Wednesday, October 13, 2010

On Monetary Policy

Today I finally got around to reading Lawrence H. White's paper from a few years back entitled "Did Hayek and Robbins deepen the Great Depression?" in which White points out that:

1. The Hayek-Robbins Austrian business cycle model was not used by nor was it influential on the U.S. Treasury or the Federal Reserve of the 1920s and early 1930s.

2. The Hayek-Robbins model calls for monetary policy that stabilizes nominal income (PxY).

3. Both Hayek and Robbins, contrary to their model, called for a deflationist liquidation during the Great Depression which they both later regretted and recanted. Hayek later stated that there is no useful role for deflation in such setting.

(HT: David Beckworth)

I got there because of this week's buzz about the minutes from the latest FOMC meeting indicating that the FOMC had a discussion about both price level and NGDP (PxY) targeting. I have been "converted" to this idea by Scott Sumner and a few other economist bloggers whose voices have grown louder over the course of the last year in the face of falling inflation expectations and a prolonged economic recovery.

I find it interesting that Hayek's idea above, and his agreement with Milton Friedman in regards to the Fed's role in the Great Depression, is rejected by many Austrians, who I would call "hypercalvinist Austrians."

It's worth noting, however, that both New Keynesian-type and Austrian economists believe the Fed "leaned with the wind" both in the 1920s and the 2000s. (*update* okay, maybe I'm wrong about this). During a time of increasing real output/income (increasing productivity) the Fed responded by pushing down interest rates. David Beckworth has been one of the biggest critics of the Fed about the 2002-2006 period, as is John Taylor (ie: the Fed inflated the housing bubble). In the 1920s it was because the Fed was following a "real bills" doctrine that White describes in his paper, while in the 2000's we were too worried about becoming Japanese. The Fed saw disinflation and panicked.

Meanwhile, the difference between New Keynesians and New Monetarists has apparently narrowed to nothing. Krugman calls himself a New Keynesian (which some take issue with) and he calls guys like Sumner "quasi-monetarists," which they take no issue with--and both camps are on the same page in regards to the Fed. New Keynesian stalwarts like Greg Mankiw long ago called on the Fed to break the "liquidity trap" using unconventional monetary policy--with most quoting Milton Friedman along the way. And these folks have firmed up my beliefs in the importance of PxY or aggregate demand.

The only camps left out in the cold are those who believe that:
1. There is no such thing as aggregate demand.
2. Aggregate demand must never be mentioned-- we must only talk about the supply side.

Such people have spent the last couple years warning of hyperinflation due any minute, claiming most of our unemployment is either voluntary or structural, and generally wanting everyone to forget that they told us the Dow would hit 36,000 soon or that housing prices wouldn't necessarily fall very far, or that the Bush tax cuts would pay for themselves.

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