Scott Sumner on Money and the Fed
Jan 2 2012

Scott Sumner of Bentley University and the blog The Money Illusion talks with EconTalk host Russ Roberts about the state of monetary policy, the actions of the Federal Reserve over the past two years and the state of the economy. Sumner argues that monetary policy has been too tight and helped create the crisis. He disputes the relevance of the so-called liquidity trap and argues that aggressive monetary policy is both possible and desirable. The conversation closes with a discussion of what we have learned and failed to learn during the crisis.

David Beckworth on Money, Monetary Policy, and the Great Recession
Was the Financial Crisis of 2008 caused by a crisis in the housing market? Or did the Federal Reserve turn a garden-variety recession into the Great Recession? David Beckworth of Western Kentucky University talks with EconTalk host Russ Roberts about...
Scott Sumner on Interest Rates
Scott Sumner, of Bentley University talks with EconTalk host Russ Roberts about interest rates. Sumner suggests that professional economists sometimes confuse cause and effect with respect to prices and quantities. Low interest rates need not encourage investment for example, if...
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.


Jan 2 2012 at 10:09am

Great podcast, thank you.

I think that we should at least try following Scott’s advice but I still have 2 questions.

1. What assets should the fed buy and what sequence. E.g. do they start buying all short term treasuries then, if NGDP is still too low, go to longer and longer term treasuries and then to corporate bonds and then to stocks and then to land and then to homes or do they try to estimate what are the most undervalued assets and start there?

2. If the fed is successful in getting inflation to 4%/year and it causes a loss of value of some of the t-bills that the fed is holding, can the fed still reabsorb enough assets to keep inflation below 10% a year?

Jan 2 2012 at 11:50am

The reserves are there as show for the creditors of the bank holding the reserves; they don’t want it spent. It’s a credit-confidence contribution.

The economy isn’t recovering not because of anything monetary but because of huge new regulatory wedges against exchange, for instance the health care and environmental, and because of the demise of rule of law in contracts. The government can take anything you have these days, if you’re a business with any contract agreements.

The monetary policy guy isn’t going to spot that the partial derivatives don’t work they way they used to, once most of the familiar GDP activity is now in fact unprofitable owing to these wedges (wedge = government levying a dead weight cost on transactions). Trades that used to be mutually profitable for large numbers of people now are profitable only for a few or none.

You can’t make these trades profitable by changing the monetary unit! They can’t be driven to happen by monetary policy.

Then the question is what happens if you try monetary policy anyhow. The answer is huge inflation and nothing else.

Jan 2 2012 at 7:08pm

Great podcast. Sumner comes across as smart and non-ideological, and is convincing. But I agree with Floccina, and also Russ, who pushed Scott into getting specific about how to increase nominal GDP if banks won’t lend and demand for loans is weak. What assets, specifically, should the Fed buy? Is it possible Bernanke realized that it would be politically risky for the Fed to start roaming garage sales? Who would get first dibs on the Fed’s dollars? Could you separate politics from the decisions about what assets to buy, and in what order? Russ, isn’t one of the central Austrian criticisms of conventional monetary policy precisely that it distorts investment decisions and relative prices?

William B
Jan 2 2012 at 11:31pm

Russ – Have you ever read America’s Great Depression, by Murray Rothbard? I am not a Rothbardian, but it is a great book and gives a very different view than Friedman.

Also, what’s with all these Johnny Come-Lately’s like Sumner pretending to be experts on the recession? Many Austrians saw it coming and offer a valid solution (e.g. let the market correct itself, however painful), whereas people like Sumner were blind-sided yet still claim to have the answers. Hasn’t the idea of the “liquidity trap” been disproven time and time again throughout history?

Jan 3 2012 at 9:47am

Great interview.

One of my questions for Scott would be…does this formula for 5% NGDP apply regardless of fiscal policy and these other factors that impact real GDP growth?

What if government policy was so bad that there was chronic low or negative growth, and the Fed continued pushing a 5% target…wouldn’t that just result in high inflation and ultimately do more damage?

David B. Collum
Jan 3 2012 at 4:54pm

The reason deflation scares everybody so much is because, as Russ said, it is rare (in an inherently inflationary system.) It also results from bad monetary policy preceeding it. (Bernanke never mentions this part in his roll as Fed Chair.) I am more forgiving of the Fed in the 1920s than I used to be, recognizing that the Fed was new (very green) and were wrestling with some nasty post war problems (nicely described in “The Lords of Finance”.) With that said, you can still criticize them for trying to head off the inevitable post-war deflation rather than let it run its course. But modern policy wonks never want to mention the three years in the 1920s in which the money supply was really ramped up and the multiple reductions in the reserve requirements. (This is all spelled out in living color in “Banking and the Business Cycle” by Nelson, Phillips, and McManus, 1937). Of course, we eventually got deflation anyway. I think the monetary policy of the Greenspan Fed, however, was unforgiveable. AG wanted to be the hero by precluding all recessions and crises. (I don’t like throwing up, but I don’t stick a rag in my mouth when I feel nauseous.) AG gets this mess on his resume.

All this intervention is what is spooking the markets. Hayek argued that even arbitrary and capricious rules can be dealth with by the free market. The rapidly changing set of rules–rapidly changing adjustments in monetary policy–are replusive to those who would like to move forward with some sense of what is coming. My dad was a contractor and president of a state builder’s exchange. In this latter job, he negotiated with state trade unions for contracts. Despite his role as a contractor, he argued that unions offered the advantage of providing predictable wages. You desperately need that when you are planning. The Fed is in the business of displacing markets away from their anthropomorphic efforts to find equilibrium. There is no way to plan for what the Fed will do because they haven’t a clue what they will do.

Some of us don’t believe that a panel of characters can sit around a table and determine the appropriate cost of capital. It seems like arrogance at its finest. Bernanke’s “fatal conceipt” is his belief that he actually has a say in what happens. When Japan has deflation and Bernanke says they need inflation, what is this based on? The markets seem to be saying that they need deflation. How can anybody think they are that smart? From the outside looking in, I find the whole concept of monetary policy a paradox wrapped in an enigma. Can you imagine if a bunch of biologists sat around and tried to design a new and improved elephant because the current version wasn’t working so well as they had hoped? We got into this mess because of excessive interventions. We will not extricate ourselves from this mess using the same tactics.

BTW-Paul Krugman wrote an article in 2002 suggesting Greenspan needed to create a housing bubble. I would not hitch myself to his wagon.

Jan 3 2012 at 7:39pm

Great podcast! I found it so interesting that I stopped what I was doing to just listen to the podcast.

Jan 3 2012 at 8:03pm

I thought it was a very good podcast. I’m still a little unclear on why there are so many excess reserves, and how the Fed is supposed to stimulate (although I find it reasonable that they could boost nominal GDP if they were determined). Do banks really have nothing better to do than earn 0.25% on reserves, even if short-term T-bills are yielding zero?

Gary Rogers
Jan 3 2012 at 11:38pm

I will add my praise for an excellent podcast.

Not considering the effects of huge deficits on money supply, though, seems like working blindfolded and with one hand tied behind your back. After all, isn’t government borrowing the exact opposite of quantitative easing. With QE, the Fed buys debt to inject liquidity; but when the government borrows $1.5 trillion per year it is removing that amount from the liquidity of the most productive sector of the economy. I know that most economists will answer that the borrowed money is offset by stimulus spending but I would argue that the money is taken from productive uses and is spent on questionably productive stimulus projects.

In fact, all of the failed efforts of governments to fix their economy with deficit spending that I know about have resulted in the central bank scrambling to provide liquidity to stop the stagnation. Sometimes they go too far like the Weimar Republic or Zimbabwe and sometimes they just strugle as we did in the 30’s, 70’s and recently or like Japan as discussed in this podcaast. Maybe the Fed is trying to provide a transfusion to a badly bleeding patient and what really needs to be done is stop the bleeding. In any case I don’t think the Fed can be successful by only looking at their small piece of the picture.

Thanks again for an excellent podcast. It was very informative.

Trevor C
Jan 4 2012 at 9:28am

You and Scott keep using the word recovery. How would you define it?

Or what kind of growth? Standard of living, GDP, Employment, Decrease in Debts/Deficits?

I personally don’t spend a lot because I don’t need any more stuff, I would need a bigger house.

It’s like politicians and bankers live on the other side of the looking glass while economists try to translate their actions to the layman.

Jan 4 2012 at 1:27pm

In the beginning of this podcast it is mentioned that their is concensus that monetary policy can increase nominal GDP (seems true) but it is questionable whether it can structuraly increase real GDP on the long term. Even your guest did not seem certain about the fact whether an increase in real GDP can be obtained.

To me this seems to make the whole debate somewhat irrelevant. Is all this talking only about decreasing the variability of real GDP growth, without the belief it will increase the real long term growth? What is the point of that, given that apparently even that is very difficult?

Jan 4 2012 at 4:24pm

A great podcast again…this one really piqued my interest on several topics.

1. As usual great subtext…OWS was a looming topic in the whole discussion, practically jumping out in the first half. Maybe you should send this podcast as a lecture to the various OWS encampments. Of course we would have to hope they would see the point. Then again…they all have Ipads so why send them anything.

2. Were you really talking about velocity in regard to how the interest rate on excess reserves alters money demand? Look at the historical M2 velocity chart as compared to the “hockey stick” excess reserves chart…correlation or causation? It’s further supported by the interest rate on those excess reserves…M2 plummeted in response to the 1% rate and now is flattening and increasing during the adjustment to the flat 1/4%.

3. Is there an available estimate on the effect of the above? I mean, even removing the actual value of the excess reserves (which I agree is almost meaningless with the current monetary policy), can we estimate the effect on nominal spending, and by extension overall growth (and jobs), if we werent lining the pockets of the bankers (see OWS above)? I have read the estimated overall loss to the economy due to this policy is about $210 billion…thats what, about 7% of gdp. Interesting number no?

4. Finally, and I plead almost total naivete on this, but might the above be an illustration of the effects of going back on a gold standard? I have always thought that a weakness of a gold standard is the fact that every unit of currency came with a built in value loss due to production. Not to mention the looming political cost when we run out of gold (as illustrated by the oil economy of today). Anyway, I see the rate on excess reserves as comparablet to the production cost of gold, bringing with it all the negative effects you discussed with Scott (and have previously discussed) as being an illustration why the gold standard is imperfect.

Jan 5 2012 at 6:13am

Great podcast, but I wondered about the following.

If govt is borrowing 9% of GDP to create 2-3% ‘growth’ of GDP, surely this is long term not going to work based on the math dynamics alone?

Doesn’t this idea of NGDP targeting rest on the assumption people will take out more debt?
How will this happen if there are no worthy borrowers (from the bubble). i.e. IR will remain low until borrowers show up, which could be a while id debt needs to be repaid.

Don’t reserves follow loans being made, how will tinkering with 0.25%-1% paid on reserves affect things in the real world?

Jan 5 2012 at 6:40am

Rather than debating who and what the person running the Fed should do to move prices around why not cut out the games and just fix prices or at least floors for favoured assets of people like Sumner, say bank stock prices, or the assets they own, or say for that matter housing?

At least it would be more honest.

I think what these Wizard of Oz type of characters overlook is that the market is trying desperately to reprice what was an incorrect relative pricing structure in the economy out and simply ignoring that and trying to move prices by various monetary policies ignores the underlying cause of the problems in the first place (and in my view will only deepen the underlying problems).

An Austrian minded person would note that the the Fed itself is largely culpable and if it listened to people like Sumner who seems to think the solution is simply getting prices back up again then we have learnt very little from this crisis.

Jan 5 2012 at 6:56am

Also lets assume that NGDP targeting is successful and the Fed achives 4% NGDP growth achieved by 2.5% inflation and 1.5% real growth.

Doesn’t it come down to how you are actually measuring the ‘inflation’ component.
For example in the Feds ‘QE2’, money just poured into speculative markets, oil etc. It’s hard to argue this has any benefits for the economy overall, yet isn’t included in core CPI as the Fed ‘strips’ it out as being volatile, when the Fed itself makes up at least some component of that volatility.

Jan 5 2012 at 11:12pm

After listening to the podcast from yet another expert, I am ever more convinced that the Austrians have the problem correctly identified: The Fed and government at all levels over the past 2 decades have created a giant amount of poorly allocated scarce resources. And to make matters worse these same agencies are fighting the self correcting Price System and drawing out some very painful changes that must happen in the economy.

And I am even more convinced that the best solution is the Austrian Solution which is to stop trying to correct the problems and let consumers and entrepreneurs allocate scarce resources through the price system.

But doing nothing is way too radical instead the guest recommends that the Fed embark on a massive purchasing spree buying stuff (Does not identify exactly what stuff) off the conventional markets driving up prices to create a nominal growth rate of more than 4%. And this will change consumer expectations as they see their currency become worthless and force them to go on a buying spree.

I think this is the radical solution that will not put the country into Growth Frenzy but instead will devalue savings even further, turn what is left of private enterprise into full blown Fascism or worse Fed/Government Owned Industry. What a nightmare!!!

Gold and oil will be great investments if we follow the advice of the guest.

Mike Montchalin
Jan 6 2012 at 12:06pm

For now, with the reserves being pseudo-sterilized, we have apparent deflation.

Under what conditions will those reserves be liberated?

I would guess it would be rising interest rates, which could be brought on by sovereign offerings. Since bankers know they will always be bailed-out, they will not acknowledge the risk and will buy those risky offerings.

The apparent monetary stability may not be so stable.

Scott Sumner
Jan 6 2012 at 2:06pm

Floccina, I don’t think the Fed would have to buy any assets if they set a higher NGDP target, level targeting. But if they did, I’d have them buy T-securities.

I am travelling, and will answer other comments when I return.

Scott sumner
Jan 6 2012 at 2:32pm

Rhhardin, I,m not suggesting we “try monetary policy”, we are doing monetary policy every day. The problem is that our current monetary policy is highly unstable, and worsens the business cycle. I want a stable money policy.

Obama,s interventions have not helped, but those sorts of policies are trivial compared to what LBJ did, and the economy boomed under LBJ. It is not plausible that some mild regulatory changes could suddenly cause unemployment to rise from 5 percent to 10 percent.

Scott Sumner
Jan 6 2012 at 2:42pm

William, No one, including Austrians, is able to predict recessions. I agree that liquidity traps are a myth.

TMS, Inflation is not damaging unless accompanied by high NGDP growth. The damage most economists believe is caused by inflation is actually caused by high NGDP growth. We should completely ignore inflation and focus on NGDP. Hayek had some good things to say on this issue.

Jan 6 2012 at 6:20pm


“It is not plausible that some mild regulatory changes could suddenly cause unemployment to rise from 5 percent to 10 percent.”

covers the effect of regulation upon regulation, and the magical thinking that just one more regulation won’t hurt.

It takes a decline and makes it permanent by making transactions unprofitable.

Jan 7 2012 at 12:34am

Sumner is wrong on so many levels.

Without diagnosing the problem as unsustainable private sector debt expansion based on ponzi asset price rises – with the banks creating money as they make loans…

… his solution is completely without merit. Targetting nominal income when a good proportion of the prior spending income (~18%, 2007) was new loans to the private sector is ridiculous.

What’s the fundamental problem? Thinking that someone’s loan comes from someone else’s savings. It doesn’t (sorry Mises/Hayek) – it comes from the banks who create money when they issue loans.

So ultimately money is created by private sector demand for loans – that’s the unrecognised problem.

Unless you are Steve Keen from Australia.

Please please can Econtalk interview Steve Keen

William B
Jan 7 2012 at 11:54am

Professor Sumner,

You say:

“No one, including Austrians, is able to predict recessions.”

That statement is simply untrue. I highly recommend you watch Peter Schiff’s speech at the Mortgage Bankers Conference in 2006. It might be the best hour you’ve ever spent.

And when you’re done with that, take a look at his speech at the Henry Hazlitt Memorial Lecture in 2009. That will clearly explain HOW he was able to see it coming.

And if you want further evidence of his predictions, just take a look a the viral “Peter Schiff Was Right” video.

I know there are other Austrians who made similar predictions, but Peter happens to be the most prominent.

You are TRULY doing yourself a disservice if you don’t watch at least the speech at the Mortgage Bankers Conference.

Kenneth Knox
Jan 8 2012 at 1:28pm

Hello all,

William B, I am listening to the first link you posted so far. The speech is pretty good as of (43 minutes in).

Scott Scumner, I look forward to the next interview and I will begin frequenting your blog.

Russ Roberts, I am a huge fan of your weekly podcasts. May I suggest a future podcast where you interview Satyajit Das (author of Traders, Guns, and Money and other derivatives based books) on the economics of hedging and derivatives markets. NPR’s Planet Money has interviewed him a couple of times and I think it would be entertaining and enlightening.

Kenneth Knox

William B
Jan 8 2012 at 6:03pm


Glad to see you took an interest in those links. If you enjoy the first one, I would highly recommend the other two as well. Schiff is one of the best speakers out there, and he does it all without a script.

If you do find them insightful, please do everyone a favor and post your opinions so that others might take an interest in them as well.

Jan 9 2012 at 9:05am


I actually did watch all the videos and would add that it would be great if Russ could interview Mr. Shiff at sometime in the future as well.

I want to add that I agree with quite a bit of what he had to say in the clips I listened too. I disagree with him on how our system will unravel though.

I am in the process of finishing Japan’s Policy Trap: Deflation, Dollars, Deflation, and the Crisis of Japanese Finance by Akio Mikuni and R. Taggart Murphy. I bring this up because I think China is using the dollar for the same reasons Japan (as outlined in the book referenced). I believe both countries want to stimulate their economies through exports, so the government/political parties can maintain power in their respective countries.

In essence, I think that we will meet our day of reckoning when those economies inevitably collapse (albeit in another 9-10 years). I consider this a mutual relationship, so even though China may posture about selling off treasurers I don’t see them doing it anytime soon.

Having said that, I agree with Peter’s dire warnings about what is ahead for the U.S. I believe that if the Eurozone wasn’t in crisis, money would have flowed out of U.S. debt into that of the Euro.

I am not a huge fan of commodity investments because there are way too many unknowns, in my view, compared to investing in stocks and bonds. We can speculate about input costs that China may need but in the end it is pure speculation.

Still, I think Peter Shiff is worth listening to whether someone agrees with him or not. As a side, I think gold is in the longest bubble in history.

Russ and Scott

To switch focus back to last weeks podcast, I learned much from Scott Sumner in the hour or so podcast. I, like him, tend to disagree with Paul Krugman on many levels. I will be adding The Money Illusion to my list of blogs I frequent which include: Calculated Risk, Footnoted, Dealbook, Mymoneyblog, Zerohedge, Profit Times and the Business Insider.

I appreciate Russ for the awesome podcasts, transcripts, and forum for likeminded individuals to communicate.


Scott Sumner
Jan 9 2012 at 9:44am

David Collum, I agree that the highly unstable monetary policy is a big problem.

Thanks Dave.

Andy, You said;

“Do banks really have nothing better to do than earn 0.25% on reserves, even if short-term T-bills are yielding zero?”

That must be the case, otherwise why would they hold so many ERs?

Gary, I don’t think it is the opposite, as the essence of M-policy isn’t the purchase of debt, but rather the sale of money.

Trevor, It would mean more jobs.

Rutger, It is very inefficent to have the periodic bouts of high unemployment, that’s a waste of human resources. In addition, it leads to bad policies in other areas, like bailouts of GM and 99 week unemployment insurance.

Tracy, $210 billion is barely 1% of GDP, not 7%.

I didn’t understand your question about M2.

RobertM, You asked:

“Doesn’t this idea of NGDP targeting rest on the assumption people will take out more debt?”

No, that might happen, but it should not be a goal of policy, and is not a necessary condition for recovery.

I agree the fiscal deficits are not sustainable.

Jonathan, You said;

“An Austrian minded person would note that the the Fed itself is largely culpable and if it listened to people like Sumner who seems to think the solution is simply getting prices back up again then we have learnt very little from this crisis.”

I don’t favor targeting inflation. Like Hayek, I believe stable NGDP growth means relative prices will stay closer to their equilibrium value.

Robert M, Money doesn’t go “into markets”–that’s a myth.

Bogart, You said;

“And I am even more convinced that the best solution is the Austrian Solution which is to stop trying to correct the problems and let consumers and entrepreneurs allocate scarce resources through the price system.”

That most certainly is not the Austrian view. Austrians favor correcting the currently highly unstable monetary regime with a much more stable one. So do I.

Scott Sumner
Jan 9 2012 at 9:55am

rhhardin, Look, I’m 56 years old, and have seen presidents that were much more interventionist than this one. Often the economy boomed (1963-69). There is no evidence that the sorts of interventions we’ve seen could cost millions of jobs, and indeed most of the job losses occurred under the last year of Bush.

Mark, Just because we have bad public policies in the debt area is no reason to compound the problem with bad monetary policy.

William, With all due repsect the evidence you present is meaningless. Recessions occur on average every 4 years. To say that at one time, one man, predicted a recession would occur in the future, when the economy is not in recession, is not very indicative of forecasting ability. If I predict snow, and it snows in Boston two days later, does that prove I’m a weather forecaster? Even if he predicted three recessions in a row it would prove nothing. It would probably just be luck.

And why not also tell me about the Peter Schiff predictions that proved false?

Thanks Kenneth.

William B
Jan 9 2012 at 11:53am


You say:

“With all due repsect the evidence you present is meaningless. Recessions occur on average every 4 years. To say that at one time, one man, predicted a recession would occur in the future, when the economy is not in recession, is not very indicative of forecasting ability.”

It is obvious from that statement that you have not watched the videos that I linked to. Schiff very clearly explains how, why, and when the downturn would occur. It is not possible to be perfectly accurate, of course, since the market behaves in odd ways at times, but he was far more accurate than pretty much any other person or computer model that I’m aware of.

Why don’t you do a Google search for Henry Hazlitt’s book “Thinking as a Science” (available in PDF format), and read the chapter on Prejudice. It has a good explanation of why you are unable to accept that someone might have seen the recession approaching.

Jan 9 2012 at 1:13pm

William B, I agree: I watched the first link video and it’s a great talk giving a very precise explanation of what was about to happen. Clearly not a talk of somebody who foresees doom all the time and then is right onetime.

Thanks for the links!

Jan 9 2012 at 5:32pm

Great interview and insights, especially from middle of 2008. I would love to have those running for President be forced to sit in a room and listen to this, and thereafter make commentary on what they agreed or disagreed with. Likely it would all be new information, as politicians pride themselves on superficial knowledge of economics, and not listening to those who are experts. I cannot see how we can get out of our country’s present mess(es) until we are able to at least understand discussions like those in this podcast. Impressed that Sumner is trying to change the minds of other economists, that everyone is still learning, and what will happen if the EU sinks.

Jan 10 2012 at 5:46am

Scott, you say ‘I don’t favor targeting inflation. Like Hayek, I believe stable NGDP growth means relative prices will stay closer to their equilibrium value.’
I guess there is some confusion around the definition of inflation. The Austrian guys think an expansion of the central bank’s balance sheet is inflation. In that case, your recommendation is inflationary.
The more mainstream definition is that inflation is higher prices… granted if you are expanding the CB balance sheet to try and prevent certain prices falling this is not inflation but you are interfering with the relative price signals of the market.

I do not understand the underlying premise that prices need to be kept ‘up’ nor the other premise that anyone person knows the ‘equilibrium prices’. Far too high a proportion of the world’s best educated minds spend their whole lives trying to figure out what prices should be for all manner of currencies, commodities, bonds, equitites etc. Why do we think a central banker will know any better?

I would note that in England, the value of a sovereign was worth more at Queen Victoria’s death than at her birth. Money increased in value during one of the greatest increases in productivity in history.

Given central bankers googleably poor ability to predict the future which in essence is what they are being required to do, versus a free market in money which history has shown to be compatible with coping with supply/demand without limiting growth, what is the reasoning behind the need for a planner to interfere with the currency?

David W
Jan 10 2012 at 9:56pm

This was a truly fabulous podcast and I learned a great deal. Thanks to Russ and Scott for an excellent exchange. I particularly appreciated Scott’s point that fiscal stimulus and monetary stimulus do not operate in isolation from one another and therefore tend to cancel one another out. Well done!

Joe Siegel
Jan 10 2012 at 10:10pm

Scott makes a great point that even .25% is reason enough in an essentially zero interest rate environment for banks to hold on such a large level of excess reserves, especially for smaller banks where this amount may make or break them.
What I found curious was that there was no mention of another reason why banks are not lending much. And that’s the free spread between borrowing at zero at the Fed’s discount window, and earning free $ using that money for then purchasing T-bills. A rational move by any bank CEO, as is holding on to excess reserves earning a risk free premium, even if a small one.

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Podcast Episode Highlights
0:36Intro. [Recording date: December 21, 2011.] Broad topic, my ignorance: I have trouble figuring out what's going on in the area of money and monetary policy. You seem to understand it, so I'm coming back to you to ask some of the same questions I've been asking for a while to see if I can get a little bit smarter. Let's start with a little bit of a review. In your perspective, what does monetary policy have to do with the mess that we are in right now? Basically, I see monetary policy as driving nominal spending in the economy, nominal income. By nominal you mean just the dollar value, rather than corrected for inflation? Right. So, if your listeners were to imagine their own income, and then add up everyone else's income in the entire United States, that would be total nominal income. And so that's the variable that I think is the key to the business cycle. Now, I don't think it's a key to long term economic growth. In fact, I don't think it really even matters much in that area. But in terms of the business cycle, I think fluctuations in nominal income or spending are really the key. I want to stop you there again. So, when you said it doesn't matter in the long run--you mean, for example, if we doubled nominal income, our wages doubling, but we didn't produce anything more, we'd have twice as much measured income, but we wouldn't be any richer. Right. Prices double, and then your real power of purchasing would be unchanged. So, that's an example of where the government could affect, say, nominal income as a whole, but in that example, we wouldn't be any better off. I think in most people's minds, this is one of the great sources of confusion in macroeconomics. "Well, but I'd have to double the income." Famous Mark Twain passage. People have trouble perceiving that your income--it depends what it can buy. If you can't buy any more, you are not any richer. Right. And I think one of the big confusions in macro is that people confuse two issues, the real and the nominal. So, some people talk about what can the Federal Reserve (Fed) do? There's one question which is: Can the Fed boost nominal spending or nominal income? And there's the second question, which is: Would more nominal income boost real output? And those are two very distinct questions. I think most economists believe that at least in the long run, monetary policy can target nominal variables or control them in some sense by controlling the quantity of money. There's somewhat more disagreement about how that plays out in terms of real variables--whether they are affected in the short run or not at all or over a fairly extensive period of time. But, when you see a lot of the debates about Fed policy, you see people mixing and confusing the two issues. What does it mean to say the Fed is out of ammunition or not able to do anything? Are you talking about nominal spending or are you talking about real output? Two very different questions. A good example would be Zimbabwe, which produced spectacular growth in nominal spending, but almost all through inflation, so there was no growth in real output. To the point where inflation was sufficiently high that real output would fall because the normal channels of exchange were so uncertain. Exactly. And of course, they had other supply side problems, too. So, that's one issue. My view is that there really should not be a serious debate about whether monetary policy can drive nominal variables. It's just a question of how determined the Central Bank is. They can print almost unlimited amounts of money. I think the real debate, in my mind, is: What is the proper path of nominal spending or inflation or whatever nominal variable you wish to target--could be the money supply, as Milton Friedman proposed. There's going to be some nominal variable that's going to be the anchor for the monetary system. Another example is the gold standard, where it was anchored to a fixed nominal price of gold for many years. So, you have a monetary policy that in some sense determines nominal aggregates--and I happen to think nominal income is the best one to stabilize. And then the second question is: If you do that, what sort of real outcomes in the economy do you get? And that's where I distinguish between the business cycle and long-run growth. I think monetary policy can help smooth out the business cycle by having a stable path of nominal income growth, but it can't speed up the real growth in the economy. That's due to structural factors, government policies, incentives, all sorts of productivity, etc.
5:47So, what went wrong, do you believe--there's two parts to this question. What went wrong to get us into the mess, and what has gone wrong with getting us out with respect to monetary policy? We debate in the policy sphere about every aspect of policy. We debate fiscal policy, we debate monetary policy, the structural things, side-issues about what to do with the housing market. But basically you focus a lot on monetary policy. So, what went wrong with monetary policy, both to get us here and to fail to get us out? First of all, if you just look at the path of nominal GDP over the last 5 years and knew nothing about the rest of the economy--you didn't know there was subprime bubble and crash and banking crisis and all that stuff, you didn't know who was elected President in 2008--you would predict a fairly severe recession, just based on the path of nominal GDP. In 2009 it fell at the fastest rate since the Great Depression, and it's grown very slowly since, much more slowly than in a normal recovery. So, that's one level of causation. But then of course people will say: But that doesn't really explain anything. Why did that happen? When we have a recession, isn't nominal income going to go down? No. For instance, in 1974 we had a very severe recession, and nominal income rose fairly briskly because we had high inflation. That was the famous oil shock case. So, real Gross Domestic Product (GDP) falling is actually the definition of a recession. So, if I were talking about real GDP I would have just stated a tautology. But nominal GDP, I do think there is a causal relationship between a fall in nominal GDP, which as I say I think is controllable by the Fed, and the impact on real output. And then the next question is: What caused GDP to fall? Certainly the Fed probably didn't want this to happen. There I think it's kind of a complicated story where parts of it have to do with the financial crisis sort of unintentionally made monetary policy more contractionary than the Fed wished or desired. And second, in late 2008 the financial crisis was a big distraction, so I think the Fed wasn't really focusing on the fact that its monetary policy stance was inadequate to promote nominal growth. And another thing is I think there is a tendency to confuse symptoms and causes. When you have a severe crisis, all sorts of things happen to an economy that look like causes that might very well be symptoms. For instance, almost every crash in nominal spending is associated with a financial crisis of one sort or another, throughout history. And there is a tendency at the time for people to blame the problems on the financial crisis because that's much more visible than the fall in nominal spending. So, that was the original view of the Great Depression--that it was caused by financial problems. Later, Milton Friedman and Anna Schwartz started to convince economists that it was actually monetary policy failure. I could point to examples like Argentina about 10 years ago where their deflation and all of nominal GDP led to the severe financial crisis. And then of course more recently--well, what's interesting about the current situation is you had, in both the United States and Europe, very real problems that had nothing to do with monetary policy. In the United States, it was our subprime fiasco. And in Europe it was fiscal policies, especially in places like Greece. So, those are outside of the story I'm telling. But what happened was that when nominal GDP fell in both places, each of those crises spread and became much larger than the original problem. So, you so of started with some bad loans made for a variety of reasons, and then you had this fall in nominal GDP. And instead of just having a subprime crisis in America, we had a huge debt crisis that spread into commercial loans, and municipal loans, and sorts of other things. And then in Europe instead of there being a Greek debt crisis, there became a Eurozone debt crisis because of the fall in nominal GDP. So people view the financial crisis as the problem, whereas I see it more as a symptom of a deeper problem, which is inadequate nominal income, which makes it tougher to repay loans. After all, most loans are nominal loans. They are not indexed to inflation. So, when nominal spending falls, it's much harder for people or governments to repay loans.
10:44Let's digress about that for a minute. My presumption remains, after many conversations, some on this program, that the real danger of deflation is a simple danger. It's not as frightening in and of itself as people make it out to be. The reason it's dangerous is that it's rare. It's often unexpected. And if I have made a promise to repay you $1000, which is as you say a nominal promise--meaning it's just a certain amount of money, that's all we mean by "nominal," it just means dollars, some absolute numbers--so if I promised to repay you $1000, if there is a deflation and I have trouble and my wages fall for example, all of a sudden my ability to repay that has changed. And you are expecting to get that money and do something with it. I might not be able to keep that promise. However, if we had expected deflation then we would have had a different interest rate implicit in that loan and things would have been very different. So, it's unexpected deflation that can lead to contractionary problems as people struggle. I think that's right. But let me just make one little addendum there. A good example was in the late 1920s when we had a little bit of deflation--maybe 1% or something per year. I'm not sure the exact number. But real GDP was growing strongly, so people's nominal incomes were going up maybe 3% a year, something like that. Because monetary policy was relatively neutral, you are saying. Relatively neutral. So, people sort of expected back in those days that there might be a little bit of deflation. So that didn't really create any problems for the economy. It did very well in the late 1920s, until the end of 1929. But what tends to happen is that when you get a severe deflation, it's almost always unanticipated. So, in the 1930s, we had this big drop in prices. And the reason why it's almost always unanticipated is: It's hard to have anticipated deflation at a rapid rate, because that would do is make the real return from holding cash become very high; and that's not like just an equilibrium solution to an economy. It's sometimes called a liquidity trap. So, if you had 10%/year deflation, people holding cash would earn a real rate of return of 10% on just sitting on cash in their wallets. And the economy isn't really capable of generating that kind of real rate of return on a safe asset like cash. So, instead you get a liquidity trap developed. What do you mean by that? I don't really mean "trap" in the sense most people use it. I don't think it's a barrier to expansionary monetary policy. All I mean is that you get a situation where people sort of hoard currency, and interest rates on other assets, like government bonds, fall close to zero. But that sort of environment--because that's not an equilibrium condition for the economy, to have that sort of real interest rate on cash, what would tend to happen is if you tried to run a deflation that was very rapid, you'd probably end up in a depression, for various reasons. But mild deflation which still allows for a positive interest rate is still a feasible solution, and we saw that in the late 1920s. Now, in our modern world unfortunately we are expecting not a 1920s situation but a positive rate of inflation and also positive real GDP growth. So, most people are probably expecting about 5% nominal growth, and they made their plans on that basis. They made wage contracts, signed debt contracts on those expectations, and when they didn't pan out--nominal income fell about 4% from mid-2008 to mid-2009, that fall was 9% below what people expected based on trends. So that really made it a lot harder to repay debt, and it pushed a lot of marginal debts over the line into problem debts. It still is true that much of the debt problem was bad decisions, but the amount of actual distress you have depends also on the ability of people to service those debts, which is national income basically.
15:12I want to come back to this parallel between our subprime crisis and the European crisis and how people see them as two different things, and you see them both being exacerbated, made worst dramatically by a failure of monetary policy. We'll come back to that. Let's stick with your observation a few minutes ago. You said the Fed, very focused in 2008 on the financial crisis, for whatever reason failed to note or failed to respond to this drop in nominal income and dropped the ball, made things worse. So, as a casual observer, I would be puzzled by that; and here's the obvious question. Help me understand it. Around that time, the Fed was doing some of the most aggressive monetary interventions of our lifetime. They were injecting a trillion, two trillion--I don't remember the numbers, you probably do--trillions of dollars in what's called high-powered money. That is not like literally printing money and dropping it from a helicopter, but entering it into its books; buying up assets from various banks and entering it into the books of those banks. Reserves, which they would now be free to lend. So, you are suggesting that the Fed was being negligent in being insufficiently aggressive and having too tight a monetary policy. But on the surface, it's the most aggressive, expansionary monetary policy in recent history--maybe ever. So, reconcile those two broad points. Let's be clear what we are talking about here. You are presenting what would be the liquidity trap view, that they pushed all this money out there and it didn't do anything. I'm not presenting anything. All I know is you look at the balance sheet. I have a mild horse in this race; we'll get to my horses later. Let me put it this way: I'm characterizing your view . In other words, there are two issues here. One is, would more nominal spending boost real spending; and the other is, would expansionary monetary policy boost nominal spending. And we just know from the data that we haven't gotten a lot of nominal spending in the last three years. So, the real question is why haven't we gotten much nominal spending given this big increase in the monetary base. And I think there are several reasons for that--probably three reasons I could cite. One reason is when they started doing this in late 2008, they simultaneously instituted a program called Interest on Reserves. They'd never done this before--paying banks interest on the reserves the banks held. And so what actually happened is almost all of this new money the Fed injected into the economy went into the banking system and sort of sat there as what's called excess reserves. Meaning cash that sits on the bank balance sheet but they are not doing anything with it other than collecting interest from the Fed. The Fed requires that they keep a certain minimum amount, and they are well above that minimum. Most banks. Usually what happens is required reserves would be like $50 billion, say, and excess reserves might be $1-2 billion. Now we have required reserves still being around $50-60 billion, across the whole system, but the excess reserves have gone into the trillions. Or maybe between $1-2 trillion. And that's from $1 billion or $2 billion. So, we're seeing an increase of a thousand fold, order of magnitude increase in excess reserves. It's almost all gone into the excess reserves category. I think there are two reasons for that. One is that the Fed started paying interest on reserves. Now, this might really surprise you, because people don't really remember it this way, but during the big crash in nominal GDP, which basically took place in the second half of 2008, the Fed's interest rate target was not yet at 0. It was running around 1-2%. And the Fed decided they wanted to put a lot of money into the banking system, a lot of liquidity to sort of bail out the banks, prevent the system from freezing up; but they didn't want a highly expansionary monetary policy. So, the reason they started paying interest on reserves, surprisingly, was to prevent interest rates from falling to zero sooner than they actually did. Now, in the end, in the middle of December, interest rates were finally cut close to zero. But during that big injection of money in the middle of 2008, the Fed specifically wanted it to stay in excess reserves and paid banks interest on that in the hopes that it would stay there and prevent interest rates from falling too fast. In other words, the policy was basically contractionary in its intent. And that's pretty generally accepted. Now, it was offset by the fact that a lot of money went in there. It didn't do anything. A term we use in monetary economics is that it was sterilized. It was made so that it didn't really have any effect. They paid banks to just sit on the money. Hang on. We are getting close to getting rid of some of my ignorance, because this is one of the deepest and strangest parts of this whole episode. Currently, banks are earning about a quarter of a percent on those excess reserves. Yes. And those who sneer at the implications of paying interest on those reserves say, well, a quarter of a percent on $2 trillion. Say, between $1 trillion and $2 trillion. People say that's such a small amount of money. But of course it was higher initially, as you point out. It was close to 1% initially. They changed it several times in late 2008, but it was somewhere around 1%. The other thing you have to look at. I'm not sure that right now that's a big problem, but even a quarter point is more than banks can earn on, say, Treasury Bills or certain alternative investments. You have to look not just at the amount that is paid but also at the banks' alternatives for other safe investments.
22:20All right, but so here's the question. You state it as if it were fact when you say why the Fed did this. We don't really know what's going on in the mind of the decision makers at the Fed. Ben Bernanke's the most prominent, but there are other people with influence. It's somewhat of an emergent decision. It's deeply puzzling, why at a time when the American economy, when unemployment stinks, when the economy is recovering at a tepid pace, very disappointing to everybody across the political spectrum--why would the Federal Reserve discourage its activity from having an impact? It does nothing. Let me state it in a way that's not at all controversial, and give you something that's in the public record. Two days after Lehman Brothers failed in September, the economy was clearly worsening. The Fed had a meeting and they decided not to cut interest rates. They left their target at 2%. Here's my question. If in the fall of 2008, the Fed was doing all it can to revive the economy, why would it not have cut the Fed target from 2% to say, 1.75%, 1.5%, 1.25%, 1%, .75%? This is certainly what I favored at the time. I think we compress history in our minds, and we remember the Fed getting more aggressive in early 2009 when it started the first quantitative easing program. But I think we tend to forget that in the last half of 2008, when the actual collapse in nominal GDP occurred, the Fed was actually pretty passive. After Lehman Brothers failed they issued a statement saying that "we see the risks of inflation and recession as being equally balanced." In other words, from their point of view, the economy was right on target, but there was some risk that there would be too much spending in 2009, and some risk that there would be too little spending in 2009. Those risks were balanced, so they said: On balance, we're not going to cut interest rates. At the same time they wanted to push a lot of money into the banking system. Other things equal, that's clearly expansionary. My point about interest on reserves is that it essentially neutralized that injection. The injection of all the money was expansionary; then the decision to pay interest on reserves sort of tied up the money and made it non-expansionary. So, if you net the two out, it's simply a passive stance by the Fed. So, I've suggested--it's a depressing suggestion--that the policy of paying interest on those reserves was simply a back door subsidy to the banking system. Again, people say: Well, it's only $5 billion at the current rate--$2 trillion in reserves at a quarter percent is about $5 billion. At 1% it's about $20 billion. And you can argue whether $20 billion is a lot or a little bit of money. I think for some banks it was a great deal of money. You can't just look at the entire system and say: Well, for the overall system it's a trivial subsidy. I think for certain banks it may have been the difference between survival or not. That's certainly possible. That's the empirical question I'd want to investigate. It's possible they had these twin objectives--they wanted to put money in there to help the banks, and they wanted to not have interest rates fall to zero. As you probably know, if you inject a lot of money into the system, the free market interest rate will tend to fall, normally, because you are increasing the supply of money, so that depresses interest rates through the liquidity effect. That's how monetary policy normally operates. So, this huge injection, late 2008, normally would have pushed interest rates immediately to zero if the Fed had not done the interest on reserves. So, why did--let's give the Fed the benefit of the doubt--why was that an unattractive outcome for them? To push interest rates to zero right away? Yes. As I said, believe it or not, they said that the risks of inflation and recession were equally balanced. They were sort of looking through the rear view mirror. Inflation had been high in the previous 12 months, but the futures markets, or more specifically what's called the TIPs spreads, which is the difference between interest rates on regular bonds and indexed bonds, those financial market indicators showed that investors expected about 1.2% inflation per year over the next 5 years. Very low. That's below the Fed's implicit 2% target. So, I've argued that actually the Fed should have worried about inflation being too low, not too high. But they were sort of like driving a car by looking in the rear view mirror, and trying to notice when it was going off the road; and they weren't looking at the market indicators, looking down the line to see where the economy was headed. And if they had done so, they would have seen that inflation was probably going to come in below target. Now, let me hasten to add--these are just futures indicators. They are often incorrect. It just so happens that the one I cited the day after the meeting the day that Lehman failed did turn out to be fairly accurate--we've run about 1.2% inflation on average since that meeting. Although it's been highly volatile. Deflation in 2009 and much higher inflation in 2011. But on average we've had about 1.2% inflation over the last 3 years. That was one of their mistakes, to have a backward looking policy and not take market indicators into account. I think if they'd done so they would have been more aggressive. I think if they could go back in a time machine, seeing what's happened I think they now realize they made a mistake in late 2008; and some of the aggressive moves they've done which have not had much effect, which I'll get to in a moment, would have been more helpful back then. The problem we are in now is once interest rates get near zero, even eliminating interest on reserves may not be enough to get the money circulating in the economy. Because with interest rates near zero there is almost no opportunity cost for banks to just sit on money. What you really need then is a more aggressive policy of targeting some variable, like inflation or nominal GDP, at a level that will raise expectations of future nominal growth and make the price of assets go up and the demand for credit go up and boost spending in the economy. And the Fed is unwilling to do that. So, they've missed their chance to play around with conventional policies like cutting interest rates, which they could have done after Lehman failed. Now they are in a more difficult, unconventional world where they can't cut interest rates any more because they are near zero; and they are simply afraid of using, for whatever reason, unconventional policies that would be effective. Although they've tried some ineffective unconventional policies. Let me be more precise--not completely ineffective, but not effective enough. I would say that all the things they've done probably have prevented the economy from being in a deeper depression right now--I'll concede that--but not enough to promote a rapid recovery like we saw from the 1980s recession, for example. Which was also a fairly large one. Another deep recession. And that one had a very fast recovery, along with very fast nominal GDP growth. Again, to me in a way there's no mystery about the weak recovery. If people say: Where are the jobs? There's no jobs because GDP growth is slow in real terms. Why is real GDP growth slow? No mystery there either--nominal GDP growth is very slow. So, in the 1983-1984 recovery, nominal GDP growth averaged about 11% annual rate for six quarters. In this recovery, it's been a little over 4, 4-4.5%. What does that mean? It means that in a world of low inflation, you are only getting about 3% real growth, which is barely above trend. And that's why we've had such a small reduction in the unemployment rate. We're growing in this recovery over the last few years just barely above trend.
31:18But all of this presumes that somebody's in charge of nominal income and nominal spending. If we went back to that 1983-84 recession, can you point to things that the Fed did rather than things that just turned out that way? Well, they had an easier job, because all they really needed to do was just cut interest rates to promote a more rapid recovery, and they did that aggressively. They started high. Now, in our situation--and by the way, it's not just the Fed. What I found looking around the world today or looking back through history, is every single time, I believe, that countries get into this zero-rate situation, monetary policy tends to be less expansionary than expected. You tend to stay in this slow nominal growth phase for often an extended period of time, and we went to low interest rates in the early 1930s and they stayed that way almost all the way into the early 1950s. Japan went to near-zero interest rates some time around the mid-1990s and they are still there. Europe and the United States have gone into a low-interest rate environment in the last three years and are basically still there. And even more interesting is the fact that twice in Japan and twice in Europe they tried to escape from it by raising rates, and they did so prematurely; and each of those four occasions, the Central Bank had to do an embarrassing about-face very quickly and cut them right back down. It occurred in Japan in 2000, in 2006 where they raised rates--the economy slowed and they quickly had to cut them again. And in Europe, the European Central Bank raised rates in mid-2008 and then had to cut them soon after; and they did it just this year in April, I believe they raised rates from about 1 to 1.5%; and then the European economy slowed in the latter part of this year and the European Central Bank has recently cut them right back down. So, those are four very embarrassing about-faces for central banks, all because they were anxious to get out of the zero-rate trap but hadn't created the robust nominal growth that would support higher interest rates. So, they did it prematurely, essentially. But where's the cause and effect? If you ask a person, somebody running a business, and say: Interest rates are really low. This is your chance to go out there and really do some great projects. Why isn't that happening? The standard answer you hear is: Banks are uneasy about lending because the future is uncertain, and businesses are uneasy about investing, because the future is uncertain, and that's why interest rates are low. Is that true? Excuse me--that's why we don't see a lot of investment. It depends on what you mean by uncertain. There's kind of two arguments on this, the liberal argument and the conservative argument. And they are both probably true to some extent. The liberal argument is that the low interest rates haven't helped because there's not much demand in the economy. Not much spending. So companies are operating factories at, say, 75% of potential; they don't need to borrow to expand their plant, equipment because there's not much demand for their goods. Or, in the housing market, sure there are low interest rates, but since house prices keep falling why would someone want to buy a house now? So, there's not much demand for credit. And so the interest rates reflect a weak economy. The conservative argument is that a lot of bad government policies scare businesses, deter investments--taxes, regulation, and so on. And that may be true, and I think it is true to some extent. But the liberal argument here is really all you need. I don't think it's a complete explanation of the recession, and I've argued to some extent against liberals on some issues like unemployment insurance and other things that I think are increasing the structural rate of unemployment in the economy. But on balance I think that when you have very weak nominal spending, the free market interest rate will tend to fall to zero even in an economy that doesn't have a lot of structural weaknesses. It's not an assumption you need to explain what's going on here.
35:49But then what's the implication of what we ought to be doing? The left-of-center approach is, say: We just need to spend more. We need to get nominal income up--they agree with you. Nominal income has been falling or is not rising at a fast enough rate, so something needs to fill that gap by spending more money. That's their standard argument. Why are they wrong? They are arguing for government spending, which I think first of all won't really help very much. And second, monetary stimulus. The best way and probably the only way to promote faster nominal GDP growth is to get a more expansionary monetary policy. So, I think the mistake on the left is to put too much faith in fiscal stimulus. Fiscal stimulus is relatively weak, and it also tends to be offset or neutralized by monetary policy. But let's say monetary policy stayed as it is; the President and the Congress got the Keynesian religion; they listened to Paul Krugman and they increase government spending in the United States by over a trillion dollars this year, which is what many people are advocating who are Keynesians. They argue interest rates are too low; the Fed has no bullets left. So, they can't lower the interest rate any more; so the best thing to do is have government spend. Government spending a trillion dollars--isn't that going to increase nominal income? Here's the tricky part: When you said, let's leave monetary policy as it is, you slid over a very subtle and complicated question, and that is: What is monetary policy? And I find when I talk to people, everybody I talk to seems to have a clear and definite idea in their mind about what we mean by holding monetary policy constant. But they don't equate with each other. So, for some people that means the Fed keeping the money supply constant. For others it means keeping interest rates constant. Which is a very different policy. And I think both of those are wrong because it's not what the Fed is actually doing. What the Fed is actually doing is adjusting monetary policy to conditions in the aggregate economy. So, they'll do some quantitative easing (QE), then they'll back off; they'll do some more. Or Operation Twist. Or they'll promise to keep interest rates low for two years. And these policies are not highly effective, but they are probably effective in slightly nudging the economy a little bit faster, a little bit slower. So, what the Fed is doing is these on and off policies as it reads the incoming economic data. If the data gets stronger, the Fed does less. When the data gets weaker, the Fed does more. What that means is fiscal stimulus does succeed in promoting a little bit faster growth; the Fed will react by doing less quantitative easing and other policies of that sort; and it will very likely neutralize most of the effect of the fiscal stimulus. Now, I'm not trying to stake out an extreme position here. If the Federal government did an enormous amount of fiscal stimulus, yes, I think it would boost nominal GDP. Whether it would be a good idea would be another question. But obviously, if you took it to the extreme like the spending in WWII, it would definitely boost measured GDP in the economy. But for the amounts that are politically realistic, I really don't think--let me put it this way: The original stimulus bill was originally around $800 billion, in 2009. Ended up being $825 billion. I think it was a mixture of spending and some tax rebates. About 1/3 each--1/3 tax rebate, 2/3 spending, and of that 2/3, 1/3 on payments to the states and 1/3 on various so-called expansionary activities of various kinds. And that was done in early 2009. About the same time the Fed was getting very worried about the economy. It wasn't "done" in 2009. The legislation authorizing it was enacted. It took a while to spend it; it spent out over 2 or 3 years. Right. But importantly, by the way, a lot of modern theories say the effect on demand should come with expectations; so it should start even when the program is not enacted. You've got that program, then. The standard way of looking at it is to assume the Fed is just this passive bystander. But everything we know about Ben Bernanke, throughout his career, tells us very clearly he had no intention of allowing a Great Depression II on his watch. He's a scholar of the Great Depression. He passionately believes the Fed blew it by not being more aggressive. He's also insisted all along the Fed has lots of ammunition they haven't used. He's talked about things they could do, things he recommended the Japanese do that he hasn't done yet. So, the Fed has a lot of ammunition left including the most powerful tools, which they haven't pulled out yet. Which are? Setting a higher inflation or nominal GDP target is the most powerful one probably. If they could. That would be politically controversial, especially if they did it in terms of inflation. I prefer nominal GDP. But here's my point: Suppose Obama did nothing in 2009. There's no way the Fed would have just sat back passively and watched the economy collapse. What would have happened is with less fiscal stimulus there would have been a lot more monetary stimulus. I don't know exactly what it would look like. I'm not saying it would have exactly made up for the lack of fiscal stimulus, but my point is this: Any estimate of the effects of fiscal stimulus are probably really wildly exaggerated by not taking into account the reaction function of the monetary policy makers. And that's the big flaw in the way we think about fiscal stimulus. And no matter how many times I make this point, I find it's very hard for people to absorb it. They want to think in terms of other things equal--like, okay, there's the monetary policy; now let's see what fiscal policy can do. It doesn't work that way. If fiscal policy does more, monetary policy will do less. That's how things work.
42:21I agree with your idea--I've always felt it's an interesting psychological insight--that the greatest living scholar of the Great Depression is Ben Bernanke. Nothing could be more embarrassing than for his legacy to be that he allowed it to happen under his watch. For one thing he's a great scholar of the Great Depression. For another, there's this famous conference where he, in the presence of Milton Friedman, who is not with us any longer and who I'd argue would be the number 1 scholar of all time, but fine, Ben Bernanke's second but now he's first because Milton's gone--but at that conference while Milton was still here, Ben Bernanke said: Don't worry, Milton, we won't let it happen again. Now, as you said earlier, maybe he's achieved that level. He did enough to avoid a Great Depression. He didn't do enough to avoid a Great Recession. But why would he even get this close? Why would he, when he saw that that $787, now $825 billion of stimulus wasn't doing very much, why would he counteract it? You are suggesting he counteracted it, and that's why it had no effect. Is that what you are saying? Yes. The way I would put this is: He didn't go out and say: Aha, I'm going to go out and counteract this now. If you asked him, he would deny counteracting it. No doubt. In his own mind he would not believe that he did that. But I believe that if you really think through the logical implications of what the Fed would have done in the absence of fiscal stimulus, that in essence it was sabotaged. I know that's a very counterintuitive and controversial statement, and almost nobody agrees with me. But I think that's because they are not thinking about the issue clearly enough. It's not that the Fed would ever set out to hurt the economy intentionally or anything of that sort. I happen to believe the Fed underestimated the amount of stimulus that was needed. If there had been no fiscal stimulus, their estimate of what was needed on the monetary side would have been substantially higher, and that's the logical point I'm making. Now, if you word it in a certain way, it sounds very appalling, like the Fed is sabotaging fiscal stimulus; and that's not it at all. But that's really kind of what it amounts to when you think about it logically. Let me give you an example of how the way we're thinking about these issues is so unlike the orthodox view. Can I take one minute to read a quotation--and I bet you cannot guess who said this, in 1999. This is about Japan.
What continues to amaze me is this: Japan's current strategy of massive, unsustainable deficit spending in the hopes that this will somehow generate a self-sustained recovery is currently regarded as the orthodox, sensible thing to do - even though it can be justified only by exotic stories about multiple equilibria, the sort of thing you would imagine only a professor could believe.
So, this is my view, interjecting. Continuing:
Meanwhile further steps on monetary policy - the sort of thing you would advocate if you believed in a more conventional, boring model, one in which the problem is simply a question of the savings-investment balance - are rejected as dangerously radical and unbecoming of a dignified economy.
So, he's amazed that people are suggesting that Japan do deficit spending when they already have this big debt and asking why aren't we doing the conventional monetary stimulus. Now do you know who said this in 1999? I'm going to guess it's Ben Bernanke from the way you are talking. No. Paul Krugman. That was my second guess! So, here's Paul Krugman saying exactly what I'm saying now, and I feel like my view of monetary and fiscal policy was the standard view, and in a sense the only reason we're even having this conversation right now is that in some strange way, the conventional view became very unconventional in 2008 and 2009. As you probably know, I'm not a particularly well known economist, at least prior to getting into blogging; and so the only reason we're having this interview is once I started blogging, I found that my view, which I thought was the conventional view, was in fact a fairly radical view and it got a lot of attention. A lot of people sort of thought of it as a very provocative, unconventional view. This is what I find so strange about what is going on. We have this situation where the standard view somehow twisted around from being monetary policy as the natural way of preventing a depression, which is the story that came out of the Great Depression, supposedly, to the view that it's actually fiscal policy that needs to do this. Now, some people will say it's different now because we're in a liquidity trap; but Japan had zero interest rates in 1999, roughly, when Paul Krugman made this statement. It's not really different. I'll just read you one really quick quotation out of the number 1 textbook in money:
Monetary policy can be highly effective in reviving a weak economy even if short-term interest rates are already near zero.
So, that's what we are teaching our students, right out of the number 1 textbook; and I found in late 2008 almost none of my colleagues believed this. They were all saying: Monetary policy can't do anything right now; we have to use fiscal stimulus. What textbook is that? Frederic Mishkin, Money and Banking.
48:03So, one thing that Krugman's been saying a lot lately is that people who worried--this would be me, and others--that the injection of $2 trillion or so of reserves into the banking system is going to cause inflation--look how stupid they were. They were crazy. They were wrong. It didn't happen. When people ask me why didn't it happen, I quote Allan Meltzer. He said, on this program maybe two years ago: That's because they are not spending it. Then you come to the question of it's not in the economy; of course it didn't cause inflation. They are sitting on it. So, the question I think it comes down to is I think Krugman would justify his current position by saying: It's true that in theory monetary policy could do something, but when the banks aren't going to spend the money you give them, then you are stuck and the government has to step in. And you are suggesting that that's partly because of the bad policy on the part of the Fed of paying interest on reserves, and partly because of other things. Here's one other point he would make, and where I partly agree with him. He would say: What Japan really needed to do was to set a higher inflation target. That is, create expectations on the part of folks. To lower the real interest rate. So, if the nominal interest rate is stuck at zero--let's say you have a 4% inflation. I think that's the number Krugman recommended. Then the real interest rate becomes -4%. In other words, it doesn't really cost anything to borrow money because you are paying it back with cheaper dollars in the future. This is something Ben Bernanke recommended the Japanese do as well. Do what? Raise their inflation target. To 4% rather than its current appearance of zero. I don't know that he mentioned the number 4, but to do what's called level targeting, which means make up for the deflation. So, Japan has had some mild deflation, and what Bernanke said was they should have some inflation now to sort of catch up for the previous fall in prices. I can't remember the number, but I think it may have been numbers like 3-4% mentioned in his article. This is something he wrote I think in the early 2000s. But interestingly he's rejected that for the United States and his argument is that we don't have outright deflation like Japan, so that's the reason he's able to reconcile these positions. It's hard to know. Given the way that the Department of Labor calculates housing prices into the Consumer Price Index (CPI), they've made some arbitrary choices; they might be right; it's a bizarre method; I'm sure the measurement of it is flawed. They have all kinds of problems with quality control, holding quality constant. One quick example that's really striking: According to official CPI data over the last 5 years, housing costs are up about 7.5%, total. That's a little weird. According to the Case-Shiller index, they are down like 32%. That's a 40% discrepancy between Case-Shiller and the CPI on housing, and housing is like a third of the CPI, roughly. In other words, I'm not trying to argue that we are really in deflation this year. This particular year, probably inflation is a little bit positive. But what I would argue is that in general the CPI is unreliable, and that's why I tend to focus on nominal GDP. And if you look at nominal GDP, it's just unambiguous. Instead of the normal 5% a year growth in nominal GDP, for the last 3 years it's been going up about on average I think 1-1.5% a year. And that's barely above population growth. So, basically what we are doing is we are not providing enough income, where we could have a fast recovery even if our economy was perfect. In other words, even if we had none of these flaws that you and I don't like about the regulatory system, the tax system, and everything. It's very unlikely that this amount of income will allow for a fast recovery, because to get a fast recovery we'd have to have rapid deflation, and you just don't tend to see fast recoveries during periods of rapid deflation. At least in a modern economy where probably wages are stickier than they used to be.
52:30So, let's have a little fun. Let's suppose on December 31, Ben Bernanke writes a letter to President Obama and he says: I've always wanted to spend more time with my family, so I'm resigning. And to the surprise of many, the President, desperate for a healthy economy over the next 9 months, 10 months, for obvious reasons, puts in place Scott Sumner of Bentley University; he's approved, and on January 1st he takes control of the Fed's Chair. What would you do? What might you do? What would be your announcements and actions that you would think be the best in this situation? That's a good question. I'll give you a week if you want, but we are recording it now. You've got ten days, but let's pretend it's now. I can give you a quick answer, but it may not be a simple answer. First of all, any Fed policy has to be a strategy. It can't be just a tactic for the moment. So, I can't really know what's best for right now unless I know what the long term trajectory is. If I had to choose, I might just default to what the Fed was doing prior to the recession, which was promoting about 5% nominal GDP growth, maybe a little bit lower. Maybe 4%. That would be the long-term target. How do you get to a target like that? What would be your actions or words? Okay, but the second part is I think we need a little bit of catch up in the next two years because we are so far below trend. I don't think we should try to go all the way back up to the old trend line. I'd like to see us promote maybe 6-7% growth for the next couple of years, and then whatever we decide on. Let's say I pick 4% thereafter. Now, how do we get there? The ideal policy would be to create nominal GDP futures contracts. And peg the price of them. That is, issue enough money until the market expected nominal GDP to grow that fast. So, you would just keep injecting money until you got the nominal GDP futures contract showing the amount of growth that the goal of the policy was. How would you do that? How would you inject a sufficient amount of money given that the past injections have had no effect? First, if you want to make them more effective, you'd stop paying interest on reserves. That's a start. Now, let's suppose banks continue to sit on the money even at zero interest rates. You could always make the interest on reserves negative. You could charge them. That would be a fairly radical move. Now, I happen to think that's not necessary. That's a fairly radical option. That doesn't seem so radical. Well, it would probably for instance destroy the money market mutual fund industry, because people would be better off keeping money in safes in their house at zero interest--cash--than they would sitting in money market mutual funds at negative interest rates. I don't know if you see what I'm saying. I don't. There would be some distortions to the financial system. That would be really bad. I would prefer that instead of going to negative interest on reserves that the first option would be to simply buy as many assets as necessary. The Fed hasn't even scratched the surface for what they could buy. There's a lot of assets out there. But I think the more important point is that people tend to look at this problem backwards. What the Fed has been doing is injecting money and promising that they'll pull the money out again before we get a lot of inflation. Or anything of that sort. Mop it up. So, it's a temporary currency injection. Those are not going to boost GDP very much, or spending or inflation. To have an effect, it has to be more permanent. So, what the target does is it tells you the Fed is going to leave enough money out there permanently to try to hit this track that you've laid out, this trajectory that you are targeting for nominal income. Again, the optimal solution in my mind would be for the markets to determine how much money and what interest rates for this futures contract technique. Essentially the Fed just targets the price of the futures contract and passively adjusts the money supply as needed to make that target price stick. In other words, the analogy would be like the gold standard, except instead of pegging the price of gold, you'd be pegging the price of nominal GDP futures. In both systems the quantity of money in circulation is determined by how much the public wants to hold, given that trajectory for nominal GDP. Now, people will say: What if no amount of money gets you there? You can't really seriously argue that because in the reductio ad absurdum, the Fed would buy up all of planet Earth. And pay for it with currency. Obviously that's not an equilibrium outcome. Long before you got to that point, inflation expectations would start rising and you'd have to stop the injection. I would even go further, though. I would predict that if my policy were put into effect, the monetary base--that's the money created by the Fed--would actually go down. In other words, we have plenty of money in circulation right now. Too much to hit that target. The reason we are not having faster growth is that there is too much demand for money, partly because of the interest on reserves and partly because of the low expected nominal GDP growth. If we had a robust, more expansionary policy people and banks wouldn't want to be sitting on reserves. They would move the money into places where they could earn higher rates of return. And it would turn out we could actually need much less currency to achieve our target than we currently have in circulation. Or base money, to be precise. When I talk about the monetary base I mean including both money in the banks that they are sitting on--the so-called excess reserves--and also the cash in circulation. That you and I hold. What would happen is the banks would probably stop sitting on all those excess reserves. The public certainly doesn't want to hold $3 trillion in cash. So, what would happen is at some point the Fed would have to pull some of that money out of circulation that was injected during the emergency, because in a healthy economy you simply don't have that much demand for liquidity. So, I'm not really worried that the Fed wouldn't be able to buy enough assets to make that happen. I would expect once they started buying assets, expectations would increase sharply, and that very quickly they would have to reverse course and start pulling money out of circulation.
59:50So, you attended the University of Chicago, as I did. Did you ever by chance take a class from George Stigler? Yes. I did as well. I don't know if he talked about it when you learned with him, but he would say, he would contrast his theory of regulation with what he would call the Ralph Nader theory. The Ralph Nader theory is: the reason we have lousy regulation that doesn't serve the public, that serves special interests, that serves corporations unfairly is because we have the wrong people in the job. We just need better people. If we had the right people in the job it would turn out okay. So, the George Stigler theory is: it really doesn't matter who is in the job. There are these fundamental underlying incentives and that's what you need to look at. And once you understand those, you know how they are going to behave. It doesn't matter who is in the job. And a variation on that is Milton Friedman's observation that you don't want the right people in office; you don't want to create a system where you have to get the right people in office to get the right policy. You want a world where the wrong people can get in office but they are encouraged to do the right thing because of the nature of the political system. So, I look at the Fed, and you could have argued--I think many people did argue in 2006 or 2007 or 2008--that there couldn't be a better person than Ben Bernanke for this job. Because of what we talked about before--he was aware of the risks of monetary contraction and he would never let that happen on his watch. Now, you've suggested through a variety of forces, again nothing sinister, that that's actually happened. And you've written recently about other decisions the Fed has made, and made the point that they've been contractionary at times when they should have been expansionary. Where does that leave us with what the Fed is good at? It seems it's an institution that for political reasons--I argued recently that it's some unfortunate political forces that encourage the Fed to be nice to some of its friends who are not my friends, meaning the banking system, the financial sector. Why would we ever--and I don't think Scott Sumner is going to get picked on January 1st--and even if he did, George Stigler would say maybe he wouldn't be like Scott Sumner any more. He'd be more like any other Chair of the Fed. So, where does that leave us for where we ought to go as a society, as a nation, with respect to the Fed? Seems to me they have done a horrible job, and they are incapable of doing the fine tuning and textbook corrections that we teach our students. It seems to me that we need something more radical than just a different kind of policy, a better Chair of the Fed. What are your thoughts on that? I kind of have mixed feelings on that. I think for the banking system they probably do get a little too cozy with the banks and start to think that what's good for the banks is good for the country. So, that part of Stigler's argument, I think there's some merit to. But for macroeconomics I don't think it works very well. Certainly you couldn't really use that sort of argument for the Great Depression, if the monetary theory is correct. One possibility is the Great Depression is completely not due to bad government policies. But if you buy the Milton Friedman argument that I accepted, that tight money played a big role, the damage of the Great Depression to all classes of society was so great that there's no plausible special interest argument for why the Great Depression happened. No, it's just incompetence. Yes, incompetence. That falls under my theory too. If you look at the current situation, most economists are basically comfortable with what the Fed is doing. So, I wouldn't expect the Fed to do anything different from the consensus of economists. So, I'm not necessarily shocked by what the Fed's doing. I'm shocked by what my fellow macroeconomists believe that I thought they didn't believe a few years ago. And I was pretty naive, obviously. I'm out there trying to change opinions. Not to be too fatalistic, you could argue that we do make incremental progress. It's possible that if we hadn't had some of the insights from Milton Friedman and Anna Schwartz and so on, maybe this crisis would have led to another Great Depression, not just the Great Recession. I know that's not a very--it's certainly a weak defense. That's not trivial. Obviously as Adam Smith said, there's a lot of ruin in a nation. Anybody who focuses on economics is always going to be dealing with big problems of one sort or another. There's just lots of big problems out there. So, I don't think one can just look at the fact that there are big problems and necessarily come to the conclusion that the entire system is in some way flawed. Maybe it is. But maybe we are just making little incremental progress, once step at a time, and we have to make a lot more progress. Do better next time around. I happen to think that based on what we know now, if the same thing were to happen again, the Fed would not do the same thing. They would have been much more aggressive. I'm on record saying that if Europe collapses and faces another Lehman moment, the Fed won't behave the same way. They'll do something not necessarily my nominal GDP targeting, but something fairly dramatic and analogous that is much more effective than what they did in 2008. I hope it isn't tested; I hope Europe doesn't collapse. I do feel the Fed has sort of learned some lessons out of this, and in a weird way I think the popularity of my blog is evidence that other people seem to think I have something useful to say about the crisis that was missed in early 2009 when I started blogging. And so I'm hoping we've learned some lessons from this. But obviously we won't know until next time around.