Double standards everywhere
Over the last 10 months I have become increasingly aggressive in my criticism of the current state of macroeconomics. I talked about all of the double standards. Fiscal policy is discussed in terms of whether it can create jobs. Monetary policy is discussed in terms of its impact on inflation. Which sounds better, jobs or inflation? Obviously jobs. Yet there is nothing in macro theory that would justify this dichotomy. Indeed, if anything an AD shock driven by government spending would be expected to be more inflationary than equivalent shock created by monetary policy. That’s because the private sector can usually spend money a bit more efficiently than the public sector.
If your intuition still tells you that monetary policy is more of an inflation threat than fiscal policy, you are probably right. But that is because, and only because, you intuition is correctly telling you that monetary policy is a far more powerful tool for boosting NGDP. Which begs the question of why so many economists support fiscal stimulus, and so few criticize the Fed.
Another point of confusion is to assume that because I am a Chicago libertarian, there is something right wing in my argument. Here is Matt Yglesias making a similar argument. And of course Krugman recent acknowledged that monetary policy is the best way of stimulating the economy.
And then there is my argument against the Fed’s policy of paying interest on reserves. I don’t know how many times I have read, or been told by other economists that the policy couldn’t possibly have been a big deal, after all the current rate is only 0.25%. Of course they conveniently ignore the fact that the rate being paid was much higher in the early stages of the program (October and November 2008) when all the damage was being done. But it is far worse than that.
One of the most famous mistakes in Fed history was the decision to double reserve requirements in 1936 and 1937. How many times have you heard about this example? How many times have people said “Let’s not make the mistake this time that we made in 1937, prematurely tightening policy.” It’s the example always used in textbooks to show why higher reserve requirements are a tight money policy.
What the Fed did last October was essentially the same. The interest on reserves program also dramatically increased the demand for reserves, and this also greatly reduced the money multiplier. So why isn’t this getting equal criticism? It seems all people can think about is interest rates. But if we are going to play that game, then shouldn’t we at least think about real interest rates? James Hamilton suggested that the Fed began to pay interest on reserves to prevent a big increase in inflation. OK, but if nominal rates are stuck near zero, wouldn’t a big increase in inflation represent a sharp fall in the real interest rate? So why wasn’t this a really tight money policy? I know, you’re thinking “but the interest paid today is only 0.25%, surely that can’t be significant?” I give up.
Or at least I gave up until I decided to check to see what impact the famous tight money policy of 1937 had on nominal interest rates. If you look at Friedman and Schwartz page 454 you will see a graph. I can’t tell exactly, but it looks to me like both short term interest rates series rise from about 0.15% in 1936 to 0.40% in 1937. So rates did go up, and it looks like the increase was about 0.25%. Sound familiar?
So we are constantly bombarded with reminders that we must avoid the mistakes of 1937. Then when I point out that we already made exactly the same mistake back in October 2008, people say, “yeah, but the interest rate is only 0.25%, surely a quarter point can’t make much difference?” And then when I check the data for 1937, I find that the infamous Fed tight money policy raised rates by exactly the same measly quarter point.
A few weeks ago I called out the profession, basically saying they were making fools of themselves, confidently talking about ‘easy’ and ‘tight’ money without having the faintest ideas what the terms mean. Often using the meaningless nominal interest rate indicator. Then when called on it, they revert to real rates. But they still insist Fed policy was easy last year, despite overwhelming evidence it was extremely tight. Ex ante real interest rates on 5-year government bonds soared 360 basis points between July and November 2008.
There were lots of comments after that post, but not one economist has been able to refute my argument. Not one economist has been able to show that the economics profession has attached any coherent meaning to the terms ‘easy’ and ‘tight’ money. And this confusion continues to cause great damage, and indeed is ultimately behind our recent monetary policy failures. At least one economist has realized there is a problem, although he differs with me as to what the solution is. Thank God for Arnold Kling:
I am prepared to offer pushback against the Sumner-Hetzel viewpoint. However, it really deserves the status of the “null hypothesis.” In a more reasonable world, everyone would be starting from the presumption that Sumner and Hetzel are correct. Those of us arguing folk-Minskyism and telling the Recalculation Story should be the ones fighting an uphill battle to bring our ideas into the policy debates. That this is not the case, and that SC [the scholarly consensus] is now on the fringe, is one of the most remarkable stories of this whole macroeconomic episode.
See how grouchy I get when my blog goes down a couple days.
PS. NGDP will fall over 1% this year. Last time it fell that sharply? Nineteen thirty-eight.
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10. December 2009 at 13:48
And here we have a quote from the Economic Cycle Research Institute on jobs:
begin quote
Unemployment Is Down, But Business Cycles Are Key
…The jobless rate usually sees a sizeable drop during the economic recovery “” and bigger recessionary spikes in unemployment are typically followed by larger declines during the first year of improving unemployment. So it would be no surprise if, a year after the unemployment rate begins to drop, it falls to the nine percent range.
The real problem is that the rate of decline in joblessness slows during the rest of the economic expansion. The annual postwar pace of decline in unemployment during these periods has been reasonably uniform, the median being 0.5% a year.
If that pattern persists, the U.S. economy needs to keep expanding without interruption until 2020 for unemployment to fall to its pre-recession low of 4.4%. Should the next recession arrive earlier, as we suspect, it will take much longer. The implications constitute nothing short of a wake-up call for policy makers who promise to get job growth back on track.
end quote
Expansion without interruption till 2020! To get back to where we were. The odds of that are exactly zero – if we go on like we are.
Dave Rosenberg is calling this a depression – not a recession. A depression caused by the failure of analysis as described in the above Sumner post.
We are giving ourselves a depression. We don’t have to – it is neither fate nor inevitable. But we are doing it, with this astonishing and unimaginable passiveness.
10. December 2009 at 14:18
One mistake many people make in various aspects of life is that they make a suggestion, and if it is ignored, they shut up. If on the other hand they had repeated their suggestion later, perhaps in a different context, then someone would have heeded that advice, improving things.
So…don’t give up Scott. You are getting noticed more and more, and at a minimum are forcing people to try to counter your views and explain why they think they are right when you think they are wrong.
10. December 2009 at 14:55
Is there some way we can nominate you to replace Bernanke? 🙂
10. December 2009 at 15:00
Compared to 1938, the scale of government fiscal spending (at all levels, not just temporary but the automatic stabilizers too) moderates the impact of the deleveraging we’re experiencing (at significant cost); without this activity, one would expect NGDP to fall even further than the 1% decline we’re observing. So the comparison to 1938 may be overly generous to the Fed.
BTW, just wanted to call your attention to the narrowing trade deficit data today… The rapidity of the response of actual trade (not merely asset prices) to the lower dollar, and in turn the response of employment and finance markets, may be a shorter term phenomena than you had initially anticipated – indeed, could be accelerating versus 70 years ago. I wonder how long it would take the US to recover via “export led growth”?
Also, was wondering – since you mentioned your Chicago roots – has anyone modeling the impact of subsidies on trade modeled the impact of IO/macro considerations like specific capital stocks and underutilization? I’m struck by Japan’s version of the Cash For Clunkers program. Leaving retaliatory effects out, does the standard analysis still always apply to trade shifting subsidies (e.g. they are costly to the subsidizing country) when:
– the industry has low capacity utilization
– unemployment is high
– the govt is supporting the unemployed via transfers
– the industry is a high fixed cost/low marginal cost industry, and real capital depreciation occurs (regardless of what the real interest rate is)
– price elasticity of demand is high (potentially driven by cross product switching among offshore consumers)
In the Japanese case it’s an import-substituting subsidy, but it’s really the same issue. I’m not sure the classical result carries through in the above setup.
10. December 2009 at 17:42
Just about every academic economist I’ve read is up in arms over the Feds’ anemic monetary response. So, why isn’t Bernanke following the advice his own research would suggest?
My guess has been that he just gets out-voted by some number of the other 11 on the FOMC. If so, then maybe pressure as you mentioned can be brought upon the Fed to make them do what they should. Maybe the congressional leaders can use the audit the Fed bill as a blunt weapon?
10. December 2009 at 18:19
Mike
Personally I think it is much harder than that. If you watch a show such as the Kudlow report you see the really crazed deflationists in full cry. Take a listen. I just do not see how Bernanke could openly embrace higher inflation as a direct policy goal without support from Obama. And I see no signs of such support. If the man wants to get re-elected he is really going to have to grow some Roosevelt backbone.
The deflationists will grind us into dirt because they really do think it is just dandy and fun to do so. It is, I think anyway, a matter more of political power than it is of having or not having the correct economic theory.
10. December 2009 at 19:14
JimP, I know how you feel. Sometimes it just seems like the whole economics profession has fallen asleep. I can’t imagine how economists have become so complacent about high unemployment. It’s like if the economy is growing at 3% things are ok. But three percent growth won’t lower unemployment at all.
happyjuggler0, Yes, I’m starting to realize that you have to repeat things to get heard. So that’s why I am getting a little more aggressive each time.
Kevin, I just want to be his advisor. 🙂
Statsguy, Yes I agree about fiscal policy being worse back them, so you are right.
I noticed the trade data. US exports to China are up 50% since January, and hit an all time high in October. Sure helps to have a strong Chinese economy. Yes, I know the numbers are still very small, but total US exports hit $100 billion in October, a pretty impressive number for a world still deep in recession. I strongly think the “income effect” is more important than the terms of trade effect. But it’s hard to tell because the Asian recovery has corresponded to the fall in the dollar. (That’s why I cited the big percentage rise in US exports to China.) Here’s a new argument I’ll try out:
Suppose an asteriod destroys the rest of the world. By definition our trade deficit falls to zero. I say our GDP falls sharply. I assume the trade deficit worriers would say it would increase, because we’d have no trade deficit.
On your question about second best policies, you can definitely make an argument for almost anything if unemployment is high and is expected to stay high. But I recall some articles suggesting that the cash for clunkers wasn’t very effective by any standard. If we are looking for second best policies, my hunch is that trade measures aren’t the best idea, rather the European approach of subsidizing employment with lower payroll taxes and other measures might work better. Payroll tax cuts directly address wage rigidity, and do so in a relatively non-distortionary way. It seems like Europe has seen less of a rise in unemployment. I don’t know much about the Japanese program, but the recent Economist suggested the new government is really worried about deflation and is pushing the BOJ hard.
Mike, I may not be in the best position to know, but your comment kind of surprises me. I thought most economists were either supportive of Bernanke, or actually worried that policy was to expansionary, and we were facing high inflation in the future. Maybe I am wrong. But I have very rarely read anyone say money is too tight and a more expansionary monetary policy could have made the recession much milder. Of course many who post here believe that, (Woolsey for instance), and then there is Hetzel. But I am surprised by your comment. I hope you are right. BTW, please send me any articles that suggest a groundswell for monetary stimulus is developing. I may be to close to the issue to see what’s happening out there.
JimP, That was also my impression. But I have a tiny bit of hope that all the negative publicity about the size of our future fiscal imbalances may make some economists take a second look at monetary stimulus. You’ve certainly seen some movement in that direction in the liberal blogosphere, as well as Free Exchange, which I assume is more centrist.
10. December 2009 at 20:08
I was driving around today listening to am radio, out of whatever desperation, and RL went on about how recessions fix themselves as long as the gubment doesnt intervene. the disheartening part is you realize, in that context, the idea of Rush even addressing something as arcane as monetary policy is absurd. Yet Rush’s dumbed down worldview probably reflects not only his median listener, but that of the median member of congress. As much momentum as Sumnerianism has achieved in the blogosphere, i doubt it can achieve escape velocity. thanks to am radio and fox news politics, and thus economics, are now popular sports. your pragmatacism wont sell.
10. December 2009 at 20:17
ive doubled up on my stockmarket shorts. i believe gloomsday is near (but im still long sugar as a silly hedge)
10. December 2009 at 20:41
As an autistic macroeconomist speaking it’s incredibly hard to read your long winded blog from beginning to end when it is contantly down. Despite this fact I have now read through your April postings.
Cheer up. There’s a lot of us with you!
P.S. I’m a libertarian inflationist too! (I voted straight Libertarian from 1982 through 2000.) I get what you’re trying to do more than you may know.
11. December 2009 at 02:59
Krugman endorses the Gagnon proposal:http://www.nytimes.com/2009/12/11/opinion/11krugman.html?_r=1&hp
11. December 2009 at 05:41
rob, I agree, but I am trying to change the views of economists, not talk radio. The Fed is influenced by other economists.
Thanks Mark. We are going to a new system in January.
Thanks marcus. I am going to have a lot of fun with this one.
11. December 2009 at 06:36
As someone coming at this from the Free Exchange/Yglesias angle I view loosened fiscal policy with an accommodative Fed as the ideal position. Fiscal policy would be loosened in large part through automatic stabilizers, ie not trying to cut spending or raise taxes to cope with revenue declines and greater demands on public services.
In any case, I think your point in paragraph one about the relative efficacy of private vs public is generally true except for the issue of the credit channel. It seems to me the doubts surrounding that credit channel are a significant source of worry about QE among some economists. I am thinking of things like Roubini’s ‘mother of all carry trades’ carping.
11. December 2009 at 08:21
I view paying interest on reserves as a good idea with bad timing. I read once that paying interest reduces some kind of overnight bank shenanigans, and makes it easier for the fed to achieve its target*. And it’s not a big deal to start paying interest if the increased reserves are exactly offset by an increase in the money supply (BIG IF).
Perhaps Bernanke thought this crisis would be a good opportunity to slip in this technical improvement — but then was hamstrung and prevented from offseting the change by creating more money. In this charitable view, it was merely a terribly damaging political miscalculation.
*I can’t remember how this works, or where I read it
11. December 2009 at 11:03
JimP,
You can look at this in one of two ways.
First, the Fed is under attack in the congress and would drowned out by the inflation Chicken Littles. So, the Fed should play it safe and let the economy struggle mightily lest it risk losing some measure of independece.
Or second, the Fed is under attack anyway and would be drowned out, but could try to rely on a more rapid recovery during which Fed issues would largely be forgotten.
I favor the second.
11. December 2009 at 11:09
Scott, I’ve watched the Fed for over 20 years now, and in all that time I’ve always had the distinct impression that the Fed has never really believed in the efficacy of monetary policy. There are two reasons for this. The lesser reason is that Fed governors and economists are all government employees, and hence tend to be political liberals. Activist fiscal policy grows the government, principled monetary policy does not. The more important reason is that if monetary policy really has big, predictable effects on the economy, then at any given time the Fed is largely responsible for the state of the economy, and that violates the number one bureaucratic imperative, which is always to avoid accountability.
11. December 2009 at 11:17
Dr. Sumner,
I probably self-select those economists I read, which is one of the reasons I read this blog. Others I read included DeLong, Krugman, and even Roubini at times, though I think he’s too worried about deficits right now, despite claiming that both types of stimulus have been ineffective. There is also Stiglitz.
Since it seems to me that these are the economists who have the biggest media presences, it seems an important consensus.
11. December 2009 at 11:18
Correction: Roubini has stated that both types of stimulus have been insufficient.
11. December 2009 at 16:59
OGT, I don’t worry too much about carry trades.
JJ, I agree with your remarks about interest on reserves. It might be a good idea, but the timing was bad.
Mike, Yes, pressure from Congress might trigger a backlash. I’ve always focused on trying to get a lot of academic economists to favor quantitative easing. I don’t think the Fed would feel its independence was lost if the pressure came from academic economists, who are supposedly more idealistic because they don’t have to worry about getting re-elected.
Jeff, I discussed that point in an earlier post. I argued that the Fed never blames itself for current recessions, but sometimes the Fed looks back and blames earlier Fed decisions, as when Bernanke blamed the Fed for the Great Contraction. I do think they believe they have some power over inflation, but I agree they don’t blame themselves for the drop in AD.
Those economists are more on the liberal side. You might also check out some conservatives like John Taylor, or moderates like James Hamilton.
11. December 2009 at 19:35
Sumner- I am not sure that I do either, though hot money flows certainly have had the developing countries spooked since the late nineties Asian crisis. My point was rather that a number of prominent economists seem to be exercised about it, which may influence the Fed to be over cautious about QE.
12. December 2009 at 06:48
OGT, I think there is a misconception that the late 1990s crisis was caused by open capital markets. That was partly because American economists had this arrogant “it doesn’t happen here” attitude. Now that it has happened here, I think people are looking more deeply. I haven’t heard anyone propose that American capital markets be closed to prevent another subprime crisis, which is good, because that would be chasing the wrong problem.
I agree that a carry trade might influence Fed policy, but that would be unfortunate.
12. December 2009 at 10:00
[…] Scott Sumner: Suppose an asteriod destroys the rest of the world. By definition our trade deficit falls to zero. I say our GDP falls sharply. I assume the trade deficit worriers would say it would increase, because we’d have no trade deficit. […]
29. June 2010 at 22:45
Scott, you could write an open letter and ask for as many economists as possible to sign it – and then send it to Fed asking for more accommodating monetary policy.
30. June 2010 at 05:52
Mikko, I had a petition around the time of my Krugman posting. It’s still there (in the March 2009 archives I believe.) Almost no one signed it.
It would not work unless someone famous started the ball rolling.