30 Sep 2016

Developing Story: Leading Market Monetarist Rebukes Christian

Austerity, Market Monetarism, Shameless Self-Promotion 9 Comments

Recently Scott Sumner focused his attention on 1946 (here and here), which (he claimed) was quite embarrassing for Keynesians. This is the opening of his second post, which gives a flavor of his analysis:

Over at Econlog I did a post discussing the austerity of 1946. The Federal deficit swung from over 20% of GDP during fiscal 1945 (mid-1944 to mid-1945) to an outright surplus in fiscal 1947. Policy doesn’t get much more austere than that! Even worse, the austerity was a reduction in government output, which Keynesians view as the most potent part of the fiscal mix. I pointed out that employment did fine, with the unemployment rate fluctuating between 3% and 5% during 1946, 1947 and 1948, even as Keynesian economists had predicted a rise in unemployment to 25% or even 35%—i.e. worse than the low point of the Great Depression. That’s a pretty big miss in your forecast, and made me wonder about the validity of the model they used.

Everyone got that? Keynesians are big on fiscal policy being the key to avoiding recessions, and so it’s really awkward for them that there was so much fiscal tightness in 1946, with no plunge into Depression. Sumner thinks this is a pretty big smoking gun to tell us that Keynesian models are wrong. I agree with him.

But what’s interesting is that the end of World War II also coincided with extreme monetary tightening. I am old school and like the monetary base as a key indicator. Check it out:

Can’t get a much crisper “regime change” than that, right? From December 1941 – December 1945, the monetary base almost doubled, but starting in 1946 the base was basically flat for the next 5 years.

As far as short-term safe interest rates, they were steady throughout 1946 but then began rising sharply in mid-1947:

But as we all know, Market Monetarists are not fooled by the monetary base or interest rates. Instead they focus on NGDP growth as the ultimate criterion of whether monetary policy is tight or loose.

On this count, it’s not as clear cut as with the monetary base, but nonetheless (using annual data) you see the growth in NGDP collapsed to zero after the war:

And, Sumner himself reports that if you look at the beginning of 1945 through the beginning of 1946, NGDP actually drops 10%. (For context, using quarterly data, the biggest drop from the preceding period in NGDP during the 2008 financial crisis was -7.7%. So for an annual drop of 10% after World War II, that was way way worse of a monetary shock, if you’re a Market Monetarist.)

So, I think the above shows that there was, by all accounts, monetary tightening (or at least a failure to engage in “monetary offset”) following World War II. Since the standard Market Monetarist story is that massive fiscal contraction is indeed bad because it reduces Aggregate Demand, but can be offset with appropriate monetary loosening, it seems that this year 1946 poses a pretty big challenge to the Market Monetarist model as well as the Keynesian model.

Someone brought this up in the comments of Scott’s Money Illusion post. And yet, not only did Scott not provide a satisfactory explanation, he blew the guy off like it was a stupid question.

*whistles innocently*

P.S. It’s not just 1946. The Market Monetarists tried to say Canadian fiscal austerity only worked in the 1990s because of monetary offset, but there again I showed (here and here) that using all sorts of reasonable metrics, the Bank of Canada tightened right at the crucial moment.

9 Responses to “Developing Story: Leading Market Monetarist Rebukes Christian”

  1. David R Henderson says:

    I don’t get the use of “Christian” in the title.

    • Bob Murphy says:

      David the guy in the comments that Sumner blew off was named Christian.

  2. Transformer says:

    ‘Since the standard Market Monetarist story is that massive fiscal contraction is indeed bad because it reduces Aggregate Demand, but can be offset with appropriate monetary loosening, it seems that this year 1946 poses a pretty big challenge to the Market Monetarist model as well as the Keynesian model.’

    I think Market Monetarists would say that while a massive fiscal contraction i would be a negative demand shock – monetary offset would not be needed if there was an equivalent positive demand shock at the same time . The end of WW2 and the unleashing of post-war optimism and pent-up demand would probably,y qualify..

    Of course, this would also give Keynesians an easy out – so Sumner would still have some explaining to do.

    • Bob Murphy says:

      Transformer–right. I didn’t say it, but my perspective is that any excuse Sumner can give, Krugman can too. And yet it seems Sumner thinks this is a stake in the heart for Keynesians.

    • Andrew_FL says:

      Pent up demand has been the standard Keynesian line since Lawrence Klein, one of the few contemporary Keynesians to predict there would be no depression caused by demobilization.

      Except, it’s not quite right. What happened after the war was, mainly, a recovery of private investment, not consumer demand.

  3. Major.Freedom says:

    Market monetarism has long ago been refuted on economic grounds. Merely observing incompatible events is just a side dish.

  4. Bob Roddis says:

    A. The market does not fail.

    B. The statists cannot point to that special historical incident where it did fail.

    C. Since the market does not fail, it does not require external “stimulus” to provide it with “momentum”. Thus, there is no basis whatsoever to support either “fiscal” or monetary “stimulus”.

    D. The statists behave as if they were graduates of the “Frankfort School” and ignore Austrian analysis which points to price distortions caused by central banks and fractional reserve banking as the cause of economic problems.

    E. Violent interventionists should have the burden of proof to justify their violent interventions. They cannot justify themselves and don’t even try. And no one demands that they justify themselves.

    F. Why do Austrians behave as if our opponents were honorable?

  5. Patrick Szar says:

    I’m trying to understand this idea of NGDP targeting in this historical context and i’m a little confused. First of all, I’m under the impression that NGDP targeting is a relatively new theory. So that could easily be the problem if I’m wrong.

    Calling the fed’s policy tight or loose based on this criterion is fine as far as describing history. But calling their policy stance tight or loose based on this is not. Wouldn’t the Fed at the time have to have been operating with the goal of NGDP targeting for any recourse to this theory to apply? I’m not trying to put words in Scott’s mouth, but I’m under the impression he would try to defend his theory in all historical cases, right? So he’d call it accidental NGDP targeting?

    The whole idea that one could debate this era in terms of success or failure based on fiscal or monetary policy, monetary base or NGDP targeting, seems to me a little odd. The macro theories as I understand them are lacking the basic qualitative aspect that Austrians focus on routinely–heterogenous capital and production for consumers vs war–that is critical for understanding the post-war economy.

  6. Andrew_FL says:

    Dang of all the times for me to take a sabbatical from this kinda stuff I miss out on a post like this!

    I actually singled out the WWII demobilization austerity as an interesting instance where I thought both Keynesian and Market Monetarist models failed last year in the comments here at this blog!

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