In her Five Books Interview:
When you asked me for my list of books, I debated about whether to put The GeneralTheory by John Maynard Keynes on the list. The General Theory is an incredibly important book, but it’s basically a theoretical explanation of how aggregate demand could affect output. It was Friedman and Schwartz who provided the empirical evidence that supported the theory. That’s why A Monetary History went to the top of my list.
Just a couple of comments on a very enlightening interview. Her third listed book is Bernanke´s essay collection on the Great Depression and in particular the essay “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression”. According to Christina it “has added to our understanding of financial downturns”:
Bernanke’s focus on the non-monetary effects of financial crises turned out to be incredibly important. It started a whole literature on how credit matters, above and beyond what’s reflected in interest rates. He changed our view of how monetary policy affects the economy.
This has had practical implications:
His work and the subsequent research it inspired made us realize how important it is in a financial crisis not to just prevent the money supply from falling, but also to make sure that credit keeps flowing. We learned from the Great Depression that when credit dries up it has devastating consequences.
That idea had a huge impact on the Federal Reserve’s behavior in the most recent crisis. In response to the financial crisis in the fall of 2008, the Fed not only followed the conventional central bank remedy – flood the system with liquidity and make sure there’s plenty of cash out there – but they also took extraordinary actions to keep credit flowing. When they saw credit markets were not functioning, the Fed was incredibly creative in finding ways to make sure that firms could get credit. For example, many businesses issue commercial paper to cover payroll and finance day-to-day operations. When that market stopped functioning and no one was willing to buy commercial paper, the Fed said, we’ll buy it.
But quite likely Bernanke´s “Credit View” had very “negative” implications. According to Scott Sumner:
Ben Bernanke published an influential article back in 1983, in which he argued that debt-deflation could worsen a depression by reducing bank intermediation. He saw the reduction in intermediation as sort of “real shock,” which could not be completely addressed by easier money (otherwise his model would not have differed from Friedman and Schwartz’s.)
In 2008 he was given a chance few academics ever see—he was allowed to try out his theory on the US economy. The Fed decided to focus on bailing out the banking system in the second half of 2008, rather than adopting an aggressive policy of monetary stimulus. Indeed the famous interest on reserve program of October 2008 was implemented precisely to prevent the injection of funds into the banking system from ballooning the money supply and raising prices. The Fed argued that without IOR the fed funds rate would have fallen close to zero. (The ff target was in the 1.5% to 2.0% range at the time.)
Unfortunately, Bernanke’s theory is based on a misreading of the Great Depression. The bank panics were problematic, but only because they led to monetary contraction. The direct effects were trivial. How do I know this? Obviously I cannot be sure, but consider the following evidence:
1. There were more than 600 bank failures each year during the Roaring Twenties, and yet the economy boomed. Over 950 banks failed in 1926, a relatively prosperous year.
2. The rate of bank failures did increase in the early 1930s, but they were mostly the same small rural banks that failed in the 1920s, and the share of deposits affected was a small fraction of the total banking system.
3. There was one exception, during 1933 bank failures rose dramatically. The deposits of failed banks were 11% of all deposits. Much of the banking system was shut down for many months.
And what happened to the economy during this “mother of all bank panics?” Prices and output soared (as I discussed in the previous post.) This occurred because in 1933 (unlike 1930-32) the bank crisis was not allowed to lead to monetary contraction.
I would never argue that banking problems had zero impact on productivity, but the evidence from the booming 20s, and from 1933, suggests that as long as NGDP is growing, banking difficulties are not a major factor in the business cycle. And we also know that banking problems don’t prevent NGDP from growing. So it looks like Bernanke was relying on the wrong model of the business cycle, and fighting the wrong problem.
Towards the end of the interview, when the discussion turns to “The End of One Big Deflation” Christina Romer says:
What we learned from the Temin and Wigmore paper is that one way out of a recession at the zero lower bound is by changing expectations. To do that, often what is needed is a very strong change in policy – something economists call a “regime shift”. The most effective way to shake an economy out of a terrible downturn when we’re at the zero lower bound is an aggressive change in policy that makes people wake up, say “this is a new day” and change their expectations. What the Fed has done since early 2009 is much more of an incremental change.
I think that what the Fed needs instead is a regime shift. A number of economists have suggested that the Fed adopt a new framework for monetary policy, like targeting a path for nominal GDP. If the Fed adopted such a nominal GDP target, they would start in some normal year before the crisis and say nominal GDP should have grown at a steady rate since then. Compared with that baseline, nominal GDP is dramatically lower today. Pledging to get back to the pre-crisis path for nominal GDP would commit the Fed to much more aggressive policy – perhaps more quantitative easing and deliberate actions to talk down the dollar. Such a strong change in the policy framework could have a dramatic effect on expectations, and hence on the behavior of consumers and businesses.
And that folks puts Christy smack in the Market Monetarist camp. Yes, she mumbles about the relevance of “Fiscal Stimulus”, mostly on if there hadn´t been one the situation would be worse and that it was always “too small” anyway. But she indicates that what makes all the difference is the conduct of monetary policy.