Today Scott Sumner writes:
There’s a reason most economic forecasters were not predicting a recession as of June 2008; net worth models are useless. The huge decline in house prices between 2006 would not be expected to cause a major recession, and indeed would not have caused one had NGDP not declined.
OK so there are two things here. First, although I have yet to be vindicated in my warnings about price inflation, here’s what I wrote in a Mises Daily that ran in early October 2007, based on analysis I had actually done in July 2007 for a client:
On September 18 the Fed cut its target for the fed funds rate by 50 basis points (0.5 percentage points), from 5.25% to 4.75%. The move surprised many analysts who had been expecting a more modest cut of 25 basis points.
For those versed in the Austrian theory of the business cycle, as developed by Ludwig von Mises and elaborated by Friedrich Hayek, the aggressive Fed “stimulus” is ominous indeed. Not only will it pave the way for much higher price inflation than Americans have seen in decades, but it will also exacerbate what could be the worst recession in twenty-five years.
Looking back at the chart above, we can see why the worst may be yet to come. In (price) inflation-adjusted terms, the early-2000s levels of the actual fed funds rate is the lowest since the Carter years. And many readers may recall the severe recessions of 1980 and 1982 that followed that period.
In the Austrian view, the boom-bust cycle is caused by the Fed’s maintenance of artificially low interest rates, which causes businesses to expand, hire workers, buy other resources, and so forth, even though these projects are not justified by the true supply of savings in the economy. The greater the “stimulus” the worse the malinvestments.
From 2001–2004, the Fed kept (real) rates at the lowest they’ve been since the late 1970s. One of the consequences that has already manifested itself is the housing bubble. But a more severe liquidation seems unavoidable. The recent Fed cut may postpone the day of reckoning, but it will only make the adjustment that much harsher.
So Austrian business cycle theory certainly equipped an analyst to think a really bad crash was coming. And I didn’t pull “the worst in 25 years” out of a hat; in the article I explain why I said that.
But what of the second part of Sumner’s quote, where he says: “The huge decline in house prices between 2006 would not be expected to cause a major recession, and indeed would not have caused one had NGDP not declined.” ?
I still say there’s something really screwy about this approach. Absent huge swings in the price level, a recession is the same thing as a drop in NGDP.
I’ve asked this before, but I don’t think I got a great answer. What if we outdid Sumner, and said the Fed should target, not NGDP, but the unemployment rate? Or, actual RGDP as a percentage of potential RGDP? You would find those things tracking recessions and booms like hand-to-glove. I could say stuff like, “Market monetarists think the doubling of the reserve ratio in 1937 led to a double-dip depression, but actually it was the spike in unemployment. If policymakers had simply kept unemployment at 4% like I keep telling them they should, there wouldn’t have been a double dip in 1937. But, they had added insufficient Murphy Sauce in the economy, as evident from the fact that unemployment was above 4%. They confused the doubling of reserve ratios with inadequate Murphy Sauce. This happens a lot among macroeconomists.”
I am exaggerating a tad, because I can anticipate what the first round of replies would be from Sumner et al. on the above. But still, I think it’s good for me to occasionally spell out why I think he’s totally wrong.