By now there should be broad agreement on one point in the grand debate on macroeconomics. A recession born of a severe financial crisis is an especially destructive force, and one that isn’t easily solved. Irving Fisher outlined the basic problem more than 80 years ago in his prophetic paper “The Debt-Deflation Theory of Great Depressions. The blowback cycle of unusually deep recessions and protracted recoveries after acute turmoil in the financial sector is a familiar syndrome, as economists Carmen Reinhart and Ken Rogoff detail in This Time Is Different: Eight Centuries of Financial Folly.
Recognizing the historical and recurring nature of the current ills doesn’t lessen the pain, but ignoring or minimizing the lessons of the past can deepen and extend a crisis. That’s the charge leveled against the Obama administration’s response to the Great Recession in early 2009, according to a story by The Washington Post’s Ezra Klein. For example, here’s one telling mea culpa from Peter Orszag, the former head of the Office of Management and Budget, on his thinking during the dark days of early 2009: “I don’t think it’s too much of an exaggeration to say that everything follows from missing the call on Reinhart-Rogoff, and I include myself in that category. I didn’t realize we were in a Reinhart-Rogoff situation until 2010.”
In December 2008, Rogoff wrote that “it is time for the world’s major central banks to acknowledge that a sudden burst of moderate inflation would be extremely helpful in unwinding today’s epic debt morass,” Klein notes. The Federal Reserve did in fact respond by engineering a large increase in the monetary base. There was also a sizable (at least by historical standards) fiscal stimulus.
All of which prompts Reinhart to tell Klein:
“The initial policy of monetary and fiscal stimulus really made a huge difference,” she says. “I would tattoo that on my forehead. The output decline we had was peanuts compared to the output decline we would otherwise have had in a crisis like this. That isn’t fully appreciated.”
In that way, Reinhart says, this time really was different — at least from the Great Depression, when output shrank by 30 percent and a quarter of the workforce was unemployed. “If the choice was this or the ’30s,” she says, “I’d take this hands down.”
But the so-called “market monetarist” school argues that the monetary stimulus hasn’t been sufficient (advocates for fiscal stimulus make a similar case from the Keynesian perspective). And there’s no shortage of evidence to support these complaints. Everywhere you look, the statistics are ugly. From high and persistent unemployment to feeble job growth, there’s ample evidence that the policy response was insufficient this time. Indeed, a new study shows that household income has continued falling in the two years since the recession ended.
Even so, this is macroeconomics and so cause and effect are hotly debated. Harvard University economics professor Martin Feldstein tells The Wall Street Journal that the current recovery is “about as bad an expansion as I’ve ever seen.” Nonetheless, he says the Fed “has gone too far recently in pushing for lower interest rates.” Huh?
This type of thinking is alien to market monetarists such as Scott Sumner. He argues that “any definition of easy money is arbitrary, unless it is relative to the policy objective.”
So, has Fed policy been “easy”? In terms of looking at the increase in the monetary base and the fall in nominal interest rates, yes, policy has been easy, or so it appears. But relative to what’s needed, there’s a strong case for arguing that the Fed has been engaged in a policy of passive tightening.
How do we know this is true? Lars Christensen explains:
In a world of monetary disequilibrium, one cannot observe directly whether monetary conditions are tight or loose. However, one can observe the consequences of tight or loose monetary policy. If money is tight then nominal GDP tends to fall – or growth is slower. Similarly, excess demand for money will also be visible in other markets such as the stock market, the foreign exchange market, commodity markets and the bond markets. Hence, for Market Monetarists, the dictum is money and markets matter.