The Fed can do what King Canute could not
By Scott Sumner
Alex Tabarrok has a new podcast on monetary policy, over at Marginal Revolution University. He presents a fairly standard view of the Great Recession, emphasizing how an easy money policy during the early 2000s led to low interest rates and helped to inflate the housing bubble.
My view is different. I don’t think the low rates were caused by easy money—rather it was weak investment in the US and increased saving in Asia. And I don’t think low rates caused a housing bubble. But I’d like to focus on something else that caught my interest.
At the end of the video, Alex mentions NGDP targeting as a policy that some have suggested might have helped to prevent the Great Recession. He then suggests that it’s not clear whether the Fed would have been able to push back against the powerful contractionary forces that were hitting the economy in late 2008. He notes that the monetary base increased rapidly in late 2008, and thus presumably even more rapid increases would have been required to stem the tide of recession. Finally, he suggests that it’s not clear whether the Fed could have produced a substantially larger increase in the base (alluding to possible political barriers.)
I believe that’s the wrong way to think about the problem. A truly effective NGDP targeting policy, with level targeting, would have required a much smaller increase in the base, as we saw in Australia. That’s because the nominal interest rate would probably have stayed well above zero.
People often think about this issue in terms of nautical analogies. The Fed is like a ship captain fighting valiantly against the powerful winds and waves of a storm. I’ve used that metaphor myself. But in some ways it’s more useful to think of the Fed as causing the storm. NGDPLT doesn’t give you a stronger engine or rudder, it actually causes the ocean to become placid.
The expectation that NGDP will return to the trend line in the future causes the current drop in velocity and NGDP to be much milder than otherwise.
This relates to the fireman/arsonist metaphors. Economists such as Paul Krugman tend to view the Fed as a fireman, which may or may not have the power to put out a fire (i.e. the unstable free market economy.) In this video, Alex suggests the Fed might have been an arsonist in the early 2000s, and a fireman who failed to contain the resulting conflagration in late 2008. I see the Fed as being broadly neutral in the early 2000s and an arsonist in 2008.
Does a fireman have enough power to prevent a conflagration? Sometimes yes, sometimes no. Does an arsonist have it in their power to prevent a fire? Yes, 100% of the time. They simply need to refrain from lighting the fire. NGDPLT is a way of preventing fires by not lighting them. Recessions are typically caused by sharp declines in expected 2-year forward NGDP. Under NGDPLT, expected 2 year forward NGDP stays on trend. Recessions would still occur on occasion, but they’d be far milder.
Somehow I wandered from nautical to firefighting metaphors, but hopefully you get the point.
PS. The video is entitled “When the Fed does too much”. That’s not a good title. The question is whether the Fed has the right or wrong policy. When it comes to monetary policy, it’s not at all clear what “doing more” actually means. More money? More volatile money supply? More volatile interest rates? More aggregate demand? That sort of title leads to confused thinking about what monetary policy actually does.
HT: Ben Klutsey