Sunday, October 30, 2011

Phone call for Dr. Bernanke

In the 1970s, in response to a real shock (the oil crisis), the Fed poured money into the economy.

What did we get? Stagflation. No growth and high inflation.

Paul Volcker (with support from President Reagan and the newly Republican controlled Senate) dramatically reduced money growth, ratcheting interest rates skyward, and creating a sharp recession.

But inflation fell and has stayed under control ever since.

Now, in response to a real shock, the Fed has been pouring money into the economy and we are not getting any growth. At least this time we are not getting inflation either.

What is Christina Romer's takeaway from the historical episode I describe above? That Bernanke needs to "steal a page from the Volcker playbook" and ....... pour even more money into the economy!

WTF??


Look, the Fed did a great job as lender of last resort in the 2008 crisis. Without their actions, I believe things would have been very much worse.

But beyond the financial panic, we have had a very adverse real shock to the economy (housing price collapse). People are not as wealthy as they thought they were by a long shot. Households are trying to de-leverage and rebuild their balance sheets. The Federal government is making it hard for them to do that by taking on ever more debt on their behalf. This isn't a nominal shock, it's a real shock.

We have no evidence that monetary policy can or should be used to attempt to offset real shocks. The Fed absolutely did their job in the crisis. They should stand ready to guard against potential deflation. But the Fed simply does not have a magic wand to "heal the economy". It's not a patient, Bernanke is not a doctor, and monetary expansion is not medicine.

6 comments:

voxrationalis said...

Why are you setting up an equivalence to the 1970s when the 1930s is clearly more appropriate? The key difference between the 1970s and both the 1930s and today is the gap between potential and actual GDP, for which unemployment is a useful proxy. In the 1930s and today, we have persistently high unemployment and an economy working well below potential. In the 1970s, unemployment was quite low. It makes perfect sense that expansionary monetary policy would be inflationary in the 70s, just as it makes perfect sense that the vast expansion of the Fed's balance sheet recently has had little effect on inflation.

Apples and oranges, fellow Cards fans.

Anonymous said...

On what planet was unemployment low in the '70s? Here are the numbers from BLS for the years after the oil shock:
5.6, 8.5, 7.7, 6.1, 5.8. Now, half of those are near historical standards, but compare them to the five years before the shock ('68-'73): 3.6, 3.5, 4.9, 5.9, 5.6, 4.9.
As for the lack of inflation, maybe if you don't eat or drive a car. Or buy a car, for that matter.

Kindred Winecoff said...

If the problem is debt/deleveraging, then why wouldn't higher inflation help speed up the adjustment? This is Rogoff's argument. Munger calls it theft, and it certainly has distributive consequences, but many creditors (ie the banks) have benefitted quite a lot from recent policy so there's a case to be made that inflationary policy now just evens up the score a bit.

I think, with vox above, that the 1930s provides pretty strong evidence that monetary policy has a big effect following real shocks. The Fed pursued contractionary monetary policy during a debt/deleveraging cycle and the result was... contractionary.

The 1970s was not a debt/deleveraging cycle.

Dave Hansen said...

"Why are you setting up an equivalence to the 1970s when the 1930s is clearly more appropriate?"

Uh, yeah, why is Christina Romer making this comparison? I thought that was the main point of Angus's post.

Jeff said...

Angus, I'm a KPC fan but I think you're off base here, so I must comment:
(1) You said "the Fed has been pouring money into the economy and we are not getting any growth". By what measure is the Fed pouring money? I hope you are not referring to M1, M2 or the likes, because I'll just have you look at the velocity of those aggregates.

(2)You said: "the Fed did a great job as lender of last resort in the 2008 crisis" and then two paragraphs later said "We have no evidence that monetary policy can or should be used to attempt to offset real shocks". So I say, "huh?"

Bruce B said...

One historical quibble: Volcker was appointed by Carter and started jacking up interest rates before the Reagan administration, so it took a little longer than implied in the post to tame inflation. Carter, after a few years of ineptness and on-the-job training, starting doing some things right towards the end of his term (he also never seems to get credit for airline deregulation). The combination of high inflation and high interest rates helped doom his re-election chances (yes there were multiple other reasons as well).
Note that this is not a defense of Carter's term or saying that he should have been re-elected, or elected in the first place (although speaking of inept, I'm not sure Ford would have figured out what to do any faster).