Scott Sumner writes,

Many economists simply assume that the current contraction has been caused by the financial crisis. After all, isn’t that obvious? Actually, no. For nearly a year after the onset of the financial crisis nominal GDP continued growing at better than a 3% clip. Now it is plunging. Most seem to assume that this new state of affairs was somehow caused by the Lehman failure, and the subsequent loss of confidence in the entire financial system. My view is that this reverses the causality; it seems much more plausible that the current problems in the financial system are being caused by the recent (and expected future) sharp fall in nominal GDP.

…Too many economists merely look at the sharp fall in interest rates, and the sharp increase in the monetary base, and assume policy has been expansionary. But the Fed also cut rates sharply and increased the base during the early 1930s. Just as during the Great Contraction, policy has been highly contractionary in the only sense that matters, relative to what is needed to meet the Fed’s policy target for nominal spending.

Tyler Cowen recommends all of Sumner’s posts, but I particularly recommend the one above.

The important point to note is that Sumner is the only economist around making any use of recent macroeconomic theory, by which I mean the theory of the last thirty years. I have explicitly scorned that theory, and many other economists have implicitly scorned it by reverting back to what they think of as Keynes.

Recent economic theory says that expectations matter. Sumner says that the Fed has to create expectations that nominal GDP will increase. That sounds fine. But how do they do that? Should the Fed start playing the commodities markets?

Elsewhere, Sumner points out that the Fed’s policy of paying interest on reserves is contractionary. If your goal is to save the banks, then paying interest on reserves may seem like a good idea. However, if your goal is to save the economy, then paying on interest on reserves is a bad idea, because it loosens the link between the monetary base and the money supply, making monetary policy harder to execute. You can pour reserves into the system, and banks can choose not to lend but instead take the safe earnings from excess reserves. Conversely, when you you contract the monetary base, you sop up excess reserves without forcing banks to contract lending.

Ironically, according to this reasoning, by paying interest on reserves the Fed might have weakened banks. Because the monetary expansion was stifled, the economy tanked, and that weakened the banks. As I read Sumner, he would argue that paying interest on reserves was a major policy blunder.

My instinct is that Sumner’s focus on rational expectations and on interest on reserves is too subtle. I still hold to the view that the market panic and rapid de-leveraging were exogenous shocks. However, Sumner’s views are provocative and coherent.