Wow. I have been immersing myself in the monetary economics blogosphere discussions, and I don’t likes what I sees. In this post I’ll talk about Nick Rowe, whom you may recall I previously dubbed a kung fu master.
As with Scott Sumner, so too with Nick: I want to preface this post by saying he’s a funny guy, very smart, and a good economist. But when it comes to monetary policy, it’s not merely that I disagree with him, it’s that I am shocked by the words coming out of his keyboard.
In light of QE3, Nick was relieved that the tide had turned and put up a post saying, “We’re winning.” To show how much better things were now, Nick linked his readers to a post he had made in May 2010. It is this older post from which I want to quote, because it really should terrify the average Joe. So here’s Nick Rowe from a little more than two years ago, lamenting the state of the macroeconomics profession:
I think we are witnessing the biggest silent shift in macroeconomic thought since the Second World War. For 70 years we have taught, and believed, that we would never again need to suffer a persistent shortage of demand. We promised ourselves the 1930’s were behind us. We knew how to increase demand, and would do it if we needed to.
The orthodox have lost faith in that promise; only the heterodox still believe it. And the heterodox have nothing in common, except for keeping the faith.
The orthodox haven’t lost hope. They hope that monetary and fiscal policy will be enough to get us out of this recession, and that the limits on monetary and fiscal policy will not be binding this time around. And they are probably right. But they have lost faith that monetary and/or fiscal policy will always be enough – that there are no limits.
And if the Eurozone too turns Japanese, they may start to lose even that hope.
There are two types of macroeconomist.
The first says “What do you mean you can’t increase aggregate demand? You run out of paper? Ink? You scared of inflation?”
The second says “But monetary policy won’t work at the zero lower bound. And there are limits on fiscal policy, because we daren’t let the national debt get too big.”
Scott Sumner and Modern Monetary Theorists are examples of the first type of macroeconomist. They have nothing in common, except that one thing. But that one thing is more important than all their differences. And they are heterodox.
Traditional Keynesians and monetarists, the competing schools of the old orthodoxy, belonged to the first type of macroeconomist. They differed only on tactics. They kept the faith. But they have now gone, and only monetary cranks sing the old religion.
The second type of macroeconomist represents the new orthodoxy. Few orthodox macroeconomists today will admit point-blank to having lost the faith, any more than a bishop, no matter how liberal, will admit to being an atheist. But if you believe that monetary policy is ineffective at the zero bound, and that there are limits to how long you can have a big fiscal deficit, it comes to the same thing. You have lost faith that you can always and everywhere increase demand by whatever it takes for as long as is needed.
Losing faith in monetary and fiscal policy, the orthodox turn to financial policy. “If we had better regulation and/or supervision of financial markets and institutions, we wouldn’t have gotten into this mess in the first place”. That’s probably true, but it’s also a distraction from the loss of faith. Financial markets and institutions are inherently unstable. They borrow short and lend long; they borrow safe and lend risky; they borrow liquid and lend illiquid; they borrow simple and they lend complex. Finance is magic; you know it can’t really be done. Regulation and supervision can never eliminate financial instability. If your faith is contingent on being able to prevent financial crises, you have lost the faith.
Good financial regulation and supervision are important in their own right. A good financial system will better serve the interests of borrowers and lenders. It will create benefits on the supply side. And financial crises will almost certainly cause demand to fall. But just because something causes demand to fall doesn’t mean monetary and fiscal policy can’t work. The whole point of Keynesian policy was that when (not if) something did cause demand to fall, monetary or fiscal policy could and should be used to increase it back again.
OK, and now that you’re warmed up, Nick follows the above with what must be one of the most unintentionally damning indictments of his whole worldview ever written:
Even suppose the financial system totally collapsed. Why should that prevent monetary and fiscal policy working to increase demand? The biggest flaw of orthodox macroeconomic models is that they have no financial sector. So, if the financial system disappeared, that ought to mean those models would work even better.
We’re kind of at the point where my commentary on the above is superfluous. If you read all that and are nodding your head saying, “Yes, yes, I like what you’ve done here, Nick,” then my criticism will seem crude and irrelevant to you. If, on the other hand, you’re reading that and thinking, “Wait a second. He doesn’t think there are limits to monetary and fiscal policy, even in principle? What exactly does he mean by that? And he’s using the fact that his models don’t have financial sectors as further evidence that we ought to be trusting them right now? Huh?!” then you don’t need me to spell out the problems here.
So instead of me criticizing Nick, let me be a nice guy and give my own explanation of what happened. In his latest post (which I link above but from which I’m not quoting), Nick is happy but baffled as to why his pessimism of May 2010 is now turned back to optimism. In other words, Nick can’t understand why so many of his peers lost the faith in the first two years of this crisis, but now they seem to have it back all of a sudden. Here’s my take:
==> Although there were a few Cassandras (including Nouriel Roubini from the interventionist side and Peter Schiff from the hard-money/deregulate side) who had very prescient descriptions of what was coming, generally speaking most economists had no idea just how bad things would be in 2008.
==> Even though most economists taught and published on the academic models that form the core of Nick’s religion (hey, I’m just continuing his metaphor), they didn’t believe it in their bones. They actually had common sense, and realized that this type of picture was scary:
The above picture isn’t the current one; it shows what the monetary base looked like, as of May 2010. So I’m saying I think most economists had common sense, looked at that chart, and thought, “You know, I just can’t agree with Scott Sumner that that is a picture of the tightest monetary policy since Herbert Hoover. I understand how back in the Depression, M1 and M2 actually fell sharply, and so did prices. But we’ve had rising Ms and CPI since the start of 2009. Sure, CPI growth hasn’t been high by historical standards, but we haven’t had outright deflation. And man, the Fed sure has pumped in a lot of base money. Maybe pushing harder on that particular lever isn’t really the answer. I’m not even sure running up more government debt will help, since we’ve had multiple years of trillion-dollar-plus deficits and that too doesn’t seem to be working very well.”
==> So why the turnaround? I think it’s because guys like Peter Schiff, Marc Faber, and (to a much lesser extent, since I’m not famous) me, were going nuts in 2009 warning everybody about Bernanke’s mad plan to debase the dollar. When our warnings didn’t come to pass, Krugman and Sumner (mostly Krugman) were running victory laps, saying “nana nana boo boo, we were right and the critics are idiots.”
==> Seeing that unprecedented money-creation didn’t seem to hurt, economists slowly got convinced to give it another try. In this effort, guys like Sumner were instrumental, because he relentlessly used very cogent arguments and data to show why everything made sense, from his perspective.