Scott Sumner on *The Midas Paradox*, the Fed, and More

How failures in monetary policy and a defective international gold standard sparked the Great Depression, and subsequent supply side policies impeded recovery.

Scott Sumner is the director of the Program on Monetary Policy at the Mercatus Center at George Mason University, and is finishing up a long career at Bentley University. His economic blog, "The Money Illusion," popularized the idea of nominal GDP targeting after the crisis in 2009. Scott also challenged the conventional view that The Great Recession was caused by a housing bust and a financial crisis, rather it was caused by the Fed tightening monetary policy in 2008. In the inaugural episode, Scott Sumner joins host David Beckworth to talk about Scott's new book *The Midas Paradox*, which advances a bold new explanation of what caused the Great Depression. They also discuss Scott's path into macro and monetary economics as well as what the Fed got wrong in 2008.

Read the full episode transcript

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Scott, welcome to the show.

Scott Sumner:  Thanks for inviting me, David.

Beckworth:  Scott, how did you get into macroeconomics?

Sumner:  I'd been interested in macro for quite a while. When I was young, getting in the college, I read a book by Friedman and Schwartz called "The Monetary History of the United States." That book really fascinated me, the mixture of a lot of data to look at. I love looking at data.

The models of the quantity theory of money and the idea that you could explain important historical events like the Great Depression by looking at these underlying monetary forces really fascinated me.

Beckworth:  At what point in that journey did you become aware of nominal GDP targeting as your ideal approach to monetary policy? I know your ideal was nominal wage targeting, which is very similar, but at what point in this journey did you say, "Hey, this is the way the Fed should be run?"

Sumner:  I don't remember exactly when but quite a long time ago, at least back in the '80s I was thinking along those lines. The way I approached it was that, I was first intrigued by Friedman's proposal for a simple money supply rule, keeping the money supply growing at three or four percent a year.

In the early '80s some of the criticism was that while velocity is unstable, so maybe the money rule won't work very well. It seemed logical to me that if unstable velocity was the problem the solution was to adjust the money supply to offset any movement in velocity. That was my thinking then. Now, today I have other ideas but that was what originally interested in.

Beckworth:  Since you began blogging in 2009, you've become associated with nominal GDP targeting. In fact, many people have attributed some of Fed's QE program, particularly QE3 and the overall rise in popularity of nominal GDP targeting to you and your blogging. Do you think you're forever linked to nominal GDP targeting?

Sumner:  That's interesting. I doubt that I directly influenced that policy in any way, but I do think people do associate me with that policy. From my own point of view, I would say I think of myself in two other ways. A lot of people have proposed nominal GDP targeting. What I've tried to contribute in my blogging is two key ideas.

One is that the profession tends to misdiagnose business cycles in real time, that is when there's a lack of aggregate demand and we have a recession due to inadequate monetary policy, at the time, it's usually blamed on other forces. It doesn't look like monetary policy because interest rates are usually falling. Getting a correct diagnosis is one idea I've popularized.

The other is that monetary policy should take whatever it takes to equate the market forecast of the goal variable with the policy goal. If your goal is five percent nominal GDP growth, the Feds should do whatever it takes so that the market expects five percent nominal GDP growth.

Beckworth:  That's where the title, "Market monitors" has come into play, is that correct?

Sumner:  That's exactly right. Lars Christensen coined that title because we're using market forces. He was saying Laura Spenson talked about targeting the forecast. All he wanted to do was equate the Feds own internal forecast with a policy goal. That's an interesting approach, but we prefer using the market forecast. We believe that's more efficient than the Fed's internal forecast of the goal variable.

Beckworth:  As I mentioned earlier, you're now at the Mercatus Center and you had the program on monetary policy. Can you tell us about that, your goals, and how you plan to meet those goals?

Sumner:  From my perspective, what I'm trying to do is promote research and a discussion about pragmatic solutions to monetary policy problems. I see unstable monetary policy as a key factor in the business cycle.

I'm really worried that when monetary policy fails it leads to bad public policies in other areas, bailouts, fiscal stimulus, things like that. I'd like to promote a monetary policy that makes the market economy work well, and also appear to work well, which is important in sound public policy. What we're trying to do here is promote research.

We have like working paper series. I'm working on a book, I do blogging. Of course, your podcasts are contributing to this. Today's New York Times column is a perfect example of getting these ideas out for other academics, policy makers, pundits to think about. Again, I keep emphasizing the word, "pragmatic."

We're looking for, not high level abstract mathematical research, but real pragmatic solutions to monetary policy problems.

Beckworth:  One of the projects you've recently completed that contributes to this objective of yours is a book on the Great Depression, it’s titled “The Midas Paradox: Financial Markets, Government Policies and the Great Depression.” This has been long time project. It's a lifetime work?

Explaining the Great Depression

Sumner:  Right. Starting in the late '80s and early '90s, I did research on the gold standard and the Great Depression that led to some journal articles. After a while I had enough journal articles where people suggested, "Why don't you turn that into a book and put it all together in one place." For various reasons it got endlessly delayed. I'd finished writing the book about 2005, but it did finally come out this year. It's nice to see it out in print.

Beckworth:  Listeners out there need to go buy their own copy.

Sumner:  Right. I should warn you though that it's not a beginning level book. It was written as an academic study. If you're someone that follows the news and follows monetary policy and understands the basic idea, you'll be OK with it, but it does require a certain knowledge going in.

Beckworth:  In the book you argue there were two main reasons for the Great Depression, a demand‑side part of the story and there is the supply side. Could you talk us through those two different forces behind the Great Depression?

Sumner:  If you think in terms of the basic aggregate supply and demand model that's taught in Principles of Economics, you can have a drop in output due to either less demand, which essentially means less nominal spending in the economy, a fall in nominal GDP, or less supply which is factors that reduced output at any given level of spending.

In the early 30s it was mostly demand‑side, so nominal GDP fell to half between 1929 and '33. That's an incredibly large negative demand shock. It resulted in both sharply lower output and falling prices. I believe it was failures in monetary policy and really a defective international gold standard at the time that contributed to this negative demand shock.

Now there were also bad supply‑side policies during the Hoover administration, like his attempt to artificially prop up wages, Smoot‑Hawley tariff and sharp tax increases in 1932, but the fall in nominal GDP alone would have been enough to produce a major depression.

The supply‑side policies perhaps made it a little bit worse but I believe it was only after 1933, where the negative supply‑side policies took over center‑stage and I believe slow the recovery over the next eight years.

Beckworth:  We have the Great Depression, which was caused by inappropriate monetary policy. We'll come to that in a minute, the gold standard. Then on top of that we have a supply‑side drag for the rest of the decade after 1933. Now, officially there's two recessions within the Great Depression. There is the one from 1929 to 1933 and the one '37 to '38.

What you're suggesting here is that on top of those two recessions there was this drag in supply‑side. Now on the demand‑side where we had poor monetary policy, your story is that there was a failure of proper coordination, of proper work by central banks in managing the international gold standard of that time. This is the interwar gold standard. Can you tell us first, how should ideally a gold standard work?

The Gold Standard’s Role in the Great Depression

Sumner:  At the time there was a discussion of a concept of rules of the game that movements in gold were supposed to lead to corresponding movements in the money supply. One way of interpreting that is that the ratio of gold, the money should have been fairly stable.

Now, I'd like to emphasize that the rules of the game were very vague and informal. There weren’t rules like you'd have in a football game, where violations are very clear and countries were spanked for doing the wrong thing. It was more of a sense of how central banks were expected to behave.

Even in the heyday of the classical gold standard they didn't adhere exactly to the rules of the game but there were some pretty major deviations or violations of those rules in the period after 1929 and it's a hard hypothesis to explain in a short time but if you wanted to boil it down to the basics, it was really too much demand for gold in the early 1930s.

A big deflation is essentially a rise in the purchasing power of gold. Gold was the monetary standard back then. What would make gold become much more valuable, have much more purchasing power? More demand for gold, or less supply.

But, it wasn't less supply. The gold wasn't disappearing. Mines continued to churn out more gold. It seems to have been excess demand raising the value of gold, and central banks were a major factor in demanding more gold, and pushing up its value.

Beckworth:  Scott, who exactly was responsible for hoarding the gold? You've written, and others have written, that France and the US were some of the bigger culprits in this. Is this right?

Sumner:  Yeah, those were the two most important countries. It's a complicated story. In 1929 and '30, a number of central banks accumulated gold, the US, Britain, and France. But, over a longer period, France was very notable for sharply increasing its gold holdings.

The reasons were a little bit different. In the United States, some of it reflected the banking panic. People were hoarding currency and there was more gold required to back up that currency.

In France, it was the central bank raising the ratio of gold to currency. It wasn't keeping that ratio stable as under the rules of the game. Some of the smaller countries in Europe acted in the same way as France did.

At the time, the US and Europe were really the key parts of the international gold standard. Those were the center of the world economy. That's really where the center of the deflationary forces took place, the United States and western Europe, especially France.

Beckworth:  We had the classical gold standard, was late 1800's, early 1900's, and that one worked relatively well. Like you said, it wasn't perfect. But, then you go to the inter‑war gold standard and it falls apart, and leads to the Great Depression and, some have argued, also led to the rise of the Nazi's in Germany.

Which, is interesting. You often think of the problems in Germany being tied to the hyperinflation, but there are a number of historians who argue it was Great Depression that led to many of the problems in Germany leading up to World War II.

One question that I have, and often comes up, is can we return to a gold standard? There's many people out there who advocate for a gold standard, and history isn't very favorable in terms of it working out well. Do we have any reason to believe that if it were to be adopted today, it would turn out any better than it did, during the inter‑war period?

Sumner:  It would be a mistake to return to it today. In fact, even if we had the pre‑World War I classical gold standard, it probably would not work as well today as it did then because the economy was more flexible then.

There were many more self‑employed farmers, wages were more flexible then. It was a different type of economy. The periods of occasional deflation that weren't that costly, although even then there were some recessions, but not that costly. I think would be more costly today.

On the German question, I very strongly feel that it was the deflation of the early '30's. As I got into this, I noticed that the Nazi party was still very tiny in 1929. Germany was doing OK at the time. People were pretty optimistic about the prospects for Europe in 1929.

There was talk of creating a European Union, and things were going pretty well, and the Nazi party was tiny. Then, as they went into a deep depression and the Depression hit Germany hard, much harder than France. You saw the extremist parties, the Communists and the Nazi's, rising very rapidly in strength.

I think that today, the gold standard would not work very well. I think that, really, the difference between the pre‑war and the post‑World‑War‑One system isn't so much that the system changed, as that the conditions were different.

Coming out of World War I, the price level was artificially high because the gold standard had been abandoned by the European countries during the war. That created a difficult problem that I think even under the classical gold standard would have been difficult to handle.

Beckworth:  We had the Great Depression. It was a global phenomenon. The whole world goes under. Then, we have a recovery in 1933. In fact, one of the strongest recoveries on record in 1933. There's been a few recent papers on this, how sharp it was. Then, of course, it subsequently died a early death.

But, the '33 recovery was pretty remarkable. The question is, "Why did it occur?" FDR comes in to office during that time. You write in your book and explain what he did that led to that sharp recovery. What is it?

Sumner:  It's very simple. He did a lot of things, but there was only one thing that really mattered for the recovery, and that was devaluing the dollar against gold. This was not a devaluation that was forced on the US. We had the world's largest gold reserves. We could have stayed on the gold standard. We were expected to stay on the gold standard by the markets.

FDR sharply devalued the dollar over a period of about eight or nine months, gradually, but very, very significantly. This sharply raised prices and output in the United States. But, it's interesting. If you look at the data at a monthly level, you see a pattern that's missing with the annual data.

Between March and July '33, industrial production rose 57 percent. Just think about that number 57 percent. We regained, in four months, almost half of the damage done in the previous four years.

Beckworth:  That's amazing.

Sumner:  We were halfway out of the Depression in terms of industrial production. Now, that was unsustainable, probably. But, when July came along, FDR felt workers weren't getting enough of a cut of the recovery.

He issued an executive order that effectively raised hourly wages by 20 percent over two months, and the industrial production recovery came to a screeching halt. Output leveled off for about two years.

In the middle of '35, it was ruled unconstitutional, and the recovery took off again from the middle of '35. We had a step‑wise recovery. I argued that this decision to raise wages 20 percent really delayed the recovery of the Great Depression substantially.

Beckworth:  The reason FDR did that, his push for higher wages, is he identified the symptom of the underlying cause. He wanted higher prices, and he thought raising wages was the way to go, as opposed to addressing the actual symptom, which was the collapse and demand.

He was experimenting. He tried a number of things. One of them happened to work, the devaluation of the dollar, which did boost demand. But, when he got to the wages, he dealt with the symptom, not the underlying cause.

You argue in the book that from '33 on, after these wages go up, there's a number of programs you mentioned already. The wage growth under the National Industrial Recovery Act in '33 was ruled unconstitutional, but that was replaced by the Wagner Act, which also put wage pressure on the economy?

Sumner:  Exactly. We had this strong recovery from the middle of '35 into early '37. Although the Wagner Act was passed in '35 to replace the unconstitutional wage fixing thing, and it enabled the formation of unions, it took a while for the union movement to gain strength.

But, it really gained strength in late '36, especially after his re‑election in a huge landslide. That really emboldened the unions. They had the president behind them, they had a lot of power, and union membership doubled in the US between, I believe, '35 and '37. Or, maybe '36 and '38.

It was incredible growth of labor unions. Wages started rising fairly sharply again. For a few months, it didn't cause a problem because prices were rising quickly for other reasons. The international gold standard had collapsed in late '36 as France finally left it, and there was a flood of gold onto the market which created inflation.

But then, everything came together in '37, both supply and demand shock. This is a more complicated business cycle than the first downturn. We had the rising wages, which are reducing aggregate supply. Then on the demand side, things turned negative starting in about the middle to late part of '37.

We went in to a period of deflation, the gold market switched from gold flooding in to hoarding again, as people began to fear FDR would devalue again during a slowdown.

Expectations of devaluing led to hoarding of gold, that raised the value of gold, creating deflation. It's a complicated story. Then, there were also Fed policies like raising reserve requirements and sterilizing gold inflows.

A lot of things came together on the supply and the demand side to create a pretty substantial depression in late 1937 and '38. It's not as well‑known as the earlier one, but it's still maybe the second or third biggest downturn of the 20th century. But, much less than the first.

Beckworth:  It's interesting, your story about the supply side drag created by FDR's policies. There are some economists who argue, like Eggertsson has the paper, "The Great Expectations," that it was it was both the devaluation and the expectations of higher prices from these supply‑side policies.

So FDR would literally have cut output, or he did cut output production, which would have caused prices to go up as well. He argued it was both those policies.

Then, in more contemporary discussion, Paul Krugman, for example, will often argue against wage flexibility in a recession. He argues it can be deflationary, and you're making the other argument here. How do I reconcile these two views, or are they making a mistake?

Sumner:  I strongly think they're making a mistake. By the way, the Eggertsson paper is excellent on the expectation side, the role of the gold standard, the devaluation. All that stuff I strongly agree with him on.

But, on the question of artificially raising wages and prices, it was called The National Industrial Recovery Act, an Orwellian title because it was stopping recovery, I strongly feel they were wrong. Let me give you a few reasons.

Back then, there were five major wage shocks I've identified. In all five cases, four very clearly and one clearly, output growth slowed sharply, almost immediately subsequent to this. I mentioned the July '33 decision to raise wages 20 percent, there were four others.

So you have a strong sign in the data that there's an immediate negative impact. You also have things like markets responding to the news. The stock market fell very sharply on the decision to raise wages. There's a lot of marketing indicators that were indicating a slowdown when this was done.

Then, in modern times, you also have some experiments of countries, like France trying to artificially raise wages and running into problems with employment. Or, Germany doing the opposite, reforming its labor markets, reducing labor costs, and seeing the German unemployment rate fall very sharply after 2004. There's many other examples you can point to.

There's a real strong set of data points that suggest the classical theory, if you make something more expensive, like labor, companies are going to want to hire less of it. Now, if it's a small increase, like a tiny increase in the minimum wage, it may not show up.

But, in the Great Depression, these were major changes. This 20 percent wage increase affected all workers, not just minimum wage workers. You can see the effects on the data right away. I think that was a mistake, and hopefully that will not happen again  .

Beckworth:  You've argued on your blog that, ideally, you would like to see the Fed stabilize demand, stabilize nominal spending, but allow increased wage flexibility. Because as long as the central bank is stabilizing demand, it's also going to be stabilizing income growth as well.

Sumner:  That's right.

Beckworth:  This really shouldn't be a concern that's often raised. Now, we've talked about the '37, '38 recession. As you mentioned, it was both the aggregate demand, shock and aggregate supply shocks or drags as well. That takes us, then, toward the end of the decade.

Finally, the US does get out of The Great Depression with World War II, the standard story being that the military spending goes up, the country mobilizes for war, and that we see demand begin to recover.

Are you comfortable with that interpretation? Does that seem like a reasonable story? Did the recovery really begin in World War II?

Did WWII play a Role in Economic Recovery?

Sumner:  I think the recovery was related to World War II. The more difficult question is, what's the actual mechanism? I don't feel I fully understand that.

Let me mention, as an aside, that there's three dates you could think about for when World War II began in the West. In '39, Germany went into Poland. That did not seem to have much effect on the global economy. I think it was because, at the time, people still were not certain it was going to lead to a World War.

Then in, and as late as, the spring of 1940, the US economy was still pretty deeply depressed. That's when Germany went into western Europe, especially France, and now people perceived it as a World War.

Then there's December '41 when Japan bombed Pearl Harbor. By that time, I think the US was essentially out of The Great Depression. What can we take from that? It wasn't the US fighting a war that got us out of The Depression, because the day before Pearl Harbor, we were already out of The Great Depression.

But, when Germany went into France 18 months earlier, we were not out of The Great Depression. One idea is that the huge global arms buildup, as World War II got under way, had indirect effects like raising the equilibrium interest rate, so making monetary policy effectively more expansionary.

Nominal GDP grew very rapidly over that 18 month period. It could have been a side effect of all the spending taking place, which indirectly made monetary policy more expansionary. In modern times, I argue that monetary policy often offsets fiscal stimulus, but at that time, it was more of an automatic system. The Fed wasn't targeting inflation or things like that.

With the monetary policy being fairly passive, I think all that arms spending probably effectively made it more expansionary. Rates were still at zero, but those zero rates were more expansionary because of the fiscal stimulus.

Beckworth:  So we have a recovery in World War II, the arms build‑up, and some of our friends on the right would push back and say, "We have the recovery, but it was a wartime recovery. It wasn't a true peace‑time recovery. There's also the draft. The draft is why the unemployment rate dropped."

Are you comfortable with that critique that, "Yeah there was full employment, so to speak, but it wasn't the type of full employment we really want in normal circumstances"?

Sumner:  Yeah. I'm not a fan of fiscal policy. Let me be clear that there are some situations where fiscal policy can raise GDP, but even when those situations occur, it would be more effective to use monetary policy.

As far as World War II, there's a difference ‑‑ you're right ‑‑ between boosting GDP and helping living standards. We normally think of GDP of tracking living standards in a very rough way, but clearly in World War II that wasn't true.

GDP was rising because of arms production, but consumption was falling. There was rationing and soldiers were serving in the military  instead of having traditional jobs. All the economic indicators were very misleading during World War II.

On the other hand, it certainly did, in some mechanical sense, get us out of the high unemployment equilibrium. That's clear. But, why artificially create a war, or even other fiscal stimulus that wouldn't otherwise be justified, when you can do the same thing much less costly without doing deficits through monetary policy?

Beckworth:  That gets us through The Great Depression. Again, I encourage you to buy Scott Sumners' book. Let's take those insights in The Great Depression and apply them to the Great Recession in 2008, 2009, and the slow recovery we've had since then.

You've written extensively about this period. It's part of your blog, it's what got you going again back into monetary economics.

However, if I recall correctly, you put down your monetary writings. For a while, you were doing more cultural economic type work, and then The Great Recession triggered the inner monetarist in you to come back out and start writing.

What insights to be carried forward from The Great Depression to The Great Recession that we've gone through?

Examining the 2007-09 Great Recession

Sumner:  Yes. I had given up because I thought the monetary policy problem was solved.

Beckworth:   Right.

Sumner:  Ironically, right before this hit, I was thinking about a model where I was trying to explain why we never seem to be able to forecast recessions ahead of time.

Even maybe six months into a recession, the economist's often still fail to forecast it, even though it's been going on for six months. How is it that we're doing such a bad job?

One conclusion I reached is that central banks, their job is not to forecast recessions, it's to prevent them. If you really saw a recession coming, you should take steps to prevent that from happening. That means all recessions are going to be things that you didn't forecast, essentially mistakes.

I was thinking about that model, and then around September, October, of 2008, I suddenly saw there's something wrong here, because it's clear we are going to have a deep recession next year. But, my model says we shouldn't be able to predict that. The central banks should offset that.

I realized that policy, in some sense, was very different from during The Great Moderation. During the previous several decades, at any moment in time, policy was set where the consensus forecast was, "Next year will be a decent year."

Now we have a policy set in a position where the forecast was, "Next year is going to be a horrible year." In my view, that meant policy was insufficiently expansionary in late 2008. I couldn't understand why there wasn't a lot of criticism of the Fed. It seemed obvious to me that it was too tight.

I started to talk to other economists, and a lot of them agreed that clearly there was a problem with the economy, that they didn't think there was much the Fed could do about it.

Again, that shocked me because I thought there had been this consensus among American economists that monetary policy was still highly effective at the zero bound.

There'd been all this criticism of Japan. "Why didn't Japan get out of deflation. They could do much more." Ben Bernanke had done this criticism. So why isn't there the same criticism of the Fed?

It was a real mystery to me, and that got me on a crusade to publicize these ideas through blogging and other methods, and talk about a perspective that was missing. I know you were doing similar work in your blog, at the time. That's when I first found out about your work.

But, not too many people were talking about this at the time.

Beckworth:  You were probably the first person ringing the alarm bells that monetary policy was too tight. The only thing I noticed in late 2008, that's on my blog somewhere  , late 2008 was when the Fed first introduced interest on reserves.

To me, the timing of that was very poor. In my mind, the silly and natural rate was dropping rapidly, and that interest in reserves put a cushion. It guaranteed it'd be hit, and monetary policy would be tight.

But, you were the one who was actively doing this. I learned a lot from following your blog, as many others have. "Does this, though, share some similarities, then, to The Great Depression?" is my question. Similar mistakes made?

Sumner:  Yeah. Interest on reserves is a lot like the Fed's decision in '37 to raise reserve requirements '36 and '37. It's a policy that raises the demand for bank reserves and, hence, is contractionary. The Fed admits it's a contractionary policy.

What's funny about this, there's a real disconnect in the economics profession about how they think about this stuff. When you talk to other economists, they are reluctant to criticize the Fed.

They think, "Oh, the Fed clearly knows what it's doing. It has good reason for doing this." The Fed was doing all it could, and they really have a hard time explaining things like this, interest on reserves, because it's really clear, in October 2008, they did this policy that was explicitly designed to be contractionary, to prevent interest rates from falling.

It hasn't sunk in with most economists that the Fed was doing this. If you polled most economists, they would say the Fed was doing all it could to stimulate the economy in late 2008, which is the opposite of what the Fed was doing.

Beckworth:  I agree with that. The Fed introduced interest on reserves during that time, and I've argued, along with Hugh, that the Fed in 2008 made things worse. Yes, we probably would've had an ordinary recession, some kind of recession. Housing was taking some toll, but to get from a housing recession, which if you go back and look at the data, housing begins to contract in early 2006.

You get almost two years of a sector recession. Housing, so construction, the real estate industries, those things were. Employment was getting smaller, so income from those sectors was going down. In the rest of the economy was doing relatively well.

Both of us have said before, about that, that the Fed did a decent job for those first two years, but something went terribly wrong in 2008. Was your diagnosis of that?

Sumner:  It's a complicated story. At one level, it's a simple story, nominal GDP growth fell, fell, and then turned negative in the latter part of 2008, and that was the key policy mistake, but the more complicated question is, why did this happen?

I mean, the Fed certainly didn't want another great recession to occur. They did a pretty good job of stabilizing the economy for the previous several decades. What was the trigger that caused Fed policy to be so negative in 2008?

It was some bad luck in a number of areas. The two I would point to was, the housing bust lowered what's called the Wicksellian equilibrium interest rate. That is, it lowered the interest rate that is necessary to stabilize the economy. People weren't buying as many houses, banks were tightening their standards because of these losses.

With less effective demand for credit, market interest rates fell sharply. The Fed didn't cut them fast enough. Even with that mistake, that would probably be enough, but also in 2008, we were unfortunately hit by a negative supply shock of sharply rising oil prices.

That pushed up the headline rate of inflation to fairly scary levels, from the Fed's perspective. They were worried about inflation throughout most of 2008, and this is one reason they were reluctant to cut interest rates, despite what they saw going on in housing.

I would say, then the final nail in the coffin was, in late 2008, the markets realize that the emperor had no clothes, to use a metaphor. In other words, they realized that the Fed was not really on top of things, and the Fed did not really have a solution for the zero bound in the economy.

They didn't have a solution to prevent a major recession, or promote a quick recovery, and they saw, there was nothing holding up the economy from below. That is, a sharp drop would not lead to a quick recovery, but could lead to a major downturn.

When markets realize that the Fed policy was inadequate to prevent a major recession, markets turned very bearish. This is the period people remember as the crashing of the various asset markets.

Stocks, commodities, real estate was already going down in housing, but interestingly, in late 2008, it spread from the sub‑prime states, to the heartland states, which had held up until then, and also to commercial real estate, which had held up until then, but when nominal GDP expectations plunged, all of those asset prices plunged.

Beckworth:  Looking back at this period, and also at Europe, the European Central Bank, it seems to me that the biggest mistakes occur because the banks get misleading signals from inflation. You mentioned in 2008, the supply shocks, commodity prices went really high. It made the Fed nervous, they decided not to act.

If you're either transcripts, the minutes from 2008, it's really striking. They were almost more concerned about inflation than they were about growth. This is as late as their September 2008 meeting, Lehman has collapsed, Fannie and Freddie have been acquired by the government, and the Fed says, "Oh, we're going to do nothing."

It speaks to me, to the problems or deficiencies with inflation targeting. If you go to Europe, the ECB raised interests rates in 2008, for the very same reason. They also saw those higher prices. Again, in 2011, it raised interest rates twice. It's going through the Eurozone crisis, and it's mind blowing that they could raise rates.

Stepping back, what I see from this is, the central banks, in real‑time, have a hard time divining whether they should respond to inflation. We both agree that, in the case of supply shock, they should ignore it. They shouldn't respond to changes in inflation driven by supply shocks, only in cases of demand shocks. Doesn't this suggest that maybe it's time to reconsider inflation targeting?

Sumner:  Yeah, exactly. You've pointed out correctly, the reasons why. Nominal GDP targeting gives you the right signal. It has the Fed respond to the shocks that would likely lead to a real, persistent inflation problem, that would work its way into wages, which are very sticky.

As long as you keep nominal GDP growing at a steady rate, any short‑term burst in inflation will be very temporary, and it will go back to the normal rate once that shock passes. 2011 is very important. You mentioned the ECB made the same mistake.

You know, people that are skeptical of our explanation 2008 should think about this fact. The same forces hit the economy in 2011, the ECB made the same mistake it made in 2008 of tightening monetary policy. It was worried about a rise in inflation, due to rising oil prices and rising VAT taxes.

The Fed did not make this mistake, this time around. The Fed continued along a more expansionary path than the ECB, and now, unlike 2008, where both Europe and the US went into deep recessions at the same time, Europe goes into a double dip recession in 2011. The US keeps growing, and has recovered since.

The fact that the same situation arose a second time, Europe made the same mistake, we didn't, and we got the results the market monitors would predict. It's a very important thing to think about. If they had focused on nominal GDP instead of inflation, they could've avoided that mistake in 2011, and also in 2008.

Beckworth:  That is interesting. You're framing this as a natural experiment for macro‑economics. We don't get many of those, but that definitely seems like a good one. What about the recovery period? After we hit bottom in June of 2009, we have a slow, slow recovery.

Some would argue we haven't truly recovered, even today, although we've gotten closer. The Fed used quantitative easing, large‑scale asset purchases as one of its main tools to get us through that period. It also used forward guidance on interest rates. What are your thoughts on QE? how effective was it?

Thoughts on Quantitative Easing

Sumner:  I've argued that that's the wrong way to think about the issue. QE is A tool that can be used effectively, or ineffectively, depending on the overarching policy. The real question is, what is the Fed trying to do, and how aggressively is it trying to do that?

QE, if done in a tentative and temporary way, can be almost completely ineffective. QE can be modestly effective, as it was with the Fed, with certain signaling associated with it, or QE can be highly effective if it accompanies a real, robust policy like what's called level targeting of nominal GDP.

The effectiveness of any tool, whether it be QE, or negative interest on reserves, or forward guidance, depends on the broader context of what the Fed is trying to achieve. I believe that if the Fed in, say, 2009 had said, "We're going to do level targeting of nominal GDP, and try to get back to that trend line, and we're going to do whatever it takes," they could've promoted a much faster recovery, with much less QE.

In my mind, it isn't so much more or less QE. It's, what is the policy trying to achieve? Their goals were way too tentative. They were trying to regain the previous trendline. Market saw that most of the QE was going to be a temporary injunction, or equivalently, was going to be neutralized later by higher interest on reserves, which is what they've done recently.

The markets correctly saw that. If the Fed is going to do what it did in December, and raise interest rates, given where the economy was at that moment. There is no particular reason why the recovery should've been any faster, from 2009.

In other words, the actual recovery that occurred is the recovery that would've happened if markets had perfect foresight, and saw what the Fed is going to do in 2015. Now, I don't believe markets had perfect foresight, but it's interesting that we got the recovery that would've been rational, and a rational expectations model, given the Fed's future policy.

Beckworth:  Another way of saying that is, we got the recovery the Feds wanted, right?

Sumner:  Essentially, yes.

Beckworth:  In my mind, that goes back to the inflation target. The Fed wants a low level of inflation. If you look back at it's preferred measure, the core PCE deflator, if you look back at that measure, it's averaged about one and a half percent since the bottom of the crisis. It has an official target at two percent, so it's preferred to keep inflation low.

I know the Fed has argued, "Well, we've had these oil prices, we've had supply side shocks," but for seven years, those answers have to at some point fall back on. There's a systematic bias or tendency to keep inflation really low. You make the point that QE is as good as the overriding objective of the Fed, that makes complete sense.

The Fed would never have allowed those tools, whether negative interest rates, forward guidance on interest rates, QE to have done anything that would have raised inflation above some low, low level.

Sumner:  Let me be clear when I say, this is the recovery the Fed wanted. I'm going to qualify that a little. The Fed would've liked to see real GDP grow more rapidly during the early years of the recovery. What I'm really saying is, their actions last year, in starting to raise interest rates, shows that they're happy with the economy where it is now, in terms of the current level of nominal spending.

Given that fact, that they're happy with things now, and want to raise interest rates so we don't overheat, this is the recovery you get. If the Fed says, "Well, we would've really liked to have a faster recovery," maybe that's true, but what they weren't willing to do was the things necessary to make that happen.

That's where we're really in, and I keep coming back to this term, level targeting, which means returning to the previous trend‑line. The Fed isn't willing to bite the bullet and go that route. That's something academics talk about, including Ben Bernake, when he was an academic, but central bankers don't like being under pressure to have that level of constraint on that policy, where they have to go back to the previous trend line.

The fact that they were willing to settle to a new and lower trend line meant that given their tools, and so on, they simply weren't able to get as much growth as they probably would've liked. Even with inflation, probably the Fed does want two percent inflation, but they're not willing to take the actions necessary to prevent inflation from persistently falling short during a long, sluggish recovery.

We've ended up with, mostly in the one to two percent range.

Beckworth:  If the Fed had adopted a nominal level GDP target, and used its toolset to get there, wouldn't that have required inflation temporarily going above two percent, at least for a short while?

Sumner:  It might have, but let me point something out here. As you know, inflation was, on average, considerably less than two percent during the recovery. There is some policy, in between those, where inflation would've been two percent, on average, during the recovery.

Even that would've been a much better average monetary policy than what we had. if they had done enough to create, two percent inflation, on average, from 2008 until today, the recovery would've been much faster. Maybe still not optimal compared to the level targeting system, but better than what we had.

I don't think we can let central bankers get away with this excuse. "Well, we didn't do more because this inflation target is really important." Sorry, that doesn't work, because you are under shooting your inflation target. Then, when you add in the dual mandate, if the dual mandate means anything, it must mean that inflation should run above target during recessions, and below target during booms.

A lot of economists don't recognize the implication of that. If you say that's not true, that inflation shouldn't run above target during recessions, then you're essentially arguing there shouldn't be a dual mandate. You should target inflation always at two percent. Then you'd have a single mandate, but Congress gave the Fed a dual mandate.

If it means anything, it means the Fed should not be precisely targeting inflation at two percent every single year. They take unemployment into account as well, and that means a little bit above two percent during recession, below during booms.

Guess what? The Fed does the exact opposite. They run inflation below target during recessions, so they're missing both their employment, and their inflation objectives, and they're missing them in the same way. Not sufficient expansionary monetary policy to hit either objective, so that makes policy look even worse than it would've been.

Under a single inflation targeting objective, it was too tight during a recovery. They can't use that as an excuse.

Beckworth:  This Also speaks to why fiscal policy couldn't do a whole lot more. The Fed's real preferences showed that the Fed was comfortable, or happy with this low inflation. I've often had a conversation with someone who's said, "Well, fiscal policy could have picked out another half a percent of inflation, a little bit more inflation, a little bit more aggregate demand growth."

But the Fed, if it's comfortable with the low inflation it had, would've offset fiscal policy. Is that right?

Sumner:  Yeah, that's my view. I would put it this way. That should be the standard assumption until proven otherwise. If the Fed has any goals, even not the goals that I favor, any goals for inflation or nominal spending, then when fiscal policy adjusts, the Fed should adjust it's policy to keep on target.

Now, of course, there's a lot of criticism about this view at the zero bound, and then it becomes an empirical question as to whether the Fed it would offset a major change in fiscal policy. We did have an interesting test in 2013. The budget deficit in 2013 dropped about $500 billion in one year.

That's really a huge, sudden reduction in the budget deficit. Many Keynesian economists predicted a slowdown in the economy as a result of that austerity, or fiscal tightening. Instead, GDP growth increased slightly in 2013 over 2012. Job growth was slightly higher.

There was no evidence in the data, from the one natural experiment we had during the recovery. I still think the base line assumption is that the Fed drives nominal spending, and will offset fiscal policy. Now, I don't argue that's always true. As I said, maybe in 1940 and '41, they didn't offset the military buildup, but that should be the baseline assumption unless proven otherwise.

Beckworth:  Going back to the nominal GDP level targeting idea, to have implemented it, it would've required, at this point I mentioned earlier, inflation temporarily going above two percent, at least until we caught back up to trend growth. My question is, is the body politic willing to accept that?

The Fed may be a reflection of society at large, and since the Fed has done such a great job getting expectations for inflation low, and becomes a norm that we only and always have low inflation, it puts the Fed in a straitjacket where it's not able to have the flexibility to do something like nominal GDP level targeting.

My question, ultimately, is this. Is something like nominal GDP level targeting even feasible, given the political environment we're in?

Is NGDP Targeting Politically Feasible?

Sumner:  It is, but it's a hard argument for me to make, because that the public sees the problem of inflation differently than any economists do. Economists think of it as a technical thing, like a change in the CPI. The public thinks of inflation is falling living standards, and it's clear, when you talk to the public, that when you think about inflation, they're thinking about what economists call supply‑side inflation.

In 2010, Bernake said, "We need to raise inflation a little bit, because it's too low." There's all this outrage on talk radio, raise inflation.

Beckworth:  Debase the currency.

Sumner:  Yeah. Probably the average American thought, "Oh, this is going to reduce my real income, because stuff will be more expensive at the store," but what Bernake was arguing is that we need to increase nominal spending, and one of the side effects will be inflation, but the other side effect will be more real GDP.

If he's right, the average American won't see falling living standards, they'll see rising living standards as real income grows. There'll be more jobs, more hours worked, more profits, more income coming from all sorts of sources. When the average person thinks of inflation, they visualize their own income as constant, and the cost of gasoline and food going up.

They're really visualizing supply‑side inflation, but that's not the inflation that the Fed creates. They create demand‑side inflation. The other thing, is that people talk more about inflation when they see signs of things like printing money, QE, low interest rates.

They're seeing what looks like easy money, but you and I both know that's misleading. It really wasn't that easy. When inflation was a little bit above two percent in the '90s, or maybe the mid‑2000s, when the economy was booming, it was not a big issue. Politicians were talking about it when it was two and a half, or two and three quarters for a year or two.

I think that ironically, even two percent inflation becomes controversial in a deep recession because people are angry about falling living standards, and inflation becomes a target to attach that to, even though it's really not what's wrong with the economy. What's wrong with the economy is not enough nominal GDP.

Beckworth:  That's why we have the program here at McCade. Part of our objective here is to help people see this point that you're making.

Sumner:  Let me add that, if Bernake in 2010 had said, instead of "We're trying to raise the public's cost of living," said, "We've noticed the economy does poorly when Americans incomes fall, so we're going to try to boost incomes in America at five percent a year."

I don't think the public would've heard that as a negative story. It sounds good to have a healthy economy, Americans incomes should be growing over time. That's how you sell nominal GDP to the public. Stable growth and total national income leads to a stable economy.

Beckworth:  Part of this project is the marketing and selling of normal GDP level targeting. That's an important...

Sumner:  Let me add that, I'm arguing in a strange way that my way of selling it rather than at Madison Avenue is also more truthful in a way because when Ben Bernanke said, we're trying to raise the cost of living. That's not what the Fed wanted to do.

When Bernanke said we need a little more inflation, what he really meant was, we need more nominal GDP growth, so that we will have more real GDP growth and as a side effect we will also have more inflation. He didn't want this extra aggregate demand to show up in inflation and no real growth.

He clearly wanted more real growth. So why not talk about the things you're really trying to achieve instead of essentially a side effect of the things you're trying to achieve, which is the inflation.

Beckworth:  That's because the Fed has an inflation targeting Central Bank and it goes back to the point that you need a regime change where we change the language. We're talking about income and demand.

Sumner:  We need to start thinking about nominal GDP as the real thing, the thing we're trying to stabilize, not inflation. We've had too much even within the profession of economics of inflation targeting models.

Models that really obsess about inflation and it's so misleading because demand supply‑side inflation are different problems that we need a different variable to focus on, that really captures the essence of monetary policy and what it does to the economy.

Beckworth:  On that positive note we have to end. We've run out of time. Scott, thank you for being on our show.

Sumner:  Thank you David. I enjoyed it.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.