The Latin phrase Nemo judex in causa sua can be roughly translated as: No man can judge his own cause.
This ancient maxim is a bedrock principle of English common law. In this post I’ll argue that violation of this principle has caused great damage to the field of macroeconomics. Macroeconomists have sat in judgment of their own decisions, and failed to reach an accurate assessment. Here’s my hypothesis:
In areas when economists play a major role in policymaking the economics profession will fail to provide a fair and balanced appraisal of the extent to which bad outcomes are due to policy mistakes and the extent to which bad outcomes are due to exogenous shocks.
[Update, 12/26: Peter Boettke directed me to a recent book he coauthored with Alexander Salter and Daniel Smith, which anticipated the key point of this post (p. 60-61):
The failure to incorporate institutional incentives in our monetary models and policy prescriptions is likely due to the fact that, when it comes to central banking (and higher education, as in Adam Smith’s example), economists themselves are often players in the game! The temptation for actors to rationalize their own behaviors, and thus overlook the institutional influences on their behavior, underlies the principle of nemo judex in causa sua, that no man should be his own judge. This is a troubling oversight.
They focus on central bank incentives, but they also note how it is a more general problem. In this post, I focus not so much on the issue of central bank incentives, rather the way this problem affects how theorists interpret the economy.]
To be clear, I’m not suggesting that economists are doing anything illegal, or even unethical. Rather, I’ll argue that in the normal course of “doing macroeconomics”, the profession ends up sitting in judgment of their own decisions, and almost inevitably a certain bias seeps into the way they evaluate the effects of policy. That has led to important blind spots in our understanding of contemporary macroeconomic events.
Here are some specific claims:
1. Economists (broadly defined to include key monetary policymakers without an economics degree) have great influence over the course of monetary policy. Monetary policy tends to mostly (not entirely) reflect the consensus view of economists.
2. Economists are unlikely to reach the conclusion that their policy views were wrong. Instead, they will blame any resulting macroeconomic problems on various “shocks”, even when the evidence strongly points to a failure of monetary policy.
3. In contrast, economists will be willing to criticize the policy decisions made by earlier generations of policymakers, or the policy decisions of economists in other countries.
Here is some evidence:
1. At the time, most economists did not believe that a Fed tight money policy was a major cause of the Great Depression. Today, that is a widely held view among economists, even Fed economists.
2. At the time, most economists did not believe that a Fed easy money policy was the cause of the Great Inflation of 1966-81. Today, that is a widely held view among economists, even Fed economists.
3. Many western economists were highly critical of Japanese monetary policy during the late 1990s and early 2000s, despite the fact that Japan had cut interest rates to zero and done some QE.
4. These same economists tended to be much less critical of Fed policy during 2008-09, despite conditions being quite similar to the Japanese case.
5. In the case of the recent high inflation, American economists focused most of their blame on supply side problems and excessive fiscal stimulus.
I believe that American economists were also more likely to blame the ECB’s tight money policy for the eurozone’s double dip recession in 2011, whereas European economists were more likely to point to the debt crisis. (I’m less confident on this point than the other five—please correct me if I’m wrong.)
Here is some evidence for the claim about Japan.
In 2003, Princeton economist Lars Svensson published a paper offering a “foolproof” way out of its liquidity trap and deflation. The term foolproof suggests that even a fool could accomplish this task. But the Japanese failed to do this, so what are we to infer?
In 1999, Paul Krugman had this to say about Japanese policy:
What continues to amaze me is this: Japan’s current strategy of massive, unsustainable deficit spending in the hopes that this will somehow generate a self-sustained recovery is currently regarded as the orthodox, sensible thing to do – even though it can be justified only by exotic stories about multiple equilibria, the sort of thing you would imagine only a professor could believe. Meanwhile further steps on monetary policy – the sort of thing you would advocate if you believed in a more conventional, boring model, one in which the problem is simply a question of the savings-investment balance – are rejected as dangerously radical and unbecoming of a dignified economy.
Will somebody please explain this to me?
In 1999, Ben Bernanke published a paper entitled: “Japanese Monetary Policy: A Case of Self-Induced Paralysis?* In a nutshell, the answer he provided was “yes”:
I tend to agree with the conventional wisdom that attributes much of Japan’s current dilemma to exceptionally poor monetary policy-making over the past fifteen years . . .
I do not deny that important structural problems, in the financial system and elsewhere, are helping to constrain Japanese growth. But I also believe that there is compelling evidence that the Japanese economy is also suffering today from an aggregate demand deficiency. If monetary policy could deliver increased nominal spending, some of the difficult structural problems that Japan faces would no longer seem so difficult.”
Japan had suffered a real estate and banking crisis, followed by recession and near-zero interest rates. In 2008-09, the US faced a quite similar situation. But this time most of our economists failed to blame the central bank for the severe decline in “nominal spending”. Instead, the problem was attributed to various “shocks”, and the central bank was excused because there was a feeling that they had done all they could.
In fact, the Fed failed to do the specific things that we recommended the Japanese do. The Fed did not do level targeting. The Fed did not do a “whatever it takes” approach to QE. Instead, the Fed warned of various vague costs and risks associated with open ended QE, concerns that were brushed aside when advice was given to the Japanese.
The underlying problem is that the Fed’s policy was close to the consensus view of American economists, and no one likes to admit that they were wrong.
The case of the recent inflation is a bit more ambiguous. Many economists did suggest that the Fed waited a bit too long to raise rates. Even in this case, however, you find very few economists plainly stating that the Fed caused the high inflation of 2021-23 with a recklessly expansionary monetary policy. Instead, the overwhelming majority of the attention has focused on two other factors—supply problems due to Covid/Ukraine, and overly expansionary fiscal stimulus. In my view, economists have put about 50% of the blame on supply problems, 40% on excessive fiscal stimulus, and at most 10% on Fed stimulus.
In fact, almost 100% of the cumulative inflation since 2019 is due to monetary policy. Full stop. It’s the Fed’s job to take fiscal stimulus into account and offset it so that aggregate demand grows at a rate consistent with its dual mandate. Although the Fed doesn’t have to offset supply shock inflation (due to its dual mandate), those effects have mostly unwound over the past year. While some of the inflation of late 2021 and early 2022 was supply side, over the longer run the rate of excess inflation (inflation above 2%) is almost identical to the amount of excess NGDP growth (nominal growth above 4%.) Real GDP growth over the past 4 years has been about 2%, slightly above the Fed’s estimate of trend RGDP growth (which is 1.8%). So the cumulative excess inflation since 2019 is almost all demand side.
The Fed created the high inflation of 2021-23, and now Powell is being lionized by the profession for creating a soft landing. Powell has done a good job of fixing the problem (so far), but it’s a problem that was almost entirely created by the Fed.
In my view, this is a fatal flaw with modern macroeconomics. Because monetary policy reflects the consensus views of economists, we cannot expect our economists to accurately diagnose the causes of policy failures. At best you’ll get a few heterodox economists pointing to the role played by Fed policy, people like Robert Hetzel and Tim Congdon.
How can this problem be solved? We need a policy regime where policy failures are able to be clearly identified. I thought FAIT would be such a regime, but the Fed spoiled it by later deciding that average didn’t mean average. We need a clear and specific target path for NGDP, and a promise to return to that path when the economy deviates from stable growth in nominal spending. Only then will it become apparent who deserves blame for policy failures.
BTW, I’m not saying policy must immediately return to the trend line. NGDP data can be noisy, and during periods like Covid it makes sense to allow a year or two to return to trend. But policy must commit to a long run trend line if we are to avoid repeating the mistakes of 2008-09 and 2021-22.
PS. In fairness, Paul Krugman did argue (correctly) that the Fed should be more aggressive during the post-2009 recovery. That was a minority view. But in my view he overlooked the role of tight money in the 2008 recession, which he attributed to exogenous shocks.
PS. Merry Christmas!
READER COMMENTS
Rajat
Dec 26 2023 at 5:52am
Scott, I agree with your three claims 100%, and your evidence 90%. I’ll come back to the claims.
On the evidence, one excuse some economists might use is that what may be possible for a smaller country Is not possible for the US. I’m not sure whether what Krugman, Svensson and Bernanke thought would work for Japan would in their view work in the US. But I’d say the same more generally about US macroeconomists and Japan or Europe – it’s regarded as meaningful to devalue against the ‘global reserve currency’, but how does devaluation *of* the reserve currency work? Monetarists like you and Nick Rowe would say the US Fed could easily devalue the USD against the CPI basket, but don’t many mainstream economists reflexively think that devaluations work via the trade balance?
The other point is that Krugman has never been an actual central banker, and Svensson was an iconoclast even when he was one. His own countrymen didn’t listen to him when he made the same criticism of domestic Swedish monetary policy as he had made of the BoJ! So I don’t think the fact that the Fed and the Riksbank didn’t adopt the policies that Krugman and Svensson, respectively, advised is strong evidence for their hypocrisy. Bernanke is a different case and a depressing puzzle for the naive (like me). Maybe it’s to do with the structure of the Fed. Maybe a weakness in his personality. But I do recall you at the time being incredibly forgiving of Bernanke’s lack of follow-through on his earlier beliefs due to a combination of these factors – and more generally about the influence of the Fed ‘Borg’.
Which takes me back to the claims. I first recall you making the second half of claim 1 (monetary policy tends to mostly reflect the consensus view of economists) in the early 2010s. At the time, this was a revelation to me and struck me as truly profound. Why it had eluded me so long I can only put down to my immaturity. But in spite of my resistance to accepting that smart people will not apply good policy even when faced with compelling evidence, history is a testament to the veracity of this principle. I’ve since moved to working in antitrust and can see how Australian policymakers follow trends and fashions from the dominant creators of policy paradigms – the US and UK. Robin Hanson made a similar point in a recent podcast discussion with Dan Schultz. Robin said:
“That is, say a century ago, the world was roughly described as a set of countries who are competing and within each country there were elites who were mainly oriented around that country and promoting that country’s interests and competing within that country.
And since then, instead, the world switched to a world where our elites within each country are largely mixed in with and identify with the elites of other countries. There’s more of a world elite class. And this world elite class mainly cares about their reputation and stance within that world elite community. And that’s created an enormous convergence of policy around the world.”
https://www.danschulz.co/p/1-robin-hanson
On the recent inflation, I think attributing blame for this is trickier than you acknowledge. You say: “Although the Fed doesn’t have to offset supply shock inflation (due to its dual mandate), those effects have mostly unwound over the past year. While some of the inflation of late 2021 and early 2022 was supply side, over the longer run the rate of excess inflation (inflation above 2%) is almost identical to the amount of excess NGDP growth (nominal growth above 4%.)”
I don’t disagree. But I keep thinking back to David Beckworth’s conversion with Jason Furman in June 2021: https://www.mercatus.org/macro-musings/jason-furman-overheating-inflation-and-fiscal-policy-era-low-interest-rates
Furman mocked NGDPLT by implying (correctly) it would have required a rising Fed Funds rate in Q2/2021 when unemployment was still around 5.5%. At the time, if you listen to the discussion, I think even David had doubts as to whether ‘liftoff’ at that time made sense. It would have required a great deal of faith in the stickiness of wages relative to prices to implement a higher FFR, on the basis that with NGDP returning to trend, real wages (in terms of W/NGDP) would continue to fall sufficiently for the labour market to fully recover. And of course, we were then faced with another supply shock with the Ukraine invasion in early 2022. While it may be true, as you say, that in the long run supply shocks even-out, given that in reality supply shocks tend to be autocorrelated (as they were in the early 2020s and the 1970s) it takes a great deal of courage to act on the presumption that they will ultimately reverse and to continue to haul NGDP back to its long term trend. What if a 4% NGDP trend had proved insufficient to allow real wages to fall enough to reequilibriate the labour market?
marcus nunes
Dec 26 2023 at 3:30pm
On the recent inflation, I think attributing blame for this is trickier than you acknowledge. You say: “Although the Fed doesn’t have to offset supply shock inflation (due to its dual mandate), those effects have mostly unwound over the past year. While some of the inflation of late 2021 and early 2022 was supply side, over the longer run the rate of excess inflation (inflation above 2%) is almost identical to the amount of excess NGDP growth (nominal growth above 4%.)”
I made some considerations here:
A monetary policy whodonit – by Marcus Nunes – Money Fetish (substack.com)
Rajat
Dec 26 2023 at 7:21pm
Thanks Marcus, I largely agree of course. Your chart on W/NGDP doesn’t go back to 1H2021, but I would be interested in what the ratio was then. My point is that to commence raising the FFR in 1H2021 (as required by strict NGDPLT), one would need to be confident that either UnN would continue to fall with the same W/NGDP ratio (due to lags in job-filling?) or that the ratio would continue to fall due to sluggish growth in nominal wages even as NGDP growth was brought back to trend. Scott says that it’s not necessary to return to trend immediately, but how should a central bank decide how strictly it should apply LT in a given instance? Is it that the CB needs to take a view on the outlook for the supply side?
Scott Sumner
Dec 26 2023 at 9:16pm
Very good comment. Regarding this:
“Furman mocked NGDPLT by implying (correctly) it would have required a rising Fed Funds rate in Q2/2021 when unemployment was still around 5.5%.”
I have a different view. I don’t see the instrument setting as the issue—the problem is that we had the wrong policy regime. With NGDPLT, longer-term rates would have risen in 2021 in anticipation of the future S-T rate increases required to get back to the trend line.
Unfortunately, the Fed lost credibility in 2021, and markets realized that they were not truly committed to average inflation targeting and would allow the average inflation rate to greatly exceed 2%.
As for Svensson’s proposal, yes, that’s might not work for the US. I was just looking for examples of economists critical of Japan, but should have picked a better example. But the Krugman and Bernanke critiques also fit the US. I believe there are other examples (McCallum, etc.), those were just off the top of my head.
I agree that there’s no guarantee that NGDPLT would work, but I think it would have done better than the actual policy that was pursued.
Rajat
Dec 26 2023 at 11:39pm
Thanks Scott. I guess under a NGDPLT regime, the question might’ve switched to its fitness if long rates had started rising in early 2021. Would ‘lay’ critics like Furman – and potentially much of the mainstream profession – have questioned the wisdom of the regime if indicators like long rates had moved in an apparently counter-intuitive direction at the time? More broadly, is discretion a necessary PR release-valve for any monetary policy regime? I believe there was plenty of discretion under each of post-1990 inflation targeting, Bretton Woods and the interwar gold standard.
spencer
Dec 26 2023 at 7:11am
If the FED would target N-gDp, then there would be a more intense scrutiny of that metric. It would lead to a higher accuracy of the prediction target. A future’s market is not necessary. Atlanta’s gdp now is a good example.
Ronaldo carneiro
Dec 26 2023 at 7:23am
Excelent input to reflection
Alex Salter
Dec 26 2023 at 10:06am
Scott: Pete Boettke, Dan Smith, and I make this argument in our 2021 CUP book: https://moneyandtheruleoflaw.com
Scott Sumner
Dec 26 2023 at 9:05pm
Thanks Alex, I added an update.
Todd Ramsey
Dec 26 2023 at 10:31am
How can we get to NGDPLT and NGDP securities markets for the 2029 Fed framework? (I think it’s too late for 2024).
Scott Sumner
Dec 26 2023 at 9:04pm
The Fed has to want to reform. I’m not optimistic.
Thomas L Hutcheson
Dec 26 2023 at 10:55am
I fully agree with the criticism of mainstream opinion about monetary policy. I hope Sumner continues to advance the idea of a Fed self- evaluation of its own instrument settings in the recent past.
But this:
“Fed spoiled [FAIT] by later deciding that average didn’t mean average.”
No, a forward-looking average from a situation in which inflation is ON target is quite proper. The “F” in FAIT is meant to signal that in response to extraordinary shocks — demand or supply — the Fed will engineer temporarily higher inflation to facilitate the adjustment in relative prices for markets to clear.
I think that the Fed made mistakes in the way it set its monetary policy instruments mainly QE and the EFFR after COVID and actually engineered MORE inflation than was necessary to facilitate those adjustments.
Although a Flexible Average NGDP Target might be easier to explain to politicians and the public, many of who still seem to think that the best inflation target is zero, I doubt the actual monetary policy instrument setting would differ. The settings that produce the NGDP trajectory that maximizes real income are probably the same settings that produce the inflation trajectory that maximized real income.
Scott Sumner
Dec 26 2023 at 9:04pm
“No, a forward-looking average from a situation in which inflation is ON target is quite proper.”
I have two problems with that. First, it’s false advertising. Don’t use the term “average”. Second it’s a lousy policy idea, as we saw during 2022.
Scott H
Dec 29 2023 at 6:20pm
Does it make sense to claim that monetary policy is neutral over the long term when central bank mistakes can become long term? I understand the gist of the statement, but there’s got to be a more precise way to put it, right?
Anders
Jan 4 2024 at 4:14pm
Trying to get my head around these issues, I sometimes think I should start with quantum physics and the Arab Israeli conflict first and work my way up to monetary macro.
I know monetarism has been discredited for reasons beyond the ability of my mental faculties, but they represent a rule based way of ensuring Keynesian countercyclicality, no? If not, what am I missing.
Given that the unicorn of independent, perfectly informed central banking falls so far short even in countries sworn to keep it alive, how is simple control based on money supply not a less worse option? Would not such an approach have created the liquidity needed in the credit crunch and stop there? And avoided the expansion through quantitative easing that went far beyond that point?
Also, would that not forced us to hold back on the revanchist Dodds Frank act in the middle of a slump and credit crisis (shielding banks from competition through artificially excessive barriers to entry through compliance costs and hence preprogramming the reemergence of the too big to fail morass), as we would not be able to compensate for the crunch on credit by printing money?
Please help me understand what I am missing and excuse my ignorance. As I never studied economics, my only weapon is curiosity.
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