I’ve been meaning to write something about this for some time. If I understand the case for monetary policy über alles, the argument runs roughly as follows. After the financial crisis of 2008, we saw a dramatic fall-off in consumer demand for goods and services, and a dramatic increase in demand for money – for safe stores of value. This produced the deep and long recession whose effects – particularly high unemployment – still plague us. The solution is to reduce demand for money by increasing expected inflation. If inflation expectations rise, people will be less willing to hold safe stores of value – because they will not be perceived as safe stores of value anymore. So, instead, they’ll spend their money on goods and services, or invest their money in ventures that produce a higher return. And either will produce a return to growth.
My problem with this story is it leaves out the why of the increase in demand for money. The implicit, unstated assumption behind the story is that there is some natural rate of real growth that everybody knows is achievable, and that therefore the sudden rise in demand for money reflects some kind of irrationality on the part of the participants in the economy. But I don’t think that’s the case. We don’t know what the “natural” rate of achievable real growth is. It seems to me that the story of the Great Recession is that people suddenly realized that the rise in consumption over the 2000s had been based on fantasy. Housing values would not go up forever, and people were consequently not as rich as they thought they were. More to the point: if the apparent increases in household wealth of the 2000s were revealed to be illusory, then expectations for future increases in wealth would have to be recalibrated as well. If we weren’t as rich as we thought we were in 2006, maybe we wouldn’t be as rich as we thought we’d be in 2016 either.
The recession, then, was caused by a rational drop in expectations for real growth. If real growth is projected to be poor, then it is rational to save more for rainy days, and to keep that savings in safe stores of value.
The problem, of course, is that this becomes a self-fulfilling prophecy. The question is whether the cycle can be broken merely by undermining faith in the safe store of value.
I don’t think so, because I think making money less safe will only encourage people to seek other sources of safety that appear money-like. These could, in fact, be highly risky – whether we’re talking about fake AAA securities or highly volatile commodities – but whether or not they prove to be as safe as hoped, a shift out of money and into these kinds of assets will not spur either aggregate demand or real growth. You might well get more inflation – indeed, I’d expect you would – but this would be offset by lower real growth.
Now, this might not be true for a smaller economy. A small economy can devalue its currency and thereby increase demand for other currencies without materially affecting the incentives for those currencies to devalue in turn. Such a small economy can, thereby, capture a greater share of global demand to offset the drop in domestic demand, and thereby prop up real growth at the cost of a one-time drop in everybody’s wealth. This is basically what Sweden did in the Great Recession. But a big economy like the United States can’t do this without creating enormous strains in other large economies. The likely result would be competitive devaluations that leave everyone basically where they were before – with higher inflation offset by lower real growth. And the strategy poses risks for smaller economies as well, if it becomes a habit. Countries that get a reputation for dealing with debt by repeated devaluations wind up paying very high interest rates even when times are good. These high rates, in turn, make robust real growth more difficult to achieve than in countries with better fiscal and monetary management. Pre-Euro Italy and pre-Lula Brazil are good examples.
That doesn’t mean that monetary policy has no role to play in keeping a major economy stable. It absolutely does. The role of sound monetary policy is to provide price stability. To keep inflation very low and positive. That’s precisely what the Fed has been trying to do – with considerable success – since Paul Volcker broke the back of double-digit inflation in the early 1980s. I’m not making the case against “fiat money” and for a gold standard – that would just mean yoking the economy to the vicissitudes of demand and supply in a random commodity, something that only has appeal in those circumstances where the monetary authorities stop doing their proper job. I’m making the case for doing that proper job: aiming for price stability.
In my view, therefore, the response to the short-term economic dislocation should be to focus on the long-term. Get long-term real growth expectations to rise, and the economy will recover as businesses react to take advantage of the opportunities afforded by that projected growth.
That’s not a right-wing view. It doesn’t mean that we should only respond by cutting marginal income tax rates, or even that we need to bring the deficit down. It means that we need to reorient our spending priorities around investments that will deliver for the long term – more investment in physical infrastructure and human capital, less investment in defense and current consumption. And it means we need to reorient our taxing priorities – eliminating economy-distorting tax expenditures, reducing taxes on employment, and increasing taxes on consumption. It may mean increasing government intervention in some areas – to restore confidence in the financial system, for example, or to liquify the housing market by getting rid of the burden of overhanging debt – and reducing it in others; patent and copyright reform, for example, should properly be understood as a species of deregulation, reducing the scope of government-granted monopolies. It means, in general, that we should be assessing changes in spending, taxes and regulation by what they will do to long-term expectations for real growth, and not what they’ll do for short-term demand.
The short-term focus, by contrast, should be on reducing human misery and preserving the value of human capital, while imposing the least drag on long-term economic performance. Since the Volcker recession, American employment recessions have been substantially longer-lived than recessions of comparable depth in the pre-Volcker period. This was true in 1990-1991, and again in 2000-2002, and again today. This may well be a side-effect of the successful efforts by the Fed to achieve price stability, and if so that’s still preferable to the pre-Volcker situation when unemployment and inflation both marched up in a saw-tooth pattern to successively higher peaks with each recession and recovery. But we don’t have to accept that situation as inevitable. We could tackle unemployment directly, whether through a German-style Kurzarbeit program or through Great Depression-style public employment schemes or through some other mechanism – or a combination thereof. The biggest initiative of the Obama Administration in this regard was the stimulus plan, which, by giving aid to the states, prevented massive public-sector layoffs. This was a good thing to do – but it wasn’t a fair thing to do, because it protected public employees but not the employees of private enterprises, and it provided that protection without any givebacks (on benefits or work rules, for example) that might have increased productivity in the public sector and thereby promoted long-term growth. And this, I believe, is the primary reason that the stimulus remains unpopular – not because people wanted teachers and firefighters laid off, but because people don’t like favoritism.
What I’m laying out is a case for what might be called hard-money paleo-liberalism: a state that invests in projects that are important to long-term growth (whether physical- or human-capital-related) but are too large or diffuse or uncertain to attract private sector investment, and that plays an important role in cushioning the effects of economic dislocation on those directly affected, but that pursues a monetary policy aimed at price stability rather than counter-cyclical stimulus.
The emerging conventional wisdom on the left is that the Obama Administration failed by not focusing more on short-term economic performance – getting more monetary stimulus (by packing the Fed with inflation doves) and/or more fiscal stimulus (by passing a larger or second stimulus bill of similar character to the first). Leaving aside whether the Administration could have achieved either posited goal, as well as whether the Administration could have known that more stimulus was necessary, my suggestion is that this is the wrong critique. The Obama Administration should be faulted – from the left – for not being sufficiently creative in tackling unemployment directly, for not leading an adequate reorientation of our national spending priorities, and for being insufficiently aggressive at tackling the structural problems in the housing and financial sectors that are holding back a resumption of growth. His policymaking has remained squarely within the neo-liberal consensus even as that consensus appears to have failed. But the one great achievement of the last 30 years was a monetary policy that worked. So it’s strange to see the continued support for that pillar be made the focus of what he’s done wrong.