Free Exchange picks up on a couple of good posts from Paul Krugman and Scott Sumner. The key debate is over what should be done to produce the kind of rebound growth with saw in the last two big recessions


Krugman has argued previously for fiscal stimulus while Sumner believes

In both earlier recessions the budget deficit rose by just over 3% of GDP; from a bit under 1% to 4% of GDP between 1973 and 1975, and then from 3% to just over 6% between 1980 and 1982.  I’m no expert on Keynesian economics, but isn’t that mostly the effect of the recession?  I don’t see a lot of room for discretionary stimulus.

Free Exchange rightfully notes

I think the problem with this is that Mr Sumner isn’t considering the monetary side of the previous recessions. Recall that the 1973-1975 and 1981-1982 recessions were Fed-driven. During the earlier recession, the central bank tightened into and through much of the recession; the effective federal funds rate peaked in 1974, halfway through the downturn. In the latter recession, the Fed tightened into the recession, and between the first month of the downturn and the last, the central bank cut rates from nearly 20% to around 10%.

The important part here is, however, is not that the Fed induced the last two recessions but why the Fed induced the last two recessions. In both cases inflation was running well above XXXXX

Sumner has argued well that ultimately the recession is a result of too tight monetary policy. On one level I agree with him. That is to say I think looser monetary policy could have lessoned the severity of the downtown and could produce more robust economic growth.

Where I part ways with Sumner is two points, one academic and the other practical. The academic point is whether or not the collapse was precipitated by an old fashioned bank panic. I think it was, Sumner seems to believe that monetary policy initiated the panic. More practically, however, the question is, “What exactly is loose money.” Sumner has a variety of measure he would like to point to.

I still maintain that the textbook view that essential measure is interbank lending rates.  Those of course are at or near zero. In which case the primary Fed policy tool must be generating higher inflation expectations, so as to induce negative real interest rates.

On this front we have seen very poor performance from the monetary authorities. Ever insistence that they will control inflation in the future is damaging to the economy today. Every time the Fed makes vague suggestions about raising interest rates sooner than later it is damaging to the economy today.

At the same time I recognize that the Fed cannot abandon the inflation credibility it has worked so hard to achieve. That is why now is the time to set an explicit short term inflation target of 5%.  Bernanke came to the Fed promising transparency. I was skeptical about some of his efforts. I was not sure that Wall Street could handle a more loose lipped Fed. But, if there was ever a time to state explicit goals, this is that time.

We need an explicit inflation target. We need a thorough explanation of why it is being set. We need a public acknowledgement that the monetary policy is constrained by an inflation rate that is too low. We need all of that and we need it now.