If monetary policy could have avoided it, “Secular Stagnation” is a direct consequence of monetary policy!

Larry White has a very interesting post at Alt-M, where he uses Michael Darby´s 1976 analytical apparatus to do “Some Simple Monetarist Arithmetic of the Great Recession and Recovery” (you should read the post to enjoy the simplicity of the “apparatus”):

Monetarist theory sharply distinguishes real from nominal variables.  Nominal shocks (changes in the path of the money stock or its velocity) have only transitory effects on real variables like real GDP. Accordingly, an account of the path of real GDP in the long run (and 6+ years of recovery should be enough time to reach the long run) must be explained by real and not merely by nominal factors.  An account of the path of nominal GDP, by contrast, cannot avoid reference to nominal factors.  So we need distinct (but compatible) accounts of the two paths.

A downward displacement of the steady-state path of nominal GDP, due to a contractionary money supply or velocity shock, can bring a transitory decline in real GDP.  As is familiar, people try to remedy a felt deficiency in money balances by reducing their spending.  In the face of sticky prices, reduced spending generates unsold inventories and hence cutbacks in production and layoffs until prices fully adjust.  As Market Monetarists have long argued, the Federal Reserve could have avoided the downward displacement of the path of nominal GDP if policy-makers had immediately recognized and met the rise in fluidity (the drop in velocity) with appropriately sized expansionary monetary policy. 

Although a one-time un-countered rise in desired fluidity [inverse of velocity] can temporarily knock real GDP below course, such a nominal shock should not persistently displace its growth path, as the first chart above indicates has happened.  We can expect monetary equilibrium to be roughly restored by appropriate adjustment in the price level relative to the nominal money stock, bringing real balances up to the newly desired level, within three or four years at most.  (In the data plot above, we see the GDP deflator shift to a lower path already in 2009.)  Real GDP should around the same time return to its steady-state path as determined by non-monetary factors (labor force size and skills, capital stock, total factor productivity as governed by technologic improvements, policy distortions, and so on).  To explain the continued low level of real GDP relative to estimated potential since 2011 or so, we need a persistent shock to the path of real GDP.

I suggest that real GDP has shifted to a lower path because of a shrinkage in the economy’s productive capital stock — a problem that better monetary policy (not feeding the boom) could have helped to avoid, but cannot now fix.

Some comments:

The two highlighted passages seem contradictory. In the first, monetary policy failed to offset the rise in fluidity (fall in velocity) giving rise to the steep fall in NGDP.

In the second, he goes back in time to say the problem was excessively expansionary monetary policy that fed the boom.

I have a lot of trouble with the second claim (see here). But if you assume that´s true it becomes a double critique of monetary policy, having got it wrong in sequence, first in one direction and then the other.

The hysteresis argument that bad monetary policy shrank the economy´s capital stock (permanently lowering the path of real output) is hard to accept. After all, during the great depression, real output over a long span of time climbed back to the previous trend level, despite a much larger” shrinkage in the productive capital stock”. It seems a “review” of monetary pólicy had a lot to do with that outcome.


The next charts are also shown by Larry White, but I want to go into a bit more detail.



The sequence is clear. Economic events (house price fall, troubles with financial firms, among others) induced a strong rise (jump) in fluidity (drop in velocity). Money supply did not rise by anything close to necessary to offset the fall in velocity. The result was a (almost unheard of) fall in NGDP to a much lower level.

Later, from the end of 2010 to late 2011, maybe due to the Eurozone crisis, fluidity had another “step increase”, also not fully matched by the rise in money. The NGDP path ticks down.

More recently, with the path of fluidity steepening somewhat and the money supply trend remaining stable/constant, NGDP growth seems to falter.

What the horrendous monetary policy of the past eight or nine years has accomplished is “momentous”. From the successive reductions in the level of potential output estimated by the CBO over the past years, it seems that instead of “Mohamed (actual RGDP) going to the mountain (Potential RGDP), the mountain is coming down to Mohamed”!


2 thoughts on “If monetary policy could have avoided it, “Secular Stagnation” is a direct consequence of monetary policy!

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