The Keynesian Blind Spot

by: Scott Sumner

I’ve seen recent signs that the gap between Keynesians and market monetarists is narrowing. David Beckworth reached out to fiscal advocates in a recent post, and Ryan Avent also tried to bridge the gap. As you’d expect, Martin Wolf’s new piece in the NYR of Books ends up in a suitably ecumenical fashion:

The right approach to a crisis of this kind is to use everything: policies that strengthen the banking system; policies that increase private sector incentives to invest; expansionary monetary policies; and, last but not least, the government’s capacity to borrow and spend.

But I also see a huge blind spot in Wolf’s piece, which slants the results in a very revealing way. Wolf provides a blow-by-blow account of how fiscal austerity slowed the recovery after 2010, and provides this graph to illustrate his points:

Click to enlarge

A few comments. Wolf uses RGDP, which combines the effects of supply and demand shocks. He should use NGDP, since his argument relates to austerity. If he had, the British performance would look far better than the eurozone performance. Britain has bigger supply-side problems that many Keynesians acknowledge. Also note that the second bar shows total growth over three years, thus even Germany has done poorly since 2010, worse than the US.

But here’s the big problem. Wolf’s careful account of how austerity pushed the eurozone back into recession completely ignores the elephant in the room - the ECB’s sudden move toward tight money in 2011. Indeed, Wolf cites interest rate data that gives the casual reader a very misleading impression:

Why is strong fiscal support needed after a financial crisis? The answer for the crisis of recent years is that, with the credit system damaged and asset prices falling, short-term interest rates quickly fell to the lower boundary—that is, they were cut to nearly zero. Today, the highest interest rate offered by any of the four most important central banks is half a percent.

It’s really hard to imagine a more misleading description of ECB monetary policy over the past 5 years. Yes, current ECB target rates are 1/2%, and they’ve been there for one month, i.e. for 2% of the past 5 years. In 2011 the ECB was raising rates from 0.75% to 1.25% to slow the recovery, out of fear of inflation. Had fiscal policy been more expansionary, monetary policy would have been even more contractionary. Even Paul Krugman admits that fiscal stimulus is only effective when at the zero bound. And the eurozone crisis occurred when the eurozone was not at the zero bound, indeed, policy was being tightened in the most “conventional” fashion imaginable—higher short term interest rates.

Update: Mark Sadowski corrected me - the ECB actually raised rates from 1.0% to 1.5% in 2011.

So fiscal austerity did not create the eurozone double dip recession; tight money did. Still, I don’t want to be too hard on Mr. Wolf - he’s a great journalist and in a sense we are on the same side. We both believe that weak AD (which I define as NGDP) is the core eurozone problem. But the problem is not fiscal austerity, it’s austerity more broadly defined, an irrational fear of rising nominal spending.

Yichuan Wang has a nice post showing that many economists have misremembered (is that a word?) the events of late 2008. At no time during the great NGDP crash of June to December 2008 was the Fed at the zero bound. Money was too tight, but for eminently conventional reasons:

The zero lower bound didn’t always bind. For three months after Lehman’s collapse on September 15, 2008, the federal funds rate stayed above zero. In this period of time, the Fed managed to provide extensive dollar swaps for foreign central banks, institute a policy of interest on excess reserves, and kick off the first round of Quantitative Easing with $700 billion dollars of agency mortgage backed securities. Finally, on December 15, 2008, the Fed decided to lower the target federal funds rate to zero.

It is important to remember the sequence of these events. It is easy to think that the downward pressure on interest rates was the inevitable consequence of financial troubles. Yet the top graphic clearly contradicts this. Each of the dotted lines represents a FOMC meeting, and each of these meetings was an opportunity for monetary policy to fight back against the collapsing economy. The Fed’s sluggishness to act is even more peculiar given that there were already serious concerns about economic distress in late 2007. As, the decision to wait three months to lower interest rates to zero was a conscious one, and one that helped to precipitate the single largest quarterly drop in nominal GDP in postwar history. The chaos in the markets did not cause monetary policy to lose control. Rather, the Fed’s own monetary policy errors forced it up against the zero lower bound.

This is not to say those mistakes were purposeful. But in the high stakes game of central banking, even benign neglect can be dangerous. These failures in the last three months of 2008 can teach us many lessons about what should be done for future monetary policy. Only this way can we be more sure that careless mistakes won’t jeopardize the future path of monetary policy.

One of the first steps would be to switch to a nominal GDP target.

Yichuan then explains how NGDP targeting would improve Fed performance. I also recommend this interesting Wang post, one of many I don’t have time to adequately discuss. It tries to combine NGDP targeting with the Taylor Rule approach.

This post over at Free Exchange discusses a BIS report making an even worse mistake than Wolf:

CENTRAL banks are unable to repair banks’ broken balance sheets, to put public finances back on a sustainable footing, to raise potential output through structural reform. What they can do is to buy time for those painful actions to be taken. But that time, provided through unprecedented programmes of monetary stimulus since the financial crisis of 2008, has been misspent. Neither the public nor the private sector has done enough to reduce debt and to press ahead with urgent reforms. Yet only a forceful programme of repair and reform will allow economies to return to strong and sustainable growth.

That is the message from the Bank for International Settlements (BIS), the closest that central bankers have to a clearing-house for their views.

Nope, ECB policy was ultra-tight, especially in 2011. That caused a eurozone NGDP growth collapse, and explains why so little progress has occurred on the debt front.

Maybe this post was poorly named. If there is a Keynesian blind spot, what do you call the BIS view?