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Free Banking has a new post by George Selgin.
Booms, Bubbles, Busts, and Bogus Dichotomies:
Having learned my monetary economics from both the great monetarist
economists
and their Austrian counterparts, I've always chafed at the tendency of
people,
including members of both schools, to treat their alternative explanations
of
recessions and depressions as being mutually exclusive or incompatible.
According to this tendency, a downturn must be caused either by a deficient
money supply, and consequent collapse of spending, or by previous, excessive
monetary expansion, and consequent, unsustainable changes to an economy's
structure of production. During the 1930s and ever since, this dichotomy has
split economists into two battling camps: those who have blamed the Fed
only for
having allowed spending to shrink after 1929, while insisting that it was
doing
a bang-up job until then, and those who have blamed the Fed for fueling an
unsustainable boom during the latter 1920s, while treating the collapse of
the
thirties as a needed purging of prior "malinvestment." As everyone except
Paul
Krugman knows, the Austrian view, or something like it, had many adherents
when
the depression began. But since then, and partly owing (paradoxically
enough) to
the influence of Keynes's General Theory, with its treatment of deficient
aggregate demand as the problem of modern capitalist economies, the
monetarist
position has become much more popular, at least among economists.
It is, of course, true that monetary policy cannot be both excessively easy
and
excessively tight at any one time. But one needn't imagine otherwise to see
merit in both the Austrian and the monetarist stories. One might, first of
all,
believe that some historical cycles fit the Austrian view, while others fit
the
monetarist one. But one can also believe that both theories help to account
for
any one cycle, with excessively easy money causing an unsustainable boom,
and
excessively tight money adding to the severity of the consequent downturn.
I put
the matter to my undergraduates, who seem to have little trouble "getting"
it,
like this: A fellow has an unfortunate habit of occasionally going out on a
late-night drinking binge, from which he staggers home, stupefied and
nauseated.
One night his wife, sick and tired of his boozing, beans him with a heavy
frying
pan as he stumbles, vomiting, into their apartment. A neighbor, awakened by
the
ruckus, pokes his head into the doorway, sees our drunkard lying
unconscious, in
a pool of puke, with a huge lump on his skull. "What the heck happened to
him?,"
he asks. Must the correct answer be either "He's had too much to drink" or
"I
bashed his head"? Can't it be "He drank too much and then I bashed his
head"? If
it can, then why can't the correct answer to the question, "What laid the
U.S.
economy so low in the early 1930s?" be that it no sooner started to pay the
inevitable price for having gone on an easy money binge when it got
walloped by
a great monetary contraction?
In insisting that one shouldn't have to blame a bust either on excessive or
on
deficient money, I do not mean to expose myself to the charge of making the
opposite error. My position isn't that excessive and tight money must both
play
a part in every bust. Nor is it that, when both have played a part, each
part
must have been equally important. The question of the relative historical
importance of the two explanations is an empirical one, concerning which
intelligent and open-minded researchers may disagree. The point I seek to
defend
is that those who argue as if only one of the two theories can possibly have
merit cannot do so on logical grounds. Instead, they must implicitly assume
either that central banks tend to err only in one direction only, or that,
if
they err in both, only their errors in one direction have important cyclical
consequences.
The history of persistent if not severe inflation on one hand and of
infrequent
but severe deflations on the other surely allows us to reject the first
possibility. What grounds are there, then, for believing that money is
roughly
"neutral" when its nominal quantity grows more rapidly than the real demand
for
it, but not when its quantity grows less rapidly than that demand, as some
monetarists maintain, or for believing precisely the opposite, as some
Austrian's do? New Classical economists, whatever their other faults, are at
least consistent in assuming that money prices are perfectly flexible both
upwards and downwards, leaving no scope for any sort of monetary
innovations to
affect real economic activity except to the extent that people observe price
changes imperfectly and thereby confuse general changes with relative ones.
Both
old-fashioned and "market" monetarists, on the other hand, argue as if the
economy has to "grope" its way slowly and painfully toward a lowered set of
equilibrium prices only, while adjusting to a raised set of equilibrium
prices
as swiftly and painlessly as it might were a Walrasian auctioneer in charge.
Many Austrians, on the other hand, insist that monetary expansion
necessarily
distorts relative prices, and interest rates especially, in the short-run,
while
also arguing as if actual prices have no trouble keeping pace with their
theoretical market-clearing values even as those values collapse.
Of these two equally one-sided treatments of monetary non-neutrality, the
monetarist alternative seems to me somewhat more understandable. For
monetarists, like New Keynesians, attribute the non-neutral effects of
monetary
change to nominal price rigidities. They can thus argue, in defense of
their one
sided view, that it follows logically from the fact that certain prices, and
wage rates especially, are less rigid upward than downward. That's the
thinking
behind Milton Friedman's "plucking" model, according to which potential GNP
is a
relatively taught string, and actual GNP is the same string yanked downward
here
and there by money shortages, and his corresponding denial of the existence
of
business "cycles." But "less rigid" isn't the same as "perfectly flexible"
or
"continuously market clearing." So although Friedman's perspective might
justify
his holding that a given percentage reduction in the money stock will have
greater real consequences than a similar increase, other things equal, it
alone
doesn't suffice to sustain the view that excessively easy monetary policy is
entirely incapable of causing booms. What's more, as Roger Garrison has
pointed
out, the fact that real output appears to fit the "plucking" story doesn't
itself rule out the presence of unsustainable booms, which (if the Austrian
theory of them is correct) involve not so much an expansion of total output
as a
change in its composition.
Austrians, in contrast, tend to attribute money's non-neutrality, not to
general
price rigidities, but to so-called "injection" effects. In a modern monetary
system such effects result from the tendency of changes in the nominal
quantity
of money to be linked to like changes in nominal lending, and particularly
to
changes in the nominal quantity of funds being channeled by central banks
into
markets for government securities and bank reserves. The influence of
monetary
innovations will therefore be disproportionately felt in particular loan
markets
before radiating from them to the rest of the economy. It is not easy to
see why
monetary "siphoning" effects, to coin a term for them, should not be just as
non-neutral and important as injection effects of like magnitude. To the
extent
that the monetary transmission mechanism relies upon a credit channel, that
channel flows both ways.
A division of economists resembling that concerning the role of monetary
policy
in the Great Depression has developed as well in the wake of the recent
boom-bust cycle. Only this time, oddly enough, several prominent
monetarists and
fellow travelers (among them, Anna Schwartz, Allan Meltzer, and John Taylor)
have actually joined ranks with Austrians in holding excessively easy
monetary
policy in the wake of the dot-com crash to have been at least partly
responsible
for both the housing boom and the consequent bust. With so many old-school
monetarists switching sides, the challenge of denying that monetary policy
ever
causes unsustainable booms, and of claiming, with regard to the most recent
cycle, that the Fed was doing a fine job until until house prices started
falling, has instead been taken up by Scott Sumner and some of his fellow
Market
Monetarists.
Scott Sumner, like Milton Friedman, forthrightly denies that there's such a
thing as booms, or at least of booms caused by easy money, to the point of
taking exception to a recent statement by President Obama to the effect
that,
among its other responsibilities, the Fed should guard against "bubbles."
But
here, and unlike Friedman, Sumner basis his position, not merely on the
claim
that prices are more flexible upwards than downwards, but on a dichotomy
erected
in the literature on asset price movements, according to which upward
movements
are either sustainable consequences of improvements in economic
"fundamentals,"
or are "bubbles" in the strict sense of the term, inflated by what Alan
Greenspan called speculators' "irrational exuberance," and therefore
capable of
bursting at any time. Since monetary policy isn't the source of either
improvements in economic fundamentals or outbreaks of irrational
exuberance, the
fundamentals-vs-bubbles dichotomy implies that monetary policy is never to
blame
for changes in real asset prices, whether those changes are sustainable or
not.
If the dichotomy is valid, Sumner, Friedman, and the rest of the "monetary
policymakers shouldn't be concerned about booms" crowd are right, and the
Austrians, Schwartz, Taylor, and others, including Obama and his advisors,
who
would hold the Fed responsible for avoiding booms, are full of baloney.
But it isn't the Austrian view, but the bubbles-vs-fundamentals dichotomy
itself, that's full of baloney. That dichotomy simply overlooks the
possibility
that speculators might respond rationally to interest rate reductions that
look
like changes to "fundamental" asset-price determinants, that is, to
relatively
"deep" economic parameters, but are actually monetary policy-inspired
downward
deviations of actual rates from their genuinely fundamental ("natural")
levels.
Because actual rates must inevitably return to their natural levels, real
asset
price movements inspired by "unnatural" interest rate movements, though
perfectly rationale, are also unsustainable. Yet to rule such asset price
movements out one would have to claim either that monetary policy isn't
capable
of influencing real interest rates, even in the short-run, or that the
temporary
interest-rate effects of monetary policy can have no bearing upon the
discount
factors that implicitly inform the valuation of amy durable asset. Here
again,
the burden seems too great for mere a priori reasoning to bear, and we are
left
waiting to set our eyes upon such empirical studies as are capable of
bearing
it.
In the meantime, it seems to me that there is a good reasons for not buying
into
Friedman's view that there is no such thing as a business cycle, or Sumner's
equivalent claim that there is no such thing as a monetary-policy-induced
boom.
The reason is that there is too much anecdotal evidence suggesting that
doing so
would be imprudent. The terms "business cycle" and "boom," together with
"bubble" and "mania," came into widespread use because they were, and still
are,
convenient if inaccurate names for actual economic phenomena. The expression
"business cycle," in particular, owes its popularity to the impression many
persons have formed that booms and busts are frequently connected to one
another, with the former proceeding the latter; and it was that impression
that
inspired Mises and Hayek do develop their "cycle" or boom-bust theory rather
than a mere theory of busts, and that has inspired Minsky, Kindleberger, and
many others to describe and to theorize about recurring episodes of "Mania,
Panic, and Crash." Nor is the connection intuitively hard to grasp: the most
severe downturns do indeed, as monetarists rightly emphasis, involve severe
monetary shortages. But such severe shortages are themselves connected to
financial crashes, which connect, or at least appear to connect, to prior
booms,
if not to "manias." That the nature of the connections in question, and the
role
monetary policy plays in them, remains poorly understood is undoubtedly
true.
But our ignorance of these details hardly justifies proceeding as if booms
never
happened, or as if monetary policymakers should never take steps to avoid
fueling them. On the contrary: the non-trivial possibility that an ounce of
boom
prevention is worth a pound of quantitative easing makes worrying about
booms
very prudent indeed, and prudent even for those who believe that monetary
shortages are by far the most important proximate cause of recessions and
depressions.
Does my saying that Scott and others err in suggesting that monetary
policymakers ought not to worry about stoking booms mean that I also
disagree
with Scott's arguments favoring the targeting NGDP? Not at all. I'm merely
insisting that the soundest monetary policy or arrangements is one that
avoids
upward departures of NGDP from target just as surely as it does downward
ones.
Nor do I imagine that Scott himself would disagree, since his preferred NGDP
targeting mechanism would automatically achieve this very result. But I
worry
that other NGDP targeting proponents have allowed themselves to become so
wrapped up in recent experience, and so inclined thereby to counter
arguments
for monetary restraint, that they have allowed themselves either to forget
that
a time will come, if it hasn't come yet, when such restraint will be just
the
thing needed to keep NGDP on target, or to treat Scott's boom-denialism as
grounds for holding that, while there can be too little NGDP, there can't
really
be too much. (Or, what is almost as bad, that there can't be too much so
long as
the inflation rate isn't increasing, which amounts to tacitly abandoning
NGDP
targeting in favor of inflation targeting whenever the the latter policy is
the
looser of the two.) I urge such "monetarists" to recall the damage Keynes
did by
taking such a short-term view, while disparaging those who worried about the
long run. "Keynesiansim" thus became what Keynes himself never intended it
to
be, which is to say, a set of arguments for putting up with inflation.
Let's not
let Market Monetarism become perverted into set of arguments for putting up
with
unsustainable booms.
Read the full post and join the discussion at:
http://www.freebanking.org/2013/08/30/booms-bubbles-busts-and-bogus-dichotomies/
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Best regards,
Free Banking
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