One can learn a lot about monetary theory from studying either commodity standards or fiat money regimes.  But perhaps the most illuminating examples come from an in between system, a transition from one commodity regime to another.  Although most of this (very long) post will seem far removed from current issues, in the end I will argue that there are important lessons.  We will look at 1933, the year of transition from one gold standard (1879-1933) to another (1934-68.)

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Right after this I will post a long piece on monetary policy.  Because I am still not well, I will take a brief break before starting to address yesterday’s comments.  But I thought it might be helpful to clarify a few points that have been raised in several comments:

1.  I am not an inflationist.  If the Fed policy is 2% inflation, I favor they continue with business as usual, not adopt some sort of inflationary bailout of foolish debtors.  If debts were made on expectations of 2% inflation, the Fed shouldn’t suddenly change its policy to 0% inflation.  If they later decide a lower rate is better, don’t make the policy shift in the midst of the worst credit crisis in world history.

Actually I think their “dual mandate” means that they implicitly favor something closer to a 4.5% or 5.0% nominal GDP growth target.  If so, they should continue on with that target, business as usual.

2.  I am not much interested in the various sectors of the economy.  I understand that the housing sector has declined sharply between mid-2006 and mid-2008, but except for a tiny drop in late 2007, real GDP rose continuously.  Yes growth slowed in the first half of 2008, but I don’t know whether that was due to the real estate decline or the oil shock.  So if commenters tell me that he “real problem” is housing, or banks, or some other sector, I will only believe you if you can show me that it would somehow prevent the Fed from boosting nominal GDP at 5% a year.  That’s not to say that these things don’t matter, I can envision these sectoral shocks impacting productivity, and thus turning 5% nominal growth into a bit less real growth and a bit more inflation than we’d like, but there’s nothing we can do about that (from either monetary or demand-side fiscal policy.)  And I think with 5% nominal growth we’d find that the “productivity shock” is much less than most people envision–partly because 5% nominal growth, even that sort of expected nominal growth, would immediately improve the banking system’s balance sheets.

3.  I understand why people might find my causality thesis confusing.  I claim tight money caused the late 2008 crisis, but my specifics seem to point to financial stress triggering an increase in money demand.  There is precedence for this sort of “policy errors of omission” view of causality–Friedman and Schwartz used it for 1929-32 (although Krugman doesn’t buy it.)  But I think it is especially appropriate for the modern Svenssonian view of monetary policy targeting the forecast, which the Fed seemed to be following in 1982-2007.  (And  Bernanke even hinted that they were following this approach.)

Acknowledgements

I’d like to thank Bill Woolsey for helping me out in the comments section.  Bill and I both worked on unconventional monetary systems in the early 1990s, and he probably knows my thinking as well as anyone.  He read this blog from the beginning.  My colleague Aaron Jackson has also been very helpful.   And while I am thanking people, I’d like to thank my wife and daughter for supporting me during the long and frustrating period when no one was paying any attention to my policy views (and when my Depression manuscript was rejected by CUP.)  I’d also like to thank my sister Carol and colleague Swati Mukerjee for strongly encouraging me to go public with my policy views.  (And my other colleagues.)  And also my former student Tianning Yu, for suggesting that I start a blog to publicize my views.

I am still piecing together how I suddenly went from obscurity to semi-obscurity yesterday.  I had sent Brad Delong my piece on Friedman and Schwartz, and he was kind enough to link to it (without comment.)  I assume that Tyler Cowen saw that link, and his very kind comments suddenly pushed my blog into the public eye.  Then Arnold Kling also had some nice things to say here.

Now that I have readers, I obviously need some new material.  Please be patient as my teaching responsibilities (and my cold) will slow things down for a few days.  However, this weekend I plan two of what I hope will be my best posts.  So please stop back later.  I greatly appreciate all those who commented.  I will reply to recent comments later today.

Ironically, I had already been planning a post to send to some of my favorite pragmatic libertarians (such as Tyler Cowen, Will Wilkinson, Deirdre McCloskey, Robin Hanson) on a non-monetary topic (my recent research on cultural values and neoliberalism.)  I’ll try to have that ready by Sunday.  By Saturday you can expect a longer than average post on rational expectations, policy lags, and monetary transmission mechanisms that will give you an idea of how I developed my somewhat unorthodox take on monetary theory.  I think you will find it interesting.

Update:  Andrew Sullivan linked to me here.

I didn’t get to the comments today, but will tomorrow, and will also add an interesting post (well at least it’s a topic I find interesting.)

Because of the mention on Marginalrevolution.com, I am suddenly getting a lot of comments.  Unfortunately I currently have to approve new comments before they are posted.  (I am not very tech savvy.)  I plan to ask the tech people here about a better mechanism to block spam, but meanwhile please be patient.  For now, I will approve new comments every few hours.  I plan to respond to today’s comments this evening.

Update:  I am told that only the first post from an address needs my approval.  Let me know if anyone has trouble getting their second or third comments in without approval.  The tech people are also working on installing anti-span programs, and I hope to have further improvements soon.

Second update:  I have just begun the reply process.  Please be patient.  You will see that I did give full replies to the very few visitors that I had before today.  That will be my long term goal–but today’s replies will have to be a bit briefer.

When I discuss the effect of monetary stimulus on aggregate demand with other economists, I notice that they often want an explanation couched in terms of the major components of GDP.  I find this very frustrating, as this approach does more to conceal than illuminate.  Suppose you were policy czar in a liquidity trap (such as right now), and you were asked to increase nominal GDP by 3-fold (i.e. 200%) in the next five years.  If you were given a choice of only one tool, which would it be–monetary or fiscal policy?  Any economist with an ounce of common sense would take monetary policy.  OK, so how would you explain its effect in terms of the 4 components of GDP?

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I’ve already argued that the current depression was caused by an excessively tight monetary policy.  But why did policymakers get it so wrong?  I don’t think it’s just the Fed, there is a deeper problem in way the profession as a whole approaches these issues.

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A few years ago it was difficult to find many elite macroeconomists who put much faith in fiscal stimulus.  Now suddenly it is all the rage.  What happened?  The only explanation I can think of is that as soon as nominal interest rates fell close to zero, and aggregate demand seemed to be spiraling downward, much of the profession assumed that we had entered a “liquidity trap.”  I haven’t seen much evidence that very many economists actually know anything about liquidity traps, but perhaps they have a vague memory of the concept being mentioned in their undergraduate macro classes.  Unfortunately, what they learned is almost certainly wrong.

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I plan to reread parts of the General Theory in the near future, but before doing so I thought I’d sketch out why I’ve never been able to take the book seriously (unlike the Tract on Monetary Reform, which is a fine book.)  It seems clear to me that in the GT Keynes was focusing almost entirely on aggregate demand.  That is, he was primarily concerned with nominal income determination, not how nominal income gets partitioned between prices and real output.  Unfortunately, he doesn’t seem to have any model of nominal income.  If you search the GT for an explanation of why U.S. nominal GDP is roughly $15 trillion, rather than $15 billion or $15 quadrillion, you won’t find any explanation beyond a perfunctory nod to the long run role of the classical model (MV=PY.)

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I’m certainly no expert on Austrian economics, but I have always viewed Friedman and Schwartz’s Monetary History as a sustained attack on both the Austrian and Keynesian views of the Great Depression.  Now we have a revival of the Austrian view from an extremely unlikely source.  Before considering her arguments, let’s first look at the F&S analysis of monetary policy during an asset price bubble.

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One thing that the current crisis has done is to expose just how much economists differ in their mental models of the macroeconomy.  It seems as if we often talk right past each other, not really understanding the points the other side is trying to make.  And I don’t think this is an inevitable part of academic discourse.   In microeconomics, for instance, Chicago economists may differ from salt water economists about just how competitive most markets are, but at least they can debate the issue using a commonly understood language.  Not so in macro.

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In a recent post, James Hamilton argues that even if a stimulus package were to substantially boost nominal spending, the paralysis in our financial system would prevent an increase in real output, and we would instead end up with stagflation.  I do think there is a grain of truth in this argument, and more than a grain if considering fiscal projects that call for resources to be quickly reallocated.  Hamilton may be too pessimistic about the potential of monetary policy, however.  (Interestingly, we end up with similar views on stimulus policy–(3% inflation targeting in his case), but I am more optimistic about what that can achieve.   Here’s two reasons why:

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I have spent the past 6 days feverishly creating 15 posts, so now it’s time for a break. Because I have only now begun to publicize the blog, most of you have probably just arrived. The “About the blog” post provides the motivation for the sustained assault on recent Fed policy that follows. Now that I have got some (but not all) of my pent-up criticism off my chest, I hope to gradually become more like a normal blog, commenting on current events and other blogs. Here are some coming attractions:
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Lots of economists pay lip service to rational expectations, but don’t really believe it in their bones. By that I mean they use it in their theoretical models and then casually analyze real world problems using the old, pre-Ratex, Keynesian model. Here’s an example of why rational expectations are so important.

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I only met Bernanke once, when he presented a seminar at Bentley on his 1983 paper claiming that that disintermediation played a big role in the Great Depression, independent of the contractionary monetary policy.  I asked just one question:  “What impact would the banking problems have had if the Fed had successfully targeted nominal GDP growth?”  It was many years ago, and I don’t recall his precise answer, but I am fairly certain that he hesitated, and then said something to the effect that the bank failures would still have had an impact on output, but that impact would be somewhat lessened. 

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In an earlier post I discussed my favorite monetary policy regime, under which the Fed buys and sells unlimited CPI or nominal GDP futures contracts at a price equal to the policy goal.  There is actually a fairly large literature on this idea, including people like Kevin Dowd, Bill Woolsey, David Glasner, and (my coauther) Aaron Jackson.  Slightly different approaches were taken by Robert Hall and Robert Hetzel.  At one time I thought that I had discovered the concept back in 1986, but I later learned that Earl Thompson had already mentioned the idea, but never published it.

Because it’s such an unusual way of thinking about monetary policy, it might help to compare it to the gold standard.  The U.S. successfully pegged the price of gold at $20.67/oz. from 1879-1933, and at $35/oz, from 1934 to 1968.  So in a technical sense a gold standard is very doable, even the devaluation of 1933-34 was not done because we ran out of gold, but rather to further FDR’s macro objectives.  But that is also exactly what is wrong with a gold standard, pegging the nominal price of gold does not stabilize the relative price of gold (in terms of other goods.)

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Since this past October I have been so alarmed about the worldwide collapse in demand that I have become something of a pest, badgering everyone who would listen about the urgent need for monetary stimulus.  At first the economics community seemed totally focused on the various bank bailout proposals.  The prevailing view was that the financial system was the fundamental problem and falling demand was a symptom.  I never understood this argument, as modern macro theory says falling AD is a symptom of monetary policy that isn’t expansive enough.  Now perhaps things are getting bad enough that people are beginning to understand that it does no good to bail water out of a boat if it is coming in even faster through a hole in the hull.

From a piece in Tuesday’s FT by Martin Wolf:

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Krugman has criticized people who view depressions as a necessary price to pay for our previous sins of profligate spending and borrowing, or as a way of purging excesses from the system.  I think he is right that this attitude exists, especially (although not exclusively) among those on the right.  I find that this mindset makes it especially hard to argue for monetary stimulus, even compared to fiscal stimulus.

When most people visualize the myriad economic crises that we face, it seems as if we carry an almost unbearable burden on our collective shoulders.  If someone comes along saying that we merely have to debase our currency, and the burden will be magically lifted, the solution seems incommensurate with the problem–it seems to good to be true.  Even fiscal stimulus, often called a politician’s dream, evokes thought of future sacrifice, as we eventually must repay the massive debts we incur.

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An awful lot of words have been expended on whether the stimulus package will “work,” and yet we don’t seem to be getting any closer to a consensus.  Chinn used a textbook approach to clarify the debate, while McArdle and Sachs have questioned the value of the goods produced by the stimulus package.  But maybe we are all looking in the wrong place.  Perhaps even the more specific question “will it boost measured GDP?” is so ambiguous that no consensus is possible.

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We all know what tight money means, don’t we?  Some of us lived through the double-digit interest rates of 1979-81.  But what does it really mean?  What is the tightest money imaginable?

It seems obvious that the tightest conceivable monetary policy would cause deflation, or at least let’s say expectations of future deflation (as prices are sticky.)  So that rules out 1979-81.  One percent deflation is pretty tight, but why not try for 5% or 10%?  Beyond some point you run into a problem–the real return from holding cash would rise to implausible levels.  Perhaps with severe expected deflation price stickiness would evaporate from the sort of goods that are easily arbitraged.  So let’s just stop with a policy tight enough to generate 3% expected deflation.

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Try this–it works almost every time (except with knowledgeable macroeconomists):

Someone asks your opinion on the economy.  You say the solution is a more expansionary monetary policy to boost nominal GDP.  They reply “But rates have already been cut to zero, we’re in a liquidity trap, businesses aren’t investing, ‘the problem’ is the financial system, etc.”  You reply with a really aggressive scenario that has the Fed buy up almost every asset on planet earth.  Make it sound dramatic enough and almost every single time you’ll hear “But wouldn’t that cause hyperinflation?”

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