If there is one thing almost every macro book agrees on, is that a large, sudden, and unexpected drop in nominal expenditure relative to trend is a really, really bad thing. Aggregate demand shocks destabilize the economy, and lead to needless unemployment. I don’t know about you, but I don’t recall reading; “Severe AD shocks are really, really bad, except when the economy is also suffering from some other structural problem. Then they’re just dandy!”
As an analogy, suppose you had pneumonia, and then someone stabbed you in the gut. You show up at the hospital, and the doctor says “there’s no need to patch up that knife wound, your real problem is pneumonia.” I think you’d look for another doctor. A severe AD shock causes lots of unemployment; that’s true whether you start from full employment, or whether you already have lots of unemployment from structural problems.
So when economists react to the sharpest fall in NGDP since 1938 by announcing that the economy really needs tighter money, I’m inclined to react as if a doctor ordered leeches for someone already bleeding from a knife wound. I’m going to look for another economist. In fairness, many proponents of structural causes of the recession do understand this point. Tyler Cowen favors monetary stimulus, even though he thinks much of the problem is structural. Even Arnold Kling thinks it’s worth a shot.
I was reminded of all this by a recent debate between Raghu Rajan and Paul Krugman. Rajan has said elsewhere that we need tighter money. Krugman strongly disagrees. Here’s part of Rajan’s response to Krugman:
First, Krugman starts with a diatribe on why so many economists are “asking how we got into this mess rather than telling us how to get out of it.” Krugman apparently believes that his standard response of more stimulus applies regardless of the reasons why we are in the economic downturn. Yet it is precisely because I think the policy response to the last crisis contributed to getting us into this one that it is worthwhile examining how we got into this mess, and to resist the unreflective policies that Krugman advocates.
I believe both Krugman and Rajan are wrong. Rajan thinks the real problem is structural, and that more monetary stimulus might just blow up another housing bubble. You already know what I think of that argument, so I’d like to focus on Krugman’s response. Krugman rightly argues that we need much more AD and then suggests that it doesn’t matter why AD fell, we have the tools to boost it now. I agree we need more AD, but I also think it does matter how we got here.
Both Rajan and Krugman believe the severe fall in NGDP in late 2008 was caused by the financial crisis. Rajan thinks that means our dysfunctional financial system is the real problem, whereas Krugman thinks the current low level of AD is now the real problem. In contrast, I think the sharp fall in NGDP during 2008-09 was caused by tight money, and that the solution is easier money.
But why does it make a difference that Krugman and I disagree as to how we got here, isn’t the important thing that we both agree that we need more monetary stimulus? Yes and no. Yes, in the sense that you need to patch that knife wound regardless of how you got it. But if Krugman is right that tight money didn’t cause the fall in AD, then it creates doubt as to whether easy money can patch the wound.
Most economists disagree with my view that if the Fed had done 5% NGDP growth targeting, level targeting, from mid-2008 forward, we wouldn’t have had steep fall in NGDP. The standard view is that the financial crisis was an exogenous shock, and a devastating shock, and the drop-off in lending would have caused aggregate demand to fall in any case. Suppose my opponents are right, and the Fed couldn’t have prevented a severe decline in NGDP in late 2008. Doesn’t that raise doubts as to whether the Fed could now fix the problem? After all, even in 2010 banks continue to maintain a much more restrictive lending regime. If that’s the “real problem” then arguably it is just as much a problem today as in 2008.
Of course I don’t think this would prevent easy money from triggering a robust recovery, and perhaps Krugman share’s my view. But even if he does, it isn’t something you can just assume away. I don’t face that problem because I believe the big fall in AD was caused by tight money—in September 2008 the Fed’s 2% target rate was way above the Wicksellian equilibrium rate. But Krugman doesn’t believe that tight money caused the recession, he believes the financial crisis caused the big drop in NGDP. So he faces a much bigger burden in showing that monetary stimulus can fix the problem. He needs to show that monetary policy could not have prevented NGDP from falling in late 2008, but now the Fed can boost NGDP. That’s certainly possible, but it’s not a given.
BTW, unless Rajan’s just making up facts, it seems to me that his response to Krugman is pretty persuasive on the issue of the financial crisis. He has lots of evidence that Krugman is flat out wrong in asserting that government encouragement of low cost housing didn’t play a major role in the housing bubble. Here’s just one example:
So Krugman shifted his emphasis. In his blog critique of a Financial Times op-ed I wrote in June 2010, Krugman no longer argued that Fannie and Freddie could not buy sub-prime mortgages.[v] Instead, he emphasized the slightly falling share of Fannie and Freddie’s residential mortgage securitizations in the years 2004 to 2006 as the reason they were not responsible. Here again he presents a misleading picture. Not only did Fannie and Freddie purchase whole sub-prime loans that were not securitized (and are thus not counted in its share of securitizations), they also bought substantial amounts of private-label mortgage backed securities issued by others.[vi] When these are taken into account, Fannie and Freddie’s share of the sub-prime market financing did increase even in those years.
In 2008 the left gleefully argued that the banking crisis represented a failure of laissez-faire. As a result they over-reached, even defending the GSEs. They would have been better off arguing that the GSEs were private (which isn’t really true, but is sort of plausible.) By defending the GSEs, they implicitly acknowledged their public dimension. Now more and more evidence is coming in that the problems with our financial system all start with the letter ‘F’. (Fannie (OTCQB:FNMA), Freddie (OTCQB:FMCC), FDIC, FHA, etc.) And what does ‘F’ stand for?
HT: Patrick R. Sullivan