Guillermo Calvo on the Crisis, Money, and Macro
Oct 21 2013

Guillermo Calvo of Columbia University and the National Bureau of Economic Research talks with EconTalk host Russ Roberts about the nature of macroeconomic crises and what we have learned or should have learned in the aftermath of the most recent one. Based loosely on his recent paper, "Puzzling Over the Anatomy of Crises," Calvo discusses a wide array of issues related to macroeconomics and the role of financial instability in economy-wide crises. Topics include the role of money, the problem of short-term lending in the financial sector, the black-box approach of modern macroeconomic theory and the forgotten economists we might want to reconsider.

Explore audio transcript, further reading that will help you delve deeper into this week’s episode, and vigorous conversations in the form of our comments section below.


Greg G
Oct 21 2013 at 11:58am

John Maynard Keynes did NOT expect or predict a depression after the end of WWII.

Hayek, for one, has said that it was inflation that Keynes was worried about after the war. And that did prove to be prescient because we did have a few years of significant inflation after the war.

Now Russ, I realize you are making a distinction between Keynes and “THE (emphasis added) Keynesian outlook” but this simply will not do. Keynes wanted government to pay down debt in times of full employment, not continue to increase debt indefinitely.

Surely our definition of “the Keynesian outlook” should be broad enough to include those who actually followed what Keynes rather than Samuelson said when they disagreed.

I’m pretty sure that if someone advocated an economic prediction that was the opposite of what you believed and then called it “the Russ Robertsian outlook” you would not be OK with that even if they added a disclaimer that your views might have been a bit subtler than that. Calling it “vulgar Russ Robertsism” in the style of Don B’s references to “vulgar Keynesianism” probably wouldn’t satisfy you either. Nor should it.

Referring to the predictions of a depression, you say that “nothing happened” after WWII. But something did happen.

What happened was that, for an entire generation, we followed broadly Keynesian policies. We sharply reduced federal debt to GDP in good times and sharply increased deficits in recessions. The result was a full generation of one of the best and healthiest periods of economic growth in all of human history. That is about as good a natural experiment as you are likely to get in economics.

Keith Vertrees
Oct 21 2013 at 12:59pm

Question: did Calvo praise Bernanke not because he stabilized the the money supply, but because he effectively stopped the run by declaring he would bail out everything/everyone?

Oct 21 2013 at 5:35pm

Guillermo calvo said, “The liquidity crunch is a phenomenon that should not surprise us at all, because we know that liquidity is something that is very difficult to define. But everybody knows what a liquid asset is–something that you can sell easily in the market.”

Calvo’s definition lacks utility. Nearly everything can be sold quickly and easily if a seller is willing to drop the price far enough. In other words, “liquid” describes all the possible price points at, or below, the equilibrium price. In an informed-Just-voluntary-competitive market [an ideal market], all prices below the equilibrium price are arbitraged up to the equilibrium price. So, in practical terms, a liquid asset is an asset priced the same as the market’s equilibrium price.
However, not all markets are ideal. If there are few buyers, poor information, government regulation, violence or coercion, then it is entirely possible for a price point to exist above the market’s equilibrium for an indefinite period of time. This price discrepancy leads to a “surplus,” where more people want to sell than there are people willing to buy. In media slang, it is “stagnant”.
My worry is that the slang used in the media is working its way in to the vocabulary of economists, to the detriment of both groups.

Greg G wrote, “Vulgar Russ Robertsism.”
That is seriously funny, and a good point too. In his defense though, Keynes intentionally courted the media. Is it any wonder that we remember him almost entirely through his sound bites and not his academic work?

Shayne Cook
Oct 22 2013 at 9:18am


I’ve pestered you to bring Frederic S. Mishkin in for a chat here. I’m withdrawing that. The information and perspectives offered by Dr. Calvo here, and Dr. Laidler a couple of weeks ago, addressed the substance of what I suspected Mishkin would have explained.
Well done, Russ.

One quibble (question, really) with Dr. Calvo’s discussion here. He describes the U.S. (and probably larger global) financial system as still being “dysfunctional”. While I don’t disagree with that – it is still somewhat constrained – I’m not convinced the current state of affairs is entirely a “credit supply side” phenomena.

The U.S. private sector began a deleveraging cycle in 2008 that continues today. A portion of that private sector deleveraging is certainly attributable to “involuntary” reduction in credit use, due to financial sector dysfunction. But I suspect a non-trivial portion is “voluntary” private debt reduction. That would suggest a “credit demand side” weakness as well. Perhaps Dr. Calvo addresses that in his paper. I haven’t read it yet, but will.

Oct 22 2013 at 9:58am

[Comment removed pending confirmation of email address. Email the to request restoring your comment privileges. A valid email address is required to post comments on EconLog and EconTalk.–Econlib Ed.]

Julien Couvreur
Oct 22 2013 at 12:27pm

For some reason the concept of liquidity trap or crunch does not quite make sense to me. Maybe it’s not explained clearly?

Here’s my current interpretation (with an Austrian angle): apples are made artificially attractive relative to bananas (price controls, regulations, etc), there is a boom in apples, but later on the truth comes out that people didn’t really want so many apples, they want bananas.

Now consider that apples are future dollars (projects and assets that should pay at a later time) and bananas are present dollars. The interest rate is the relative price of both.

Liquidity trap is when you have too many apples, but you want bananas? Is that about right?

Lawrence D'Anna
Oct 22 2013 at 11:06pm

I’m disappointed that you’ve done another podcast on monetary policy and aggregate demand without mentioning market monetarism and NGDP.

I wish you’d engage more with the market monetarist point of view and the NGDPLT idea. If you think it’s a bad idea, tell us why. Tell us what monetary rule you’d prefer instead. You’ve made it clear you’re not a fad of Fed discretion and flexible inflation targeting, so what would you put in its place, if not NGDPLT?

Greg G
Oct 23 2013 at 12:46pm


Thanks for your support above. I think it is worth noting that, even in his countless sound bites, Keynes still did not predict a post war depression. There is a very, very obvious reason why so many other economists did, including some self described Keynesians.

The vast majority of economic predictions are ALWAYS extrapolations of existing trends. The long existing trend at the time was continued depression.

Note the irony that I am agreeing here with the Austrian position that the measured GDP growth caused by conscription and forced military production is not (or at least should not be) what we mean by real prosperity.

The slightest application of Ockham’s Razor here explains why most economists expected the depression to continue. We should look to William of Ockham not John Maynard Keynes to understand why so many economists made that mistake.

On a different topic, I’m not sure I understood your point on liquidity above. It is true that almost any asset can be sold if you drop your price enough but selling at a big loss is not what most people mean by liquidity. Almost everyone uses the term to refer to a situation where you can sell quickly near or above what you paid for the asset.

We do need a word for that and “liquidity” works very well because the metaphor implies that the liquid is conserved as it is poured from one vessel to another.

Oct 23 2013 at 3:06pm


Scott Sumner has been a frequent EconTalk guest – if having *him* on the program is not “engaging with the market monetarist point of view” I don’t know what is.

I would be very interested in interviews with other MM types (Nick Rowe, David Beckworth, Josh Hendrickson, etc.) but all in all I think market monetarism has gotten more airtime on EconTalk than in many other corners of the internet.

Sri Hari
Oct 23 2013 at 9:30pm

Another great podcast !
Calvo made it clear to the listeners government can’t distinguish between useful demand (preferred goods & services by consumer) so will most definitely fail to boost the economy in a recession by increasing spending. Recessions are most definitely caused by ‘malinvestment’.

Referring back to the podcast by William Black, it is clear that poor underwriting laws and lack of criminal prosecution was the primary cause for the ‘malinvestment’ in the financial industry which led to the financial crisis.

I agree the current fiscal & monetary stimulus may provide a temporary relief, but will NOT inhibit the brewing of another crisis.

Calvo seems to have brushed aside the criminal nature of the market manipulation. Exactly what Black referred to in his talk- inability of academia to discuss the 5 letter word ‘FRAUD’.

[Typo fixed by author request–Econlib Ed.]

Lawrence D'Anna
Oct 23 2013 at 9:51pm

Michael, oh I didn’t know he’d done more than one with Sumner. I can’t wait to listen to them.

Still, I wish he’d asked Calvo what he thought about NGDPLT. Especially after Calvo said “And I think probably the Fed could not be more expansionary, more pro-active, because the Fed does not have a mandate”. I mean the market monetarists have been saying the exact opposite of that for years now. It’s frustrating to see a statement like that just go unchallenged and undefended. I’m not saying Calvo’s wrong, but if he’s going to say something like that I’d like to hear him rebut the detailed arguments that market monetarists have been making for the exact opposite conclusion.

[Sumner’s podcasts (4 to date) are here: –Econlib Ed.]

Shayne Cook
Oct 24 2013 at 8:54am

@ SaveyourSelf:

Calvo’s definition lacks utility. Nearly everything can be sold quickly and easily if a seller is willing to drop the price far enough.

While your statement, and your follow-on logic, is true, you may be missing a subtle but critical distinction in the nature of types of investments – critical to the “utility” of Calvo’s discussion.

Calvo is speaking exclusively of bonds, or bond-like/bond-derived financial instruments (MBS, CDO, etc.) which have decidedly different risk characteristics than equity-type investments, such as stocks. Bond-like/bond-derived financial instruments are designed – and protected by law – to have much lower risk of, and much greater protection from, loss of principal than equities have. Pure equity instruments (corporate stocks, for example), by definition, have no protection from loss of invested principal.

Both equity holders and bondholders/creditors have a legal claim to the underlying assets – homes, in this context. But bondholders/creditors have the superior legal claim, in the interest of preserving their lent principal, by design and by law.

You are correct that any financial asset can be sold (considered “liquid”) if the price is dropped far enough. But the presumption that a bond/bond-like/bond-derived financial instrument is afforded greater protection from loss of principal – price drop not below lent principal value – and “liquid” – is the essence of Calvo’s research and discussion here.

Oct 24 2013 at 12:43pm

Greg G wrote “I’m not sure I understood your point on liquidity above.”

  • Apologies. Not my best work.

Shayne Cook wrote, “The presumption that a bond/bond-like/bond-derived financial instrument is afforded greater protection from loss of principal – price drop not below lent principal value – and “liquid” – is the essence of Calvo’s research and discussion here.”

  • Both you and Greg G seem to agree that “liquid” implies the ability to sell an asset quickly AND without loss. Webster’s dictionary has a definition that reads, “Capable of covering current liabilities quickly with current assets,” which seems to go along with your understanding.
  • I find your definition more useful than the one Calvo gave in the podcast, but still rather dubious when discussing economics. It describes an ideal circumstance but gives no clue as to what factors contribute to that circumstance or what factors may undermine it. It is descriptive only, which is why I say it lacks utility.

Julien Couvreur wrote, “For some reason the concept of liquidity trap or crunch does not quite make sense to me.”

  • I had trouble finding a definition of the liquidity trap online, but I found one in Minky’s book “Stabilizing an unstable economy”. On page 148 he wrote, “This is the famous liquidity trap–which holds that an increase in the quantity of money for certain ranges of income does not lower the interest rate.” Thus rendering monetary policy ineffective. He says a liquidity trap can follow financial cricis and is characterized by low interest rates on “default-free securities” and “substantial interest premiums on riskier securities.” He said it was based on the IS-LM model.
  • Clear as mud, right? So if it does not make sense to you, it is probably because the IS-LM model doesn’t work, and that is its foundation. To make it work, you have to employ suspension-of-disbelief, which is a questionable strategy for a field of science.
Shayne Cook
Oct 24 2013 at 2:15pm

@ SaveyourSelf:

Way cool – I think we’re getting to the core of the mis-understanding.

From an investors perspective, a debt instrument (bond, or any bond-like/bond-derived financial instrument) becomes and is considered “illiquid” (within Calvo’s meaning) if it can only be sold to someone else at a price lower than the principal value. A more common vernacular term is “haircut” on a bond, or bond-like/bond-derived debt instrument when its market value goes below invested principal value.

Again, it is only a matter of the definition/purpose of the financial instrument.

Conversely, an equity type financial instrument, such as common stock, can never be considered “illiquid” – even if market value goes to zero. There can be no “haircut” with an equity instrument – even with total loss of invested principal. Because there is never a a presumption of principal preservation associated with an equity position.

Regards the Webster’s definition, I suspect they are referring to organizational liquidity, rather than specific financial instrument liquidity characteristics.

With regards to Julien Courveur’s comment above, I was thinking about responding to it, but decided to wait for someone else to explain. Frankly, I’ve seen so many different, varying and sometimes mutually exclusive implied definitions of the term “liquidity trap” over that past few years, I’m not sure my definition would do anything other than add to the confusion. Which is a wordy way of me admitting that I have no idea what a “liquidity trap” actually is in this context.

(I suspect Calvo feels the same way – hence his creation/use of the term “crunch” instead of “liquidity trap”. But Calvo does define/discuss “liquidity trap” in his paper [linked above]. It’s well worth reading and it may add to your understanding.)

Greg G
Oct 24 2013 at 5:54pm

I could be on thin ice here but my understanding is that a liquidity trap and a liquidity crunch are two entirely different things.

The Keynesian idea of a liquidity trap was a rejection of the earlier idea that savings can always be relied on to flow into investment in a relatively unproblematic way. At the micro level this means people can be too scared to take real investment risks and will sometimes hold onto cash or cash like investments even if they earn little or nothing. These individual decisions can accumulate to the point that there is an aggregate demand problem at the macro level.

My understanding is that a liquidity crunch is what happens when an over leveraged financial institution finds it cannot turn assets into cash fast enough to meet its obligations.

Oct 25 2013 at 2:56pm

Greg G, your definition of a liquidity trap is certainly more palatable than Minsky’s. If your explanation is true, it makes me wonder why Keynes felt the need to come up with an alternate model to explain such behavior when it is easily explained with basic price theory plus a little money supply analysis.

In the “Capitalism, Government, and the Good Society” podcast I posted this model:

PRICE THEORY: Price signals/shifts have undeniable importance in determining individual rationing decisions. Normally price reflects an enormous amount of data about supply and demand in a particular market AND the supply and demand in all other markets by way of the currency-market. Prices are expressed as simple numbers devoid of any labels. When a change occurs in the supply-demand relationships, prices USUALLY change accordingly. People get used to the association between meaningful shifts in supply and demand showing up as shifts in prices.

MONETARY THEORY: The trouble arises when something replaces prices with made-up-numbers or numbers that reflect something different than meaningful supply-demand relationships. When people don’t realize that a substitution has occurred, they behave inappropriately by behaving the same as always. Consider when the government prints money in secret or when large numbers of private citizens suddenly become eager to loan out their savings (following government increases to taxes on savings or government subsides on lending or government guarantees against default.) In all of these cases, the increase in the money supply overwhelms any meaningful price information, leaving only useless numbers where prices had once been. Ignorant that the numbers no longer convey useful information, people in ALL markets react to an increase in the numbers as if they were actually increases in demand: they open new businesses; hire new employees; move their homes and families to new places; invest in new areas; and take on new debts. That last bit–taking on new debts–is important. Leverage increases naturally in response to inflation. People think they are investing money to meet the demand-signals. Except that they aren’t demand signals. They are just changes in the amount of money in circulation. All these “investments” are guaranteed to fail because the demand they were intended to satisfy isn’t there.

The opposite is also true! When money supply decreases it sends a signal through prices that demand everywhere has decreased. People react to the negative signals by closing businesses; laying off employees; postponing moves or big purchases; postponing investing; increasing savings; and paying off debts. And this is where your “Liquidity Trap” definition comes in to play. The rational response of people to save their money when they cannot see any good place to invest it leads to another decrease in the money supply, which leads to even more saving, which decreases the money supply even further, on and on in a negative spiral.

The BIG problem with this scenario is not so much that it happens, since it is a perfectly rational behavior. The problem is that it happens simultaneously everywhere in all markets. A shift in the money supply affects every market that uses prices, which is all of them. Messing with the money supply is like letting your infant child play with radioactive plutonium–there is just is no up side!

So how do we avoid such a preventable catastrophe? Easy, don’t mess with the money supply (Austrian). But when we do mess with the money supply–it appears we are genetically incapable of leaving it alone–what do we do then (Keynes)? Keynes proposed borrowing from the future to inflate the money supply enough to stop the spiral. Once that spiral is broken, pay the future back. The trouble is that paying the future back amounts to decreasing the money supply, so Keynes solution can’t work, it is a trap in too.

Oct 25 2013 at 3:48pm

I have a solution to the negative spiral described above. I call it the Warren Buffet solution.

Warren Buffet understands, more than anyone else in the world, that sometimes prices lie. So he just sits on cash, valuing businesses as a full time job. His secret, so far as I can tell, is that he values them in terms of cash AND other variables. When prices shift downward but he doesn’t see his alternative-valuation-variables change, he starts buying at fire sale prices. When prices normalize a short time later, he makes a killing. At various times this strategy has made him the richest man in the world.

So the Warren-Buffet-Solution is just to make people aware of his winning strategy. Let the Fed Chairman say to the world–I remember Alan Greenspan saying this once–that assets are globally underpriced, providing some huge opportunities for bargains. This announcement gets people thinking that the prices are mistaken, so they start looking at other variables to make their valuations. This unhinges investor-value from price-changes and stops that negative spiral that the price-heuristic sometimes causes. [A “heuristic” is a rule of thumb that generally works well for making quick decisions in a real world environment, but sometimes doesn’t. In this case the “price-heuristic” is the assumption that changes in price reflect changes in supply and demand, which is usually true…except when it isn’t.]

That’s it. Just tell people the prices are wrong, so they stop reflexively responding to the price-changes and start responding to the real world.

Oct 25 2013 at 4:21pm

Hmmm, I just noticed that the Price + Monetary model [above] also explains the behavior of the financial sector in response to inflation. The inflated prices lead investors to borrow money to meet a perceived increase in demand. The borrowed money inflates the money supply, which creates a signal that demand has increased, which triggers more borrowing, on and on in a cycle upwards. It is the mirror opposite of the liquidity trap.

Wow. That is cool.

Greg G
Oct 25 2013 at 4:24pm


Referring to inflation you wrote “Ignorant that the numbers no longer convey useful information, people in ALL markets react to an increase in the numbers as if they were actually increases in demand…”

This is where we disagree. Usually when I discuss these things with people who are far more libertarian and Austrian than I am in their outlook I wind up arguing that entrepreneurs are less wise and/or heroic than the other guy represents them to be. Here the roles are reversed.

In your account, businesspeople are fooled every time by inflation. They never learn. It always leads them into mal-investment. I think they are smarter than that. I think they have powerful incentives to recognize, account for, and adjust effectively to inflation. And they usually do. For example:

I graduated from college in 1973 and immediately started managing a clothing store my father was apart owner in. Two years later I borrowed enough money from him to buy a majority interest in that business which I ran until I retired and sold it in 2007.

So I started right as the 1970’s inflation was taking off. It never caused me to make any mal-investments. Oh, I made plenty of mistakes but none of them involved mistaking inflation for an increase in demand. I simply tracked units sold and reordered on that basis rather than reordering based on a fixed dollar amount.
It seems odd to me that the 70’s are talked about today as an economic wasteland. It was easy to get a job or start or grow a business then.

I do think that the leverage part of your argument gets some real traction but not for the reason you cite. I don’t think it’s because investors misunderstand demand. I think it’s because investors are always willing to take risks with somebody else’s money that they wouldn’t take with their own.

Greg G
Oct 25 2013 at 4:38pm


You don’t need to invoke a perceived increase in demand to understand why inflation encourages borrowing. With inflation the borrower gets to pay back in dollars that are worth less than the ones he borrowed. That is plenty of incentive to borrow even if you understand demand in an undistorted way.

Oct 26 2013 at 8:09am

Greg G writes:

“You don’t need to invoke a perceived increase in demand to understand why inflation encourages borrowing. With inflation the borrower gets to pay back in dollars that are worth less than the ones he borrowed. That is plenty of incentive to borrow even if you understand demand in an undistorted way.”

Ins’t this a wash, since lenders will factor their inflation expectations into the interest rates they offer?

Greg G
Oct 26 2013 at 8:38am


Lenders would always like to be compensated for inflation but that doesn’t mean they will always be able to be. It depends on the market. They have to choose from the options available to them, not the ones they wish were available to them.

For quite some time now almost everyone purchasing a CD has accepted less than the rate of inflation. Many bonds have been sold below the rate of inflation.

Jim Glass
Oct 26 2013 at 4:31pm


Russ: The puzzle here is we didn’t have [deflation] … People were very worried about deflation in this current crisis, because they’d seen correctly that that’s what Japan had struggled with in their stagnation. So we didn’t have that deflation. But you are making the point that we didn’t have it overall in general…

Hello? We did have general economy-wide deflation. In July 2008 deflation began and rapidly accelerated to a 13% annual rate (Q over Q). This was the first deflation since the 1950s and matched the *worst* deflation of the start of the Great Depression itself.

Then, to stop it, the Fed hit the market with QE1 in November and the deflation reversed itself on the proverbial dime in 2009 — exactly as Friedmanite monetary policy predicts. But even so the 2008 price level wasn’t reached again until the end of 2010.

Two economists lecturing on all this don’t remember these facts? It was even a big public political issue — we’ve all forgotten all the AARPers howling about how they weren’t getting their annual Social Security benefit increases (via COLAs) for the first time ever, and the politicians rushing to appease them?

Russ: … you suggest that [the Fed’s] actions are to be celebrated. One, I’d say it’s a little too early to tell … I agree with you–they did respond in a financial-sector way by repairing the balance sheets of the banks. But that appears to be all they did. They didn’t have much of an impact”

Reversing the biggest deflation since 1930 (to keep 2009 from becoming 1931) via a policy explicitly adopted to do so, QE1, “isn’t having much of an impact”?

Professor, your ‘healthy skepticism’ that you so often invoke, when others interpret (select, change, ignore) facts to fit their favored theories and ideologies, is usually very well appreciated — but it can be pushed to become a fault of its own along the same line.

You can certainly say: “I am skeptical that the dramatic deflationary plunge of 2008 was broken by the Fed’s monetary response of QE1. I admit the course of factual events went exactly as monetary theory indicates they would, and as Bernanke wanted them to go — with the big monetary injection promptly followed by a reversal of the deflation — but we must remember, that might have been only coincidence.”

However, one cannot say: “Since there was never any overall deflation in the US, how can we say if the Fed’s policy had any counter-inflationary effect? Maybe it did, maybe it didn’t. Since there was no deflation, who can tell? There is no data to help us. It’s just a matter of believing in one’s own ideology ahead of facts”.

Well, one *can* say the latter, of course — but in that case reflexive healthy skepticism itself shows signs of becoming an ideology which blinds one to facts, just like any other ideology.

Along the same lines, all the talk that Friedman claimed keeping the money supply stable would have avoided the Depression via some kind of unexplained “black box” effect, specifically with no mention of the Fisher Effect, is another thing.

Friedman called Fisher “the greatest economist the United States has ever produced,” so one would think he appreciated the Fisher Effect, and the copy of Friedman and Schwartz that I read was replete with invocation of Fisher effects in its discussion of the Depression. But you don’t have to take my word, take Anna Schwartz’s,

Let not healthy skepticism become a righteous ideology of its own.

Finally, your podcasts are great, extremely appreciated here. I’ve been listening for years, this is my first carping comment — they are gold to me. So don’t take this carping as any kind of personal criticism … just a comment reaction.

Oct 27 2013 at 7:51pm

@Greg G

“In your account, businesspeople are fooled every time by inflation. They never learn. It always leads them into mal-investment. I think they are smarter than that.”

  • This is a good point you make. Not all people, for various reasons [like lack of capital to invest and/or inability to borrow money to invest] are led to mal-investment by inflation. I believe at the depth of the great depression, for example, only 25% of people were unemployed. This implies that at least 75% were employed intelligently during the inflationary wind-up. Additionally, different sectors of the economy tend to be affected differently. The finance sector, it seems to me, suffers first and worst from the negative effects of inflation.

“So I started right as the 1970’s inflation was taking off. It never caused me to make any mal-investments. Oh, I made plenty of mistakes but none of them involved mistaking inflation for an increase in demand. I simply tracked units sold and reordered on that basis…”

  • So inflation shows up, initially, as an apparent increase in demand. People find they have more money in their wallet than they expected or budgeted, so they start spending. This would show up to you as an increase in “tracked units sold,” not higher prices. To you, the individual business owner, the increase in sales might never be enough to attract your notice. You might not realize that you needed to raise your prices. By not raising prices, you are unknowingly giving a discount to your customers. This unintended discount might not harm you much. But if your business makes its money on very tiny margins, that unrealized discount may be enough to put you out of business.

“It seems odd to me that the 70’s are talked about today as an economic wasteland. It was easy to get a job or start or grow a business then.”

  • The pattern you recall is predicted nicely by the Price + Monetary model above. Inflationary periods SEEM like a boom time for businesses.

“You don’t need to invoke a perceived increase in demand to understand why inflation encourages borrowing. With inflation the borrower gets to pay back in dollars that are worth less than the ones he borrowed.”

  • I second Michael’s point. Although your statement is valid, lenders efforts to counter losses to inflation makes it unlikely that this is the dominant cause of inflationary mal-investment.
Daniel Barkalow
Oct 28 2013 at 3:11pm

I think it’s worth noting that there were multiple things wrong with the economy, and you can’t tell whether the Fed solved some of them from the state of the economy afterwards. I’d say that monetary policy solved the risk of deflation and the ability of businesses and banks to operate. We don’t have a deflationary outlook, and businesses and banks are operating. I think the primary aspect in which the economy is bad is unemployment and household income/wealth (and, in turn, consumer expectations, durable goods orders, etc.), and that this is due to the relative value to businesses of additional workers versus additional profit. Having the Fed try to solve a problem that’s relatively far from what they can affect directly tends to lead to even more unintended consequences than usual.

Greg G
Oct 28 2013 at 5:04pm


Well, we certainly agree that inflation hits different sectors differently but the most pernicious effects are usually seen in the financial sector. No dispute there.

I’ve got to tell you that, sadly, through the entire period of inflation in the 70’s and early 80’s I never once had the experience you describe of finding more money in my wallet than I expected. I also never failed to notice when my margin was being squeezed. I always decided how much I could afford to take out of my business after I got the accounting results. Some business people don’t do it like that but they are the same ones that tend to fail in all possible inflation scenarios.

When I was able to take out a higher income, I can assure you that I had been noticing that the things I had been paying for had been increasing in price also. Likewise, when my employees got their annual raise I can assure you they were keenly aware that they were paying out most or all of it in higher prices. If anyone was fooled by all this it wasn’t anyone I knew and I knew a lot of businesspeople.

Now whether or not I could raise my prices was not determined by what was happening to my margins or to inflation. That was determined by competition in the marketplace. Customers don’t care what your margin is. They only care if they are getting the best deal they can find. I never failed to raise prices when I could get away with it or drop them when I couldn’t. I was keenly aware that an increase in demand is the main way the market tells you that you can increase prices.

Now I do think that a modest inflation stimulates business. But I think that is because it makes people more willing to borrow for investment purposes. Inflation benefits borrowers and they know it. This effect is less today than it used to be because a higher percentage of loans are now adjustable.

Interfluidity blog recently had a fascinating post on the 70’s inflation. He said that permitting the high inflation of that period was probably the best of a choice of all bad policy options at that time. His point is that inflation makes it easy for employers to lower real wages as needed. And with the Baby Boom generation providing a huge bump to the supply of labor real wages needed to drop then.

Hey, what did you think of Minsky’s theory that the main thing that drives the business cycle is the fact that economic stability tends to reward risky finance and that, over time, this causes stability itself to be destabilizing?

Nov 5 2013 at 3:04pm

It’s very strange to try to use the voice of Ben Bernanke to speak against the insights of Irving Fisher. Some of Ben Bernanke’s most important contributions were bringing Fisher’s debt deflation insights into modern macro. Please see Agency Costs, Net Worth, and Business Fluctuations, AER (1989) and Bankruptcy, Liquidity and Recession, AER (1981).

Nov 7 2013 at 10:19pm

Now, when that channel sort of collapses momentarily, then you had to go back to lending directly to the house buyers. So the price, or the interest rate that the house buyer faces now increases. And that’s equivalent to a sudden stop in credit. Which is what I call a sudden stop.

I need help understanding where this is coming from. Looking back at historic interest rates with Freddie Mac I don’t see any huge jump in interest that would cause a flight to safety for house buyers. What am I missing?

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0:33Intro. [Recording date: October 7, 2013.] Russ: Our topic for today is a recent paper you've written titled "Puzzling Over the Anatomy of Crises: Liquidity and the Veil of Finance". Now there are many who argue that the current crisis is nothing new, that old models can explain the new world we find ourselves in. But your title suggests some uncertainty about what got us into this mess. And your focus is on the role of money and the financial sector. I want to start with the expression 'Money is a veil.' What do economists mean when they say that? Guest: Well, that's a very deep concept, if you wish, that economists developed in order to show that money really does not pass[?] anything substantial to the economy beyond what the real sector can do for you. And that has to, for example, explain the possibility that if you increase the money supply, all that will happen is that prices will increase in the same proportion. So that helps to sort of put money in its place, if you wish. But that result is based on some assumptions that, when you make them explicit, you realize that you are talking about a special case. So, once again, coming back to the concept of the veil of money, intends to convey the notion that money could or is essentially a veil. But it doesn't imply that in practice it will be a veil. And actually the veil was removed by macroeconomists many years ago. I mean, when Keynes and other economists worked on the subject and it was shown that there were some price or wage rigidities, the veil proposition will not hold. And money, not only when you increase it, will have an effect on prices, but it might also have an effect on output. Russ: Now, on the real side of the economy as opposed to the nominal side, for those who want to hear the jargon. The nominal side of the economy is just the level of prices. That shouldn't matter; in theory that shouldn't matter at all. If everything is twice as high and all prices are doubled, all incomes are doubled, in theory then money is what economists call 'neutral.' It doesn't have any real impact on how much I can produce, what I do with my income, etc. But obviously, that requires, as you say, some special assumptions about expectations and knowledge about what's going on. Now, as you point out, economists over the last 70 or 80 years, and across the board, across the political spectrum, across the ideological spectrum, have worried about whether money has real impacts. There's still lots of disagreement about that. But what you focus on, which is related, which I think David Laidler said in a recent episode of EconTalk, that we kind of treat monetary policy--we've come to understand that monetary policy is important, but we seem to suggest in our models and sometimes in our policies, that monetary policy is somehow independent of the financial sector. Which is a rather extraordinary idea. And you describe it as 'Finance is a Veil'--that what the exact structure of the banking system is not so important, the Fed does its thing. But as you point out, we really should question that assumption. Guest: Right. And it's amazing that the assumption has been kept for so many years, for the entire 20th century, in the United States and in advanced economies. The assumption became less tenable in an obvious way to analysts for emerging markets, because emerging markets started to have the kinds of crises that we have now in developed countries around the 1990s; 1995 was actually the first, so-called 'Tequila Crisis,' in Mexico. But those crises seemed, economists thought, did not apply, if you wish, to the United States, to Europe, and other countries like that. So in our models, I mean the models used in advanced economies and in all Central Banks, the assumption is that there is a sharp difference between money and the financial sector. And that the financial sector will take care of itself. And actually monetary policy has essentially nothing to do with the borrowing and lending that goes on in financial markets, and that the best that we can do is to let the market work and for that sector to equilibrate without the intervention of government. So, from a foreign point of view what we did was to not focus at all on the role of finance and financial disarray or disfunctionality; those sort of things, which for some analysts, microeconomists who specialize in banking, those people paid attention to those things. But macroeconomists sort of left them out because macroeconomics is already a very complicated subject and they felt-- Russ: Right. Too hard already. Guest: Right. Let's leave that out if it doesn't bother them; let's not bring it in. Russ: And some of that--and we'll talk about that generally throughout the conversation--but some of that is just specialization. There are people who are, so-called, 'finance economists'--they didn't know much about macro. And macroeconomists didn't know much about finance. And a lot of the time that was fairly harmless. It didn't seem to matter so much, any more than a macroeconomist would be an expert, say, on, oh, I don't know, the high-tech sector. Sometimes it's an important part of the economy. But you don't have to be a health economist to do macro. But it may turn out you may need to be a financial economist to do macro. Guest: Exactly. And one explanation why macroeconomists felt comfortable leaving out the financial sector is that for a macroeconomist a problem deserves attention if it is a macro problem or if it is a systemic problem. But micro problems under a macro problems all the time some banks go under, there is a [?] there in the system--those things are important from the point of view of a microeconomist but the macroeconomist could live very well without paying attention to those things. Unless they become systemic. And I think the big difference in the present crisis is that we have a systemic financial problem. Russ: Yeah. I like to make a contrast of the current mess with the so-called 'tech bubble,' when internet stocks went very high; a lot of capital flowed into the internet. And when that stopped happening--when there was some fallout and some reorganization of the tech sector, when it became clear that not every business that was losing money would eventually make money--a lot of those firms went bankrupt. They laid off their workers; it was very tough on some of those workers and some of the regions where those workers were located for a little bit of time. But the macroeconomic effects were fairly mild. That was not true in 2007 and 2008, when the financial sector exploded. Or at least doesn't seem to be true. Guest: Exactly. And that's interesting because what you are saying is the tech bubble kind of reassured macroeconomists that there was no need for them to be paying too much attention to the financial sector because they knew how to take care of themselves and did not complicate the rest of the economy. So it came as kind of a surprise, what happened in 2008.
9:42Russ: Now, in your paper, and we'll put a link up to it for those who want to read the paper itself; I recommend it. It has a lot of interesting insights into the current mess as well as the history of economic thought, which we will be getting into in a little bit. But in your paper you talk about what you call a 'sudden stop.' And I want to talk about this issue of liquidity and credit having a sudden change in the climate, which seems to be the provoking, the instigating problem, that leads to a cascade of other problems. What do you think happened in this last crisis--just in terms of the logistics? What went wrong that caused the sequence of problems? Guest: In a nutshell I see the crisis as being triggered by a liquidity crunch; and we can talk about it. Russ: Talk about what that means. Guest: Yeah. But let me draw the implications that I will elaborate on, too. Russ: Go ahead. Guest: That is that a liquidity crunch brings, given the characteristics of the financial instruments that were hit by the liquidity crunch, that had an impact on the credit market and brought about what I call a [?]. Now, the liquidity crunch is a phenomenon that should not surprise us at all, because we know that liquidity is something that is very difficult to define. But everybody knows what a liquid asset is--something that you can sell easily in the market, that you can find a counterpart someplace in the market to sell it in a short period of time. So the standard financial instruments like bonds and stocks and so on for which there is a very fluid market; you can sell them almost instantly. So those things are liquid. But the liquidity depends on other people thinking that instrument is liquid. It's like with paper money. Paper money is accepted not because it has any value in itself but because the one who takes paper money thinks that he will find another guy in the market to whom he can buy by giving this paper money to him. But if for some reason somebody says that paper money is not accepted any more, then it loses completely its value, because it's not like a glass of milk. You cannot eat it. There are very few things you can do with paper money. But that characteristic translates or also affects any asset that this endowed with liquidity. And something that happened prior to this crisis is financial innovation generated assets that turned out to be very liquid. And one problematic example is mortgage-backed securities. Prior to the invention of that instrument, mortgages were loans that banks held in their balance sheets. So, they lent $100,000 to somebody and they had to wait until that person paid them back, say, in the next 15 years or so. Now, mortgage-backed securities is a very clever device by which the banks put all of those mortgages and bonds, and the bond is traded in the capital market. So what that does is to make your mortgage more liquid. Because now--before the invention of this instrument, it was very hard to sell a mortgage, a single mortgage, in the market, because a buyer had to know all the characteristics of the mortgage holder. But after you put those mortgages, not [?] mortgages, under the umbrella of a bond, it becomes much easier to sell because not every borrower is the same, but statistically have a fairly good idea of the percentage of people that pay, etc. So, you have something that delivers a flow of income that is predictable, highly predictable. And that does not imply that you have to know any of the characteristics of any one of the mortgages. So, you make, you create an asset that is much more liquid, and it yields a return. So it's more attractive than money.
15:11Russ: So, if I may skip ahead. It is a brilliant idea. The problem is, is that people--banks bought those using an enormous amount of borrowed money rather than equity. Is that correct? Guest: Exactly. Russ: Explain how that went wrong when things fell apart. What I was saying, you see, led to the view that if you put lots and lots of mortgages, and bonds, the bond will look very much like money, but now is a money that yields a positive rate of return. Which is what--the sum of the mortgage payments included in the bond. So, it's more attractive. It's denominated in terms of money. And so the banks, what they did, shadow banks in particular, held those bonds in the assets and borrow against those bonds. Now, the lender or depositors to these other banks felt safe because they thought that those assets were liquid, that if for any reason they needed to withdraw real money, no problem--the bank would be able to sell those assets right away. They have been very stable because we went through what was in the U.S. we call the 'Great Moderation.' So, very little volatility in the markets. So that encouraged the depositors to go into that. Now, it's not the retail depositor that was important or relevant for big corporations, special funds, and so on, that would not have the protection of FDIC (Federal Deposit Insurance Corporation), for example. So now they sell protected, even though they did not have FDIC, they sell protected by the liquidity of the assets, of these assets held by banks. Russ: So, what went wrong? Guest: Well, because liquidity is in the eye of the beholder. So some day somebody says the emperor is naked. If people say somebody doubts--suppose for example you say, okay, that's liquid, so individually you can sell your bonds. No problem. Somebody says a substantive number of market players, for some reason, coordinate expectations--they start to doubt; they think, wow, there are problems in the sub-prime market. Yeah, that's true, it's a small market; but here we have all of this huge stock of MBS, Mortgage-Backed Securities, and other securities of that nature. Maybe that would be infected by what is going on in this prime market. Well, that's good enough to provoke what we call a 'run.' Because it now says 20% of the bond holders want to sell, it has to find a sufficient number of buyers on the other side of the market. But if you see that 20% of all those assets are supposedly no better than you are trying to sell, you probably will step back and say, Well, let me wait a little bit. So when they tried to sell, what can they get? The problem is that bonds have mortgages behind them. And these are promises to pay in the next 15 years, for example. So, they don't pay right away. There is not cash enough to keep the prices up. And the prices collapse. Russ: Is that the sudden stop? Guest: The sudden stop is the next stage. The next stage is as follows. Russ: Let me interrupt for one second. On the surface, it's like: What's the big deal? So, you found out it's not so liquid; you go out to get your money; you can't get it. Maybe you panic and you try to sell it. And so what should have happened is a lot of banks lost some money. They had a bad quarter. But that isn't what happened. Guest: Yeah. And it could end right there. The thing is that the money was being channeled to house buyers at a relatively cheap cost for the buyer. And I will explain why I said 'relatively.' Because the bank could easily wrap up those mortgages under the umbrella of a bond and sell it in the open market there. Now, when that channel sort of collapses momentarily, then you had to go back to lending directly to the house buyers. So the price, or the interest rate that the house buyer faces now increases. And that's equivalent to a sudden stop in credit. Which is what I call a sudden stop. So that's how it happened. It happened because you are destroying a vehicle that was accepted to a certain extent because it was liquid. But now the liquidity momentarily [?]. So the vehicle is destroyed because prices are falling by 50%, and everybody is very confused. So at least momentarily everybody holds back and says--I mean, the potential savers. The savers hold back and say, Hey, wait a second, I don't want to put my money in that bank any more. I want to hold Treasury Bills. And that's what we call the liquidity trap. Which is the other side of the seller's[?] stock. Russ: Explain that. Guest: Yeah, because prior to that people were willing, say if you have an income of $1000 you were willing to deposit $20 in a bank; or in one of those shadow banks. Now the credibility, reliability of shadow banks is shattered. And so the depositor keeps the money in his pocket. Or tries to buy Treasury Bills. So you take the money away from the credit market, and that's how credit dries up immediately. Russ: So you are suggesting also that there is a flight to safety. People want very safe stuff. So safe stuff suddenly is in very high demand. Which means the return on the safe stuff has to go down dramatically. And you are suggesting that's why interest rates are so low? Is that correct? Guest: Exactly. That's precisely the idea. And that's why, even though the epicenter of the crisis is in the United States, we've seen the demand for U.S. liquidity--dollars and dollar-official liabilities--went up sharply. And that's why interest rates went down.
23:45Russ: So, why did all that spill over into areas outside the housing sector and outside the financial sector? Again, if you are naive, you might think: Well, so banks are going to have a bad year, a bad two years; and the housing market is going to be hurt; there's going to be low prices for housing. Which is great if you are in the market for a house; not so good if you have to move. Coming back to our original question of money being a veil or finance being a veil, why do we now have to pay attention to this? Why isn't that just: Okay, so a bad time for these two sectors? Guest: Well, that's hard to explain in full because we don't know. The problem with the financial sector is like the nervous system. It touches every note of your body. So you don't know. Once you have a credit crunch in the large sector you start to ask yourself how reliable, how credit-worthy are the potential borrowers? Because there are interactions between the housing sector, construction, and other sectors of the economy. So if construction has to go down, output will go down and there will be unemployment; then the demand for the stuff that you use for construction will go down, etc. And besides, in addition, just to focus on the financial sector, as anybody knows, trade--there is a lot of trade credit--Sometimes it is called 'interfirm', or 'interenterprise' credit--going on. And so if the borrowers and lenders involved in operations where all of a sudden you know your partner, you know the guy that you sell stuff to and extend credit, say, 90-day credit or something like that, but now you don't know if that guy is not involved, has now[?] lent to the construction sector, and now is unable to get his money back and he won't be able to pay you. There are all of those interactions which nobody knows well that lead to individuals becoming more risk averse, if you wish. Russ: Let me make an analogy. We all understand from reading history and a little bit of common sense that when there is hyperinflation, when prices are rising very, very fast, all of a sudden the role of money as a medium of exchange, as a way to avoid having to find someone who likes what I like, breaks down because I can't use it very effectively. And what you are saying here is that credit forms a very central role in all the ongoings of business. And 99% of the time you don't have to think about it. Except when it's broken, and then it causes a lot of problems. Now that subtle and complicated mechanism that you are describing is not the standard mechanism that is invoked by Keynesians or monetarists for why we are in the mess. And I've never thought about this before but your description of finance as a veil makes me think about monetarism. Monetarists tend to think, well, as long as the money supply is increasing in a nice steady way everything goes great; but if there is a sudden drop then things can get really bad. And we don't explain--we don't need to explain why: it's an empirical regularity. And if it comes from the financial sector, yeah, we know; that's bad. But that's the only way the financial sector gets into the model. It's like, after the fact, there's been a contraction because of, say, the shadow banking system having a run, then things are going to be bad for a while. And we know how to fix that according to the monetarists: you just need to push the money supply back up. It's a little more complicated than that, and to put that in context let's talk about some of the history of economic thoughts insight you have from the paper. And why don't we start with--we'll get to the monetarists, but let's start with Keynes. You suggest that The General Theory and Keynesian insights are part of the reason why finance has been ignored in macroeconomic models. Guest: Yeah. That's exactly what I said. But I'm not prepared to accuse Keynes of leaving out the financial sector himself, of the picture, because he had a much wider, [?], had a much wider scope than that. But I think what happened is he was trying to convince his peers that some of his insights were relevant. So he played very much by the rules of economics at the time. So his analysis, as you know, hinges upon one basic rigidity--wage rigidity in particular. He is concerned about that. But he just focuses on that rigidity and then the rest is very classical, if you wish; and one of the characteristics of the classical model is that markets work very well. But then the popularizers of Keynes, particularly Hicks's model that became very popular and economists call the IS-LM (Investment-Savings, Liquidity-Money) model, builds upon that and that became very, very popular. That's a model of the 20th century. Still we are using it and many central banks have the bare bones of that model. So I think that's how it happened. And since we didn't have a crisis like this from the 1930s until now, that seemed to work. Russ: When you mention the IS-LM model, I'm sure that the economics majors in my audience gave a quiet groan. Besides being used by central banks, it's often frequently used by teachers of macroeconomics for complicated exam questions. The question is: Is it an effective way of capturing the problems and policy solutions out in the real world? And: If you look at the current mess, how do you think it's done? There are defenders of it who say, see, this proves that Keynes is right; that we are in a liquidity trap, for example, so monetary policy is ineffective; the stimulus and fiscal policy is very effective, but it just wasn't big enough. How do you think the Keynesian outlook--not Keynes; I agree with you; I think he was subtler than some of his followers and givers of exams and some central banks--but how has Keynesianism fared in the current crisis? Guest: The fact that the IS-LM model gives you unemployment and gives you a role for money and a role for fiscal policy doesn't imply that that's a useful insight. You can agree with some of the building blocks of the Keynesian model but not with all of his policies. There is a big, big leap of faith to go from this little model to say what you have to do is increase, substantially increase, government expenditure to get out of this mess. Now, my reaction to this is: let's take all of these building blocks, some of which are rigidities that we have to live with, so we let's not forget about those. But let's bring in something that we have left out that is central, and that is the financial sector. And try to understand what's going on and what are the policies that should have to solve the financial problem. It sounds very strange when you realize that the main factor behind the current crisis lies in the financial sector, to say that solution should then be an increase in government expenditure. There's a big jump there. Maybe that's the solution because we don't find anything better than that. But before we do that we should pay much more attention to how to fix the financial sector as such. And that's a little bit how I think about it. It's not easy, but I think we should focus on that.
33:22Russ: I think what's powerful about the Keynesian model--and may be correct; I'm a skeptic but it could be correct--is it kind of cuts through the diagnosis problem and simplifies it. Instead of saying, well, the sickness was in the financial sector so we have to fix the financial sector, they say, well, when the financial sector gets sick--or whatever caused the problem, we don't have to worry about that. We just have to increase Aggregate Demand. So, spending does that. Monetary policy can do it. So we have this sort of magic cure that works for all diseases. But it sort of comes on the scene after the fact. It doesn't say--and no good economic model right now I think is very good at diagnosis ex ante--it's an ex post story. It says, okay, things went wrong but we can fix it; we have this magic pill, it's called Aggregate Demand. Guest: That's a very good point. Let me emphasize something. Keynes's theory applies to issues that you have to face after a crisis. Keynes does not have a good theory--in fact, his theory is very, very poor--about how the crisis comes about. The only thing he mentions in the book is animal spirits. Russ: Which is a euphemism for 'I don't know.' Guest: Exactly. And besides it's not very clear, either, because in macro, as we said before, for something to be relevant it has to be macro, therefore systemic. So to say that we are in this mess because of animal spirits--what you are saying is not only that there is something like that, and everybody may agree that there is something like that going on and therefore there is some microeconomic playing with ideas like that; I don't disagree with that. But the other thing is to say that Monday morning all of a sudden we all decided that investment in housing was a bad idea, and we have a thousand crisis on your doorstep. That is what a good theory should explain. And to say that it is animal spirits--I mean, what is behind that coordination that took place? So, coming back to what I was saying: The reasons for the crisis are not generally discussed in the General Theory. And then there is this little model that comes out where, as you said, we have this magic pill that may work; at least it works in the model. But it's kind of strange. It's like going to your doctor and you say, I have a chest pain; and he says, Oh, that's animal spirits; let me give you a glass of water; you will probably feel better with a glass of water. For the next few minutes; and then you died. Because he doesn't know what happened to you. So, that's what I'm afraid of. I see many economists, Keynesian economists--a la Krugman, for example--insist this is the right pill, when actually we have not tried that pill. We tried that pill in the second World War, and I was looking at some numbers: the government deficit [expenditure--Econlib Ed.] increased by, I don't know, 600%[?], something like that. Not the deficit, expenditure, doubled on average during the war years. Now, that's something to think about now. I mean, maybe it worked but from a political point of view it's just simply unthinkable. Russ: Well, at the same time--my skepticism is, and we've had Robert Higgs on this program to talk about it: the real economy didn't do so well in WWII. Measured GDP (Gross Domestic Product) went up; it was not a time of prosperity. And then after the war, when government spending fell 60%, the Keynesians predicted a horrible depression--literally, a depression, worse than the recent one--and nothing happened. It was pretty good times for a few years. Then there was a little downturn, but it wasn't related necessarily to the spending, and it wasn't anything catastrophic. So, there's problems. I want to defend 'animal spirits,' by the way. I was making fun of it when I said it was a euphemism for 'I don't know.' I don't deny the fact that psychology matters a lot and there can be coordination in psychology that has systemic effects. It's just that we don't have a very good understanding of it. Guest: Yeah. Let me say something. I don't like the 'animal spirits' the way they are presented by Keynes and the Keynesians, when they insist that people all of a sudden are feeling depressed and investing much less, like 50% less, than they did in the recent past. I think that hard for me to swallow. Let me put it that way. But on the other hand, with liquidity it is a different story. I was mentioning before that there was some coordination. The difference is subtle but it's worth mentioning. In the Keynesian setup, if I want to have a real big effect from investment contraction to output, I have to have a big change in investment. When you think about liquidity, it's something that can be destroyed without any big switch anywhere. Because there are multiple equilibria--if I can use economists' jargon. There is more than one equilibrium because there is this phenomenon that liquidity is much more subtle, less of the fundamental than production, productivity, technical progress--those things are there and they stay there. They are not destroyed. Liquidity can be destroyed. Imagine all of a sudden Obama comes on TV and he says, Look, the dollar is now replaced by the Americano, which looks completely different. Russ: I wonder whose picture would be on it. But never mind. Go ahead. Who knows. No comment. Guest: Yes, maybe, who knows; I agree. But if that were to happen, the dollar would be worthless. It would be something that people would give to show their grandchildren. So, that's a problem with liquidity. I agree with you, that's why I'm not against animal spirits. But you need a little bit of animal spirits to destroy some assets, like liquid assets. A little bit of animal spirits are not enough to destroy capital.
40:55Russ: Let's turn to Irving Fisher, who is sort of the forgotten man of the time, the Great Depression. There are a lot of forgotten people there, but let's look at Irving Fisher. What was his insight, why is it important, and why did it get forgotten? Guest: Yeah, that's a very interesting story. His insight is really at some level very simple. The famous paper was written in 1933, and he had a book before, but he was very influenced by what he saw during the Great Depression, and what he saw is that wholesale prices for example fell by more than 30%. So, if you have a corporation and you borrow money at, say, 5%, and after the Depression or because of the Great Depression the price of your output falls by 30%, all of a sudden the real burden for you has increased tremendously. Because it was supposed-- Russ: The burden of your loan. Guest: The burden of your loan. In terms of your output, in terms of your income. So, what he points out is that when prices fall precipitously like it happened in the 1930s, that it increases the real value of the debt and may make some debts not payable. And lead to bankruptcies; and once you have bankruptcies, it's the stuff that we were discussing before: since we are all in this mess together, they have to know what happens and there is a generalized flight to safety. And then you have the liquidity trap, and so on and so forth. So, his insight was that it was based on a rigidity, another type of rigidity; and the rigidity is that many loans, in practice, even today, are what economists call 'non-state contingent'--nominal loans. Very simple loans. You get a loan at 10%, independently of how well you do. Or independently of whether it rains or snows, whatever. So, you don't make a loan contingent, especially, say, for housing. You get a mortgage at a certain rate; and you will have to pay that independent of what happens to the price of your house. And so on. So, those loans, which are very simple, very rigid, are common and are subject to this phenomenon that he called 'debt deflation.' Russ: And it's costly to renegotiate, obviously, in any one case. Guest: Exactly. Russ: The puzzle here is we didn't have--and we did a podcast on Fisher's insight with Garett Jones, by the way. People were very worried about deflation in this current crisis, because they'd seen correctly that that's what Japan had struggled with in their stagnation. So we didn't have that deflation. But you are making the point that we didn't have it overall in general, but we had it in the housing sector, and that debt cascade was very destructive within that sector. That's not a trivial sector. We've been talking about it like it's one little corner of the economy. Obviously the housing market is extremely important. It's where a lot of people have the bulk of their household wealth. Guest: Yeah. I meant the subprime was a corner of the market. Russ: Correct. Well, should Irving Fisher get more attention now? Guest: Yeah, no. I think the "mistake", you can attribute to Friedman and Schwartz. And Friedman particularly. He pushed very much the idea that the big mistake in the 1930s was for the Fed not to increase the money supply and keep prices from falling. He doesn't discuss why. It's kind of a very empirical observation. Russ: It's the magic black box of money affects things. Just like aggregate demand affects things. Guest: Exactly. Exactly. But a possible rationalization, and I'm surprised that he doesn't mention that, they don't mention that in the great book that they wrote: they don't mention Irving Fisher. But Irving Fisher has an explanation why you don't want to do that, and that is the real value of the debt goes up and then you may have a slew of bankruptcies, and so on and so forth. But they stop there. So now what we have done is to follow his advice and keep prices from falling. But it is the CPI (Consumer Price Index); it does not include the price of housing. So, we are still not out of the woods. It would seem to indicate that the credit market is still quite stagnant, even here in the States. So that seems to indicate that you have to do more; and when you think about it with the lens of Irving Fisher, I guess what he would say is: the CPI has not collapsed but those who are indebted, being indebted in order to buy a house, face exactly the same problem that he was concerned with--the debt deflation. Russ: You say the CPI doesn't include housing. It does include a measure of the price of houses. Guest: No, I agree. Russ: What you are really saying is that you can't just look at prices generally, as an aggregate. You have to sometimes look at pieces of it. Correct? Guest: Exactly. Exactly.
47:35Russ: So let me defend Friedman a little bit, at least intellectually. And who knows what he would have said in response to your challenge. But I can use his surrogate, which is Ben Bernanke. So, famously, Ben Bernanke said: We learned in the Great Depression, we learned from Milton Friedman, in the Great Depression the big mistake we made was we let the money supply drop. So he also ignored Irving Fisher. And then he came along; he happened to find himself in a position of power; he's Chair of the Fed; the crisis does come. And sure enough he injects a lot of money into the banks--and we can debate whether he injected the right amount. We can debate whether it was a good idea to pay interest on reserves--I think not. But whatever. Ben Bernanke, if he were listening, would say, All this stuff about the financial sector and Irving Fisher is irrelevant. All we need to do is keep the money supply up. We did that, and that's why we didn't have a Great Depression. And similar to the magic black box of Keynes and aggregate demand, you don't have to worry about the financial sector. You just have to keep the money supply going. And we found a mechanism to do that. We did it through interest rate policy; we did it through Quantitative Easing (QE). Didn't the Fed do a good job? Wouldn't that be his defense: I can ignore all that stuff you are worried about, Professor Calvo. Guest: Yeah. I'm not accusing him of doing the right thing. I think the Fed, what they did is really something to be celebrated, studied. So, nothing against that. I will agree that we avoided a Great Depression, maybe because of the very proactive policy of the Fed. Not only here but around the world, the developed markets and central banks. So, I don't deny that. The fact that the Fed however--the interest rate was not strong enough shows that the first QE was an attempt to buy toxic assets, indicates that they went beyond just controlling the money supply a la Friedman. This was a rather heterodox policy that they followed. So I don't think they were following the book of Friedman. They went beyond that. Of course, maybe Friedman would have said the same thing. Unfortunately he died before this process developed. But it became clear to them that increasing money supply as a pure monetarist would have said, without touching anything else, was not enough. Otherwise, why buy toxic assets? Why buy commercial paper? Stuff like that, which was unprecedented for the Fed. So I have nothing negative to say about the Fed. And I think probably the Fed could not be more expansionary, more pro-active, because the Fed does not have a mandate. The charter doesn't allow Bernanke to be more aggressive. But he was as aggressive as you can be, and different from a pure monetarist. So, I'm not accusing any of these people. These are fantastic economists and actually rather the exception in the profession. Russ: Let me push back on that a little bit. Maybe a lot. We'll see. But you suggest that their actions are to be celebrated. One, I'd say it's a little too early to tell. The Fed has a very large balance sheet, and we are not quite sure what the consequences of that will be as it, I hope, gets unwound. We don't know. And I guess the second question would be: Why do we praise the Fed for injecting money into the banking system that's still sitting on the books of the Fed? Where is the stimulus aspect of that? Where is the increase in the effective money supply? Where is the increase in liquidity? What they did was--I agree with you--they did respond in a financial-sector way by repairing the balance sheets of the banks. But that appears to be all they did. They didn't have much of an impact. You can argue that it would have been much worse. But the economy right now is extremely unhealthy, it seems. And it's not obvious that monetary policy has been helpful in that dimension. Especially when it's sitting on the books of the Fed. What's your response to that? Guest: Well, my response is that we do not have to forget that we have a financial problem. The financial sector is dysfunctional. More firms, households, because of the crisis and the collateral they have has shrunk and made it more difficult for them to borrow. There is some confusion in the market, things that I do not know the details but we can read about it, that prevents or stops banks from extending credit because they don't have enough information. This is a very difficult issue that is very unlikely that you build [?] from the Fed unless you follow much more micro[?] policy that the Fed is not intended to pursue. So, I agree with you that we are still in the middle of a crisis, and coming out of it very slowly. No doubt about it. But my only point is that the Fed, they probably did as much as they can. But I would make a point though, more of a conjecture than anything else, about interest rate policy. I'm not so much concerned about [?] liquidity, that is the [?] that is in the hands of the banks. The fact that the Fed and the central banks, they follow the standard practice of using the interest rate as an instrument--so they used the interest rate until it hits zero. And then, if that was not enough [?], they started the QE process. I'm a little concerned. It's not obvious that you should let the interest rate go down to 0 before you use QE. Because QE, I call it 'defragmentation policy.' It's a policy to try to open up, in my mind, to open up the credit channel. And the fact that interest rates went down to 0, I still, you see that as reaction in the market. It's an indication that the interest rate controlled by the Fed has very little impact on the credit market. Which is quite clear. The gray market was broken in the private sector and all you do by lowering interest rate was lending cheaper. I mean lowering the cost of borrowing for the official sector but not for the household- or the small firm-sector. So it's not clear that when you are using an instrument that became, that apparently became, was obviously ineffective. But instead of stopping it and saying, we have to do something else, we kept lowering that interest rate. Now, what is my concern. My concern is by lowering the interest rate on very liquid assets you may be giving incentives for the system to, for investors, to go out in search of other liquid assets. Different from U.S. liabilities. And that may have encouraged the flow of funds that went into emergent markets, for example. And that now, in my view, has perhaps increased the vulnerability of emergent markets. Something that we saw recently by the sale tapering experiment that didn't take effect but had a very big impact on countries that until then had received funds that in my mind are very much motivated by search for yield and liquidity at the same time. At once they feel, the markets feel that there is a threat that interest rates in the United States will go up or there is some type of illiquidity in the United States. The fads[?] fly back in [?], and then you have, in emergent markets, the phenomena that we discussed a moment ago: a liquidity crunch, and after that a sudden stop, something that those countries have experienced in the past.
57:06Russ: That's a very deep thought. And obviously we don't know if it's true. But it reminds me, and I think it should remind all of us how complicated this world is. You allude to it in your paper, the complexity of the world. And of course, central bankers have to pretend that everything is under control, they know exactly what they are doing. Before we are out of time: Your paper is very complementary to the Austrian economists Mises and Hayek. As far as I know, you don't have a past academic history as an Austrian economist. Those who are Austrian economists tend to like Mises and Hayek. Those who aren't Austrians tend to ignore them. So I was rather struck by the fact that you said we have something to learn from the Austrian business cycle of the 1920s and 1930s of Mises and Hayek. So talk about why their insights are potentially very important today. Guest: First of all, why I ignore Hayek and Mises. And the reason is that you don't see their names mentioned in standard economics courses in the best universities in the United States. There are exceptions, of course. But the most, those authors are not read. So that's not an excuse for being ignorant about it, but I declared myself ignorant before I started to think about these things, about these factors, these observations of the Austrian school. Now, this paper, which, as you mentioned the title of the paper is puzzling on this crisis, on the anatomy of this crisis, I am still puzzling. In the process of puzzling about it I went back and read these guys. And I was impressed by the fact that these guys were very well aware that these, for example, credit booms could foster a credit bust, and so on. And these two authors in particular, they were very forceful about making those cases. And I think Hayek makes it the most subtle of the two, for my taste. So, we having known them, partly I think also--I mean I am declaring myself at fault. But on the other hand they were not easy to read. Russ: They are not the best stylists. Especially Hayek is not--he's very difficult to read. Guest: Very difficult. And I was reading that Mr. Friedman once said: His theory was incomplete. Maybe it was. He intended to--right? You probably know much better than me--to continue writing on some of the topics. But the way that the theory has been, we have inherited, they have very good insights which are very relevant from an empirical point of view. But on the other hand they say[?] to develop a theory that is comparable to the other theories that have been developed in the 20th century. So it seems more like a statement than an elaboration where you can from assumptions into theory. They didn't write that way. We have become much more mathematical in the economics profession. Which is good on the one hand, but on the other hand it is bad because you miss from very deep insights from people like Hayek and from von Mises. So that's my explanation. Russ: Let 'a' be animal spirits is not really a mathematical solution. Would you say that also about Hyman Minsky? Do you think we need to pay more attention to Minsky? Guest: Yeah, another guy who is difficult to read. He is fighting--he was--I am surprised how unsuccessful he was even to persuade somebody like Jim Tobin. Jim Tobin has a review of his famous book, his latest book. And he is quite negative. And I was surprised because Tobin was one of the few that wrote into the picture different liquidity, liquid assets, and so on. But it's difficult. I mean, the lesson is that simple models carry the day. And the danger is that, precisely--simple models carry the day. And so the IS-LM was so powerful, perhaps because it was very simple. But it was too simple.
1:02:44Russ: To quote your paper--you have a sentence in there I loved. It says: "One has to realize that it is very hard to see beyond conventional models because reality is immensely complex." And I think--let me just put a plug in for Hayek's Nobel Prize Address, "The Pretence of Knowledge." What I think he reason he didn't do more in this area was he found it too hard. And your paper has some very interesting things. People who are professional economists listening and students will enjoy talking about these issues of how do you preserve rationality or some of the basic assumptions of economics within the context of, say, herd behavior, coordination. There are a lot of interesting methodological challenges that you are interested in taking up. And on that note, let's close on your thoughts about where you think macroeconomics is headed. So, Guillermo Calvo is reading Hayek and Mises and Minsky, and that's great. But you are a little bit alone. You are not totally alone. But it's quiet. It's not a big group that is with you. And many, many first-rate economists--I've read a lot of this literature, how people respond to the crisis--they say: My model was right before and it's still right. This is nothing unusual; there's nothing different here; it's just the standard application of what I've been saying all along. Do you think that viewpoint is going to persist or do you think we are in for some more fundamental changes in macroeconomics than might appear right now? Guest: I'm very concerned about that. Because not only many of our other colleagues think that way. And that's natural. Russ: Absolutely. Guest: Right. We all-- Russ: You have to dance with the one you came with. People are loyal. That's right. Guest: Right. And thinking is costly. I don't want to disparage anyone. But the thing is that-- Russ: And some of them can be right! They might be right. My view is, I'm not being critical of any one person. But they can't all be right. Because there are all too many models [?] that don't fit together so well. Guest: Right. My concern is that I think graduate students being fettered by their advisers and following on those lines because the want to get a Ph.D. and then they want to get their papers published in good journals, and so on. So there is an inertia, an enormous inertia there. And some of the papers that I see coming out, say, for example, in the National Bureau of Economic Research--I'm amazed. There are many papers that are coming out these days, especially theoretical papers, by outstanding analysts, where the assumption is, one key assumption is that the credit market is perfect. It's working perfectly. And then try to apply the implications of the model to what we see out there, to government[?] debate or whether fiscal policy is the right thing to do or not. When, in my mind, it's just the very assumptions that they make involved the very thing that they try to get out of. So, these are kind of intertia and still very high respect for mathematical sophistication, which I have nothing negative to say, but concern when mathematics overtakes economics. And I, in fact, the paper you mentioned, I made a very conscious attempt to keep myself out of technicalities. Because I think we are that point--and that's what I try to tell my students--where we have to think about some basic issues. We have to look at the real world. There are a lot of data available, with a minimum of theory and minimum of prejudice, and see what the numbers are telling us. I mean, what's happening out there. I think that's very valuable. This urge to go back to the old models and have them tell you an answer which looks like this is in line with the facts--I think it's a very dangerous practice, because, you know, one of the things that has become very popular is calibration. And calibration, what you do is have a model which has become a completely theoretical construct; put some shocks into the model, play with the shocks, and then see if the model replicates what you see out there. Well, if you keep playing with the shocks, eventually you hit the mark. But that doesn't mean you are closer to reality. Another thing--to do that, you spend lots and lots of hours programming your models and so on and so forth, and not thinking about the real world but thinking about your model. And there is a lot of activity, effort, put into those things. That's why I'm really concerned that at least from top academic places we are not going to get new, fresh ideas which are useful. On the other hand, policy makers are very active. And I'm having more fun now going to meetings of central bankers. Because those guys, they have to face the real world. They cannot pretend, I mean hide themselves, behind a model.