Agreements and Disagreements

The discussion seems to be careening into ever more technical issues, with George Selgin now invoking “Calvo-pricing probability parameters” and “Ramsay-optimal monetary policy.” Although I find this all quite fascinating, I fear it is too esoteric for the bulk of Cato Unbound’s readers. And unnecessarily so, because the essential questions under consideration can be examined and expressed in accessible terminology. So let me try to enumerate them. This should help clarify the agreements as well as disagreements. If I misunderstand or mischaracterize anyone’s position, I expect that he will correct me.

1. What initiated the recession that began in 2007?

Scott Sumner and James Hamilton both think the initiating event was a supply-side, real shock, emanating from the financial sector, particularly subprime mortgages. Selgin in contrast identifies what he considers an easy monetary policy beginning after 2001 as setting the stage for the subprime crisis. Sumner and Hamilton concede that monetary policy may have made a minor contribution to the subprime crisis but do not assign it a primary role. I actually think Selgin is correct about low interest rates (with other factors) being a significant causal factor, but I deny that those low rates resulted primarily from Fed policy, which according to the various monetary measures, was not all that easy after 2001.

Hamilton partly attributes the subprime crisis, in turn, to inadequate financial regulation, whereas Selgin and I (and possibly Sumner?) believe the opposite to be true: the problem was too much regulation and subsidization of the financial system, although this controversy has not really been a focus of our debate.

2. What made the recent recession so severe, beginning in mid-2008?

All four participants in the discussion seem to agree that the economy was hit with a negative velocity shock (i.e., an increase in the demand for money) that deepened the recession. Sumner, Selgin, and I further contend that the Fed could have dampened that shock better than it actually did, although we seem to have minor disagreements about exactly how. At one extreme, Sumner argues that a precise targeting of nominal-GDP expectations in operation by September 2008 would have prevented most subsequent financial failures, whereas I suspect that outright expansion of the monetary base should have started sooner, could not have been conducted with much precision, and while far superior to Bernanke’s policies, may not have been as fully successful as Sumner projects.

Hamilton is the only one who has been specific about the source of the velocity shock, blaming the mortgage crisis. But he denies that a more expansionary monetary policy could have made a lot of difference, presumably because some kind of liquidity trap would have counteracted any expansion with further declines in velocity. Interestingly enough, this parallels the online debate that Arnold Kling (here and here), Bryan Caplan (here and here), and Bill Woolsey (here and here) have been carrying on over the efficacy monetary policy. I should hastily add that Hamilton does not go to the bizarre lengths of Kling, who asserts that monetary policy, within a very broad range, is always offset by changes in velocity.

By the way, a belief that the Fed was too tight in 2008 is shared by David Henderson and now, to some degree, by Tyler Cowen, who recently stated that expansionary monetary policy “would have eased the crisis, in my very rough guesstimate, by one-third.” Cowen, however, also endorses most of the Fed’s and Treasury’s targeted bailouts, unlike Henderson, Sumner, Selgin, and me.

3. What is the best gauge of monetary policy?

On this question, there are some interesting disputes that have not yet surfaced. Hamilton embraces the mainstream view that interest rates offer the best indicator for judging and conducting monetary policy. Sumner argues persuasively that interest rates are seriously misleading, yet he accepts the mainstream view that the monetary measures are no longer helpful either. His alternative indicator is expectations about nominal GDP. Although Selgin appears to agree, quibbling merely about the optimal rate of nominal GDP growth, in other writings he has employed interest rates and even the Taylor Rule to evaluate monetary policy. Moreover, I very much doubt Sumner’s precision targeting of the forecast is compatible with Selgin’s support for a return to some kind of commodity money base. I’ve always understood Selgin’s “productivity norm” as a second-best approximation of what would happen under free banking.

As for me, while I accept the truism that less volatility in nominal GDP is tantamount to diminished business cycles, I cling to the now unfashionable view that what happens to the money stock still matters. Despite alternative measures and sometimes-erratic velocity, analyzing central bank policy requires a subtle examination of many factors, with assorted monetary measures receiving prominence. But this leads to my final point of contention.

4. How should we characterize velocity shocks?

One of the most perceptive and telling of Hamilton’s observations was the following from his second comment: “Sumner is welcome to describe changes in velocity V as ‘monetary shocks,’ if he so wishes.” Given their fixation on nominal GDP, both Sumner and Selgin treat changes in money or velocity as virtually equivalent. Why should such a question of semantics be important? Because conflating the two variables obfuscates causation. No matter what happens to aggregate demand, Sumner and Selgin have tautologically defined it as the result of monetary policy, good or bad. I think we should distinguish between a decline in aggregate demand that stems from a money-stock shock and one that stems from a velocity shock not counteracted by monetary expansion. Doing so is not just of historical interest; it opens up a possible argument about market failure versus government failure. At least some velocity shocks could arise from changing preferences rather than government policy, and surely that should matter in some way, especially to an Austrian economist like Selgin. Recognizing the distinction between shocks to M and to V also requires Sumner and Selgin to take monetary measures more seriously. Unfortunately, what in fact triggered the recent velocity shock remains a major under-addressed question in our discussion so far.

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.”