Parting Shots

For my last comment in the conversation portion of our exchange I want to mention how much I have enjoyed and learned from the discussion. I expressed my admiration for Scott Sumner in my initial contribution, and I will add to that my amazement at his ability to respond calmly, rapidly, and in detail to every query or objection raised, including nearly all those made in the comments he receives on his blog. I don’t know how he does it; I couldn’t reply that copiously even if I devoted every waking hour to the activity. As for George Selgin, those who have read my review of his latest book know how much I respect his work. And James Hamilton’s frequent posts at Econbrowser have been some of the most useful explanations and depictions of the Fed’s machinations over the last year or more. He and the others have all brought great insights to the discussion.

I conclude with an elaboration on why the distinction between monetary and velocity shocks deserves far more attention than Scott is willing to give it. The fundamental economic question about business cycles, although often unarticulated, is whether they are primarily market failures or government failures and, if they are market failures, whether government can do anything to alleviate them. This was the basic issue that divided Austrians and orthodox Monetarists on one side from traditional Keynesians on the other. Nearly all other macro differences stemmed from their answers to this question, despite the fact that the conclusions of any particular economist may have had no explicit political motivation. Consider the scrap heap of abandoned Keynesian fallacies — secular stagnation, exhaustion of investment opportunities, administered prices, totally endogenous money stock, etc., etc. — or the fact that New Keynesians have now embraced inflexible prices and wages, the very neoclassical explanation for cyclical unemployment that the early Keynesians rejected. There has been a collective, if unconscious, effort on the part of Keynesians to opportunistically seize whatever handy argument will prove that depressions or recessions require government intervention.

The distinction between money and velocity goes to the heart of this debate. Unless one embraces a pure, real business cycle approach, in which depressions and recessions are neither market failures nor government failures but economically optimal, then one must blame either government mismanagement of the monetary and financial system, erratic velocity driven by irrational bubbles and “animal spirits,” or some combination of the two. Lumping the two together not only obscures the fundamental issue, but also biases the answer toward the view that some government involvement is necessary. The more we get enmeshed in technical controversies over rules versus discretion, over inflation versus interest-rate versus nominal GDP targeting, and other secondary minutiae that simply assumes the necessity of a government central bank, however fascinating they may be, the more we lose sight of the central question of what does in fact cause the business cycle.

Scott’s last reply to me echoes Hamilton’s initial denigration of the equation of exchange (sometimes misleadingly called “the quantity equation”) because there are alternative definitions of M and therefore V. Multiple definitions of M and V merely reflect differences in how we organize our thoughts about the evidence. Thus, if we focus on the behavior of M1 and M2 from 1930 to 1933 during the Great Depression, we observe the bank panics causing a dramatic fall in the money stock. But if instead we focus on the monetary base, we will describe the panics as significantly decreasing base velocity (that is, increasing base money demand). In algebraic terms, VmKm = Vb, where the subscripts m and v refer respectively to broader definitions of money or the base, and K is the relevant multiplier for whatever M we are using.[1] If Km falls dramatically, ceteris paribus, Vb must be falling. Notice also without a sufficient change in the multiplier, the two velocities always move in the same direction.

These alternative ways of describing the same phenomenon should enhance our understanding, rather than bewilder us, as is clear from Friedman and Schwartz’s sophisticated handing of these matters in their Monetary History.[2] Their narrative about the depression is quite clear; they accuse the Fed of pursuing an actively tight policy prior to the onset of the banking panics in October 1930. Once the bank panics began, the Fed failed to counteract the falling multiplier with a sufficient expansion of the base. When the Fed finally expanded the base, it was too little and too late. Which measure is better depends on both convenience and what questions we are asking. What we should be looking at to understand the Great Moderation and the current recession is a puzzle to be explored[3], not brushed under the rug with a tautological definition of “monetary shocks.”

In the final analysis, I find the quest for better, self-enforcing central-bank rules naïve. When the market fails (as it often does), the alleged solution is more (or better) government regulation. And when the government fails, the alleged solution is more (or better) government regulation. This asymmetry, a dramatic illustration of Harold Demsetz’s nirvana fallacy, has already made the financial system one of the most, if not the most, highly regulated and subsidized sectors in the U.S. economy. It is high time to reverse the trend.


[1] The money multiplier is defined as Km = M/B, where B is the monetary base. If you substitute that definition into the above equation, you get MVm = BVb, which must be true, because both sides of the new equation are equal to nominal GDP.

[2] Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867-1960 (Princeton: Princeton University Press, 1963).

[3] As David Henderson and I have attempted to do in our Cato Briefing. (

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.”