A Monetarist Explanation for the Great Recession
February 4th 2010 11:13
The main concerns of this blog are immigration, trade, and competitive government (I promise I will get to the latter two much more soon), but I would like to take a sidetrack to start a three or four-part series on different explanations of the current recession. The different schools I would like to touch on are Monetarists, Keynesians, and Austrians. Naturally, this exercise will involve oversimplification of the views, but it will hopefully be a useful resource for those of you without extensive knowledge in economics.
Today I will begin with the "Monetarist story" of the current recession. This story of the 2007-2009 recession reaches its climax in late 2008. Until that point, the economy had merely experienced a mild recession, due to the sub-prime crisis. Banks had made bad bets on loans to people who could not pay them back. As a result, a few major local housing markets collapsed. The economy stagnated for half of a year. The unemployment rate did not rise above 6%, from a starting point of 5% in December 2007, until August of 2008. It was not until late 2008 that the recession spread nationwide. This was when the Great Monetary Sin was committed by the Federal Reserve Bank. The Fed had lowered the Fed Funds Rate from 4.25 in January to a lower bound of 0 by December. This meant they had run out of conventional monetary tools to boost the economy. What was the result? Inflation (or, nominal GDP) expectations plummeted. Markets predicted that the Fed would throw its hands up in the air and call it quits when the Fed Funds rate hit zero. The markets were right. Nominal GDP did indeed fall, from around a healthy 5% to -3%. This was a drop not seen since the depression-era 1930s. This meant deflation from August to December of 2008, which was the first year-over-year deflation since the 1950s. Needless to say, the occurrence of deflation was an ugly force.
Ok, so prices fell across the economy for the first time in over half of a century. Why did this cause so much trouble for the economy? The reason is the phenomenon known as "money illusion." People do not differentiate between the number they see on a price sticker or their paycheck (nominal value) and the value of that number after factoring in inflation (real value). Over the past couple decades, inflation has been relatively stable at about 2% in the U.S. We have not had to think much about inflation, and definitely not at all about deflation. This leads to people assuming that they should see a slight increase in what they get paid each year. However, when the economy experiences deflation, people have become OVERpaid, even if their income stays constant in nominal terms. If employees agreed to take a pay cut and job-seekers were willing to work for less than they normally would be willing to, then this situation would adjust. However, people are (irrationally) stubborn when it comes to accepting lower nominal wages. As well, contracts are not renegotiated daily, which leads to a lag time in wages adjusting. Thus, money illusion and lags lead to what is called "sticky wages." Wages do not adjust downward quickly enough to prevent employers from laying-off/not hiring workers. And when employers and employees are behaving this way, we get unemployment. As predicted by the monetarist school, the sharp drop in NGDP (aka deflation) led to, in the next 8 months, an unemployment rate of 8.9% and rising.
MONETARIST SOLUTION TO RECESSION: Reinflate! Adding inflation into the system will defeat the money illusion by forcing a pay cut (in nominal terms). This will entice employers to begin hiring again. As well, the extra money in the economy will turn into extra spending before prices have time to rise. Sure, the Fed Funds Rate hit zero, but there are UNconventional tools to overcome that. For example, the Fed could announce they will pump enough money into the economy to hit a certain nominal GDP/price level target!
CRITICISM OF MONETARISM:
1. Increasing the monetary base by too much will just lead to INFLATION!!!
RESPONSE: First off, we need inflation! That is the cure. Second, if nominal GDP grows faster than the set target, the Fed just needs to slightly contract the money supply to choke off inflation.
2. The Fed did expand the money supply a lot, but it did not work
RESPONSE: True, they did, but then they paid interest to banks to hang onto the reserves, which means that money never actually saw our economy.
3. The Fed can try inflating, but our banks are too broken.
RESPONSE: Print out a trillion new dollars, give them to the "broken" banks, penalize them for holding on to them, and then see how ineffective the Fed is at inflating.
STANCE ON FISCAL STIMULUS:
If the fiscal stimulus is effective and boosts the economy, this will lead to higher NGDP/inflation. Good! However, the Fed, if acting correctly, should have already been targeting a certain level of NGDP. Therefore, they will simply counteract the stimulus and make it useless. If the Fed does not act correctly, then there will be a temporary boost from the spending, followed by a "double-dip" when the stimulus runs out and the Fed has yet to get enough money into the economy. In other words, either the stimulus needs to be monetary or we should just sit around and wait until prices/wages readjust. Fiscal stimulus has no place in the recovery plan.
Best resource for Monetarist view: TheMoneyIllusion
Follow me on Twitter: @AGoldenDoor
Today I will begin with the "Monetarist story" of the current recession. This story of the 2007-2009 recession reaches its climax in late 2008. Until that point, the economy had merely experienced a mild recession, due to the sub-prime crisis. Banks had made bad bets on loans to people who could not pay them back. As a result, a few major local housing markets collapsed. The economy stagnated for half of a year. The unemployment rate did not rise above 6%, from a starting point of 5% in December 2007, until August of 2008. It was not until late 2008 that the recession spread nationwide. This was when the Great Monetary Sin was committed by the Federal Reserve Bank. The Fed had lowered the Fed Funds Rate from 4.25 in January to a lower bound of 0 by December. This meant they had run out of conventional monetary tools to boost the economy. What was the result? Inflation (or, nominal GDP) expectations plummeted. Markets predicted that the Fed would throw its hands up in the air and call it quits when the Fed Funds rate hit zero. The markets were right. Nominal GDP did indeed fall, from around a healthy 5% to -3%. This was a drop not seen since the depression-era 1930s. This meant deflation from August to December of 2008, which was the first year-over-year deflation since the 1950s. Needless to say, the occurrence of deflation was an ugly force.
Ok, so prices fell across the economy for the first time in over half of a century. Why did this cause so much trouble for the economy? The reason is the phenomenon known as "money illusion." People do not differentiate between the number they see on a price sticker or their paycheck (nominal value) and the value of that number after factoring in inflation (real value). Over the past couple decades, inflation has been relatively stable at about 2% in the U.S. We have not had to think much about inflation, and definitely not at all about deflation. This leads to people assuming that they should see a slight increase in what they get paid each year. However, when the economy experiences deflation, people have become OVERpaid, even if their income stays constant in nominal terms. If employees agreed to take a pay cut and job-seekers were willing to work for less than they normally would be willing to, then this situation would adjust. However, people are (irrationally) stubborn when it comes to accepting lower nominal wages. As well, contracts are not renegotiated daily, which leads to a lag time in wages adjusting. Thus, money illusion and lags lead to what is called "sticky wages." Wages do not adjust downward quickly enough to prevent employers from laying-off/not hiring workers. And when employers and employees are behaving this way, we get unemployment. As predicted by the monetarist school, the sharp drop in NGDP (aka deflation) led to, in the next 8 months, an unemployment rate of 8.9% and rising.
MONETARIST SOLUTION TO RECESSION: Reinflate! Adding inflation into the system will defeat the money illusion by forcing a pay cut (in nominal terms). This will entice employers to begin hiring again. As well, the extra money in the economy will turn into extra spending before prices have time to rise. Sure, the Fed Funds Rate hit zero, but there are UNconventional tools to overcome that. For example, the Fed could announce they will pump enough money into the economy to hit a certain nominal GDP/price level target!
CRITICISM OF MONETARISM:
1. Increasing the monetary base by too much will just lead to INFLATION!!!
RESPONSE: First off, we need inflation! That is the cure. Second, if nominal GDP grows faster than the set target, the Fed just needs to slightly contract the money supply to choke off inflation.
2. The Fed did expand the money supply a lot, but it did not work
RESPONSE: True, they did, but then they paid interest to banks to hang onto the reserves, which means that money never actually saw our economy.
3. The Fed can try inflating, but our banks are too broken.
RESPONSE: Print out a trillion new dollars, give them to the "broken" banks, penalize them for holding on to them, and then see how ineffective the Fed is at inflating.
STANCE ON FISCAL STIMULUS:
If the fiscal stimulus is effective and boosts the economy, this will lead to higher NGDP/inflation. Good! However, the Fed, if acting correctly, should have already been targeting a certain level of NGDP. Therefore, they will simply counteract the stimulus and make it useless. If the Fed does not act correctly, then there will be a temporary boost from the spending, followed by a "double-dip" when the stimulus runs out and the Fed has yet to get enough money into the economy. In other words, either the stimulus needs to be monetary or we should just sit around and wait until prices/wages readjust. Fiscal stimulus has no place in the recovery plan.
Best resource for Monetarist view: TheMoneyIllusion
Follow me on Twitter: @AGoldenDoor
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