More important — and more disturbing — is that it is not at all clear that we have learned from the mistakes of the 1930s. Those central bankers believed that money was easy because interest rates were low and the monetary base (the supply of money under the Fed’s control) had expanded. They worried that further easing would reduce confidence in the dollar. British economist R. G. Hawtrey, writing in the late 1930s, described the climate of opinion in his country at the start of the decade: “Fantastic fears of inflation were expressed. That was to cry ‘Fire! Fire!’ in Noah’s Flood.” The economy was actually deflating, not inflating. Under the influence of the “real-bills doctrine,” some central bankers believed that the money supply should respond only to traders’ need for credit. Anything else would only fuel speculative excess.
Today’s inflation hawks employ the same reasoning that those firefighters did. And they are not wholly wrong. Easier money can lead to a destabilizing run on the currency. Inflation can be associated with low real interest rates and an expanded monetary base. But not always: Not in the 1930s, and almost certainly not today, either. The late Milton Friedman, perhaps the most famous inflation hawk of his generation, spotted the fallacy in his analysis of 1990s Japan: Low interest rates can also be a symptom of an excessively tight monetary policy that has choked off opportunities for growth. A looser policy, by increasing expectations of future economic growth, could actually raise real interest rates.
I coudln’t agree more. The neutral interest rate tends to go down in a weak economy. The neutral interest rate estimates of Laubach-Williams confirm this is presently the case.
So what should the Fed do? His answer makes my day:
[The] Fed policy should aim to stabilize the growth of nominal spending — roughly, the total value of the economy in current dollars…. That policy is superior to trying to grow the base at a steady rate, a much-discussed idea in the past, because it allows the base to change in response to changes in the money multiplier and velocity. It is superior to trying to hold inflation constant because it allows the price level to respond to changes in productivity. It would create a stable environment in which economic actors could make their decisions and contracts.
Most debts — notably, most mortgage debts — are contracted in nominal terms, with no inflation adjustment. If people are used to 5 percent growth in nominal incomes each year and make their arrangements accordingly, then an unexpected drop will make their debt burdens heavier and also make them reluctant to make plans for a suddenly uncertain future.
That’s what happened during the recent crisis. Scott Sumner… often notes that in late 2008 and early 2009, we saw the sharpest fall in nominal income since 1938. In his view, much of what we think we know about the recession of 2007–09 is wrong. Not only has money not been loose since the crisis began, but tight money is the fundamental reason the recession was so severe and the recovery has been so halting. He argues that it was more fundamental than the housing bust, since residential-construction employment started falling long before the crisis hit.
Based on this understanding, Ponnuru reinterprets monetary policy over the past few years:
An alternative theory of the crisis goes something like this: While a recession may have been inevitable, it was the Fed’s passive tightening that made it a disaster. The recession began in late 2007, although many observers knew it only after the fact. The Fed passively tightened mildly in mid-2008. In the fall of 2008, the financial crisis caused velocity (and the money multiplier) to drop dramatically — in part, perhaps, because political and financial leaders were scaring everyone. The Fed did not act aggressively enough to accommodate the increased demand for money balances, and what had been a mild recession became a severe one.
As panic subsided, velocity stopped falling, and the economy then began to recover. But in mid-2010, the eurozone crisis resulted in a flight to the dollar. Increased demand for dollars again had a contractionary effect, and the Fed took months to respond to it. Finally, in the late summer, it began letting it be known that it would dramatically increase the money supply — an initiative called quantitative easing, or QE2, the first QE having been the injection of money into the financial system in late 2008 — and then, in the fall, it followed through.
Originally published at Macro and Other Market Musings and reproduced here with permission.
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