Can’t? Or Won’t?

Everyone seems to be giving the last rites to orthodox macro.  Here’s Nick Rowe:

I think we are witnessing the biggest silent shift in macroeconomic thought since the Second World War. For 70 years we have taught, and believed, that we would never again need to suffer a persistent shortage of demand. We promised ourselves the 1930’s were behind us. We knew how to increase demand, and would do it if we needed to.

The orthodox have lost faith in that promise; only the heterodox still believe it.

I have certainly lost faith in the promise that we “would do it if we needed to.”  But I still believe it can and should have been done.  Arnold Kling makes this observation:

The only thing I will add to Nick’s post is that the exponents of the orthodox view were contemptuous of dissenters when they held their views of three years ago, and they are just as intolerant of dissenters to the new consensus.

A few years ago, pretty much everyone said that monetary policy could correct any aggregate demand shortfall coming from the collapse of a bubble. Now, pretty much no one, other than you know who, says so. The new consensus is that banks matter, and bailing out banks was a key policy move to prevent calamity.

This sounds similar to Nick, but is actually a radically different proposition.  When Bernanke was asked why he didn’t follow the advice he gave Japan—shoot for 3% inflation—he didn’t say the Fed couldn’t create inflation, he said it would be a bad idea to have higher inflation.  Krugman doesn’t think a higher inflation target won’t work, he thinks the Fed is too conservative to do it.  Woodford doesn’t say OMOs won’t work at zero rates, he says OMOs won’t work at zero rates unless the Fed has a price level target.  Which is what he said before the crisis.  Mishkin revised his text in light of the economic crisis, and kept the part about monetary policy being highly effective when nominal rates are zero.

When Kling says “you know who” he is really saying “that well known monetary crank that needs no introduction.”  How do I feel about that?  It’s nice to be well known.  But I really shouldn’t be well known, because I am still in the mainstream group of economists described above who believe monetary policy can be highly effective at boosting NGDP at the zero bound.  And let’s not forget about all those right-wing economists who think the liquidity trap idea is silly, but oppose higher NGDP because they think it would be inflationary.  So is orthodox economics dead?  From one perspective it does seem dead.  From another it doesn’t.  There are certainly internal contradictions, which I think can only be resolved when we get rid of all the policy lag hocus-pocus and start targeting NGDP futures prices in real time.

Tyler Cowen made the following comments in response to my analysis of the Greek crisis:

I don’t yet follow Scott’s reasoning.  If anything, in very recent times the ECB has shown it is willing to abandon independence to monetize various national debts.  How much that will boost nominal GDP I am not sure, but I don’t take it as negative news for nominal GDP, relative to previous expectations.

I am usually reluctant to play “market psychologist,” but I see potentially insolvent banks as a major issue, plus their connection to money market funds.  That has an AD link to be sure, but the uncertainty of another major bailout, and its fallout for intermediation, would be paralyzing to financial markets.  Most of all, the fear is that “Europe-as-we-knew-it” was a bubble of sorts, and that other people’s digestion and comprehension of that possibility will create adjustment problems around the world, including China.

I’m not convinced that the “end of the tunnel” for Europe on this one has to be so dire.

A few comments:

  1. I also don’t see why things have to end so badly for Europe.  I’m not even convinced this is the end of the euro (although a few members may drop out.)
  2. Markets soared May 10 on news of the trillion dollar bailout, and then fell back when they realized the ECB’s action was mostly smoke and mirrors.
  3. The stocks of US manufacturing firms are not plunging because German banks are exposed to Greek debt—they are plunging because markets fear falling AD will lead to falling orders for manufactured goods.  Sure, you can always tell a disintermediation story as Bernanke did for the Great Depression, but I just don’t see how it’s plausible in this case.  We don’t have 9.9% unemployment because firms can’t get financing to meet orders, we have 9.9% unemployment because their order books are half empty.  We need more NGDP, banking will then take care of itself.

One final point.  It’s important to separate out two issues:

  1. Was the recession caused by a nominal shock?
  2. Could monetary policy have stabilized NGDP growth in 2008-09?

Kling thinks the recession was due to real factors, whereas Krugman thinks it was a shortfall of nominal spending.  I seem to recall that Tyler thinks it’s 1/3 nominal 2/3 real.  My hunch is that mainstream macroeconomists (center-left economists at salt water universities) are somewhere between Tyler Cowen and Paul Krugman.  So am I; roughly 20% real and 80% nominal.  So I am very mainstream on that issue.  It’s true I have been more optimistic than most about the possibilities of monetary policy.  But that’s nothing unusual.  In the 1930s NGDP fell in half and most economists didn’t blame the Fed.  Years later the profession slapped themselves on the forehead and wondered how we could have been so obsessed with the gold standard that we let NGDP fall in half.  In the years to come we’ll get the same re-evaluation.  Economists will wonder how the Fed could have been so worried about a return to 1970s-style inflation that they didn’t act aggressively to boost NGDP.  It will take a decade or two of low inflation, but we’ll eventually realize that we were merely afraid of ghosts.  You don’t stumble into high inflation by accident; not after you understand the Taylor Principle.

Off topic:  Is the new banking bill really as bad as the press is making it out to be?  Is Congress really passing a bill that fails to address either of the two problems that caused the financial crisis?  I have to assume I am wrong, but I am reading nothing about bans on subprime mortgages, and nothing about reining in F&F.  (I don’t have time to read these long bills.)  Someone say it ain’t so.  Does Congress really believe the crisis was caused by “derivatives,” and not by foolish loans that people couldn’t repay?

About Scott Sumner 490 Articles

Affiliation: Bentley University

Scott Sumner has taught economics at Bentley University for the past 27 years.

He earned a BA in economics at Wisconsin and a PhD at University of Chicago.

Professor Sumner's current research topics include monetary policy targets and the Great Depression. His areas of interest are macroeconomics, monetary theory and policy, and history of economic thought.

Professor Sumner has published articles in the Journal of Political Economy, the Journal of Money, Credit and Banking, and the Bulletin of Economic Research.

Visit: TheMoneyIllusion

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