Black swans and eels
By Scott Sumner
Yesterday I stumbled upon a strange sight, a couple of black swans swimming above some eels in a New Zealand lake. The swans would occasionally lift a leg out of the water, perhaps to avoid getting bitten by the eels. (At least that’s what the locals said.) That got me thinking about the financial crisis of 2008.
Most observers of this scene probably have more sympathy for the noble and elegant swans than the dark and slithery eels. When looked at objectively, however, both are rather primitive creatures with small brains, which act instinctively. We project the nobility and the deviousness. And I believe the same is true of financial crises.
When people discuss Fed policy during a financial crisis, there is often an implicit framing that portrays the central bank as a hero and the economy as a villain. Large injections of liquidity are seen as a sort of “rescue”, in response to sharply elevated demand for reserves during a financial crisis. The economy is seen as wild and out of control, something that needs to be stabilized by the central bank. This framing isn’t just wrong, it leads to bad consequences.
Let’s back up and think for a moment about the nature of fiat money. In the US and in most other countries, the central bank has been given a monopoly on the production of fiat money. Along with that monopoly, the central bank has been assigned the responsibility to stabilize the value of money according to some metric.
In the past, governments often told the central bank to make sure the value of fiat money was stable in terms of gold. More recently, they’ve been assigned the duty of stabilizing the value on money in terms of an index of goods and services prices. I favor stabilizing the value of money as a share of NGDP. Monetarists such as Milton Friedman wanted to the central bank to stabilize the quantity of M1 or M2.
Almost no one favors a policy of stabilizing the monetary base. Almost everyone believes it is the duty of the central bank to adjust the monetary base in such a way as to stabilize some other variable, whether it be gold prices, the CPI, NGDP or M2. Thus, it’s the job of the central bank to adjust the monetary base to accommodate changes in the demand for base money.
Each November, the turkey industry boosts the supply of turkeys to meet the public’s demand for those tasteless birds around Thanksgiving. We don’t think of the turkey industry as valiantly rescuing a public with a recklessly unstable demand for turkeys. Rather, the turkey industry is just doing its job.
If the Fed did not meet an increased demand for reserves with injections of new base money, then they would not be able to stabilize gold prices, the CPI, NGDP, M2, or any other plausible goal of monetary policy. When they are doing their job, a monetary injection is not some sort of heroic action that bails out an evil and irresponsible financial system, rather it is simply a way of meeting the demand for reserves, in order to stabilize the central bank’s goal variable. That’s equally true of an increased demand for reserves that originates in the banking system, and an increased demand for cash that results from people in Venezuela hoarding US dollars. But for some reason, many people view these two situations quite differently. The latter case is seen as normal policy, while the former is viewed as extraordinary.
When people ask me if the government should bail out the financial system in a crisis, I reply that the answer is no. Instead they should supply enough reserves to keep NGDP growing at around 4% a year. It just so happens that if they did so there would never (by definition!) be the sort of financial crisis that reduced aggregate demand. (There might be other sorts of financial crises.) In addition to not bailing out banks, the Fed should not try to reduce unemployment, or inflation, or pop asset bubbles, or undertake any other objective. Just keep NGDP growing at about 4%.
The hero/villain framing is unfortunate as it leads to bad monetary policy. With this framework, people expect too little of the central bank, as I explained in this recent post. If we expect too little of the central bank, then they are more likely to take their eye off the ball and pursue tangential objectives. They will fail to stabilize aggregate demand. Thus in 2008, the Fed did not see itself as causing a fall in NGDP with a tight money policy, and that failure of imagination contributed to their unwillingness to do “whatever it takes” to hit their policy targets.
Recessions in the US are not caused by private sector “shocks”, they are caused by bad monetary policy. As we expect more of monetary policy, these imaginary “black swans” will become much less frequent. Ironically, in Australia (home of the black swan) they already are quite infrequent.
PS. People on the right often unwittingly play into the hands of statists when they complain that reserve injections during a financial crisis are some sort of “bailout” or “rescue” of the banking system. That framing makes the free enterprise system seem feeble, and in need of government help.