A New-Old Critique of Monetary Policy

Today, John Cochrane, Mickey Levy, Kevin Warsh & I spoke at a roundtable discussion on the Fed’s monetary policy at the Hoover Economic Policy Working Group. Cochrane talked about the fiscal side, Levy about the best inflation measures, Warsh about regime change, and I talked about the big deviations in policy from standard monetary policy rules. Many of the speakers had written about these issues for a year or so, but bringing them together revealed different perspective but with a common theme: the main concern was the high inflation rate induced by the new policy actions, whether the super low policy interest rate, the high money growth, or the big balance sheet expansion.

Some talked about how the Fed got into this difficult situation, and that brought back old memories of the 1970s where the critique was similar. All agreed that the Fed was now behind the curve, and the question was when and how rapidly to get back on track. The event had many commentators and guests–including monetary experts alike Mervyn King, Andy Levin, David Papell, and Robert Heller, who also spoke out on the same theme.

The whole Zoom event was video-recorded, and can be found here: https://www.hoover.org/events/roundtable-economic-policy-john-cochrane-mickey-levy-kevin-warsh-and-john-taylor along with the list of participants and slide presentations, which contain many useful charts and background references.

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Bill McGurn Shows Nice Video Clip of Milton Friedman

Bill McGurn make a lot of good references to Milton Friedman in a video just posted on the Wall Street Journal web site. We hear Milton talking about the power of the market. https://www.wsj.com/video/series/main-street-mcgurn/wsj-opinion-joe-biden-milton-friedman-and-a-lesson-in-inflation/E3400D7C-AA91-49CC-8341-65721E37BDF4 It is a great video and I always use it my Economics 1 introductory economics lectures at Stanford. Below is a review slide from the lecture on September 29 of this year with the link to Friedman’s video at the end, and here is the link: https://www.youtube.com/watch?v=R5Gppi-O3a8

Of course, a big reason to refer to Milton Friedman these days is the ongoing increase on inflation which virtually every person is now seeing and talking about. That is the main message of McGurn. It is also the message of a recent book Choose Economic Freedom with George Shultz, Milton Friedman and me in which we trace out the history of the 1970s, and see it repeating itself, unless the Federal Reserve takes action soon.

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New Principles of Economics Now Available

I am very happy to say that the new edition of Principles of Economics v9.1 is now officially published. Here is where you can find it on the FlatWorld web page: https://catalog.flatworldknowledge.com/catalog/editions/principles-of-economics-9-1.  It has been pleasure for me to continue to work on this edition with Akila Weerapana of Wellesley College, who brings terrific experience and knowledge of teaching basic economic principles.

The book continues to cover basic economic principles at the introductory level, and it shows how economics is more important than ever. It remains grounded in the central idea that people make purposeful choices with scarce resources and interact with others when they make these choices. The new edition covers key issues related to COVID-19 and the economic policy responses. It is updated to reflect the current economic situation, and incorporates the latest GDP, inflation, and unemployment data in charts and figures. It includes tables and a discussion of the start and end dates of the 2020 recession sparked by the coronavirus pandemic. Applications reflect the impact of the coronavirus pandemic, and the book shows how students can use the basic model to understand the impact of the COVID-19 on the economy .

The book now has over 180 new links, including brief video lectures scripted and recorded by me that have been usefully aligned to introduce, explain, and illustrate key economic concepts. There are also links to videos that apply to real-world situations. The new book covers the fiscal policy responses and special monetary policy actions including the rapid growth of the Fed’s balance sheet in response to the impact of the COVID-19 pandemic and prospects for eventual unwinding.

There will also be separate volumes of the book, titled Principles of Microeconomics and Principles of Macroeconomics, available. All of the supplements for the books are updated to reflect the new videos and the content updates made in this version.

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“The Most Reckless Monetary Policy Since Arthur Burns”

Today the Editorial Board of the Wall Street Journal wrote that the Federal Open Market Committee has shown “little interest in reeling in what has been the most reckless monetary policy since Arthur Burns roamed the Eccles Building.”

Last month I published an article, which Project Syndicate cleverly headlined “Is the Fed Getting Burned Again?” It summarized research consistent with this Wall Street Journal editorial. I presented the research in detail in an April 2021 paper “The Optimal Return to a Monetary Policy Strategy” which I gave at the City University of New York.

This story goes back to memo reprinted in the book Choose Economic Freedom which George Shultz and I published last year (and because we quoted Milton Friedman so much he is a coauthor.) The memo was written fifty years ago (June 22, 1971) from Arthur Burns, who was then Chair of the Fed, to President Richard Nixon.  Inflation was picking up, and Burns wanted Nixon and others to understand that the inflation was not due to monetary policy or to any action by the Fed. Instead, Burns recommended “a strong wage and price policy” to Nixon. The memo convinced Nixon, and he instituted a wage and price freeze, and followed up with wage and price controls and guidelines for the whole economy. It was a disaster, and, as the Fed was off the hook, money growth sored, inflation and unemployment got worse for the rest of the decade.

So look at where we are now. Inflation has picked up, and the Fed is saying that it is not responsible for that development. Instead, the Fed argues that today’s high inflation just reflects the bounce back from the low inflation of last year.

And the Fed is more interventionist now than it was in Burns’s day. Its balance sheet is exploding as the Fed purchases massive amounts of Treasury bonds and mortgage-backed securities. M2 growth has risen sharply. The federal funds interest rate is now lower than recommended by many trusted policy rules, including the Taylor Rule, listed on page 44 of the Fed’s most recent July 9, 2021 Monetary Policy Report.

“History hasn’t been kind to Burns” as the Wall Street Journal says in its editorial. It’s not too late to learn from past mistakes and adjust monetary policy. As John Holland of Olathe, Kansas said in a letter to the Wall Street Journal on March 1: “Powell Shouldn’t Repeat Arthur Burns’s Mistakes.”  

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Shortest Recession in US History

The Business Cycle Dating Committee of the National Bureau of Economic Research has a very important job. It is responsible for determining the peaks and troughs of business cycles in the United States. It thus decides how long recessions are and also how long expansions are. The Chair of the Committee is Professor Robert Hall of Stanford University.

The latest decision of Committee occurred just this week on July 19, 2021. The Committee decided that a trough in monthly economic activity occurred back in April 2020. They also determined that the previous peak occurred back in February 2020. Thus the recession, measured by the decline in employment from peak to trough, lasted only two months. It was the shortest recession in United States history. It was completely caused by COVID-19.   

This chart shows total employment in the United States. You can see that the peak in employment occurred in February and the trough occurred in April. Though only lasting two months the decline in employment was huge at 25.4 million.

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Monetary Policy a Half Century Ago, and Now

Today I  published an article in Project Syndicate. It starts with a memo sent fifty years ago, on June 22, 1971, by Fed Chair Arthur Burns to President Richard Nixon. Inflation was rising and Burns wrote to Nixon that the Fed was not to blame. Rather the economy had changed and a new policy – a wage and price freeze and controls—was needed.  

The memo convinced Nixon, and wage and price controls were implemented. But the intrusive nature began to show and the government controls were failing. Moreover, the Fed let the money supply increase, inflation rose to double digits, and the unemployment rate rose.

Last year, George Shultz and I wrote a book about this period, and we included the full text of the Burns memo because it is a perfect example of how bad ideas lead to bad policies, which in turn lead to bad economic outcomes. By the same token, good ideas lead to good policy and good economic performance, as Schultz and I showed.

The lesson for today is clear: inflation is picking up, and the Fed is once again claiming that it is not responsible for that development. Rather it is simply a bounce back from low inflation of 2020.

Moreover, the Fed’s policy is interventionist. The balance sheet has exploded, the growth rate of M2 has risen sharply, and the federal funds interest rate is now low compared to monetary policy rules in the Fed’s Monetary Policy Report.

It is not too late to learn and to change, but time is running out.

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Amazing New Facts About the 2007-2009 Global Financial Crisis

This week Raghu Rajan spoke at the Hoover Economics Policy Working Group on “Going the Extra Mile: Distant Lending and Credit Cycles” a joint paper João Granja and Christian Leuz. Here is a video of his presentation https://www.hoover.org/events/policy-seminar-raghuram-rajan-1 along with the slides https://www.hoover.org/sites/default/files/going_the_extra_mile.pdf and the paper itself https://www.hoover.org/sites/default/files/going_the_extra_mile_may_3_2021.pdf

Raghu focused on the causes of the Global Financial Crisis of 2007-2009. He brought entirely new data to the question of what caused the crisis. He examined the distance between lender and borrower. Raghu argued that greater distance is a measure of increased risk, holding the technology of making loans, which can provide better information on the probability of repayment, constant. The lower the interest rate–as generated by the federal funds rate which is in turn set by the Fed–the more there is a tendency to go to longer distances and thus increase risks in an effort to preserve profit margins.

Raghu and his colleagues find by this measure that the period leading up to the financial crisis was a period of increased risk taking. A higher federal funds rate set by the Fed would have reduced long distance lending, and thus riskiness of the loans. A higher federal fund rate would have resulted in less risk taking, and would have avoided or at least greatly mitigated the financial pressures which led to the crisis. In this sense, Raghu Rajan argues that a monetary policy closer to what I argued for back in a 2007 paper would have been better.

The following chart of the interest rate illustrates the issue. The chart is from the 2007 paper which I gave at Jackson Hole, “Housing and Monetary Policy,” and published in Housing, Housing Finance, and Monetary Policy, the proceedings of FRB of Kansas City Symposium. I did not use the informative data or the measures that Raghu and his colleagues use now. I simply looked at policy rules and the deviations from the rules. The counterfactual interest rate is what would have been implied by a policy rule. The actual rate is much lower. The conclusion is clear and Raghu’s recent work supports it: a somewhat higher interest rate in 2003-2006 would have been a better approach for the Fed and would have avoided much of the Global Financial Crisis.

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The Impact of the Pandemic and Lasting Lessons for Teaching Economics

Yesterday, I gave a keynote talk at the tenth American Economic Association Conference on Teaching and Research in Economic Education (CTREE). I have been teaching economics for 53 years. I love teaching economics. I love researching economics. And I love doing policy in economics. So it was a pleasure to talk about teaching economics, and the questions from other economic teachers and researchers in the audience were really good. Here are the slides. I talked mainly about teaching introductory economics. My main message is that students and teachers have benefited greatly, and can benefit greatly, from the new technology–including Zoom– but that basic economic ideas still work just fine when applied to the recent pandemic around the world, especially if we learn how to use the new technology well.

Ten years ago, I gave a keynote talk at the first CTREE and here are my slides from ten years ago. Yesterday I built on that earlier lecture. The Conference was then a major new initiative of the AEA to focus on teaching economics at all levels.  The first conference was an outstanding success, as was the one held virtually in the past few days. It is a great idea to have a conference on teaching. I have written economics textbooks, including one with Bob Hall that was first published 35 years ago and one on Principles of Economics with Akila Weerapana that was first published 25 years ago, and is now in the 9th edition with FlatWorld.

But much has changed about teaching over the years, and COVID-19 and the responses have provided more lessons. My talk is in three parts

(1) What we learned about teaching following the Global Financial Crisis?

(2) What we learned about teaching in the current crisis?

(3) What are the lessons about teaching for the future?

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A New Look at Income Inequality in the US

Yesterday, at the Hoover Economic Policy Working Group (EPWG), David Splinter of the Staff of the Joint Committee on Taxation discussed a paper he wrote with Gerald Auten of the Office of Tax Analysis at the Department of Treasury. A video of Splinter’s presentation, including many questions and answers, is posted on the EPWG web page here along with the paper “Income Inequality in the United States: Using Tax Data to Measure Long-term Trends” My internet went down so the video is really nice to have. There are also links there to Splinter’s excellent web page.

The paper and presentation explore in fascinating detail various data sources that bear on the widely reported finding of Thomas Piketty and Emmanuel Saez that the income distribution has widened. By adjusting for key technical issues and examining alternative assumptions for distributing income, their paper shows that there was little change in after-tax top income shares since the early 1960s, in contrast to the findings of Piketty and Saez (2003), which are based on individual tax returns.

Many have written about this topic and many, including me, have noted limitations of the data, including that IRS data are not ideal for measuring income because, for example, people report more income when the tax rate goes down, or because transfers are not in the data.  The important and highly original contribution of Splinter and Auten is that they have actually done the empirical work in a convincing quantitative way. Here is a graph from their paper which illustrates the difference.

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But even if the Piketty-Saez series are correct, policy should focus on the cause of the change. Is it a poor education system in which educational opportunities are restricted, especially for those who are disadvantaged, a fact that COVID 19 has made very clear? More generally, the explanation for the widening inequality may be restrictions on economic freedom. Not extending economic freedom to all in education is one example. Regulatory capture, crony capitalism, deviations from the rule of law are other examples.

Ironically some argue that moving away from the principles of economic freedom—higher marginal tax rates, more regulations, more discretion for regulators, more interventionist macro policy—is the way to change the distribution of income.  That would be a great tragedy since history shows that it has been more economic freedom that has pulled people out of poverty. And as Splinter and Auten show, it may not even be a distribution problem.

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Time for a Reentry to a Monetary Policy Strategy

In a new paper I examine the ways for the Fed to engage in a reentry to a rules-based monetary policy. For several years, starting around 2017, the Fed had begun to move to a rules-based monetary policy that had worked well in the US in the 1980s, 1990s, and in other years. Many papers were written at the Fed about the benefits, and the Fed began to report on rules-based policy in its Monetary Policy Report.

That move was interrupted in the first quarter of 2020 when COVID-19 hit. The Fed took a number of actions to deal with the effects and by most accounts these actions were special and were not consistent with rules-based policies. The Fed also stopped reporting on rules-based policy in its Monetary Policy Report.

Later in 2020 the Fed completed a review of its monetary policy and reported on possible changes in policy. By early 2021 the Fed began to put rules back in its Monetary Policy Report and the new rules reflected some of these changes.  But these changes have not yet affected actual monetary policy decisions and there is evidence of big difference between the rules-based policy and the actions of the Fed.

To develop an optimal reentry, I consider a recent paper by David Papell and Ruxandra Prodan.  For the Taylor (shortfalls) rule & the balanced approach (shortfalls) rule, they replaced the difference between the unemployment rate in the long run and actual unemployment rate with minimum of the difference and 0. If the unemployment rate is 3.5 percent and long run level is 4.0 percent, the interest rate is not raised.  That is, zero is the minimum of .5 percent (=4.0-3.5) and zero.

They also considered another adjustment which results in a Taylor (consistent) rule and a balanced approach (consistent) rule. They assume that the Fed would not adjust the interest rate if inflation is 2.0 or 2.1 percent; rather it would watch for inflation going above 2.2 percent.  Also assumed is that the equilibrium real interest rate is .5 percent.

I looked at the period from the 4th quarter of 2020 through the 4th quarter of 2023. Figure 9 from the paper copied below shows a big difference between the rules-based policy and the actions of the Fed.

It is time for reentry.

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