Bonfire Of The Verities

by: Scott Sumner

Back in 2007 one could take some pride in being an economist. There were a set of truths that were pretty widely accepted, at least among the more elite macroeconomists. Now that entire edifice seems to have gone up in smoke, and I’m not entirely sure why. This will be a very long post, as I’ll try to document just a few of the truths we used to accept, which have been recently tossed aside.

1. ”Monetary policy can be highly effective in reviving a weak economy even if short-term interest rates are already near zero.” The quote is from Mishkin’s text editions 1-9 (removed from 10). Friedman and Bernanke made similar statements, as did many others.

2. A much more stimulative monetary policy, perhaps involving leaving the gold standard, would have prevented the 50% fall in NGDP during the early 1930s, and thus would have largely prevented the Great Depression. Here’s Noah Smith discussing a recent survey of economists:

All of these results are interesting, but to me, the last one is huge. Milton Friedman claimed that the Fed caused the Great Depression by keeping monetary policy too tight. Ben Bernanke agreed with this view. This survey shows that most economists (or, at least, most of those surveyed; it was not a random sample of the profession) now think that Milton Friedman was utterly wrong.

3. When a central bank targets inflation, the fiscal multiplier is essentially zero. (This was the standard NK view.)
4. When AD is off target it makes absolutely no sense to say; “It’s not the central bank’s job to ‘fix’ the problem.”

5. Low interest rates do not imply easy money. (Again, Bernanke, Mishkin, Friedman, and many others made this point. It’s what we’ve been teaching our students from the number one money textbook.

6. Higher minimum wage rates and extended UI benefits increase the natural rate of unemployment.

7. When output and inflation both fall sharply, the economy suffers from a lack of AD. When falling output is accompanied by rising inflation, we have a real (or supply) shock.

8. Monetary policy should focus on AD, not the real return earned by savers, or the real Brazilian exchange rate, or the price of oil. Nor should monetary policy put pressure on fiscal authorities to behave better. The central bank’s job is to control AD.

9. Changes in the monetary base tell us very little about whether money is easy or tight. Keynesians obviously believe this, but even Milton Friedman made this point about the QE of the early 1930s.

10. When consumers have borrowed/spent too much, they should tighten their belts by consuming less, perhaps paying more taxes, and perhaps running a smaller trade deficit. But for God’s sake you don’t tighten you belt by having millions of consumers suddenly take multi-year “vacations.” Unemployment doesn’t help a country to work off its debt.

11. Natural disasters do not cause higher unemployment in big diversified economies, AD shocks do. This explains why Japan’s unemployment rate rose after its NGDP fell sharply in 2008-09, but did not rise at all after the tsunami.

12. Big increases in government spending, taxes, and regulation may cause harm to the economy, but don’t really play much of a role in the business cycle. They don’t cause the unemployment rate to rise in the short run, as FDR and LBJ showed.

13. Big stock market surges and crashes like 1929 and 1987 have no impact on consumption or AD or RGDP growth.

14. Capital income taxation is undesirable. The conservative side favors a flat consumption tax and the liberals favor a progressive consumption tax.

15. Chinese exchange rate policy has no impact on the U.S. unemployment rate.
16. Internal devaluation is not a sensible way for a modern developed economy to fix a massive AD shortfall.
17. Price gouging is actually a good thing.
18. The “broken windows fallacy” really is a fallacy.
I could go on and on, but I’m getting too depressed. Neoclassical consensus circa 2007, R.I.P.

PS. What most depresses me is that (with a few exceptions such as the minimum wage) I can’t see any facts, any empirical evidence, which would have led a reasonable economist to abandon these verities. But they did.