Scott Sumner  

For some strange reason Keynes and Hayek caused the Great Recession

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The title of this post has probably angered 90% of the profession, and perplexed another 9%. Obviously I'm taking a few liberties here; both individuals died long ago. And it's not even clear their policies caused the Great Recession. But for some strange reason they seem implicated.

I've often argued that the Great Recession was caused by mistakes in monetary policy. I began a crusade for monetary stimulus in late 2008, partly because I saw almost no one else doing the same (with a few exceptions like David Beckworth and other market monetarists.) As I got deeper into the policy debate, I noticed that two problems kept cropping up; lots of people didn't think stimulus was needed, and another large group thought it was needed, but that the Fed was out of ammunition. The latter group often called for fiscal stimulus, which turned out to be ineffective.

At this point defenders of Keynes and Hayek might make the following arguments:

"But Keynes also favored monetary stimulus, not just fiscal stimulus."

"But Hayek favored targeting NGDP, and don't you market monetarists favor the same thing?"

Yes, that's all true, but for some strange reason they seem implicated.

Let's start with Keynes. During the Great Contraction, Keynes favored both monetary and fiscal stimulus, although by 1932-33 he thought that the Fed had basically run out of ammunition. Rates were near zero. In public statements, he argued that it was time to focus on fiscal stimulus. Then something very interesting happened. FDR devalued the dollar between April 1933 and February 1934, and prices and output started rising rapidly. At first Keynes approved, but as the dollar depreciation got deeper for some strange reason Keynes turned against the policy. When FDR finally agreed to stop any further devaluation in early 1934, for some strange reason Keynes congratulated the President for ignoring the pleas of the "extreme inflationists."

Much later, Allan Meltzer noted that for some strange reason Keynes had overlooked an obvious solution to monetary policy ineffectiveness at the zero bound--a positive inflation target. Modern Keynesians did not overlook this solution; Paul Krugman and many others have recommended a 4% inflation target. If we had had that target in 2008, we could have avoided the deep recession in exactly the same way Australia did, by continuing with Taylor Rule-type policy adjustments. (BTW, I don't favor this policy, as there are equally effective techniques that do not require higher inflation, but it would "work.")

What if Meltzer and Krugman could go back in a time machine and explain the merits of this idea to Keynes (assuming they could agree to sit in the same tiny time machine.) Twenty years ago I would have guessed they could have easily convinced Keynes of the merits of their plan. Now I don't think so. I think Keynes would have smiled in a condescending way, and told them; "that's all well and good in theory, but an unanchored fiat money regime will eventually end up in hyperinflation---look what happened in Germany." For those who don't know, Keynes once called an unanchored fiat regime the worst possible monetary system, even worse that a rigid inflexible gold standard.

For non-Austrian readers my Hayek claim might seem less far-fetched, after all, modern Austrians have tended to be skeptical of "stimulus" as a solution to the Great Recession. But defenders of Hayek point to his support of NGDP targeting. That's true, and yet for some strange reason Hayek opposed monetary stimulus in the early 1930s, even as NGDP was obviously plunging much lower in most developed economies. In the US it fell in half. Yes, we didn't have good GDP data, but it was very clear that BOTH prices and real output were falling rapidly, so there can be no doubt that Hayek knew that nominal income was falling. Much later Hayek regretted his opposition to monetary stimulus in the early 1930s, which damaged the reputation of Austrian economics at the time.

In 2007 the number one monetary economics textbook taught students that low interest rates don't mean easy money, and that you need to look at other asset prices to ascertain the stance of monetary policy. Yet for some strange reason most economists thought money was highly expansionary. This textbook also taught students that monetary policy is still "highly effective" at near zero rates, and yet for some strange reason most economists assumed the Fed was out of ammunition.

Around 2010 when inflation in some countries rose slightly above target (due to oil prices and higher VATs) many hawks insisted that we needed to focus like a laser on the inflation target. A few years later when inflation fell below the target, for some strange reason these same hawks saw merit in missing the target--perhaps deflation could restore "competitiveness."

More recently, for some strange reason Keynesians like Larry Summers began to worry that monetary stimulus could create bubbles, even though standard Keynesian theory says that monetary stimulus is needed when unemployment is high and inflation is below target, and there is no respectable model that would justify ignoring the unemployed because of some highly questionable bubble theory that isn't even consistent with the EMH. Commenters tell me that Keynesians favor monetary stimulus. Yet in poll after poll of economists since 2008, for some strange reason only a very tiny percentage assert that money is too tight, despite the fact that most economists are Keynesians of one sort or another. For instance, almost all economists (in polls) claim that fiscal stimulus boosted GDP. For some strange reason they have the same blind spot about money as Keynes.

To summarize, people talk a good game, but for some strange reason when a crisis hits, most of the profession loses it heads. I suppose if you polled Americans in 2013 and asked; "do you think Americans should freak out like it's the end of the world if one or two cases of a not easily caught disease spreads from Africa to America?" the answer would have been no. I suspect in 2014, when this actually occurred, you'd get a different answer. . . .

. . . For some strange reason.


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COMMENTS (14 to date)
Thucydides writes:

"For some strange reason"---if so many intelligent theorists from different schools of economic thought are tending away from your preferred views, are you perhaps the one who is missing something?

Andrew_FL writes:

My guess would be, that in Hayek's case, he was concerned that if he could be construed as suggesting that the economic problem could be solved by inflation, then the political process would take that argument well beyond merely holding MV constant (which would mean, my sense would be, that Hayek would have agreed money was too tight circa 2008, but would not agree with the assertion that it is too tight right now-if anything, this norm implies it is presently too loose).

If you believe that the politicians are monetary cranks, do you do anything to encourage their belief that they can make everyone richer by printing money? Does your answer to that question change when money actually is too tight? Mine wouldn't. The advice I would offer would be heavily contingent on how much I trusted those I was advising to follow my advice as opposed to abusing it.

ThomasH writes:

Agreed that Krugman and Summers (and many other economists) were wrong not to call for additional monetary stimulation during 2008-14.* But when borrowing costs fall to near zero, it was also wrong for other economists not to call for additional public expenditure (as Krugman and Summers did) on projects whose net present value becomes positive. Although it is always a good time to reduce expenditures on things with a net present value of less than zero, a period of high unemployment is the wrong time to reduce expenditures across the board or to reduce the deficit per se and that, unfortunately, has been the locus of the actual political debate that K-S have been involved in, not the proper monetary rule.

* I'm still not convinced that the K-S failure to advocate for both more monetary "stimulus" was not based on an estimate that the Fed was already pressing against political constraints and hence would be unresponsive to such calls, as it in fact has been.

Nick Rowe writes:

It is strange Scott.

But in Keynes' case, maybe he thought that Roosevelt had raised the price of gold sufficiently for the economy to recover, given a little time, and didn't want to overshoot the (implicit) target?

Lorenzo from Oz writes:

Great fun post. But I would like, wouldn't I, having posted something similar, at much greater length, a few years ago.

John T. Kennedy writes:

Did Americans really freak out like it was the end of the world over Ebola? I gues if you mean "some" but it doesn't seem like all that many. Many more are concerned, but saying they're acting like it's the end of the world is pretty overblown.

Nathan W writes:

Keynes and Hayek are well worth the read, but why should we concern ourselves with what they would have done when we can look at the situation plain as day in front of us now with the advantage of analytical tools which did not even exist in those days?

Does supply or demand matter more in this context? Does nominal or real growth appear to be more important in unemployment and prices at the moment?

Once you're talking about Keynes and Hayek, you're layering in all manner of assumptions about how As cause Bs, while it is clear in most cases that sometimes A causes B, sometimes B causes A, sometimes both A causes B and B causes A, and that there are also other things involved.

It can be very useful in presenting the diversity of opinion, preferred methods, preferred objectives, etc., in some more summarized manner which presents the general scope of opinion and views, but I'm not convinced that either of these are often particularly useful or instructive in telling us enough about the context of a specific situation to know whether Keynes or Hayek might be more instructive at the moment.

The point is something like ... Who cares what Keynes said in 1933. Let's look at the present situation and make up our own minds. If you find yourself agreeing with either Keynes or Hayek too readily without thinking through the specific context, then most likely not enough independent thinking is taking place, imo.

That having been said, I always applaud/appreciate historical views in economics, even if I'm not convinced of the presentation of the arguments or their placement in historical context (both of which points are not so relevant for this article).

Scott Sumner writes:

Thucydides, That sounds like an appealing answer, until you start to look at the internal inconsistencies of the Keynesians and Austrians.

Even if I am completely wrong, these internal inconsistencies are an embarrassment.

Andrew, That may be, but if so Hayek was right to eventually apologize for those views.

Thomas, Actually Krugman did call for more monetary stimulus, at certain times. At other times he said it wouldn't work.

I've always supported doing projects whose NPV is positive.

Nick, That can't be it, because he still thought we needed lots more fiscal stimulus. We had nearly 25% unemployment at the time. Market sensitive wholesale prices were still far below 1929 levels.

It's very interesting to read the things Keynes said about actual real world policy issues, from a modern perspective. It's often quite bizarre, but bizarre in exactly the same way lots of stuff being said today is bizarre. Remember when the BOJ said a few years back that monetary stimulus would not have any effect, and also that it might lead to hyperinflation? That's Keynes in 1933. He would have been right at home on the BOJ board.

Lorenzo, I only steal from the best.

John, Maybe you are right---but some of the politicians certainly overreacted.

ThomasH writes:

Another Krugman column today favoring monetary stimulus in under-performing countries when this seems politically feasible, as it has become in Japan.

Scott Sumner writes:

Thomas, Krugman's only mistake was in assuming it was ever politically infeasible.

Lorenzo from Oz writes:

For the record, I thought it was great minds think alike, but you do it more efficiently :)

Lawrence D'Anna writes:

Don't be coy. What's the strange reason?

Scott Sumner writes:

Lawrence, Cognitive illusions?

Chris Mahoney writes:

“The reality is that unconventional monetary policy is difficult, perceived as risky, and never pursued with the vigor of conventional monetary policy.” --Paul Krugman, NYT, March 17, 2010

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