Tight Money Caused the Recession

According to monetarist Scott Sumner.

The sub-prime crisis that began in late 2007 was probably just a fluke, and has few important implications for either financial economics or macroeconomics. The much more severe crisis that swept the entire world in late 2008 was a qualitatively different problem, which has been misdiagnosed by those on both the left and the right. Most economists simply assumed that a severe intensification of the financial crisis depressed spending throughout much of the world. In fact, the causation reversed in the second half of 2008, as falling nominal income began worsening the debt crisis. …

We cannot hope to understand what happened late last year without first recognizing that the proximate cause of the crash was not a financial crisis, but rather a steep decline in nominal spending. Like any other fall in aggregate demand, this represented a failure of monetary policy.

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J@m3z Aitch is a two-bit college professor who'd rather be canoeing.
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16 Responses to Tight Money Caused the Recession

  1. D. C. Sessions says:

    Like any other fall in aggregate demand, this represented a failure of monetary policy.

    If you posit ab initio that falls in aggregate demand (which Our Gracious Host has elsewhere condemned as an invalid metric) then it follows tautologically that the current economy with its low aggregate demand was caused by monetary policy. The rest is window dressing.

  2. “which has been misdiagnosed by those on both the left and the right.”

    If only the economy didn’t care so much about our arbitrary political axis! Otherwise, this sounds like Lamarckian economics, where vague fluids and forces cause everything.

  3. James Hanley says:

    If you posit ab initio that falls in aggregate demand …then it follows tautologically that the current economy with its low aggregate demand was caused by monetary policy. The rest is window dressing.

    Not so. Keynes’ theory of shortfalls in aggregate demand was not based on monetary policy, but on consumers failure to spend their money. It was Friedman who began arguing that the Depression (and, according to him, all other financial crises in U.S. history) was caused by a decline in the money supply, and he was making a direct attack on Keynes. So whatever the validity, or lack of, of monetary theory, it’s not possibly tautological that low AD is caused by monetary policy. And noticeably, Krugman and others Keynseian-inspired macroeconomists are arguing that monetary policy cannot reverse the current low AD, so there must be more to the story, whereas Sumner is arguing that of course monetary policy can reverse it, if we just do it right.

    The “low AD” argument I critique is the non-monetary policy based theory of Keynes and Krugman. If Arnold Kling is right, then this monetary argument is bunk, too, but I’m very sympathetic to it, although I am skeptical whether pumping money into the market will actually reduce real demand or just nominal demand (through price inflation).

  4. Dr X says:

    This probably fits better under the Great depression graph, but It could kind of fit anywhere in the broader discussion. So, to stir the pot, yet again:

    http://marginalrevolution.com/marginalrevolution/2011/09/the-luck-of-the-irish.html

  5. James Hanley says:

    Yeah, I saw that. But as much as I like Tyler Cowen, if you follow the link to the Krugman piece, it’s not clear he’s saying what Krugman says he’s saying. Still, notice that Krugman can’t restrain himself from going for the personal attack, suggesting Cowen doesn’t have a good economics education because he doesn’t buy into Keynesianism. Apparently everyone in the monetarist school, everyone at Chicago, everyone in the Public Choice school, and the macroeconomist who sits across the hall from from me, none of them have a good economics education because they don’t agree with Keynesianism; that is, because they don’t agree with Krugman. The man seems incapable of recognizing that there is serious intellectual disagreement here among very intelligent and well-educated people.

    And, hell, he’s given so much ground on Keynesianism, admitting that it’s only excess reserves that are to be tapped for stimulus, that I’m not sure how much of Keynesianism is really left, even for him. I’ll reiterate what I’ve said before: despite being best-known now for his macro views, Krugman’s important research was in trade theory, not macro. And he’s arguing in part against people who have been doing research in macro.

  6. D. C. Sessions says:

    And noticeably, Krugman and others Keynseian-inspired macroeconomists are arguing that monetary policy cannot reverse the current low AD, so there must be more to the story, whereas Sumner is arguing that of course monetary policy can reverse it, if we just do it right.

    Not, “cannot.” Much more like, “less effective than in times when the ZLB isn’t in effect.”

    If you actually read Krugman or DeLong (or others) they’re quite clear that the proximate cause of unemployment is lack of demand (that appears undisputed here) and that the lack of demand stems from deleveraging. At which point there are multiple paths to get demand back up. Only one of those is fiscal stimulus; it’s just that with the current low rates on borrowing and the screaming need for infrastructure repair, it’s a very good idea.

    Others that they mention are, in fact, a large increase in the money supply intending to increase inflation to accelerate deleveraging. The problem comes from the means of increasing the money supply. Printing greenbacks is nice, or loaning money to banks, etc. However we then run up against the question of, “and then what?” Money sitting in banks’ reserves doesn’t really do much. Ultimately that money that the Fed creates has to go somewhere, and it’s not at all obvious that it will.

    Sumner et. al. are not nearly so clear on that one.

  7. James Hanley says:

    However we then run up against the question of, “and then what?” Money sitting in banks’ reserves doesn’t really do much. Ultimately that money that the Fed creates has to go somewhere, and it’s not at all obvious that it will.

    Sumner et. al. are not nearly so clear on that one.

    I take your overall point, but I disagree with this. The point–as even Krugman himself has made clear–is to make money less valuable, which encourages people to borrow and spend it. Especially, by making it clear that goods will be more expensive in the near future because money is now less valuable, it encourages people to spend now, before prices go up. That’s as clear and direct as Krugman’s “and when the government spends, everybody else will start spending, too.” In each case assumptions are made about what people will do.

  8. D. C. Sessions says:

    But “we’ll print more money!” is lacking a step that “we’ll spend more money” isn’t. Again, printing money that sits in Fort Knox alongside a lot of gold bars doesn’t alter the value of money in circulation. And as soon as you say what you’re going to do with those greenbacks, like for instance “spend them on infrastructure,” you’re right back in Krugman Kountry.

    The usual approach to “create more money” is for the Fed to loan it to banks, which in turn loan it to people like me who are, perhaps, buying a second home. That works very well indeed when there’s a market for money that’s robust enough that the trade in it is supply-constrained. Alas, that’s not the situation right now: banks are piling up reserves against the day when all of those bad loans they wrote have to be written off, and there aren’t many takers for new loans even at 3.25% Mostly because the only people who would qualify are busy deleveraging.

    Instead much of that money being loaned at 0% is going to buy Treasuries, which are in short supply and thus the price of them gets pushed up to (hard as it may be to believe) above 100% of expected return. In a market economy, one would expect that something in such short supply would signal the producer to make more of them, but there’s a market failure here and that’s not happening.

  9. James Hanley says:

    Yes, when money is tight people hoard it. Make money readily available and people won’t hoard it. The intermediate step problem disappears because the problem causing it disappears. At least that’s what Scott Sumner’s effectively arguing on his blog. His claim is that if you look at the spread between Treasury Bonds and Treasury Inflation Protected Securities (TIPS), they’re indicating that the money supply is, contrary to popular wisdom, really tight.

    Now that’s an all-new issue to me, and I’m still trying to digest and figure it out. So I’m not so much giving my own considered opinion here as what I think Sumner would say in response.

    He also argues that in retrospect economists recognize each prior recession as caused by tight money, but in each current recession they cast about looking for explanations of why “this time it’s different.” That’s a pretty strong claim on his part, but it’s not much out of line with what M. Friedman has said, too.

  10. D. C. Sessions says:

    Yes, when money is tight people hoard it. Make money readily available and people won’t hoard it. The intermediate step problem disappears because the problem causing it disappears.

    I’m not seeing the solution to the Underpants Gnome problem. How, again, does 200 billion Benjamins in Fort Knox induce anyone to do anything (other than dream of a raid on Fort Knox?)

  11. James Hanley says:

    It relieves banks fears about being on the hook for bad loans. It makes some of those bad loans renegotiable and it gives banks coverage for those that go bad,

    Keep in mind that fiscal policy has its own panty-gnomes problem. Sure the money gets spent by the federal government, but what then? If people are holding onto cash tightly, then the guy who gets hired onto the government-funded project may not be willing to make purchases with it–especially if he sees his job prospect as being short-term (Keynesians and Monetarists generally agree that people are less responsive to short-term changes than expected-to-be permanent changes). Saying “the money gets spent (by government)” doesn’t really answer the question, which is whether the money gets re-spent (and re-spent, and re-spent) by the private sector. There’s an assumption that it does, but it’s only an assumption.

    Beyond that, all I can say is that Sumner claims it’s always a tight money problem and loose money always solves the problem. If I can find time, I’ll try to dig further into what he sees as the mechanism, because despite my efforts to rebut you here, I fully agree that having a clear understanding of the mechanism is crucial. It’s precisely what I ask students in all of my classes, regardless of the topic, so I can hardly just wave it away here. And it’s your insistence on it that is a big part of what makes you a valuable discussion partner.

    [Addendum: I wonder if the panty-gnomes claim ignores the marginal analysis? If you give people enough of anything, eventually they'll have too much and want to get rid of some of it for something they value more. To say otherwise is to reject the concept of declining marginal value. Of course theoretically it could take a shocking large amount of such stuff in some circumstances, but it's worth pointing out that Sumner is supportive of any size change in the money supply that will get the trick done. His argument is that we should not focus on or care about the size of changes in the money supply, but that the Fed should publicly commit to a particular nominal GDP target, then add money until we get there (of course inflation hawks hate this idea passionately, but Sumner thinks the Fed can, albeit imperfectly, control inflation as long as it doesn't overshoot its NGDP target).]

  12. D. C. Sessions says:

    If you give people enough of anything, eventually they’ll have too much and want to get rid of some of it for something they value more. To say otherwise is to reject the concept of declining marginal value.

    Tell that to a junkie.

    Yes, declining marginal value implies substitution to a rational analysis.

    News flash: animals didn’t evolve to be rational, they evolved to follow behavioral strategies that had statistical survival benefits in the environment where they evolved. Like eating sugar, salt, and fat whenever it’s available.

    When a marginal dose of heroin declines in utility, one response is to pursue other sources of reward. The other is to take larger and larger doses of heroin. To assume that either model will always apply to human behavior is not only contrary to what we know of behavioral psychology, it’s flatly contradicted by too many examples to count.

    However, since we’re on economics I’ll just point to any billionaire you care to name. After a few hundred million bucks, there’s little marginal utility in having more — it’s already at Larry Ellison’s “buy your own F-15 squadron for a few flight hours” point. Pursuit of more money gets in the way of enjoying what you have in the limited amount of time you can’t buy more of, and most of us would find other things to do with that limited time.

    Of course, there are always exceptions who get their rewards not from having money, but from pursuing it. Or power, which is much the same thing. In which case, there is never going to be “enough” because the activity is self-rewarding, so applying a marginal-utility analysis isn’t going to work very well.

  13. Matty says:

    Of course, there are always exceptions who get their rewards not from having money, but from pursuing it.

    I’m going to speculate that this actually covers the majority of the ultra rich since as you say many keep actively building their wealth long past the point where they could spend even a fraction of it. In other words their source of reward, the buzz from successfuly growing the number on their bank balance, does not appear to have a declining marginal value or at least not one linked to what that number is relative to anything else.

  14. Matty says:

    While we’re on it asking if people rationally pursue what they value strikes me as an unanswerable question before we establish what it is they value.

  15. James Hanley says:

    D.C.,– Um, give a junkie more heroin than he can take in the foreseeable future and he’ll damn sure give it away to his junkie friends or trade it for something else. Your analogy suggests that some people are so addicted to cash that if you give them more of it they’ll continue to stick it under the mattress and not do anything with it. But then the rest of your analysis is about wealth, not money, so it doesn’t really hold together because you’re talking about two different things.

    And while you’re absolutely right that humans didn’t evolve to be rational, that observation doesn’t get us very far in this case. Rationality is just a model, but it’s a useful one because it produces accurate predictions so often. And your speculation is battering at the walls of some pretty strong empirical and historical evidence about what humans actually do, both in the overwhelming number of cases of different goods and in the case of that specific good we call money.

  16. D. C. Sessions says:

    Rationality is just a model, but it’s a useful one because it produces accurate predictions so often.

    Which is not the same thing as “always.” When you’re working far out on the tail of the distribution, it’s pretty bold to assume that the behavioral rules of thumb that apply to the majority still apply.

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