Scott Sumner  

In the 1930s it seemed "obvious" that financial turmoil had caused the Great Depression

PRINT
Rent Control Devalues the Whol... Jason Furman: Excellent or Sad...

But now we know the actual problem was tight money, which caused NGDP to fall in half.

Here's Noah Smith:

This seems to be the overwhelming consensus in academic macro these days. It seems obvious to most people that the Great Recession was caused by stuff that happened in the financial sector; the only alternative hypothesis that anyone has put forth is the idea that fear of Obama's future socialist policies caused the recession, and that's just plain silly.
Perhaps some day economists will realize that the models they were teaching their students in 2007 imply that the world's central banks caused the Great Recession.

Here's Ludwig Wittgenstein:

Tell me," the great twentieth-century philosopher Ludwig Wittgenstein once asked a friend, "why do people always say it was natural for man to assume that the sun went around the Earth rather than that the Earth was rotating?" His friend replied, "Well, obviously because it just looks as though the Sun is going around the Earth." Wittgenstein responded, "Well, what would it have looked like if it had looked as though the Earth was rotating?
Now let's assume Wittgenstein was a market monetarist:
Wittgenstein: Tell me, why do people always say it's natural to assume the Great Recession was caused by the financial crisis of 2008?

Friend: Well, obviously because it looks as though the Great Recession was caused by the financial crisis of 2008.

Wittgenstein: Well, what would it have looked like if it had looked like it had been caused by Fed policy errors, which allowed nominal GDP to fall at the sharpest rate since 1938, especially during a time when banks were already stressed by the subprime fiasco, and when the resources for repaying nominal debts come from nominal income?


Inevitably when I make this argument there are a few tiresome "people of the concrete steppes" who insist the Fed did not cause the recession, they merely failed to offset the fall in velocity. Unfortunately they haven't bothered to look at the data. After rising at roughly a 5% rate for many years, the Fed brought growth in the monetary base to a complete halt between August 2007 and May 2008. That triggered the onset of recession in December 2007. Velocity actually rose during that 9 month period, but not enough to offset the Fed's tight money policy.

Of course later on V did fall sharply, and the Fed failed to take affirmative steps like level targeting of NGDP, which would have prevented the mild recession from turning into the Great Recession. But it's the Fed's job to control AD. When they do it well they take credit for their success, as when they took credit for the Great Moderation. And when they fail? Well let's just say Milton Friedman would not be surprised by any of the Fed's recent excuses. Here he describes what it's like to read all their annual reports, back to back:

An amusing dividend from reading annual reports of the Federal Reserve System seriatim is the sharp cyclical pattern that emerges in the potency attributed to monetary forces and policy. In years of prosperity, monetary policy is a potent instrument the skillful handling of which deserves credit for the favorable course of events; in years of adversity, other forces are the important sources of economic change, monetary policy has little leeway, and only the skillful handling of the exceedingly limited powers available prevented conditions from being even worse.
There were only 45 reports to read back in 1959. Now there are 100. But nothing has really changed.

PS. I do understand that Noah's "financial system" could be read as including central banks. But the rest of his post makes clear he is looking at the financial causes in the same way as 99% of other economists do--banking distress and associated problems.

PPS. A note on my earlier comment that we've forgotten everything we taught our students back in 2007. I was thinking of these sorts of lessons, which back in 2007 appeared in the number one money textbook (by Frederic Mishkin):

It is dangerous always to associate the easing or the tightening of monetary policy with a fall or a rise in short-term nominal interest rates. . . .

Monetary policy can be highly effective in reviving a weak economy even if short term rates are already near zero.


In my earlier days of blogging (in 2009) I tried to do a humorous take on how everything changed after 2008:

Now I'm starting to feel like Kevin McCarthy in the film Invasion of the Body Snatchers. Have I "misremembered" my history of progress in 20th century macro? Has some quantum fluctuation plunged me into a parallel universe where post Keynesian theory accurately describes the laws of macroeconomics?

I try to remain dispassionate and look at things logically. What are the odds that some pod-people from space have not only rewired Paul Krugman's brain, but that of most other macroeconomists? Isn't it more likely that I am going crazy? Like a character in a Borges story, I am now afraid to open Mishkin's textbook, for fear that the passage I remember may not be there. If you see a tall thin guy at the Harvard or MIT economics parking lots, jumping on the windshields of cars, please call the appropriate authorities.


Now I can update that story. There's a scene at the end of the film where the authorities hear of a truck overturning that is full of giant pods. There's a palpable shudder as they realize that Kevin McCarthy is no raving lunatic. I had a similar feeling when I opened the newest addition of Mishkin's text, and found that "highly effective" was no longer there, merely "effective." Here are some other mysterious changes in Mishkin's text.

It's starting to happen. Keep an eye on Noah Smith, I fear he may be one of the space aliens.

PPPS. Marcus Nunes has a reply to my previous post. I have no objection to his claim that money was not too tight during 2003-06. I also have no objection to the claim that money was too tight, given the Fed's 2% inflation target, or even a "dual mandate" of 2% inflation target plus minimizing the output gap.

HT: TravisV.


Comments and Sharing





COMMENTS (19 to date)
Michael Byrnes writes:

That Wittgenstein quote is fantastic!

Alex writes:

Fascinating post! Just one question: what do you think of the quoted statement that it's "simply silly" to consider that regulatory uncertainty could have contributed to the contraction? How can Keynesians bemoan the animal spirits of businesses, whom they conceive to be easily spooked herd animals in continual need of government nudging, while at the same time scoffing at the notion that those businesses are affected by uncertainties in government regulation?

Phillip writes:

When a macroeconomist says "we know X," what they usually mean is "I believe X."

I'm talking about the first sentence of this post.

Dan writes:

I've read much of Scott's stuff since the recession started, but I have never been clear about why he thinks AD and/or monetary base fell so much in 2007-08, and I have not seen anything where he explains it (I agree I might have missed it). What happened to cause the drop? Scott, if you have written about this, please link.

Scott Sumner writes:

Michael, I love that quote too.

Alex, I suppose the term "silly" is inappropriate, but I do think that regulation cannot explain the recession. The changes were far too small. Other eras of "big government" like the 1960s saw a boom.

Phillip, I'm a Richard Rorty-style pragmatist, which means anytime anyone says "we know . . . " they are always saying "we believe . . . "

Dan, The Wicksellian equilibrium rate fell faster that the Fed's target interest rate. That meant tighter money, and a smaller base was one symptom of the tighter money.

Steve J writes:

What actions would the Fed take to implement NGDP targeting? Considering many people thought QE was radical I am interested to hear what the Fed would have had to do to maintain NGDP growth after the financial crisis.

Dave Tufte writes:

Hey Scott, gotta cite for that excellent Friedman quote?

Squarely Rooted writes:

I largely agree, but have one question - you say:

After rising at roughly a 5% rate for many years, the Fed brought growth in the monetary base to a complete halt between August 2007 and May 2008. That triggered the onset of recession in December 2007. Velocity actually rose during that 9 month period, but not enough to offset the Fed's tight money policy.

That "brought" is doing a lot of work, especially since the effective fed funds rate plummeted from ~5% to ~2% in exactly the time period you cite. Now, I know you should reason from an interest rate change, but one does have to wonder - does a rapid slashing of rates suggest a deliberate slowing of monetary growth or an insufficiently vigorous reaction to exogenous slowing of monetary growth? That's where I think I have some difficulty with how you present the data.

Bob writes:

I do not think Wittgenstein's friend had much imagination. There are far better guesses, like the fact that we have a much easier to observe object that rotates around the earth. It's very easy to extrapolate from the moon. It'd be just as easy to tell that the sun does not revolve around the earth if it wasn't quite so bright, so we could tell its facing.

Having very different rules for sun and moon makes good sense the minute you have the right data to see the heliocentric model fails, and it's pretty hard to do that without a telescope.

In macro, we now have a telescope, and it's pretty surprising that so many people just refuse to see how the evidence doesn't match their old model.

BC writes:

Why do so many non-market monetarists seem so unwilling to consider tight monetary policy as a plausible explanation for the Great Recession, given that many of them agree that tight monetary policy caused the Great Depression? In the language of Wittgenstein, have they just failed to consider that the Earth may be rotating or do they think that a rotating Earth would look different from what they see?

Eric Falkenstein writes:

Since gdp growth and inflation shows up with a lag relative to current policy, how do you think the Fed should or is evaluating its policy stance? What's the metric of whether it's tight/loose right now, in your opinion?

Don Geddis writes:

@Steve J: You sound like a Person of the Concrete Steppes. Nick Rowe wrote a brilliant post a few years ago, that may help you.

The basic answer is: the vast majority of the "work" is done via expectations. The Fed simply asserts the NGDP path that it wants. Of course, like Chuck Norris, it needs a backup weapon to make the threat credible, and in this case the weapon is: QE infinity. The Fed threatens to buy up all of planet Earth, unless/until inflation/NGDP rises.

But the reality is, with a credible threat, you never have to actually execute on it. The public will adjust its own spending behavior, for the new equilibrium.

Dan writes:

But why did the Wicksellian equilibrium rate fall faster than the Fed's target interest rate? What is the factual effect (not the conceptual effect, such as a change in the Wicksellian rate)?

I don't mean to sound like a 3-year-old that keeps asking "why" but Scott needs to provide some facts as well, or data.

Steve J writes:

@Don Geddis - thanks that was exactly what I was looking for. While I live on the Concrete Steppes I do not have a Yorkshire accent and my background is electrical not mechanical engineering ;-)

sourcreamus writes:

The comment about Wiksellian equilibrium means that something happened to lower the demand for credit, which should have lowered the interest rate. The interest rate should have been lower than what the fed targeting, so this caused deflation somehow?
What caused the natural interest rate to go down?
How does the difference in the natural interest rate and the fed rate cause deflation?
How could the fed have seen this at the time?

M.R. writes:

If slower base growth starting in Aug. 2007 was an indication of tight money, then was the explosion in base growth after Lehman failed an indication of loose money?

Scott Sumner writes:

Steve, Set a level target, and target the NGDP forecast. That's all. The base becomes endogenous.

Dave, A Program for Monetary Stability, 1959, page 86.

Squarly rooted. I don't think the base is a good indicator of monetary policy, I am simply responding to those people of the concrete steppes who claim it wasn't because The Fed did anything to M, it was V. No, it was M. If the Fed doesn't want to control M, that's its choice. But it determines M.

Now some advocate looking at nominal interest rates, which is an even worse indicator. Rates are high during hyperinflation, but no one thinks money is easy. Some point to real interest rates, but then ignore the fact that the Fed raised real interest rates on 5 year TIPS from 0.57% in July 2008 to over 4% by the end of November. Isn't that tight money? No, but if you are a person of the concrete steppes you should think so. So why don't they?

My opponents have no model, just a desperate search for excuses.

Bob, Good point.

BC, Both.

Eric, Good Question. Back in the 1980s I presented a paper at the NY Fed explaining that they needed a NGDP future market. They said they didn't need such a market, they can forecast fine without it. OK, so use your internal forecasts and target the Fed's internal forecast of 12 month forward NGDP, or perhaps 24 month forward. Do as Svensson suggested and set your instruments so that the policy target equals the policy goal. If they do need the NGDP futures market, then create one right now.

Dan, It was mostly the slowing housing market. The market had already been falling since early 2006.

sourcreamus, Ignore interest rates, they don't cause anything. They are effects. The cause was M*V rising too slowly.

M.R. No it wasn't, because lower base growth is not a reliable indicator. You want to look at M*V. My point was in response to those people who insist on concrete steppes. They are foolish in doing so, for exactly the reason you suggest.

sanchk writes:

Krugman just linked to his own article in Slate that contained this paragraph:

Here again, however, there is a deeper answer. It is possible for economies to suffer from an overall inadequacy of demand--recessions do happen. However, such slumps are essentially monetary--they come about because people try in the aggregate to hold more cash than there actually is in circulation. (That insight is the essence of Keynesian economics.) And they can usually be cured by issuing more money--full stop, end of story. An overall excess of production capacity (compared to what?) has nothing at all to do with it.

Now - the article was written in Jan 1997, his paper 'It's Baaack' wasn't published until 1998, and he's claimed to have collected more evidence since then to support using fiscal stimulus at the zero bound. But the 'essence' of Keynesian economics has gone from being 'recessions are a monetary phenomena' to 'at zero lower bound, fiscal stimulus can raise aggregate demand'. And from how he's written that particular paragraph, he's the one who puts the full stop/end-of-story line on the solution being looser monetary policy, not the zero bound.

I wonder if economists will one day document the Great Unlearning of their profession between 1998-2007 as well as they've documented the causes of the Great Depression...

PeterP writes:

We got served tautologies here, as usual. All of a sudden for no reason the Fed caused tight money. No mention of debt and deleveraging, it was just a coincidence that 4M households were about to default on their mortgage at the same time.

Btw the Fed cannot make money tight, it defends the rate, you can swap all you treausuries into reserves at the Fed rate. The problem was income and net worth, something the Fed has only tenuous influece on.

Btw about expectations: do you think rain dance causes rain? Apparently you do, because it definitely causes expectations of rain, at least in brains of confused people. But there is no causal link, just like there isno link from base to spending, so indeed lack of mechanism kills this little theory.

Comments for this entry have been closed
Return to top