We are all monetarists now

(Heavy use of Google is recommended for most readers of this post.)

As the tenth anniversary of the Lehman Brothers collapse passed by us earlier his month, it reignited a flurry of discussion about the 2008 economic downturn. Perhaps most visibly, Paul Krugman and Ben Bernanke have been trading commentary via Krugman’s column in the New York Times. And I do recommend anyone interested in the crisis read all of Krugman’s recent columns, as well as Bernanke original paper and subsequent responses.

(Despite heavy criticism, I do actually generally recommend Krugman’s column. It is the second best column in the New York Times—behind Michelle Goldberg’s of course. Krugman has the capacity to be an accurate and mainstream voice for the new (actually-left) liberal consensus and a good metre for the current mood of the average once upon a time Clinton enthusiast. But he also has a unique gift for partisan hackery. I call it the ‘Krugman Tourettes‘ phenomenon. In between all of his reasonable commentary he will insert out of place partisan barbs. Something like “conservatives constantly underestimates the fiscal cost of their tax policies on the same services which their constituents support—something they only do because they hate their voters,” to paraphrase one of his recent columns.)

However, the more interesting debate in my mind is the one tackled in Ramesh Ponnuru’s feature for a recent issue of National Review. Ponnuru argues that we need a return to the monetarist belief in the supremacy of monetary policy. This runs contrary to the consensus view that monetary policy failed to deliver after 2008. Despite the quality of the piece, I think Ponnuru has missed the far larger question looming over all economic policy subsequent to 2008: Do any of our policy tools even behave the way we have traditionally assumed they should? Or are traditional schools of thought misunderstanding important facets of the economy?

Ponnuru points to signs that the neutral interest rate of the U.S. economy was even lower than was widely understood by policymakers at the time, and suggests that despite the Fed’s exceptionally loose monetary policy, it was still too tight to achieve the stability of monetary growth advocated by monetarists like the much acclaimed Milton Friedman. The odd thing is how when decidedly non-Friedman-ites like Krugman and Larry Summers have put forward theories such as that of modern secular stagnation they have said things that sound a whole lot like Ponnuru.

The secular stagnation theorists have argued that the insufficiency of monetary policy to fully stimulate the economy in the aftermath of 2008 has lead to consistently overstated growth projections, which were unable to be realised and we are subsequently entering a new norm of low growth. Their solution is a new policy approach to the classic Phillips curve tradeoff. They argue that fiscal policy should be used to push inflation up and consequently trim real interest rates down into the negatives. In essence, they (Krugman in particular) have argued that Congress should step into the Federal Reserve’s domain and push inflation back up to, and even over their inflation target. Indeed, Krugman’s policies would in effect mean the end of conventional inflation targets as the primary measure of healthy monetary policy.

The irony is that by rethinking conventional inflation targets they have found common ground with monetarists. Instead of discretionary policy in service of an inflation target, monetarists believe in controlling the underlying monetary base directly. This means that monetarists would place far more importance on neutral and real interest rates, which are focused on the circulation of money through the financial system, as opposed to specific measures of inflation such as CPI.

This is not to say that monetarism and modern Keynesianism are synonymous. Indeed, monetarists remain sceptical of the whole Keynesian argument that post-2008 stagnation had anything to do with insufficient stimulation: the Fed’s tightness in the immediate years was more than made up for by unprecedented their looseness in the aftermath, according to the monetarists’ narrative.

But what they do increasingly share is a recognition that the key to addressing slackening nominal growth is policy transmission mechanisms which target the flow of money in the economy. Keynesians no longer believe that fiscal stimulation simply funds increased employment by creating jobs directly, they now correctly emphasise that fiscal policy pumps cash into the economy, thereby affecting credit markets and inflation so as to stimulate more aggregate demand. Monetarists also argue that monetary growth dictates demand, they just theorise that monetary policy has the most important effect in the final analyse.

As Ben Bernanke noted in the paper which earned Krugman’s hearty criticism, the key gap in macroeconomics as field prior to 2008 was not its fundamental understanding of the economy, but rather it lacked enough specific understanding of how tightly linked aggregate demand and the financial system are together as one unit. I humbly submit that Bernanke is correct, and that once that link is more fully understood, the inherently monetary effects of fiscal policy may lead us to rethink important assumptions made about Keynesian policy models—and perhaps integrate monetarism into a new mainstream economic mode of thought.

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