In his “Models of Business Cycles” presented as the Yrjö Jahnsson Lectures in 1985 and published in 1987, at the very start of the “Great Moderation”, in the conclusion to chapter 3 Robert Lucas writes:
…This is not to say that economic fluctuations are a trivial problem, for fluctuations at the pre-Second World War level, especially combined as they were with an absence of adequate programs for social insurance, were associated with large costs in welfare. But it suggests that the main social gains from a deeper understanding of business cycles, whatever form this deeper understanding may take, will be in helping us to see how to avoid large mistakes with policies that have minimally inefficient side-effects, not in devising ever more subtle policies to remove the residual amount of business-cycle risk”.
And, as if by “magic”, business-cycle risk was greatly reduced (50% reduction in volatility of Real GDP growth rates) and inflation remained low and stable. The fact that from that point nominal spending evolved around a 5.5% clip along a stable trajectory (see picture) has everything to do with how monetary policy was conducted, showing a marked change from the inflation inducing performance of policy in the 1970´s.
As David Henderson pointed out some time ago in his defense of Greenspan´s record:
Greenspan, however unintentionally, came close to freezing the domestic monetary base. He therefore still stands out as the only truly successful chairman of the Fed, which, by the way, is one good reason among many for abolishing it. We simply can’t depend on his like coming to the fore again, as Ben Bernanke’s disastrous tenure is making clear.
The operative word is “unintentionally”. Therefore it turned out to be due to “chance” – “luck of the draw” by Greenspan. By “freezing the base”, which in practice means keeping the level of reserves stable, something Milton Friedman recommended long ago, the base multiplier “moves around” in such a way that the money supply offsets movements in velocity (an indicator of money demand) which, through the (expanded) equation of exchange (BuV=Py), keeps nominal spending (Py) stable. The moments of instability (2001-2005) observed in the picture above reflect destabilizing Central Banks interventions. The figures illustrate.
In 2001-03, money supply did not grow to offset the fall in velocity (increase in money demand). On the contrary, money supply growth shrank. The result was that spending dropped below trend and unemployment went up.
Stability was recouped in 2005-06 when money supply reinforced the rise in velocity (fall in money demand), a necessary move to close the spending “gap”. Unemployment fell.
In 2008-09, Bernanke made his “fatal” mistake when, with the economy “wounded” by the house price crash and ensuing financial sector problems, factors that increased money demand (as illustrated by the increase in money and money like assets – cash & checkable deposits, saving & time deposits, money market fund shares and treasuries – in the picture below), money supply growth was allowed to shrink – akin to “throwing salt in the wound” – moved by the Fed´s fear that rising “headline” inflation, reflecting oil and commodity prices, could “contaminate” the more relevant “core” indices. The result was a steep drop in spending (which turned negative for the first time since 1938) and soaring unemployment.
The 2007-09 recession ended when the Fed again worked monetary policy in a “stabilizing” fashion, allowing money supply to offset changes in velocity, but at a much reduced spending level (which itself is growing at a rate that is lower than the previous trend). The spending gap obviously keeps rising and unemployment remains high.
There is a deep irony in all this. In January 2000, long before becoming a Fed governor, so we can assume he was speaking based on results from his economic research and analysis, Bernanke co-authored an article titled “What happens when Greenspan Is gone”.
U .S. monetary policy has been remarkably successful during Alan Greenspan’s 121/2 years as Federal Reserve chairman. But although President Clinton yesterday reappointed the 73-year-old Mr. Greenspan to a new term ending in 2004, the chairman will not be around forever. To ensure that monetary policy stays on track after Mr. Greenspan, the Fed should be thinking through its approach to monetary policy now. The Fed needs an approach that consolidates the gains of the Greenspan years and ensures that those successful policies will continue—even if future Fed chairmen are less skillful or less committed to price stability than Mr. Greenspan has been.
We think the best bet lies in a framework known as inflation targeting, which has been employed with great success in recent years by most of the world’s biggest economies, except for Japan. Inflation targeting is a monetary-policy framework that commits the central bank to a forward-looking pursuit of low inflation—the source of the Fed’s current great performance—but also promotes a more open and accountable policy-making process. More transparency and accountability would help keep the Fed on track, and a more open Fed would be good for financial markets and more consistent with our democratic political system.
The real irony, in my view, is that at that exact time discussion – and Bernanke was smack in the middle of it – had already begun on “How to conduct monetary policy in a low inflation environment”, the thinking being that interest rates were already low so that the ZLB could be binding if a shock hit!
And Bernanke fell into the “trap”. That´s what “disastrous” refers to in David Henderson´s quote above. The Fed feels constrained by the (implicit) inflation target and does not adopt many of the same measures that in late 1999 Bernanke advised the Japanese to take in order to get their economy “moving” again!
So things bog down to 3 groups (plus some fringes):
- The Fed inflation hawks who think even “lightweight” measures like the QE´s, designed basically to forestall deflation, are pernicious.
- The “conservatives” (GOP) that think that what´s constraining the economy is all the regulatory and tax “uncertainty.
- The “liberals/progressives” that think government alone holds the key to ”redemption”.
The views of the 3 FOMC Stooges (F, K & P) are well known. The “conservative” view is represented at a high level of discourse by Gary Becker:
Although regulatory discretion failed leading up to the crisis, Congress nevertheless added to the number and diversity of federal regulations as well as to the discretion of regulators. These laws and the continuing calls for additional regulations and taxes have broadened the uncertainty about the economic environment facing businesses and consumers. This uncertainty decreased the incentives to invest in long-lived producer and consumer goods. Particularly discouraged was the creation of small businesses, which are a major source of new hires.
The “liberal” view is well represented by Paul Krugman:
The fact is that the fading out of the stimulus, and in particular of aid to state and local governments, is already and noticeably leading to substantial withdrawal of government demand. Look, in particular, at actual government purchases of goods and services — governments at all levels buying stuff — which is what standard macroeconomics says should have the highest multiplier, since unlike transfers and tax cuts it is by definition spent rather than saved. Here’s the picture, showing changes in real spending over the previous year:
When the recession officially ended, spending was rising at an annual rate of around $60 billion; now it’s declining at an annual rate of $60 billion… That makes the turn toward austerity a major factor in our growth slowdown.
So, either expansionary monetary policy will only succeed in bringing inflation or it´s basically seen as ineffective.
But as I have tried to show, monetary policy, if it could only make explicit a spending level target (as it implicitly did for twenty years), holds the key to the “door to salvation”.
Update: This Roger Farmer Vox article gives a twist to the “conservative” view. Although not explicitly mentioned, “Monetary policy” in his framework would be used to “target” the stockmarket!