Last month I had the privilege of finally meeting one of my very favorite economists—Robert Hetzel, who works at the Richmond Fed. When I read his work on monetary economics I see a kindred spirit, almost a doppelgänger. We both studied at the University of Chicago, we were both deeply influenced by Milton Friedman, and in 1989 we both published papers discussing how asset prices could help guide monetary policy (he used TIPS spreads, I used NGDP futures). Of course he’s had a more distinguished career. And the other major difference is that he seems like a much better person that I am. A real gentleman.
Over the next few months I plan to do a number of posts on his work. Today I’ll look at a key paper from early 2009, which correctly diagnosed the mistakes the Fed had made in 2008. As far as I know he was the only economist within the Fed who understood (in 2008) the mistakes that we now know were being made. But I’d like to start earlier, with his basic approach to monetary economics.
Very broadly, I place explanations of cyclical fluctuations in economic activity into two categories. The first category comprises explanations in which real forces overwhelm the working of the price system. According to the credit cycle, or “psychological factors,” explanation of the business cycle, waves of optimism arise and then inevitably give way to waves of pessimism. These swings in the psychology of investors overwhelm the stabilizing behavior of the price system. “High” interest rates fail to restrain speculative excess while R. L. Hetzel: Monetary Policy 203 “low” interest rates fail to offset the depressing effects of the liquidation of bad debt. In the real-bills variant, central banks initiate the phase driven by investor optimism through “cheap” credit (Hetzel 2008a, 12–3 and 34). Speculation in the boom phase drives both asset prices and leveraging through debt to unsustainable levels. The inevitable correction requires a period of deflation and recession to eliminate the prior speculative excesses. At present, this view appears in the belief that Wall Street bankers driven by greed took excessive risks and, in reaction, became excessively risk-averse (Hetzel 2009b).
Within this tradition, Keynesianism emerged in response to the pessimistic implication of real bills about the necessity of recession and deflation as foreordained because of the required liquidation of the excessive debts incurred in the boom period. As with psychological-factors explanations of the business cycle, investor “animal spirits” drove the cycle. The failure of the price system to allocate resources efficiently, either across markets or over time, produced an underemployment equilibrium in which, in response to shocks, real output adjusted, not prices. In a way given by the multiplier, real output would adjust to the variations in investment driven by animal spirits. The Keynesian model rationalized the policy prescription that, in recession, government deficit spending (amplified by the multiplier) should make up for the difference between the full employment and actual spending of the public. Monetary policy became impotent because banks and the public would simply hold on to the money balances created from central bank open market purchases (a liquidity trap).
Another variant of the view that periodically powerful real forces overwhelm the stabilizing properties of the price system is that imbalances create overproduction in particular sectors because of entrepreneurial miscalculation.
I think that most people hold one of these views, even if they differ on the desirability of the Fed “rescuing” the economy when it gets into trouble. But not monetarists:
In the second class of explanations of cyclical fluctuations, the price system generally works well to maintain output at its full employment level. In the real-business-cycle tradition, the price system works well without exception. In the quantity-theory tradition, it does so apart from episodes of monetary disorder that prevent the price system from offsetting cyclical fluctuations. Milton Friedman (1960, 9) exposited the latter tradition:
The Great Depression did much to instill and reinforce the now widely held view that inherent instability of a private market economy has been responsible for the major periods of economic distress experienced by the United States. . . .As I read the historical record, I draw almost the opposite conclusion. In almost every instance, major instability in the United States has been produced or, at the very least, greatly intensified by monetary instability.
Friedman, Hetzel, and I all share the view that the private economy is basically stable, unless disturbed by monetary shocks. Paul Krugman has criticized this view, and indeed accused Friedman of intellectual dishonesty, for claiming that the Fed caused the Great Depression. In Krugman’s view, the account in Friedman and Schwartz’s Monetary History suggests that the Depression was caused by an unstable private economy, which the Fed failed to rescue because of insufficiently interventionist monetary policies. He thinks Friedman was subtly distorting the message to make his broader libertarian ideology seem more appealing.
I’d like to first ask a basic question: Is this a distinction without a meaningful difference? There are actually two issues here. First, does the Fed always have the ability to stabilize the economy, or does the zero bound sometimes render their policies impotent? In that case the two views clearly do differ. But the more interesting philosophical question occurs when not at the zero bound, which has been the case for all but one postwar recession. In that case, does it make more sense to say the Fed caused a recession, or failed to prevent it?
Here’s an analogy. Someone might claim that LeBron James is a very weak and frail life form, whose legs will cramp up during basketball games without frequent consumption of fluids. Another might suggest that James is a healthy and powerful athlete, who needs to drink plenty of fluids to perform at his best during basketball games. In a sense, both are describing the same underlying reality, albeit with very different framing techniques.
Nonetheless, I think the second description is better. It is a more informative description of LeBron James’s physical condition, relative to average people. By analogy, I believe the private economy in the US is far more likely to be stable with decent monetary policy than is the economy of Venezuela (which can fall into depression even with sufficiently expansionary monetary policy, or indeed overly expansionary policies.)
Just to be clear, I do understand Krugman’s point, and it is a defensible argument. But in the end I side with Friedman and Hetzel, for two pragmatic reasons:
1. I think that most non-monetarists underestimate the extent to which seemingly “real” or “psychological” shocks are actually caused by monetary shocks that were misidentified. I hope I don’t need to remind readers about how often easy and tight money are confused, due to excessive focus on interest rates as an indicator of the stance of monetary policy. Thus I believe that the Great Recession was triggered by tight money in late 2007 and early 2008, and that the onset of the recession made the economy seem unstable, and in need of what Krugman would regard as a “rescue” from the Fed, and then later from fiscal stimulus, once the Fed (supposedly) ran out of ammo. If you insist on a “concrete steppe”, then use the sudden stop in the growth of the monetary base, but I’d prefer not to focus on concrete steps at all, as they are unreliable indicators. Note that Krugman specifically points to the growth in the monetary base during the early 1930s, to refute Friedman’s claim that the Fed caused the Great Depression. But does anyone recall Krugman complaining (in the spring of 2008) about the sudden stop in base growth during August 2007 – May 2008?
2. Second, I worry that Krugman’s way of thinking will make the public insufficiently demanding of sound monetary policy. We will expect too little of the Fed, as we clearly did in 2008, when rates were still above zero. I’m not surprised that the public, the Congress, the President, and the media failed to blame the Fed for excessively tight money in 2008-09, monetary economics is deeply counterintuitive. But even our best and brightest macroeconomists failed us. Go back to late 2008 and look for op eds blaming the recession on insufficiently expansionary monetary policy. You wont find them.
If LeBron James had leg cramps in a game where his trainer had forgotten to bring the Gatorade, we would quite rightly blame the trainer, not the fact that James’s body is “naturally unstable”, unable to do well unless “rescued” by an injection of fluids. We need to have equally high expectations of the Fed. Any major shortfall (or overshoot) of NGDP is the Fed’s fault, and all eyes should be focused on the Fed when those problems develop. In the 1930s, people looked elsewhere. Even Bernanke now admits that the Depression was the Fed’s fault. In the 1970s, people looked elsewhere. Even Ben Bernanke now admits that the high inflation was the Fed’s fault. In September 2008, people looked elsewhere. Even Ben Bernanke now admits the Fed should have cut rates.
The more we demand from central banks, the better the policy that we will get. When expectations are especially low (as in the 1930s, or during 2008-13 in the eurozone), the performance will be especially poor.
When NGDP is unstable, it’s ALWAYS the Fed’s fault. Even if my underlying philosophical interpretation of causality is wrong, or not to your taste, it’s a useful fiction to believe in.
PS. For non-basketball fans, James does occasionally have a problem with leg cramps. Perhaps because he is among the most athletic “big men” in the history of sports, and puts huge demands on his body.
PPS. George Selgin has a very good post on interest on reserves. He knows more about banking than I do, and gets deeper into that issue than I’ve done in my critiques of IOR. He also has a podcast explaining his views.