September 16, 2008

And my first 10 posts

My life can be divided into two parts, before and after September 16, 2008. (Yes, that’s technically true of any day of the past 69 years, but this date forms a useful division.) The Fed met two days after the Lehman failure, with the economy already nine months into recession, and refused to cut its 2% fed funds target. That was the date I transitioned from being an ordinary monetary economist to a sort of monetary crank, tilting at windmills.

With another important Fed meeting coming up almost exactly 16 years later, I thought it might be useful to revisit the first week of my blogging. I wanted to see where my mind was at the time, with the perspective provided by another 16 years of experience. (Note that my blog didn’t actually get up and running until February 2, 2009, as I’m not good with technology.)

Here’s an excerpt from the first post:

A blog is not the place for a lengthy dissertation, and so here I'll merely list three views that underlie my unusual take on the current recession:

Premise 1: The only coherent way of characterizing monetary policy as being either too"easy" or "tight" is relative to the policy stance expected to achieve the central bank's goals.

Premise 2: "Monetary policy can be highly effective in reviving a weak economy even if short-term interest rates are already near zero."

Premise 3: After mid-2008, and especially in early October, the expected growth in the price level and nominal GDP fell increasingly far below the Fed's implicit target.

In plain English, the first premise means the Fed should adopt the policy stance most likely to achieve its goals.  It is a point forcefully advocated by Lars Svensson, who Paul Krugman recently cited as an expert on the role of expectations in monetary policy.  The second is a quotation from Mishkin's best selling monetary economics text (p. 607), i.e. it's what we have been teaching our students.  And I have encountered few if any economists who disagree with my third assumption.  Indeed, if this were not so, why would Bernanke be calling for fiscal expansion?

That still seems like a decent summary of my basic view of the problem.

Next I’ll look at a portion of the third post, before circling back to the second:

James Hamilton noted:

“You could argue that if the Fed is doing its job properly, any recession should have been impossible to predict ahead of time.”

Strictly speaking, Hamilton’s observation only applies to recessions caused by demand shocks, but in practice, supply shocks are also pretty unpredictable.

I ran across Hamilton’s observation in early 2008 while working on a paper arguing that economists would never again be able to forecast recessions. I had assumed the Fed now followed Svensson’ criteria–i.e. always set monetary policy in such a way that the forecast equals the policy target. And since the Fed presumably doesn’t target recessions, they should be unforecastable as well.

Little did I know that events would discredit my hypothesis within months. Not because economists successfully forecast this recession (the consensus didn’t see a recession until a couple of months after it had begun) but because the Fed clearly no longer follows Svensson’s criteria–by late 2008 nominal growth forecasts for 2009 were far below what the Fed would like to see. . . .

When people used to ask me whether Fed policy was too easy or too tight, I usually said “I don’t know.” By October 2008 I was able to answer that question with confidence. That’s when I knew we were in trouble.

I suspect that the research I was doing on the unforecastable nature of recessions put me in the right frame of mind to develop my heterodox explanation of the Great Recession. When I saw widespread expectations of a deep recession, I knew we were off course.

In my previous (second) post, I had criticized the Fed’s adoption of interest on bank reserves (IOR) in early October 2008. I began the post by citing David Hume:

“If the coin be locked up in chests, it is the same thing with regard to prices, as if it were annihilated.” David Hume — Of Money

Translation: A fall in M and a fall in V have the same effect.

I suspect that economists like John Cochrane would regard my view that monetary policy is a set of tools that impact the supply and demand for base money as being rather quaint and old-fashioned. And it is quaint and old fashioned. But it also happens to be true, as it is an approach based on the fundamentals of economic theory—the value of any asset is determined by the supply and demand for that asset. And the monetary base is the medium of account.

The post then cited a contemporary complaint about Fed policy by Robert Hall and Susan Woodward:

“Oddly, he [Bernanke] explained the new policy of paying 1 percent interest on reserves as a way of elevating short-term rates up to the Fed’s target level of 1 percent. This amounts to a confession of the contractionary effect of the reserve interest policy.”

I loved the use of the term “confession”. Hall and Woodward were assuming that it would have clearly been desirable to have a higher level of nominal spending in late 2008. That was also my view. But that means that any Fed statement indicating the contractionary intent of a policy could be seen as a sort of confession of a policy blunder.

I wasn’t at all surprised by the views of Woodward and Hall; what shocked me is that other famous macroeconomists weren’t also complaining about IOR.

The post also demonstrated my interest in the Great Depression:

Almost every money and banking textbook mentions the infamous Fed decision to double reserve requirements in 1936-37. We teach our students that the last thing a central bank would want to do is to reduce the money multiplier in a depression.

I believe David Beckworth made a similar observation. As we will see, this wasn’t the only interesting parallel to the Great Depression.

The fourth post was entitled Friedman’s 4% Rule, Version 2.0”, and contained this proposal:

Have the Fed commit to buy and sell unlimited quantities of 12 month forward nominal GDP futures.  The price paid by the Fed will start at a level 4% above current nominal GDP, and rise by 4% per year.

This proposal is not politically feasible at the current time. Nonetheless, it does provide a useful way of framing the problem. Monetary policy should always be set at a position where the consensus market forecast called for 4% NGDP growth (with level targeting.)

In the third post I was basically saying “target the forecast. In the fourth post I was saying “target the market forecast”. I still believe they should do that, with or without an NGDP future market. If the market doesn’t exist, then estimate a synthetic market NGDP forecast based on a wide range of other asset price indicators.

My general view of the business cycle is that recessions occur when nominal wages are too high relative to nominal GDP. That’s usually caused by a sharp fall in NGDP growth in an environment of sticky nominal wages. But on a few occasions the government can actually create a nominal wage shock through misguided policies that artificially push nominal (and real) wages higher, a problem discussed in my fifth post:

Table 12.2: Four month (nonannualized!) growth rates for industrial production

Before        After
July   1933 wage shock   +57.4%     -18.8%
May   1934 wage shock   +11.9%    -15.0%
Nov.  1938 wage shock   +15.8%     +2.5%
Nov.  1939 wage shock   +16.0%     -6.5%

And there was also a slightly more complex fifth wage shock:

Historians argue that the huge union drives of late 1936 and 1937 were due to both the Wagner Act and FDR’s massive election victory.  Whatever the cause of the union gains, they led to rapid wage increases in late 1936 and much of 1937.  This time, monthly industrial production did not fall immediately, as prices were also rising fast in late 1936 and early 1937.  But when prices stopped rising, industrial production began falling sharply under the burden of high wages.

Progressives hate this type of argument, as they view FDR as a hero. And it is true that FDR played a major role in spurring a recovery, almost entirely due to his dollar depreciation program. But his misguided NRA and AAA programs were based on the fallacy that the depression was caused by falling prices, and that falling prices were aggravated by “overproduction”. That’s right; output plunged in 1929-33 because we were producing far too much. 🤔

Once again, here’s the highly quotable James Hamilton (who was responding to criticism from progressives):

I openly confess to believing that government policies that were explicitly designed to limit manufacturing, agricultural, and mining output may indeed have had the effect of limiting manufacturing, agricultural, and mining output.

In the sixth post I cheekily suggested that if Fed stimulus were not credible then they should engage in insider trading and buy lots of assets that would benefit from stimulus. Then do enough stimulus to profit. That reductio ad absurdum argument was probably a tad too cute, and likely to be misunderstood. The point of that sort of hypothetical is not “It’s easy to get rich”, rather, the point is that “It’s hard to get rich, and hence we should not expect the situation to occur where it would be easy to get rich.” In other words, a determined Fed will be believed by the markets. Lack of credibility is only a problem when institutions are not in fact reliable.

In the first week of blogging I was fighting a battle on two fronts. Half the people complained my monetary policy would do nothing due to the “liquidity trap’, while the other half complained the policy would lead to hyperinflation. After responding to the left in the fifth post, I addressed the right in the seventh post:

Someone asks your opinion on the economy.  You say the solution is a more expansionary monetary policy to boost nominal GDP.  They reply “But rates have already been cut to zero, we’re in a liquidity trap, businesses aren’t investing, ‘the problem’ is the financial system, etc.”  You reply with a really aggressive scenario that has the Fed buy up almost every asset on planet earth.  Make it sound dramatic enough and almost every single time you’ll hear “But wouldn’t that cause hyperinflation?”

That’s why you need guidance from market signals.

Both the progressive left and the Austrian right were misdiagnosing the situation due to a misguided belief that monetary policy was all about interest rates. In the eighth post I pushed back on that view by considering what things would look like if monetary policy became ultra-contractionary:

Now ask what this tight money would look like.  As long as real interest rates were below 3%, such a policy would produce zero percent nominal interest rates.  If wages and prices are sticky, a severe recession might also occur.  The severe recession and deflation would depress stock prices sharply, especially at the point where the deflation became anticipated by the market.  The recession would also cause highly cyclical commodity prices to fall much more than the general price level.  Deflation and recession makes loan repayment difficult, so many banks might fail.  One might imagine that the monetary base would fall as well, but that’s not obvious.  Cash and reserves become highly attractive assets in times of deflation and instability, so suppose the real demand for base money rose by 60%.  If the Fed wanted to prevent deflation from exceeding 3%, they’d have to partially accommodate the higher real demand for cash with a 57% increase in the monetary base.

Later on I came across a famous Ludwig Wittgenstein anecdote, which I cited at the beginning of my book on the Great Recession:

“Tell me,” the great twentieth-century philosopher Ludwig Wittgenstein once asked a friend, “why do people always say it was natural for man to assume that the sun went around the Earth rather than that the Earth was rotating?” His friend replied, “Well, obviously because it just looks as though the Sun is going around the Earth.” Wittgenstein responded, “Well, what would it have looked like if it had looked as though the Earth was rotating?”

That anecdote nicely describes what I was trying to do with my blogging. I was attempting to get people to see the current situation with a radically different framing from the conventional wisdom. A framing that was fully consistent—indeed even more consistent—with basic economic theory.

In the ninth post, I explained why I thought fiscal stimulus was pointless:

Until recently, the upper echelon of macro theorists had begun to focus more and more on forward-looking monetary rules.  Few people seem to appreciate the fact that under such a policy regime the “multiplier” is precisely zero, even without Ricardian equivalence and without full employment.    If the Fed is always setting policy in such a way as to equate its price and/or spending target with its forecast, then fiscal policy becomes just another extraneous shock, which needs to be offset by adjusting the fed funds target.

The problem is that the “stimulus” is aimed at the demand side, the same side of the economy that monetary policy influences.  If my nine-year old daughter reaches over and pushes the steering wheel while I am driving, I push back equally hard to make sure the car continues straight down the road.  When massive fiscal expansion went head to head with tight money in 1981-82, it wasn’t hard to see which policy was more muscular.  Nominal growth plummeted dramatically.

[Technically, I should have said “tax and transfer multiplier”, but as a practical matter that’s mostly how fiscal policy is done in America. Shovel-ready projects take too long.]

The tenth post was entitled “Puritan attitudes toward monetary stimulus”, and pushed back against a common attitude on the right:

When most people visualize the myriad economic crises that we face, it seems as if we carry an almost unbearable burden on our collective shoulders.  If someone comes along saying that we merely have to debase our currency, and the burden will be magically lifted, the solution seems incommensurate with the problem–it seems to good to be true. 

Many people thought high unemployment was a price we had to pay for our previous sins. I argued that if we had borrowed too much, the solution was not to take a long vacation, rather to work harder. Tight money gave workers a long vacation, whereas we needed monetary stimulus to push workers back to their jobs, to pay off their debts. (A shoutout to Kevin Erdmann, who is very good on how misguided framing distorts our policy views.)

We’re only 4 days into my blogging, but 10 posts is more than enough. All my major themes were there from the beginning. The following 15 1/2 years mostly elaborated on those points.

When I review these early posts, I’m reminded of how lucky I was to have the right set of research interests. In particular, I had published numerous papers in these areas:

1. The Great Depression, with a focus on how policy shocks impacted asset prices.

2. Using NGDP futures contracts to guide monetary policy.

3. How the Japanese liquidity trap was misdiagnosed.

4. Why temporary currency injections are ineffective.

And as mentioned above, at the time I was just starting work on a paper explaining why recessions could not be forecast. All of this was ideal for putting me in the right frame of mind to see what was going wrong in late 2008.

So what about tomorrow’s Fed meeting? I suppose I’m supposed to recommend an specific interest rate setting, but I don’t believe in interest rate targeting. A 25 or 50 basis point cut might be too little or too much depending on what comes next. And without NGDP level targeting we have no way of knowing what comes next. In 2021, I wasn’t too worried about the interest rate setting because I believed they were doing average inflation targeting. It turns out they were not. I was wrong.

If the Fed is actually torn between 25 and 50 basis points, the solution would be obvious to a third grader—pick a number in between, say 35 or 40 basis points. For years, I’ve been suggesting that the rate be adjusted daily, to the median vote of the FOMC. Long ago, the stock market moved away from these silly fractional increments and adopted a decimal system.

The good news is that unlike late 2008, the Fed is not obviously off course. I still haven’t given up on my bias toward optimism, the “Whig” view that monetary policy gradually improves as the Fed learns from its mistakes. I get very frustrated with the mistakes (notably 2008-09 and 2021-22), but taking the longer view it’s two steps forward for every one step backward. I won’t try to predict the next recession, but I will predict that the unemployment rate will gradually become less volatile over time, even if we do have a 2025 recession.

Or perhaps AI will completely upend all of our macro models. We economists always need an excuse. :)