Arnold Kling  

Cyclical Monetary Theory

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Read Scott Sumner's post. I would distill it as arguing that macroeconomics and monetary theory follow a cyclical pattern.

1. During good times, such as the Great Moderation, a view develops that the monetary authority can stabilize the economy by aiming for a steady path for the price level or for inflation.

2. When a financial crisis occurs, people decide that the "good times" were an illusion. Instead, they revise history to describe good times as a bubble. They become receptive to what Paul Krugman calls "hangover theory," thinking that the bad times that follow a financial crash are the fair punishment for the previous excesses.

3. As bad times persist, people decide that the punishment has become excessive and unwarranted. Having lost faith in monetary policy as part of step (2), they become fiscal stimulus advocates, like Keynes of the General Theory.

Scott's main question is why people lose faith in monetary policy between steps 1 and 2.

I personally lost faith in (1) well before this crisis. I thought that the monetarist explanation of the Great Moderation was an attribution error. That means that I do not attribute the recent boom-bust cycle to loose-tight monetary policy. I think that to the extent government is to blame, it is for housing poilcy and bank capital regulations. See Not What They Had in Mind.

Otherwise, however, I have been pushing something close to (2). That is, of course, the Recalculation Story. If Sumner is correct, the longer that high unemployment persists, the less plausible this story will seem. That may be a fair observation of how intellectual fashions operate, but it is fairly ironic. I expect that the Recalculation will take many years to work out. In fact, if employment bounces back quickly, I would count that as tending to support the theory of fiscal stimulus and tending to weaken the case for the Recalculation Story. So a prolonged slump in employment might strengthen my belief in (2) while the intellectual cycle would move toward (3).


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CATEGORIES: Macroeconomics



COMMENTS (5 to date)
Ryan Vann writes:

Mr. Kling,

You are very clear and concise with your interpretation of recent events here. Whether your view is the accurate one or not, it is a big plus that there is no ambiguity. I also believe your story about unemployment metrics is the correct one. It makes sense that a recalculation (primarily a labor recalculation) requires time for labor to withdraw from the labor force, become gain knowledge in sectors that were previously neglected, and eventually be rehired.

In contrast, if there was no miscalculation (which requires a recalculation) and the recession was primarily the result of poor monetary policy, as soon as rates became palatable, labor would just revert to prior sector knowledge. It will be interesting to see how employment in areas like general contracting or financial representatives looks a year or two into the future. I would like to say that I do think Sumner's view is valid too. There isn't any reason the primary force of the recession couldn't be a miscalculation and that bad monetary policy exacerbates things.

Lord writes:

I would call the cyclical pattern the psychological explanation, and recalculation the technological explanation. One would hope psychology could be changed within a short period of time. Technology could take a very long time as it takes new discoveries and new knowledge, none of which can be made to happen on demand. Neither is exclusive to one another.

Patrick writes:

I too was always skeptical of the monetarist's claim that the technocrats got better.

I've always thought that the great moderation was in part a technological one due to changes in management practices, logistics, and manufacturing, that make it significantly harder to have supply / demand imbalances. Things like 'Just In Time', really cut inventory problems. Further, global trade makes it easy to take smooth supply or demand disruption. Another reason would be changes in financial markets and financial technologies make it easier for firms to make long term plans or adjust things on the fly in ways you could not do a hundred years ago.

That and just the huge change to a knowledge economy, means that our consumptive and productive aspects are much smoother and harder to disrupt with technology or cultural norms.

I always liked this hypothesis because we don't need to explain it by some bureaucratic reason, but rather it explains the changes in much the same way we don't have famines. We don't have famines (in rich nations) today, mostly because our technology of producing, transporting, and storing food is so much better. There are some important institutional factors involving markets and rules and regulations, and governments could play some role in that, but it's mostly the technology.

What's your explanation for the great moderation Mr. Kling?

Greg Ransom writes:

OC California -- ground zero of the housing boom & and the subprime industry -- has lost 35,000 construction jobs in 3 years and 15,000 Real Estate & Finance jobs in 1 year.

Only a shut inor an economist could deny the existance of Restructuring. But perhaps I'm repeating myself.

Ryan Vann writes:

Greg Ransom,

Unfortunately I think, all too often, your assessment is correct. There seems an oversupply of Economists with zero private industry experience. Thankfully, Mr. Kling does not seem to be one of those

Patrick, seems like a tenable explanation to me. With that said, I believe monetary policy as well as statistical reporting methodology changes in the last 20 years have distorted our view of the performance of the Economy. I think we traded stability for a future recession of higher magnitude in the 90s and of course 2001.

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