Christy´s “Dangerous Idea” is alive and well

In “Kids prefer cheese”, blogger Angus must have failed his economic history class. Likely so has Adam Posen, who has done a stint at the BoE´s MPC before moving to head the Peterson Institute and has been a co-author with Bernanke:

On the limited power of monetary policy to control the real economy, you can start with Adam Posen’s recent review essay. Here’s a good bit:

Indeed, central bankers should be far humbler today than they were in recent decades, when some claimed credit for the so-called great moderation, the period of reduced economic volatility that lasted from the late 1980s to the early years of this century. It is now clear that the prosperity and stability much of the world enjoyed during those years were largely the result of good luck. 

In my view, Posen, if anything is overstating the power of monetary policy over the real economy.

Consider post 2007 US monetary history. The Fed promptly took the policy rate to zero. We still had big problems. So the Fed started QE. We still had big problems. So the Fed did further rounds. We still had big problems. So the Fed tried forward guidance. We still had big problems. So the Fed tried outcome-based as opposed to calendar-based forward guidance. Guess what? We still have big problems (I know, counterfactuals are a b**ch, but the Fed clearly didn’t fix things).

You may say, “but recoveries after financial crises are always slow”. But people, that’s just another way of saying that Central Banking is not that powerful when it’s most needed!

You may say, “but they should have done more and that would have fixed things”.

That’s borderline epistemic closure. “The right monetary policy can do anything. The economy is not fixed, so the right monetary policy was not employed”, is going to be pretty hard to ever disprove.

I think some of the Summers backlash is because Larry understands that the power of monetary policy for the real economy is rather limited.

It´s not a question of “doing more” but doing differently. Angus is really a slave to what Christy Romer called “The Most Dangerous Idea in Federal Reserve History: Monetary Policy Doesn’t Matter”.

As to “The economy is not fixed, so the right monetary policy was not employed”, is going to be pretty hard to ever disprove” is not true because that´s exactly what FDR did in March 1933, even if his other mistakes held things back.

Central bankers who dismiss monetary policy effectiveness off hand have no place being central bankers. Note, for example that the “Great Inflation” went on for more than a decade. During seven of those years Arthur Burns also thought monetary policy was powerless to restrain the inflation that raged on. After all, it was due to supply side (or real) factors – unions, oligopolists, etc. Funny, isn´t it, that monetary policy can neither constrain aggregate demand nor increase it (or keep it on a stable path)! If it can´t do anything, drop it from the textbooks and never mention the words again.

5 thoughts on “Christy´s “Dangerous Idea” is alive and well

  1. Pingback: Economy Still Clearing the Low Bar « J.uris D.ebtor

  2. Hello sir. My Econ history class was taught by Doug North and I got an A. I freely admit that I would abysmally fail any class on Market Monetarism.

    • Angus, DN was a great economic historian, But for the monetary history you should check Christy Romer.
      What´s interesting about economics is that there are more “denominations” than protestantism.

  3. “Consider post 2007 US monetary history. The Fed promptly took the policy rate to zero. We still had big problems. So the Fed started QE. We still had big problems.”

    For three months after Lehman’s collapse on September 15, 2008, the federal funds rate stayed well above zero. In that period, the Fed found the time to provide dollar swaps for foreign central banks, instituted a policy of interest on excess reserves, and started QE1 with $700 billion in Agency MBS. Finally, on December 15, 2008, the Fed decided to lower the target federal funds rate to zero.

    It is important to remember the exact sequence of these events. It is a false memory to think that the Fed immediately took the policy rate to zero in response to the financial crisis. There was not one, not two, but three separate FOMC meetings between Lehman’s bankruptcy and the ultimate decision to take the policy rate to zero where each time the FOMC failed to seize an opportunity use its main policy instrument to fight back against the collapsing economy.

    The Fed’s sluggishness to act is even more peculiar given that there were already serious concerns about economic distress in 2007. The decision to wait three months to lower interest rates to zero in late 2008 was a conscious one, and one that helped to precipitate the single largest quarterly drop in nominal GDP in postwar history.

  4. “I know, counterfactuals are a b**ch, but the Fed clearly didn’t fix things.”

    It might be useful to compare the US with another large currency area that is also up against the zero lower bound in policy interest rates and has done no QE at all. That would be the eurozone. Since August 2008 the Fed has increased its monetary base by 260% and the ECB by only 43%.

    According to Econ 102 there are primarily two ways that policymakers can regulate aggregate demand (AD): fiscal and monetary policy. And by definition aggregate demand is nominal GDP (NGDP).

    The best way of measuring fiscal policy stance is by changes in the cyclically adjusted primary balance. The April 2013 IMF Fiscal Monitor projects that between 2010 and 2013 the cyclically adjusted primary budget balance as a percent of potential GDP will increase by 4.0% in the US and by 3.8% in the eurozone.

    The IMF WEO projects that from 2010 to 2013 that NGDP will increase by 12.0% in the US and by 4.6% in the eurozone. The IMF also projects that from 2010 to 2013 that real GDP (RGDP) will increase by 6.0% in the US and by 0.5% in the eurozone. So AD increased by nearly three times as much, and real output 12 times as much, in the currency area that actually did QE, and nevertheless contracted its fiscal policy stance more.

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