, as I wasn’t really calling those theories wacky, I was suggesting that others view them that way.

    As far as low interest rates and easy money; approximately 99.9% of economists thought money was easy in late 2008, mostly because rates were low.

    Mark, That’s right.

    Dan, I strongly disagree–there’s all sorts of evidence supporting it. Start with Friedman and Schwartz’s Monetary History.

    Greg, I agree about incompetence.

    Saturos, Good point. BTW, I view IS-LM as part of the problem. Economists reverted to undergrad economics, and forget everything they learned in grad economics.

    Steve, I’m still inclined to think the overallocation to housing was mostly regulatory failure (moral hazard.)

  10. Gravatar of dwb dwb
    6. April 2012 at 08:04

    you also forgot, Pat Robertson now favors legalizing pot (i NEVER EVER thought i’d live to see that day).

    OT: I hate the way Krugman calls for more “inflation” (see his column today). a) we have no idea what the breakout between growth/inflation would be with more stimulus (nor does he) but most models i’ve seen say there would be more real growth than inflation; b) whos in favor of more inflation (no one thats who!! – this is one of those normative phraseology issues).

    I left comments, people should gang up on him send nasty emails and comments until he just says “higher nominal income.” bang the drum until people forget the i-word. its irrelevant and only feeds the hawks.

    happy easter to all.

  11. Gravatar of Shane Shane
    6. April 2012 at 08:33

    If you subtract the part about returning to gold, the conventional wisdom is actually closest to 1, even among supposed liberals. You find all sorts of establishment types espousing the view that “fundamentally unsound” bubbles risk recessions (that’s Krugman’s term from this post: http://krugman.blogs.nytimes.com/2012/01/24/a-tale-of-two-bubbles/)

    Krugman is always careful not to say that easy money per se caused the bubble. But when most people here “unsound bubble,” it acts as a prime, like in psychology experiments, and they unconsciously supply the second half of the argument: too much spending (i.e. easy money) was the cause. Hence Planet Money, supposedly liberal NPR’s economics team, gives very favorable coverage to the notion that interest rates being too low for too long caused the crisis (http://www.npr.org/blogs/money/2012/01/29/146063837/blame-the-u-s-for-the-housing-bubble-not-china).

    They also gave a very, very sympathetic interview to Thomas Hoenig that barely challenged any of his wacky claims (http://www.npr.org/blogs/money/2011/07/07/137555278/the-friday-podcast-fed-behaving-dangerously-fed-president-says)

    Even if Krugman doesn’t argue that easy money per se created the bubble, shouldn’t bubbles still lead to stagflation, not depression and deflation, according to standard New Keynesian thinking? Was there a single mainstream model before the crisis that said that too much demand, caused by loose money or loose regulation, leads to a crash?

  12. Gravatar of Jason Jason
    6. April 2012 at 10:17

    I guess you can call anything you want crazy, but I would check out the Architects and Engineers for 911 truth website before I would jump to that conclusion. I am a very skeptical person but have been convinced by the evidence for controlled demolition.

    I agree with you about the economics of the post at least.

  13. Gravatar of ssumner ssumner
    6. April 2012 at 14:43

    dwb, I agree.

    Shane, A few years ago I did a post entitled “We’re All Austrians Now” making a similar point. Nevertheless the Ron Paul view is still seen as being wacky, just like MMT and MM.

    Jason, No comment.

  14. Gravatar of Shane Shane
    6. April 2012 at 15:33

    That’s funny, I almost used the line “we are all Austrians now” at the end of that. Something stopped me, perhaps an unconscious sense that it would be plagiarism!

  15. Gravatar of Maximillian Maximillian
    7. April 2012 at 05:28

    I’m not sure your characterisation of the change in thinking is right. We didn’t know whether money was tight pre crash until nominal gdp figures came in. In fact you could say money was neither too tight nor loose until the crash happened, nominal gdp plummeted and hence money was too tight.. I.e velocity crashed along with the financial system. Also most people didn’t know to look closely at nominal gdp because we weren’t taught by this different drummer and also everyone missed bernanke 2003

  16. Gravatar of ssumner ssumner
    7. April 2012 at 11:43

    Maximillian, If we didn’t know (and we most certainly did know) why the hell hasn’t the US Federal Government created an NGDP futures market? I presented my NGDP targeting idea to the New York Fed in the 1980s, and they said “thanks but no thanks, we don’t need the market to help us forecast.” Now we are told they do?

    In addition, one reason NGDP fell was that the markets knew the Fed wasn’t doing level targeting, and hence expectations turned very bearish.

  17. Gravatar of Maximillian Maximillian
    7. April 2012 at 15:34

    Ss can use the royal ‘we’ but the rest of the unwashed had to wait till 2009. I don’t mean this facetiously But most of us, had no idea what went wrong. I think even people that had been taught the conventional wisdom at you put it had either no idea what it meant, or no idea how to apply it to what was going on. Seriously, I don’t think we went from perfect knowledge to panic, to finding your blog. We went from total ignorance to finding your blog, with obvious panic in the middle. Ok, bernanke remains a bit of a mystery but can be easily accounted for by politics.

    In other words, you are completely right but you should be less shocked. The ignorance above was definitely of ngdp targeting, (I created the Wikipedia page for that only recently!) and certainly of the importance of nominal variables especially GDP. Of course, it all seems perfectly reasonable in hindsight even to laymen, but no one really mentioned any of this until your blog, which is your stated reason for blogging.

    It is true that we had the confirmation of a unique collapse of nominal GDP caused by ‘mere’ financial panic causing an unprecedented recession, in last fifty years, but the fed had most economists had no idea what was going on, because they didn’t do or write anything about it. So yeah they might have been taught this and it’s shocking they didn’t ‘learn’ it, but there’s no way they “abandoned” this thinking having previously held it, otherwise they would be you and you would be unknown.

  18. Gravatar of ssumner ssumner
    8. April 2012 at 14:33

    Maximillian, It’s true that not many people were using the term ‘NGDP’ in late 2008, but everyone understood the concept of deflation, and of falling output, and of falling aggregate demand. In the fall I was in such a state of shock that I went down to Harvard to talk to Mankiw. I said to him “doesn’t the Fed know that AD is going to greatly undershoot their target?” He said something to the effect “oh, they know, they just don’t know what to do about it.” Every day the media had news reports of demand collapsing all over the world. Shipping rates plunged 90%, factory output was plummeting everywhere in the world. All asset markets were crashing, except T-bonds. They knew there was a problem, but they were so obsessed with banking that they forgot that monetary policy also controls AD, it’s not just about banking.

    It would have been better if we’d had a NGDP futures market, but in late 2008 we didn’t need that to see we had a problem.

  19. Gravatar of Postkey Postkey
    21. July 2015 at 10:33

    According to S. Keen.

    In the USA, in the ‘Great Depression’ private aggregate demand fell and, in the 1930’s, real GDP declined by 28%. 
    In the USA, in the ‘Great Recession’, private aggregate demand fell by a greater amount than it had in the ‘Great Depression’ but real GDP declined by ‘only’ 5%. http://keenomics.s3.amazonaws.com/debtdeflation_media/2012/12/Keen2012FiscalCliffLessonsFrom1930s.pdf

    ‘Someone’ did something {belatedly?} ‘right’?
    Or was it the ‘built in stabilisers’?

  20. Gravatar of Postkey Postkey
    21. July 2015 at 11:20

    Or no government directed increase in the money wage?

  21. Gravatar of ssumner ssumner
    21. July 2015 at 16:32

    Postkey, No, private AD fell much, much more in the Great Depression.

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