Expectations Matter More than Size

Martin Wolf says its time to unload both barrels of the gun and resort to true helicopter drop-types stimulus.  He has the right idea, but it could be better implemented through an explicit price level or nominal GDP level target.  Doing so is important because as Josh Hendrickson notes no one at the Fed or the ECB knows exactly how much to print. What the central banks can do, though, is properly shape expectations about future nominal spending and price growth.  Doing so would cause the markets themselves to do much of the heavy lifting (through expectation-induced portfolio rebalancings) and in the process ensure the Fed's goals are realized. Josh Hendrickson sums it up this point nicely:

The Federal Reserve’s focus on the size of its asset purchases represents a grave mistake. There is no model that tells us the precise size increase in the central bank balance sheet will get us to a desired level of nominal income. Those who continue to claim that the magnitude of monetary and fiscal policy haven’t been large enough fail to recognize this point. This is the lesson of the Lucas Critique. Expectations matter.

Update: Here I go into more detail as to how the Fed would work to shape expectations through a nominal GDP level target.

What Is Wrong With this Statement?

Following a speech on Wednesday, Fed Chairman Ben Bernanke had this to say in a Q&A:

"If inflation itself falls too low or inflation expectations fall too low, that would be something we'd have to respond to because we don't want deflation[.]"

At first glance this statement seems reasonable, but upon further reflection there is something troubling about it.  It is the monetary policy equivalent of locking the barn door after the horse is already out.  Bernanke is saying here the Fed will respond after inflation falls too low.  Why not lock the barn door up front by explicitly targeting inflation expectations so that the public's expectations about future spending and price growth are anchored and not likely fall in the first place?   If this were the way monetary policy were conducted the Fed would be a little more concerned right now about the now 6-month downward trend in inflation expectations.  

If there is one lesson the Fed should have learned from this crisis is that it needs to take a more forward-looking approach to monetary policy.  Nowhere is this more clearly seen than in the Fed's September, 2008 FOMC meeting where it decided against further monetary easing because of concerns about rising inflation.  Had the Fed been giving more weight to the forward-looking inflation expectations coming from TIPs, it would have noticed that the outlook had been deteriorating since mid-2008.  Instead, the Fed was looking in its rear view mirror and saw the realized inflation rates of the past few months that had temporarily gone up because of supply shocks.  

Of course, in my ideal world the Fed would go one better and target nominal GDP futures contracts.  They don't exist now, but I am hoping that one they do and the Fed explicitly targets them.  Not only would such a policy better anchor nominal spending expectations, it would also make the Fed a whole lot more transparent and thus accountable to the public.

How Big is the Fiscal Multiplier?

Scott Sumner once compared arm wrestling with his daughter to the relationship between monetary and fiscal policy.  Scott explained that no matter how hard his daughter tried to win the arm-wrestling contest he would always apply just enough pressure to offset her efforts and keep her in check.  Likewise, no matter how hard fiscal policy may attempt to stimulate aggregate spending the Fed has the ability to offset such actions and place aggregate demand where it so chooses.  In other words, the size of the fiscal multiplier ultimately depends on the stance of monetary policy.

Recent studies by Eric Leeper, Nora Traum and Todd Walker, Lawrence Christiano, Martin Eichenbaum, and Sergio Rebelo, and Michael Woodford all lend support to this understanding.  They show using formal models that in a world where nominal and real rigidities exist the impact of fiscal policy on economic activity is muted when the central bank follows something like a Taylor Rule.¹  Eric Leeper et al. explains why:

Active monetary policy reacts to a persistent fiscal expansion and the attendant increase in inflation by sharply raising the nominal policy interest rate. This raises the real interest rate, which reduces consumption and investment demand to attenuate the stimulative effects of the fiscal expansion. It is not too surprising that in this monetary-fiscal regime, very large fiscal multipliers are unlikely.

These studies also show, however, that the fiscal policy multiplier can be large if monetary policy is passive and does not raise the policy interest rate to check expansionary fiscal policy.  These studies say this is particularly true when monetary policy hits the zero bound since at that point the short-term interest is effectively pegged.  Here again is Leeper et al.:

Since the 2007–2009 recession, many central banks have shifted their emphasis from stabilizing inflation to stimulating demand by maintaining low and constant policy interest rates—near zero in some economies. When monetary policy makes the interest rate unresponsive to inflation, a “passive” stance, it amplifies fiscal policy’s impacts. By fixing the interest rate, monetary policy allows higher current and expected inflation to transmit into lower real interest rates. Instead of attenuating the demand stimulus of a fiscal expansion, monetary policy amplifies it: lower real rates encourage greater consumption and investment demand. Lower real rates induce a positive substitution effect from higher government spending, substantially raising output, consumption, and investment multipliers.

All the papers make this point that the fiscal multiplier is large and above 1 at the zero bound.  I, however, see several problems with this argument. First, just because the short-run nominal interest rate hits zero percent it does not follow that stimulus will be added by lowering the real interest rates via fiscally-induced higher inflation expectations.  What if, because of worsening economic conditions, the natural interest rate was falling faster than the real policy interest rate? There would be no stimulus.

Second, in the scenario above it is possible that the reason the economy is getting worse and causing the natural interest rate to fall in the first place is because the central bank is falling to sufficiently respond to adverse aggregate demand shocks. For example, if the zero bound is already binding and then a spate of bad news causes the public to become even more pessimistic about future economic growth the central bank would need to aggressively respond to these developments just to maintain the existing stance of monetary policy.  If the central bank failed to respond, this unchecked worsening of expectations would amount to a passive tightening of monetary policy.  In other words, even at the zero bound a central bank can passively tighten monetary policy and offset any attempt at fiscal expansion.   This point is particularly relevant for the Fed today.  Even though the federal funds rate is more or less at the zero bound, the Fed is still concerned about stabilizing inflation and unwilling by its own admission to use all of its monetary tools even though the U.S. economic outlook is worsening.  How possibly could a fiscal multiplier be above 1 in this environment?  Fiscal policy at this point looks to me like a fool's errand.

Third, even if fiscal expansion were to work as well at the zero bound as these studies claim, the expected and actual improvement in economic activity from the fiscal expansion should quickly lead to higher interest rates.  But if there are higher interest rates then this zero bound channel through which fiscal policy works disappears.  So there is a paradox here.
 
So where does that leaves us?  The aggregate demand slump problem is and has always been the Fed's.  It  has been shaping the path of nominal spending during this crisis and therefore has been determining the effectiveness of fiscal policy.  Yes, monetary policy to some extent becomes fiscal policy if Fed did something like a helicopter drop, but this is not the type of fiscal policy  being considered above and does not seem to be a politically viable option.  My takeaway from this is that our time is better spent encouraging the Fed to act more aggressively than pushing for more fiscal policy stimulus. 


¹Leeper et al. show that these rigidities are essential for fiscal policy to have any expansionary effect at all in these models. See Robin Harding's discussion of this point.

Stephen Colbert's Solution to Global Economic Woes

Stephen Colbert invokes his inner Keynesian spirit to propose a plan to end the Eurozone crisis and and revive the U.S. economy at the same time.

The Colbert Report
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The Geithner Plan to Save Europe is Not Enough

The latest initiative to save the Eurozone is the "Geithner Plan." It would have the Eurozone leverage up the EU's €440 billion bailout fund to €1 trillion by making it act as an insurance fund for investors buying up debt of the troubled Eurozone countries.  Though big, this plan would only address the current debt problems.  It would not solve the large real exchange rate misalignment--30% according to Ambrose Evans-Pritchard--between the core countries and the the troubled periphery. The ECB, on the other hand, could address fix this problem.

Here is how.  If the ECB were to sufficiently ease monetary policy, it would cause inflation to rise more in those parts of the Eurozone where there is less excess capacity and nominal spending is more robust.  Currently, that would be the core countries, particularly Germany.  Consequently, the price level would increase more in Germany than in the troubled countries on the Eurozone periphery.  Goods and services from the periphery then would be relatively cheaper.  Therefore, even though the fixed exchange rate among them would not change, there would be a relative change in their price levels.  This would provide the much needed real depreciation for the Eurozone periphery as they move forward in their attempts to salvage their economies.  

Ambrose Evans-Pritchard explains it this way:

Nor can this gap in competitiveness be bridged by austerity alone, by pushing Club Med deeper into debt-deflation and perma-slump. Such a strategy must slowly eat away at Italian and Spanish society, undercutting the whole purpose of the EU Project. It would ultimately risk trapping them in a debt spiral aswell, leading to collosal losses for Germany in the end. 

The Geithner Plan must be accompanied a monetary blitz, since the fiscal card is largely exhausted and Germany refuses to lower its savings rate to rebalance the EMU system. The only plausible option is for the ECB to let rip with unsterilized bond purchases on a mass scale, with a treaty change in the bank's mandate to target jobs and growth.

This would weaken the euro, giving a lifeline to southern manufacturers competing with China. It would engineer an inflationary mini-boom in Germany, forcing up relative German costs within EMU. That would be the beginning of a solution, albeit a bad one.

So how much inflation would this approach entail?  Paul Krugman gives his estimates based on a 20% real misalignment:

A reasonable estimate would be that Spain and other peripherals need to reduce their price levels relative to Germany by around 20 percent. If Germany had 4 percent inflation, they could do that over 5 years with stable prices in the periphery — which would imply an overall eurozone inflation rate of something like 3 percent.

Ambrose Evans-Pritchard says this solution would be unfair to Germany, but he also says that is the cost of a monetary union.  It may be unfair to Germany now, but arguably Germany helped pave the way for this crisis over the past decade.  For the decisions of the ECB were influenced heavily by developments in Germany at the expense of the periphery.  Could this dynamic change in a new and improved Eurozone?  If not, it may make more sense to have two currencies in the EU.

Actually, the Markets Did Drive Down Their Growth Forecasts Because of the Fed

What explains the big sell off in markets today? As Ezra Klein notes, many observers are attributing it to the FOMC saying it sees "significant downside risk" to the economy.  Felix Salmon, however, objects to this line of reasoning:

It’s silly to think that the decline in stock-market prices was a rational reaction to the FOMC statement. If the FOMC is more pessimistic than the market expected, that’s normally a good sign for markets, since it implies that monetary policy will remain looser for longer. The market cares about the Fed because the Fed controls monetary policy. And so Fed forecasts are important because they help drive that policy. No one revised down their growth expectations as a result of the FOMC statement.

Actually Felix, the decline in equity markets, the drop in treasury yields, and fall in expected inflation all indicate the public has revised down its growth expectations and the most likely reason is Fed policy.  Over the past three years the FOMC has effectively kept monetary policy too tight by failing to respond to shocks that have kept current dollar spending (i.e. aggregate demand) depressed.  This passive tightening of monetary policy started in mid-2008 and continues to this day.  Based on this experience,  markets understand that when the Fed downgrades its economic forecast it means the Fed is going to allow things to get worse. 

Thus, when the FOMC announced last month that it anticipated keeping its target federal funds rate at exceptionally low levels through mid-2013, it was most likely interpreted as the Fed revising down its economic forecast over the next two years and adjusting accordingly the forecast of its target interest rate over this time to maintain the current (not very stimulative) stance of monetary policy.  In other words, the Fed was expecting the natural interest rate to remain depressed longer than previously expected and thus needed to keep its federal funds rate target lower longer than previously expected.  The Fed wasn't adding stimulus, but maintaining the status quo as the economic outlook worsened.  Such an interpretation was entirely reasonable given the FOMC's failure to fully restore aggregate demand over the past three years.

The question, then, is what can the Fed actually do to change the economic outlook.  As I have argued numerous times, the Fed needs to commit to an explicit nominal GDP level target.  To do this, the Fed would (1) announce its targeted growth path for NGDP and (2) commit to buying up as many securities as needed to reach it.  Knowing that the Fed would be willing to buy up trillion of dollars of assets if necessary to hit its target would cause the market itself to do much of the heavy lifting.  That is, the public would adjust their portfolios in anticipation of the Fed buying up more assets and in the process cause current dollar spending to adjust largely on its own.   I go into more detail here how this would work, but the key point is the Fed would be better managing nominal spending expectations.  No more spooking the markets.  Something like it worked for FDR in far more dire circumstances and would most likely work for the Fed today.  And, as Scott Sumner argues, had a nominal GDP level target been in place in 2008 it is likely the economic crisis would have been far milder all along.

Twist and Yawn

The Fed decided today it would lower the average maturity of publicly-held treasuries by selling $400 billion of shorter-term treasuries and buying the same amount of longer-term treasuries.  In addition, the Fed also reconfirmed its commitment to maintain the size of its mortgage holdings and anticipated its targeted interest rate would remain low through mid-2013.  The burning question now is how big of an impact will the Fed's new treasury maturity transformation or "operation twist" program have on the economy?  Not much in my view.  It should add some monetary stimulus, but like the original operation twist its effects will probably be modest and do little to spark a robust recovery.  

So how would it add monetary stimulus?  The standard story is that it would transfer duration and other risks from the private sector's balance sheet to the public sector and thus add to the private sector's ability to take on more risk.  Other riskier asset would be bought by the private sector including corporate bonds and stocks.  This would create wealth and positive balance sheet effects that would spur spending.  In turn, this would increase demand for credit and banks would start lending more. In addition, banks would be willing to lend more because the Fed's program would have increased their capacity to take on more risk. Deposits, therefore, would grow and cause the money supply to increase.  The Fed's actions, then, would ultimately result in a larger money supply.

Another way of looking at this is from a monetary disequilibrium perspective.  Currently, there is an elevated, unmet demand for safe and liquid assets, mainly treasury bills. This elevated demand for treasury bills has pushed their yield down to zero and made them near-perfect substitutes for money.  Because the demand for these safe and liquid assets is not being met by the available supply of treasury bills, it is spilling over into the demand for money assets, the near-substitute for treasury bills at the zero interest rate bound.  This creates an excess demand for money that in turn leads to a drop in aggregate spending.   The Fed's new program puts more treasury bills back into the private sector and thus removes some of the overflow excess demand into money assets.  It should also raise the yield on treasury bills and make them less of a substitute for money assets.  Either way, there should be less of an excess money demand problem and thus more aggregate spending.

Still, I am not sure this new operation twist will pack much of a punch.  The reason being is that the Fed is once again adding monetary stimulus without setting an explicit target. Without an explicit target to permanently shape expectations about future spending and inflation, it is hard to see how this new stimulus program will have any more lasting power than QE2.  The Fed needs to quit throwing  large dollar programs at the economy and instead commit to buying up as many assets as needed until some nominal GDP (or price) level target is hit.  This would signal to the public that the Fed is willing to spend whatever is necessary to restore robust aggregate demand.  QE2 and the new the operation twist, on the other hand, only commit to spending a limited amount of dollars and after that point, well, the economy is on its own.  Nominal expectations are allowed to drift and become unanchored. This is why I find this the Fed's announcement today underwhelming.  Wake me up when the Fed really gets serious about doing monetary policy.

Update: Mark Thoma, Brad DeLong, and Bill Woolsey take a similar view on operation twist. Also, FT Alphaville provides a nice roundup of Wall Street views on operation twist.  Finally, Edward Harrison does a great code red take on operation twist.

Maybe the GOP Leadership Has Known All Along

That additional monetary stimulus would help the economy.  That is the only sense I can make of the letter from Republican leaders in Congress sent to Federal Reserve Chairman Ben Bernanke asking him to refrain from further monetary stimulus.  They may realize that a truly bold monetary stimulus program like FDR's original quantitative easing program of 1933-1936 can turn a depressed economy around and affect political outcomes.  If so, this understanding would also explain Governor Rick Perry's comments about Bernanke committing treason if he printed more money before the election.  It would be truly tragic if in fact these politicians were making this tradeoff between political gain and economic gain. 

There is, though, a silver lining to these developments. Marcus Nunes notes that the congressional letter actually opens the door for the Fed to do something bold if they can justify it:

But you don´t have to read far [in the letter] to see the message Bernanke should heed:

They said Fed officials should avoid further action, “particularly without a clear articulation of the goals of such a policy, direction for success, ample data proving a case for economic action and quantifiable benefits to the American people.”

Yes, the GOP just gave Bernanke an opening to establish a NGDP target!

As Josh Hendrickson recently explained in the National Review, nominal GDP targeting is consistent with Republican ideals and provides an opportunity for the GOP presidential candidates to promote a meaningful rule-based approach to monetary policy.  I concur and have similarly argued that a nominal GDP target would provide Republican lawmakers a way to narrow the Fed's mandate.  I hope they are listening.

Is It Time for the Eurozone to Get Rid of Germany?

Back in April 2010 when it first seemed the Eurozone was about to crack up, I did a post on the lessons of the Eurozone crisis.  I argued then that the main lessons were, one, countries joining a currency union should take seriously the optimal area criteria and the real exchange rate and, two, central banks should take seriously the task of stabilizing the growth of nominal spending.  I still think these points are valid,  but I now see a more important lesson from this ongoing crisis: avoid relationships where one party to the relationship is domineering and has a history of abuse.  In short, avoid bad relationships.

In the case of the Eurozone relationship the dominant party is Germany.  Its desires have largely shaped the direction of the Eurozone and continue to do so today, even though it only has historically made up at most about 30% of the Eurozone economy.  This uneven relationship has been very apparent lately as the future of the Eurozone seems to hang on the day-to-day developments in Germany.  For example, the fate of the currency union inched closer to collapse a few weeks ago when German's constitutional court ruled against a supranational fiscal authority and when a German vote of no confidence was effectively issued for the ECB by the resignation of the German representative Jurgen Stark from the ECB's board.  Then, last week the mood improved when German Chancellor Angela Merkel said the Eurozone must stick together.  Now new polls show Merkel loosing influence and the Eurozone's breakup looks more likely.  That these German developments can so easily drive the ups and downs of the Eurozone outlook speaks to dominance of Germany in the Eurozone relationship.

Another way to see the inordinate influence of Germany is to look at the inflation-hawk culture of the ECB inherited from the Germans and its influence on the evolution of ECB monetary policy.  Many studies, such as this 2010 report from Barclays Capital or this one from the WSJ, have shown using Taylor Rule estimates that while ECB monetary policy has been stabilizing for Germany over the past decade it has been destabilizing for the periphery.  In particular, monetary policy was too loose for the periphery when the Eurozone was first formed and more recently have become too tight for them.

This tendency to change ECB monetary in a manner that best serves Germany can be vividly seen by looking at the history of nominal spending for Germany and for the rest of the Eurozone.  The first figure below shows the case of Germany along with a trend.  It shows that not only has Germany's nominal spending returned to trend, but that it is has slightly exceeded it in recent quarters.  This explains why the ECB raised interest rates earlier this year and has failed to cut them despite the severity of the crisis.  The German economy needed some tightening and the ECB delivered it.

The next figure shows nominal spending for the rest of the Eurozone.  The difference between the two figures is shocking.  Not only is nominal spending below trend, but the difference continues to increase.  The ECB is failing miserably here to stabilize nominal spending for the other 70% of the currency union.  This should remove any doubt about the inordinate influence of Germany on the Eurozone.

Finally, it is worth nothing that the Eurozone crisis is not the first time Germany's internal policy goals were promoted at the expense of partner countries.  The European Monetary System (EMS), which tied other European currencies to the German Deutsche Mark, erupted into a crisis in 1992 when the German central bank adopted a tighter monetary policy that was appropriate for Germany but too tight for the other countries in the exchange rate system.  Thus, there is an tendency for Germany to use its inordinate influence over European monetary affairs in a manner not conducive to the overall monetary system.  This suggests to me that maybe the best solution to the Eurozone crisis is not to fix the currency union but for Germany and like-minded countries to leave it.  Ambrose Evans-Pritchard, Ramesh Ponnuru, and others have  made the case for something like a two-tiered EMU where Germany and other austerity-embracing countries adopt a harder currency while letting France lead the Euro block.  Here is Evans-Pritchard's idea:

My solution - like that of Hans-Olaf Henkel, the ex-head of Germany's industry federation (BDI) - is to split EMU into two blocs, with France leading a Latin Union that keeps the euro. This bloc would devalue but not by 60pc, yet uphold its euro debts intact. The risk of default and banking crises would decrease, not increase.

The German bloc could launch their Thaler, recapitalizing banks to cover losses from rump euro debt. Disruptions could be contained by capital controls at first. None of this is beyond the wit of man. My bet is that aggregate losses would be lower than the status quo, and the long term outcome much healthier. The EU might even carry on, unruffled. 

I haven't always held this view, but am becoming increasingly sympathetic to it.  Sometimes it is for the best of all that a bad, abusive relationship gets terminated.  Maybe it is time for Germany to leave the Eurozone.

The Passive Tightening of ECB Policy

I recently argued that the Fed and the ECB were passively tightening monetary policy and thus responsible, in part, for the increasing economic stress in their regions.  Michael T. Darda makes the same argument today for the Eurozone in his note titled "Anatomy of a Deflationary Debt Collapse":

As the ECB fiddles with its forecast, European inflation-indexed bond spreads have plunged to record lows, while eurozone corporate bond spreads continue to hit new highs for the year. Inflation breakeven spreads in the indexed swap market in Europe have tumbled to the lowest level on record (i.e., below both the 2008 and 2010 lows). With corporate bond spreads at new 2011 highs this morning, the European Central Bank can now be blamed for a passive tightening of monetary policy. Why? Central banks are responsible for responding to velocity shocks by adjusting the supply of money to offset changes in the demand for money. If there is a spike in the demand for money and a central bank does nothing, a “passive tightening” of monetary policy will ensue. The message from plunging inflation breakeven rates and surging corporate bond spreads is that the eurozone could now be headed for a negative velocity shock and thus a deflationary debt collapse. There will simply be no way for governments in the periphery (including Spain and Italy) to pay debts with credit markets shutting down, economic activity collapsing and policymakers either not responding or responding in a way that is likely to make matters worse.

Indeed.

Who Needs Professional Wrestling When There is the FOMC?

Via Jon Hilsenrath we learn this about the FOMC members:

Fed Chairman Ben Bernanke has asked Philadelphia Fed President Charles Plosser and Chicago Fed President Charles Evans, two intellectual adversaries, to work with Vice Chairwoman Janet Yellen on how the Fed can better explain its economic goals to the public. One issue high on the agenda: Detail what changes in unemployment and inflation it would take to make the central bank veer from its low interest rate target...

Mr. Bernanke and many other officials dismiss the idea that he’s confronting a rebellion inside the Fed. They argue that internal disagreement is a sign of strength because it shows officials are wrestling earnestly with hard questions and have their eyes wide open to the challenges they face. “My attitude has always been: if two people always agree, one of them is redundant,” Mr. Bernanke said earlier this month in Minneapolis.

This would be fun to watch if the Fed's internal divisions were not such a serious issue.  Maybe the Evans-Plosser assignment is Chairman Bernanke's way of letting the inflation hawks be heard while still pushing through additional monetary stimulus.  That seems to be Hilsenrath's interpretation of these developments.  The only problem is that the options the Fed seems most likely to adopt--shrinking the average maturity of publicly-held national debt (i.e. Operation Twist II) and/or lowering interest paid on excess reserves--are not brazen enough to meaningfully change nominal spending expectations.  The public needs a sharp expectation shock, a bold slap to the face to wake it up from its economic lethargy.  Instead the Fed looks ready to place a mild kiss on the check that will only add to the economic stupor.  These half-measures are the product of political compromise not unified leadership at the Fed.

So what would a bold policy change look like? Charles Evans knows the answer.  In a speech he noted the following:

There are other policies that could give clearer communications of our policy conditionality with respect to observable data. For example, I have previously discussed how state-contingent, price-level targeting would work in this regard.  Another possibility might be to target the level of nominal GDP, with the goal of bringing it back to the growth trend that existed before the recession. I think these kinds of policies are worth contemplating—they may provide useful monetary policy guidance during extraordinary circumstances such as we find ourselves in today 

In other words, the Fed would allow faster-than-normal growth in nominal spending (and by implication the price level) until there was no longer insufficient aggregate demand.  That would be a bold shock and might even freak out many people about future inflation.  Money demand would be sure to drop.  But that is the point: implement a policy that would catalyze rapid nominal spending by household and firms.  Nominal GDP level targeting would do just that.  And, at the same time, such a level target would actually anchor long-term nominal expectations by restricting nominal spending to its long-term trend growth path after catch-up period.

Unfortunately, not everyone on the FOMC appreciates level nominal GDP targeting like Charles Evans.  Thus, we end up with the half measures the FOMC is most likely to adopt this week.  These half-measures are not likely to spur a robust recovery, but are likely to attract further political criticism of monetary stimulus.  The Fed is digging its own grave.

Maybe FDR Should Get More Blame

I have mentioned many times here how the decision of FDR and his Treasury to devalue the dollar and not sterilize gold inflows sparked a robust recovery from 1933-1936.  This development can be called the original QE program and it worked wonders despite the fact that the private sector was still deleveraging through at least 1935.  

The recovery fell apart when the recession of 1937-1936 hit.  The standard story for this recession has been that some fiscal policy tightening and a lot of monetary policy tightening caused it.  On the latter point, the conventional view is that monetary policy tightened when the Fed raised reserve requirements on banks.  Douglass Irwin, however, has a new paper that calls into question this conventional wisdom.  He says it was largely a tightening of monetary policy that caused the recession, but it was not because the Fed raised reserve requirements.  Rather, it was because the Treasury started sterilizing gold inflows.  Here is Irwin:

The severity of the Recession of 1937-38 was not due to contractionary fiscal policy or higher reserve requirements. By contrast, the policy tightening associated with gold sterilisation was not modest – it did not simply reduce the growth of the monetary base by a few percentage points, it stopped its growth altogether. While the Federal Reserve is often blamed for its poor policy choices during the Great Depression, the Treasury Department was responsible for this particular policy error.

This is amazing.  One of the key decisions that drove the 1933-1936 recovery in the first place--choosing not to sterilize gold inflows--was reversed by FDR's Treasury.  It was FDR, then, who cut short the robust recovery he started.  Throw in some of the market distortions caused by his other New Deal programs (e.g. NRA) and FDR's record is looking rather checkered.  Still, I credit FDR with being bold enough to try what effectively turned out to be a robust QE program anchored by a price level target.  He showed us it can work. 

Update:  This started me thinking about the big debate that intermittently raged in the blogosphere over the 2007-2009 period about the legacy of the New Deal.  I did a post back in early 2009 where I created the figure below to summarize this lively debate.  Enjoy!

 

How to Make Central Banks More Accountable For Passive Tightening

Yesterday we learned that despite the ongoing spate of bad economic news in both the Eurozone and the United States, monetary authorities in both places have decided to do nothing new for now.  In the Eurozone, ECB president Jean acknowledged the Eurozone economy faces "particularly high uncertainty and intensified downside risks" yet chose, along with the rest of the ECB authorities, not to further loosen monetary policy.  Across the Atlantic, Fed Chairman Ben Benarnke gave a speech where he too acknowledged the economy was surprisingly weak. He then noted that the "Federal Reserve has a range of tools that could be used to provide additional monetary stimulus" that he and other Fed offiicials "will continue to consider... at our meeting in September..."  In short, both central banks have decided to sit on the sidelines for now despite the ability and need to do more.

There is a term for this. It is called a passive tightening of monetary policy. It occurs whenever a central bank passively allows total current dollar or nominal spending to fall, either through an endogenous drop in the money supply or through an unchecked decrease in velocity.  This failure to act when aggregate demand is falling has the same impact on the stance on monetary policy as does an overt tightening of monetary policy.  Bernanke has made this point himself recently as a justification for maintaining the size of the Fed's balance sheet.  The passive tightening of monetary policy is like a school crossing guard who could have but failed to stop a student from running into traffic.  Though the guard didn't cause the student to cross into traffic, he still bears responsibility for failing to save the student.

Now the damage done by a passive tightening is no different than that of an overt tightening. The only difference is that the public is more aware of the overt form.  Consequently, the ECB and the Fed are not questioned for the harm they cause by allowing such passive tightening of monetary policy.  Thus, most people observing the economic problems in Europe and the United States never connect the dots between these central bank's inaction and what they are witnessing.  This allows the central banks to be conservative, play it safe, and not be held accountable for their passive tightening.

There is a way to change this.  Introduce a market for nominal GDP futures contracts.  It if were a deep and liquid market, it would provide real time analysis on market expectations of future nominal spending. And since the market's forecast of future nominal spending affects current dollar spending, it would provide real time analysis on how a central bank is actively and passively shaping the current stance of monetary policy.  For example, if a nominal GDP futures market existed currently for the U.S. economy it would probably indicate a sharp tightening of monetary policy.  The public would then interpret this as a dereliction of duty by the Fed.  

Such a market would instantly asses the nominal spending impact of any speech, news, action, or inaction taken by the central bank.  The Fed would not have the luxury to sit on the sidelines.   Having the Fed's performance judged in real time would make it far more accountable. This is why Scott Sumner has been arguing for it for so many years.  And this is why we need it so badly today.

The Fed Gets Schooled Again on Central Banking: the Swiss National Bank Edition

I have continually stressed the need for the Fed to (1) publicly and forcefully announce a level target and to (2) back up such an announcement with a commitment to buy up as many assets as needed so that the target is hit.  Well, the Swiss National Bank has amazingly just done that in a way that would make Lars E. O. Svensson proud.  Below is the press release (my bold):

The current massive overvaluation of the Swiss franc poses an acute threat to the Swiss economy and carries the risk of a deflationary development.

The Swiss National Bank (SNB) is therefore aiming for a substantial and sustained weakening of the Swiss franc. With immediate effect, it will no longer tolerate a EUR/CHF exchange rate below the minimum rate of CHF 1.20. The SNB will enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities.

Even at a rate of CHF 1.20 per euro, the Swiss franc is still high and should continue to weaken over time. If the economic outlook and deflationary risks so require, the SNB will take further measures.

Any question as to the SNB's resolve here?  Didn't think so.  Swiss monetary officials are concerned about weakening economic activity and deflation and therefore have made a forceful, unambiguous commitment to expand the central bank's balance sheet until these problems are gone.  Moreover, in the last sentence they note more will be done if necessary. 

Someone I know in the financial industry in Europe wrote me the following when the SNB made this announcement:

The trading floor that I am sitting for very natural reasons exploded in trading activity and general jubilation on the announcement...

Now we can only hope that the ECB and the Fed learn a bit...

Indeed. First the Fed gets schooled on central banking by the Swedish central bank and now by the Swiss National Bank.  This is getting embarrassing.  It is like watching a talented basketball player getting dunked on by Kobe Bryant and then by Lebron James.  Normally, such a talented basketball player would go study these other players and learn from them.  But the Fed seems determined to get repeatedly dunked on.  Fortunately, it has a teammate, the ECB, that is willing to get dunked on too and thus share the embarrassment.  It is time for the Fed and the ECB to go back to basketball camp.  I recommend the ones put on by the Swedes and Swiss.

HT: Lars Christensen