Wednesday, April 6, 2011

The National Review on Monetary Policy

Ramesh Ponnuru is a breath of fresh air.  Unlike many conservative commentators who get lulled in by the siren song of hard money, Ponnuru takes an informed and nuanced approach to monetary policy. He understands that currently there is an excess demand for safe, liquid assets that is preventing a robust recovery. He believes the Fed should be addressing this problem.  In his latest National Review article, he once again makes this case.  Here are some excerpts:
More important — and more disturbing — is that it is not at all clear that we have learned from the mistakes of the 1930s. Those central bankers believed that money was easy because interest rates were low and the monetary base (the supply of money under the Fed’s control) had expanded. They worried that further easing would reduce confidence in the dollar. British economist R. G. Hawtrey, writing in the late 1930s, described the climate of opinion in his country at the start of the decade: “Fantastic fears of inflation were expressed. That was to cry ‘Fire! Fire!’ in Noah’s Flood.” The economy was actually deflating, not inflating. Under the influence of the “real-bills doctrine,” some central bankers believed that the money supply should respond only to traders’ need for credit. Anything else would only fuel speculative excess.

Today’s inflation hawks employ the same reasoning that those firefighters did. And they are not wholly wrong. Easier money can lead to a destabilizing run on the currency. Inflation can be associated with low real interest rates and an expanded monetary base. But not always: Not in the 1930s, and almost certainly not today, either. The late Milton Friedman, perhaps the most famous inflation hawk of his generation, spotted the fallacy in his analysis of 1990s Japan: Low interest rates can also be a symptom of an excessively tight monetary policy that has choked off opportunities for growth. A looser policy, by increasing expectations of future economic growth, could actually raise real interest rates.
I coudln't agree more.  The neutral interest rate tends to go down in a weak economy.  The neutral interest rate estimates of Laubach-Williams confirm this is presently the case.

So what should the Fed do? His answer makes my day:
[The] Fed policy should aim to stabilize the growth of nominal spending — roughly, the total value of the economy in current dollars.... That policy is superior to trying to grow the base at a steady rate, a much-discussed idea in the past, because it allows the base to change in response to changes in the money multiplier and velocity. It is superior to trying to hold inflation constant because it allows the price level to respond to changes in productivity. It would create a stable environment in which economic actors could make their decisions and contracts.
He goes on to explain why having a stable nominal spending or income environment is important:
 Most debts — notably, most mortgage debts — are contracted in nominal terms, with no inflation adjustment. If people are used to 5 percent growth in nominal incomes each year and make their arrangements accordingly, then an unexpected drop will make their debt burdens heavier and also make them reluctant to make plans for a suddenly uncertain future.
That’s what happened during the recent crisis. Scott Sumner... often notes that in late 2008 and early 2009, we saw the sharpest fall in nominal income since 1938. In his view, much of what we think we know about the recession of 2007–09 is wrong. Not only has money not been loose since the crisis began, but tight money is the fundamental reason the recession was so severe and the recovery has been so halting. He argues that it was more fundamental than the housing bust, since residential-construction employment started falling long before the crisis hit.
Based on this understanding, Ponnuru reinterprets monetary policy over the past few years:
An alternative theory of the crisis goes something like this: While a recession may have been inevitable, it was the Fed’s passive tightening that made it a disaster. The recession began in late 2007, although many observers knew it only after the fact. The Fed passively tightened mildly in mid-2008. In the fall of 2008, the financial crisis caused velocity (and the money multiplier) to drop dramatically — in part, perhaps, because political and financial leaders were scaring everyone. The Fed did not act aggressively enough to accommodate the increased demand for money balances, and what had been a mild recession became a severe one.
As panic subsided, velocity stopped falling, and the economy then began to recover. But in mid-2010, the eurozone crisis resulted in a flight to the dollar. Increased demand for dollars again had a contractionary effect, and the Fed took months to respond to it. Finally, in the late summer, it began letting it be known that it would dramatically increase the money supply — an initiative called quantitative easing, or QE2, the first QE having been the injection of money into the financial system in late 2008 — and then, in the fall, it followed through.
This is the same story us quasi-monetarists have been making for some time. Actually, Ponnuru himself should be called a quasi-monetarist.  This is not the fist time he has taken a quasi-monetarist view on the pages of the National Review.  If only he could convince the Republican leadership to adopt the quasi-monetarist view. Then we could start thinking about a robust recovery.


  1. Terrific article in NRO.

    I do wonder about the prescription for "mild deflation" as some point in the future. This has not worked in Japan.

    My gut tells me that people will not buy or invest in real estate, in a deflationary environment. Or maybe other kinds of businesses as well. "Wait 'till next year," might become the investor national athem.

    The money illusion is powerful, and at times is beneficial. Mild inflation provides a bit of Dutch Courage to investors--and thus helps spur investment.

    Otherwide, great article.

  2. "If only he could convince the Republican leadership to adopt the quasi-monetarist view."

    First he would have to convince the Republican leadership that it's okay for the economy to be doing well in 2012 even if it makes it harder to defeat Obama.

    Good luck with that.

  3. Benjamin:

    Note that the mild deflation would only occur when there was rapid productivity and economic growth. That is far different than what Japan went through. It is also an implication of NGDP targeting. Say the Fed targets 5% NGDP growth. And because of a productivity boom we have 6% real GDP one year. Maintaining the NGDP target would require -1% deflation.

  4. Anonymous:

    Good point. Still, I hope congressional leaders get the chance to hear there is more than a hard money approach to monetary policy. Thanks to Ponnuru they might.

  5. David-

    Good point. Actually, I think something close to that happened in the 1990s in the USA. Nice productivity gains, nice output growth, and low inflation.

    BTW, even at one percent inflation as measured by the CPI, we might be in mild deflation. As I am sure you know better than I, it is difficult to measure product and service quality. I carry a cell phone that makes life so much simpler than before. It costs $50 a month, and I can call Thailand on it for 1.2 cents per minute.
    Ditto computers, Internet, and maybe some kinds of health care.
    If I don't die in an auto accident due to air bags, what is that worth?

    All in all, I favor running a little hot when it comes to inflation. Also, I suspect the Niagara of capital will keep interest rates down.

    The next global boom could turn out very nicely.

  6. BTW, the WSJ ran an guest op-ed today advocating a return the gold standard, and crimping the fed.

    I wrote them a letter asking why they did not run the op-ed on April 1.

    Beckworth: Why don't you write a retort?

  7. 1) Ramesh Ponnuru is a blithe fool, as anybody who has made the mistake of paying attention to him should know.

    2) This

    "there is an excess demand for safe, liquid assets that is preventing a robust recovery."

    is utterly false. There is no demand. The average American is tapped out. The house credit card is maxed out. That is what happened in 2008 and what has not yet been fixed. There is no more demand for further debt. The bad loans have not been written off. Multiple large companies are still cooking their books. The debt has to be paid off. There is no recovery and will not be until the bad debt is defaulted.

    3) QE2 is the direct cause of the skyrocketing prices at the gas tank and grocery store and - for exactly that reason - the North African revolutions (the Egyptian pound, among others, is pegged to the dollar). You can afford a 30% year over year rise in the price of wheat. Marginal economies can't. Bernanke has blood on his hands, as does everyone who defends and supports him - and it won't end with North Africa.

    You are utterly ignoring a multitude of facts that have been pointed out repeatedly over the past 4 years. You're either a liar or an idiot.