In a recent post I pointed out the uncanny correlation between the very small group of economists that either explicitly or implicitly criticized Fed policy as being too tight during the recent crisis, and the even smaller group that had published articles advocating a forward-looking policy of “targeting the forecast.”  It seems that having this forward-looking perspective made us especially likely to view monetary policy as too contractionary last fall.  When I came up with that list, I was thinking only of those who had made a contribution to the futures targeting literature, not minor figures who merely endorsed the ideas of what others.  I know only one economist who falls into the latter category:

Milton Friedman.

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Fasten your seatbelts; it could be a very interesting next few days.  I will get to all the comments from yesterday, but first there is breaking news that I found quite exciting (when you hear it you’ll probably be thinking:  “Exciting?  Get a life.”)

First a bit of background.  When I started the blog in February I focused on the sharp collapse in the economy after the failure of Lehman in mid-September.  I argued that the stock market crash of early October 2008 reflected a loss of confidence in the Fed’s willingness and/or ability to maintain adequate NGDP growth going forward.  But many readers found this “errors of omission” argument unconvincing.  Monetary policy looked accommodative, and it seemed implausible that it was the Fed’s fault for not immediately staunching the bleeding from the financial crisis.  Surely the causation went from financial crisis to falling AD.  Perhaps the Fed didn’t do enough to offset this shock, but (so the argument went) they can hardly have caused the problem.

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A few months ago an astute commenter mentioned a study (was it an IMF study by Rogoff?) that examined nearly 100 previous financial crises.  He said they found that real GDP fell sharply in every case.   He then used this evidence to refute my argument that easier money could have prevented a severe collapse in output during the late 2008 financial crisis.   My response was “yeah, but how many of those countries saw their currencies sharply appreciate during the midst of the financial crisis.”  I’d like to return to this issue, but first I will discuss recent market news.

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If I knew Mankiw was going to link to my last post, I wouldn’t have made it so meandering and confusing.  So here is the mop-up, what I really wanted to say.  But first a few clarifications, as I am getting a lot of comments that are challenging whether my question on movies was fair.   Here’s what I was trying to get across:

Question:   Suppose that people buy more of product X when the price is high, and less of product X when the price is low.  Does that violate the laws of supply and demand?

The answer is no.  It’s not maybe, or it depends, it is no, non, nein, nyet, bu shi, etc.  And it doesn’t depend on what the product is, what the two prices are, what the two quantities are, the answer is always no.

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Maybe you don’t find it confusing, but I do.  It all started a few years ago when we noticed that we had a “trick question” on our placement exam at Bentley.  The question asked what would happen to the demand for tea if there was a health scare regarding coffee.  Obviously coffee and tea are substitutes.  So if the health scare reduces the price of coffee then the demand for tea will . . . well, let’s think about it a bit more.

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My impression is that most right-wingers in America are deeply suspicious of the European Union.  And fearful that the model will spread here.  But I think they are looking at things exactly backward; in fact the EU model is so good that we should adopt it right now in the US of A.

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I probably picked on Anna Schwartz enough last winter, but since readers keep sending me her new editorial in the NYT, I suppose I should say something.  Here is her explanation for why monetary policy was easy last fall:

Let me begin with the former. It is standard practice for a central bank like the Federal Reserve to ease monetary policy to combat a recession, and then to tighten it as recovery gets under way. Mr. Bernanke so far has only had to do the first half, and has conducted a policy of extreme ease. The Fed’s Open Market Committee cut the federal funds rate in October to 1 percent from 1.5 percent, and then in December to a range of zero percent to 0.25 percent.

Extreme ease?  If this quotation sounds familiar, it may be because the argument used is essentially identical to an earlier Joan Robinson analysis of the German hyperinflation:

“An increase in the quantity of money no doubt has a tendency to raise prices, for it leads to a reduction in the rate of interest, which stimulates investment and discourages saving, and so leads to an increase in activity.  But there is no evidence whatever that events in Germany [in the early 1920s] followed this sequence.”

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I ended my previous post by pointing to a striking correlation:

It’s interesting to consider the small group of economists who have suggested that monetary policy can and should have done more, and/or the payment of positive interest on reserves was a mistake:  Thompson, Hall, myself, Woolsey, Glasner, Svensson, Jackson, etc.  Every one of them was in the even smaller group of economists that focused on forward-looking monetary regimes of one form or another.  Once you start looking at monetary policy in a forward-looking fashion, everything seems different.

To give you an idea just how striking this pattern is, consider the following two facts:

1.  In addition to this short list, I know of only two other economists who wrote papers advocating that monetary policy “target the forecast,”  Robert Hetzel and Kevin Dowd.  That’s just nine people.

2.  The ideas that I have promoted on this blog are widely viewed as quite heterodox, departing from the prevailing views of economists on both the right and the left.  Indeed, very few economists have publicly argued that Fed errors in late 2008 made monetary policy much more contractionary that it appeared, and that these errors (perhaps just errors of omission), contributed to a severe intensification of the recession.

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Here is a very interesting WSJ article on Lars Svensson.

STOCKHOLM — One of the architects of inflation targeting — now a widely used central-bank policy — says central banks should encourage expectations that they will let prices overshoot their target, and then do so.
That would help combat rising unemployment and aid economic activity around the world, Lars E.O. Svensson, deputy governor of the Swedish Riksbank, said in an interview.

At first glance, the overshooting would seem to violate my proposal to “target the forecast.”  But on closer examination it is exactly the same idea.  We both support the concept of “level targeting” which would make up for any shortfall in one period, by having the target variable grow extra fast the next period:

Mr. Svensson stressed that underlying price levels were a more effective target than inflation rates for a central bank in the long run.

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This is my most requested post so far (and thanks to JKH for the idea for the title.) I hope it’s not as “awful” (to quote Bill) as my previous post.

Here’s how Bernanke started off his recent editorial in the WSJ:

The depth and breadth of the global recession has required a highly accommodative monetary policy. Since the onset of the financial crisis nearly two years ago, the Federal Reserve has reduced the interest-rate target for overnight lending between banks (the federal-funds rate) nearly to zero. We have also greatly expanded the size of the Fed’s balance sheet through purchases of longer-term securities and through targeted lending programs aimed at restarting the flow of credit.

These actions have softened the economic impact of the financial crisis. They have also improved the functioning of key credit markets, including the markets for interbank lending, commercial paper, consumer and small-business credit, and residential mortgages.

Isn’t this basically what Herbert Hoover’s Fed did?  Didn’t they also cut rates to near zero levels?  Didn’t they also massively expand the Fed’s balance sheet, causing rapid growth in the monetary base?  Didn’t Hoover also bail out the banking system with taxpayer money through his Reconstruction Finance Corporation?  So does that mean the Fed was also “accommodative” in the early 1930s?  And if so, what’s the difference between ‘accommodative’ and ‘expansionary.’

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At least according to the US government.

The BLS claims that housing prices are up 2.1% in the last 12 months.  Why does this matter?  For all sorts or reasons, but first let’s try to figure out what really happened.  According to the BLS, housing makes up nearly 40% of the core basket of goods and services.

Category    weight     inflation

Housing     39 %             2.1%

Other         61%              1.4%

Overall      100%             1.7%

Suppose that instead of rising 2.1%, housing costs have actually fallen 2.1% over the past 12 months?  In that case the core rate would be zero.  Which number seems more likely?  For much of the past year house prices have been falling at more than 2% a month.

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Because I picked on Ahamed a bit in the previous post, I want to make up for it by pointing out some excellent passages in his fine book.  Here he discusses the common misconception that money “goes into” markets:

There was the erroneous notion [in the 1920s] that a rising stock market “absorbs” money from the rest of the economy.  This is sheer nonsense, because for every buyer of stock there is a seller and whatever money flows into the stock market flow immediately out.

This issue has come up a lot in this blog, with some people claiming that expansionary monetary policy blows up bubbles, because the money “has to go somewhere.”

Update 7/20/09,  I misread the quotation.  In the comments below Jon points out that Ahamed ignores the increased demand for transactions balances that often accompanies a rising market.  (Although steeply falling markets also can see increases in transactions.)

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A few weeks back I did a post on a passage from Lords of Finance, trying to refute the widely held view that Keynes was a great investor.  I got some negative feedback from some commenters who knew more than I did.  But now I have completed the book, and feel even more strongly about this issue.  I’ll start with Keynes, but my real target is much bigger.

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A few days ago I debated the famous John Cochrane on monetary policy.  (No, not the “if the glove don’t fit . . . ” Johnnie Cochran, rather the University of Chicago professor.)  He seemed to go easy on me, perhaps because I was from a small school.  So it was a pleasant debate.  But we certainly found many points where we disagree.  I probably talked too much.  Here is the link.

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This post was triggered by a recent Will Wilkinson essay on inequality.  Earlier I linked to a Wilkinson essay where he cast a bemused, skeptical eye on happiness research.  His inequality essay is more serious, as the issue is much more highly charged.  BTW, it’s interesting to consider why “happiness,” the supposed goal of humanity (according to economists) is regarded by many as a fairly frivolous research topic, where as inequality is very serious.  One answer is that we can’t measure happiness very well, but as Wilkinson shows there’s no evidence that our inequality measures are any better.  Indeed I’ll add a few criticisms of my own.

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In earlier research Dr. Krugman pointed out that monetary policy could be effective in a liquidity trap, as long as it was expected to be permanent.  One way of doing that is with inflation targeting (level targeting.)  The Fed should commit to a rising price level path, which could lead to lower real interest rates and higher AD.  Dr. Krugman recently argued that the Fed is too conservative to adopt such a policy today, and things would have to get worse for them to do so.  Of course Ben Bernanke is a student of the Great Depression, and obviously wouldn’t let things get too much worse.  Indeed the so-called “QE policy” instituted in March of this year was a tacit admission by the Fed that things had gotten worse, and that more aggressive steps were necessary.  Since then the outlook has become a tiny bit better, although it’s hard to say exactly why.  (In my view it’s 80% China, 15% QE, and 5% fiscal stimulus.)

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Before I begin I’d like to thank Dilip, who sends me many useful articles, and Scott (aka “Lawton”) who recommended that I set up the “FAQs” link.  It already got a nice review from Bryan Caplan, so I think it was an excellent idea.  I plan to improve it when I have a bit more time.  BTW, that language snob Bob Murphy insisted “Frequently Asked Questions” should be “FAQ.”  He doesn’t realize that not only are there lots of questions, but they are asked over and over again by newcomers.  So the double plural is required.

No one commented on my pathetic attempt to channel Lovecraft in the final paragraph of my “Mind Snatchers” post.  I’ve always been fascinated by Lovecraft, despite his schlocky writing style.  Especially his collection of letters, which depict a life that mine is increasingly resembling.

[BTW, Michel Houellebecq insists Lovecraft is a superb stylist.  Yes, he's French, but he makes an interesting argument.]

Speaking of Lovecraft’s style, I am afraid my Austrian readers may find this essay to be an unspeakable horror.  But if you find yourself muttering “Sumner can be provocative, but this time he’s gone too far,” remember that new insights can often come out of very far-fetched thought experiments.

In my Snatchers post I linked to an interesting piece by Leigh Caldwell.  He discussed a speech where New York Fed president Dudley recommended that the Fed try to prevent asset bubbles.  I was once offered a job at the NY Fed, and so I tried to picture myself working in the economics research unit.  I can just imagine us getting a memo from the Fed president, instructing us to figure out when stock prices are inflated, and then recommend corrective action.

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At this point my indebtedness to GMU’s economics department is only slightly below the fast rising national debt.  You have probably seen some very kind comments from Tyler and Bryan, and there have been some behind the scenes favors as well.  I have a persistent feeling of guilt that I am not able to reciprocate.  Thus I was horrified to recently discover that I had not even answered a question posed by Bryan a few months ago.  He had asked whether investor panic might have been an independent shock hitting the markets last October.  I responded, but never saw his follow-up:

In the comments, Scott graciously replied:

“As long as you define “panic” as “correctly ascertaining that the monetary authority was about to embark on a dramatically lower NGDP growth trajectory that would plunge the world into depression” then I am completely with you.”

I’m afraid I’ve got more in mind.  Why can’t we think of the public’s mood as an independent – and highly volatile – causal variable?

I didn’t expect a panic in October, 2008.  But when it happened, it sure didn’t seem to be due to news about nominal GDP.  It seemed to be due to news about the public’s mood.  A week before, the natives were calm.  Then they suddenly got amazingly restless.

As long as this restlessness is unpredictable, it’s perfectly consistent with EMH.  So this account seems to meet Scott’s objections to distant “root cause” theories.  And it seems to fit our experience of actually living through those days, doesn’t it?  So what’s wrong with blaming an exogenous panic attack?

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Wars make people think and do stupid things.  So does deflation caused by tight money.  The intellectual low point of 20th century macro occurred in 1938, when a promising recovery in 1936 turned into renewed depression and deflation.  Interest rates fell to zero, feeding the view that money was irrelevant.  A 1938 EJ article by Joan Robinson provides a good example of the zeitgeist.  Here she criticizes Bresciani-Turroni’s argument that the German hyperinflation was caused by their government printing too much money:

“An increase in the quantity of money no doubt has a tendency to raise prices, for it leads to a reduction in the rate of interest, which stimulates investment and discourages saving, and so leads to an increase in activity.  But there is no evidence whatever that events in Germany followed this sequence.”

So easy money couldn’t possibly have caused the German hyperinflation because German interest rates were not very low.  And everyone knows that easy money is associated with low interest rates.  I won’t insult the intelligence of my readers by explaining what is wrong with her reasoning.

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I just added a FAQ section on the right side of the blog.  But I don’t plan to answer comments over there.

Today I’ll start with a very brief bio of four uber-important economists who were together at Princeton back around the turn of the century.   Since I can’t go five minutes without talking about myself, I’ll add a brief explanation of how their work relates to mine.  Then I’ll use their careers to speculate about what an ideal FOMC would look like.  Keep in mind I don’t know any of these people, and thus the portraits will be very sketchy.

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