Demystifying Monetary Policy (Again)

Ramesh Ponnuru of The National Review does a first-rate job of summarizing the counterintuitive nature of monetary policy and how it applies to recent history. In particular, he explains in clear and (mostly) non-technical terms how and why the Fed’s “passive tightening” in late-2008 helped turn what might have been a relatively modest recession into something much worse. He also outlines why the subsequent QE2 was necessary and how many commentators (primarily conservatives) have misunderstood the necessary monetary policy solution, along with the fact that low interest rates of late aren’t a sign of loose money.

These and related subjects have been discussed in great detail in recent years by such economists as Scott Sumner, David Beckworth and others. But the finer points of how a surge in the demand for money can change the rules of monetary policy still aren’t widely understood. As Ponnuru explains,

Easier money can lead to a destabilizing run on the currency. Inflation can be associated with low real interest rates and an expanded monetary base. But not always: Not in the 1930s, and almost certainly not today, either. The late Milton Friedman, perhaps the most famous inflation hawk of his generation, spotted the fallacy in his analysis of 1990s Japan: Low interest rates can also be a symptom of an excessively tight monetary policy that has choked off opportunities for growth. A looser policy, by increasing expectations of future economic growth, could actually raise real interest rates.

Ponnuru isn’t breaking new ground here, but he is outlining crucial details of how monetary policy ticks these days—details that (still) need to be discussed. Maybe because The National Review is pushing this story, it’ll finally resonate with those on the right. In any case, this is a valuable overview that’s worthy of everyone’s attention.