How Important Is Monetary Policy?

Krugman's Case That Macroeconomic Policy Matters

[I]t’s quite possible for economies to get into a snarl that can be solved by printing more money, or having the government spend more.

I know that this is a conclusion many people hate. They really, really want to believe that bad things must have good causes — that if you are suffering from high unemployment and low output, it must be because there is something deeply wrong, probably the fault of liberals. But what was deeply wrong with the US economy in late 2008 that wasn’t true of the US economy in late 2007? Recessions happen, and any halfway plausible story about how they happen is likely to suggest that non-fundamental government interventions, like printing money, can make things better.

It’s important to emphasize the conditionality here. The haters love to claim that people like me view more demand, more money printing, as the solution to all problems. But of course that’s not true. Aggregate demand won’t solve a problem of low productivity, or inadequate productive capacity, or for that matter extreme inequality due to technology or market power. But it can solve certain problems, which happen to be the problems we have now.

- Paul Krugman (February 4, 2013 post).

Economists Focus Too Much On Monetary Policy And Fiscal Policy

The issue the Krugman presents in the post quoted above goes to the core of the validity of the work done by applied professional economists and their academic counterparts.

I don't disagree that microeconomics has some very solid analytical and quantitative insights that have held up time and time again in the face of tests of their empirical validity.

But, macroeconomists have a far less solid empirically validated track record of making correct consensus predictions, and offering consensus policy prescriptions for a given set of facts that consistently work, despite making up a very large share of all applied professional economists, despite dominating a large share of the academic publications in the field.

In a nutshell professional macroeconomists are inappropriately obsessed with monetary policy and fiscal policy at an aggregate amount level.

Despite the theoretically broad scope of their mandate, in practice, macroeconomists devote a very large share of their efforts to a very small number of big issues: (1) the impact of the money supply of GDP and employment, (2) the impact of government intervention in relation to interest rates on GDP and employment, and (3) the impact of aggregate levels of government spending and aggregate government budget deficits on GDP and employment.

Economists, in real life, are extremely oriented towards the role of government intervention in the financial and investment sectors on the health of the real economy. It is something of an article of faith among them that monetary policy, interest rates and fiscal policy at the grossest level are instrumental to the course of wise management of business cycles in a national economy.

But, this article of faith simply isn't true.

Monetary Policy Is Not Very Important

My general predisposition is to say that two-thirds of that isn't true, that the other third requires more fine tuned analysis to handle sensibly, and that many factors that are critically important to the wise management of business cycles are virtually ignored by mainstream professional economists.

I am deeply skeptical of the proposition that government involvement in managing the aggregate money supply and interest rates is particularly important to the management of business cycles.

These tasks aren't completely irrelevant to the health of the economy.

It is possible to really screw up the economy with unexpected extreme expansions of the money supply (hyperinflation) or unexpected extreme reductions in the money supply (deflation) relative to the size of the GDP. Basically, the value of the dollar is through a highly involved and diffuse process a function of how much money (the aggregate money supply) is chasing how many goods and services (GDP) and unexpected serious price level shocks of either kind are bad in an economy like that of the U.S. whose history of relatively stable monetary policy in recent decades has given rise to transactions in the private sector that aren't well tuned to be adapted to anything other than historically expected fairly steady low levels inflation that are incorporated via interest rates into deals structured in nominal dollars rather than more inflation sensitive benchmarks.

Likewise, government intervention that successfully distort interest rates from the natural inclination of the private market participants, can screw up the economy by leading to inappropriate levels of investment and debt, and can be very costly to maintain while providing few benefits to the economy.

But, it is my contention that within a wide range of "reasonable" choices regarding monetary policy and interest rate interventions, these decisions are merely secondary or tertiary contributors to the course of business cycles, at best. These are the two-thirds of the factors that economists obsess about are vastly overrated in importance.

Fiscal Policy Is Considered In Too Little Detail And Is Useful Mostly To Prevent Economic Resources From Being Underutilized During Recessions

Fiscal policy is another matter. Unlike monetary policy and interest rates, which basically just set units of economic exchange in a way that has slight incidental impacts when the rate of change in prices is unexpected, making these tools basically irrelevant to non-financial sector sourced woes in the economy, fiscal policy involves intervention in the "real economy." Government pays people to generate genuine goods and services that actually do directly impact GDP and employment.

In a nutshell, good fiscal policy, which is to say government spending and tax expenditures that cause goods and services to be produced with idle resources, and cause people who would otherwise not be engaged in gainful work to be working in a way that creates goods and services, clearly is valuable any time that a failure of the private sector entrepreneurs to find worthwhile activities for idle productive resources to be devoted to, is present.

As long as the goods and services that the government pays for have any value, dead weight waste in the economy arising from a failure to but economic factors of production that are available to use have been avoided by this public sector entrepreneurship. Value of those goods and services relative to their price could be lower than it is in private sector economic activity during economic booms. But, almost by definition, during a recession the private sector doesn't have worthwhile ways to employ idle economic resources so some value is better than no value, especially if the goods and services produced are of a kind that won't cut into future private sector production, for example by tying up the relevant resources through the next economic boom.

So, well managed fiscal policy, i.e. government stimulus spending during a recession to address a genuine shortage of aggregate demand does work, although insufficient attention is devoted to what particular kinds of government stimulus spending provide the most value in terms of goods and services produced and people employed for the money spent. The how is often almost as important as the how much, yet professional economists tend to be over focused on the how much question.

What Caused The Great Recession?

Going back to Krugman's question about the relevance of the pillars of macroeconomic policy, "what was deeply wrong with the US economy in late 2008 that wasn’t true of the US economy in late 2007?"

As someone who is focused on the non-fiscal aspects of the macroeconomy, my answer would be that:

1. The housing bubble collapsed.  The collapse was inevitable once a bubble developed.  Bubbles almost always collapse dramatically, rather than gradually wrecking havoc in the process if they are big enough.  The root problems were the factors that allowed the housing bubble to develop.

Macroeconomists should know this as a matter of repeatedly proven empirical fact.  But, they often seem baffled by this reality.

2.  Why was there a housing bubble (which was the real problem that its collapse only made us feel)?

a. The housing bubble was primarily a defect in a particular set of commodity prices in a fairly small number of states that either had de facto non-recourse mortgages pursuant to particular state laws, or derived most of their real estate financing from states that had non-recourse mortgages whose existence led to real estate sector investment policies for investors based on non-recourse state analysis that was applied injudiciously to state without non-recourse lending.  This created a heads I win, tails you lose approach to risk taking by thinly capitalized residential real estate buyers. 

Economists should have sounded the alarm and identify this key source of risk but didn't.  Few economists even after it all fell apart have any sense of how important a factor this was in giving rise to the housing bubble and as a result, the problems caused by the bad incentives this creates remain and could return in the future to cause future housing bubbles.

b. The housing bubble was also facilitated by the availability of inadequately regulated securitized financing sources for which a broken system of complexification and poor disclosure of loan risks which who industries bought into as sufficient via industry group think and self-dealing incentive. In other words, finance professionals developed elaborate ways to finance real estate at rates that did not reflect the real risk by obscuring the risks.  This was basically a case of regulatory capture and its private sector equivalent in securities ratings agencies and due diligence firms. 

Macroeconomists should have been far more concerned about the effectiveness of the functioning of national economic institutions beyond Congress, the OMB, and the Federal Reserve.

c. Another factor was that tax incentives encouraged high risk leverage structures over equity investments and encouraged loosely underwritten second liens to low equity borrowers over better underwritten mortgage insurance policies where firms recognized and more accurately assessed the risks and priced their products appropriately. 

A highly leveraged economy is far less robust than a less leveraged economy, something that macroeconomists should be acutely sensitive to, but were not sufficiently alarmed by in the actual fact.

d. In short, the real estate financing with bad incentives and regulations produced obviously excessive real estate prices that in turn produced bad allocations of resources in the real economy to housing construction that wasn't needed and starved investments that really were needed of funds at the margins. 

Macroeconomists spend to little time connecting the dots to realize that the real villain in most collapsing bubbles that cause huge economic downturns is market failure in the pricing of something that is important in the economy, which leads to a massive misallocation of resources.  It is the misallocation of resources, and not the intermediate mechanism that cause this misallocation, that is the ultimate problem.

e. The price bubble was unsustainable and like all price bubbles, it built up over a much longer period of time than it collapsed.  Basically, we all woke up one day and realized that our economy was stupidly paying people to construct unneeded real estate developments and then stopped doing that all at once.

One of the extremely important concerns in the business cycle which is a uniquely macroeconomic problems that microeconomists largely assume away in their models, is that group think in an industry can have catastrophic consequence for the economy as a whole; overcoming the usual protections that market forces provide in an economy against inappropriate pricing of goods and services.

3. The collapse of the housing bubble in these markets financed via national securities markets and financial institutions produced such huge losses that a financial crisis from overleverage and poor valuation of these financial assets resulted, and these losses together with housing losses, led to a recession as misallocations of resources caused by inappropriately prices real estate and real estate financing investments were corrected when the prices returned to normal. The imbalance was so massive and pervasive that it has had a global impact and a long duration.

Macroeconomists devote too few resources studying what circumstances cause isolated problems in one part of the economy to propagate across the entire economy.

4. The financial collapse and housing bubble bust caused the collapse of aggregate demand which reduced spending and thus caused the Great Recession. 

Aggregate demand is the mechanism by which price bubble collapses led to generalised recessions.  People reduce their spending on goods and services when their wealth declines in a way that seems permanent.

5.  Decline aggregate demand wasn't adequately compensated for by the right kinds of stimulus and was aggravated by inappropriate and counterproductive government austerity programs. So, a failure of entrepreneurs to come up for new uses for economic resources that were misallocated at the wrong prices caused economic resources to be wasted and thus caused GDP to contract and unemployment to rise.

Knowing that aggregate demand shortfalls translate asset price collapses into recessions should led economists to devote more resources to devising "automatic stabilizers."  This is one of the most generalized ways that policy makers can respond to early signs of a recession. An aggregate demand means of translating industry woes to economy-wide woes provides a natural point of genetic intervention akin to prescribing ibuprofin for a fever, regardless of the cause.

A lack of consensus among economists regarding the relative desirability of austerity and fiscal stimulus when the conclusion should be obvious to them did not reflect well on the macroeconomic profession.  Politics triumphed over good empirically based social scientific analysis here, and it continues to do so.

Thus, in 2007 the economy was rotten but the shoe hadn't dropped, and in late 2008 the house of cards based on unsustainable commodity prices and excessively low interest rates for risky real estate investments collapsed.  And, professional economists, collectively, weren't doing the right things to prevent it or address it.

There Was Nothing Wrong With The Parts Of The Macroeconomy Economists Obsess Over

What is the take away point here?

Yes, government produced a horrible disaster in the economy.  Dispropoprtionately, the problems were poor state and local government regulation of the real estate markets in key states, deficient securities market regulation, and poor federal income tax incentive, which acting together created massive systemic risk in the U.S. economy.  These risks were eventually and inevitably realized.

But, none of the core matters that professional economists worry about: the money supply, risk free interest rates in the economy as a whole, or aggregate levels of federal spending and deficits prior to the housing market bust, played meaningful roles in causing the Great Recession. And, neither management of the money supply, nor the risk free interest rates in the economy as a whole, were particularly relevant to getting the U.S. economy out of the Great Recession. This task is nearing its end but is still not completed as we still haven't returned to the pre-collapse, pre-bubble baseline.

If economists had been looking at the right things, instead of the things that they are in the habit of worrying about even though they are rarely important, they could have done us some good.  But, the big problem in the profession of macroeconomics leading up to the Great Recession was that macroeconomists were overwhelmingly focusing on the wrong things and not paying attention to what was really important.

The Fundamental Problems That Caused The Great Recession Solved Themselves, For Now

The fundamental problems that lead to the Great Recession were (1) excessively high pricing of real estate in selected important markets, and (2) excessively inadequate pricing of the returns on the financial investments that financed real estate purchases.   Together these led to a massive misallocation of resources and extremely high levels of leverage in the U.S. economy.  But, through market forces, these fundamental problems solved themselves almost immediately, at least in the short to medium term.  (It isn't clear that the legislative remedies that address the root causes of these problems were adequate.)

The investment of investors in firms contributing most heavily to the problems (real estate finance companies and investor owed investment banks and AIG) were promptly obliterated in a market driven punishment.

New legislation enacted by Congress has partially, although probably not sufficiently, addressed some of the regulatory failures and incentives that brought about the housing bubble and financial crisis that caused the Great Recession. The last mop up operations in the aftermath of these huge losses to enforce the debts created and defaulted upon during the bubble period are in their final stages with just a few years to go.

We Still Need Stimulus Spending Rather Than Austerity Right Now

Krugman notes that "Aggregate demand won’t solve a problem of low productivity, or inadequate productive capacity, or for that matter extreme inequality due to technology or market power."

Stimulus spending can still address inadequate aggregate demand in the economy and fiscal cliff legislation that did the opposite by enforcing austerity measures was probably a case of doing the right thing at the wrong time. But, risk free interest rates and the money supply have never been the problem and thus, not surprisingly are not very relevant to the solution.

But, we have also been dragging our feet another measures that can address inadequate aggregate demand.  For example, liberalizing immigration laws for individuals who can generate aggregate demand in the economy by making positive economic contributions with their intellectual resources and willingness to work, that could address aggregate demand problems in the same ways that stimulus spending does.

Bottom Line: The Economics Profession Hasn't Learned Its Lessons From The Recession

One of my big concerns is that economists, as a profession, still haven't internalized the reality that they spend most of their collective resources paying attention to the wrong problems. 

They continue to obsess over the money supply and risk free interest rates.

They continue to turn a blind eye to far more important issues like how to address herd behavior in financial and commodity markets, how to reduce systemic risk so that our economy can be made more robust, and casting a wide net to identify all economic indicators in the real economy that suggest that something is out of whack and needs to be address before it sows the seeds of the collapse and resulting recession.

Unless macroeconomists can start to develop a much more detailed descriptive understanding of the national and regional regulatory and policy choices that collectively drive the macroeconomy, they are doomed to deny us the value of wise macroeconomic guidance that they claim to be in the business of dispensing.  And, there is little to no indication that the profession is inclined at all to move in this direction.