David Laidler of the University of Western Ontario talks about money and monetary policy with EconTalk host Russ Roberts. Laidler sketches the monetarist approach to the Great Depression and the Great Recession. He defends the Federal Reserve's performance in the recent crisis against the critics. He argues that the Fed's monetary policies have not been unconventional nor impotent as some critics have suggested. The conversation closes with a discussion of the state of macroeconomics and monetary economics.
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Readings and Links related to this podcast
Podcast Readings
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About this week's guest:
David Laidler's Home page
About ideas and people mentioned in this podcast:
Books:
A Monetary History of the United States, 1867-1960, by Milton Friedman and Anna Schwartz.
Lombard Street: A Description of the Money Market, by Walter Bagehot. On Econlib.
Articles:
"Two Crises, Two Ideas and One Question," by David Laidler. University of Western Ontario Working Paper, August 2012. PDF file.
"Reviving Japan," by Milton Friedman, Wall Street Journal, December 17, 1997, reprinted in the Hoover Digest, April 1998.
Hoover's Economic Policies, by Steven Horwitz. Concise Encyclopedia of Economics.
Money Supply, by Anna Schwartz. Concise Encyclopedia of Economics.
Monetarism, by Bennett T. McCallum. Concise Encyclopedia of Economics.
Milton Friedman. Biography. Concise Encyclopedia of Economics.
John Maynard Keynes. Biography. Concise Encyclopedia of Economics.
Irving Fisher. Biography. Concise Encyclopedia of Economics.
Robert Lucas. Biography. Concise Encyclopedia of Economics.
Podcasts, Videos, and Blogs:
Friedman on Money. EconTalk podcast.
Hanke on Hyperinflation, Monetary Policy, and Debt. EconTalk podcast.
Eugene White on Bank Regulation. EconTalk podcast. Banking regulations in Canada.
Podcasts with Allan Meltzer. EconTalk podcasts.
Podcasts with John Taylor. EconTalk podcasts.
Don Boudreaux on Macroeconomics and Austrian Business Cycle Theory. EconTalk podcast.
More EconTalk podcasts on Money, Banking, and Monetary Policy.
Highlights
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0:33
Intro. [Recording date: August 26, 2013.] Russ: So, I want to start with the Great Depression and Friedman and Schwartz's work. They had very revolutionary views of what caused the Depression and the failure of the economy to recover. What did they try to teach us in that book? Guest: Well, let's first remember that that book was from 1867-1960. It wasn't just about the Great Depression. What they tried to teach us about the Great Depression specifically was that it was a particularly extreme example of a pattern that you could see throughout American monetary history, namely that if you allowed the rate of money growth to collapse, you were going to bring about a downturn in the economy. More specifically, as far as the Depression was concerned, they argued that the Federal Reserve System turned a fairly routine downturn that started in 1929 into an absolute catastrophe by first of all failing to act to support the banking system in the first year of the downturn, and then just failing to take vigorous action to get the monetary system expanding again over the next two years. Culminating in the Bank Holiday of 1933 and the raising of the price of gold and all the rest of it. So, in a nutshell, the message was: the Great Depression was not a sign that there was some deep flaw in the market economy. It was the Fed's fault. Russ: And how have those arguments held up in the current crisis that we're in, sometimes called the Great Recession? Guest: Well, it depends on who you talk to. If you talk to Paul Krugman or read his blog, he's been very insistent that those arguments have been blown out of the water by the last recession. He argues that this time around the Fed did indeed react quickly and vigorously, and basically nothing happened. I think he's just wrong about that. One of the things that didn't happen-- Russ: Why? Guest: Well, one of the things that didn't happen this time is that the money supply didn't contract by about 30% in the wake of the financial market crisis. The price level didn't fall the way it did in the early 1930s. The inflation rate went down to about 0% but it stabilized. And though the first year of both crises in terms of contraction in national income and the impact on the labor market looked very alike, at the end of the first year things stabilized this time around rather than spiraling on down for another couple of years. So I think this time around we got pretty much what Friedman and Schwartz's analysis would have led us to expect. Now, that's not to say that the Fed couldn't have done better this time around. I think in hindsight people like me could argue they could have been even more expansionary. But that's another story. And of course there's another part of the story: that you had fiscal stimulus as well this time around, which you very much didn't have in the 1930s. So there's always an issue of sorting out just how much to attribute to monetary policy, how much to attribute to fiscal policy--all those old debates that have been going on since the 1930s, on and off. Russ: Let me just ask you one question about that. Hoover gets blamed for being a do-nothing president. But government spending did rise during the Hoover Administration, correct? Guest: Yeah, no, Hoover got a very bad rap. He really did. People forget that Hoover, when he was Secretary of Commerce, was a big supporter of the National Bureau of Economic Research's data collection and business cycle analysis programs. And Hoover's aim was actually to put in place a system in which the Federal government and the United States could deploy countercyclical fiscal policy. And indeed, when the Depression first came, that was what he wanted to do. The trouble was, the collapse was so prodigiously fast that what was available for the Fed to do was just, by no means, big enough. But the Friedman and Schwartz argument is then relevant here: basically the rather puny fiscal efforts that Hoover was trying to make were just undermined by the incompetence of the Federal Reserve System.
5:37
Russ: So, coming back to the Krugman criticism--and he's not alone, of course. Many people have argued that because of the lower bound of 0 on nominal interest rates, that the Fed is impotent: that it can't really do anything. You've argued that they've actually been somewhat effective; they could have been more effective, but they forestalled a disaster. What's your view on this issue of the so-called 'liquidity trap'--the idea that the Fed can't really affect any monetary policy as interest rates get as low as they have? Guest: Let's just get one thing in the history of economic analysis straight. This is not really an argument about a liquidity trap, that Krugman and people are putting in the traditional Keynes sense. It's an argument about what Ralph Hawtry in the 1920s and 1930s called a 'credit deadlock'--a state of affairs in which the business sector was so depressed that it just wouldn't borrow from the banking system. And because it wouldn't borrow, credit didn't expand; and because credit didn't expand, the money supply didn't expand. Now, Hawtry and other people in the 1930s were arguing: well, when that happens, the Federal Reserve System has got to be proactive; it's got to go out there and buy securities, buy long-term government debt, buy anything that's there and just stuff the banking system full of reserves until it starts lending actively on its own account. And I would argue that policies like that have been available this time, but the 0 lower bound is a problem for conventional everyday monetary policy that focuses on the overnight rate. But it's not an insuperable barrier to monetary policy when an economy is getting into trouble. It's just something you've got to take account of and you've got to do other things. And I do wish people wouldn't call these policies 'unconventional,' because they are not. They've been in the economics literature for nearly 100 years. Russ: Do you think Friedman would have been an advocate of quantitative easing (QE) along those lines? Guest: Well, I want to be careful here. Because Friedman is not with us. And a guy that imaginative, you're never quite sure what he would have said this time around. I think what we can say is that his analysis of the Great Depression and his analysis of Japanese issues--you know in the 1990s, roundabout the year 2000, 2001, he certainly was in favor of what we now call quantitative easing in those cases. I'd like to think he'd be in favor of it this time around, but I say you have to be careful. A striking feature of the recent debate was for example that the late Anna Schwartz, early on in this recession, was actually very critical of the Fed. That surprised me; but she was. So you can't count on these things. Russ: We're going to come back to the criticisms of the Fed from monetarists, which has been very interesting. Right now we're talking about the criticisms of the Fed from the people who are more advocating fiscal stimulus. But my question is that, you are suggesting that the 0-lower bound is not so relevant because the Fed can go out and buy assets and inject money directly into the banking system; that the interest rate issue is not so important. But how do you reconcile that, given that you give the Fed decent marks, with the fact that so many reserves have piled up in the banking system? And there seems to be so little expansion of credit? Guest: Well, first of all, since 2011 roughly speaking, money growth has picked up in the United States. Let me refer to another monetarist economist, Phillip Cagan, who did a lot of the background work for the Monetary History of the United States. The way he put it was this: When people look to the United States after 1933, many people argue that the Fed was expanding the reserve base; the money supply was growing a little bit more; but all of this was like pushing on a limp string. It still didn't get the economy going. And what Phil Cagan said was: really not so. The right analogy is pushing on a coiled spring. And you start pushing, and first of all the spring starts to compress and nothing much happens. But as you keep on pushing harder and harder and for longer and longer, eventually the other end of it begins to move. And I think we've been seeing that happening in the United States this time around. It's been remarkably consistent with the later 1930s, I think. I wish that QE3 was perhaps a little more vigorous, because money isn't growing quite as fast as one would like to see it; it's stuck somewhere in the 5-10% per annum expansion range, depending on which aggregate you look at. And I think the economy could stand a bit more of that. But things are now moving in the right direction. There is a recovery underway. It's not all that vigorous, but all the signs are the economy is coming around; and it's doing that in the face of some fiscal contraction, as well. Which I think is quite striking. Russ: Now, on this program in the past Steve Hanke has argued that using broader-based measures of money, other than M1 and M2, that growth remains well below its trend. The growth of the money supply. And that despite the expansionary aspect of the Fed, it hasn't offset the contractionary aspect of the shadow banking system's collapse and the regulation of that system that's contracted the supply. What are your thoughts on that? Guest: Well, I think--I'm not an expert on the day-to-day workings of the U.S. monetary system right now, but I think there's probably something to that. And I think it's probably consistent with my own judgment that the conventional aggregates--you know, M2 is not all that narrow, after all. There's quite a lot of assets in there. That that could be more vigorous without putting anything very much at risk. I know Steve Hanke likes those things called 'divisia aggregates.' Russ: Yeah; that's what he uses. Guest: Yeah, he uses Divisia M4. Now a divisia aggregate is one in which you weight the rate of growth of the particular component by its liquidity. So if it's a very liquid asset, you give it a bigger weight. Russ: It's more 'moneyish.' Guest: Right, more moneyish. And you measure its degree of moneyishness by the difference between the rate of return that's paid on that asset and some representative market rate of interest. Now all those spreads have narrowed. And what the divisia aggregates are showing is the rate of growth of, shall we say, M1--demand deposits, transactions money--is not getting the amount of weight in those broader aggregates as it usually does, because the difference between the 0 rate of return on that kind of bank liability and overall market rates of interest has shrunk. My general take on monetary aggregates is that there's no reason to suppose that one aggregate is going to tell you the story all the time, under every historical circumstance. You need to keep an eye on a range of monetary aggregates. And if they start telling you different stories depending which one you are looking at, then the next step is to go into the data and try to find out why. I don't think there are mechanical rules here to apply to policy. I wouldn't want to argue this. That's a long answer to a short question. I wouldn't want to argue with Steve Hanke about this. He's closer to the data than I am, and as far as I can see, what he's saying is consistent with what I've been saying. Russ: And that's just a way of explaining the slowness of the recovery relative to the depth of the shock. Guest: That's right. I've certainly been surprised at the amount of quantitative easing that the Fed has had to carry out to get the monetary system moving again. And, as I say, I'd like to see it moving even faster; but I'm not sitting in the policy chair wondering how I'm going to unwind all this eventually when the economy comes around. I don't think that's the problem for next year. I think we've got a way to go yet. Russ: That's a rare moment of honesty, even from an EconTalk guest. I appreciate that.
14:24
Russ: I want to go to a question that I've asked many times to different guests, and I appreciate my listeners' patience. But I think you actually have a lot of insight into this question relative to some of the people I ask. And that's the following. I was trained, as you were, at the U. of Chicago, and I was taught that when you think about monetary policy, you think about quantities. You think about the quantity of money. Now, you might debate or be unsure as you alluded to as to which definition, which aggregate measure is the right one. But we were told to look at quantities. If you want to understand the impact on the nominal economy, if you want to look at the impact of monetary policy on inflation, you look at money. The quantity of money. And yet, over the last 10, 15, 20 years, the Chairs of the Fed, plus many monetary economists, always talk about interest rates. What's going on there? Why are there two different approaches? Help me understand that. Guest: Well, what I think happened was that people like me, in the 1970s and 1980s, overstated the case for the reliability of the rate of growth of the money supply as the anchor for monetary policy. Things didn't work out as well as expected in a number of places. You also have Milton Friedman's really catastrophically bad call at the end of the Volker disinflation, that double-digit inflation was just around the corner again. And central banks were put off relying on money growth. And I think they threw the baby out with the bathwater. I think money growth targeting wasn't very effective for a policy framework; but I don't think that was a good reason to stop looking at these variables altogether. But a lot of people did. And parallel to that, of course, you had developments in monetary theory, starting in the 1980s, 1990s. Big names there, people like John Taylor and Michael Woodford, Lars Svensson, who started building models of monetary policy in which they simply cut out the financial system altogether and just concentrated on direct links between policy interest rates and the level of spending in the economy. And that kind of model works just fine when the monetary system is functioning. When the monetary system is functioning you can ignore it. And I'm afraid we had about 15 years when leading scholars of monetary economics just cut the monetary and financial system out of their analysis. And that's been a shame. I hope that one beneficial side effect of the last few dreadful years is that people will start paying attention to those monetary aggregates again. Just as a side remark: In Europe, the European Central Bank had a reference value for the rate of growth of M3 as sort of backup to its regular policy-making framework. And for reasons that are quite beyond me, this reference value disappeared altogether in the last 3 or 4 years. Money growth has been incredibly sluggish in the EU (European Union); and look at the stagnation in that economy. I don't think that's an accident. Russ: Is there a parallel in the U.S. economy? I remember after I interviewed Milton in 2006, I questioned him about one of his claims about the Great Moderation--which we were of course at the tail end of at the time; we didn't realize it. It was one of the thrills of my life that a 90-plus-year-old economist--I think Milton was 92 at that point--sent me a spreadsheet and he said, Oh, you don't want to look at M1; you want to look at M2. And M2 was very, very steady, as he had essentially claimed. But it hasn't really--has M2 reflected this crisis that we are in? Guest: My recollection is that it did indeed. That its growth rate really went into a bit of a spin after the collapse of Lehman Brothers. But that in the last little while it's got back again. Yeah, I've just got this up on my computer screen just to check, and M2 at the end of 2008 was actually growing for a little while close to 10%, it just peaked; and then it went into a spin and almost got down--its growth rate--to 0%, by early 2010. And then the growth rate has been coming back since. So, what you don't find in the U.S. monetary aggregate data is any sign that there was going to be a major downturn starting in 2008. There's no big contraction in money growth before the downturn started. That's one of the mysteries about this particular episode. But once it got going, you got this spiraling downwards. And, as I say, this time around, unlike the 1930s, the Fed's expansionary reaction to that put a stop to the contraction before it gathered too much momentum. Russ: Well, obviously there's a cause and effect issue in monetary policy, especially when it's linked to a financial crisis. And as you point out-- Guest: Well, that's right. The process is a recursive one. Monetary policy causes the economy to contract; and a contracting economy, if you don't watch it, starts making the money supply contract even further. That's what was going on there. Russ: And I would say especially if it originates in the financial sector. There's some debate--you allude to it in your writing--about what I would call the 'real side' or the microeconomics side. And you point out that the Austrian view, the idea that both the 1929 collapse and the current mess did see a very rapid run-up on asset prices that suddenly collapsed; and that obviously caused some challenges for the financial sector. Guest: Yeah. I mean, that's right. People keep calling these things 'financial crises'. They are really asset market crises. And they happen on the margin between markets for financial assets and markets for real assets. Like real estate and factories and physical investment. I don't think the monetarist story of the onset of the Great Depression by the way, or the monetarist story about the onset of this Great Recession, is quite plausible enough. I can't find anything in the data in the 1920s or the data in the run-up to this event, that shows a degree of sort of conventional tightening of money growth that can account for the speed of the subsequent downturn. That really looks like, in both cases, an economy where something was going badly wrong in real asset markets, and it just needed a little bit of tap from the financial markets to set a downward spiral going. And, you're right--the Austrians were the pioneers of this kind of analysis, in the 1920s even; and of course there are still Austrians around. And if I may sort of put in a plug for Cambridge, England, where John Maynard Keynes was, Keynes's colleague, Sir Dennis Robertson was developing a parallel analysis to this in the 1920s. And he wrote a little textbook; and its 1928 edition has got a couple of paragraphs expressing his fears about what was likely to happen in the United States if that asset market boom kept on going. And this was before the Great Depression and before the stock market crash. In contrast, the representative of monetarism in the United States in the 1920s was probably Irving Fisher; and Irving Fisher didn't see anything coming. He was just concentrating on the behavior of the price level and saying all is well, right down to October 1929. And indeed afterwards. So, I think we've got to give the Austrians and Dennis Robertson some credit. And I'd like to see our profession start taking that analysis a little bit more seriously. I mean the mainstream of our profession; because of course the people who have been propounding it are certainly professionals themselves. But they are in a minority.
23:13
Russ: Yeah. I think the biggest challenge--you refer to it in one of your working papers, a very nice paper--you refer to monetarism without money, meaning this focus on interest rates. And I would phrase that a little bit differently, which you alluded to a minute ago, which is: Macroeconomics without the financial sector seems to be not a good idea. But the division of labor is limited by the extent of the market. And as economists have gotten more successful and there are more of us, we've specialized a lot. It seems to me now that economics needs to integrated that a little more successfully. Guest: Oh, I think that's right. Let me give you a sort of quick take on what I think happened. We talk about a market economy, and we talk about markets determining prices and allocating resources and all the rest of it. And if we go to the world we live in, what we see is, when we look and see how markets actually function, it's: we exchange goods and services against money or in credit transactions, and money passing from hand to hand, credit transactions among agents are absolutely fundamental to the way in which the markets work. Fair enough. But we can't model the monetary and financial system every time we try to address an economic problem about the effectiveness, shall we say, about tax policy or the desirability of a free trade deal with some other country. So we abstract from it, and we talk about the market functioning. Now, that kind of analysis, that microeconomic analysis, has been enormously successful, and one of the big movements in macroeconomics in the last 30 years has been to use that kind of microeconomics as a basis for macroeconomics. Well, my take on that has always been, is that abstracting from the monetary and financial system is all very well for many problems, but not for the problems of the macroeconomy. And you've seen a lot of people trying to put monetary and financial factors back into this kind of model of the market economy, not realizing that it's already in those models. A tacit assumption that the monetary and financial systems are functioning all very well, thank you. So they are trying to put the monetary and financial system into the same model twice, with different assumptions about the way it works. And it comes out as a bit of a mess. And I think that's where we've been. Russ: Before I move on, do you want to say anything about the decision by the Fed to pay interest on reserves? Why you think they did that and if it has any significance? Guest: Gee. If I remember, Milton was in favor of paying interest on reserves way back in the 1950s with his program for monetary stability. Russ: What was the argument he made for it? Guest: The argument was that if you paid interest on reserves you would give the banking system less incentive to try to evade the reserve requirements, and hence you would give the Fed more control over the behavior of the monetary aggregates. That was the essence of Milton's argument. The other argument for it that became very popular in the 1970s, up here in Canada at least, is that forcing banks to hold non-interest-bearing reserves was putting a tax on banks; and there was no particular reason for taxing those institutions. So, pay them interest on reserves and relieve them of that tax. The way we went in Canada was the opposite direction: we just phased out reserve requirements and essentially we've got a monetary control mechanism that no longer relies on the reserve base. But that's a different story, and it's not a story that's 100% relevant to the way things work in the States. I'm sorry--I haven't really given a straight answer to your question. Russ: Well, let me ask it a different way. Guest: I haven't lost any sleep about the Fed paying interest on reserves; I really haven't. But I do notice that it makes the banks more willing to hold the proceeds of quantitative easing without getting out into the market and making loans, and I wonder if the Fed noticed, paid quite as much attention to that side effect as it deserved. But that's a technical detail in the execution of policy, and takes us back to: Has policy been expansionary enough?
27:43
Russ: But it's a nice segue to the next topic, really, which is some of the criticism of the Fed that have been coming not from the fiscal side but from monetarists. I'm going to read a quote from a working paper of yours, talking about criticisms of the Fed:
that it has exceeded the bounds of its responsibilities as lender of last resort by rescuing insolvent investment banks and insurance companies rather than limiting itself to providing liquidity to solvent commercial banks; that by co-operating with the Treasury in many of these activities it has surrendered its policy making independence, and that the massive increase in its cash liabilities that has resulted from these policies and subsequent quantitative
easing, carries with it a serious inflationary threat.
So, why don't we take these one at a time. Guest: And be clear: I was trying to paraphrase people I was disagreeing with. Russ: I understand. This is not your view. But I thought it was a fabulous summary of what many people have accused the Fed of. You are going to defend the Fed against most, if not all, of these charges. Let's start with this one of, traditionally--goes back to, I suppose, Bagehot, who said that the Fed should be the lender of last resort, but only solvent banks; it shouldn't be propping up insolvent banks. And yet the Fed seems to have propped up everybody, once Lehman Brothers failed. Guest: Well, first of all, Bagehot didn't say that. Okay? If you comb Lombard Street on your computer and look for the word 'solvent', you are only going to find it in one place; and he's talking about Britain being solvent in a case of a balance of payments crisis. So Bagehot really didn't say that. He said some things about you probably don't want to bail out really badly run institutions. But he thought that that was a minor problem. I think something that people have forgotten about these principles of the lender of last resort that we inherited from the 19th century--when Bagehot wrote Lombard Street, there was no limited liability in banking. Okay? The banks were partnerships or they were joint stock companies, but there was unlimited liability on their owners. So the notion of an insolvent bank in 1873 was a very different thing to a notion of an insolvent bank now. Okay? Russ: That's a good point. Guest: It's a family business; the family has to be broke before the institution is insolvent. Russ: But it doesn't change--and I appreciate what you wrote; you wrote that the world changes and Lombard Street doesn't exist any more, so we need to be thinking about this in a different way. And I certainly accept that, the logic of that. The problem is, the way I understand Bagehot--whether I'm right about it, and I apologize if I'm misrepresenting him about the solvency issue. But basically, the thing that was appealing about that is you don't want to be the lender of last resort to every bank, because if you are, there is a terrible moral hazard problem. That banks will have an incentive to misbehave; their creditors, more importantly, will have an incentive to lend imprudently. And it seems to me we've gone down a very dangerous road. But you are more sanguine. What's your optimism? Guest: Well, it is a dangerous road. But the whole, that's because the financial system is a dangerous place when a crisis is beginning. The first issue is: Can you really tell the difference between a solvent institution and one that's just lacking in liquidity when there is a run on it. Northern Rock, for example, the first example in British history for heaven knows how long, over a century, of an institution that had customers lining up outside the doors to get their cash. Now, as far as I can tell, Northern Rock had a pretty good, solid portfolio of mortgages. There was nothing the matter with the mortgages it was holding. Its problem was that its supply of lending in the commercial paper market had just dried up, as part of the worldwide commercial paper market collapse. And it was a classic issue of an institution being short of liquidity. But the Bank of England sat on its hands, just for a little while; allowed this run to develop. And by the time they got everything settled with Northern Rock, the financial crisis had taken its toll; the economy had turned down; and what had started out as a liquidity problem for that institution did indeed turn into a solvency problem. But you can make a cogent argument that the reason it did turn into a solvency problem was that the liquidity problem wasn't handled early enough. A similar thing where an argument can be made about the case of the Bank of the United States in 1930 in New York--that the Fed let that one go broke. And yet they paid a pretty good proportion of their debts when the bankruptcy was finally settled in, I think, 1932 or 1933. It's not clear that they were insolvent. They might have been illiquid. But the point is, it's difficult to tell the difference, and I would rather err on the side of making sure the financial system doesn't start to seize up. So, I'm not too keen on a strict interpretation of that solvency, the liquidity-solvency thing. I would rather err on the expansionary side, to keep the system moving. Russ: Well, I take your point. Guest: I mean, a lot of people would disagree with me. I don't think it's the kind of thing that you can lay hard and fast rules down about. Similarly whether you should stick only to banks. Well, there are two arguments about what the lender of last resort should be doing. The first is the traditional monetarist one. The real object of the exercise is to stop the money supply from contracting. So, keep the institutions whose liabilities make up the money supply in business. There's another argument that says what's really important is the market for short term interbank credit, because that's what oils the wheels of commerce and keeps industry going; and you've got to make sure that those markets don't get disrupted. That's the kind of argument that's associated with Ben Bernanke's work. But if you actually go back to the 19th century literature, you'll find both of these arguments around, even in the 19th century. And the second argument, the Bernanke-style argument in particular, which by the way was also partly Bagehot's, that's an argument that says you don't want to be too strict in drawing the line between what's an institution that's the kind of institution that you are going to rescue and what's the kind of institution you've got no business going near. Once again, if the collapse of a merchant bank, or the collapse of an insurance company, is going to impinge on the ability of the commercial banks to function, it's the job of a lender of last resort to make sure that doesn't happen. And again, there's a lot of precedence for this. The Baring Crisis of 1890 in London evolved because Baring Brothers, who weren't a commercial bank--they were a merchant bank--were marketing Argentinian bonds in London. And they got caught with big inventory of Argentinian bonds that they couldn't sell. And the Bank of England essentially organized a bailout of Baring Brothers by getting their creditors to hold off calling in their debts until the episode was over. It was a little bit like the way the Fed handled the Long Term Capital Management. Russ: Yep, the same thing. Guest: There was an eerie similarity. And that's lender-of-last-resort activity, but it's not the traditional lend-freely only to solvent banks in order only to stop the money supply collapsing. So, there's a lot of precedence for these things.
35:53
Russ: So, reminding myself, or warning, our reminder earlier that we're not sitting in the policy chair; we're just having a nice chat on a late summer afternoon: It does seem that that viewpoint, which I totally understand from a policy-maker's perspective--you know, err on the side of caution, make sure that you don't let the banking system collapse. Once we're in that world, which I would argue is the world we've lived in for the last 25 or 30 years, we've created a situation where the large creditors of large financial institutions know that they are part of a complicated, tangled system. Now, we could debate whether that is the result of policy mistakes, or policy decisions, or whether it's just some natural progression of technology and globalization. Doesn't matter. That's the world we live in. In that world, the presumption is: Intervene. The presumption is: Lend. The presumption is: Rescue. The presumption is: Bailout. We're in a world where that sector of the economy is effectively being highly subsidized by this inevitable decision. It seems like a very unhealthy political economy. Guest: Well, I think you've said two things about it. First of all, to the extent that the monetary and financial system are public goods as well as made up of a lot of private-sector institutions there is a sort of traditional case for the provision of public goods with subsidies that comes out of welfare economics. I don't want to make too much of that. But I think one has got to distinguish among who actually gets bailed out in these operations. If financial institutions make dumb loan and look like collapsing, I'm 100% in favor of their shareholders losing all their equity and I'm 100% in favor of the managers who made those mistakes being flung out on their ear. And if it turns out there's been fraud involved, being prosecuted and put in prison. What I would like to do is keep the network of credit markets functioning and stop the money supply collapsing. And I would have thought it was possible in a rough and ready sort of way at least to devise a policy that does that. I mean, an awful lot of people lost an awful lot of equity by holding stock in the wrong banks in the United States. Russ: But they're the wrong people to look at. They are the people who rolled the dice, diversified, a lot of them made a killing along the way; some got out in time, some didn't. It's the creditors, the fixed income folks, who worry about the solvency of the institution, not the equity people. The equity people don't want to be wiped out obviously. But you get the upside. The creditors don't get the upside. If you take away the downside risk for them, the loss of bankruptcy and a haircut, potentially 100% haircut, we've got it seems to me a very unstable system. An unhealthy system. And you alluded to the fact that in the old days, banks were partnerships and we've moved away from that. And I argue that's because we've subsidized moving away from it. Guest: Yah, but you surely can devise means of keeping the institutions functioning while having some of their bondholders take some fairly sizeable haircuts, and stop the entire financial system from collapsing. Look, I'm not arguing that moral hazard isn't a problem. What I'm arguing is that when a financial crisis gets going these things happen so fast, policy makers have to make decisions; I would just as soon they erred on the easy side. But I recognize the moral hazard issue. And I don't have a straight answer to it. I recall Charles Goodhart in England saying, some time in early 2009, that moral hazard is something we worry about next year; for the moment we have to keep the financial system functioning. And there is a lot to that. Russ: Yeah; it's the road to hell, too, if you are not careful. Right? Guest: I take it--I've heard the argument made and I don't have a straight answer to it. Somebody had to be allowed to collapse and it may as well have been Lehman Brothers. Russ: I think you said the right thing when you said there is a way to design a system that keeps some of the incentives. But for some reason--I think we know the reason, political reasons-- Guest: Yeah, yeah-- Russ: it doesn't seem to happen. I'm not so much disagreeing with you as the tendency we have as economists to advocate what we think is the best policy, neglecting the fact that the way we want it implemented and the way it actually gets implemented is not the same thing. Guest: That's fair enough. That's a fair enough point. I won't pretend to have a straight answer to it, because I don't. I really don't.
40:47
Russ: Let's go to the second part of your response to the critics of the Fed's behavior, which is to me incredibly interesting, especially given the history of monetary policy. Many monetarists, Allan Meltzer being one who I've interviewed on this program who has said exactly what you were criticizing, have said that this Fed policy of massive quantitative easing, the enormous buildup in high-powered money on the balance sheet of the Fed, is going to cause huge inflation. It's going to be very disastrous. We know inflation is a terrible virus once it starts to spread. And yet nothing has happened. They've been forced to argue--and I'm one of those people; I'm not an expert, don't pretend to be one, but I still thought it was going to happen--we've been forced to say: Well, it's coming; it's just a matter of time. What are your thoughts on that? Guest: Well, first of all, I really don't understand particularly why Allan has paid so much attention to the behavior of the monetary base and so little to the behavior of the money supply during this episode. If we go back to Friedman and Schwartz and the story of the early 1930s, between 1930 and 1933, the monetary base actually expanded. Not very much--about 2 or 3% per annum was the average rate of expansion. The money supply collapsed by about a third, and the economy collapsed. Now that to me is devastatingly powerful evidence that what matters is the money supply and not the monetary base. This time around we've had this huge expansion of the monetary base, and believe me, nobody's been looking more closely at the behavior of the money supply more closely than I have to see when that was coming through. And beginning to register an inflationary threat. But here we are, what--4, 5 years later, and it hasn't happened yet. Well, the people saying it's going to happen eventually: Yeah, maybe it is going to happen eventually. If I may just deviate for a moment, my first senior colleague in monetary economics, my first job, was Hyman Minsky. In 1963 he was explaining to me that our financial crisis was just around the corner. And eventually Hyman Minsky was right. But it was 50 years later, almost. Yeah, they'll be right eventually. But I've asked Allan, and I don't think I've really had a very good answer: Why are you paying so much attention to the monetary base and why have you been paying so little attention to the behavior of the money supply this time around? And he tells me that the monetary base is the policy instrument; policy is our measure; it's extremely expansionary, and policies like that have always led to inflation eventually in the past. Well, maybe he'll be right eventually, but I see no sign of it yet. Russ: Yah. When I asked him--and this was a few years ago and it still hasn't happened yet, but when I asked him at the time, his argument was that when the economy started to recover, those reserves that the banks are holding at the Fed would start to go out into the economy, and there would be terrible pressure on the Fed to let that happen at high levels, because the economy would be recovering. It would be very difficult to tighten at a time when the economy is finally starting to recover. And it hasn't quite worked that way. The recovery has been so mediocre, there hasn't been this sudden, exhilarating whoosh of money and confidence. Guest: No, there hasn't. These are exactly the worries that the Fed had in 1937, when it doubled reserve requirements. There were lots of free reserves building up in the system, and the Fed was very nervous that it was going to lose control of the money supply. There was an expansion going on; they doubled reserve requirements and what happened was that the banks that were subject to those reserve requirements immediately built up a stock of reserves again. That contributed to a downturn in the money supply, and that downturn in the money supply contributed to the recession of 1937-1938. So, I think there have been precedents for this kind of behavior in the past. And I'm glad the Fed hasn't followed Allan's advice this time around. And I'm frankly a little bit nervous even now about the sort of rumbling about beginning to phase out QE3. I hope they don't do it prematurely, because we've been there before in the late 1930s.
45:31
Russ: What about John Taylor's arguments. He's been very critical of Bernanke. He's very critical of Greenspan in the run-up to the crisis--although that was ex post criticism: he was in the Administration at the time of those decisions and maybe was not so eager or comfortable being critical at the time. But certainly ex post he's been very critical of Greenspan and Bernanke. What do you think of those criticisms and the idea of a monetary rule that would be interest-rate based? Guest: Well, two things. First of all, I mean, I was critical of the Fed in those years as well. I thought the Fed should have raised interest rates a little bit faster in 2005, 2006. We did have an upward blip of interest rates here in Canada, which was separate from anything that happened in the States. And I think that just put a damper on the economy in the nick of time. And I wish the Fed had done that. And I did actually say so at the time, not that anyone would take any notice. So I think there's something to John Taylor's argument there. It boiled down to whether in the States you took the indicator of inflation as being the behavior of the Consumer Price Index or you looked at something more esoteric, like the Core Personal Expenditure Deflator (CPCE). And the Fed were looking at the CPCE, and that of course, because it's a core index, it takes out the behavior of food and energy prices. And it missed a fairly significant uptick in inflation in fact, as a result. So I think there's something to John Taylor's argument about the Fed not having been careful enough in the run-up to this crisis. But that having been said, I still think you've got to look at something more deep going on in asset markets to explain the severity of the downturn. Russ: So, you think it's much more than just a monetary phenomenon. Guest: Yeah, I do. I never thought I would live to say this, but on this particular instance, I'm inclined to line up with the Austrians. I think they really have a point about this issue, about asset market distortions. After long periods of monetary stability. Russ: This again puts you in a small group of economists who have learned something from the crisis. Most economists--I find it remarkable how many people have managed to keep their theological views unchanged by this experience. Guest: Well you must remember that I'm retired, so I don't have to worry about pleasing journal editors any more. Russ: Yeah. Well, no comment. What would be your view on, going forward, would be the ideal monetary policy? Should we be doing something like the Taylor rule? Do you think anything positive about Scott Sumner's approach and that of others who argue for nominal GDP targeting? Milton at one point--he changed sometimes, but he argued for a steady growth rate in the rate of money. Where do you think we are right now? Guest: Let me back up. Let's think about a state of affairs in which we are out of the aftermath of the recession. So, two or three years more down the path. I still am pretty happy with the inflation rate as the target of policy. I base this a lot on Canadian experience. We've been targeting the inflation rate since 1991; we've done it pretty successfully. We didn't have a big asset market crisis here. We had not had a recession until 2008 since 1991. So inflation targeting worked pretty well for us. And it worked I think because it was a very explicit policy target agreed between the government and the Bank of Canada. It wasn't an informal thing, as it was in the Fed. It was discussed continually. And as time passed, the targets were hit and it gained in credibility. So I would see no reason to go from that to a nominal GDP target. I don't like nominal GDP as a target for policy, for the simple reason is: that's a variable that's measured with a lag and it's subject to a lot of revision. And I don't see how you can run forward-looking monetary policy targeting the behavior of a variable that you don't get a good reading on for 18 months after it's happened. With inflation targeting based on a Consumer Price Index, you get timely data and it's not subject to revision. The indices are not perfect, but they are well understood by policy makers and the general public understands them as well. If I tell my wife the Bank of Canada is targeting nominal GDP, she'll just look at me and wonder what on earth I'm talking about. If I tell her they are telling her they are targeting the rate at which the cost of living goes up, she understands that. And knowing that there is that target out there affects the behavior of ordinary consumers and producers, not just financial markets. Russ: Yeah, I think that's very important. Guest: So I'm a big fan of, first of all, the target of policy should stay the inflation rate. Now, in the 1990s we developed this kind of policy model that John Taylor made huge contributions to, in which the central bank used this control of the overnight rate, the Federal Funds rate in the U.S. context, to target the inflation rate. So long as the economy was running along fairly smoothly, that kind of model worked. I think we got the Great Moderation, as it was called, out of that kind of policy, and I don't think you can take that kind of achievement away from people like John Taylor. But the trouble with that policy regime, if you think of it as a complete regime in and of itself, is that it's for fair weather. It's a policy that works so long as the economy is running smoothly, and the shocks that come along are fairly small. But it's really bad for the kind of stormy weather that we've had in the last 3 or 4 years. The 0-lower-bound problem for interest rates is a big manifestation for that in that particular literature. These guys really didn't know what to do about it, and now they've started talking about unconventional policies. So I think there is a role for a secondary policy regime, as well, if you like, that goes back to Friedman and doesn't have a rigid target for the rate of the money supply but monitors the rates of growth of the monetary aggregates. So long as it's not telling you anything different from the conventional analysis, well, you just get on with it. But when it does occasionally start giving you different information, you go behind the numbers and ask why, and maybe modify your policy stands, if the monetary aggregates are telling you, giving you some extra information that isn't there in the interest rate based model. This is messy and it's eclectic, but I don't think we can do much better in the current circumstances, quite honestly.
53:00
Russ: Now you mentioned the Canadian experience. My impression is that not only did you not have a recession between 1991 and 2008, but your 2008 experience was not nearly as drastic as the American one. Is that correct? Guest: That is correct. We did not have a big asset market crisis in Canada. We largely imported that recession from the rest of the world. Russ: And isn't it also true that in the Great Depression the Canadian economy did better than the average economy? Guest: I don't have those numbers right in front of me but the Canadian economy didn't do very well in the 1930s, I know that. What is true is that there weren't any bank failures in Canada during the Great Depression, though we had all the agricultural problems and we had all the backwash from collapsing export markets and things like that as well. So that's not an experience I would want to repeat. Russ: No, but the bank failure part of it--you'd think Americans would look and say, hey, here's an economy, rather close--next to us; they treat their banks differently than we treat our banks; their banking system seems dramatically more stable. Stability is a good thing. We don't seem to copy you guys. Guest: Well, we've got 5 big banks and a few more smaller ones. Russ: That's what we have. Our 5 are just bigger than yours. Guest: Well, you are finally catching up with us. These guys have got a long tradition of nationwide branching. They are quite tightly regulated. I don't know what more to say. In part Canada escaped this time around because we got a bit lucky. We did have a problem in the commercial paper market in 2007. But our mortgage market was much more controlled and regulated than the U.S. mortgage market. In fact, the government was in the process of deregulating the mortgage market in the run-up to the Great Recession. It's just that the deregulation hadn't got far enough to do serious damage. And spent the last 2 or 3 years re-regulating the mortgage market and putting things back where they were in about 2004. So I think we got a bit lucky. We also, I think, had some banks with good managers who--I remember hearing about the 'ninja mortgage' from a senior economist in one of our big commercial banks, again, before the crisis; and he explained to me what a ninja mortgage was, and I said: Well, I hope you are not going to buy any of those. And he said: You bet not. Well, lots of other financial institutions south of the border did, but by and large our banks stayed out of that market. So, a combination of good luck, good management. Canadian banking's got a 200-300 year history. I don't think you can export 200 years of the history of institutional development just like that. We didn't have Andrew Jackson as President, you know? Russ: That's true. But I do see it as a public choice problem more than a paying-attention problem. I think if your realtors and home builders were as powerful as ours, maybe you'd have the government subsidizing home ownership as perilously as we have. And I think that's a huge part of the problem. Guest: Well, our government does subsidize home ownership of course through a mortgage insurance program. And the mortgage insurance program was pretty tightly regulated. And they began to deregulate it. I think if the United States had taken another 18 months to turn down, we might have been following with a big collapse in the mortgage market. But it just hadn't got going. The problems hadn't developed far enough.
57:02
Russ: Let's close and talk about Keynes. When you were in graduate school, Keynes was on the rise. Keynesianism was the dominant view. And you played a role, the role you played with that book, The Monetary History of the United States--you were part of that counterrevolution that Friedman and Schwartz led along with others you mentioned. Phillip Cagan; of course there were many others. In a way it started back with Irving Fisher, who was opposing Keynes before Keynes came along. But there became during the beginnings of your professional career a different view of the macroeconomy, of the business cycle. And monetarism became much more important, which was so dormant; nobody paid any attention to it 5-10 years before that. We are talking about the late 1930s, 1940s, and 1950s. So, starting in the 1960s with Friedman's work--he was certainly at the vanguard of it--in the late 1950s and then the 1960s and 1970s Friedman launched, with the help of others, a counterrevolution. What has happened since then? It's a rather remarkable seeming to me resurgence of the Keynesian viewpoint. What are your reflections on that and what do you think has happened? Guest: First of all, just to go back to my own intellectual origins, it's pretty important to remember I did the history of economic thought both as an undergraduate and as a graduate student. So, I have, for example, Lionel Robbins, who insisted that I read Henry Thornton's Paper Credit; and I'd read Bagehot's Lombard Street. I had read some of the literature of the 1920s as an undergraduate and a graduate student. So I wasn't ever in a position to be persuaded that everybody had been talking nonsense before Keynes came along. Maybe I had an unusual education. Russ: He wasn't the first macroeconomist. Guest: No; but I also read the Tract on Monetary Reform, you know, which Milton said was his favorite book by Keynes. That's the quantity theory book that deals with post-WWI monetary problems. In a very monetarist framework, by the way. So I knew that Keynes was one of these agile minds. And I don't know where he ended up. I know that his book How to Pay for the War was again very much in a monetarist tradition. He switched from his analysis of the world as always in depression to--a flexible mind--he said: Now we have to worry again about the economics of scarcity and how to allocate scarce resources in order to finance the war effort. And actually, Keynes's work on that was one of the roots of Milton Friedman's monetary economics. Friedman himself didn't know that. Friedman, when he was a young man, became aware of the 1941 British budget and its analysis of the inflationary gap and how to deal with that; and he didn't realize that was Keynes's budget. But he picked up that analysis and brought it into American debate through his articles on the inflationary gap and things like that. Okay, I've sort of made a big detour from the second part of your question. Russ: But fascinating. Keep going. Guest: I think what's happened in the interim, is that the monetarist counterrevolution never got really brought to fruition. What happened was that Bob Lucas and co. came in with rational expectations modeling. This was really a wonderful source of research topics for graduate students, and the whole profession went running with it and began to forget the kind of institutionally-based empiricism that went along with Friedman and Schwartz, in particular. It's remarkable that the most influential work of the monetarist counterrevolution wasn't a work of economic theory. It wasn't a work of high-powered econometrics. It was a work of narrative economic history that dealt with the evolution of institutions and their interaction with economic experience. Well, all that went out of the board with this fancy rational expectations modeling. Which had its benefits. But monetarism faded into the background. Now, by the time we got down to 5 or 6 years ago, we had a framework called 'dynamic stochastic general equilibrium analysis.' Which is the basis of all those John Taylor style policy models which central banks use, which literally was not capable of encompassing financial crisis within its intellectual framework. Bob Lucas himself said this in 2003--we've got some really good models but this is a residual--'residue of its use' was his phrase--they can't deal with. Like the Great Depression and financial crises. Well, we've had to deal with those things. And some people, like Paul Krugman, who were unreconstructed Keynesians, noticed it was time for a rematch between their very old-fashioned brand of macroeconomics and another old-fashioned brand of macroeconomics called monetarism. And they've been leading that debate. And I'm not quite sure where the up-to-date mathematical guys are at the moment. I think they are desperately trying to integrate financial markets into those models and catch up. So the whole state of macroeconomics at the moment is very, very fluid indeed. Russ: You are very honest about it. I think a lot of people I've read say: This fits; I don't have to change anything. Some of those folks have Nobel Prizes. I find that-- Guest: What I really find depressing is the way some of these guys--you must have heard the phrase--that they are introducing 'financial frictions' into the models. And this seems to me to be just bizarre. Just listen to what they are saying: We have a model of a smoothly functioning economy which we thought was adequate and it turns out not to be quite adequate--oh, there's a financial market and that introduces frictions into the economy. Well, that's bizarre. What's the financial and monetary system for? It's to overcome the frictions that are inherent economic life, that actually it's there to make a market economy possible in the first place. So these guys have still I think got things upside down. Which doesn't mean they aren't going to produce models that won't be useful. I've been surprised often enough in that respect.