:format(webp)/cdn.vox-cdn.com/uploads/chorus_image/image/35301368/8463683689_23d1da43d6_k.0.jpg)
For the last five years, economists and policymakers have been debating what caused the Great Recession and what America should do to recover from it. Liberals argued that massive deficit spending was needed to boost demand and pull America out of its economic slump. Conservatives have countered that too much government spending and regulation was to blame for the crisis in the first place, and that spending cuts and deregulation were the key to getting the economy going again.
In recent years, a third perspective has been gaining ground. Known as market monetarism, it holds that the Great Recession happened because America's central bank, the Federal Reserve, didn't do enough to support the economy in the wake of the 2008 financial crisis. And it argues that Fed has had the power to accelerate growth and bring down unemployment all along. It just needed to create more money.
Bentley University economist Scott Sumner has emerged as the most prominent advocate for this view. Since 2009, he has been telling anyone who would listen that the conventional wisdom on both the left and the right is wrong. Most conservatives thought the Fed had done too much already; many liberals thought the Fed was "out of ammunition." Sumner has persistently built the case that the Fed should — and could — do more.
Scott Sumner
And he has been surprisingly successful. His preferred monetary policy, known as nominal GDP targeting, earned a wave of high-profile endorsements in 2011. In 2012, the Federal Reserve took a big step in a market monetarist direction when it announced a new program to boost economic growth by creating more money.
Sumner argues that the results have vindicated the market monetarist point of view. The US economy has grown steadily over the last 18 months, despite spending cuts and tax hikes that economists such as Paul Krugman warned would be a drag on the economy.
"Krugman himself said that 2013 was going to be a test" of market monetarist ideas, Sumner notes. Sumner argues that market monetarists were vindicated by the strong performance of the US economy in 2013.
And he says that events overseas provide further support for the power of money creation to boost economic growth. In Japan, an aggressive program of money printing has started pulling that country out of its two-decade-long economic slump. In contrast, Sumner says, too little money creation in 2011 pushed the Eurozone into a double-dip recession.
Sumner argues that it's essential that we learn the right lessons from the last six years. "If we hit low interest rates again, the Fed needs a better backup plan than they had in 2008," Sumner says. He argues that his ideas provide the key to avoiding another 2008-style meltdown.
Monetary policy is a complex and subtle topic. Read below for a primer on monetary policy and the market monetarist viewpoint. Then click the "interview" tab to read Sumner in his own words. The transcript has been edited for length and clarity.
What's monetary policy and why does it matter?
Monetary policy is how a central bank such the US Federal Reserve controls the amount of money in circulation. While managing the nation's money supply might seem like a dry, esoteric subject, economists believe it has a powerful effect on the health of the economy.
The Federal Reserve chooses between two basic options. It can expand the money supply by creating new dollars and introducing them into circulation. This is known as an "easy," "loose," or "expansionary" policy. The alternative is to pull dollars out of circulation, known as "tight" or "contractionary" policy.
When the Fed eases, it uses freshly-created dollars to purchase assets — most often government bonds. That puts more cash in the pockets of businesses and consumers. Some of them will spend it, boosting demand for goods and services. Businesses respond by hiring more workers and expanding production, creating an economic boom.
But there's a natural limit to the quantity of goods and services the economy can produce. If the Fed injects more cash into an economy that is already close to the limit, it will push up prices without significantly increasing output. This is called inflation.
Monetary policy is all about striking the right balance between these two extremes. Two little money leads to idle resources — a recession. Too much money leads to rising prices — inflation.
I thought monetary policy was about raising and lowering interest rates.
It's true that central banks talk a lot about interest rates. That's because the traditional way to inject money into the economy is by purchasing short-term government bonds. That lowers the interest rate the government has to pay for short-term loans and exerts downward pressure on other interest rates.
This mechanism for expanding the money supply has become so ingrained in central banking culture that central banks prefer to think about interest rate targets instead of the size of the money supply.
For example, if you were reading a newspaper in October 2008, you might have seen a story about the Fed cutting interest rates to 1 percent. This meant that the Fed was committing to buy as many government bonds as it took to reduce a key interest rate to 1 percent. Conversely, when the Fed wants to remove money from the economy, it will "raise interest rates," selling previously-purchased bonds until the rate rises to a target level.
But don't be fooled: "lowering interest rates" and "expanding the money supply" are two different ways of describing the same process of buying government bonds with freshly created dollars.
The economy was terrible in 2008. So the Fed needed to pursue easy money, right?
That's right. When the economy begins to contract, as it did in 2008, the Fed's job is to expand the money supply to help offset the downturn.
But there was a problem: the Fed normally conducts monetary policy by setting interest rate targets. But by the end of 2008, the Fed had pushed interest rates all the way to zero. They couldn't go any lower, and the economy was still deep in recession.
Keynesian economists such as Paul Krugman call this a "liquidity trap." They argue that once short-term interest rates reach zero, monetary policy becomes ineffective. Printing more money can't lower interest rates, they argue, and lower interest rates are the primary way that central banks stimulate the economy.
This is why President Obama sought a massive stimulus package from Congress in early 2009. Believing the Fed to be impotent, Obama and his advisors argued that only massive budget deficits could pull the economy out of its slump.
What is market monetarism?
In February 2009, Bentley University economist Scott Sumner created a blog called The Money Illusion and began to argue that the conventional view of monetary policy was all wrong. His key arguments:
- Monetary policy was too tight in late 2008. With interest rates at 0 percent, many people believed that monetary policy was as loose as it could be. But Sumner argued that monetary policy should be judged based on results rather than interest rates. With prices falling and unemployment skyrocketing, he said, it made no sense to say the Fed was doing all it could.
- Liquidity traps are a myth. Sumner rejected the conventional focus on interest rates as the key lever for monetary policy. In his view, the Fed can always do more, even when interest rates are zero. If buying short-term bonds becomes ineffective, the central bank can always purchase other assets.
- Market expectations matter. Sumner argued that the market doesn't just respond to the Fed's current actions, but also to its statements about future policies. While the Fed took some aggressive actions to cushion the economic downturn in late 2008, Sumner argued that it didn't commit strongly enough to continuing expansionary policies in the future. That made businesses reluctant to invest.
- Stimulus spending is unnecessary and probably counterproductive. Given that the Fed already had the ability to provide as much stimulus as was needed, Sumner thought the Obama stimulus package wasn't needed. He predicted that if deficit spending succeeded in boosting economic output, that would simply lead the Fed to proportionally reduce its own stimulus efforts.
While Sumner became the best-known advocate for this point of view, a community of like-minded economists and bloggers soon developed. In 2011, the economist Lars Christensen coined the phrase "market monetarism" for this school of thought.
Why is it called market monetarism?
Market monetarism builds on monetarism, a school of thought that emerged in the 20th century. Its most famous advocate was Nobel prize winner Milton Friedman. Market monetarists and classic monetarists agree that monetary policy is extremely powerful. Friedman famously argued that excessively tight monetary policy caused the Great Depression. Sumner makes the same argument about the Great Recession. Market monetarists have borrowed many monetarist ideas and see themselves as heirs to the monetarist tradition.
But Sumner placed a much greater emphasis than Friedman on the importance of market expectations — the "market" part of market monetarism. Friedman thought central banks should expand the money supply at a pre-determined rate and do little else. In contrast, Sumner and other market monetarists argue that the Fed should set a target for long-term growth of national output and commit to do whatever it takes to keep the economy on that trajectory. In Sumner's view, what a central bank says about its future actions is just as important as what it does.
What's nominal GDP and why are market monetarists obsessed with it?
Nominal gross domestic product (frequently abbreviated NGDP) is a measure of the total output of the economy. ("Nominal" means not adjusted for inflation.) Nominal GDP in the United States is currently around $17 trillion:
Ordinarily, NGDP grows at about 5 percent per year. The growth rate slows a bit during recessions and rises during booms, but its growth is pretty steady overall.
But in the fall of 2008, total economic output fell drastically. And in the view of market monetarists, that was the telltale sign that the Federal Reserve wasn't doing enough to boost the economy.
Sumner argues that NGDP should be the first, last, and only criteria a central bank uses to decide if monetary policy is too tight or too loose. He wants central banks to print less money when NGDP goes above its long-term trend line and print more money when it falls behind.
More important, Sumner wants the Fed to publicly commit to doing this in the future. He believes that a credible commitment to do whatever it takes to hit pre-defined NGDP targets will give businesses confidence that the Fed will act decisively in the face of the next downturn, helping to prevent another 2008-style meltdown.
That just sounds like wishful thinking. Is there evidence that central bank statements can be so powerful?
After each meeting, the Federal Reserve issues a statement known as "forward guidance," which provides the market with guidance about the central bank's future plans. Every word of these statements, which the Fed issues about once every six weeks, is scrutinized by the markets for clues about future Fed policies. In Sumner's view, the contents of these statements can actually matter more than short-term decisions about the money supply.
"We just saw a powerful example in Japan," Sumner says. For the last 20 years, Japan has been stuck in an economic slump similar to — but worse than — the one the US has suffered since 2008. For years, the Japanese central bank had been trying and failing to boost the economy using easy money.
But early last year, Japan did something it hadn't done before: it explicitly said that its goal was to raise the inflation rate — and that it would do whatever it took to achieve that goal. The result was a dramatic improvement in the Japanese economy. "The yen fell sharply in the foreign exchange markets," Sumner says. That made Japanese products cheaper on the world market, boosting exports.
"Stocks increased sharply," Sumner says. "Then GDP started rising — both nominal and real [inflation-adjusted] GDP. Inflation started rising."
"These are things that the skeptics said should never happen," Sumner says. "The skeptical view that the Fed couldn't do more has I think been decisively rejected by the Japanese example."
The key to Japan's success, Sumner argues, was the central bank's pledge to do "whatever it takes" to reach its inflation target. The Bank of Japan can create an infinite number of yen, so there's no doubt it can raise prices if it really wants to. But previous efforts were too half-hearted. The Bank of Japan would inject money into the economy only to abandon the effort later.
But ordinary people don't pay attention to the Fed's statements. How can they have such a powerful effect on the economy?
"I know the average person doesn't pay attention to the Fed and they don't really think forward guidance is going to matter that much," Sumner says. "But forward guidance affects a lot of things that do affect average people."
"When long term interest rates fall, or the stock market booms, or the dollar falls in the foreign exchange market, that sets in motion changes in corporate America that do affect average people."
Who favors nominal GDP targeting?
In 2011, the concept of nominal GDP targeting attracted a wave of influential endorsements:
- Michael Woodford, a widely respected monetary economist who wrote a leading monetary economics textbook, endorsed NGDP targeting at a monetary policy conference in September.
- The next month, Christina Romer wrote a New York Times op-ed calling for the Fed to "begin targeting the path of nominal gross domestic product." Romer is widely respected in the economics profession and chaired President Obama's Council of Economic Advisors during the first two years of his administration.
- Also in October, Jan Hatzius, the chief economist of Goldman Sachs, endorsed NGDP targeting. He wrote that the effectiveness of the policy "depends critically on the credibility of the Fed's commitment" — a key part of Sumner's argument.
How has market monetarism affected economic policy in the United States?
In late 2012, the Fed announced a new program of monetary easing that was widely interpreted as a step toward market monetarist ideas. The program was dubbed "quantitative easing" (QE) because it focused on the quantity of money created rather than on interest rates.
This wasn't the first time the Fed had tried this kind of unconventional monetary policy. Twice before — the first time between 2008 and early 2010, the second time between late 2010 and mid-2011 — the Fed had purchased hundreds of billions of dollars of assets. But the Fed made clear that these were temporary measures, and that they would be halted if inflation started to rise above the Fed's 2 percent target.
"They went out of their way to say don't worry about inflation," Sumner says. "We'll pull this money out of circulation if there's any sign of inflation picking up. That guidance was a mistake." The first two rounds of QE did have some effect, but as in Japan their effectiveness was undermined by muddled communication about the Fed's future plans.
With QE3, which started in late 2012 and continues today, the Fed took a different approach. Instead of announcing a time limit, the Fed made the program open-ended, promising to buy tens of billions of dollars of assets per month for as long as it took for the economy to start growing again. The Fed said it was willing to tolerate inflation as high as 2.5 percent — above its 2 percent target. And the bank said it would keep interest rates at 0 percent for an extended period even after the economy began picking up.
QE3 wasn't Scott Sumner's ideal policy. But it was a big step toward the kind of policy he has advocated. And Sumner argues that the results have vindicated the market monetarist viewpoint.
Sumner points to an April 2013 blog post in which Paul Krugman — a Sumner critic — argued that "we are in effect getting a test of the market monetarist view right now." One reason the Fed launched a new round of QE was that it knew Congress was about to hit the "fiscal cliff," a combination of tax hikes and spending cuts that could slow the economy. Krugman predicted that this would lead to a slowdown despite the Fed's efforts. Sumner, by contrast, predicted that the Fed would be able to offset the effects of these policies.
"Keynesians predicted a slowdown in growth from all this fiscal austerity," Sumner says. "Market monetarists like myself didn't think it would have much effect. And if you look at growth in 2013, it was actually higher than in 2012. Growth picked up a little bit. So we don't really see much evidence of fiscal austerity slowing the economy as the Keynesians predicted."
Is there other evidence for the effectiveness of monetary policy?
Sumner argues that comparing the US to the Eurozone provides further support for his thesis. He notes that from 2008 to 2010, the two regions experienced similar economic performance — a severe recession producing unemployment of almost 10 percent. But then the two regions diverged. The US economy slowly emerged from its recession. Meanwhile, things got worse in Europe.
"The Keynesians blame fiscal austerity [e.g. spending cuts and tax hikes] for the Eurozone's double-dip recession," Sumner argues. "But the US did as much or slightly more. The big difference was monetary policy."
Two rounds of quantitative easing have helped to keep the US out of recession, while a poorly timed interest-rate hike undermined Eurozone economies.
How would nominal GDP targeting work in practice?
Sumner's proposal is deceptively simple: the Fed should announce a target growth rate for nominal GDP of around 5 percent. And then it should do whatever it takes to achieve that result. Of course, that might be easier said than done.
Sumner argues that two things are needed to make NGDP targeting work. One is called level targeting. Under this approach, the Fed would commit to make up any under- or over-shooting. So if the target is for NGDP to grow at a 5 percent annual rate, but NGDP only grows at 4 percent in one year, then the Fed would seek a 6 percent growth rate the following year to make up the shortfall.
Level targeting makes the economy more predictable. And Sumner believes it can act as an insurance policy against economic meltdowns like the one that occurred in 2008. Even if the Fed can't halt an economic contraction in the short run, the commitment to make up lost ground later will make businesses more willing to make long-term investments. And that investment, in turn, will actually make downturns less severe.
The second principle for effective NGDP targeting is called "targeting the forecast." Currently, the Fed has an official 2 percent inflation target. Yet in recent years the Fed has often published predictions that inflation would be below 2 percent. Sumner argues that this is a mistake. If your forecast says you're going to under-shoot your inflation target, that means your monetary policy is too tight.
The same principle would apply in an NGDP targeting regime. Market monetarists would have the Fed use projections about future NGDP growth as the primary indicator for whether monetary policy was too loose or to tight. If Fed economists were forecasting NGDP growth below 5 percent, the Fed would ease. Forecasts above 5 percent would lead to tightening.
To improve the accuracy of the Fed's NGDP forecasts, Sumner advocates the creation of an NGDP futures market. There are already futures markets that help economists forecast the future price of commodities like oil and pork bellies. A similar market could be set up to help forecast the growth of the overall economy.
In the long run, Sumner argues that monetary policy could be almost completely automated by tying Fed policy directly to the NGDP futures market. Under his proposal, the Fed would automatically buy or sell bonds until the NGDP growth rate forecast by the market was equal to the Fed's target, almost completely eliminating the discretion of Fed officials.
Is market monetarism a conservative viewpoint or a liberal one?
Market monetarism doesn't have a clear place on the political spectrum. Right now, most conservatives are monetary hawks, believing that the Fed is already doing too much to try to boost the economy. Most liberals share Paul Krugman's view that, as a practical matter, the Fed has done everything it can to boost the economy, and that deficit spending by Congress is a more effective way of ending the recession.
Sumner views himself as a free-market thinker, though he concedes that he isn't an orthodox conservative. He favors carbon taxes and a modest amount of income redistribution. And his arguments for monetary activism will rub some conservatives and libertarians the wrong way.
While no one called themselves market monetarists before 2011, elements of the market monetarist view have long been held on the right. When he was asked about Japan's economic slump in 2000, the free-market economist Milton Friedman sounded a lot like Scott Sumner talking about the Fed today. Friedman argued that the Japanese central bank should buy as many long-term government bonds as it took to get the economy growing again. Bill Niskanen, the late chairman of the libertarian Cato Institute, advocated an approach to monetary policy similar to NGDP targeting.
More recently, Sumner's ideas have influenced writers at the conservative American Enterprise Institute. AEI scholars James Pethokoukis and Ramesh Ponnuru have both argued that monetary policy has been too tight in recent years. Both have endorsed nominal GDP targeting as an alternative.
Sumner argues that there are two reasons thinkers on the right ought to embrace his point of view. First, he emphasizes that NGDP targeting would drastically reduce the discretion of Fed officials.
"I favor NGDP futures markets where monetary policy is set at the level where the market expects it to be on target," Sumner says. "I believe that's a very market-oriented system that takes a lot of discretion away from government bureaucrats."
Second, he argues, bad monetary policy is a major source of hostility toward the capitalist system. When the economy is growing robustly, people are more open to free-market reforms.
He points to the 1990s as an example. "All over the world, there was lot of deregulation, privatization of companies, cuts in marginal income tax rates, welfare reform," he says. "Things that were at least modestly in the right direction from a free-market perspective." But since the Great Recession, he says, "capitalism has gotten a negative reputation, and things haven't gone well. It looks like capitalism doesn't work but it's really a failure of the monetary system."
What's the future of market monetarist ideas?
Sumner says he's optimistic that people inside the Federal Reserve have learned the right lessons from the Great Recession.
"Even though I don't think the Fed has learned everything they could have learned from [the 2008 crisis], I think they've learned something," Sumner says. "In recent years, they've started to move a little bit in the direction of what the market monetarists like myself have been talking about in terms of doing more QE, doing more forward guidance. It suggests to me that they realize now that they weren't aggressive enough in 2008-9."
In the long run, the success of market monetarism depends on developing a following among younger economists. And economists in their 20s and 30s have proven receptive to Sumner's ideas. Sumner says the middle-aged economists who are running the Fed today came of age during the high-inflation 1970s, and as a result they're still obsessed with fighting inflation — even though inflation hasn't been a serious problem in decades.
Younger people, are forming their views now, in the midst of the worst economic slump in generations. They're likely to be more receptive to Sumner's argument that the Fed should have done more.
Correction: This story originally stated that the fiscal cliff would lead to tax cuts and spending hikes, when it actually did the opposite. Also, the article originally stated that Paul Krugman believed the Fed had done everything it can; I revised this to state that he believes the Fed had done everything it could practically speaking.
Timothy B. Lee: Start at the beginning: what's NGDP targeting and why is would be better than what the Fed is doing now?
Scott Sumner:Nominal gross domestic product targeting is targeting the growth of NGDP along a certain path, perhaps 5 percent increase per year. And there would be a commitment to come back to that trend line if you deviated from it for some reason. In the long run, you'd get a relatively stable growth in NGDP.
NGDP growth is the sum of inflation and real growth. So if you target NGDP growth, in a sense, you're picking up both sides of the Fed dual mandate. [Congress has instructed the Fed to minimize both inflation and unemployment.] You're tending to keep inflation low on average, but also you have a policy that's able to smooth out the business cycle. The reason for that is that nominal GDP targeting is superior to inflation targeting whenever there's a supply shock.
Let me use 2008 as an example. There was a large rise in energy prices in 2008. The Fed responded to that with a monetary policy that was too contractionary for the needs of the economy. They specifically cited a fear of high inflation. As an example, they did not cut interest rates two days after Lehman failed in their meeting. If they'd been targeting NGDP instead, they would have seen that the total level of spending in the economy is weakening, and that there was a threat of recession. They would have been more expansionary I believe.
Really, over the last 6 years, policy would have been more expansionary under NGDP targeting. That's because NGDP fell very sharply in 2009 relative to the trend line — it was a much clearer indicator of the weakness of the economy than inflation. Inflation does usually fall a little bit in recessions, but it's not as accurate an indicator of the needs of the economy for additional money. Because inflation is affected by both demand shocks and supply shocks.
Two other reasons NGDP are important have to do with wages and debt. Because most wages and debt contracts are made in nominal terms [e.g. not indexed to inflation], changes in NGDP tend to cause problems in the labor market and in financial markets. NGDP is the total nominal income available to pay worker's wages, and the total income available to individuals, companies and governments to repay nominal debts. When it falls you get unemployment and debt crises.
Timothy B. Lee: To unpack that a little bit, if you have an oil shock or some other factor that makes the production of goods more expensive, that's going to be a drag on the economy and you want the Fed to loosen. But if the Fed is targeting inflation it will tighten instead?
Scott Sumner:I can give you a good example in Europe recently. Many European countries raised their value added tax to reduce their budget deficits. That's obviously a contractionary fiscal policy, which would tend to slow the economy. The European Central Bank (ECB), responded with a tight money policy in 2011 because they were afraid that the increase in VAT was pushing up inflation. Ironically, a policy that was aimed at reducing budget deficits and was contractionary, indirectly led under inflation targeting to a contractionary monetary policy.
The ECB raised interest rates several times in 2011. That pushed the Eurozone right back into double-dip recession. In retrospect it was a very clear mistake by the ECB. It was made because they were targeting inflation instead of NGDP, which was pretty weak at the time. They would have had a more expansionary policy with NGDP targeting.
Timothy B. Lee: There's a widespread perception that the Fed's monetary policy has been as dovish as it can get. We've had 0 percent interest rates, and this quantitative easing (QE) that freaks people out. And some think that more accommodation wouldn't do any good. What's the evidence that this is wrong, that the Fed could have done more?
Scott Sumner:Let me just start with a perception that monetary policy has been expansionary in recent years. You're correct that that's the perception. In my view, it's an embarrassment to the [economics] profession that this is a widespread perception. The same things that people cite today, low interest rates and QE, occurred during the 1930s. Most economists would say that monetary policy was highly contractionary during the 1930s.
When I push economists on why do you think it's expansionary, they can't give me any good reason other than low interest rates. Look, interest rates are never higher than during hyperinflation. Almost everybody agrees that's an easy monetary policy. You can't look at interest rates to tell whether monetary policy is easy or tight. Interest rates reflect the condition of the economy.
What I do — and this is actually [former Federal Reserve chairman] Ben Bernanke's idea — is look at NGDP growth as an indicator of whether money is expansionary or contractionary relative to the needs of the economy. That's really all that matters, is whether they're doing enough to get their nominal growth on target, or inflation if they have an inflation target. So by that standard, ever since 2008, we've had monetary policy that's too contractionary.
Now, in terms of what more could the Fed have done. One thing they could have done is they could have done the things that Ben Bernanke recommended the Japanese do 10 years earlier when he was very dismissive of this idea that Japan had done all it could. One of those ideas is something called level targeting, where you promise to try to come back to the original trend line if you fall short.
Let's say the Fed is targeting inflation at 2 percent. One of the things they could have done is say, "Look, over the last few years inflation has run below 2 percent since 2008." So we're going to draw a trend line of 2 percent from 2008, and if we fall short we're going to try to come back to that trend line. If they had made that commitment, policy would have immediately been a lot more expansionary.
Timothy B. Lee: I think a lot of people are skeptical of the idea that central banks can have a big impact just by announcing a commitment like that. What's the evidence that that kind of approach can work?
Scott Sumner:We just saw a powerful example in Japan. They finally did what Ben Bernanke had been recommending, raising the inflation target, early last year. Immediately, after raising the inflation target, all sorts of things happened which are consistent with monetary stimulus.
The yen fell sharply in the foreign exchange markets. Stocks increased sharply. Then GDP started rising — nominal and real GDP. Inflation started rising. All of these things occurred when the bank of Japan raised their inflation target from 0 to 2 percent, and these are things that the skeptics said should never happen. The skeptical view that the Fed couldn't do more has I think been decisively rejected by the Japanese example. Although I think we already knew that from earlier periods of history where unconventional policies were tried.
Timothy B. Lee: In recent years, the US, the Eurozone, the UK, and Japan have all pursued different types of monetary policy. What lessons can we learn from the results of those experiments?
Scott Sumner: I think a lot of lessons. We know that Japan did poorly up until they adopted the 2 percent inflation target in the beginning of 2013 and have done much better since. That's one example. About the same time, the British replaced their central bank head with a new chairman named Mark Carney. Carney started more aggressive forward guidance, and the British economy picked up about the same time. Now we can't be certain it was all due to Mark Carney. I don't think it was. But that was one more experiment with the government shifting toward a more expansionary monetary regime. It seemed to work.
The US and Eurozone are a beautiful comparison because we both had recessions in 2009 of roughly equal severity. By 2010, we both had unemployment rates in the 9 to 10 percent range. We'd each gone through recessions. And then policy diverged, but only monetary policy. Both the US and Eurozone did about the same amount of fiscal austerity [e.g. spending cuts and tax hikes] in recent years.
The Keynesians blame fiscal austerity for the Eurozone double-dip recession. But the US did as much or slightly more. The big difference was monetary policy. The Fed did QE, QE2, and QE3 [expansionary monetary policies]. The ECB was more contractionary. They didn't do this unconventional monetary stimulus. They actually bumped interest rates up a little bit in 2011. So the big difference was monetary policy.
And as a result, the unemployment rate in the Eurozone has risen to almost 12 percent, from 9 or 10. The US has fallen to 6.3 percent, barely half the European level. It's a classic experiment of both regions doing similar austerity, and the US doing a more expansionary monetary policy. And you can really see the difference in the outcome. To me that shows monetary policy is really the driver of growth in nominal spending, not fiscal policy.
Timothy B. Lee: In April 2013, Paul Krugman said we were in the middle of a test of the market monetarist viewpoint, based on contractionary policy in Congress and expansionary policy from the Fed. What can we learn from that experiment?
Scott Sumner:The specifics were the idea of monetary offset, which isn't just that one was easy and one was tight, but that the monetary stimulus in late 2012 was done partly to offset the fiscal austerity that the Fed realized would be occurring at the beginning of 2013.
My argument is that because the Fed tends to offset the effect of fiscal policy to keep inflation and growth close to their target values, fiscal policy really doesn't have much effect. Not what people think. Krugman himself said that 2013 was going to be a test. What he meant by that is that the Keynesians predicted a slowdown in growth from all this fiscal austerity. And market monetarists like myself didn't think it would have much effect. If you look at growth in 2013, from Q4 2012 to Q4 2013, it was actually higher than in 2012. Growth picked up a little bit. So we don't really see much evidence of fiscal austerity slowing the economy as the Keynesians predicted.
There were three types of fiscal austerity. A payroll tax hike of 2 percent on everyone, income tax increases on the rich, and also cuts in government spending. All of those occurred in early 2013. I'm not saying fiscal policy never has any effect, but I think it's largely offset by central banks when they're engaging in things like inflation targeting. Central banks just adjust policy to keep aggregate demand at a level where I think they're going to hit their targets.
Timothy B. Lee: What do you think the Fed should be doing to prepare for the next downturn? Is it practical to adopt an NGDP framework, or are their transitional steps to move in that direction?
Scott Sumner: Obviously, I'd like them to do NGDP targeting. I think it's probably appropriate that central banks move slowly in making changes and let academics do a lot of research and debate of issues before they jump into a new policy regime. I think the Fed needs to learn the lessons of what went wrong this time. In my view (and others like Paul Krugman) we're likely to hit low interest rates in future recessions because low interest rates have become the new normal of the 21st century economy.
If we hit low interest rates again, the Fed needs a better backup plan than they had in 2008. One policy would be to move to level targeting, which even with inflation targeting gives you a little more ability to be stimulative. As I mentioned, if they promise to come back to the 2008 inflation trend line, we'd be doing better. I think NGDP targeting would be even a little bit better.
In other words, they might want to move toward NGDP targeting in baby steps rather than all at once. That's just because central banks tend to be cautious about doing a radical switch in policy. I would like them to do NGDP targeting, but I do understand they're a bit cautious having just announced a formal inflation target of 2 percent a few years ago.
Timothy B. Lee: To be more concrete about it, right now the Fed has a formal 2 percent inflation target, but mostly conducts monetary policy by setting target interest rates and quantitative easing. What specifically do they need to change to get to an NGDP targeting regime?
Scott Sumner: There's a lot of things they could do. One is what's called a "targeting the forecast" approach, which means they promise to do enough stimulus at each meeting so that the forecast of where the economy is going is equal to their target.
Let me explain that with a simple example first. Let's stick to the 2 percent inflation target they have. Under targeting the forecast, they wouldn't be saying, "Well, we think inflation will be 1.5 percent in the next year but we'd like it to be 2 percent." Rather they would do enough monetary stimulus so either they think it would be 2 percent or the market thinks that. By the market I mean things like the TIPS spread and bond yields — market indicators that forecast inflation rates.
My dream policy would be creation of a nominal GDP futures market so that we would know at each moment in time what the market thinks the growth of nominal GDP will be. Then the Fed would do a "whatever it takes" approach.
Ironically, I think that if the Fed did a whatever it takes approach, they wouldn't have to do as much. This is where I think people often get confused. Many people say to me, "The Fed has done so much, they've done all this QE, they've lowered interest rates to 0. How much more would they have to do?"
Ironically, central banks that are ineffective, that let nominal GDP fall, have to do much more than ones that are effective at keeping the economy growing at a brisk rate. The reason for that is that when the economy is growing at a nice rate like in Australia, interest rates never fall to zero, the monetary base never expands that much because banks don't want to sit on a lot of reserves if they can earn positive interest rates elsewhere. So countries that have the strongest growth in NGDP actually look like they're doing the least monetary stimulus.
But that's an illusion. When you have a tight money policy relative to what you need, you get a very weak level of NGDP growth, then interest rates fall to zero and banks want to hold a lot of excess reserves. That forces the central bank to do QE. So measures that look stimulative are actually sort of a sign of weakness on the part of the central bank.
That's why we live in this topsy-turvy world where Japan has done the most QE of any country, I believe, and has had deflation. Australia has had the strongest NGDP growth among the developed countries and done almost no QE at all. It's had interest rates above zero. That's really a sign of the strength of the economy.
So I think a credible policy would allow the Fed to do less. I know that's counterintuitive, but that's the way monetary policy works.
Timothy B. Lee: The Fed periodically issues forward guidance to signal the future stance of monetary policy. How well do you think this has worked?
Scott Sumner: I think they've been marginally effective. But they've also opened the Fed up to a certain amount of ridicule, because the Fed has occasionally changed the wording in their forward guidance. I can understand why people would want to ridicule them for saying one thing and then giving different guidance later.
The Fed is in a difficult position. They have an official inflation target, but unofficially I think they care more about NGDP. But they can't really put the forward guidance in terms of NGDP because it would look like they've abandoned their inflation target. So instead they've tried to talk in terms of both inflation and unemployment rate, and they've used unemployment as sort of a proxy for real growth in the economy. Normally when you get strong real growth unemployment falls.
But in this recovery, the unemployment rate has fallen much faster than you'd expect given slow NGDP growth. As the unemployment rate has fallen below 6.5 percent [the Fed said in 2012 that it would keep interest rates at 0 percent until unemployment fell below 6.5 percent], the Fed has had to back off and say "well we actually intend to keep rates lower for even longer than we thought." Because what they really care about isn't so much the unemployment rate but nominal growth, and nominal growth has still been weak. That's sort of forced them to change their forward guidance a little bit.
If they were able to talk in terms of what they care about, NGDP growth, then they wouldn't have to be be backtracking and adjusting their guidance as they have.
Timothy B. Lee: Why are the Fed's forward-looking statements so important? Isn't the really important thing what the Fed actually does?
Scott Sumner:I can give you a simple example. The quantity theory of money says that if you double the money supply, prices should double in the long run. You should get a lot of inflation.
But if you think about it for a moment, that's only true if the monetary increase is permanent. If the Fed says we're going to double the money supply and then a month later take it all back out of circulation, it wouldn't do anything. No one is going to pay twice as much for a house that they think will fall in price a month from now. Ultimately what investors care about is the path of monetary policy over the next few years.
That's the backdrop. Now, you might think no central bank would just inject money and then remove it. But that's exactly what the Japanese central bank did in their first QE in the early 2000s. They injected a lot of money. Then they removed it. And they went right back into deflation a few years later.
It turns out that to really make QE work, it's not enough to inject money into the economy. You have to send some signals about how much inflation you're willing to tolerate in the future, which is really how much money you're going to leave in the economy in the long run. If you don't send those signals, it won't have the same effect. People might just think it's a temporary gesture on the central bank's part.
So the forward guidance is really about telling the markets where your policy is going over the next few years, where inflation is likely to be. That affects current market prices very strongly. We know this, we see asset markets respond quite a bit to forward guidance. And as those asset markets respond, it can affect long term interest rates, stock prices, exchange rates. All these things affect aggregate demand and the economy.
I know the average person doesn't pay attention to the Fed and they don't really think forward guidance is going to matter that much. But forward guidance affects a lot of things that do affect average people. So when long term interest rates fall, or the stock market booms, or the dollar falls in the foreign exchange market, that sets in motion changes in corporate America that do affect average people.
Timothy B. Lee: Is that why the Fed's first two rounds of quantitative easing, between 2008 and 2011, didn't have that much effect? They started easing and then stopped after a few months.
Scott Sumner: Exactly. In fact, they went out of their way to say, "Don't worry about inflation, we'll pull this money out of circulation if there's any sign of inflation picking up." That guidance was a mistake. They actually needed to signal, "We're going to tolerate a little bit of above-target inflation. We just had low inflation in 2009. Maybe we should have 4 percent inflation in 2010."
But they were really reluctant to do that. The Fed was ironically getting criticized much more strongly by people on the right that were worried all this money would create hyperinflation. Those on the left, maybe they wanted more monetary stimulus, but they kind of ignored it. They mostly focused on fiscal policy. The Fed was really reluctant to do aggressive guidance.
Here's a great example, in 2010, Ben Bernanke gave some guidance that the Fed would like a little more inflation. The core rate of inflation had fallen below 1 percent. There was a firestorm of criticism on things like talk radio. They would say, "look, the chairman of the Fed just announced he's trying to raise your cost of living. You people are already suffering from a weak economy." How does that sound to the average listener, that the Fed is trying to raise the cost of living?
What the listener doesn't know is that the Fed was actually trying to boost the incomes of Americans. It would have sounded much better if Bernanke had said, "we've noticed that America has a healthy economy when America's incomes rise by 4 to 5 percent a year. We're going to try to push up incomes at that rate." That would sound good. But instead he said we need higher inflation.
Most people don't understand the connections between inflation and aggregate demand, jobs, and all this stuff. So what they did is after the firestorm of criticism, they started signaling, "Oh we're not trying to create too much inflation — don't worry." The message got muddled. They didn't have strong forward guidance, or even what I would call moderate forward guidance, until the end of 2012. Finally, in that period right before the fiscal austerity we talked about earlier, the Fed did some more specific forward guidance. I think it did have more effect in 2013.
The Fed didn't want to have numbers like 3 or 4 percent inflation floating out there because that would sound like they'd abandoned their 2 percent inflation target. Inflation, as measured by the consumer price index, was negative in 2009. So we really could have used a bit of inflation above trend as a catch-up in 2010, 2011, or 2012. But instead we've been averaging 1 to 2 percent. Occasionally we've been a little above 2 percent. Basically we're below the target and that's one of the reasons the recovery has been slow. It's a combination of the wrong target — inflation — and not pushing hard enough to even maintain even an average of 2 percent inflation.
Timothy B. Lee: Are we in danger of another 2008-style disaster? Or is the next recession likely to be more like the recessions in 1991 and 2001?
Scott Sumner: I think there's a risk because we're likely to hit the zero bound. Do I think a 2008-style disaster is likely? Probably not, for two reasons.
First the banking crisis make the Fed's job a little harder in 2008-9 than usual. I think they could have done a lot more even with the banking crisis but that made it tougher.
Second, even though I don't think the Fed has learned everything they could have learned from this, I think they've learned something. In recent years, they've started to move a little bit in the direction of what the market monetarists like myself have been talking about in terms of doing more QE, doing more forward guidance. It suggests to me that they realize now that they weren't aggressive enough in 2008-9.
Also, a lot of academics that are much more respected than myself, like Michael Woodford and Christina Romer, have talked about NGDP targeting. I think there's a critical mass in the New Keynesian community that sees sort of eye to eye with a lot of us us on a lot of monetary issues in terms of what the Fed should have done.
[These ideas have] worked their way into the Fed and probably they will do better next time. But I suspect they still will be a little bit behind the curve during the next recession because of the zero interest rate problem. I would actually like them to move away from targeting short-term interest rates. But I don't think I'm going to win that battle. It seems like too radical a step for central banks to target something else.
Timothy B. Lee: Forty years ago, in the 1970s, the world found itself in a situation opposite of the one we see today. Monetary policy was loose but a lot of people thought it was tight. Forty years before that, we had the Great Depression, a period when monetary policy was really tight but a lot of people thought the Fed was out of ammunition. Do you think there's a natural cycle where each generation over-reacts to the errors of the previous one?
Scott Sumner: I agree with you. I divide it up into three generations. The first one I call Generation Depression. They were young in the 1930s, and by 1960 they were middle-aged, which means they were put in charge of policymaking. The lesson they learned was that we've got to avoid another Great Depression. So policy became too expansionary in the 1960s. We had a lot of inflation.
My generation, call it Generation Inflation, came of age in the 1970s, and the lesson was we need to be eternally vigilant of inflation. My generation—I'm the same age as Bernanke and Krugman, and others — a lot of people of that age became in charge of central banks and became too contractionary in recent years.
My prediction is that the generation that came of age in the 2000s will be Generation Bubble. They're also going to learn the wrong lesson. They're going to think bubbles are what it's all about because of the tech and housing bubbles. I don't know if young people know this but before these two bubbles they weren't really a big issue in economics. My fear is central banks will devote too much attention toward trying to stabilize asset prices and prevent bubbles. And in doing so, they'll lose sight of the business cycle.
Back in the 1920s, there was pressure on the Fed chairman, Benjamin Strong, to do something about the stock market bubble. He said, "If one of my children misbehaves, do I have to spank them all?" Meaning if the stock market speculators are misbehaving, do I have to raise interest rates and hurt Main Street, too?
He died in 1928 without trying to kill the bubble. The people who took over finally had their chance to squash the stock market bubble. They did that in 1929, and we went into a Depression as a result. I think that lesson has been forgotten.
You've got people at the Bank for International Settlements talking about central banks needing to be more vigilant about asset price bubbles. I think this younger generation might learn the wrong lesson. There's really not much central banks can do about bubbles. They need to stabilize NGDP growth and let regulators try to fix the problems in our banking and housing system. You can't do it with a blunt instrument like monetary policy without just crushing the whole economy.
Timothy B. Lee: You occupy a little bit of a strange place on the ideological spectrum. You identify as a free-market guy, but a lot of the things you've written aren't really in sync with the contemporary conservative movement. How do you see yourself on the ideological spectrum and why do you think there aren't more people who think about things the way you do?
Scott Sumner: I think it's partly because my value system is pretty much identical to a lot of economists on the left. I'm sort of a utilitarian. Most people that are utilitarians are on the left because it just seems logical that government can make the world a better place by doing a lot of interventions. I actually think that's true to some extent. I favor government programs like carbon taxes and a certain amount of redistribution from high-wage workers to low-wage workers.
So why am I not on the left? I think that reality is much more "right-wing-economic" than it seems at first impression. Supply-side effects are much more powerful than common sense suggests. The government can do much less than common sense would suggest.
I think there are all sorts of cognitive illusions out there on things like income on capital, which I think shouldn't be taxed at all. A lot of people on the left used to believe that. They favored a progressive consumption tax, but they moved away from it. The New York Times used to favor abolishing the minimum wage. They don't any longer.
I still think what center-left economists believed in the 1990s is true. I think a lot of what's happened in recent years with growing inequality has sort of — this will sound pejorative, but I don't mean it that way — slightly thrown the left off course mentally. They've overreacted and abandoned a lot of really smart neoliberal ideas that they had in the 1990s.
I think those ideas are still basically right. They might have to be tweaked a little. Like we might have to weaken IP laws so people can't make such big fortunes for really minor innovations in tech industries and things like that. But basically we shouldn't tax savers more heavily than others, we shouldn't have minimum wage laws, we shouldn't have highly regulatory fixes like Sarbanes-Oxley and Dodd-Frank. I just don't think these things work. We have to get to the root of these problems like moral hazards created by government backstops of finance. Those are some reasons I'm more on the right on some issues.
Where I differ from people on the right is I'm not really one of these natural rights libertarians who thinks we're born with the right to whatever property we've accumulated, with this legal system, which is an arbitrary legal system. It's an arbitrary system of intellectual property.
If you can do a modest amount of redistribution from high-wage people like myself to low-wage workers, that makes sense. It helps to preserve the free-market system because then low-income people feel like they have more of a stake in it.
Timothy B. Lee: How do you see monetary policy fitting into this? A lot of people perceive the Fed as a government program that's meddling in the economy. I don't think that's how you think about it. What's the right way for people who care about free markets to think about monetary policy?
Scott Sumner:Here's my way of selling this to libertarians. I favor NGDP futures markets where monetary policy is set at the level where the market expects it to be on target. In other words, the money supply and interest rates should not be determined by the Fed. They should be set at a level where the markets believe NGDP growth will be on target.
That's a very market-oriented system that takes a lot of discretion away from government bureaucrats. Yes, the Fed still sets up the rules of the game, they set the nominal GDP target and they do the printing of the mone. But the amount of money would be controlled by the market under NGDP futures targeting regime.
Also if you have NGDP stable, it makes it easier for other libertarian goals. When GM asks for a bailout, you can say "look we're targeting NGDP. If we bail you out and more money is spent on GM cars, then by definition less money will be spent on other parts of the economy."
In contrast, when we go into a recession, like say the Great Depression, free-market ideas lose ground because the public doesn't think free markets work. You get all these statist policies when NGDP collapses. That happened in the US in the 1930s. It happened in Argentina in the early 2000s. So I think it's easier to sell libertarian policies to the public when you have a stable path of NGDP.
When we did have that stable path like in the 1990s, even a lot of people on the left began to buy into neoliberalism. All over the world, there was lot of deregulation, privatization of companies, cuts in marginal income tax rates, welfare reform, things that were at least modestly in the right direction from a free-market perspective.
Since the Great Recession, capitalism has gotten a negative reputation, and things haven't gone well. We've raised minimum wages, extended unemployment compensation, bailed out GM, right down the line. This is what happens when we let NGDP growth collapse. It looks like capitalism doesn't work but it's really a failure of the monetary system.
