The monetary nature of the ‘longhorn-shaped’ economy

The ‘longhorn-shaped’ economy is a good description of a depressed economy.  This post will show the monetary nature of a depressed or ‘longhorn-shaped’ economy. This two and a half year old post “An alternative script: one where interest rates don´t make an appearance” is useful for a better understanding of my conclusions.

How, might one ask, can the economy be depressed if it is growing? The answer is that depressed is a relative concept. I say the economy is depressed if it remains below the trend level. The picture below illustrates, where the trend level begins in 1870, so it´s not just a short-run construction!

Monetary Nature of Longhor_1

Why is the ‘longhorn-shaped’ economy a good description of a depressed economy? The following chart indicates that to avoid a ‘longhorn-shaped’ economy, once the economy ‘slides-down’ the face of the bull, growth has to be above trend for a while to ‘make-up’ for the losses incurred during the ‘slide’. Just going back to trend growth is not enough! You would have to design a ‘nonsymmetrical’ longhorn!

Monetary Nature of Longhor_2

In my post yesterday I showed that in the present cycle employment was longhorn-shaped. So is real growth. The pictures are reproduced below.

Monetary Nature of Longhor_3

Taking nominal spending (NGDP) as the major driver of the economy, something closely controlled by the Fed, we should find, in the case of a depressed economy the same longhorn-shape for NGDP. The next picture illustrates. Nominal spending is indeed ‘longhorn-shaped’.

Monetary Nature of Longhor_4

Now, I go back to the linked post above to describe the concept of ‘excess money’, the Fed´s instrument to control economic activity. The 1998 Annual Report Essay from the Cleveland Fed should have been read by Bernanke before the collapse. In the conclusion it says:

There is another, equally important point. If the economy does suffer a downturn exacerbated by financial market corrections, it would be wrong to conclude that a monetary policy geared toward price stability was a mistaken choice. Price stability represents a significant improvement over managed economic growth. But price stability is, after all, a means to an end. And, as has been demonstrated, it has limitations as an overall indicator of economic health. During a period of rapid technological change and exuberant financial markets, monetary authorities must still account for —and reckon with — excessive monetary growth.

And I continue:

Sounds like a “prelude” to 2008? So, let´s start there. First let me define “excessive monetary growth”. I shall call it “net money” (as suggested by Lars Christensen) since it refers to money supply growth in excess of money demand growth by more than 5.5%, which is the growth rate of nominal spending (NGDP) along the level path that characterized the “Great Moderation”. Stated in the Cambridge form of the equation of exchange: M=kPy, where k is the inverse of velocity, M is money stock, P the price level and y real output (RGDP), we can write it in growth terms as: gMS-gMD=gP+gy=5.5%.

So let´s see how ‘net money’ behaved in this cycle.

Monetary Nature of Longhor_5

Yes, clearly defective, giving rise to the longhorn-shaped economy.

Now let´s observe what went on in the 2001 cycle. The ‘longhorn’ is asymmetrical. (And note the ‘slide’ was much shallower)

Monetary Nature of Longhor_6

Net money growth is corrected following the recession, belatedly and not because interest rates dropped to 1% but because the Fed introduced forward guidance in August 2003!.

Monetary Nature of Longhor_7

So yes, not only could the Great Recession have been avoided (being a mild recession) as the recovery could have been much stronger. If only the Fed had wished it so!

2 thoughts on “The monetary nature of the ‘longhorn-shaped’ economy

  1. One question about the last point “Net money growth is corrected following the recession, belatedly and not because interest rates dropped to 1% but because the Fed introduced forward guidance in August 2003!.” How does just saying ‘we’re going to do thus and so tomorrow or the day after,’ for example, make the money supply grow? Does it mean that people opened up their wallets and parted with the hoard, or does it mean that the Fed would accommodate demand for money rather than turning it away, or a bit of both? In reality then, if it means some of both, the Fed could possibly correct the current situation by stating matter of factly that money is too tight and it will do whatever it takes to loosen it up starting now.

    But it doesn’t do that because 1) an obsession with ultra low inflation 2) no clue what to do about it if it becomes a probem. So we are all living through hard times simply because these guys are incompetent and know it?

    • Bonnie, As to my point (FG), it was that people “opened up their wallts…”. Velocity rose (money demand fell)
      Regarding your points I think it´s a bit of both. Obsession and incompetence!

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