What I'm Reading
By Arnold Kling
The Kindle sample for Robert Hetzel’s The Great Recession. I will probably buy the book, but its exorbitant price strikes me as profoundly unfair. If you are interested in the book, then I recommend my Million Mutinies series (continues here and here as helpful background. Hetzel assumes that the reader has some background in macroeconomics already.
Anyway, an excerpt from the sample:
One explanation highlights market disorder resulting from swings in the psychology of financial markets from excessive risk taking to excessive risk aversion. The other explanation highlights monetary disorder based on central bank (Federal Reserve) interference with the operation of the price system.
Within this framework, Hetzel is, along with Scott Sumner, an adherent of the monetary-disorder school. I belong to the market-disorder school, although I am not as Keynesian as is the typical market-disorderist.
Consider the following thought experiment. Call what we actually did–the bailouts, the stimulus, the actual path of monetary policy–plan A. Suppose that in March of 2008, when folks were contemplating a bailout of Bear Stearns, the Fed instead had gone with Plan B, in which Ben Bernanke says, “Folks, it looks like there is going to be some heavy weather ahead on Wall Street. A lot of firms are in shaky situations. I want everyone to know that, no matter what happens, (a) we are not going to do anything to assist any individual firm; and (b) we are not going to allow nominal GDP to fall below the path in our forecast, which calls for an increase of 5 percent per year.”
What would have happened? One possibility is that, ironically, market disorder would have been reduced by such an announcement. For example, it is highly unlikely that October’s “break the buck” incident would have occurred. Lehman would have had to negotiate from weakness with potential purchasers. And Reserve Primary would have had to think twice about loading up on Lehman paper. (Reserve Primary was the money market fund whose shares fell below $1 in value when Lehman went bankrupt.)
But let’s assume the opposite. Let’s assume that there would have been at least as much market disorder under Plan B as there was with the bailouts, and that under plan B nothing like TARP would have been considered. In that scenario, perhaps some firms would have gone under, perhaps not. But let’s assume that the “run on repo” and the overall contraction of the shadow banking system would have been as bad or worse with plan B as what actually took place.
Would the market response to Bernanke’s promise to maintain nominal GDP have resulted in the economy remaining closer to full employment? I can think of three channels.
1. Wage rates. If anything, workers who believed the hypothetical promise to maintain nominal GDP would have been less likely to make wage concessions. Thus, this goes the in the wrong direction.
2. Domestic investment. In theory, investment projects should have looked more promising. But which ones? Not housing or commercial development in the “sand” states. Construction activity elsewhere? Factories? Computers? Maybe we can tell a story in which stock market investors do not sell stocks, Tobin’s q does not fall, and so investment does not fall. Or maybe not. Perhaps the declines in the stock prices of financial stocks would have been even worse and more long-lasting.
3. International trade. If domestic demand does not respond to Bernanke, then the only way he can keep his promise is through a large devaluation, resulting in an increase in exports and a decline in imports.
If you’re a market-disorder adherent, what do you think about Plan B vs. Plan A? Again, let’s stipulate that there would have been more market disorder without the bailouts. Does that mean, not withstanding the huge currency devaluation, inflation and nominal GDP would have been no higher than under plan A?
That is the question that I would like to see posed to the IGM Experts Panel. Based on their previous answers, I would say that most of these folks are market-disorder adherents.
My own answer is a bit unusual for a market-disorder person. That is, I think that plan A exacerbated rather than alleviated market disorder. But I don’t think plan B would have done much good, either. I would have preferred a “plan B lite” which would have made an effort to keep nominal GDP growth at 5 percent, but without an ironclad commitment. My guess is that real GDP was bound to decline in the latter part of 2008, and the only way to maintain nominal GDP growth of 5 percent over that period would have been to cause a lot of inflation. But I cannot see any harm in 3 percent nominal GDP growth (in fact, it actually declined in the last half of 2008 and the first half of 2009).