Arnold Kling  

Save the Economy or Save the Banks?

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Scott Sumner writes,


Many economists simply assume that the current contraction has been caused by the financial crisis. After all, isn't that obvious? Actually, no. For nearly a year after the onset of the financial crisis nominal GDP continued growing at better than a 3% clip. Now it is plunging. Most seem to assume that this new state of affairs was somehow caused by the Lehman failure, and the subsequent loss of confidence in the entire financial system. My view is that this reverses the causality; it seems much more plausible that the current problems in the financial system are being caused by the recent (and expected future) sharp fall in nominal GDP.

...Too many economists merely look at the sharp fall in interest rates, and the sharp increase in the monetary base, and assume policy has been expansionary. But the Fed also cut rates sharply and increased the base during the early 1930s. Just as during the Great Contraction, policy has been highly contractionary in the only sense that matters, relative to what is needed to meet the Fed's policy target for nominal spending.

Tyler Cowen recommends all of Sumner's posts, but I particularly recommend the one above.

The important point to note is that Sumner is the only economist around making any use of recent macroeconomic theory, by which I mean the theory of the last thirty years. I have explicitly scorned that theory, and many other economists have implicitly scorned it by reverting back to what they think of as Keynes.

Recent economic theory says that expectations matter. Sumner says that the Fed has to create expectations that nominal GDP will increase. That sounds fine. But how do they do that? Should the Fed start playing the commodities markets?

Elsewhere, Sumner points out that the Fed's policy of paying interest on reserves is contractionary. If your goal is to save the banks, then paying interest on reserves may seem like a good idea. However, if your goal is to save the economy, then paying on interest on reserves is a bad idea, because it loosens the link between the monetary base and the money supply, making monetary policy harder to execute. You can pour reserves into the system, and banks can choose not to lend but instead take the safe earnings from excess reserves. Conversely, when you you contract the monetary base, you sop up excess reserves without forcing banks to contract lending.

Ironically, according to this reasoning, by paying interest on reserves the Fed might have weakened banks. Because the monetary expansion was stifled, the economy tanked, and that weakened the banks. As I read Sumner, he would argue that paying interest on reserves was a major policy blunder.

My instinct is that Sumner's focus on rational expectations and on interest on reserves is too subtle. I still hold to the view that the market panic and rapid de-leveraging were exogenous shocks. However, Sumner's views are provocative and coherent.


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CATEGORIES: Monetary Policy



COMMENTS (24 to date)
Bill Woolsey writes:

I think Sumner's key point is that even if market panic and rapid deleveraging are "exogenous shocks," they are only important to the degree they lead to an increase in money demand or decrease in velocity, which the Fed could have offset. If nominal income continued to grow at trend, any "stagflation) caused by reduced productivity do to inefficiencies in finance would have been minor.

El Presidente writes:

You got it right Mike Woolsey. That's what I think, anyhow.

I like his explanation but not the implied monetary policy prescription. The Fed lost control of the money supply due to all of the unmonitored private credit creation. He has the causality correct, but that hole needs to be plugged by using regulation, not monetary policy. The failures of Lehman and others were not a bunch of oopsie-daisy random events. He correctly identifies the divergence which caused the failure.

The reason I think that fiscal stimulus and downward redistribution are the necessary components of short-run policy going forward is that I believe average consumers simply ran out of money. They didn't understand that while the economy was growing in terms of output, their real incomes were actually stagnant or declining. They didn't understand that there was nothing being set aside for them. They figured they were just next in line; the big guys get first dibs but we get to come clean up once they've had their fill. Problem is, the big guys ate too much. There wasn't enough left to meet the expectations of higher nominal wages without inflation and thus the debt of households became too great and they had no choice but to curtail consumption. The gas price spike and consumption decline illustrates their sensitivity. This is where a little inflation intentionally caused/allowed by the Fed (not by private financial institutions) would have moderated the tendency of households to spend and the eagerness of financial institutions to lend at bargain-basement rates.

Now it is too late to unring the bell, so the apparent solution is to move the money around a little to approximate what would have occured if we had chosen the best policies before; to seek a sustainable equilibrium. It rubs all kinds of people the wrong way, but I am not interested in seeing punishment for punishment's sake. Suffering is not necessarily proof of morality in action, and the harm is not limited to people who acted imprudently, unethically, or immorally. I would rather we do what we can to mitigate the present harm and plan a different course going forward.

El Presidente writes:

Sorry, Bill Woolsey. Minor typo.

shayne writes:

Sumner suffers from the same research and in-depth knowledge background as Bernanke - both are 'students' of the 'Great Depression'. To paraphrase Abraham Maslow, if the only tool you are familiar with is a hammer, then the only way you can be relevant is if you re-define every problem you encounter such that it appears to be a nail.

Until folks begin to recognize and state emphatically that this isn't a 'nail' - the current economic situation bears NO similarity whatsoever to the 'Great Depression' in cause, environment, severity, duration, effect or cure - both monetary policy makers and fiscal policy makers are going to devise and implement ineffectual (at best) measures. It strikes me that the current situation is far closer in characteristic and potential to the 'Stagflation' period of the late 1970's/early 1980's than it is the 'Great Depression' - even to the point of now having Paul Volker in a position of significant influence. That's scary.

It's curious that so many alleged economists have forgotten that their field is a social science - it's about people, not about money. A direct corollary to that underlying fact being that everything economists study and profess to understand is based entirely on perception. The value of money, the value and credit-worthiness of individuals, firms, states and nations and even the definition of wealth - all merely a matter of people's perception.

So the assertions that that the current consumer spending contraction is/was caused by ABC, and therefore can only be cured by XYZ, all while every 'journalist', politician, and too many 'economists' are creating and propagating the perception that the globe is in, or nearing the second 'Great Depression' at every opportunity strikes me as being a bit odd.

Sumner says: "My view is that this reverses the causality; it seems much more plausible that the current problems in the financial system are being caused by the recent (and expected future) sharp fall in nominal GDP."

Is Macro Economics a science or a debating society?

Where are the falsifiable theories and predictions? One Econ says "A causes B" and the next one says "B causes A". Econs do research for 30 years, and many or most just decide to "revert to what they think of as Keynes".

What they "think of" as Keynes! So, no one knows what Keynes thought. Are we talking early Keynes or later Keynes. And who cares what Keynes "thought"? Where is the evidence?

If this is a debate without prediction, if this is a cloud of theories and after-the-fact "explanations", then it is a crime against our society to represent that these are more than guesses and proposals for research.

In the meantime, economists are empowering politicians to do whatever politicians want, despite the fact that the politicians are not even doing a prudent job of following the actual recommendations, no matter how unsupported those recommendations are.

Why are macro economists any better than the politicians that say "I don't know that my policies will help, but we have to do something. Anyway, my plans are just as good as the opposition plans, because they don't know what to do either".

fundamentalist writes:

The current state of macro econ is much like the old tail of three blind men trying to describe an elephant. Because they can’t see the whole animal, each focuses on the one part of the animal that he can feel, the leg, trunk or tail, and pictures that part as the whole. There is a technical term for that kind of fallacy that I can’t remember; can anyone help me out?

Sumner is the blind man who “sees” nothing but monetary policy. What he can’t see is why AD contracted so sharply and quickly. AD had built into a bubble based on very high and unsustainable levels of debt. When someone stubbed their toe and couldn’t make his payments (the technical definition of an “exogenous shock”) the whole debt structure came crashing down. Everyone tried to get rid of debt at the same time by selling assets, which causes asset prices to fall. Also, it caused people to quit buying cars and houses. What Sumner wants to do is re-inflate the bubble to the unsustainable levels of debt we had before the crash. Does that make any sense?

Hayek wrote an updated version of his groundbreaking “Prices and Production” almost ten years later called “Profits, Interest and Investment.” In it, he demonstrated the ineffectiveness of interest rates in controlling business cycles. The key determinants of business cycles are relative prices and relative profits--prices of consumer goods relative to producer goods, wages relative to income, and profits of consumer goods makers to profits of producer goods makers.

Dr. Kling writes that “the market panic and rapid de-leveraging were exogenous shocks.” So what caused the panic and rapid de-leveraging? The same thing that has always caused it in the past—scarcity of resources. As the Austrian business cycle explains, loose monetary policy causes the economy to expand beyond its production possibility frontier, to use Roger Garrison’s terminology. The capital to produce at that level doesn’t exist to support every venture. Some ventures must fail. And since those ventures are financed with debt, that debt can’t be repaid. Debt begins to contract and the process snowballs. Pretty soon panic sets in.

To avoid the blind men and the elephant scenario, economists must take off the blindfolds they have been wearing the past 80 years and look at the whole structure. Austrian econ does just that. It combines the real business cycle theory with Minsky’s insights and Friedman’s monetarism. Of course it adds others, such as 1) that the effects of monetary policy are always and everywhere self-reversing and 2) sustainable growth requires balancing capital production with consumer demand.

El Presidente writes:

Andrew_M_Garland

Is Macro Economics a science or a debating society?

As Shayne pointed out, it's a social science. Besides, even those who work in physical sciences entertain a great deal of debate in the process of reaching concensus on theory. That's right, theory. That's what they end up with, and that's what we end up with. I could vomit calculus at you, but that wouldn't do much for the process of deliberation and it wouldn't make any of this more true. Experimentation in social sciences is notoriously difficult. If you don't like them, I might suggest something abstract, like finite mathematics. That way you can be certain of everything that means absolutely nothing. =)

Will writes:

The original rationale behind the Fed paying interest on reserves is that it puts a lower bound on what the Fed Funds rate will trade at. When they changed their policy, the actual Fed Funds rate was trading well below the target rate, and arguably this move would give them greater control over monetary policy. At the time, the interest rate was set at 35 basis points below the lowest Fed Funds rate traded over the period in question. When the target was set at 0-1/4 percent, I believe the interest was set at 1/4 percent, but I am not certain about this.

I think there is a problem with this reasoning, though. It puts a lower bound on the Fed Funds rate by simply paying that amount to people who decide to forgo the Fed Funds market. It will thus change the value of the indicator, without actually changing the underlying monetary conditions causing it.

Floccina writes:

I still hold to the view that the market panic and rapid de-leveraging were exogenous shocks.
If people want to pay down their loans to de-leverage (improve their balance sheets) would it not be best to just directly give them money to do so. You could do so by eliminating FICA, matching FICA and the Medicare tax, while the Fed buys the Gov bonds sold to pay for the lost revenue? This would avoid the banks and because as people pay down their loans the money supply contracts and the more banks fail the longer it will take for banks to increase the money supply we might avoid high inflation. So could we increase base money supply without too much inflation and people get what they want now which is to pay down their loans?
Are we being scammed by the democrats, whose goals are not only to getting out of this down turn but also more government services and a more even distribution of income rather that just getting out of the down turn?

I think the title of this post should be: "Save the economy, AND save the banks."

And I now wonder whether the Austrian school includes Friedman (Minsky seems like an "honorary" Austrian)..

fundamentalist writes:

Orlando: "And I now wonder whether the Austrian school includes Friedman (Minsky seems like an "honorary" Austrian).."

Actually, no it doesn't. Friedman improved upon Keynesian econ significantly with his insights into money, but he got a lot of things wrong. His monetary theory was an emaciated version of the Austrian theory of money.

Dr. Reisman has some good insights on depression and its cure over at the mises.org blog. Here are some nuggets:

To the extent that "hoarding" or, more accurately, an increase in the demand for money for cash holding takes place, it is not because people have decided to save. What is actually going on is that business firms and investors have decided that they need to change the composition of their already accumulated savings in favor of holding more cash and less of other assets.

Furthermore, the increases in cash holdings that take place in such circumstances are not only not an addition to savings but occur in the midst of a sharp decline in the overall amount of accumulated savings. For example, the increases in cash holdings that are taking place today are in response to a major plunge in the real estate and stock markets, of numerous and sizable corporate bankruptcies, and of huge losses on the part of banks and other financial institutions.

The loss of accumulated savings is at the core of the problem of economic depressions. Recessions and depressions and the losses that accompany them are the result of the attempt to create capital on a foundation of credit expansion rather than saving. Credit expansion is the lending out of new and additional money that is created out of thin air by the banking system, which acts with the encouragement and support of the government. The money so created and lent has the appearance of being new and additional capital, but it is not.

For an individual consumer, the purchase of an expensive home or automobile in the delusion that he is rich later on turns out to be a major loss in the light of the fact that he cannot actually afford these things and would have been better off had he not bought them. In the same way, business construction projects, stepped up store openings, acquisitions of other firms, and the like, carried out in the delusion of a sudden abundance of available capital, turn out to be sources of major losses when the delusion of additional capital evaporates.

bill woolsey writes:

People can lose confidence all they want. It can only impact aggregate demand by reducing velocity/raising the demand for money. An increase in the money supply can offset that.

If nominal expenditure continues to grow, but real output fell as much, along with inflation, then, I might believe that this all about sectoral shifts or reduced effiency in financial intermediation.

I don't believe it.

ssendam writes:

bill woolsey says: "People can lose confidence all they want. It can only impact aggregate demand by reducing velocity/raising the demand for money. An increase in the money supply can offset that."

Suppose that every American was $100k in debt because they took out a 300k mortgage, then house prices dropped. Now they don't want to spend, hence AD drops. How is the Fed supposed to offset that? Not by lowering interest rates even further - people want to pay down old debt, they don't want to borrow more.

Now, the if the Fed decided to truly print money a la Zimbabwe, then they could get people to spend again - but that's because inflation destroys the value of the debt (and also the value of whatever savings was used to fund the debt). But I don't think that's what he has in mind.

bill woolsey writes:

"Suppose that every American was $100k in debt because they took out a 300k mortgage, then house prices dropped. Now they don't want to spend, hence AD drops. How is the Fed supposed to offset that? Not by lowering interest rates even further - people want to pay down old debt, they don't want to borrow more."

Who is receiving the debt repayments? What are they doing with the money they receive?

There is aways enough income to purchase all of the consumer goods that can be produced.

Income equals output.

Borrowing, lending, and the repayment of debt shifts funds about.

The way that money leaves the stream of income and expenditure is through an effort to accumulate money balances, not from making payments, including payment of debt.

If there is an effort to hold increased money balances, this will reduce expenditures on other things, particularly, capital goods and consumer goods.

For monetary policy to be ineffective, it requires that people be willing to expand their desired holdings of money faster than the central bank can increase the money supply.

Assuming that monetary policy means using open market operations in T-bills to target the Federal Funds rate may be causing confusion.

And, of course, yes, an expansionary monetary policy could have the effect of reducing all sorts of interest rates. BAA corporate bonds are about 8%. That isn't anywhere near zero.


El Presidente writes:

fundamentalist,

There is a technical term for that kind of fallacy that I can’t remember; can anyone help me out?

Concluding that the properties of a part ar transitive with respect to the whole is the fallacy of composition. You might also be thinking of the fallacy of generalization (self explanatory). There is a formal fallacy of argumentum ad temperantiam (AKA fallacy of moderation, fallacy of the golden mean). This consists of negotiating the "truth". We might be grasping for one or all of the above. I'm not sure. I can't see in here. =)

aaron writes:

What do you think of Ed Glaeser's suggestion we cut the interest rate expense deduction?

I think it's a good idea, but needs to be done smoothly. I think the way to go is replace it with a principal payment deduction and slowly fade it away.

Bill Woolsey writes:

Fundamentalist, there is always sufficient income to purchase all the output that can be produced. Income equals output.

If people choose to use their income to repay debt, those receiving the payment have the money. What do they do with it?

If they hold it.. then, that is the problem. An increase in the demand for money.

It is possible that debts repaid to banks will result in a decrease in the money supply. But then, there you have it. A decrease in the money supply is causing the problem.

If nominal income continues to grow at trend, the the Austrian "recession" phase, involves growing demand for consumer goods. High prices of consumer goods. Hihger profits for hte production of consumer goods. Higher sales of consumer goods. More production of consumer goods, and greater employment in consumer goods industries. And, perhaps, lower real wages because of the higher prices. Resources are shifted from the production of capital goods to consumer goods.

Personally, I don't see this as any more of a problem that the shifts in resources due to changes in international competitiveness.

wc0350 writes:

Save the economy or save the banks? Well, I believe that, if possible, we should save both the economy and the banks, however at this time this is not possible. So, what are we supposed to do? If we save the banks, we will further harm our economy, but if we save the economy, we will damage the banks. Both the economy and the banks are extremely important, but in my own opinion, it is the economy we should save because if we save our economy now, we will be able to repair the banks later.

Dezakin writes:

You can save both with quantitative easing at the price of higher inflation during the recovery. I dont know why discussing it is so taboo.

fundamentalist writes:

El Presidente, Thanks! I think it’s the fallacy of composition.

Bill Woolsey: “If they hold it.. then, that is the problem. An increase in the demand for money. …It is possible that debts repaid to banks will result in a decrease in the money supply. But then, there you have it. A decrease in the money supply is causing the problem.”

Are the two, an increase in the demand for money and a decrease in the supply of money, the causes or the effects? If you read Dr. Reisman’s article from yesterday at Mises.org you’ll see that the Austrian view is that they are effects of other causes. That doesn’t mean that in turn they don’t cause other problems, such as falling asset prices and more defaults on debt.

Bill: “Resources are shifted from the production of capital goods to consumer goods….Personally, I don't see this as any more of a problem that the shifts in resources due to changes in international competitiveness.”

Austrians would agree with you completely if increased investment in capital good production came strictly from increased savings. Increased savings means less consumption, so if capital goods production increases the increase comes at the expense of consumer goods production. The consumer good industry releases resourced to be used in capital good production. Then if consumer preferences change and they demand more consumer goods, the shift in resources reverses with few problems.

All Austrians make that perfectly clear. The problem comes with monetary policy, which mainstream econ has failed to integrate into its theory. It has insisted that money cannot play a role in business cycles. I haven’t found a good reason for this insistence on excluding money, but it seems arbitrary and senseless to me. The Austrian business cycle theory is a monetary theory of cycles, and as Hayek points out in “Monetary Theory and the Trade Cycle” there is no reason to label it an “exogenous” theory. Money is endogenous to the economy.

In very brief form, the problems with shifting resources from capital goods to consumer goods production is caused by monetary policy, or some say it is permitted by monetary policy. Unemployment is lowest in the capital goods industries during a depression, much lower than in the consumer goods industries. The feds reduce interest rates below the market rate in order to stimulate borrowing, which goes into capital goods production. But consumers haven’t increased savings by reducing consumption. As a result, both consumer goods producers and capital goods producers are trying to increase production at the same time. They compete for the same scarce capital resources (money and materials). They are attempting to push the economy beyond its production possibility frontier. This can work for a while if producers consume capital, but eventually some ventures must fail because of the limited amount of capital available. It’s always the capital goods producers that fail, mainly because of the Ricardo Effect.

Those business failures cause the rise in unemployment, fall in the money supply and rise in demand for cash.

El Presidente writes:

fundamentalist,

El Presidente, Thanks! I think it’s the fallacy of composition.

Excellent selection. The pleasure is mine.

Bill Woolsey, (got it right this time)

If they hold it.. then, that is the problem. An increase in the demand for money.

I generally agree, but I would like to propose a nuanced explanation. Instead of demand for money increasing, what if the marginal utility of the things money purchases is declining for those with lots of money. That is, what if people with money are reaching the point of satiation with most everything else and thus they cannot see a good reason to engage in increased present consumption (MPS & MPC)? They may be viewing money primarily as a store of value, and much less as a medium of exchange; thus the decline in velocity and output; the classic paradox of thrift.

I asked somebody of means what they would do with a tax reduction (Arnold Kling's idea) and their answer was plain yet remarkable. They said, "I already have everything I want, so I guess I would save it." What we see as demand for money might, in essence, be a lack of demand for other things in the segment of the population that has money, and the absence of money in the segment that still has strong demand (those that would buy if they could). If we consider the notion that present reduction in consumption is due to pooling money in the hands of the satiated, I think it changes our thinking on the possible remedies. It also integrates a well-known micro relationship with a macro phenomenon that lacks a convincing explanation in some theories.

fundamentalist writes:

As Dr. Reisman explains on mises.org, the increased demand for money is caused by the loss of wealth in the collapse of asset values, particularly the stock market and housing, and uncertainty caused by state intervention in the market. Consumers demand more cash to face uncertainty and to begin to rebuild their lost wealth. Consumers aren't saving more, they're re-allocating their assets and weighting cash more.

El Presidente writes:

fundamentalist,

So, if liquidity preference is increasing for some because they are in precarious circumstances and incresing for other because they are satiated, then liquidity preference is increasing for all but a single solution may not affect both groups in the same manner. In fact, it would seem that any solution would need to affect each group in exactly the opposite manner since their liquidity preference is elevated from opposite motivations. That is, it would need to moderate the extremes. Does that seem plausible in your way of thinking?

fundamentalist writes:

El Presidente: "In fact, it would seem that any solution would need to affect each group in exactly the opposite manner since their liquidity preference is elevated from opposite motivations."

That seems reasonable. And the goal is important. You don't want to increase spending on consumer goods. You want people to re-allocate their assets away from cash and into investments in private enterprise by buying more corp bonds and stocks, and for businesses to re-allocate from cash to new equipment. That will only happen when all of the insolvent businesses are allowed to fail and the economy stablizes.

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