Arnold Kling  

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Not From The Onion... Gonick the Great - and How He ...

Here.


after July 2008 there were many other indicators that money was far too tight. About this time the dollar began rising sharply against the euro; and commodity prices began a sharp decline. Real interest rates rose from less than 1 percent in July to more than 4 percent by November. In the first ten days of October the stock market crashed 23 percent, signaling much more bearish expectations for the economy. The recession spread beyond housing, depressing manufacturing and other sectors. Both real and nominal GDP fell at annual rates of 5 percent to 6 percent in the fourth quarter of 2008 and the first quarter of 2009.

Sumner continues,

most economists missed a fundamental change in the nature of the crisis during the late summer of 2008. Whereas the initial downturn was mostly caused by "real shocks," such as banking turmoil and high energy prices, the far more severe second stage of the recession was triggered by a sharp decline in NGDP, which represents a failure of monetary policy...most economists simply assumed that policy was expansionary because the Fed had cut rates to relatively low levels, and the "monetary base" (which is the money produced by the Fed) rose very dramatically in the fourth quarter of 2008. Neither nominal interest rates nor the money supply, however, is a reliable indicator of the stance of monetary policy.

Read the whole thing. It is the clearest and most persuasive exposition of Sumner's views.

Suppose that the Fed had decided to make an all-out effort to use monetary expansion to prevent a recession. What could have gone wrong?

1. We could have been in a liquidity trap. My view is that we are in a liquidity trap more often than not. The fact that the Fed can reduce the Fed Funds rate does not impress me. If the risk premium is soaring on mortgage securities, stocks, and other assets, the Fed is not going to accomplish much. On the other hand, if the Fed just keeps buying stuff until interest rates that matter start to come down, you'd think it would eventually accomplish something.

2. The shock was primarily real. In that case, if the Fed expands like crazy, we get inflation with little or no improvement in real growth.

I tend to lean on (2) more than (1) as my reason for doubts about Sumner's views. However, I assign a probability of at least 33 percent that Sumner is right and I am wrong.

One issue is that the downturn was broadbased. This makes it seem as though a lot of the unemployment was "unnecessary," or due to a fall in aggregate demand. What I need to demonstrate, both in theory and empirically, is that this was really a broad-based supply shock, in which weak firms in many industries were exposed and sent contractionary market signals.

I am thinking a lot about this issue these days, and I do not have definitive answers. But one way to think of it is that shakeouts that would have been stretched out over 8 to 10 years under normal circumstances were compressed into about 18 months during the recession.


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COMMENTS (11 to date)
Joey Donuts writes:

I have mentioned the oil price shock in a previous comment. The increase in oil prices for the period from Sep. 2007 through March of 2009 moved an additional (over and above what was occuring before the price increases) $240 billion dollars from the accounts of US consumers into the accounts of oil producers both domestic and foreign. These additional funds weren't paid out to stockholders or labor. They weren't immediately invested in new exploration either.

Instead the producers being prudent purchased interest bearing securities. There is some evidence that a substantial portion went into US treasury securities.

From May until Sept of 2008 the ONLY open market operations performed by the Fed were sales of approximately $140 billion in Treasury securities.
This is a strange thing to do if upwards of 240 billion is being withdrawn from the banking system. The Fed explains this
here. Notice that they wanted to insure that the Federal Funds rate target was met.

The simultaneous withdrawl of funds from the system by the producers coupled with the Fed reducing reserves by their open market sales put the banks in one hell of a spot.

What's strange is that neither Paulson or Bernanke understood the nature of what appeared to be a "run" on the banks.

The cause of the "run" wasn't a loss in confidence of the banking system, although given the banks precarious positions with large numbers of illiquid securities, may have become a larger "run" based on failed confidence.

One would think that the people running the Treasury and the Fed would have had the sense to look for the cause of the run. Had they done so, they would have realized that making the banks liquid would do NOTHING to stem the outflow. Nor would putting the banks in a position to make loans offset the reduction in aggregate demand caused by a sudden increase in savings brought about by the oil shock. Consumers were already burdened with debt and in many case had already exhausted the equity value of their homes. The only way consumers could react to the oil price shock was to reduce expenditures every where else.

The economy needed a quick response by somebody to
offset the reduction in spending. The only way that could have occured is with an immediate tax reduction that could eventually be removed over time to allow some breathing room for a "recalculation".

I see the financial crisis and the resulting recession not so much as bias by the Fed and the Treasury towards banks, but more as simple unadulterated incompetence. It's kind of strange that the 30's depression had as one of its causes the Fed's adherence to incorrect policies. This recession has, in my eyes, a similar cause. Bernanke may understand the 30's but he missed the major lesson. Fed leaders make mistakes because they are human and the mistakes often have serious consequences. Milton Friedman made this point over and over again. Apparently, the Fed seems to attract people that think they have enough knowledge and skill to avoid making any mistakes.

ajb writes:

One can believe a recalc story and still think monetary incompetence exacerbated the crisis. So splitting the stories between yours and Sumner's is not unreasonable. It's just a matter of figuring out the relative weights. But I find it hard to believe -- given SS's evidence -- that monetary tightness wasn't a contributor to the Fall Crisis.

Elvin writes:

Monetary policy may have exacerbated the crisis, but our banks were in so much trouble that something bad was about to happen--whether in slow motion or quickly.

Many analysts felt that Citibank, Lehman, FNMA, FHLMC, and dozens of other major institutions were bankrupt, if not on the edge of bankruptcy after Bear Stearns. It wasn't going to take much to push them over.

On the consumer side, along with the oil price increases, there was the deteriorating housing situation. With the housing ATM gone, rising energy prices, and a slumping job market, the indefatigable US consumer was finally tapped out.

In retrospect, leverage had crept up so much in system, that it was going to end badly one way or another. Monetary might have been able to avoid the spectacular September and October of 2008, but that meant slow torture and low growth for years as the bankers figured out a different way the for the government to bail them out.

The US had major imbalances for a long time: too much consumption, too much earnings grom from finance, too large a trade deficit. This couldn't last. These imbalances in the real sector had to go through a great recalculation.


happyjuggler0 writes:

Two bad things happened:

First, *bad things* happened on the "real" side of the economy, requiring a great recalculation.

Second, thanks to the above, demand to hold non-circulating money soared, and was stupidly unmatched by a commensurate increase in the supply of money by the Fed. I believe Hayek referred to this type of thing as a secondary depression, but I could be wrong.

In a Scott Sumner world, as I understand it anyway, a properly run Fed would have matched the new demand with new supply for as long as it chose to not circulate, thus meaning there is no secondary depression (and no new inflation either). As a result, the downturn from a "normal" economic growth path would be a fraction of the size as the one we had (what size fraction I suspect even SS will be willing to admit he doesn't know), and as a bonus there would be no theoretical justification (smart or stupid) for "Keynesian fiscal stimulus" to soak up "mattress money" since the fed just created a clone supply.

With no Keynesian "stimulus", the Great Recalculation happens much faster, and to boot the government doesn't go deeply in debt paying for foul smelling pork.

In short, in the tautology mv=py, if v is falling (for whatever reason) by a factor of "x", then m has to be rising by the same factor "x" or py will plummet by a factor of "x", giving us that ugly "secondary depression".

Steve Sailer writes:

The oil price bubble, which peaked in July 2008, punctured the illusion that all those exurban McMansions 50-120 miles outside of LA would ever sell for anything close to what people had paid for them in 2005-2007.

winterspeak writes:

Arnold:

You are making excellent progress. I congratulate you on your open mindedness in thinking about this issue.

You've gone from "go recalculate yourself" to "payroll tax holiday... but just for employers" to this: maybe a lot of our current unemployment is unnecessary.

I don't know if this is the next step for you, but eventually you should take a balance sheet view of the economy, and realize that the non-govt sector is made up of non-govt issued credit sitting on top of govt-financed (that is, deficit financed) net savings.

Unfortunately, Sumner does not understand how the financial system works at all and is trying to reflate credit when the problem is insufficient net non-govt savings. So you aren't going to get there from where you are now.

To increase net non-govt savings, the Govt must run deficits. The solution is firmly fiscal, not monetary.

Richard Koo has written some good stuff on balance sheet recessions, and is miles ahead of Sumner (who has not exhibited any evidence of knowing what a balance sheet is. Or how banks work.)

A good summary here:
http://bilbo.economicoutlook.net/blog/?p=5345

happyjuggler0: Fed cannot fund the desire to hold non-circulating money. Only the Treasury can do that. But you have identified a key dynamic, which is more than most.

ajb writes:

If the oil price bubble peaked, how could it matter in the long run for growth?

The relevant point is that the housing crisis was real and subprime was bound to collapse, but whatever damage it should have caused was made much worse by tight monetary policy thus destroying assets that were not part of the bubble economy. Furthermore, the unnecessary fiscal stimulus will cause other problems which show up in asset prices. On the whole Sumner is just reprising Friedman and Schwartz for the 21st century. Bad monetary policy makes a crisis into a disaster both in the short run and due to stupid government interventionism in the longer run.

Bill Woolsey writes:

Arnold:

Good post.

The liquidity trap is the relevant issue as far as whether or not keeping nominal expenditure on a stable growth path is feasible.

The size of the decrease in productive capacity and increase in structural unemployment relative to the drop in real income and increase in the unemployment rate is the relevant issue regarding the desirability of keeping nominal expenditure on a stable growth path.

There is just one more item to consider regarding that last point. Why is it better for nominal incomes to fall rather than product prices rise when an extra large recalculation is necessary? Instead of thinking of a one-shot intervention (raising nominal expenditure,) what is the better rule? What is the better macroeconomic environment for these and other sorts of microeconmic adjustments?

fundamentalist writes:

Sumner doesn't think that a decline in ngdp causes depressions. Here makes it clear that he thinks the oil shock and housing price decline shock were the causes. He seems to think that given those shocks, the Feds should have reduced interest rates dramatically and that would have prevented the shocks from causing a depression. But Sumner places too much faith in monetary policy and ignores the long lags. And he places way too much faith in the Feds' econometric models for predicting ngdp.

The best model I have seen at predicting gdp is Ray Fair's model at Yale and it's good only for the next quarter. One year out it's almost worthless.

Reading some more on the German Hyperinflation of the 1920's, I noticed that currency in circulation quadrupled between 1914 and 1918, but prices hardly increased at all in spite of the massive shortages the war caused. However, foreign exchange rose dramatically. I think Sumner should change his measure of monetary policy to foreign exchange instead of prices. Prices in Germany began to rocket after 1918, which indicates that they had about a 4 year lag between monetary policy and price effect.

For Sumner's strategy to work, the Feds would need a model that could predict ngdp four years out, and that ain't gonna happen. I don't understand why Sumner persists in insisting on lags in months when the evidence is so clear that the lags between policy and effect is several years long.

It seems to me that Sumner would be a little more concerned about heading off bubbles instead of having the Feds clean up the mess after they pop. The rise in oil and housing prices weren't random events. They had identifiable causes. But Sumner doesn't seem to be interested in them.

scott sumner writes:

Nice post. I appreciate the link to my paper. Your comment about speeding up restructuring reminded me of a graph I recently saw, which showed jobs in manufacturing (or perhaps percentage of workers) in manufacturing. It has trended down since the 1970s, but it tends to follow a "step" pattern. Steep drops in recessions, and then fairly flat for the recovery years, and then another steep drop in the next recession.

When I saw this graph I sort of assumed that without business cycles, manufacturing employment would have declined smoothly over the past 35 years. Instead, it seems we get 5 to 10 years worth of job loss in each brief downturn, and then in the long expansions we have above trend growth, which prevents the normal job loss due to technological improvements that one otherwise expects.

Regarding liquidity traps, there are no liquidity traps with a forward looking monetary rule, just as there are no liquidity traps if a central bank uses the price of gold or foreign exchange as the policy instrument. The US faces the problem that an exchange rate target is not politically feasible and forward-looking policies work best if directed by the market, but that is also not politically feasible right now. So if we are stuck with discretion the Fed must be careful not to err on the side of deflation, as it makes their preferred policy instrument ineffective. We need to either rethink monetary policy from the ground up (my preference) or have the Fed get way more aggressive when we are flirting with a liquidity trap.

Larry writes:

The thing I like about Sumner is that he is pushing a lot of people (not enough, at least not yet) with settled views to think again by asking obvious questions. This vehicle, which is in part "Modern macro says X. Why do macro folks say ~X when talking policy?" is exemplary.

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