Lessons not learned

In a recent post, Scott Sumner concludes by saying, in reference to Friedman´s “torch”:

1. Demand shocks drive the business cycle.

2.  Monetary policy is the best tool for demand stabilization.

3.  Monetary policy is very powerful at the zero bound.

So let´s check the “economist´s laboratory” – the Great Depression.

The first figure shows the huge drop in nominal spending (NGDP), a big demand shock. 

Was it monetary policy? Many argue that the monetary base started rising after 1930 and that short term interest rates were fast dropping to “zero “so MP could not be regarded as “tight”. Figures 2 and 3 show the base and short term rates.

But the fact is that NGDP kept on falling after 1930. Figure 4 indicates that the rise in the monetary base was not enough to offset the increased hoarding of cash and reserves (the drop in the money multipliers), so that both M1 and M2 kept falling significantly.

So did prices (PPI and the CPI) shown in figure 5. There is no escaping the conclusion: monetary policy was extremely tight.

Figure 6 illustrates that industrial production (monthly data) dropped precipitously after mid 1929 as did the stock market (S&P) and the P/E ratio (figure 7).

Then, suddenly everything reversed direction. What happened? On March 1933, FDR devalued the dollar, leaving the gold standard and releasing the “brake” on monetary expansion.

For 3 months things looked up. Industrial production had the highest 3 month growth in history, rising by almost 60% and deflation turned into modest inflation. Stock prices boomed in what turned out to be a very short bull market.

What interrupted the process? On July 1933, N.I.R.A – which sanctioned, supported, and in some cases, enforced an alliance of industries. Antitrust laws were suspended, and companies were required to write industry-wide “codes of fair competition” that effectively fixed prices and wages, established production quotas, and imposed restrictions on entry of other companies into the alliances – was implemented. Bad move. Two years later it was declared unconstitutional and shortly after replaced with the Wagner Act – which gave workers the right to form unions and bargain collectively with their employers. This certainly was a factor in keeping unemployment high, despite the gains in production.

In the figures we observe an almost perfect synchronization (no lags) between expansive monetary policy and gains in economic activity. N.I.R.A is the “elephant in the room”, once it´s gone, things “pick up” again.

Until, that is, the Fed intervenes by raising required reserves, from fear of inflationary dangers (reminds you of some people in power today?). As you would have guessed, production and stock prices tumble again. On April 1938 FDR managed to “convince” Marriner Eccles, Fed Chairman, to discontinue the restrictive monetary policy. Production went back up immediately. Not so stock prices. Maybe by this time the “winds of war” in Europe, coupled with a natural mistrust by the market after so many “interventions”, were strong enough to hold stocks back.

One cannot help wondering about what would have happened if the bull market that began in early 1933 had continued unabated. One implication is that the economic recovery, both in the US and abroad, would have been much more intense, possibly diminishing the likelihood of war!

Flash forward. In 2008 there was a steep drop in nominal spending and interest rates dropped to “zero”. Inflation (not prices) dropped significantly (figure 8).

In March 2009 the Fed introduced “quantitative easing” (QE1). Nominal spending reversed and so did stock prices (figure 9). Later, in 2010, just “talk” of QE2 was sufficient for a rebound in stock prices.

But monetary policy has not been forceful enough to get spending to converge to some acceptable trend level. “Opposition” to monetary stimulus is everywhere. It didn´t help that early on there was an almost undivided attention given to fiscal stimulus, that has come back to “haunt” policymakers. So we have two “elephants in the room” this time around. There is the deficit/debt path concern and, most importantly, the fear of a rebound in inflation.

To give a very current example, today (March 25^th) the Shadow Open Market Committee convenes. Below is a preview of committee member Michael Bordo “Policy Brief” presentation:

The Prospects for Inflation Ahead
Most observers today argue that since core inflation is considerably below the implicit inflation target of 2%, and unemployment and the output gap are still too high, that inflation is not an important worry for policy makers. Yet commodity prices are rising and headline inflation is also rising. It will likely take a long time for headline inflation to feed into core inflation through the conventional mark up channels but once it does it will be hard to dislodge as the experience of the Great Inflation taught us.

He really didn´t “learn” anything!