Why does Chicago ignore the markets?

In the previous post I suggested that Paul Krugman might have earned a bit of bad karma with his skepticism about monetary policy during late 2008 and early 2009.  But at least he favored monetary stimulus, no matter how much he suggested it was unlikely to occur and/or be effective.  In contrast, UC professor Raghuram Rajan is now advocating a 200 basis point increase in the Fed’s target rate.

Now I am all for higher rates, but I want them to rise as a result of expected economic expansion, not the liquidity effect.  Anyone with even a passing knowledge of the equities markets knows that this sort of move would produce  a stock market crash.  Not simply a fall in stock prices, but a world-wide meltdown of epic proportions.

I thought University of Chicago economists believed in efficient markets?  Sure, the stock market doesn’t precisely track social welfare.  But how often does a major stock market crash lead to good things?  What sort of confidence would you have to have in your policy “hunches” in order to advocate a policy likely to immediately destroy many trillions of dollars in wealth?  I’ll say this; I lack that sort of confidence, and I’m glad I do.

PS.  This is really scary:

He (William White) and Rajan will have the chance to make their case at the Fed’s annual symposium in Jackson Hole, Wyoming, this week.

HT:  Paul Krugman

Update:  A commenter named Ashwin pointed out that Rajan is concerned that low rates will bail out speculators.  Actually, low rates tend to be associated with falling asset prices.  I agree that higher rates would be desirable, but only if achieved through a more expansionary policy.  Rajan’s idea was tried in 1931.  We had experienced two straight years of job loses, and the Fed responded by raising rates by exactly the 200 basis points he recommends.  It helped turn a severe recession into the Great Depression.  And the Depression then forced rates down close to zero, where they remained for almost 20 years.  So his proposed policy wouldn’t even achieve the higher rates he envisions, just the opposite.


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46 Responses to “Why does Chicago ignore the markets?”

  1. Gravatar of Liberal Roman Liberal Roman
    23. August 2010 at 11:15

    Futher proof that the main culprit and entity to blame for the Great Recession is the economics profession.

  2. Gravatar of JimP JimP
    23. August 2010 at 12:21

    I think this article puts the case against more fiscal or monetary stimulus pretty well – stimulus leakage and a real fear of a collapse in the dollar and raging inflation. I think this is what Bernanke is probably thinking – that what we have now really is about the best we can do (long term).

    http://www.marketwatch.com/story/inflation-not-deflation-mr-
    bernanke-2010-08-22

    And Mike Pettis thinks the leakage of stimulus will likely lead to a trade war – that Germany and China will continue going as they are.

    http://www.ft.com/cms/s/0/9191856a-ae08-11df-bb55-00144feabdc0.htm

    And that seems to be what Eichengren and Temin are also saying, in a quiet way. The surplus countries will not change so the deficit countries are going to have to protect themselves.

    http://www.voxeu.org/index.php?q=node/5359

  3. Gravatar of JimP JimP
    23. August 2010 at 12:23

    The link busted – hopefully this will run/

    http://www.marketwatch.com/story/inflation-not-deflation-mr-bernanke-2010-08-22

  4. Gravatar of Ashwin Ashwin
    23. August 2010 at 12:29

    Scott – Raghu Rajan’s views can be traced back to a paper he co-authored with Doug Diamond that can be found here http://faculty.chicagobooth.edu/douglas.diamond/research/Diamond%20Rajan%20Interest.pdf . It is essentially a formal treatment of the assertion Rajan makes crudely in the Bloomberg article that the expectation of low Fed Funds rates from the Fed everytime there’s a crisis creates bad incentives. As he puts it “Blow the system up, we’ll come back and reward you with very low interest rates that allow you to build up capital, and then you could try it again next time around”.

    This is essentially an “adaptive systems” generalised moral hazard argument not unconnected to but fundamentally different from Austrian Business Cycle Theory as I discuss here http://www.macroresilience.com/2010/08/03/raghuram-rajan-on-monetary-policy-and-macroeconomic-resilience/ .

    Clearly Raghu Rajan and Bill White think that the maladaptive consequences on banking are more severe than the macroeconomic damage done by a 2% rise in Fed Funds and this is debatable but saying that they don’t have a model is not accurate.

  5. Gravatar of Benjamin Cole Benjamin Cole
    23. August 2010 at 14:14

    Japan has had two decades of average zero inflation. The BOJ there still pettifogs about inflation.

    Central bankers think about inflation the way Savonarola thinks about sex.

  6. Gravatar of W. Peden W. Peden
    23. August 2010 at 15:33

    Is there a “sticky central bankers” theory? That is, are there any theories about the way that central bankers are influenced by (a) memories of extreme economic conditions (whether depression in the 1930s or the great expansion in the 1970s) and (b) by the fact that their ordinary job involves keeping inflation from getting out of hand?

    In defence of central bankers, expecting them to adapt properly to a situation of excessively tight money is like expecting asking a group of doctors who have spent their whole lives fighting cancer to then find and execute ways of causing tumours.

    I hate to stink the place up with monetarism, but if central banks would at least have some rules about responding to extreme movements in the money supply, they would have started the proper response in mid-2008 and we’d be well on the road to recovery by now. It’s just like central banks in a country like the United States shouldn’t base their monetary policy on targeting the exchange rate normally, but if the currency becomes dangerously overvalued or undervalued they need to respond.

    Anyway, I fear that Benjamin Cole has got it spot on and we will have to wait for a long time before central bankers “get it”. Think how long it took for central bankers, who had developed in the 1930s, to adapt to the conditions of the late 1960s and 1970s. Even when inflation was over 25% in Britain, there were still fears about the possibilities of another great depression caused by monetary tightening.

  7. Gravatar of Benjamin Cole Benjamin Cole
    23. August 2010 at 16:09

    W. Peden: Thanks for noticing my post.
    There may be larger thought here: Public institutions always fight “the last war.”
    So, we have federal agencies fighting poverty and racism, a USDA tohelp farmers, and the Department of Defense spends money like crazy in a Cold War formation. It is still 1962, as far as federal agencies are concerned (well, 1932 at USDA).
    So, the Fed is fighting its last great war–inflation.
    Private companies selling out-of-date services go bankrupt. There is no bankruptcy in DC.

  8. Gravatar of Larry Larry
    23. August 2010 at 16:28

    This piece made me doubt (for the first time in a year) that monetary stimulus offers a way out.

    http://www.marketwatch.com/story/inflation-not-deflation-mr-bernanke-2010-08-22?pagenumber=2

    Thanks for your thoughts.

  9. Gravatar of Morgan Warstler Morgan Warstler
    23. August 2010 at 16:29

    +1 Ashwin, but if you try and insist on the moral hazard argument to Scott, he blanks it out. Which is not to say he doesn’t get it, its just that he’s not afraid of it, or maybe he really likes bankers. Somehow though, he is afraid that high unemployment will lead to socialism. It’s a fine needle he threads.

  10. Gravatar of JimP JimP
    23. August 2010 at 17:05

    An inside view of the latest Fed. meeting. I have to wonder if the last graph wasn’t the point the leaker of this wanted to make – that Ben will act if he thinks he must. But 7 of 17 opposed the last move – thats quite a few. Where are those new Fed nominees?

    http://online.wsj.com/article/SB10001424052748703589804575446262796725120.html?mod=WSJ_hps_LEFTWhatsNews

  11. Gravatar of JL JL
    23. August 2010 at 17:15

    @Morgan and Ashwin

    So because the banksters blew up the system, the government should now blow up the economy? Sorry, but I can’t agree to that…

    I don’t know if it would be wise, but letting banks go bankrupt and refunding consumers through the FDIC seems like the most natural way to punish bad banking.

    And if you want to prevent moral hazard, introduce better regulation. The Glass-Steagal act of 1933 makes some sense to me.

    Also, don’t try to revive the dead austrian business cycle theory. It’s been debunked. There is nothing fundamentally different between blaming easy money directly, or blaming the anticipation of easy money.

    In both cases you’re blaming easy money for causing the bad times, when easy money would actually be the cure.

    Also, do I drive to the pizza parlor because I want to eat pizza, or do I drive to the pizza parlor because I anticipate eating pizza?

  12. Gravatar of scott sumner scott sumner
    23. August 2010 at 17:17

    Everyone: I added an update to answer Ashwin’s comment.

    Liberal Roman. I entirely agree.

    JimP, I think both Pettis and Temin/Eichengreen underestimate the importance of monetary policy. I don’t buy Pettis’ macro model, as it assumes trade deficits cost jobs, which is not the case. His strong point is his analysis of the Chinese economy.

    Ashwin, Thanks for that valuable info. I don’t buy that model for all sorts of reasons, some are explained in an update that I added. BTW, it was Krugman who claimed that they didn’t have a model, not me. I said he relied on a policy hunch. Models are basically formalized hunches, nothing more.

    The Fed needs to aim for steady NGDP growth. In the long run that will produce the most stable interest rates, and will be the policy that is least likely to bail out foolish speculators. Low interest rates don’t mean easy money, contrary to what Rajan assumes.

    Benjamin, I agree.

    W. Peden, I expected more from Bernanke because as an academic he seemed to understand the danger of a single-minded focus on inflation. He was very critical of Japan, and correctly advocated monetary ease in 2002-03. But he obviously has changed, or else is intimidated by the hawks.

    Benjamin#2, That’s why I favor letting the market set monetary policy, once the government has set the numerical inflation/NGDP goal.

    Larry, That article assumes US monetary policy is loose, and it is not. Inflation will be low over the next 10 years.

    Morgan, I’m not sure high unemployment will lead to socialism, or won’t lead to socialism. But in either case I don’t like high unemployment. Why would anyone like high unemployment, except some rich jerk hoping to have cheap servants?

  13. Gravatar of scott sumner scott sumner
    23. August 2010 at 18:14

    JimP, That article is very informative and very depressing. Seven hawks at the Fed? Bernanke sure has his hands full.

    JL, NY Fed President Strong made a similar point in 1928. He said something like “do I have to spank all my children because one misbehaved?” But he died in late 1928 and the Fed decided to spank the stock market in late 1929. They ended up spanking the economy as well.

    I am afraid the FDIC is part of the problem. It encourages banks to take excessive risks.

  14. Gravatar of Morgan Warstler Morgan Warstler
    23. August 2010 at 19:33

    At the outset of the Depression, Hoover claims in his memoirs that he rejected Treasury Secretary Andrew Mellon’s suggested “leave-it-alone” approach, and called many business leaders to Washington to urge them not to lay off workers or cut wages.[38] Lee Ohanian from UCLA has argued that President Hoover adopted pro-labor policies after the 1929 stock market crash that “accounted for close to two-thirds of the drop in the nation’s gross domestic product over the two years that followed, causing what might otherwise have been a bad recession to slip into the Great Depression.”.[39] This argument is at odds with the mainstream view of the causes of the great depression, and is strongly contested by both Keynesians and monetarists, for example Prof. Brad DeLong of U.C. Berkeley.[40]

    In 1929, Hoover authorized the Mexican Repatriation program to combat rampant unemployment, the burden on municipal aid services, and remove people seen as usurpers of American jobs. The program was largely a forced migration of approximately 500,000 Mexicans and Mexican Americans to Mexico, and continued through to 1937. In June 1930, over the objection of many economists, Congress approved and Hoover signed into law the Smoot-Hawley Tariff Act. The legislation raised tariffs on thousands of imported items. The intent of the Act was to encourage the purchase of American-made products by increasing the cost of imported goods, while raising revenue for the federal government and protecting farmers. However, economic depression now spread through much of the world, and other nations increased tariffs on American-made goods in retaliation, reducing international trade, and worsening the Depression.[42]

    Yes Scott, I’m sure those 200 basis points caused the Depression.

  15. Gravatar of Liberal Roman Liberal Roman
    23. August 2010 at 19:40

    Scott, have you ever written about why you think the housing bubble happened? I know that you think the recession was caused by contractionary monetary policy but what are your thoughts on the bubble? What was the cause? Should or could anything have been done about it? Was it the too loose monetary policy of Greenspan?

  16. Gravatar of Morgan Warstler Morgan Warstler
    23. August 2010 at 20:21

    Who likes high unemployment? Scott since you’ve been off in Big Sky country, I’ve gone back to reading Dennigner and Mish, Zero Hedge, chart people who don’t live in such an Ivory Tower.

    And I gotta say it makes so much more sense, even parts I disagree with. Occams Razor style. Brutal. Simple. Like the market.

    1. Doesn’t it scare you a bit, that the guys who agree with you the most, are the VERY ONES who’s entire MO is really just short term upside for the statists? If so, how dumb are they for being as right wing free market as you and not knowing it?

    2. You say “Actually, low rates tend to be associated with falling asset prices.” – this is 100% non-responsive. If we stand against QE, like Rajan does: Either way prices are GOING TO FALL. The point is since prices are going to fall, GET IT OVER QUICKLY with higher rates, which also ends the transfer payments to the bankers on the way down. The question here is: IF the band-aid is coming off – can you explain why ripping off the band-aid isn’t better?

    I know you want QE, but it would be interesting to explain how if you aren’t getting QE, why stay at ZERO?

    3. Please once answer my continually asked question – SINCE YOUR POLICY WILL WORK – why not first have the great liquidation, crush the zombie bankers, fix the moral compass? Why not first, get ourselves a stronger Republican Congress? Whats the real downside to 6 months of finally trying it Mellon’s way?

    JL, we had giant fat piles of easy money before the tech crash, then we had them before the housing crash, trying to hide the pain from the tech crash. At neither time was there a ZERO bound interest rate. What there was in both instances: people 110% SURE what they were buying was good deal. Good deals drive things brings the money out. Right ow, nothing looks like a good deal, prices are too high.

    If you anticipate eating pizza and for some reason don’t get to, you never anticipate things, but you’ll still want to eat pizza. Wants last through blacks swans, anticipation doesn’t.

  17. Gravatar of Greg Ransom Greg Ransom
    23. August 2010 at 21:33

    You’re so right Scott, this William White fellow has been sooo wrong across the last decade …

  18. Gravatar of Scott Sumner warns against Rajan & White | Taking Hayek Seriously Scott Sumner warns against Rajan & White | Taking Hayek Seriously
    23. August 2010 at 21:39

    […] Sumner warns against Rajan & White August 23, 2010 | Posted by Greg Ransom Don’t listen to the guys who, you know, got just everything right over the past […]

  19. Gravatar of Andy Harless Andy Harless
    23. August 2010 at 21:40

    The moral hazard argument contains a large component of nonsense. Risk-taking is not a bad thing. There is some optimal level of risk-taking, and it’s not at all clear that incentives are for excessive rather than insufficient risk-taking. (My hunch is that the incentives tend to be for insufficient risk-taking but that they are counterbalanced by a natural human tendency toward excess optimism.) Surely it’s true that if we over-punish risk takers, such that, in the future, people take insufficient risks, that’s a bad thing. The argument that, rather than stabilizing aggregate demand, we should deliberately allow depressions in order to punish risk takers, is rank foolishness, especially when we’re punishing people for risks that would have paid off for everyone involved if aggregate demand had been stabilized in the first place. That’s a clear case of policymakers passing up a free lunch.

    The only valid point I can see in the Rajanist view is that low real interest rates lead to unstable asset prices. This is true because a smaller denominator in the discounting formula makes the result more sensitive to small changes in the denominator. (Thus, for example, if dividends on a particular stock are expected to grow, in perpetuity, almost as fast as the discount rate, then tiny changes in that growth estimate will lead to big changes in the value of the stock.) So at some level there is a tradeoff between growth and stability. But this tradeoff may not be very important, because, as you point out, anti-depression policies ultimately tend to raise interest rates. (I would note, though, that Roosevelt’s devaluation didn’t raise real interest rates — but only because the high rate of deflation was causing ridiculously high real interest rates prior to the devaluation. Obviously the 1929-1933 experience was not anywhere near the optimal point of the tradeoff; and if the comparison is Japanese-style mild deflation, there is a good case to be made that real interest rates would ultimately rise with easier money.)

  20. Gravatar of Liberal Roman Liberal Roman
    23. August 2010 at 22:09

    I will agree with Morgan on one thing.

    People like Scott Sumner and Paul Krugman cannot continue to ignore the arguments of the Morgans and hope they go away. Nor can they just dismiss them. They must take them on and show in the most layman terms why they are wrong.

    This might be stupid and wrong way of thinking about it but I will give it a try. Morgan think about are there any REAL reasons why we should be in economic decline? Meaning, do we face war? Do we face an epidemic? Do we face a shortage of critical resources? Are we too stupid and uneducated to manufacture the goods that we need? Do we not have the technology to produce the goods we need? Is government control so over the top as to completely eliminate the incentive for productive activity?

    You can partially say yes to all of those questions. But none of those reasons were the reason we are in this recession. Ultimately, the reason is not real but it’s NOMINAL. Meaning, that just like the title of this blog, it is an illusion. There is not enough little green papers with dead Presidents out there in circulation because everyone is scared and unemployed and hoarding whatever money they have. It is the job and the responsibility of the United States government to maintain at least a stable monetary supply in circulation. This is not happening right now, hence they must print money.

    That is my best attempt to lay this out in layman terms.

  21. Gravatar of Morgan Warstler Morgan Warstler
    24. August 2010 at 00:15

    @Liberal Roman & Andy Harless,

    The moral hazard argument is not anti-risk, not at all. I, and the the army of libertarian, small business, entrepreneur, hackers, wildcatters, etc. are as PRO-RISK as it comes.

    The moral hazard argument is that my kind of people, risk takers, should not EVER be given a better chance at success by rent seeking, or the entire magical act of human improvement through productivity gains disappears – because they will take the rent and skip the making the gains. Because capitalism works best if government acts as a NEUTRAL referee, leaving as small a footprint as possible on the playing field.

    So YES Roman, there is a reason there has to be a down cycle, thats when the losers get liquidated, and their booty gets split up by the winners at the poker table. Outmoded procedures get crushed, outmoded employees get fired, outmoded thinking is forgotten. This is progress, profit, efficient use of limited resources, mothers milk.

    The GAME being played according to the rules is the only way to keep the players at the table… if the dealer cheats, or the house gets to big a cut, well you get the Great Depression straight through to Carter’s Stagflation. We’re a smarter people now, I’ve said before I totally accept that the right has intentionally deficit spent to short circuit democracies worst effects since Reagan. We LEARNED as a people since Reagan to be far less wiling to trust government for improvements to our lives. Even though we ourselves might not be super rich, we grudgingly admit things are better when the super rich keep their chips and keep playing – this shows a deep emotional intelligence, it is the equivalent of NOT EATING THE MARSHMALLOW. It’s as big a deal as casting off racism.

    When people talk “expectations” and “anticipation” this is the most crucial thing – the rules need to be laid down, an impartial dealer has to sit down, and then nothing can change, because long as the game is played, the economy will grow.

    Look guys, China proves you can sprinkle capitalism on ANYTHING and it gets up and walks. The test for the new century is whether authoritarian capitalism or democratic capitalism is superior…. and for us to win, its really a test of whether we can control the worst parts of Democracy.

    Fundamentally, targeting NGDP is an attempt to lessen the downside of the business cycle – Scott pitches it as somehow worth a a couple points annual tax on savers in order to goose this along for the greater good.

    But it’s just the Keynesian camel’s nose, after a brilliant played 40 years – with hard fought wins, Scott wants to tell people that $100 in 5 years will be worth $82 just sitting on the poker table – and tell them to EXPECT IT, and he thinks that’ll make them happier to play the game. The only people who like that are the ones who owe a $100, and the only thing it teaches them to do is to wait to pay.

    It just SOUNDS like a guy who doesn’t take risks for living.

    Roman, I’d suggest your total disrespect of “little sheets of money,” as if there is some royal WE – theres NOT, there are people who have savings, and there are people who have DEBTS, and there is ALREADY a mechanism in place to settle accounts.

    The fact that the Fed so far has failed to be a fair referee is not an excuse, for more of same – it is the problem.

    So Roman, if Scott is going to teach me some lessons, please lets make sure he’s starting with the basic assumptions and desires and respect for the same principles (which I doubt you are)…. because I’m only here since Scott keeps saying he’s a right wing free market guy, and I can’t for the life of me find the pony in the pile of crap.

    Lastly Roman we do face a crisis that explains WHY we have an economy in decline: A Public Employee Union being overpaid to the tune of $400B annually… accounting for MOST of our national debt. We have gone through 4 decades of set up to this moment, when we can finally summon the political will to break them… Chris Christie is the future, and Scott right at the very moment when we can best strike at the cancer, wants to goose things along and give everyone the impression that public employees might be sustainable as-is.

    And I say, Scott if you really want the Fed to be neutral, well then, we’ll do your NGDP thing AFTER we crush these unions.

    Think of Scott’s formula as a jolt of adrenaline, I say fine, wait until the good guys are in power and the bad guys are in retreat, and then hit the plunger… because just in case Scott’s formula isn’t magic, at least later the spike in the graph will happen when the right guys and policies were in place.

  22. Gravatar of JL JL
    24. August 2010 at 00:29

    Scott, I agree that the FDIC is a moral hazard. My comment just assumed the FDIC.
    I have sometimes thought that a better system would let consumers choose: if they want their deposits insured by the government, they should pay a premium.
    But perhaps you have a better idea.

    Morgan, I’ll follow Liberal Roman and try and give my own easy explanantion.
    Have you ever played a long session of monopoly and then suddenly the bills run out? Kind of difficult to continue the game, right?

    The answer of the market, when faced with such a situation, is to enter into depression mode: high unemployment, low aggregate demand, slow and painful price deflation.
    You want to speed up that process, and I agree that speeding it up would be better than doing nothing.

    But the most obvious solution is to just cure the problem and print more money, so that the supply of money satisfies the demand for money.

  23. Gravatar of Ashwin Ashwin
    24. August 2010 at 00:50

    Scott – I wasn’t accusing you of accusing Raghu Rajan of not having a model, just thought it may be worthwhile if you engaged with his model rather than with his press quotes.

    The model in the paper I linked to is not really about speculators. It focuses just on bank incentives and the impact of monetary policy commitments to lower rates and keep them low whenever banks are in trouble. The most egregious example of this IMO is the LTCM rate cuts when there was no “real economy” justification for rate cuts whatsoever. Quoting from his response on his blog here http://forums.chicagobooth.edu/n/blogs/blog.aspx?webtag=faultlines&entry=22 :

    “The asymmetric Fed policy of cutting rates sharply when the economy is in trouble and not raising them quickly when it recovers gives the financial sector lower incentives to worry about credit or liquidity risk. The financial sector has come to rely on the Fed to bail it out through ultra-low interest rates whenever it gets into trouble and the Fed has developed a reputation of obliging.”

    This is a statement about the microeconomic incentives of banking and one that I think is valid – Rajan has been saying a lot of this even before the crisis and from my perspective as an ex-banker, a lot of the concerns he expressed played themselves out during the crisis.

  24. Gravatar of JL JL
    24. August 2010 at 01:02

    Morgan, your politics are seriously clouding your view of economic reality, and your ethics.
    What kind of awful person wants a whole country to suffer a depression, just so that the Republicans get a majority, and the unions get crushed?

    And don’t put China on a pedestal. They are not a healthy economy.
    Japan did the same trick China did, eventually it stops working.
    Scott links to Michael Pettis. Read him, especially the article on the sorpasso.

    Microeconomics is different from macroeconomics. We don’t need a depression in order to liquidate failed businesses: plenty of businesses went bankrupt in 1999 and in 2007.

    The only thing a depression does is liquidate businesses which would otherwise be profitable. The famous example is that during the depression, the unemployed dug up coal with their bare hands, while the coal digging machines stood still: their owners bankrupt, their operators unemployed.
    And unemployed people have no money to buy coal from entrepreneurs, but they do have free time to dig up coal with their hands.

    It makes no sense whatsoever.
    And you want to argue that coal digging machines were a misallocation of capital?

  25. Gravatar of JL JL
    24. August 2010 at 01:18

    Ashwin,

    Raghu and you are probably 100% right about the banking system and that the current state of affairs is not healthy.
    But I think Scott Sumner and Paul Krugman are mostly concerned about the economy as a whole.

    So sure, put forward good proposals to reform the banking system.
    But don’t suggest we reform the banking system at the cost of the economy. Because that is what you are doing now.

    Again, if one child needs spanking, figure out a way how to spank that child, without collectively spanking all the children.
    Sure, you will succeed at your objective, but the collateral damage is too high.

  26. Gravatar of Ashwin Ashwin
    24. August 2010 at 02:46

    Andy – This is not a generic moral hazard argument for how all economic actors take on too much “risk”. It’s a specific argument for how banks in particular (and other economic actors to a lesser extent) systematically arbitrage and extract rents from the explicit “insurance-like” commitments given to them by the central bank. In the case of banks, the commitment to allow them to recapitalise via low rates and “liquidity” facilities whenever they mess up allows banks to reorient their asset portfolios to more illiquid, cat-risk prone assets as well as more short-term liabilities. This behaviour makes the very scenario the central bank is trying to avoid, a systemic crisis, more likely. Moral hazard is probably not even the right word given that the system can evolve to this state even without any explicit intentionality on the part of economic agents via spontaneous order and “natural selection” like mechanisms.

  27. Gravatar of Ashwin Ashwin
    24. August 2010 at 03:04

    JL – I agree with you that we shouldn’t kill the economy to punish bankers! The pro-case for Raghu Rajan’s argument is two-fold:

    first, the macro-impact of distorted banking incentives is underestimated and rises with each subsequent crisis as an increasing proportion of the banking sector aligns itself to arbitrage the taxpayer. So each “jobless recovery” since 1991 takes longer and longer to work itself out as the incumbent banks take longer and longer to recapitalise themselves.

    second, the impact of raising Fed Funds from 0% to 2% on the macroeconomy is less than would be expected: As Raghu Rajan puts it “The real problem is corporations are not hiring quickly. But corporations did not hire quickly following the recession of 2001 (or that of 1990-91), and the sustained monetary stimulus that many economists supported then led, in no small part, to the housing boom and bust. It did not, however, lead to an explosion in corporate investment. Before saying the real problem is we are not providing enough monetary stimulus, should we not worry about why corporations did not invest then and what other problems will emerge as we keep rates ultra-low while hoping corporations will see the light? I am not arguing that ultra-low interest rates will have no effect on investment, only that I am not convinced the effect (relative to merely low interest rates) is huge, and recent history bears me out.”

  28. Gravatar of JL JL
    24. August 2010 at 03:48

    Ashwin, the con-case is single-fold:

    Increasing the interest rate will increase unemployment. Period.

    So whether you, or Raghu, realize it or not you are very explicitly advocating that we kill the economy.

    The great depression is proof enough for me.
    I don’t wish to personally find out if this time is really that different.

  29. Gravatar of Mike Sandifer Mike Sandifer
    24. August 2010 at 05:48

    Scott,

    One point I haven’t seen expressed elsewhere is whether the Fed guaranteeing the solvency of the major financial institutions in ’07 or ’08 would have prevented the financial crisis, perhaps without the need of much if any monetary stimulus. Perhaps they then could have started to ease in some lending standards?

    This occurred to me during the financial crisis, but only a month or two in.

    By the way, I realize of course that just because I haven’t seen this question addressed doesn’t mean it hasn’t been.

  30. Gravatar of Mike Sandifer Mike Sandifer
    24. August 2010 at 06:06

    BTW, on the issue of trade and curreny account deficits, it is my understanding that importing cheaper goods and having a 70% consumption economy are not necessarily bad things for us.

    In the case of China, for example, I see the move of jobs there as essentially hiring servants to work below the minimum wage. The Chinese artificially low exchange rates vis-a-vis the dollar merely represents an augmentation of this effect, to provide more Chinese jobs at the expense of the wages of those working in the export sector(some some inflation risks). So, in that sense, my relatively economically illiterate mind sees Krugman as wrong.

    With regard to a 70% consumption economy, this really shouldn’t be a concern if overall productivity allows it. Most job losses in American manufacturing are due to automation, but output has risen linearly for the last 30+ years. Then, cheap Chinese imports have helped as well.

    So, I see these overall productivity gains as at least partially allowing us to have more goods for less work in the US. It seems that many ignore the increases in real income here while focusing on nominal wages too much.

  31. Gravatar of Mike Sandifer Mike Sandifer
    24. August 2010 at 06:22

    Sorry to add yet another question here relating to my last above, but do you see as a consequence of Chinese dollar exchange rate policy, inflation in the US, expressed as the sort of excess liquidity described by Greenspan and others earlier in the decade, but with low CPI? And if so, did the inflation merely show up in the housing market?

  32. Gravatar of scott sumner scott sumner
    24. August 2010 at 08:45

    Morgan, Yes, all those Hoover policies were bad, and I made that argument long before Ohanian, so I am well aware of the problems. But none of them would cause NGDP to fall in half. Only monetary policy can do that.

    I agree that the 200 points were not decisive, there were many other policy failures. But it doesn’t seem to have worked, rates stayed near zero for 20 years.

    Liberal Roman, Monetary policy was not particularly loose in 2003, so that didn’t cause the bubble. I attribute it to three factors:

    1. A reaction to falling business investment. This part of the bubble was actually good.

    2. Bad public policy—F&F, FDIC, mortgage interest deductions, restrictive zoning in the Southwest (compared to Texas) and many other factors. I think Pinto has a 200 page article that just came out documenting all the stupid policies. Tyler Cowen has a link. Russ Roberts also has an excellent article.

    3. Bad decisions by private bankers and investors (who underestimated the black swan risk of a major housing downturn.) It is not true that all the villains made money, many lost a fortune. That’s simply bad decisions.

    Probably all three factors were required to create a disaster of this scale. And I am only talking about the initial 2006-08 downturn. The even more widespread 2008-09 downturn in real estate was caused by tight money leading to falling NGDP.

    Morgan#2, Actually we aren’t stuck with falling prices either way. The Fed can raise inflation back up to 2% or more, and should.

    Greg Ransom, You said;

    “You’re so right Scott, this William White fellow has been sooo wrong across the last decade …”

    If he is calling for tight money, then he obviously hasn’t been right. Tight money caused the current recession. If he predicted the banking crisis, my response is “so what” That doesn’t mean he has good ideas for monetary policy. Roubini also predicted the crisis. In the spring of 2009 he said don’t buy stocks. I ignored him and made a small fortune. I am so happy that I don’t follow people’s advice just because they got lucky with a previous prediction.

    Andy, Yes, those are good points. They really need to focus on NGDP growth and not worry about asset prices. The last time I recall them trying to restrain asset prices was in late 1929, when they were worried about high stock prices. They did pop the stock bubble, but the rest of the economy didn’t do so good.

    Morgan#3, I am just as opposed to rent seeking as you. Let’s get rid of F&F and FDIC and all those props to the real estate lobby. But monetary policy is not about rents, it’s about the macroeconomy.

    JL, I agree that if we must have FDIC, then banks must be regulated. I favor mandatory 20% downpayments for mortgages on all FDIC insured funds.

    Ashwin, You quoted Rajan as saying:

    “The asymmetric Fed policy of cutting rates sharply when the economy is in trouble and not raising them quickly when it recovers gives the financial sector lower incentives to worry about credit or liquidity risk. The financial sector has come to rely on the Fed to bail it out through ultra-low interest rates whenever it gets into trouble and the Fed has developed a reputation of obliging.”

    I think he focuses too much on interest rates. NGDP, not short term nominal rates, are the indicator of whether money is easy or tight. I will agree on one point. In 1998 the NGDP was doing fine. No need to ease monetary policy after LTCM. But this is much different–we have a huge NGDP problem.

    And I don’t see the asymmetry–rates were raised during boom years.

    Ashwin#2, I think banking problems are micro issues, and require regulatory changes. Maybe as radical as Kotlikoff’s ideas. I’m no expert on banking. But I do know monetary economics. And no one can say that a 200 basis point increase is not that big. Stocks have varied almost 5% within minutes after a Fed announcement where it was unclear whether a rate cut would be 1/4 or 1/2. 200 basis points is a very big deal in the midst of a recession. Maybe in a boom period it wouldn’t be a big deal.

    Mike, In the short run it might have prevented a crisis, but here’s where I agree with Morgan, it would have been building up even bigger problems for the future. Our bankers might have then completely run wild, like in Iceland.

    You make some good points about China. I don’t worry about that issue, it is overrated as a factor affecting us.

    I have a response above that addresses the causes of the housing boom. If the Fed was focusing on inflation, rather than NGDP as they should have, then the low inflation via China might have contributed a bit to the housing boom–but it wasn’t the main factor.

  33. Gravatar of Morgan Warstler Morgan Warstler
    24. August 2010 at 08:49

    “Morgan, your politics are seriously clouding your view of economic reality, and your ethics.”

    JL, my ethics are this very much intact thank-you. THE PROMISE that your money will not be inflated away, to save the last rounds losers is fundamental. I care not a whit about the unemployment mandate the Fed faces – I encourage them to turn up their nose to it. Just get that inflation down next to nothing, and then trust the political process.

    No one will play monopoly if the bankers are biased and make up rules as they go along.

    As I’ve noted here:

    http://biggovernment.com/mwarstler/2010/08/18/unemployed-blame-public-employees/

    Unemployment, I blame almost exclusively on Public Employees, and I’m not joking. If we believe they are making what private sector employees are making – the structural damage in our economy is gone. Period. We can be nicer about it, and say, some of them can make more than private sector employees, but to do that, they have to become more productive – but anyway you slice it, they need to receive $400B less in overall compensation while the US gets the same jobs done.

    Unemployment is heavily weighted to the people at the bottom of the economic ladder…. when the upper and middle classes who consume who consume most of low cost, low skill services, are paying the civil servants too much money, you don’t have enough left over for bikini waxes, lawn mowing, dinners out, etc.

    Frankly, I’m hoping the Fed can hold out till November, because with a Republican rout THERE WILL BO NO EXCUSE if they do not move immediately to beat back the Public Employee Unions and move aggressively to GOV2.0. This will be their final chance to build on top of what Reagan built, and solve the ONE PROBLEM he created.

    And at that point, we’ll see how the market reacts. I suspect that they will be far more impressed with an Obama who is FORCED to become Clinton, more than anything Scott is pushing.

  34. Gravatar of Morgan Warstler Morgan Warstler
    24. August 2010 at 08:50

    “If we ensure they are making what private sector employees are making”

  35. Gravatar of Morgan Warstler Morgan Warstler
    24. August 2010 at 12:27

    “And make no mistake: Protecting those 22 million public-sector jobs through borrowing has cost the 107 million private workers dearly. On Aug. 1, 2008, the portion of our national debt held by the public stood at $5.4 trillion. Now it stands at more than $8.8 trillion. As of the second quarter, GDP was growing at 2.4 percent, but many economists expect the growth rate to be revised down to 1.3 percent. So while our economy is growing at less than $19 billion per month, we are borrowing, based on the last two years, at the rate of more than $141 billion per month — 7½ times faster.”

    http://www.nypost.com/p/news/opinion/opedcolumnists/the_public_workers_you_support_S4qBz7VBAMgbzaJ4klsIhO

  36. Gravatar of Greg Ransom Greg Ransom
    24. August 2010 at 19:27

    This claim is looking more and more absurd.

    Scott wrote,

    “Tight money caused the current recession.”

    We’ve had a massive and classic malinvestment / over consumption artificial boom and inevitable bust with massive “recalculation” consequences.

    Mismanagement of the money supply in the post boom phase is the smallest of our problems.

    We’ve had a collapse of shadow money, asset prices, a great deleveraging and a return toward solvency — but no one has shown how anything but out of the causal order witchcraft magic could solve those problem without causing further overconsumption, malinvestment and insolvency, etc.

    The burden of proof is on those who are proposing magic to explain how another dose of attempted magic can cure what a belief in magic has already caused.

  37. Gravatar of Greg Ransom Greg Ransom
    24. August 2010 at 19:48

    Scott, White’s policy advice in 2003 was — don’t build a housing asset bubble and don’t build a malinvestment and over consumption artificial boom.

    Greenspan rejected White’s advice.

    What advice were you giving in 2003? What did your “model” tell you would happen?

    Here is what White argues for as an approach to macro policy:

    “It has been contended by many in the central banking community that monetary policy would not be effective in “leaning” against the upswing of a credit cycle (the boom) but that lower interest rates would be effective in “cleaning” up (the bust) afterwards. In this paper, these two propositions (can’t lean, but can clean) are examined and found seriously deficient. In particular, it is contended in this paper that monetary policies designed solely to deal with short term problems of insufficient demand could make medium term problems worse by encouraging a buildup of debt that cannot be sustained over time. The conclusion reached is that monetary policy should be more focused on “preemptive tightening” to moderate credit bubbles than on “preemptive easing” to deal with the after effects. There is a need for a new macrofinancial stability framework that would use both regulatory and monetary instruments to resist credit bubbles and thus promote sustainable economic growth over time.”

    http://dallasfed.org/institute/wpapers/2009/0034.pdf

  38. Gravatar of scott sumner scott sumner
    25. August 2010 at 07:26

    Greg, The data shows that most job losses in housing construction occurred before late 2008. The serious rise in unemployment was due to falling employment in business construction, manufacturing, and most of all services. This was due to falling NGDP causing less AD for all goods. The reallocation out of subprime housing areas was a trivial problem compared to the economy-wide collapse in AD due to tight money. Texas had no bubble, and still has 8.2% unemployment. That’s tight money.

    Greenspan was wrong on the issue of banking regulation. The banking system was allowed to make too many bad loans with taxpayer guaranteed funds. That’s a separate issue from monetary policy, which should target NGDP (as Hayek said) not housing.

    The Fed has no way to identify “credit bubbles” in real time. If they could be identified by the Fed, they wouldn’t happen in the first place.

  39. Gravatar of Greg Ransom Greg Ransom
    25. August 2010 at 08:35

    Scott, you’re not understanding the causal structure of a malinvestement / relative price discoordination / over consumption boom and bust if you think “recalculation” will only implicated housing construction and housing construction labor.

    And the dog that didn’t bark here is Ed Leamer’s point about how recovery in the housing market is almost universally typical of economic recovery in the U.S.

    We don’t have that this time.

    So what’s the story there? We simply haven’t expanded the money supply enough? (even in the face of productivity growth — more goods produced at less cost, requiring fewer dollars by consumers).

    All I’m asking is some genuine hard thinking in this area.

    I don’t see it from the tenured faculty pontificating to the rest of us from the Ivory Tower.

    Scott wrote,

    “The data shows that most job losses in housing construction occurred before late 2008. The serious rise in unemployment was due to falling employment in business construction, manufacturing, and most of all services.”

    Note also that the micro way of thinking about macro discoordination isn’t “closed economy” thinking — it extends beyond sovereign borders of any single nation state or monetary unit.

  40. Gravatar of Greg Ransom Greg Ransom
    25. August 2010 at 08:38

    Somehow William White and his BIS research team were able to do this as early as 2003 (and for 5 years in a row after that), and Greenspan was forced to deny the fact nearly as early — because of mounting evidence and argument from multiple sources.

    White confronted Greenspan in person about the matter at Jackson Hole in 2003 — and Greenspan never looked him in the eye the whole time White spoke. Hmmm ….

    Scott writes,

    “The Fed has no way to identify “credit bubbles” in real time.”

  41. Gravatar of Greg Ransom Greg Ransom
    25. August 2010 at 08:54

    Scott wrote,

    “The data shows that most job losses in housing construction occurred before late 2008. The serious rise in unemployment was due to falling employment in business construction, manufacturing, and most of all services. This was due to falling NGDP causing less AD for all goods. The reallocation out of subprime housing areas was a trivial problem compared to the economy-wide collapse in AD due to tight money.”

    Has anybody studied this? Has anyone done ANY field research on these matters? Has ANYONE taken a basic Hayekian recalculation / malinvestment model and looked for sectoral shifts, newly non-economic production goods, etc., or any other changing relations?

    These claims are coming from an imaginary magical oracle, and not from empirical study.

    And it’s not as if the recalculation / malinvestment / over consumption / insolvency understanding of things doesn’t have implications for the behavior of the magic black box called “Aggregate Demand”.

    But you haven’t engaged any of that. And neither have other “critics” of the Hayekian framework. (Past cycles have been studied empirically to a limited extent — a number of publish papers and dissertations exist empirically supporting the causal mechanism of malinvestment / recalculation — but the tenured elite tend to punish young scientists who do empirical work in this area.)

    So we are at an impasse. From the perspective of a micro approach to macro your your “criticisms” of the causal story from the micro perspective don’t seem to actually be empirically substantive (and seem not to even understand the causal mechanism), and the positive case for your own model come across as magical assertion without grounding in anything but the incantation of the magical letters “AD” and “NGDP”.

  42. Gravatar of JL JL
    25. August 2010 at 14:45

    Morgan,

    Perhaps I’m too late with my response, but your response has proven to me that your ethics are clearly screwed up.

    There is nothing immoral with inflation. Anyone can insure himself against inflation by buying TIPS bonds, or hedge himself by buying stocks, foreign currency or commodities (e.g. gold).
    It only becomes immoral when people are forbidden to insure/hedge themselves, as in Zimbabwe.
    Like gambling and speeding, the “inflation tax” is purely voluntary.
    I, for one, do not pay it.

    And you would rather have mass unemployment and poverty than inflation.
    That makes you a horrible person.

  43. Gravatar of Greg Ransom Greg Ransom
    25. August 2010 at 21:35

    Rajan answers Krugman:

    http://blogs.chicagobooth.edu/n/blogs/blog.aspx?nav=main&webtag=faultlines&entry=22

  44. Gravatar of ssumner ssumner
    27. August 2010 at 12:35

    Greg, You said;

    “I don’t see it from the tenured faculty pontificating to the rest of us from the Ivory Tower.”

    I may be wrong. Here would be the evidence:

    Stagflation.

    I don’t see any stagflation, do you?

    greg, I don’t think you understood my point about why the Fed can’t recognize credit bubbles. Telling me they didn’t, and someone else did, is not a good answer. I admit that if credit bubbles were as plain as day then the Fed could recognize them. But it is virtually a tautology that if most people recognized bubbles, they would not occur in the first place. Bubbles are by their very nature unrecognized by most people. So don’t expect most policymakers to be smarter than most people. If White was, then good for him. But he’s not the Fed. You act like if the Fed had recognized the bubble, home buyers would not have. How can you make that assumption?

    You asked;

    “Has anybody studied this? Has anyone done ANY field research on these matters?”

    Just look at the BEA quarterly GDP accounts broken down by sector since 2006 Q1.

    I responded later to the Rajan piece.

  45. Gravatar of Greg Ransom Greg Ransom
    28. August 2010 at 21:40

    Distortions would occur unavoidably even if everyone was aware that asset bubbles were growing.

    But all in all, you have a good argument here for private banking and the elimination of the Fed.

    >>greg, I don’t think you understood my point about why the Fed can’t recognize credit bubbles. Telling me they didn’t, and someone else did, is not a good answer. I admit that if credit bubbles were as plain as day then the Fed could recognize them. But it is virtually a tautology that if most people recognized bubbles, they would not occur in the first place. Bubbles are by their very nature unrecognized by most people. So don’t expect most policymakers to be smarter than most people. If White was, then good for him. But he’s not the Fed. You act like if the Fed had recognized the bubble, home buyers would not have. How can you make that assumption?<<

  46. Gravatar of scott sumner scott sumner
    29. August 2010 at 09:45

    Greg, The distortions that would occur result from wage and price stickiness and bad monetary policy. If people know it’s a bubble, there are no distortions from the price rise itself.

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