Cyclical Monetary Theory
By Arnold Kling
Read Scott Sumner’s post. I would distill it as arguing that macroeconomics and monetary theory follow a cyclical pattern.
1. During good times, such as the Great Moderation, a view develops that the monetary authority can stabilize the economy by aiming for a steady path for the price level or for inflation.
2. When a financial crisis occurs, people decide that the “good times” were an illusion. Instead, they revise history to describe good times as a bubble. They become receptive to what Paul Krugman calls “hangover theory,” thinking that the bad times that follow a financial crash are the fair punishment for the previous excesses.
3. As bad times persist, people decide that the punishment has become excessive and unwarranted. Having lost faith in monetary policy as part of step (2), they become fiscal stimulus advocates, like Keynes of the General Theory.
Scott’s main question is why people lose faith in monetary policy between steps 1 and 2.
I personally lost faith in (1) well before this crisis. I thought that the monetarist explanation of the Great Moderation was an attribution error. That means that I do not attribute the recent boom-bust cycle to loose-tight monetary policy. I think that to the extent government is to blame, it is for housing poilcy and bank capital regulations. See Not What They Had in Mind.
Otherwise, however, I have been pushing something close to (2). That is, of course, the Recalculation Story. If Sumner is correct, the longer that high unemployment persists, the less plausible this story will seem. That may be a fair observation of how intellectual fashions operate, but it is fairly ironic. I expect that the Recalculation will take many years to work out. In fact, if employment bounces back quickly, I would count that as tending to support the theory of fiscal stimulus and tending to weaken the case for the Recalculation Story. So a prolonged slump in employment might strengthen my belief in (2) while the intellectual cycle would move toward (3).