Economists Are Wrong About What Went Wrong

by: Scott Sumner

Angus expresses what seems to be the standard view among economists:

Second, the Bernank actually helped to save our asses back in the darkest days of financial panic.

Actually the Fed caused the recession with ultra-tight money, at least according Milton Friedman and Ben Bernanke's view of how to ascertain the stance of monetary policy. And no, it wasn't merely "errors of omission." I know that's the standard response when I make that claim, but that's because most economists have never looked at the data. The Fed brought base growth to a screeching halt between August 2007 and April 2008, triggering a recession. Then the Fed raised real interest rates on 5 year bonds from 0.57% to 4.2% between July and November 2008. Are those steps "concrete" enough?

Why does this matter? Because now you have lots of people claiming that "easy money" is hurting the economy. That it's causing low interest rates and hurting savers. Then there's another huge group that argues the Fed's current tight money policy is expressly aimed at helping older retired savers. I view both arguments as silly, but I'll address that issue in another post. The point is that until we figure out whether we have easy or tight money, there's no possibility of making sensible policy judgments. If you believe that easy money is in effect now, then it's only one small step to argue that it's somehow associated with our current malaise. And then it stands to reason that tighter money will boost AD (I kid you not-there are people making that argument.)

Angus continues:

Third, these are the same folks who generally believe that wages are too low and workers don't earn enough compared to capital. Yet their solution to the low growth / high unemployment problem is for the Fed to lower wages?

That confuses secular problems with cyclical problems.

Fourth, the Fed cannot automatically control the real interest rate. Do you think the Fed could set inflation or inflation expectations at 10% and simultaneously hold nominal rates at zero?

No one claimed it could, and no one supports that policy. But if any increase in inflation expectations would merely raise nominal rates, then ipso facto we aren't stuck at the zero bound, and the Fed should simply resume ordinary interest rate targeting. In that case I wonder what Angus would propose. At the end of his post he says he favors somewhat easier money. Well wouldn't it be nice if we could accomplish that with ordinary rate cuts? Even Bernanke says he'd cut rates if he could. So this fourth point, which at first glance seems a clever application of the Fisher effect, actually undercuts Angus's entire argument.

Fifth, NGDP targeting is not some magic bullet that would solve our current problems. It relies crucially on a particular path for expectations. If you think it's easy for an actor who can't easily make credible commitments to control expectations,

Actually it's incredibly easy to target a nominal aggregate along a particular path. In the 1980s central banks all over the world started to buy into inflation targeting, and they all succeeded. Because Americans never pay any attention to events outside our borders, we attributed this success to the "wizardry" of Alan Greenspan. Boy, it sure was lucky that all the other developed country central banks also had Greenspan-like wizards at the helm!

No central bank has ever tried to inflate and fail, because it's incredibly easy to debase a currency. Markets are 1000 times smarter than central banks. Believe me, if the central bank sets out to inflate the markets will know about the decision even before the central bank realizes it made the decision.

I personally support having the Fed try some additional unorthodox policies in the short run. Even if there's only a .25 chance they significantly affect employment and growth, why not try? But I do not think the Fed is sitting on policies that will definitely cure our economic ills. The Fed is not close to omnipotent.

Let's unpack this. The Fed is close to omnipotent over nominal aggregates. But it's true that not all our problems are due to a nominal shortfall. In fact, as Tyler Cowen pointed out in a new post; "monetary policy matters less every day." That's an implication of the natural rate hypothesis. When there are adverse demand shocks, the economy naturally self-corrects over time. Some people ask me why it takes so long-haven't wages and prices adjusted by now? Not completely, but the problem goes far beyond sticky wages and prices, it also includes sticky government policies and perhaps some hysteresis.

HT: Statsguy