Scott Sumner  

Beckworth and Ponnuru on 2008

Ancestry and Long-Run Growth R... Does Paul Krugman believe that...

David Beckworth and Ramesh Ponnuru have produced some excellent pieces on the mistakes made by the Fed in 2008. Here's an excerpt from their latest:

Krugman thinks the behavior of long-term real interest rates contradicts our thesis. They rose in the middle of 2008, but not, he says, catastrophically, as they should have if the Fed were really running a much-too-tight policy. Krugman is incorrect about the implications of our account. We would expect the Fed's contractionary mistakes to have led to an increase in the risk premium. It did. We would also expect it to reduce the prospects of economic growth and thus lead to a decline in long-term real interest rates adjusted for the risk premium. Again, that's what happened.

Read the whole article, it's great.

I find it very odd that Krugman would claim that real interest rates are a good indicator of whether Fed policy is effectively getting tighter. After all, real interest rates soared right after Lehman failed, to over 4%. And yet that dramatic increase is strangely missing from the Krugman post they link to:

I'd just add that if there were anything to this story, we should have seen a sharp increase in long-term real interest rates, as investors saw the Fed getting behind the disinflationary curve. Here's the real 10-year rate in the months leading up to Lehman:

Screen Shot 2016-02-10 at 9.15.26 AM.png

Why did Krugman leave off that surge in real interest rates? Perhaps because it would imply that money got really tight in late 2008 and, AFAIK, none of the mainstream Keynesians were saying that money was really tight at that time. Although I was not yet blogging, I was complaining about Fed policy to people I met, like Greg Mankiw and Robert Barro.

The second reason I found Krugman's claim to be odd is that he had previously criticized Friedman's frequent assertion that the Fed caused the Great Contraction of 1929-33 with a tight money policy. Krugman insisted that Friedman was being "intellectually dishonest" because, (according to Krugman) the Fed did not cause the downturn, they failed to prevent it.

As people like Nick Rowe frequently point out, the distinction between causing and failing to prevent is meaningless unless one can agree one what it means for the central bank to be "doing something". But economists do not agree, indeed Paul Krugman doesn't even agree with himself. When dismissing Friedman's argument he pointed out that the monetary base increased between 1929 and 1933. So in that case Krugman saw the monetary base, not real interest rates, as the proper metric of Fed action, or inaction. I suppose this is not surprising, because given the rapid deflation of 1929-33, many experts believe real interest rates shot up to very high levels. So if Krugman's current criticism of Beckworth and Ponnuru is correct, then his earlier criticism of Friedman is discredited.

But it gets even worse. Real interest rates are not a reliable indictor of the stance of monetary policy, as Beckworth and Ponnuru explain. And this is not just a market monetarist view, it's also Ben Bernanke's view:

The imperfect reliability of money growth as an indicator of monetary policy is unfortunate, because we don't really have anything satisfactory to replace it. As emphasized by Friedman (in his eleventh proposition) and by Allan Meltzer, nominal interest rates are not good indicators of the stance of policy, as a high nominal interest rate can indicate either monetary tightness or ease, depending on the state of inflation expectations. Indeed, confusing low nominal interest rates with monetary ease was the source of major problems in the 1930s, and it has perhaps been a problem in Japan in recent years as well. The real short-term interest rate, another candidate measure of policy stance, is also imperfect, because it mixes monetary and real influences, such as the rate of productivity growth. In addition, the value of specific policy indicators can be affected by the nature of the operating regime employed by the central bank, as shown for example in empirical work of mine with Ilian Mihov.

In the same speech, Bernanke suggested a better indicator of the stance of policy:

Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation. On this criterion it appears that modern central bankers have taken Milton Friedman's advice to heart.
But wait a minute, didn't NGDP and the price level fall in the second half of 2008? Yes they did, and so by Bernanke's criteria monetary policy became very tight.

Of course Bernanke later became Fed chair, and obviously isn't going to blame the Fed for the recession, but that's certainly the implication of his academic work before becoming chair. Keep in mind that we were not at the zero bound during this period, so "conventional" models apply. And conventional New Keynesian models say that falling NGDP and prices is a good indication that money is too tight. Even Bernanke admits (in his memoir) that the Fed erred in not cutting rates after Lehman failed. I suspect that privately he now wishes the Fed had been more expansionary during the entire April to September period.

Our critics seem to suggest that market monetarists are pursuing wacky theories that are out of the mainstream. Exactly the opposite is true. MMs are upholding the mainstream consensus circa 2007. It is our critics who have forgotten what we used to teach our students from the number one monetary textbook, back in 2007 (written by Frederic Mishkin):

1. 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.

2. Other asset prices besides those on short-term debt instruments contain important information about the stance of monetary policy because they are important elements in various monetary policy transmission mechanisms.

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

(Note that virtually all of the "other asset prices" implied sharply tightening money during the second half of 2008.)

Market monetarists are like those Irish monks that upheld classical learning during the long dark ages. In this case the long dark age of macroeconomics.

Comments and Sharing

COMMENTS (8 to date)
Alexander Hudson writes:

I'm glad you guys explicitly addressed Krugman's claim about interest rates, which really bugged me when I read it. Like you, I noticed that he chopped off his graph right before the large surge in rates. I assume he did so because he was focusing on the pre-Lehman period (which Ponnuru and Beckworth focus on).

So what should the 10-year real interest rate do in these cases? Go up, go down, or do we just accept that it's an unreliable indicator?

Capt. J Parker writes:

Can't the spread between long and short rates give you an indication of were monetary policy is heading? I believe Dr. Beckworth has argued this point. The 10 year - 3 month treasury rate spread started heading up at "roughly" the time it is claimed the Fed was tightening.

Brian Donohue writes:

Good post.

Hey Scott, I was looking at the historical relationship between the 1-month treasury and the Fed Funds rate.

Is it too simplistic to say that when the 1-month Treasury deviates from the Fed Funds rate, this indicates the market calling for a change in the Fed Funds rate.

I understand the two-way interaction and the markets trying to guess where the Fed is going, but, on a cursory view, this comparison seems really useful.

So, for example, in May and again in November of 1994, markets were calling for hikes (which they got.)

On August 16, 2007, the Fed Funds Rate was 5.25% and the 1-month Treasury was at 3.13%, a difference of 2.12%!

I interpret this as the market screaming for a cut in rates. The Fed acquiesced on September 18, 2007.

But the market recommenced "screaming" (>2% spread) in September, October, and December of 2007, and in January, March, April, and September of 2008, despite the Fed cutting throughout the year. The Fed was way behind the curve the whole time. The idea that they were worried about inflation or mulling "next move higher" seems awful in this context.

It seems too obvious an explanation, but...

Andrew_FL writes:

As I recall Friedman's claim was that the Fed did less than the clearinghouse association would have done in a pre-Fed crisis.

If the government nationalizes the automotive industry, is it a non interventionist, do nothing policy for them to produce zero cars?

Scott Sumner writes:

Alexander, I think we have to accept that it is unreliable in the short run. But we do know that an extremely tight monetary policy will eventually bring rates down, as NGDP growth slows sharply.

Capt. Parker, The spread often works, but not always.

Brian, I haven't studied that issue in detail, but what you say makes sense. In general, the longer the maturity the more that what the market "wants" will be equal to what the market "expects". In the short run the Fed can defy the market, but not in the long run.

Andrew, Good point, and I wish I had mentioned that as well.

Kailer writes:

I think you do your argument a disservice by citing the Lehman Brothers collapse on the 15th of Sept as the inflection point rather than the baffling Fed decision to hold rates at 2% on the following day. 5-yr TIPS yields actually fell by 7bps on the 15th, but jumped by 20 after the FOMC announcement.

I think I agree with Krugman on policy before September. Sure unemployment was rising since mid-2007, but as Brian pointed out, the Fed dropped the FF rate by over 3 percentage points Between september 07 and April 08. Between September 07 and early July 08 5-yr implied breakeven inflation rates rose from just under 2 to 2.5%. So at least until July I think you can make the case that the Fed acted about as well as you could reasonably expected them to.

This is not true for the September meeting. Breakeven inflation rates had fallen by more than one percentage point over the summer to 1.2% on the 15th. I've focused on TIPS, but obviously other indicators were screaming for stimulus. In my opinion this was where the case against the Fed begins. You could concede the argument to Krugman that Fed policy was optimal prior to September without really hurting the case against the Fed.

ThaomasH writes:

A very confused post. As usual, the problem arises because it is about how to describe policy ("tight," "loose") instead of policy instruments. In month Y of year Z should interest rates x1, x2, ... xn or exchange rates (or whatever instrument the critic thinks is relevant), have been raised or lowered from x1,0; x2,0; ... xn,0 to x1,1; x2,1; ... xn,1? And better still if the critic can point to the observable data that led him to his conclusion.

Scott Sumner writes:

Kailer, I think you misunderstood my argument, I see a policy failure in the second half of 2008, not the first half.

Speaking for myself, it was the September meeting where I realized that policy had gone off course. In retrospect it went off course even earlier, but as you say that wasn't obvious until September. But just because it wasn't obvious, doesn't mean tight money didn't cause the recession, or at least greatly worsen it.

Thomas, Interest rates are a lousy indicator of the stance of monetary policy, you want to look at things like TIPS spreads, NGDP forecasts, etc. Get those right, and let the market set interest rates.

The Fed's failure was that they had the wrong target, they were not doing level targeting. That turned out to be a huge mistake.

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