Back in 2009 John Cochrane debated Scott Sumner about the causes of the crisis, and pushed back pretty heavily against Scott’s interpretation that by 2008:Q3, money had become too tight relative to the needs of the economy. He made a few salient points, but ultimately I wasn’t very persuaded by Cochrane’s position. However, his recent paper, which is poised to be all the rage (or cause all the rage?) sooner or later, he makes a mention of the monetary disequilibrium in this passage:
Why did a financial crisis lead to such a big recession? We understand how a surge in money demand, if not accommodated by the Fed, can lead to a decline in output. I argue that we saw something similar — a “flight to quality,” a surge in the demand for all government debt and away from goods, services and private debt. In the fiscal context of (1), this event corresponds to a decrease in the discount rate for government debt. Many of the Government’s policies can be understood as ways to accommodate this demand, which a conventional swap of money for government debt does not address. This story is in contrast to “lending channel” or “financial frictions” stories for the recession, essentially falls in aggregate supply.
(I want to preface this by saying that I have only skimmed the paper so far, so Cochrane may have addressed this issue at some point)
I want to argue that these things aren’t similar in a way where you can separate the two, and claim that a “flight to quality” is a fundamentally substitutable concept with monetary disequilibrium. In fact, analyzing a “flight to quality” phenomenon as a cause is kind of foreign to me. As far as I’m concerned, any level and composition of debt structure is an effect. If there is a “flight to quality”, which depresses the yields on nominal bonds, it is almost assuredly the macro-effect of some (or many) other cause(s). The most likely (in the case of the recent recession) being an commodity price appreciation filtering into core CPI, causing the Fed — using its backwards-looking indicators — to target interest rates at a level that was patently too high for the macroeconomic conditions developing in the real-life economy. In other words monetary disequilibrium, exactly as Cochrane said in the quote.
Now there may, indeed, be some people out there that wake up on random day X, and decide that they want to drastically increase their holdings of government debt…however, I don’t think that this odd behavior is an aggregate phenomenon. Therefore, a “flight to quality” is necessarily an effect of some other variable. Cochrane seems to reject the “lending channel” and “financial frictions” models of the recession…but on the same token, he doesn’t seem to embrace the “tight money” model. So, from what I’ve read, this seems to leave him in a position of arguing that an effect is a cause.
My question is, why does he so strongly wish to reject the tight money interpretation? Isn’t it in his intellectual ‘bloodline’ so-to-speak to always be suspect of the money supply, and if not the money supply the aggregates…and if not the aggregates, some other measure of the stance of monetary policy that isn’t the Fed’s nominal interest rate? What would Milton Friedman say?
The most likely answer is that I’ve missed something.
P.S. I’m starting the analysis from 2008:Q3…which I suppose is a stylistic approach which would make my argument the same as Cochrane’s. Starting earlier may make tight money look like an effect — but Cochrane’s “flight to quality” from 2006-2008 wasn’t causing as many problems as the flight to quality which happened very suddenly in 2008:Q3-4, when the recession deeply intensified.
Update: It had been a while since I listened to the Sumner/Cochrane debate, so I decided to read Sumner’s take again. It turns out, this paper is actually an academic manifestation of the points he made during the debate:
I can’t bear to watch myself, so I’ll rely on memory. There seemed to be three areas where Cochrane had trouble accepting my views:
1. He couldn’t understand how I could claim monetary policy was “tight” last fall.
2. He was skeptical that the Fed could do much to create inflation, at least if its tools were restricted to things like setting an explicit inflation target, negative rates in ERs, and quantitative easing. He does believe that a combined fiscal/monetary “helicopter drop” could get the job done. And I recall that his first choice was having the Fed buy riskier assets.
3. He also worried about overshooting toward high inflation.
Also, Bennett McCaullum has been highly critical of the Fiscal Theory of the Price level, and is definitely worth reading.