A Failure of Imagination (The Big Think, Part I)

I was asked to participate in a bloginar called “The Big Think.”  Over the next few weeks we will be commenting on a number of interviews of leading experts on the financial crisis.  The participants are:

Marginal Revolution, Tyler Cowen
Reuters Finance, Felix Salmon
The Balance Sheet, James Surowiecki
Economist’s View, Mark Thoma
Beat the Press, Dean Baker
The Money Illusion, Scott Sumner
Café Hayek, Russ Roberts
The Atlantic Business Channel, Dan Indiviglio
Free Exchange/The Fly Bottle, Will Wilkinson
The Big Questions, Steven Landsburg
Econlog, Arnold Kling
Asymmetrical Information, Megan McArdle
Causes of the Crisis, Jeff Friedman
The American Scene/ The Corner, Jim Manzi
Economics One, John B. Taylor
Free Exchange/The Bellows, Ryan Avent
Naked Capitalism, Yves Smith
The New Republic, Noam Scheiber

I know what you are thinking, how did Sumner get included in that distinguished group?  I don’t know, but I have noticed that in the last few days “Sumnerian” has become a label for a certain type of monetary analysis.  (Here and Here.)  So maybe you first must become an adjective.

I’m going to be highly critical, but this isn’t really directed at David Wessel’s remarks, which can be heard here:

In Fed We Trusted

Who’s to Blame for the Financial Crisis?

The Future of Crises

Deconstructing the Fall

Economic Crisis, Meet the Press

Wessel (of the WSJ news page) holds fairly conventional views on the causes of the crisis.  I will be criticizing that conventional view through Wessel.

I don’t have strong feelings on the regulatory issues.  I expect Congress will pass reforms that interest them (consumer protection), not reforms that address the crisis (banning sub-prime mortgages.)  Indeed if Robert Pozen is to be believed, the Obama administration has begun subsidizing mortgages to people with no income and (effectively) no down-payment.

But regulation isn’t my area, so I’ll leave that to others.  Let’s talk about monetary policy, where I do have strong and heterodox ideas.  I believe that when NGDP growth plunges from its normal 5%, to roughly negative 3%, we can expect a severe recession.  (Doesn’t everyone believe that?)  And I believe the Fed has the tools and responsibility to prevent that from happening.  But first we need to understand how to read the stance of monetary policy.   Wessel argues:

We have 10.2% unemployment today and it’s not because of conventional monetary policy, raising interest rates because there was an increase in the consumer price index.  It’s the result of a finance bubble.

Yes, the Fed did not raise nominal rates during 2008.  But if there is one thing macroeconomists have learned over the last 100 years, it is that nominal rates are a lousy indicator of monetary policy.  Nominal rates fell during the Fed’s tight money policy of the early 1930s, and typically rise during hyperinflation.  Many economists prefer real interest rates.  I have some problems with that indicator as well, but I would point out that ex ante real rates on 5 year TIPS rose from about 0.5% to 4.2% between July and November 2008.  This is of course precisely when NGDP started its precipitous decline.  And Robert Hetzel provided a brilliant dissection of Fed minutes during those key months, which showed that policy was effectively tightened precisely because Fed officials were worried about high inflation (despite the fact that deflation was the real threat.)

Wessel argues that:

One thing is there was a failure of academic economics here.  Too many macro-economists underplayed the importance of finance and of financial institutions and their understanding of the world.

I see his point, which is that academics ignored the buildup to the sub-prime fiasco.  But once the crisis broke the opposite problem occurred.  Almost all macroeconomists blamed the recession on the financial crisis.  They should have had the courage to follow their own models, which tell us that demand-side recessions are caused by overly tight monetary policy.

Wessel was asked whether Wall Street or Washington was more to blame for the crisis.  Here is his response:

But while some aspects of the crisis were made in Washington, I think this one really falls more squarely on Wall Street.

I am one of the few macroeconomists who actually lived through the Great Depression.  No, I’m not in my 90s, but I spent about 10 years reading every NYT from 1929-38, and many other papers as well.  When you immerse yourself in a period in that way, you start to see events unfold as they were perceived at the time.  There were frequent Congressional hearings looking for all sorts of scapegoats, especially evil Wall Street traders and greedy bankers.

At the time, the stock market crash seemed a bolt from the blue, a shock that caused the subsequent fall in NGDP.  But as we learned in 1987, big stock crashes don’t reduce NGDP if monetary policy is set at appropriate levels.

The banking failures really did make the Depression worse, but people failed to understand that banks can’t be expected to make loans that will be repaid in national income falls in half.  (Bankers were actually quite conservative by modern standards.)

I suppose this is all understandable, monetary policy works in very counter-intuitive ways.  After all, the Fed cut rates sharply in the early 1930s and dramatically boosted the monetary base.  Sound familiar?  So it’s not surprising that it wasn’t until years later that economists like Milton Friedman, Anna Schwartz and Ben Bernanke established that the real problem was tight money, and that the Fed (or gold standard) was to blame.  But even if it is understandable, it is still demoralizing to experience (in real time) the same blindness that I read about in the 1930s.

In fairness to the other side, there were two differences in the recent crisis:

1.  Unlike the Great Depression, this time around the private sector really was partly too blame.  The sub-prime crisis of 2007 was caused by reckless lending practices.  But that crisis merely led to a lull in the economy between 2007:4 and 2008:2, with a small rise in unemployment.  The much more severe financial crisis of late 2008 was caused by the sharp fall in NGDP, which depressed the prices of non-subprime housing on the coasts, all housing in the heartland, and also commercial and industrial real estate.

2.  At least this time around the Fed was active enough to prevent a catastrophic 50% fall in NGDP.  Instead it merely fell 8% below trend (so far.)

Because many pundits focus on sectoral issues and miss the deeper monetary factors, there is also widespread misunderstanding about the role of exchange rates.  Here is what Wessel says about the Chinese decision to stop appreciating the yuan in 2008:

This may be something that they think is in their interest, but from where I sit, it’s slowing the process of readjustment and rebalancing the world economy and is not doing the world any favors even though it may be very popular with the Chinese exporters.

A managed exchange rate is first and foremost a monetary policy.  The Chinese decision to stabilize the yuan was an effective depreciation (given their high rate of productivity growth.)  It led China out of its deflationary slump in the dark days of March, and China led Asia out of the recession.  Given that US equity prices responded strongly to the Asian rebound in the spring, it is quite likely that the Chinese recovery removed the tail risk of a severe worldwide slump.

The mistake is to view exchange rates through a trade lens, as a zero sum game.  During a deep slump an expansionary monetary policy will raise both domestic and world output.  Holding other monetary policies constant, a more expansionary Chinese monetary policy means a more expansionary world monetary policy, and this boosts world aggregate demand.  When the US devalued the dollar against gold in 1933 it helped the entire world recover from the Depression.  When other countries devalued against gold, it further helped the world economy.  This time around it was China that led the way.

Again and again we see economists and other pundits focus on the headline news events, the storylines that compel our attention.  But these are merely the froth on the waves, and we have missed the deeper currents that are driving these events.  Most importantly, we are missing the role of monetary policy.  There is one Wessel statement with which I wholeheartedly agree:

In many respects, this crisis was a failure of imagination.

Yeah, I’d say so.

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