A recent series of articles in The Economist argued that the current financial crisis has exposed important flaws in modern economic theory. I will make a slightly different argument. The sub-prime crisis that began in late 2007 was probably just a fluke, and has few important implications for either financial economics or macroeconomics. The much more severe crisis that swept the entire world in late 2008 was a qualitatively different problem, which has been misdiagnosed by those on both the left and the right. Most economists simply assumed that a severe intensification of the financial crisis depressed spending throughout much of the world. In fact, the causation reversed in the second half of 2008, as falling nominal income began worsening the debt crisis.
Because central bankers misdiagnosed the problem, they were not able to come up with an effective policy response. It was as if a doctor prescribed medicine for a common cold to someone whose illness had progressed to pneumonia. And because economists were confused by the nature of the problem, it appeared as if modern macro offered no solutions. Thus policymakers turned in desperation to old-fashioned Keynesian fiscal stimulus, an idea that had been almost totally discredited by the 1980s.
We cannot hope to understand what happened late last year without first recognizing that the proximate cause of the crash was not a financial crisis, but rather a steep decline in nominal spending. Like any other fall in aggregate demand, this represented a failure of monetary policy. Severe demand-side recessions are almost never the result of special interest politics — the losses are too great and too widespread — but instead represent an intellectual failure by well-meaning public servants and the academic economists who advise them. To see how this happened I’ll trace out a brief history of monetary theory, and then show how the current crisis resulted not from a failure of modern macroeconomics, but rather a failure to take seriously some of the most promising recent developments in the field.
A Very Brief History of Monetary Economics
In the mid-1700s David Hume developed all of the key ideas necessary to understand the current crisis. He is most famous for his exposition of the quantity theory of money, which explains why autonomous changes in the money supply lead to proportional changes in the price level. He also noticed that in the period before wages and prices have had time to fully adjust, a change in the money supply caused output to move in the same direction. Hume even understood that a change in the velocity of money had an identical effect to a change in the money supply:
“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
If we think of Hume’s theory in terms of the famous equation of exchange (M*V = P*Y), we can see that he had a fairly sophisticated understanding of all four variables. What we would call an “aggregate demand shock” was triggered by either a change in the money supply and/or the velocity of circulation. In the long run the effects of diminished nominal spending show up in the form of lower prices, but in the short run output would also fall. And this is exactly what happened in late 2008. The level of nominal gross domestic product (NGDP) began falling rapidly. No one should be surprised that real output also fell sharply. The only question is why did NGDP fall?
You might wonder whether I was being intentionally provocative with my assertion that Hume had the answer to all our problems. Maybe a little bit, but Milton Friedman made a similar observation in 1975 regarding the Phillips Curve:
As I see it, we have advanced beyond Hume in two respects only: first, we now have a more secure grasp on the quantitative magnitudes involved; second, we have gone one derivative beyond Hume. 
The importance of “quantitative magnitudes” is obvious, but what about the phrase “one derivative beyond Hume”? Friedman simply meant that Hume thought of nominal shocks in terms of one-time changes in the price level, or NGDP, whereas Friedman suggested that what really mattered were changes in the growth rate of prices. Today we think in terms of unanticipated changes, though in practice we haven’t advanced far beyond Friedman’s focus on changes in the rate of growth.
Between the early 1990s and 2007, NGDP grew at just over five percent per year. Because the real GDP growth rate averaged nearly three percent, we ended up with a bit more than two percent inflation, which was widely believed to be the Fed’s implicit target. Beginning around August 2008, however, NGDP slowed sharply, and then fell at a rate of more than four percent over the following several quarters. Indeed the decline in NGDP during 2009 is likely to be the steepest since 1938. This produced what may end up being the deepest and most prolonged recession since 1938.
Many conservative economists favor lowering the rate of NGDP growth to three percent per year or even less. This may or may not be a good idea as a long-run goal, but as of early 2008 the U.S. economy featured many wage and debt contracts negotiated under the expectation that NGDP would keep growing at about five percent per year. Because nominal GDP is essentially total national gross income, if it falls sharply it becomes much harder for debtors to repay loans, and much harder for companies to pay wages and salaries. The almost inevitable consequence is that unemployment rises sharply, and debt default rates soar.
At this point the reader may be a bit exasperated, as I seem to be ignoring two very obvious problems:
- The “real problem” was obviously the financial crisis, and NGDP fell as a consequence.
- Monetary policy was obviously highly expansionary, and so one can hardly evoke Hume’s “tight money” explanation for this crisis.
But is there any reason to accept these two “obvious” assumptions? I will show that neither assumption is well-supported, and that this misdiagnosis explains how the world stumbled into a deep slump. The real problem was not a “real” problem at all. It was a nominal problem, and the severe intensification of the debt crisis was a symptom of an ordinary Humean nominal shock. Furthermore, monetary policy was not “easy” but rather was highly contractionary in the only sense that matters, that is, relative to the stance expected to hit the Fed’s implicit nominal targets.
My brief history of macro from Hume to Friedman left out one important strain of monetary economics: the interest-rate approach developed by Knut Wicksell and taken to an extreme by John Maynard Keynes. Wicksell argued that central banks should adjust the interest rate on short-term loans as needed to stabilize the price level. The rate that maintained a stable price level was called the “natural rate” and could vary with the business cycle. Keynes’ most important contribution to this theory was to argue that in a depressed economy with falling prices the natural rate might become negative. Because central banks cannot reduce nominal interest rates below zero, this would seem to make monetary stimulus relatively ineffective in a deep depression. He called this scenario a “liquidity trap.”
Today we know that there are important flaws in the interest-rate approach to monetary policy, and two competing approaches suggest ways of escaping from a liquidity trap. The monetarists recommend “quantitative easing,” or injecting more cash into the economy than the public wishes to hold. The only way to get rid of these excess (real) cash balances is to spend them on goods, services, and assets, thus driving aggregate demand higher.
In addition to the interest-rate and quantity-of-money approaches, there is also a third “price of money” approach to monetary policy. According to this view it is always possible to produce inflation by lowering the price of money either in terms of a commodity like gold or in terms of foreign exchange. This was the approach used by FDR in 1933, when conventional monetary tools seemed ineffective. Although FDR’s dollar depreciation policy was highly effective in boosting NGDP, a promising recovery in real GDP was aborted in late 1933 by the ill-advised National Industrial Recovery Act, which sharply raised wage rates. Nevertheless, the price-of-money approach is so effective that Lars Svensson has called it a “foolproof” escape from a liquidity trap.
Much of recent macro theory has focused on showing how and why monetary policy can be highly effective in a liquidity trap. Thus I was quite surprised to observe the general sense of powerlessness that seemed to grip the world’s central bankers as the crisis intensified last fall. In early October 2008, the world economy was in free fall, with forecasts of falling prices and output going well into 2009. And yet there was a general sense that monetary policy could do nothing to arrest this collapse, despite the fact that the Fed’s target rate was still 200 basis points above zero, and the ECB’s target rate was 425 basis points above zero. By the time the Fed cut rates close to zero in December 2008, almost all of the attention was focused on fiscal stimulus. How did this happen? Why did policymakers ignore what we teach our students in best-selling money and banking textbooks?
In The Economics of Money, Banking and Financial Markets, Frederic Mishkin says: “Monetary policy can be highly effective in reviving a weak economy even if short-term interest rates are already near zero.” 
In the next two sections I will trace out the series of errors that led to this policy failure.
Misdiagnosing the Stance of Monetary policy
Twentieth-century macroeconomics reached its nadir in 1938, when zero interest rates and falling prices led many economists to dismiss the importance of monetary policy. Keynes had argued that monetary policy could only impact demand by changing interest rates, and Joan Robinson drew the logical implication that easy money couldn’t possibly have caused the German hyperinflation, as interest rates were not particularly low. Today we tend to sneer at that sort of crude Keynesianism, but when I argued with my fellow economists that money was actually very tight last fall, the most common retort was “how can that be, interest rates have been cut close to zero?” Some might argue that at least the real interest rate is a good indicator of the stance of monetary policy. But this is also false, as tight money can easily depress real rates in a forward-looking model. And, even if it were true, real rates rose very sharply in the late summer and fall of 2008, so one can hardly use that as an excuse for the profession’s failure to recognize tight money.
The second most common rationale for believing money was “easy” was to point to the huge expansion of the monetary base that began in the fall of 2008. But the monetary base is not much more reliable that interest rates. Friedman and Schwartz showed that money was very tight during the early 1930s, and yet the monetary base rose sharply during that period. It is true that the increase in the base was even more rapid in this recession, but that simply reflects the fact that beginning in October 2008 the Fed began paying banks to hoard excess reserves. According to James Hamilton, the Fed did this to prevent its large injections of liquidity during the banking crisis from creating high inflation. This is probably true, but then it begs the question of why so many economists thought monetary policy had become ineffective. The Fed certainly had it within its power to boost NGDP last fall. Indeed, the Fed’s official excuse for paying interest on reserves was called a “confession of contractionary intent” by Robert Hall and Susan Woodward.
When I point out that neither interest rates nor the base tell us anything about the stance of monetary policy, the final fallback position is often that the broader aggregates also increased during the past year. But these broader aggregates were widely viewed as being discredited during the 1980s, when they sent out false alarms about high inflation. In fact, that episode did much to discredit monetarism, or at least the more dogmatic form that advocated targeting the money supply. Late in his life even Milton Friedman suggested that it might be better for the Fed to target inflation forecasts. If they had done so last September, I believe the current unemployment rate would be about five percent. Instead, policymakers turned to fiscal policy.
In a recent paper criticizing fiscal stimulus John Cochrane made this impassioned plea:
Some economists tell me, “Yes, all our models, data, and analysis and experience for the last 40 years say fiscal stimulus doesn’t work, but don’t you really believe it anyway?” This is an astonishing attitude. How can a scientist “believe” something different than what he or she spends a career writing and teaching?
I had the same sense of frustration regarding monetary policy. Here is what Mishkin’s best-selling text says about indicators of monetary policy:
It is dangerous always to associate the easing or the tightening of monetary policy with a fall or a rise in short-term nominal interest rates.
Mishkin then argues that:
Other asset prices besides those on short-term debt instruments contain important information about the stance of monetary policy because they are important elements in various monetary policy transmission mechanisms.
I looked at seven key economic indicators during the summer and fall of 2008, and between July and November each one signaled that monetary policy was highly contractionary:
- Real interest rates soared much higher.
- Inflation expectations fell sharply, and by October were negative.
- Stock markets crashed.
- Commodity prices fell precipitously
- Beginning in August, industrial production plunged.
- The dollar soared in value against the euro.
- In the spring and early summer housing prices had briefly stabilized, but in August a renewed decline set in. This time there were also sharp declines in markets (mostly in the middle of the country) that had avoided the sub-prime excesses. At this point the housing downturn also spread to Canada.
By early October it was obvious that monetary policy had completely lost credibility. This means that the market expectation for inflation and NGDP growth over the following 12 months had fallen far below any plausible estimate of the Fed’s implicit target. At the time few noticed this problem, as economists focused all their attention on what to do about banking.
Even when the fall in aggregate demand was noticed, its implications were not understood. Many economists associate a loss of monetary credibility with high inflation, not excessively low inflation. This bias was mirrored in the media, which frequently made the bizarre announcement that inflation was “no longer a problem,” when in fact millions were losing their jobs precisely because inflation was far too low.
A third problem was that many economists assumed that the financial crisis was causing the decline in aggregate demand, whereas the reverse was more nearly true. This should come as no surprise; monetary policy almost never appears to be the cause of deflation to those living in the same time and place. And how could it be otherwise? Deflationary policies cause massive losses to an economy, and would never be intentionally undertaken except when absolutely necessary to maintain an external currency peg. In both 1930s America and 1990s Japan, local observers failed to see the monetary origins of their deflation, and instead blamed it on problems with the financial system. Only with the perspective of time and distance were economists able to look dispassionately at the falling price-level data and ask why monetary policy was not more expansionary.
A fourth problem was that many economists focused on inflation, whereas NGDP growth is a far more revealing indicator of deflationary policies. It is true that headline inflation rates did turn negative toward the end of 2008, but this could be brushed off as merely reflecting a sharp fall in energy prices. After all, the Fed had (correctly) discounted the high inflation rate of mid-2008, noting that the core rate remained relatively low. So why shouldn’t they take comfort from the fact that in late 2008 and early 2009 the core rate never turned negative? There are several reasons.
First, because many wages and prices are very sticky, a deflationary monetary policy may affect output before it has much impact on inflation. But the more important reason is that the core rate almost certainly understated the decline in prices during the past 12 months. For instance, BLS data shows housing prices (which comprise nearly 40 percent of the core index) rising 2.1 percent in the 12 months ending June 2009, whereas it is obvious that the housing sector was experiencing severe deflation. Even if the government data correctly measure the “rental equivalent,” which they do not, those prices are not relevant for considering the macroeconomic impact of deflation. Construction workers lose their jobs when house prices fall; the fact that rents under existing 12-month leases respond much more slowly is of little importance. Thus economists ended up being reassured by economic data that was highly misleading.
In my view, the expected growth rate in NGDP is the best indicator of whether monetary policy is too loose or too tight. But even if we end up targeting inflation instead, it is essential that policymakers engage in “level targeting.” This does not necessarily mean keeping prices absolutely level — you could target a price-level path that rises at 2 percent per year. But it does require that policy have a “memory,” and make up for past under- or over-shooting of the target. The most devastating demand shocks are those that change the expected trajectory of NGDP and inflation many years out into the future. Oddly, these almost always occur around the September to November period, and in 1929, 1937, and 2008 we saw very similar stock and commodity market crashes in the autumn as investors realized NGDP growth was moving to a much lower trajectory for years to come. Only the 2008 crash was associated with a banking crisis, but the three inflection points had many similar characteristics.
Richmond Fed economist Robert Hetzel showed that during the summer of 2008 all sorts of indicators were signaling that money was too tight well before the failure of Lehman in mid-September. Although there is no doubt that the intensification of the financial crisis further reduced demand, most observers lost sight of how falling demand worsened the banking sector. Even in normal times going from five percent NGDP growth to a nearly five percent rate of decline would place a severe burden on banks. But these weren’t ordinary times. This massive deflationary shock was superimposed on a banking system that was already reeling from the earlier sub-prime crisis. The results were predictable. All sorts of commercial and industrial loans that were unrelated to the sub-prime mess, and which would have been repaid with healthy NGDP growth, became much more questionable. As asset prices declined sharply from the deflationary monetary policies, bank balance sheets deteriorated. Policymakers misdiagnosed the problem as financial, and thought it could be “fixed” by injecting more money into the banking system. But with NGDP falling rapidly, each bailout never seemed to be enough. The policies were about as effective as bailing water out of a boat without first plugging the leak in the hull.
Targeting the Forecast
Lars Svensson has advocated a policy of targeting the forecast — setting the central bank’s policy instrument at the level most likely to hit its policy goal. Thus, if a central bank had a goal of two-percent inflation, it should set the fed funds rate at a level where its own forecasters were forecasting two-percent inflation. Once one starts to think of monetary policy this way, any other policy seems unacceptable. After all, why would any central bank ever want to adopt a policy stance that was expected to fail? Ben Bernanke also seemed to find the logic of Svensson’s idea to be quite appealing, and hinted that the Fed also saw thing this way, at least with regards to its longer term forecasts:
The [macroeconomic] projections also function as a plan for policy-albeit as a rough and highly provisional one. As I mentioned earlier, FOMC participants will continue to base their projections on the assumption of ‘appropriate’ monetary policy. Consequently, the extended projections will provide a sense of the economic trajectory that Committee participants see as best fulfilling the Federal Reserve’s dual mandate, given the initial conditions and the constraints imposed by the structure of the economy.” [Italics added.]
As we all know by now, things didn’t turn out this way. Beginning in the fall of 2008, it became apparent that the Fed’s forecast was well below any plausible target. (They have no official inflation target, but it is assumed that most FOMC members favor a rate of roughly two percent.) Any doubts about whether policy had lost credibility were erased when Bernanke asked for fiscal stimulus. In the standard new Keynesian model, where the central bank targets the inflation rate, there is no role for fiscal policy in stabilizing nominal spending. His move was a tacit admission of failure.
It is difficult to understand how this happened, but three conceptual errors may have played a role.
First, monetary policymakers may have assumed that they were “running out of ammunition” as rates approached zero. But on closer examination this cannot have been the whole story, as the target rate was still two percent in early October, and at that time the Fed adopted a policy of paying interest on reserves to prevent market rates from falling below their target.
A second problem was that policy was too backward-looking. Hetzel argued that the Fed was frightened by the high inflation rates in the “headline CPI” during mid-2008, and thus was reluctant to ease aggressively. In their meeting of September 16, 2008, after both the failure of Lehman and a severe stock market decline, the Fed stated that the risks of recession and inflation were roughly balanced. Keep in mind that the U.S. had already been in a mild recession for the first seven months of 2008, and the recession intensified greatly in August and September. Furthermore, the market forecast of inflation over the next five years had plunged to an annual rate of only 1.23 percent just before the meeting. Both the inflation and growth outlook called for aggressive easing. There can be no more perfect example of the problem with backward-looking policy that ignores market forecasts.
The third problem resulted from misreading the lessons of monetarism. As I noted earlier, monetarism was pretty much a spent force after the 1980s. Nevertheless, many monetarist insights became a part of the consensus new Keynesian model. Some of these were very valuable, ideas such as the importance of expectations, and also that monetary policy was more effective than fiscal policy. But one idea turned out to cause great mischief. This was the belief that any large increase in the money supply must inevitably be followed by high inflation. This idea still holds sway despite the fact that prices have trended downward in Japan since 1994, despite huge monetary injections. Part of the problem is a widespread belief in a mysterious “long and variable lags” in the impact of monetary policy. Although monetarists are generally associated with the view that markets are efficient, they ignored the fact that any increase in the money supply expected to be inflationary should immediately show up in the financial markets, particularly in the so-called TIPS spreads, which is the difference in yields between indexed and conventional bonds.
My own research on the Great Depression convinces me that most monetarists (and Keynesians as well) underestimate the difficulty of identifying monetary shocks. Modern macro theory suggests that what really matters is not a change in today’s money supply, but rather a change in the expected future path of money. Fed actions that do not have this effect, such as the injections of liquidity into the banking system in late 2008, do not raise inflation expectations. Actions that do credibly raise the future expected path of the money supply, such as the 1933 devaluation of the dollar, have an immediate effect on all sorts of asset prices, especially stocks and commodities.
A sharp devaluation of the dollar would not have been appropriate in the second half of 2008, as much of the world faced the same problems. But we did need some type of credible policy of price-level or NGDP targeting. I have advocated a policy where the Fed pegs the price of a 12-month forward NGDP futures contract and lets purchases and sales of that contract lead to parallel open market operations. In essence, this would mean letting the market determine the monetary base and the level of interest rates expected to lead to five-percent NGDP growth. When I first proposed this idea in the 1980s, I envisioned the advantage in terms of traders observing local demand shocks before the central bank. The logic behind this idea is often called “the wisdom of the crowds.” But I no longer see this as its primary advantage. Although last fall the market forecast turned out to be far more accurate than the Fed’s forecast, in general the Fed forecasts pretty well.
This crisis has dramatized two other advantages to futures targeting, each far more important that the “efficient markets” argument. One advantage is that the central bank would no longer have to choose a policy instrument. Their preferred instrument, the fed funds rate, proved entirely inadequate once nominal rates hit zero. Under futures targeting each trader could look at their favorite policy indicator, and use whatever structural model of the economy they preferred. A few years ago I published this idea under the title “Let a Thousand Models Bloom.” I am not an “Austrian” economist, but this proposal is very Austrian in spirit. (And my preferred policy target, NGDP, is also the nominal aggregate that Hayek thought was most informative.)
Only last fall did I realize that there was another, even more powerful advantage of futures targeting-credibility. The same people forecasting the effects of monetary policy would also be those setting monetary policy. Under the current regime, the Fed sets policy and the market forecasts the effects of policy. To consider why this is so important, consider the Fed’s current dilemma. They have already pumped a lot of money into the economy, but prices have fallen over the past year as base velocity plummeted. Certainly if they pumped trillions more into the money supply at some point expectations would turn around. But when this occurred, velocity might increase as well, and that same monetary base could suddenly become highly inflationary. This problem does not occur under a futures targeting regime. Rather, the market forecasts the money supply required to hit the Fed’s policy goal, under the assumption that they will hit that goal. Today we have no idea how much money is needed, because the current level of velocity reflects the (quite rational) assumption that policy will fail to boost NGDP at the desired rate.
Futures targeting will not happen in the near future. But this thought experiment provides insights into what sort of policy would have worked last fall. The most important thing that policymakers could do right now would be to set an explicit CPI or NGDP target path and commit to make up for any future under- or over-shooting. Perhaps the easiest way to see the value of this approach is to recall the stabilizing speculation that occurs under a credible currency peg. If a government commits to peg a currency within a band plus or minus one percent around a fixed rate, then speculators will tend to buy the currency if it falls toward the lower limit, and vice versa. Now consider a price-level target rising two percent each year. Robert Barro argued that if inflation undershot a price-level target, investors would expect higher future inflation. These expectations will immediately increase velocity and hence aggregate demand, thus mitigating the original deflationary shock. In contrast, under our current “memory-less” inflation-targeting regime just the opposite occurs. After the 1.4 percent deflation over the past year, investors are (quite rationally) expecting below-target inflation for years to come. The sort of severe downturns in aggregate demand that occurred in the fall of 1929, 1937, and 2008, when long term expectations became unanchored, cannot occur under a credible regime of price level targeting.
I have devoted my career to three research areas: the Great Depression, liquidity traps, and forward-looking monetary regimes that utilize market expectations. The insights derived from this research gave me a unique and at times quite frustrating perspective on the crisis as it was unfolding. As a result, I became something of a “monetary crank,” arguing that a lack of money was causing or worsening many of our most pressing problems. Most of the time monetary cranks are spouting nonsense; economic problems can rarely be solved by printing money. But occasionally they are right. One of those times was 1933. I believe that late 2008 was another.
It is especially important for free-market economists to never lose sight of the harm that can be done by deflationary monetary policies. Because falling NGDP is almost never blamed on monetary policy, the public will end up blaming the free-market system. And I have some sympathy for this error. Monetary policy is incredibly counterintuitive, with tight money often accompanied by low interest rates and a bloated monetary base. It is no surprise that the public failed to see the role played by the Fed in the Great Depression, and instead blamed laissez-faire economic policies. The same process occurred in Argentina a few years ago, with the same political result as in America. We may (correctly) argue that the Hoover administration’s policies were not really laissez-faire, but the public instinctively understood that Hoover’s deviations from laissez-faire were not big enough to cause national income to fall in half. And they were right.
Only when Friedman and Schwartz showed that the Depression was a failure of government monetary policy, not laissez-faire, was free market ideology able to regain real intellectual respectability. If I am right, we may have made essentially the same mistake in late 2008 as in the early 1930s. Fortunately, the downturn was much milder this time, but it was still very traumatic, particularly when added on to an economy already weakened by the sub-prime fiasco. I hope other free market economists will give serious consideration to the interpretation of this crisis discussed here and in an outstanding recent paper by Robert Hetzel. A forward-looking monetary policy aimed at low and stable inflation or NGDP growth is the best way to restore the prestige of free markets.
Scott Sumner is professor of economics at Bentley University.
 That is not to say there are no lessons for regulation. I would like to see the government retreat from its policy of encouraging homeownership through sponsored entities such as Fannie Mae and Freddie Mac.
 Milton Friedman, “25 Years After the Rediscovery of Money: What Have We Learned?: Discussion,” American Economic Review 65 (May, 1975), p. 177.
 Frederic Mishkin, The Economics of Money, Banking and Financial Markets (8th ed.), p. 607.