A great deal has been written on the state of macroeconomics as a discipline in the last few weeks and I hope to respond to much of it. However, let me start with Scott Sumner.
Here is a puzzle. Almost everything we have learned from recent research in monetary history, theory, and policy points to the Federal Reserve as the cause of the crash of late 2008. More specifically, an extremely tight monetary policy in the US (and perhaps Europe and Japan) seems to have sharply depressed nominal spending after July 2008. And yet it is difficult to find economists who believe this. More surprisingly, few economists are even aware that their views conflict with the standard model, circa 2009.
Its not completely clear where Sumner’s views and my own part ways. Sumner says that the Fed was “too tight.”
To counter evidence to the contrary he argues that looking at interest rates is misleading. Low interest rates can imply low inflation and hence tight money. He says that looking at the monetary base is misleading, as it ignores changes in reserve regulations. In 2008 the Fed began to pay interest on reserves. So far this seems right..
He then, however, goes on to say that
If we learned anything from the 1980s, it is that the broader aggregates are no more reliable than the base. During financial turmoil, it is not surprising that there is an increased demand for safe, FDIC-insured bank deposits.
Now this sounds to me as if Sumner is simply saying that the crisis on Wall Street lead to a rapid increase in money demand. Its not clear to me how this is different than the standard view. The turmoil created flight to quality which drove people out of risky assets and into cash and Treasuries. In an attempt to horde cash businesses and consumers cut purchases and induced a recession.
In this story the chain of events starts with “the turmoil.” It wasn’t that the Fed tightened and thus money was too tight. It was that money demand soared and thus money became effectively tight.
The Fed then had two avenues for “loosening” monetary policy. One, it could simply expand the money supply as Sumner suggests. However, it was not clear that this would be effective at the zero lower bound. Sumner argues that it would be but I think at a minimum we can say there is no consensus that traditional monetary policy is effective at the zero lower bound.
Two, the Fed could attempt to alleviate money demand. Since, the increase in money demand was driven by fears about bank failures the Fed could move to secure the banking system. Once, the public became sure that the system would survive money demand would return to normal and policy would no longer be tight. This seems to be the path the Fed chose and it seems to have been effective.
However, Sumner discounts the second avenue by suggesting that tight money caused the bank failures.
After the failure of Lehman most economists simply assumed that causation ran from financial crisis to falling demand. This reversed the primary direction of causation – as in the Great Depression, economic weakness worsened bank balance sheets and intensified the financial crisis in late 2008.
How then do we explain money that was “too tight for the needs of the economy” when the money supply was increasing? It seems that Sumner has in mind some sort of contraction starting in early 2008. However, the financial crisis began in the summer of 2007. It seems much more straight forward that money demand had been increasing since the first spike in the Funds rate in August 2007. Perhaps, had the Fed responded more aggressively the crisis could have been muted. Perhaps, increase the quantity of money at the zero lower bound would have worked. But, I don’t see how the crisis was started by the Fed.