Monday, August 22, 2011

Central Banks Still Have Much Ammunition

Ambrose Evans-Pritchard writes there is still much monetary policy can do to support the economy:
[W]ith fiscal policy exhausted, the burden must fall on monetary policy. Here we have barely begun to use our atomic arsenal even at zero rates. As Milton Friedman taught us – though nobody in Frankfurt -- it is a fallacy to think that low rates are loose. Zero can be extremely tight. 

That may be the case now with US Treasury yields signalling deflation and M2 velocity collapsing as it did pre-Lehman. 

To those who argue that the Fed is pushing on the proverbial string, David Beckworth from the University of Texas replies that the Fed showed between 1933 and 1936 that it could deliver blistering growth of 8pc a year despite debt deleveraging in the rest of the economy.
He is referring to this post where I noted the following:
[H]ouseholds were also significantly deleveraging during the Great Depression.  This experience would fit the standard definition of a balance sheet recession.  Below is a table from his paper that shows household balance sheets in real terms.  Note that between the 1933 and 1936 U.S. household underwent a cumulative deleveraging  in real terms of 20%. This is far more in percentage terms that has happened over the past few years. And yet between 1933 and 1936 the U.S. economy had a robust recovery.  Real GDP averaged almost 8% growth during these years. 

   Source: Mishkin
The balance sheet recession view cannot easily reconcile the large deleveraging by households and the rapid real economic growth that occurred between 1933 and 1936.  What can explain it is a more nuanced view that acknowledges creditors with excess money demand were confronted by FDR's original quantitative easing program.  This QE program was far better than recent ones in that FDR clearly signaled a price level target and backed it up by devaluing the gold content of the dollar and allowing unsterilized gold inflows. In otherwords, FDR signaled that he was going to allow a significant and permanent increase in the monetary base and followed through on it.  This change nominal expectations and caused creditors to start spending their money balances.  
Unfortunately, the 1933-1936 recovery was cut short by a tightening of monetary and fiscal policy.  Consequently, many observers overlook this great natural experiment of monetary policy that shows monetary policy does not push on a string when there is significant deleveraging.  

Another natural experiment is present-day Sweden.  Its housing sector also acquired much debt and its economy was also hit hard by the economic crisis.  However, it has had a robust recovery and the reason appears to be a much more aggressive monetary policy.  All of this shows that monetary policy still can pack a punch.  The question, then, is whether the Fed has the desire and political capital to do so.

Update:  The Mishkin table above is in real terms.  To see what was happening to nominal household debt, I constructed the two tables below.  The first one converts the Mishkin table into nominal growth rate terms using the CPI.  The second one uses current dollar data from the 1940 statistical abstract on "individual and other noncorporate" debt.  Both tables indicate nominal household debt was falling through 1935.  So the recovery of 1933-1936 largely coincided with a reduction in household nominal debt too.


  1. David
    Along the same lines:

  2. Really good blogging.

    Ben Bernanke-san: Please read this blog.

  3. I'm generally quite supportive of your analysis, but I don't thing the Mishkin table stands the weight you put on it. After all, it shows (a) real household debt; and(b) the fact that real household debt in 1935 and 36 was the same as that in 1929. As estimated real GDP was also the same in 1936 as in 1929, all that suggests little or no household deleveraging through that period, and rather that the real household debt increase in the early 30s was a reflection of the unexpected fall in the price level, gradually unwound as the price level recovered. It is worth bearing in mind that household debt was only around 40% of GDP in 1929, and more than twice that in 2007. In any case, as you point out, the ability to go off gold in 1933 was a very powerful stimulus option then, and it is difficult to see anything quite that potent left in the toolkit now.

  4. Michael:

    Despite the desire of FDR to return the price level to its pre-crisis level and his policy of devaluaing the gold content of the dollar, the price level did not return to its pre crisis value by 1936. See this figure: Thus, there was a reduction in nominal debt as well. I added some tables to the post to illustrate this. If you know of better data for this period let me know.

    Have a little more faith in monetary policy. Though the devaluing the gold content of the dollar was important, it served as the fire behind FDR's setting of price level expectations The devaluation was to show FDR was serious about raising the price level. (Although it took longer than anticipated to return the price level to trend, all FDR needed was to convince the public it would.)

    The importance of setting expectations can be seen in Sweden's robust recovery that is almost solely the consequence of its monetary policy. If monetary policy is out of ammunition now, then why did it work in Sweden? Setting a nominal GDP level target should pack the same punch for the US economy.

  5. David

    Thanks for your response, and for generating the nominal data. I'd still read that as saying that by 1934 there was very little 'drag" from nominal household debt reduction (especially given that household debt to GDP was much smaller then that it is now - not far from 100% at present). A 2% fall in household debt now is more than twice the drag in GDP terms a 2% fall was then.

    I am generally quite sympathetic to nominal GDP targeting, probably even in levels terms. It would probably have been helpful during the boom years too. But my challenge to advocates of it in the present situation is "why should a nominal GDP level target be given any public or market credibility, in ways that actually influence behaviour?" Whether or not you are substantively right, there are more doubts around at present about the ability of the authorities to deliver on their goals than at any time for decades. When, for example, countries announced inflation targets many doubted their willingness to pay the price, but few doubted their ability. This time round there would be serious questions on both counts.

  6. Michael,

    Using the second table's number, HH debt to GDP was just over 50%. While this is about half the number today, the rate of hh deleveraging was far more pronounced then than currently. And I am not sure your claim about the deleveraging drag being larger now is right since one, the financial system was was more fragile then and two, the overall state of the economy was far worse. My understanding is that the corporate sector was far more indebted then than now, so that does complicate the implications.

    Do you think the Fed's ability today to do NGDP level targeting is any less likely than what FDR did in between 1933 and 1936? As Scott Sumner has shown, many of the same arguments about monetary policy were made then as now. Yet, he did something really radical. I see the real problem being a lack of political capital, not a lack of ability.

  7. Michael:

    Again, how do you wrestle with the remarkable Swedish recovery from this crisis that appears to be largely the result of aggressive monetary policy?

  8. David,
    What you are trying to explain is the “Phoenix Miracle”, where economies can recover from a crisis while deleveraging. Fortunately, Michael Biggs and Thomas Mayer at Deustche Bank have already succeeded in explaining this seeming paradox.

    In short, your problem is that the data above deals with the STOCK of credit and you fail to realize that it is the FLOW of credit that matters for GDP (also a flow variable).

    This is a link to a short paper explaining this concept:

    I highly suggest reading it. It explains both the Great Depression and Swedish examples you mention. It will be the most helpful piece you will read this year.

  9. You may have already seen this, but FT Alphaville has an interesting take on the adverse effects of QE2, namely that it has perversely convinced the market that the central bank can't really create inflation in a debt deflation.