For some strange reason Keynes and Hayek caused the Great Recession
By Scott Sumner
The title of this post has probably angered 90% of the profession, and perplexed another 9%. Obviously I’m taking a few liberties here; both individuals died long ago. And it’s not even clear their policies caused the Great Recession. But for some strange reason they seem implicated.
I’ve often argued that the Great Recession was caused by mistakes in monetary policy. I began a crusade for monetary stimulus in late 2008, partly because I saw almost no one else doing the same (with a few exceptions like David Beckworth and other market monetarists.) As I got deeper into the policy debate, I noticed that two problems kept cropping up; lots of people didn’t think stimulus was needed, and another large group thought it was needed, but that the Fed was out of ammunition. The latter group often called for fiscal stimulus, which turned out to be ineffective.
At this point defenders of Keynes and Hayek might make the following arguments:
“But Keynes also favored monetary stimulus, not just fiscal stimulus.”
“But Hayek favored targeting NGDP, and don’t you market monetarists favor the same thing?”
Yes, that’s all true, but for some strange reason they seem implicated.
Let’s start with Keynes. During the Great Contraction, Keynes favored both monetary and fiscal stimulus, although by 1932-33 he thought that the Fed had basically run out of ammunition. Rates were near zero. In public statements, he argued that it was time to focus on fiscal stimulus. Then something very interesting happened. FDR devalued the dollar between April 1933 and February 1934, and prices and output started rising rapidly. At first Keynes approved, but as the dollar depreciation got deeper for some strange reason Keynes turned against the policy. When FDR finally agreed to stop any further devaluation in early 1934, for some strange reason Keynes congratulated the President for ignoring the pleas of the “extreme inflationists.”
Much later, Allan Meltzer noted that for some strange reason Keynes had overlooked an obvious solution to monetary policy ineffectiveness at the zero bound–a positive inflation target. Modern Keynesians did not overlook this solution; Paul Krugman and many others have recommended a 4% inflation target. If we had had that target in 2008, we could have avoided the deep recession in exactly the same way Australia did, by continuing with Taylor Rule-type policy adjustments. (BTW, I don’t favor this policy, as there are equally effective techniques that do not require higher inflation, but it would “work.”)
What if Meltzer and Krugman could go back in a time machine and explain the merits of this idea to Keynes (assuming they could agree to sit in the same tiny time machine.) Twenty years ago I would have guessed they could have easily convinced Keynes of the merits of their plan. Now I don’t think so. I think Keynes would have smiled in a condescending way, and told them; “that’s all well and good in theory, but an unanchored fiat money regime will eventually end up in hyperinflation—look what happened in Germany.” For those who don’t know, Keynes once called an unanchored fiat regime the worst possible monetary system, even worse that a rigid inflexible gold standard.
For non-Austrian readers my Hayek claim might seem less far-fetched, after all, modern Austrians have tended to be skeptical of “stimulus” as a solution to the Great Recession. But defenders of Hayek point to his support of NGDP targeting. That’s true, and yet for some strange reason Hayek opposed monetary stimulus in the early 1930s, even as NGDP was obviously plunging much lower in most developed economies. In the US it fell in half. Yes, we didn’t have good GDP data, but it was very clear that BOTH prices and real output were falling rapidly, so there can be no doubt that Hayek knew that nominal income was falling. Much later Hayek regretted his opposition to monetary stimulus in the early 1930s, which damaged the reputation of Austrian economics at the time.
In 2007 the number one monetary economics textbook taught students that low interest rates don’t mean easy money, and that you need to look at other asset prices to ascertain the stance of monetary policy. Yet for some strange reason most economists thought money was highly expansionary. This textbook also taught students that monetary policy is still “highly effective” at near zero rates, and yet for some strange reason most economists assumed the Fed was out of ammunition.
Around 2010 when inflation in some countries rose slightly above target (due to oil prices and higher VATs) many hawks insisted that we needed to focus like a laser on the inflation target. A few years later when inflation fell below the target, for some strange reason these same hawks saw merit in missing the target–perhaps deflation could restore “competitiveness.”
More recently, for some strange reason Keynesians like Larry Summers began to worry that monetary stimulus could create bubbles, even though standard Keynesian theory says that monetary stimulus is needed when unemployment is high and inflation is below target, and there is no respectable model that would justify ignoring the unemployed because of some highly questionable bubble theory that isn’t even consistent with the EMH. Commenters tell me that Keynesians favor monetary stimulus. Yet in poll after poll of economists since 2008, for some strange reason only a very tiny percentage assert that money is too tight, despite the fact that most economists are Keynesians of one sort or another. For instance, almost all economists (in polls) claim that fiscal stimulus boosted GDP. For some strange reason they have the same blind spot about money as Keynes.
To summarize, people talk a good game, but for some strange reason when a crisis hits, most of the profession loses it heads. I suppose if you polled Americans in 2013 and asked; “do you think Americans should freak out like it’s the end of the world if one or two cases of a not easily caught disease spreads from Africa to America?” the answer would have been no. I suspect in 2014, when this actually occurred, you’d get a different answer. . . .
. . . For some strange reason.