Almost on the Money: Replies to Hamilton, Selgin, and Hummel

Reply to James Hamilton

I greatly appreciate that three distinguished economists took the time to write very extensive and thoughtful comments on my recent essay in Cato Unbound. Although there are some points on which we disagree, I’d like to start by clearly up a few misconceptions, in order to show that we aren’t all that far apart.

I agree with much of what Professor Hamilton says about regulation, and would defer to his greater expertise in that area. I happen to favor a requirement of a 20 percent down payment on mortgages, because of the moral hazard problem created by FDIC and “too big to fail.” I have always been strongly opposed to the government-sponsored Fannie Mae and Freddie Mac, regarding them as potential “time bombs.” But we knew that before the crisis. Here’s what I meant by the statement that the crisis was a “fluke.”

  1. Like the October 19, 1987 stock market crash it is totally inexplicable, and unlikely to be repeated. The “villains” were often very smart people, and often lost huge amounts of their own money. How can that be explained? Any attempts to install regulations specifically tailored toward this crisis are likely to be misguided; the next problem will be different.
  2. It has no implications for monetary policy. The only proper goal is targeting expected NGDP; even if we are in the midst of a bubble, or a financial crisis.
  3. It did not cause the severe slump that began in August 2008; tight money did.

Hamilton suggests that the financial crisis caused the intensification of the recession in late 2008. But the term “cause” has a slippery meaning. The late 1930 American banking panic made the Great Depression much worse. So there is a sense it which it could be said to have “caused” a deep slump. But Friedman and Schwartz showed that aggressive monetary policy could have offset the impact on the money supply. I would add that in both late 1930, and late 2008, a more expansionary monetary policy would have meant a much smaller financial crisis. So in my view both slumps were caused by monetary policy errors.

I think Professor Hamilton misunderstood the intent of my reference to the equation of exchange. He writes:

When you dive into such details, you are led to the conclusion that the above equation [MV=PY] is not a theory of income determination, but instead is a definition of V. If we use a different measure of the money supply or a different measure of nominal transactions, then we must be talking about a different number V.

I entirely agree, and regret leaving the impression that I thought the equation of exchange had some theoretical implications, particularly monetarist implications. It is merely a definition of velocity, as Hamilton indicates. I had in mind a version using the monetary base, base velocity, real GDP, and the deflator. I mentioned this equation only because it was an easy shorthand way of describing Hume’s three key insights: More money means higher prices and real output in the short run. Only prices are affected in the long run (in proportion to the increase in M.) And changes in V have the same impact on NGDP as changes in M.

Hamilton then argued:

It is necessary to spell out a mechanism other than the equation of exchange by which the Federal Reserve is asserted to have the power to achieve a particular target for nominal GDP. One mechanism that we all agree is relevant in normal times is the Fed’s control of the short-term interest rate.

I agree that this is a widely held view, but I think it is wrong. In my view the so-called “liquidity effect,” or the response of short-term rates to changes in Fed policy, is a sort of epiphenomenon that hides more important causal forces. I see things this way: A contractionary monetary shock that is expected to be permanent will lower future expected NGDP (for monetarist reasons). This will dramatically lower current asset prices for two reasons. First, because the lower future price level tends to lower current prices. Second, and much more importantly, with sticky-wages, a nominal shock will depress output, and the expectation of recession will lower the real value of stocks and commodities (and perhaps some real estate.) This transmission mechanism was crystal clear in the massive monetary shocks of the interwar period, and reoccurred in late 2008. Even worse, this time it occurred during a financial crisis, and the falling asset prices dramatically worsened that crisis.

Professor Hamilton also argues that

… most of us are persuaded that the stimulus from such a policy takes some time to affect the economy, so that, if implemented in October 2008, it is not a realistic vehicle for preventing a decline in 2008:Q4 nominal GDP.

Indeed, this is the key issue that separates us.

I agree that most economists look at things that way, but I think they are wrong, at least if the actions were taken in September. (By October, some decline in Q4 NGDP was inevitable.) Most economists assume that interest rates or the money supply are good indicators of the stance of monetary policy. Because of this they mis-identify monetary shocks, and this leads to estimates of long and variable lags in the effect on NGDP. But this view is hard to reconcile with the fact that when shocks are easily identifiable, the lags seem very short. The most expansionary monetary shock in U.S. history, by far, was the 1933 dollar devaluation and the decision to leave the gold standard. During the first four months of this policy, the WPI rose by 14 percent and industrial production soared 57 percent, regaining half the ground lost in the previous 3 ½ years. And these stunning gains in nominal output occurred during one of the worst financial crises in American history, when much of the banking system was shut down for months. Other easily-identified monetary shocks, such as the 17 percent decline in the U.S. monetary base between late 1920 and late 1921 had an immediate and severe impact on both prices and output.

Hamilton also questioned my proposal to use NGDP futures contracts to implement monetary policy. I first published this idea in 1989, but my most recent article from 2006 is more accessible. The idea is that each time there is a futures transaction, the Fed conducts a parallel open market operation with ordinary Treasury securities. Last October I would have expected NGDP growth to come in at under five percent. Thus I would have sold NGDP futures short to the Fed. Each time I did so the Fed would conduct a parallel open market purchase. The opposite would occur if investors expected the economy to overheat, and bought NGDP futures. This plan would essentially replace the 12-member Federal Open Market Committee with an NGDP futures market comprised of thousands of traders.

Even without futures targeting, a Fed commitment to five-percent NGDP growth last year would have helped prevent a severe collapse in late 2008. Current changes in aggregate demand are strongly linked to expected future changes — something the Fed can control. If NGDP was expected to grow at a five percent rate from 2008:Q3 to 2009:Q4, asset prices and real output both would have done much better in the fourth quarter.

Although we disagree on some points, I’d like to add that before I began my blog I was strongly influenced by Hamilton’s critique of Fed policy on his blog, His insightful analysis of the Fed’s new procedures influenced my thinking.

Reply to George Selgin

I was surprised by how much George Selgin and I agreed upon. As with Hamilton, I will argue that we may even be a bit closer than he thinks. Selgin says:

I am, on the other hand, less inclined than Sumner is to believe that monetary policy was excessively tight before September.

I actually think this is a very defensible view. On my blog I have argued that the first key mistakes occurred in the Fed’s September 16 meeting. I now think that in retrospect a slightly easier policy would have been desirable in August as well. Selgin may have been referring to my preference for five percent NGDP growth, which we fell short of in late 2007 and the first half of 2008 when NGDP growth was closer to three percent. However I also favor “level targeting,” meaning a five percent trend line with attempts to make up for undershooting or overshooting. Because the housing bubble was associated with more than five percent NGDP growth, a bit slower growth was acceptable during the relapse from that bubble. So I actually agree with Selgin that September 2008 is a reasonable date for policy going seriously off track.

If I suggested otherwise, that was sloppy exposition on my part. It probably reflected my belief that the intensification of the crisis was partly caused by slow NGDP growth after July 2008. Another way of making this point is to consider targeting the forecast. By Lars Svensson’s criteria we were not off course until late September, when even the Fed must have realized that NGDP growth was likely to come in too low. On the other hand, TIPS spreads indicated that inflation expectations fell sharply in August and early September, and my guess is that NGDP growth expectations also declined at this time.

I was silent on the origins of the crisis only because of a lack of space and a desire to concentrate on the issue that most economists overlooked — the role of tight money in the severe crash of late 2008. I agree that monetary policy was too easy during the 2004-06 housing bubble (although easy money alone cannot explain the bubble, as we have often had even more inflationary policies without such an unusual movement in real housing prices.) I agree with Selgin that my view doesn’t explain the size of the tech and housing bubbles; to be honest, I have no explanation. If I did have an explanation, then the factors causing the bubble should have been observable in real time, in which case the efficient market hypothesis – the view that it is hard to beat the market — would have been violated.

The most important issue raised by Selgin is the appropriate rate of NGDP growth. I strongly favored a five percent target in mid-2008, as wage and debt contracts already incorporated that expectation. Should we now gradually move to a lower rate, as Selgin suggests? Perhaps:


  1. “Optimal quantity of money” argument suggest mild deflation is ideal.
  2. Less distortion from our taxes on capital, which are not indexed to inflation.


  1. Harder to adjust real wages rates if there is money illusion.
  2. More likely to encounter liquidity traps.

If we went to a forward-looking policy, I’d worry much less about liquidity traps, and I’d be much more supportive of a two or three percent target. As it is, I am ambivalent about the optimal rate in the long run, but I think it’s probably in the three to five percent range. The less competent Fed policy at the zero rate bound, the stronger the argument for a bit higher trend rate.

I don’t quite understand Selgin’s argument that a higher trend rate of inflation makes bubbles more likely. This seems to violate the super-neutrality of money, unless Selgin is also assuming that higher trend rates are generally associated with more inflation variance (which is defensible I suppose, but this is a problem that can be fixed with an explicit mandate from Congress for X percent NGDP growth expectations.) Other than that, however, I agree with most of what Selgin says about NGDP targeting, although I have a few doubts about mild deflation under the current policy regime.

Reply To Jeffrey Hummel

Professor Hummel did a fine job of summarizing how my views of the crisis are part of a long tradition of demand-side theories of business cycles, which includes both the Keynesian and monetarist camps. He then makes an interesting comparison of this recession to the Great Contraction. In both cases, the initial slump was greatly worsened by a financial crisis. But I think there are also a few differences that command attention.

In the 1929-32 slump, the economy was already deep in depression even before the first U.S. banking crisis (of December 1930.) Indeed, the August 1929 to December 1930 slump was by itself worse than the entire current recession. Almost equally severe slumps occurred in 1920-21, 1937-38 and 1981-82, all without any significant financial crises. So there is ample precedence for nominal shocks (or declines in AD) triggering recessions as severe as the one we are now experiencing. In addition, even the early (very mild) stage of this recession was accompanied by financial distress, which is another difference from 1929-30. Indeed, I think the fact that banking problems triggered the onset of recession in December 2007 has led many economists to overestimate its role in the intensification of the recession that began in August 2008.

I would also like to emphasize that although Friedman and Schwartz pointed to the banking panics of the early 1930s as key factors worsening the contraction, they saw it working through demand-side channels: the banking crises reduced the multiplier and the monetary aggregates. I am not sure that Hummel disagrees with any of this, but I think it is helpful to always sharply distinguish between supply-side and demand-side causal factors. Hummel rightly notes that banking distress can be viewed as a supply shock, but in my view the most severe outcomes usually occur when it spills over into demand-side problems. However, I do think Hummel misunderstood one aspect of my argument. I do not think that expectations of falling NGDP explains all of the intensification of the financial crisis after September 2008, just most of it.

Hummel makes a very good point when he suggests that paying interest on reserves essentially converts monetary policy into fiscal policy. I hadn’t thought of it that way. I had argued that, even at the current reserve interest rate of 0.25 percent, reserves dominated T-bills in both liquidity and rate of return. So they are actually a sort of government bond. And there is a reason why zero-interest cash has always been treated separately as “high-powered money.” Bonds just don’t have the same expansionary impact. Indeed this is one point that I believe all four of us might agree on, but which much of the profession has overlooked. (Hamilton was one of the first to note the problems with interest on reserves.)

Hummel concludes with an argument that our centrally planned monetary regime will never produce satisfactory results, and that we should consider a laissez-faire monetary system, such as free banking. I have a few comments on this issue:

  1. I agree that in its first few decades the Fed made things worse, as it foreclosed some private mechanisms for dealing with banking crises such as occurred in 1914. I do think the Fed has gotten much better, and I (perhaps stubbornly) think that further improvements are likely.
  2. I am not sure about the White/Selgin argument that a regime of free banking would stabilize NGDP, but I also admit that I don’t have a clear idea as to how such a regime would be likely to perform.
  3. Even if the free banking argument is correct, and the Fed should be abolished, I would continue to advocate the ideas expressed in this essay. As I indicated, we are currently stuck with the system we have, and if it performs poorly (particularly in the direction of deflation), people will almost certainly blame the resulting problems on the failures of capitalism, not monetary policy. (As interest rates are low during deflation.)
  4. My proposal for using market forecasts of NGDP as policy targets goes some way toward making monetary policy less discretionary. For instance, this would take the Fed out of the business of setting interest rates. Let’s consider an even simpler futures targeting regime, one stabilizing CPI futures. How does this compare to the old gold standard? First, it replaces one commodity with a basket of goods. Second, it replaces the spot price with a futures price. But note the similarities; both regimes replace discretionary policy with a clear monetary rule. In both cases you would have the sort of policy envisioned in the Constitution, which gave Congress the power to set the value of money. Other researchers such as Bill Woolsey and David Glasner have discussed how this basic idea could be combined with a free banking system. So I hope free-market economists won’t let the perfect be the enemy of the good. A market-oriented futures-targeting approach could be a useful first step toward moving away from a bureaucratic, government-run monetary regime.

Again, I’d like to thank all three reviewers for taking the time to give serious consideration to my ideas.

I have one question: Does anyone have any thoughts on my proposal to charge a negative interest rate on excess reserves as a way of reducing the hoarding of base money? Sweden recently adopted this proposal.

Also from this issue

Lead Essay

  • In this month’s sure-to-be controversial lead essay, Bentley University economist Scott Sumner argues that almost everything economists and economic policymakers thought they knew about the role of monetary policy in the recent recession and financial collapse is wrong. Sumner contends that the resources of monetary policy were not exhausted, as many economists believed, but were barely used. Flying in the face of conventional wisdom, Sumner maintains that monetary policy in the run-up to the finacial crisis was not highly expansionary, but was in fact disastrously contractionary. Sumner offers a short history of monetary economics to put into historical perspective the role of allegedly failed monetary policy in the financial crisis and recession. He proposes a strategy for central bankers — targeting forecasts of nominal GDP — that might help avert future crises. In conclusion, Sumner warns of the political dangers of misdiagnosing the crisis: unless the record is set straight, free markets will once again take the fall for a failure of monetary policy.

Response Essays

  • University of California, San Diego economist James D. Hamilton disputes Scott Sumner’s claim that the sub-prime crisis was a fluke with few lessons for macroeconomics. According to Hamilton, the booming U.S. housing market represented a “huge misdirection of capital,” and the overexposure of key financial institution to the housing market’s downward correction crippled lending and sent the economy into a nosedive. Hamilton agrees that the Fed might have limited the damage had it kept the growth rate for nominal GDP higher, but he disagrees with Sumner about the tools available to the Fed to achieve this. Hamilton notes that tools available to the Fed depend on which of the possible specifications of the money supply and its velocity actually determine nominal GDP. Hamilton says unconventional paths to monetary stimulus were open the Fed in late 2008 and that “the preferred policy … would have been to acknowledge more aggressively the losses financial institutions had absorbed on existing loans, impose those losses on stockholders, creditors, and taxpayers, and retain as the Fed’s first priority the stimulus of nominal GDP rather than trying to lend to everybody.” Hamilton concludes with some worries about Sumner’s favored tool for targeting nominal GDP growth.

  • University of Georgia economist George Selgin agrees with Scott Sumner that “tight money was the proximate cause of the post-September 2008 recession” and that “a policy of nominal income growth targeting might have prevented the recession.” Selgin encourages Sumner to acknowledge the role easy money played in the subprime crisis, and argues that Sumner’s five-percent nominal income growth target is “unnecessarily and perhaps dangerously high.” Selgin favors a two or three percent target, which he contends would be less likely to perpetuate boom-bust cycles.

  • San Joses State’s Jeffrey Rogers Hummel begins with a brief history of economic thought about the causes of the business cycle, which leads to a call for “a measure of epistemic humility.” Hummel signs on to much of Sumner’s story about the Fed behavior in 2008, and accepts his criticism of the widespread use of interest rates as the main indicator of monetary policy. But Hummel departs sharply from Sumner’s prescription for better monetary policy — a rule to target the forecast of nominal GDP growth. “The … critical defect of Sumner’s Rule,” Hummel argues, “is its blithe assumption that money, unlike any other good or service, requires not merely government provision but detailed, sophisticated, and flexible government management.” Hummel raises doubts that even the best such rule would be well-applied, and calls for the “abolition of the Fed, elimination of government fiat money, and complete deregulation of banks.”