In the “Invisibility of market monetarism” Tim Lee writes:
Nick Gillespie rounds up the leading explanations for the slowness of the economic recovery:
Gentle reader, do you think lack of counter-cyclical spending is mostly to blame for the slow recovery? Or is that very spending (read: borrowing), compounded by regulatory and political uncertainty ushered in by a “transformative” health plan, a massive financial-regulation bill, the inability to pass a budget and create a clear path on tax rates is a larger cause here?
Gillespie doesn’t mention a third option: the market monetarist view that the slowness of the recovery stems from tight monetary policy. Standard economic theory says that if inflation is projected to be below the Fed’s 2 percent target and unemployment is way above the economy’s natural rate of 4 or 5 percent, that’s a sign monetary policy is too tight.
On the “lack of countercyclical spending” view, Krugman came out full blast and wrote: “Reagan was a Keynesian” (I bet the former President is “turning” in his grave):
O.K., by now many readers have probably figured out the trick here: Reagan, not Obama, was the big spender. While there was a brief burst of government spending early in the Obama administration — mainly for emergency aid programs like unemployment insurance and food stamps — that burst is long past. Indeed, at this point, government spending is falling fast, with real per capita spending falling over the past year at a rate not seen since the demobilization that followed the Korean War.
Why was government spending much stronger under Reagan than in the current slump? “Weaponized Keynesianism” — Reagan’s big military buildup – played some role.
We often hear that big cuts in government spending over a short time are a bad idea. The case against big cuts, typically made by Keynesian economists, is twofold. First, large cuts in government spending, with no offsetting tax cuts, would lead to a large drop in aggregate demand for goods and services, thus causing a recession or even a depression. Second, with a major shift in demand (fewer government goods and services and more private ones), the economy will experience a wrenching readjustment, during which people will be unemployed and the economy will slow.
Yet, this scenario has already occurred in the United States, and the result was an astonishing boom. In the four years from peak World War II spending in 1944 to 1948, the U.S. government cut spending by $72 billion—a 75-percent reduction. It brought federal spending down from a peak of 44 percent of gross national product (GNP) in 1944 to only 8.9 percent in 1948, a drop of over 35 percentage points of GNP.
In his comment to my post Robert Waldman states:
I think the effectiveness of fiscal stimulus was demonstrated by the huge expansion during WW II. Also the smaller US expansions during the wars in Korea and Vietnam. So the positive GDP growth anomaly in 2009 demonstrates this again.
So you see how this goes. Keynesians – Krugman, Waldman – relate the effectiveness of fiscal stimulus to war, or military buildup. The other camp indicates how the winding down of government war spending resulted in an “economic miracle”.
Note that Keynesians were very worried about the economic effects of demobilization. Paul Samuelson, the high priest of US Keynesians wrote in 1943 (quoted in Henderson´s paper):
When this war comes to an end, more than one out of every two workers will depend directly or indirectly upon military orders. We shall have some 10 million service men to throw on the labor market. We shall have to face a difficult reconversion period during which current goods cannot be produced and layoffs may be great. Nor will the technical necessity for reconversion necessarily generate much investment outlay in the critical period under discussion whatever its later potentialities. The final conclusion to be drawn from our experience at the end of the last war is inescapable—were the war to end suddenly within the next 6 months, were we again planning to wind up our war effort in the greatest haste, to demobilize our armed forces, to liquidate price controls, to shift from astronomical deficits to even the large deficits of the thirties—then there would be ushered in the greatest period of unemployment and industrial dislocation which any economy has ever faced. [italics in original].
So, what does market monetarism have to say about it all? The MM credo is “whatever you do, don´t let nominal spending (NGDP) contract. Even better, keep it growing at a stable rate along a given path”. So how has nominal spending behaved during the relevant episodes?
The charts below show the behavior of government purchases relative to GDP and NGDP and RGDP during and after WWII.
In 1946 RGDP registered a depression size contraction. According to Henderson there are technical aspects to that calculation:
If you ask most people who were young adults in those years (a steadily diminishing number of people, so talk to them soon) about economic conditions after the war, they will talk about “the postwar boom.” They saw it as a time of prosperity. Why is there a disconnect between their perceptions and the data? There are two reasons.
The first is what economists call an “index-number problem.” When price controls were removed after the war, prices shot up. Therefore, the prices used to convert nominal GNP into real GNP made real GNP look lower than it actually was.
Second, the GNP and GDP data, which are supposed to measure the value of production, instead measure government spending on goods and services at their cost—that is, at the price the government paid for them. But we have no idea what the value of all those goods and services bought by the government during the war was worth. So we can’t compare GNP during the war with GNP after.
Why, then, do I say that there was a postwar boom? People bought cars, houses, gasoline, tires, sugar, nylons, meat, and other things that they were unable to buy during the war. Also, the unemployment rate, as noted earlier, was very low.
But also note that nominal spending did not contract and was soon rising.
The next set of charts show the behavior of the same variables during Reagan´s “weapon´s build-up” and what happened with the end of the Cold War.
Again, no matter what´s happening to government purchases the economy is kept on an even growth keel (the “Great Moderation”) by a monetary policy that keeps nominal spending growth stable along a defined path.
And now for the clincher, government purchases and nominal and real GDP during Bernanke´s “reign”.
So the evidence is clear. There are times like wars, be them of the “hot” or “cold” variety, when government steps up spending. Following those times there are periods of “demobilization”. What happens to the real economy depends very much on the behavior of the Fed. An ‘appropriate monetary policy’ is key to the outcome you get. As the next chart shows, nominal spending is rising, but unfortunately the Fed is constraining it to remain far below the level it had before tanking. The “hole” goes “unfilled”!
Bottom line: It´s high time for a ‘policy rethink’.
HT Saturos and Bill Woolsey
Update: In her monthly NYT column today – “It’s Time for the Fed to Lead the Fight” – Christy Romer writes:
I agree that we need more effective fiscal and housing policies. But neither is likely to happen, at least not before the presidential election. As a result, the Fed is the only plausible source of immediate help for the American economy. It was set up as an independent body precisely so that somebody can do what’s right when politicians can’t or won’t.
I find a related argument even more frustrating: that the Fed shouldn’t act because Congress wouldn’t like it and might retaliate. This argument exposes the important truth that the Fed is only as independent as Congress lets it be.
But it also raises a key question: what are Fed policy makers saving their independence for? If rescuing millions of Americans from the torment of unemployment isn’t a reason to risk their independence, what is?
And further on:
If the Fed doesn’t want to do something as drastic as adopting a new operating procedure, it could at least make any smaller actions it takes more effective. The previous rounds of quantitative easing may have done little to improve expectations because their size and duration were limited in advance. If the Fed does another round, it should leave the overall size and end date unspecified. Or, better yet, the ultimate scale and timing could be tied to the goals the Fed wants to achieve.
Likewise, the Fed’s statement about the federal funds rate has seemed almost intended to undermine any positive confidence effects. It says the Fed expects a low rate through late 2014, which is supposed to give people hope. But the low rate is then justified by invoking continued weakness in the economy, which is likely to make people want to hide under the covers.
Yes, Chairman Bernanke, start “filling the hole”.