My Bizarre Monetary Theory, Continued
Before I respond to Bryan’s comments, let me first recommend the two Scott Sumner papers that he mentions.
This paper develops a theory that cultural values drive economic policy, which in turn drives economic outcomes. It is an interesting complement to (or substitute for?) Bryan’s view that economic education can drive economic policy.
For the issue at hand, monetary theory, Sumner writes,
Almost everything we have learned from recent research in monetary history, theory and policy, all points to the Fed as being the cause of the crash of late 2008. More specifically, an extremely tight monetary policy in the US (and perhaps Europe and Japan) seems to have sharply depressed nominal spending after July 2008. And yet it is difficult to find any economist who believes this. More surprisingly, few economists are even aware that their views conflict with the standard model, circa 2009. Even if I am wrong, and the standard view of the crisis is correct, there is an important message in this paper. The standard view of the current recession conflicts with some of the most important concepts that we currently teach our students in monetary economics courses.
He is saying that the textbooks all tell an MV = PY story for macroeconomic fluctuations. Nobody seems to be telling an MV = PY story for this crisis. What’s going on?I do not tell an MV = PY story for any macroeconomic fluctuations (other than very high inflation). Instead, I tell a Recalculation story. Thus, I do not have a consistency problem. My problem is to defend my bizarre monetary theory. As Bryan puts it,
If Arnold’s position were that raising nominal GDP wouldn’t help real GDP, I could understand it. But he’s actually questioning the ability of central banks to affect nominal variables. Even stranger, he’s using hyperinflations – airtight proof of central banks’ near-infinite power over nominal variables – to prove that this power is illusory.
I do not think that central banks control nominal GDP any more tightly during a hyperinflation than at other times. That is, in normal times, if nominal GDP wants to grow at a 5 percent annual rate next quarter, the central bank cannot hit a 10 percent target. In hyperinflation, if nominal GDP wants to grow at a 10,000 percent annual rate next quarter, the central bank cannot hit a 10,005 percent target.
Like most economists, I view real GDP in the long run as determined by real factors, such as the supply of factors of production, the state of technology, and the nature of economic and cultural institutions. However, I view average prices in monetary units as reflecting habits. The government can change people’s habitual price behavior only by making significant, long-lasting changes in the amount of deficit that it finances by printing money. On the other hand, changes in money-printing that are modest and short-term have essentially no effect.
Think of monetary policy as being like currency intervention. It seems as though it is very difficult for a government to maintain a currency at a value that the market views as unrealistic. Similarly, it is very difficult for the government to maintain an interest rate at a level that the market views as unrealistic.
Another way to express my view is that there is a probability distribution for nominal GDP growth. By printing money much faster starting today and persisting for several years, the government can raise both the mean and the variance of the distribution of nominal GDP growth many years from now. However, in the short run, both the mean and the variance are determined by things that have happened in the past, including past monetary policy but also including Recalculations and other factors that affect real GDP as well as past habits of price-setting.
Sumner’s view of the causal ordering of the current recession is that the Fed cut M, which reduced nominal GDP, which reduced real GDP. My view is that the Recalculation reduced real GDP, which also slowed the rate of price increase. The standard view is that there was a huge increase in the demand for M, which lowered nominal GDP. An interesting question is whether it is possible to use data to evaluate these differing explanations.