Rethinking the Great Recession

When I studied history, I was perplexed as to how the US could have done things like the internment of Japanese-Americans in WWII or the Joe McCarthy witch hunts of the early 1950s. Today, as I observe the growing anti-Chinese hysteria, these events are becoming easier to understand.

When I studied economic history, I was perplexed as to why economists of that period were blind to the costs of an extremely tight monetary policy that drove NGDP sharply lower during the early 1930s. Today, having seen a similar blindness in regard to the Great Recession, I’m no longer so perplexed.

The Economist has a very good (but also very depressing) article discussing how the field of macroeconomics has changed during the past decade. I take no pleasure in being right 10 years ago when I warned that misdiagnosis of the Great Recession could lead to the same sort of “dark ages” of economics as developed during the 1930s (and we escaped from in the latter 20th century).

Kevin Erdmann recently wrote a book pushing back against many of the myths regarding the housing bubble and bust, and I have a book coming out next April (University of Chicago Press) on market monetarism and the Great Recession.  Until then, you might be interested in our joint Mercatus working paper, which presents some of the key ideas in both books.

PS.  The Economist article is excellent, but does have one mistake:

Several factors might yet make the economy more hospitable to negative rates, however. Cash is in decline—another trend the pandemic has accelerated.

Actually, use of cash (mostly as a store of value) has increased sharply under Covid-19.  That makes the economy slightly less hospitable to negative rates.  Cash is a substitute for negative rate bank deposits.


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Global Imbalances and the COVID-19 Crisis

By Martin Kaufman and Daniel Leigh The world entered the COVID-19 pandemic with persistent, pre-existing external imbalances. The crisis has caused a sharp reduction in trade and significant movements in exchange rates but limited reduction in global current account deficits and surpluses. The outlook remains highly uncertain as the risks of new waves of contagion, […]

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Wasted ammunition?

The second quarter of this year saw what is probably the biggest fiscal stimulus in American history, in terms of increase in the budget deficit. And today we see the results: nominal GDP fell by 34.3% at an annual rate. That means the fiscal stimulus prevented a much bigger fall in GDP—right?

Well, that might be true, but how would we know? We have models, but these models certainly don’t predict that NGDP would fall at a 34.3% rate in a quarter where disposable income is actually rising. And not just rising, but (according to the BEA) rising at an almost insane annual rate of 42.1%.  In real terms it was even higher, due to deflation:

Real disposable personal income (DPI)—personal income adjusted for taxes and inflation—increased 44.9 percent in the second quarter after increasing 2.6 percent in the first quarter.

Why do I mention disposable income? Because the models that predict fiscal stimulus will boost the economy are based on a transmission mechanism that runs from more fiscal stimulus to more disposable income to more spending. Thus our (Keynesian) models don’t really explain why NGDP fell so sharply in Q2.  Indeed, if anything these models predict an extraordinary boom.

You might respond that our common sense does provide an answer—people were afraid to go out shopping due to the virus. I accept that theory. But as far as I know there are no models that predict fiscal stimulus will be effective when people are afraid to go out shopping. And with the new Q2 GDP data there is also no empirical evidence that fiscal stimulus boosted GDP.

Before discussing the policy implications of all this, a few caveats:

1. Yes, I understand “ceteris paribus”. It’s plausible that the fiscal stimulus had some positive effect.  After all, even during periods where the virus is the dominant factor, disposable income does matter at the margin.

2. A very large budget deficit in Q2 was appropriate, as standard public finance theory says you should take in less tax revenue during a severe slump, and spend more on unemployment compensation. Then there’s spending on the virus itself.  I accept all of that. A big deficit was inevitable and appropriate.

What I question is the part of the deficit that was motivated solely by the desire to boost disposable income. For instance, why give $1200 to middle class people with stable jobs who were actually benefiting from a decline in the cost of living? That seems like wasted ammunition.  What were they expected to do with the money?  Why not just do enough stimulus to keep disposable income stable, if the problem is that people are afraid of spending?  Why a 44% (annualized) real increase?

In fairness to the other side, the fiscal stimulus this time around was larger and timelier than I expected. I would have expected gridlock in DC to slow the process. Nonetheless, it seems plausible to me that the massive fiscal stimulus was mostly wasted, due to the reluctance of people to spend. Ironically, this might be the one recession where it would have been better to delay the fiscal stimulus until 2021.  If we get a vaccine this winter (which experts seem to think increasingly likely) then perhaps people will become more willing to shop in 2021. That’s when the fiscal stimulus might have been effective, at least if you buy the underlying Keynesian model.

For myself, I believe monetary stimulus would be more effective in boosting the economy in 2021, at a much lower cost. Monetary and fiscal policy are very different. Monetary stimulus does not exhaust ammunition; rather it actually creates ammunition by raising the natural rate of interest. Fiscal stimulus really does exhaust ammunition.

Despite the preceding comments, I actually believe the economy received too little stimulus even in Q2 of this year.  I would have preferred to see monetary policy be expansionary enough to prevent disinflation.  It wasn’t.  So I’m not one of those conservatives who argue that “stimulus” doesn’t help in a slump.  Rather, I favor monetary stimulus (which is basically costless) over fiscal stimulus that imposes a heavy burden on future taxpayers.  If there’s a vaccine this winter, then I believe that monetary stimulus alone (done properly) could give us a V-shaped recovery.

In the past, I argued that fiscal stimulus did boost GDP in Q2 of 2008, but did not boost GDP for 2008 as a whole. That’s because the Fed responded to Bush’s spring of 2008 tax rebate by tightening money to slow inflation (CPI inflation peaked at 5.5% in mid-2008.) The rest is history.

In my view the recent fiscal stimulus did slightly boost NGDP in Q2, but the gains are likely to be taken away in 2021.  We’ll do a bit less monetary stimulus in 2021 because of all of the fiscal stimulus done in 2020, money that was basically wasted.

PS. Yes, the unannualized drop in NGDP was much smaller than 34.3%, but still pretty horrific by historical standards.


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Should we root for second best policies?

The Fed is currently contemplating a set of monetary policy changes that might be viewed as “second best”. These include yield curve control and average inflation targeting. With yield curve control the central bank would peg the yield on longer-term Treasury bonds. This was Fed policy during the 1940s. Under average inflation targeting the central bank tries to make up for an inflation undershoot or overshoot, so that inflation will average 2% over the business cycle.

In my view, these are second best policies.  Holding down long-term interest rates might be expansionary, but it also might end up being contractionary.  After all, contractionary monetary policy can easily decrease long-term interest rates by reducing expectations of inflation and economic growth.

Average inflation targeting might be expansionary during a recession, but it also might lack credibility for exactly the same reason that the current inflation targeting regime lacks credibility; there is no hard and fast commitment to make up for inflation undershoots, just an intention to try to do so.

In my view, first best policies would involve level targeting (of prices or better yet NGDP) and a “whatever it takes” approach to monetary expansion to hit those level targets.  That’s the only policy regime that would give me confidence that the Fed would actually hit its target over the very long run.

So here’s the question.  Should we view the adoption of second best policies as a step forward, even if not optimal?  Or would they be a step that makes the optimal policy less likely?  That is, would average inflation targeting involve the opportunity cost of rejecting level targeting?

What do you think?


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Should the U.S. Return to the Gold Standard


Krystina Alarcon of Fox News interviewed me this morning about why the exchange rate of the dollar and the price of gold tend to move in opposite directions. I think she did a nice job of splicing together my answers to various questions. I loved the way she started it.

I referred to the work of Lawrence H. White, George Selgin, and Christy Romer, but in her editing she didn’t use those parts.

It’s just under 3 minutes long.


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This is how it’s supposed to work

Back in the early stages of the 2006-09 housing collapse, the economy behaved as it is supposed to behave. Housing construction fell by more than 50% from January 2006 to April 2008, but there was only a tiny rise in unemployment, from 4.7% to 5.0%. Jobs shifted from housing construction to other sectors. That’s how things work when the Fed is keeping NGDP growing at an adequate rate. You move along the production possibilities frontier, not inside the line. Indeed we would have done even better if not for the modest slowdown in NGDP during late 2007 and early 2008.

Then the Fed let NGDP growth collapse in the second half of 2008, and almost all sectors started shedding jobs. The unemployment rate soared to 10% as we moved inside the PPF.

The recent Covid-19 shock is even bigger, but there are a few heartening signs that we’ll avoid the worst. The Covid-19 epidemic has caused saving rates to soar much higher, as consumers hold back on buying many services. This depresses interest rates, with 30-year mortgage rates recently falling below 3% for the first time ever. This surge in saving also tends to boost sectors less impacted by Covid-19, such as housing construction:

US homebuilder confidence back at pre-pandemic levels

US homebuilder confidence jumped in July, taking it back to levels seen before the pandemic rattled the US economy as the 30-year mortgage slipped to a record low, data on Thursday showed.

The National Association of Home Builders’ Housing Market Index jumped to 72 in July from 58 the previous month. That exceeded economists’ forecasts for a reading of 60, according to a Reuters survey, and matched its reading in March.

It’s a myth that low interest rates are good for the economy. That’s “reasoning from a price change”. Low rates are often caused by a slump in investment demand, which is bad for the economy. But higher saving rates are good for the housing sector. If monetary policy is adequate, we should see a V-shaped recovery once the worst of the epidemic is behind us.


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Monetary economics: The three heresies

In the wake of the Great Recession, the field of monetary economics has developed at least three heresies—schools of thought that reject mainstream monetary models. In my view, all three models are largely reactions to an important failure in mainstream models. The fact that these three heresies differ from each other largely reflects the fact that they came from different ideological perspectives.

In Thomas Kuhn’s theory of scientific progress, a widely accepted model may run into problems when faced by empirical facts that seem inconsistent with the prediction of the model.  This leads to a period of crisis, and new models are developed to address the empirical anomalies.  I believe that this has happened in monetary economics.

Consider the following claim, which reflects the views of most mainstream economists, circa 2007:

“A policy of reducing interest rates to very low levels is highly expansionary.  When combined with massive fiscal stimulus it can lead to high inflation and/or a sovereign debt crisis.”

Over the past three decades, the Japanese have done something quite similar to the hypothetical policy mix described above.  And yet there has been no significant inflation and no debt crisis. That’s an anomaly that needs to be explained.

At the risk of oversimplification, here’s how three new schools of thought addressed this anomaly:

1.  MMTers suggest that governments of countries with their own fiat money face no limits on how much they can borrow.  They recommend that central banks in those countries set interest rates at zero.  Inflation would only become a problem if spending exceeded the capacity of the economy to produce, in which case higher taxes were the solution.

2. NeoFisherians argue that low interest rates are not an expansionary monetary policy; rather they represent a contractionary policy that will lead to lower rates of inflation.

3. Market monetarists argue that lower interest rates are not expansionary or contractionary, indeed to suggest that interest rates constitute a monetary policy is to “reason from a price change.”  Japanese rates were low because previous tight money policies had reduced trend NGDP growth to near zero.

So there are three new heterodox models, none of which agree with the mainstream model, and none of which agree with each other.  How did we end up with such a mess?

The important anomalies that were observed in Japan, Switzerland and elsewhere after 2008 made it almost inevitable that alternative models would be developed.  But why three?  The answer lies in that fact that even prior to 2008, there were important splits in the field of monetary economics.

Those who favored a more left wing interpretation of the Keynesian model (including so-called “Post Keynesians”) tended to strongly reject quantity theory oriented approaches to monetary policy.  In one sense, MMT can be seen as the most anti-quantity theory model ever developed.  Its tenets are almost the polar opposite of monetarism on a wide range of issues.

A more right-leaning group were used to employing a somewhat more classical (flexible price) model of macroeconomics.  In these models, the Fisher effect is far more important than the liquidity effect.  Thus it was natural for more classically inclined economists to gravitate toward an explanation of the Japanese anomaly that emphasized the Fisher effect—the way that changes in inflation expectations are strongly correlated with changes in nominal interest rates.  This eventually led to the NeoFisherian model.

A middle group coming out of the monetarist tradition, dubbed market monetarists, emphasized the importance of a wide range of linkages between money and interest rates, including the liquidity, income and Fisher effects.  This group accepted the monetarist view that changes in interest rates were a sort of epiphenomenon of monetary policy changes.  It rejected the assumption that changes in interest rates can tell us anything useful about changes in the stance of monetary policy.

Elsewhere I’ve described why I prefer market monetarism to mainstream models, MMT, and NeoFisherism, so I won’t repeat those points here.  (I am currently writing a paper on the Keynesian/NeoFisherian dispute.) But I will say that the mistake of equating interest rate changes with monetary policy is something like the original sin of macroeconomics.  It has caused all sorts of confusion, and gave birth to three very heterodox models.

This post is illustrated with the famous Goya print entitled “The Sleep of Reason Produces Monsters.  Let me just say that in my view the failure of mainstream economists to accurately describe the relationship between interest rates and monetary policy produced two quite misshapen beasts and one very beautiful baby.


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Reopening Asia: How the Right Policies Can Help Economic Recovery

by Chang Yong Rhee For the first time in living memory, Asia’s growth is expected to contract by 1.6 percent—a downgrade to the April projection of zero growth. While Asia’s economic growth in the first quarter of 2020 was better than projected in the April World Economic Outlook—partly owing to early stabilization of the virus […]

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Living on a one dimensional planet

This post is a bit long and slightly technical, but I also believe it is important. Think about the following pairs of statements:

The Wicksellian natural rate of interest is the policy rate that leads to stable prices.

The Wicksellian natural exchange rate is the policy exchange rate that leads to stable prices.

Monetary policy affects the economy by moving the policy interest rate relative to the natural rate.

Monetary policy affects the economy by moving the policy exchange rate relative to the natural rate.

A fall in the policy interest rate does not necessarily mean easier money, as the natural rate is often falling even more rapidly.

A fall in the policy exchange rate does not necessarily mean easier money, as the natural rate may be falling even more rapidly.

You get the idea.  Monetary policy can be described in terms of either interest rates or exchange rates.  In both cases, they are subject to misinterpretation.  In fact, interest rates are far more inadequate.  To see why, consider one more pair of statements:

What matters is not so much the change in the current short-term interest rate, but rather the change in the entire path of expected future interest rates.

What matters is not so much the change in the current spot exchange rate, but rather the change in the entire path of expected future exchange rates.

This is where interest rates are radically different from exchange rates, and greatly inferior.  To simplify the explanation, consider a small country that does not impact other countries, and also assume the interest parity condition holds. (It doesn’t hold perfectly, but it holds well enough to justify the general points I plan to make.)

A monetary policy announcement at time=0 immediately impacts the current one-year interest rate, as well as the set of expected future one-year interest rates.

A monetary policy announcement at time=0 immediately impact the current spot exchange rate, as well as the set of expected future exchange rates.

Because of the interest parity condition, we know that these two sets will be closely related.  The change in the current one-year interest rate will be the negative of the change in the forward premium of the exchange rate over the spot exchange rate.  In other words, if the policy announcement causes current one-year interest rates to fall by 1%, then the one-year forward exchange rate will appreciate by 1% more than the spot exchange rate.  Investors must be compensated for lower interest rates with a higher expected appreciation in the currency.  (That’s what the interest parity condition means.)  And even if this is not exactly true, it is approximately true.

So far, it looks like the two data sets are telling the same story.  By looking at the change in the expected path of exchange rates we can “back out” the change in the expected path of interest rates.  But the opposite is not true!  That’s because the path of interest rates tells us nothing about the change in the level of exchange rates, only changes in the various forward premia—the differentials.

Consider a central bank that uses exchange rates as its policy instrument, such as the Bank of Singapore.  If there is a policy announcement, I can describe its effect by looking at the impact on the spot exchange rate, and all forward exchange rates.  From that data, we can back out the impact on interest rates.   But if I describe the impact on interest rates, we have no way on knowing the impact on the level of various exchange rates.

Alternatively, suppose I told you that the Bank of Singapore’s action had caused the forward premium on the one-year forward exchange rate to rise by 30 basis points.  I don’t know about you, but I’d be kind of exasperated by that information.  “Yes, that’s all well and good, but what happened to the actual spot exchange rate?”  That would be the information that I’d be most interested in learning.

When someone tells you what happened to the one-year interest rate in response to a monetary policy shock, it’s like telling you what happened to the forward premium on the exchange rate, without even describing the impact on the level of the exchange rate.  That’s just totally inadequate.  It’s not that the changes in the various forward premia are completely useless, but they certainly are not the key piece of information that you’d like to know.

In March 2009, the Fed announced its first QE program, and interest rates fell sharply.  In January 2015, the Swiss announced they were abandoning their franc/euro exchange rate peg, and interest rates also fell sharply.  If interest rates were actually informative, then those two policy shocks would have been kind of similar in a qualitative sense.  In fact, they were about as different as one can imagine.  The QE announcement caused the spot exchange rate for the dollar to suddenly depreciate by over 4%, whereas the Swiss policy change caused the franc to suddenly appreciate by over 10%.  Only by looking at changes in the levels of the spot and forward exchange rates can we actually see what happened.  The change in the path of interest rates (or the change in the various forward exchange rate premia) tells us very little of value.

Markets understand this distinction, even if economists are often confused.  Stocks rose sharply on the US expansionary policy of lower interest rates when QE1 was announced, and fell sharply on the Swiss contractionary policy of lower interest rates in January 2015.  Markets focus on levels.

If you’ve followed my argument, you’ll see that I’ve explained the dispute between Keynesians and NeoFisherians.  Neither side is correct, because both describe monetary policy in an inadequate way, using the language of changes in interest rates.  They are like beings who think they are on a one-dimensional planet trying to understand a two dimensional region.  They think in terms of X going left or right along as line, whereas monetary policy simultaneously impacts X (levels) and Y (rates of change.)

This confusion distorts monetary policy.  One useful reform would be to move back to targeting levels, as we did under the gold standard and Bretton Woods.  But those specific level targets weren’t optimal; we need to target the level of prices, or much better yet NGDP.

If we had an NGDP futures market, then monetary policy shocks could be well described by their impact on the level of expected current NGDP (this quarter) as well as the impact on the level of expected future NGDP in future quarters.  We need such a market.

Even more so, we need NGDP futures “guardrails” on monetary policy, to keep expected one-year forward NGDP growth from drifting outside the 3% to 5% range.

PS.  If you are confused by the two dimensional analogy, consider a two-period model.  There is one interest rate, for bonds bought today and maturing next period.  There are two exchange rates, the spot exchange rate and the one period forward rate.  Shocks to the spot and forward exchange rates would appear on a two dimensional diagram.  Shocks to interest rates would appear on a one dimensional diagram.

PPS.  In a closed economy model you can replace the exchange rate with the money supply, the price of gold, CPI futures prices or NGDP futures prices.


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