The Wizard of the Fed

Everyone remembers that scene at the end of the Wizard of Oz, where the curtain is pulled back and we see the wizard without all the surrounding hocus-pocus.  What a disappointment!  I had that feeling reading Alan Greenspan’s new piece on the recession.  After just two sentences I was about ready to throw my shoe against the screen:

The US recovery from the 2008 financial and economic crisis has been disappointingly tepid. What is most notable in sifting through the variables that might conceivably account for the lacklustre rebound in GDP growth and the persistence of high unemployment is the unusually low level of corporate illiquid long-term fixed asset investment.

No.  The reason for the lackluster rebound in what Greenspan mistakenly calls “GDP growth” (which should correctly be called “real GDP growth,” as nominal should always be the default in economics) is very simple.  As I showed in this post, real GDP growth is very slow because NGDP growth is very slow.  And of course it’s the Fed’s job to control NGDP growth.

Then Greenspan suggests the problem is over-regulation:

As a share of corporate liquid cash flow, it is at its lowest level since 1940.  This contrasts starkly with the robust recovery in the markets for liquid corporate securities. What, then, accounts for this exceptionally elevated level of illiquidity aversion? I break down the broad potential sources, and analyse them with standard regression techniques. I infer that a minimum of half and possibly as much as three-fourths of the effect can be explained by the shock of vastly greater uncertainties embedded in the competitive, regulatory and financial environments faced by businesses since the collapse of Lehman Brothers, deriving from the surge in government activism. This explanation is buttressed by comparison with similar conundrums experienced during the 1930s.

Greenspan’s right about the 1930s, or at least the NIRA, but he’s wrong about the current policy environment.  None of the recent changes can explain the slow NGDP growth, and if that’s not persuasive enough then consider that the economy boomed in 1963-73, when government activism was far more aggressive than today.  Furthermore, a large share of corporate profits are now earned in booming overseas markets, so there is no mystery to be explained.

I found the following to be particularly dismaying, coming from a supposed libertarian:

But human nature being what it is, markets often also reflect these fears and exuberances that are not anchored to reality. A large number, perhaps a majority, of economists and policy makers see the shortfalls of faulty, human-nature-driven markets as requiring significant direction and correction by government.

Oh yes, those irrational market participants need to be herded like sheep by us hyper-rational academics and policymakers.  You know; the academics who almost universally failed to predict the crisis, and the policymakers who were acting as cheerleaders for the housing boom—complaining that banks weren’t doing enough sub-prime lending.  The policymakers who reacted to the gigantic sub-prime fiasco by finally getting around to banning sub-prime mortgages.  Oops, I mean by having the FHA subsidize even more sub-prime mortgages.

Here’s what Greenspan should have said:

Policymakers, particularly monetary policy makers, are subject to all sorts of fears that are not anchored in reality.  These include fear of unconventional monetary policy, once conventional policy is no longer possible.  Thus human-nature-driven policymakers require significant correction and direction by the markets.

HT:  Paul Krugman, who’s dismayed for slightly different reasons.

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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