A monetary story alternative to Krugman´s fiscal story

Paul Krugman writes “Did The Fed Save The World?”:

Bernanke’s basic theme is that the shocks of 2008 were bad enough that we could have had a full replay of the Great Depression; the reason we didn’t was that in the 30s central banks just sat immobilized while the financial system crashed, but this time they went all out to keep markets working. Should we believe this?

It’s not a hard story to tell — and I very much agree with BB that pulling out all the stops was the right thing to do. You don’t play games at such times.

But I’m not persuaded that the real difference between 2008 and 1930-31 (which is when the Depression turned Great) lies in central bank action, or related bailouts.

It’s true that the 30s were marked by a big financial disruption; one measure (which I learned from Bernanke’s academic work) is the soaring spread between slightly risky corporate bonds and government debt:

Alternative to Krugman story_1

But there was also a big financial disruption in 2008-2009, in fact comparable in size by this measure:

Alternative to Krugman story_2

So really, was putting a limit on the financial crisis the reason we didn’t do a full 1930s? Or was it something else?

And there is one other big difference between the world in 2008 and the world in 1930: big government. Not so much deliberate stimulus, although that helped, as automatic stabilizers: the U.S. budget deficit widened much more in 2007-2010 than it did in 1930-33, even though the slump was much milder, simply because taxing and spending were much bigger as a share of GDP. And that budget deficit was a good thing, supporting demand at a crucial time.

Again, Bernanke and company were right to step in forcefully. But I’d argue that the fiscal environment was probably more important than monetary actions in limiting the damage.

The charts below allow for a different narrative.

Alternative to Krugman story_3

Notice that the “financial disruption” in the Great depression only began 15 months into the economic contraction, being responsible (“propagating”) the second stage of the contraction. When did it end? When FDR delinked from gold and NGDP turned around.

The “financial disruption” in the Great Recession was “front loaded”, with financial disruptions beginning even before the start of the recession. What seems to have “propagated” the financial disruption after mid-2008 was the Fed allowing NGDP to “shrink”. The fact that the “financial rescue services” quickly went into action helped avoid another dive in NGDP as happened in 1931. In other words, “propagation” this time around was avoided. When did the “financial disruption end? When, in addition to rescuing finance houses, the Fed introduced QE1 in March 2009.

Just like FDR´s action in 1933, Bernanke´s action in 2009 reversed the course of “fate”, only in Bernanke´s case, the action was excessively timid.

The main point, however, is that in this version of the comparative stories the “fiscal actor” (big government) does not get to go on stage!

Update: Elsewhere someone called geerussell commented:

Those charts just show the central bank doing its job. In the 1930s by abandoning the gold standard to provide the necessary accommodation. In 2009 by furnishing liquidity and avoiding rate spikes. In doing so they don’t crowd big government off the stage, they keep the stage from collapsing so the show can go on.

If the central bank is doing its job in accommodation though, it can’t “do more” and whether anything happens on the stage or not depends on degree to which the government steps up with the necessary spending and this chartdetermines the pace and quality of NGDP recovery.

The version of his chart is on top:

fiscal-mon story

Despite increasing fiscal stimulus in 2007-09, the real economy is tanking together with nominal spending. When NGDP growth turns up, so does RGDP growth. And note that despite increasingly contrationary fiscal policy in 2011-14, RGDP growth hums along at a stable rate, dancing to the tune of stable NGDP growth.

The lack of imagination is pervasive!

Gavyn Davies summarizes:

The great financial crash of 2008 was expected to lead to a fundamental re-thinking of macro-economics, perhaps leading to a profound shift in the mainstream approach to fiscal, monetary and international policy. That is what happened after the 1929 crash and the Great Depression, though it was not until 1936 that the outline of the new orthodoxy appeared in the shape of Keynes’ General Theory. It was another decade or more before a simplified version of Keynes was routinely taught in American university economics classes. The wheels of intellectual change, though profound in retrospect, can grind fairly slowly.

Seven years after 2008 crash, there is relatively little sign of a major transformation in the mainstream macro-economic theory that is used, for example, by most central banks. The “DSGE” (mainly New Keynesian) framework remains the basic workhorse, even though it singularly failed to predict the crash. Economists have been busy adding a more realistic financial sector to the structure of the model [1], but labour and product markets, the heart of the productive economy, remain largely untouched.

What about macro-economic policy? Here major changes have already been implemented, notably in banking regulation, macro-prudential policy and most importantly the use of the central bank balance sheet as an independent instrument of monetary policy. In these areas, policy-makers have acted well in advance of macro-economic researchers, who have been struggling to catch up.

The IMF has tracked this process well, and it has just held its third post-2008 conference on Rethinking Macro Policy under the leadership of chief economist Olivier Blanchard. Olivier has summarised the conference (here and here) but so far it has it not been much discussed by macro investors.

I have therefore taken the liberty of organising Olivier’s summary and the conference material into the three tables below. Although highly simplified, the tables represent a snapshot of the current “state of the art” in macro policy, at least as seen by today’s mainstream luminaries of the subject.

And concludes:

In conclusion, what should we expect from macro-policy makers in future, assuming the economic back-drop remains relatively benign? Probably, more of the same: broadly stable central bank balance sheets, very slow declines in public debt ratios and a gradual return to using interest rates as the main weapon of monetary policy. A more rapid return to pre-2008 norms for fiscal and central bank balance sheets is somewhat unlikely.

To call the economic back-drop benign is a stretch; but while that remains the conventional thinking, Summer´s “Great Stagnation” thesis will continue to be ‘celebrated’!

Why can´t they see that the “GS” is the exact opposite of the “Great Inflation”? Interestingly, while the “GI” was going on, the prevalent thought was also that monetary policy couldn´t do much to abate it!

More than most, Terrorists understand the importance of economic history

Lars e-mailed this news:

Bin Laden´s reading list

Materials Regarding France   (19 items)
  • Call for Submissions to French Culture, Politics, and Society Journal
  • Did France Cause the Great Depression?” by Douglas Irwin, National Bureau of Economic Research
  • Economic and Social Conditions in France during the 18th Century by Henri See (2004)
  • “Economic Survey of France 2009”
  • “France Country Report,” European Network and Information Security Agency (Jan 2010)

As Lars notes: “maybe he realized that the worst form of terrorism is monetary policy failure”