Creditism and the “Great Recession”

Yesterday Lars Christensen put up a post in which he linked to a post by Kurt Shuler who writes:

During the financial crisis of 2008-09, many central banks expanded the monetary base. In some countries, the base remains high; in the United States, for instance it is roughly triple its pre-crisis level. Such an expansion, unprecedented in peacetime, has convinced many observers that a bout of high inflation will occur in the near future. That leads us to the lesson of the day:

To talk intelligently about the money supply, you must also consider the demand for money. Starting from a situation where supply and demand are in balance, the supply can triple, but if demand quadruples, money is tight. Similarly, the supply can fall in half, but if demand is only one-quarter its previous level, money is loose.

Related to that is this from the Cato Handbook for policymakers:

In the choice of monetary rules, the Fed should aim at those that minimize the need for forecasting, such as Carnegie-Mellon economist Bennett McCallum’s nominal final demand rule or the variant of that rule proposed by William Niskanen in this Handbook (Chapter 36). An even simpler rule is to freeze the monetary base and let private firms supply currency in response to market demand, as proposed by Milton Friedman.

And this from Milton Friedman´s The Fed´s Thermostat:

Admittedly, this is an oversimplification. The accumulation of empirical evidence on monetary phenomena, improved understanding of monetary theory, and many other phenomena doubtless played a role. But I believe they were nowhere near as important as the shift in the theoretical paradigm. The MV=Py key to a good thermostat was there all along.

If we write MV=Py as BuV=Py, where B is the monetary base and u the base multiplier, we can “link” the concept of “freezing the base” to the idea of targeting NGDP (Py). In this case the multiplier (u) changes to compensate for changes in velocity (V) in order to keep Py growing along a stable path.

Interestingly, a little over 5 years ago Lawrence White published this post in which he comments a letter written by Friedman to Mankiw:

Regarding the base freeze proposal, Mankiw comments:

I would have thought that the experience of the 1930s argues against such a rule. If I recall correctly, most of the decline in the monetary aggregates during that period was attributable not to high-powered money but to inside money and the money multiplier. If we abolished the Fed and kept high-powered money constant, it seems that a similar set of events could potentially unfold.

Do we need to keep the Fed around because the money multiplier might collapse again? Mankiw is right that the money multiplier declined sharply in the 1930s, but why did it? The proximate cause of the collapse in the 1930s was bank runs and fear of more bank runs. The underlying reason for the bank runs was geographic and note-issue restrictions that make US banks unnecessarily fragile. There were no bank runs and no money-multiplier collapse in Canada in the 1930s, which had neither restriction.

From 1987 to 2007 there was the “Great Moderation”, a state of affairs in which NGDP grew at a stable rate along a level path. Did “freeze the base” play a role?

The picture below is illustrative.

In it we see that after 1986 reserves remained essentially “constant” – note the Y2K and 9/11 “blips”. But the Monetary Base increased significantly, from 252 billion when Greenspan became Chairman to 804 billion when he passed the job over to Bernanke. That´s not consistent with any notion of “freeze”. But note that, since reserves remained relatively constant over the period, all the increase in the monetary base came from the rise in the currency in circulation component. In an age of ATM´s, debit cards and other technological improvements that economize on currency, it is clear that most of that increase in currency went abroad (including going into the “pockets of shady characters”). From those considerations, I believe we can approximate the notion of “freeze the base” with “frozen reserves”.

Since NGDP evolved along a stable path from 1987 to 2007, given that reserves were “frozen”, the multiplier must have changed to compensate changes in velocity (money demand). The following picture shows that for much of the time that´s exactly what happened.

Note, for example, that between early 2003 and early2006 although velocity increases the multiplier doesn´t fall. During those years, therefore, NGDP grows above “trend”. But that´s exactly what was required to bring NGDP back to the level trend from which it had deviated following the 2001 recession. The next picture indicates that starting in 2003, NGDP began the “trip back to trend”, which had been attained by the time Bernanke became Chairman. (NGDP data monthly from Macroeconomic Advisors)

And the following graph indicates what happened after mid 2008. The Fed let the multiplier tank at the same time that velocity was dropping (money demand rising strongly). This was “engineered” by payment of interest on reserves, which “saved” the banks but “destroyed” the real economy (in particular employment), with NGDP taking a “dive”.

Why did this happen? From another viewpoint: Would it have happened under Greenspan? Maybe personalities are important “causal factors”. In the closing paragraphs of chapter 18 – “The Role of Creditism in the Great Recession” – of his new book – Money in a Free Society -, Tim Congdon argues:

To summarize, the monetary (or monetarist) view of banking policy is in sharp contrast to the credit (or Creditist, to recall Bernanke´s term) view. Contrary to the plethora of misguided academic papers, the monetary view contained – and of course still contains – a clear account of how money affects spending and jobs…

The debate about quantitative easing, and the larger debate between creditism and monetarism to which it is related, will rage for years to come. Much will depend on events and personalities, as well as on ideas and journal articles. But there is at least an argument that Bernanke´s creditism was the mistaken theory which, by a remorseless logic of citation, repetition and emulation, spread around the world´s universities, think tanks, finance ministries and central banks and led to the Bedlam of late 2008…

The academic prestige attached to the lending-determines-spending doctrine and other credit-based macroeconomic theories is puzzling. [As noted earlier], Bernanke and Gertler include in their 1995 article the observation that comparison of actual credit magnitudes with macroeconomic variables was not a valid test of their theory. One has to wonder why. They claimed that bank lending was determined within the economy and so was “not a primitive force”…Bernanke and Gertler must have known that the relationship between credit flows and other macroeconomic variables were weak or non-existent, casting doubt on their whole approach.

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