Loosey Goosey and the Four-Letter Word

Quiggin (September 1st, 2013):

The idea that the stance of monetary policy can be assessed as expansionary, neutral or contractionary depending on whether the interest rate controlled by the central bank is at, above, or below its real long run average neutral value isn't just mine. It's that of nearly all economists, notably including the US Fed. Update The neutral value changes gradually over time in response to a variety of factors, but is sufficiently stable that it can be regarded, for most purposes, as a long-term average, typically assumed to be in the range 1.5 per cent to 3.5 percent. End update Sumner claims that “People get defensive when I make fun of the view that low interest rates mean easy money” but doesn’t name any names. Does anyone really deny that this is the standard view?

Timewarp Sumner (August 29th, 2013):

I have to admit that Quiggin is right. Most economists do equate low rates with easy money. That is the accepted definition. How that occurred, how the lunatics took over the asylum, is beyond my comprehension.

Here's the thing. A measurement is a comparison. To measure the size of the hole in my head you put a tape measure to it and make a comparison. Same is true with easy and tight. Tight money is tight compared to easy money. Easy money is easy, compared to tight money.

But what if you want to look at a moment in time -- like now, say -- and see whether money is easy or tight? How does that work? It's still a comparison, but what do we use for the tape measure?

Quiggin compares the interest rate to its "neutral" or "long run average" value to determine whether monetary policy is easy or tight. Scott Sumner compares NGDP growth to its long run average value to make that determination. Sumner writes:

Woodford and Bernanke are right; the stance of monetary policy depends on outcomes like NGDP growth and inflation, not interest rates and the money supply.

But Sumner makes the monumental mistake of applying "other things equal" to the real world. He assumes that nothing else has changed that could possibly be depressing growth, so that if growth is slow it must be because money is tight. But if there is some other factor causing slow growth -- or if there could be such a factor -- then Sumner's evaluation cannot tell us whether money is easy or tight.

If there is some other factor making NGDP growth sluggish, easy money is probably not the solution. If there is some other factor, Sumner's whole argument falls apart.

And what else could possibly be responsible for slow growth? The four-letter word: Debt. Accumulated private debt. With excessive debt slowing the economy, you cannot use NGDP growth as a yardstick to determine if money is easy or tight.

But what does Sumner say? He says "Forget about debt".

Queen of the Prom

"When economists write textbooks or teach introductory students or lecture to laymen, they happily extol the virtues of two lovely handmaidens of aggregate economic stabilization -- fiscal policy and monetary policy." - Arthur Okun

Isn't it odd that economists argue about whether monetary policy is loose or tight? Shouldn't that be the simplest thing to agree on?

Sumner:

It is precisely because students were taught IS-LM and IS-MP that we are in this mess. Both models teach students that easy money reduces interest rates. So 99.999% of people in 2008-09 inferred that the Fed was easing monetary policy, even as they adopted the tightest policy since 1938.

Woodford and Bernanke are right; the stance of monetary policy depends on outcomes like NGDP growth and inflation, not interest rates and the money supply.

Scott Sumner is saying we know monetary policy is tight because NGDP is sluggish.

I want to say that's oversimplified. (I know, he was dumbing it down so I could understand. But still.) Sumner is right unless something else is going on: unless there is some other factor making NGDP growth sluggish. Something like accumulated debt.

Oh, but it couldn't be debt, because Sumner tells us "Forget about debt".

When a debt is created, money is created and goes into circulation. Eventually, most of that money settles out of circulation and ends up in savings or maybe in some other nation's central bank. But the debt still exists, and the maintenance (interest) cost of the debt still exists.

And the principal repayment has to happen eventually. But from what money?

So there are costs associated with an abnormally massive accumulation of debt, costs that can be overlooked in a normal economy. Yet for some reason economists have missed those costs. Maybe it's because they have "forgotten" about debt.

Those abnormal costs hinder growth and, hindering growth, they make it appear that monetary policy is too tight. As Sumner sees it, if NGDP growth is slow, money must be tight. But it's abnormal costs that make NGDP growth slow, and Sumner's evaluation is not quite right because he continues to overlook those costs.

The other guys, the 99.999%, think money was too loose because interest rates were so low. And, by historical standards, interest rates *are* low. Yet low interest rates have done little to boost growth, because of the accumulation of debt and the abnormal costs arising from all that debt.

But what is it that's important, really? Is it that one high school clique is right and another is wrong about whether the prom queen is loose or tight? Or is it the abnormal cost arising from our massive and unnatural accumulation of debt?


Related post: The Monetary Cause of the "Macroeconomic Miracle"