A tale of two monetary policies

Christina Romer is back with her monthly opinion piece at the NYT:

RECESSIONS after financial crises are long and severe, and the subsequent recoveries are protracted. That is the bold conclusion of “This Time Is Different,” the book by Carmen Reinhart and Kenneth Rogoff, and it has become conventional wisdom.

Their title is meant to be ironic. “This time is different” is what policy makers always say before a bubble bursts. Yet each time, according to the authors, the results are fundamentally the same.

But while there are strong patterns in the authors’ mountains of data, this simple summary misses an important fact: There’s dramatic variation in the aftermaths of crises, and much of it is caused by how policy makers respond. This history has important implications today.

Oh yes, how policymakers respond makes a whole world of difference. After all why, if not for responding to “disturbances”, do we have “policymakers”?

And the response to the ongoing crisis has been dismal. Yes, the big banks were saved, so you didn´t experience a “bank fallout” like the one in the early 1930´s, which was certainly an important factor behind the depth and breadth of the GD. But even then, as Chris Romer reminds us:

There was even huge variation within the United States during this period. The Friedman-Schwartz study found four distinct waves of banking panics in the early 1930s. After the first three, output plummeted. But after the last one, in early 1933, output skyrocketed, with industrial production rising nearly 60 percent from March to July. That time was very different.

In the post WWII period, this time around is unique in the sense that it was the only time aggregate nominal spending (NGDP) was allowed to turn negative. I say “allowed” because that most encompassing nominal aggregate is controllable by the Fed.

In a recent comment in Scott Sumner´s post, Luis Arroyo (responsible for the Spanish Blog Illusíon Monetaria) says:

Simply, I see that assets prices change at much more velocity than goods prices, and the influence goes from assets markets toward goods markets, and not the opposite.

To which SS responds:

We are closer than you think. I see the connection as follows:

1. Future expected monetary policy determines future expected NGDP.

2. Future expected NGDP determines future expected asset prices.

3. Future expected asset prices determines current asset prices.

4. Both future expected NGDP and current asset prices determine current NGDP, current AD.

Point 4 is similar to your argument.

And the biggest fall in NGDP since the Great Depression most certainly could cause a large fall in asset prices.

It could be interesting, in this context, to take a look at the big drop in stock prices (the largest proportional one day fall in history) and the impact it had on NGDP, if any.

The charts below put the 87-89 period side by side with the 07 – 09 period for ease of comparison.

Luis is correct about the speed with which asset prices can change, but as we can attest, nominal aggregate spending can change very quickly too! And that´s related, according to SS´s four points, to how quickly expectations of future monetary policy changes.

For example, in March 09 the Fed announced QE1. Asset (stock) prices immediately reversed, before the same move could be detected in NGDP, but consistent with a change in expectations of future MP.

In 1987 stock prices plunged (the reasons for that are still hotly debated), but note that NGDP kept growing, so future expected asset prices did not change much, inducing a reversal in current stock prices. We get the same “shape” in 2009, but we know, even in 2011, that there is much doubt about future expected NGDP, given that the Fed seems content in keeping the economy “crawling inside the hole”!

8 thoughts on “A tale of two monetary policies

  1. Thanks Marcus, I try to expose my position.
    The graphs are very goods and elocuent. I agree with you (and SS) just until a point: Monetary Policy is less efective if the crisis is a huge fall in prices of all assets, because is more dificult to restablish confidence.
    I don´t know exactly how to measure incertitude, but I suppose that volatility is a quite good proxy. Here we have the VIX (Volatility Index) of the S&P 500 for an ample period since 1985.
    http://es.finance.yahoo.com/q/bc?s=%5EVIX&t=my&l=on&z=l&q=l&c=
    We can see that around the Great recession we got the highest level of volatility, a sign that incertitude was not negligable.
    I don´t believe that to restablish the confidence in capital market is so easy than for goods markets.
    So, I , m only saying that the return to normality is harder this time than in a normal recession.

  2. Isn’t the biggest flaw of the Reinhart and Rogoff study that it deals with lots of small, open economy financial crises? A small open economy that loses competitiveness has to bite the bullet and restructure, and it takes time to rebuild competitiveness. A closed economy that has a monetary crisis recovers as soon as monetary policy is fixed, no?

    • Steve Take the Asia crisis of 1997. Those were open economies. Competitiveness was rebuilt pretty quickly in those countries, Korea for example, that let the exchange rate float and devalued significantly.

  3. Steve, what you say is quite right; That is why I think that not all conditions are equal.
    And I agree with Marcus that Bernanke was too late, but that is not the only reason to the longness of the crisis.

  4. Marcus, I recommend you

    Click to access Howels.pdf


    Where it is demonstrated that income velocity is not the same that transactions velocity; That the differences correlate to financial transactions; So, that the ecuation MV=PY is not a so good proxy for the original MV=PT as it used to be until 1976.
    That what accelerate the velocity in growth fases is capital markets, correlated with financial credit.
    From the text:
    “We might expect spending on intermediate goods to change only slowly with
    trends in the degree of vertical integration in production (which is presumably the
    basis for the widely held view that short-run divergence between PT and PY are
    unlikely). But the purchase of existing dwellings, is a category that has increased
    substantially over the last fifty years and become extremely volatile in the last thirty,
    while financial transactions, whose motive we might describe (in broad terms) as
    speculative has also increased dramatically and become more volatile.”
    That is a result that we had must expected, since the growing importance of capital goods in NGDP has change dramatically the composition of NGDP.
    That is a result that we had must expected, since the growing importance of capital goods in NGDP has change dramatically the composition of NGDP.
    Where it is demonstrated that income velocity is not the same that transactions velocity; That the differences correlate to financial transactions; So, that the ecuation MV=PY is not a so good proxy for the original MV=PT as it used to be until 1976.
    That what accelerate the velocity in growth fases is capital markets, correlated with financial credit.
    from the text:
    So, we can say that monetarism is not false, but is a lot more complicated than 50 yeras ago. Specially when the crisis has battered the dwellings sector.

  5. Pingback: Christina Romer Really Gets It « Uneasy Money

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