Thanks to Mark Thoma for keeping the debate going. In a defense of what Paul Krugman would call Dark Age Macroeconomics, David Beckworth unleashes that most medieval of weapons, the dreaded Vector Autoregression. More on that below the fold. Also below the fold, I will discuss Nick Rowe and Josh Hendrickson.

What happened one year ago that caused the economy to tank over the winter?

(a) a credit crunch. Banks would not lend to one another, and they cut back on credit to businesses, which in turn caused the contraction in economic activity.

(b) a recalculation. People found out that their housing wealth was lower, so they spent less. The home construction, real estate brokerage, mortgage lending, and securitization industries found out that their services were in much less demand than they had been, and they cut back. Finally, Ben Bernanke and Henry Paulson shouted “The Great Depression might come back!” in this crowded theater, and everybody ran for the exits. For example, law firms started telling new hires to go do something else for a while.

(c) people woke up to find that the elves and helicopters had left less money lying around.

(d) people woke up to find that the Fed had lowered its de facto inflation target.

The economists I consider to be most sensible are pushing some combination of (a) and (b). I differ from the consensus in that I push (b) exclusively and minimize (a). Lots of folks–defenders of Bernanke in particular–push (a) more than (b). What Scott Sumner and David Beckworth wish to defend is (c) and/or (d). Their advantage is that they are consistent with the way macro was taught (in graduate school, not in undergrad) the past thirty years. Their disadvantage is that this macro is, in fact, completely bizarre.Nick Rowe argues that money is different because it is a medium of exchange. I would say that it is a medium of exchange because it is a temporary store of value, so that I am willing to lump together the store of value function and the medium of exchange function. Rowe says that because money is the medium of exchange, it is the “hub” of transactions. He offers the metaphor of a hub-and-spoke system in airlines. Remember what always happened to USair–Or Allegheny, as we used to know it–when Pittsburgh got rainy. Where I disagree with his hub-and-spoke story is that in the case of money, I don’t think that USair gets messed up because of what happens in Pittsburgh. I think that what happens in Pittsburgh is a symptom of what happens when USair gets messed up. That is, when the economy is Recalculating, money circulates less rapidly.

This issue of causality is a natural segue to the empirical issues raised by Josh Hendrickson. What if we can show that fluctuations in GDP are preceded by fluctuations in money demand or money supply? Would that not be strong evidenced against my monetary theory? Hendrickson points to a long tradition of economists, including Friedman and Schwartz, Allan Meltzer, and others, who claim to have found such evidence. While I recognize that this work is formidable, I retain some influence from the late Franco Modigliani, who conducted the Money Workshop at MIT. Modigliani was so frustrated by the way that monetarists would search for a definition of money that correlated with nominal GDP that Modigliani mockingly referred to M1, M2, and so on as Milton1 and Milton2.

All of the different Miltons lead me to say this: there is no single medium of exchange. Instead, there is a lot of substitutability in media of exchange. Think of all the different ways you have to pay for stuff. The way I see it, there is a lot of substitutability among stores of value, including among temporary stores of value. Because substitutability is not perfect, the Fed can fiddle around in asset markets and change the relative values of some assets. By a little bit. For a little while. But I don’t equate this fiddling with being able to hit a precise GDP target.

I think that my theory leads to a view of inflation as a fiscal phenomenon. Certainly, that works for hyperinflations–you cannot have a hyperinflation without an out-of-control government budget. The question is (and I guess we’re about to find out) whether you can have an out-of-control government budget without a lot more inflation. The monetarist view would be that if you don’t monetize the debt, you don’t get more inflation. The view that assets are close substitutes would suggest that whatever liabilities the government issues to pay for its deficits will eventually cause inflation.

Finally, we get to David Beckworth, who writes,

I have posted below some figures from another VAR I did that looks at the effect of unexpected changes or shocks to the monetary base for the period 1960:3 – 2008:2.

VAR is the dreaded vector autoregression. The monetary base is Milton0.

What the VAR says is this. Suppose that Joe the Plumber is influenced by surprise changes in Milton0. We pretend that in 1975 Joe had access to all the data from 1960 in the third quarter until 2008 in the second quarter, and that he used state of the (future) art in time series econometrics to come up with a statistical model to predict Milton0. We use forecasting errors of this model as indicators of the surprises that Joe experienced from the elves and helicopters. We then correlate these surprises with inflation and/or real output.

Seriously. And I wonder how well this model does out of sample. In late 2008 and early 2009, Milton0 goes through the roof, and the economy goes through the floor.

Sumner would point out that the relationship between Milton0 and Milton1 changed drastically during the crisis, because the Fed started paying interest on reserves. That is an important point. I would add that, as best as I can recall, the relationship between Milton0 and Milton1 also changed quite a bit in another important monetary episode, the Nixon re-election monetary expansion of 1972. I may be wrong, but I have a recollection that the Fed made some technical change that affected reserve requirements that year.

Anyway, my view of how Joe the Plumber figures out that the monetary regime has changed is that he gradually notices that prices are going up at a different rate than they were before. Because of this, it takes a really long time for changes in the rate of printing money (or rate of running government deficits) to show up as changes in the rate of inflation.