Scott Sumner On Why Monetarism Might Be The Best Macro Perspective

See Tyler Cowen and the Four Blind Men.

"Tyler Cowen has an excellent new video out that looks at four schools of thought in business cycle theory, with application to the Great Recession. I agree with most of the specifics in the video, but differ in how to interpret the bigger picture. I'll try to explain why.

Tyler starts with the metaphor of 4 blind men trying to understand the nature of an elephant, each touching a different part of the beast. The implication is that each of these four perspectives offers something useful, and we should not confine our view to just one perspective. The wise man takes an eclectic view of things.

I see the video as mixing up very different types of disagreement. Consider his description of the 4 views:

1. Keynesian: Focus on shortfall in aggregate demand, look at C+I+G factors.
2. Monetarist: Also look at AD, but see unstable monetary policy as the root cause.
3. Real Business Cycle: Slowing productivity growth before the 2008 recession helps explain the instability of AD. Taxes and subsidies slowed the recovery.
4. Austrian: Government programs encouraged home lending, led to malinvestment. Fed policy was too stimulative before the recession.

To some extent, I agree with all four views. And yet I think monetarism is true and Keynesianism, RBC and Austrianism are false. So here's how I look at things:

1. One split is between nominal and real theories of the business cycle. I believe the AS/AD model is true. This model suggests that both nominal (AD) and real (AS) factors play a role in the cycle. I believe AD shocks are the biggest factor in the US, and AS shocks are the biggest factor in Venezuela. But each play a role in both countries.

2. What do RBC proponents believe? Some RBC models do incorporate sticky prices. But I recall Bennett McCallum arguing that if real business cycle theory was not a denial of the importance of nominal shocks, then it's hard to see how it's a distinctive theory at all. After all, even in textbook Keynesian AS/AD models you see AS shocks playing a role.

Furthermore, prominent RBC theorists often tend to scoff at claims that high unemployment is caused by a lack of AD, and point to factors such as government programs and regulations that create a disincentive to work.

Tyler suggests that slowing productivity growth in some way have contributed to a slowdown in AD during the Great Recession. I think that's true, although I see the mechanism in a way that may differ from his view. I believe slowing productivity growth lowered the equilibrium interest rate. The Fed tried to keep up by lowering actual rates, but did not do so rapidly enough, and money became tighter. So I don't see that as evidence in support of hard-core RBC theory, in which AD shocks are not very important because wages and prices are pretty flexible. Again, not all RBC proponents take that extreme view, but it's the only thing really distinctive about the theory. Otherwise it's two blind men both touching the trunk of the elephant, and assigning different names to the same appendage.

So this is why I believe that while slowing productivity growth played a modest role in throwing monetary policy off course, and government programs like 99 week extended unemployment benefits slightly raised the natural rate of unemployment during the recovery, the RBC model is fundamentally wrong. It's simply not a useful model. It adds nothing useful to AS/AD analysis. We already knew that both real and nominal shocks matter---the RBC proponents differ in incorrectly exaggerating how much they matter.

3. Let's put aside the nominal/real argument, and think about different nominal theories. The Keynesians are right that a lack of AD led to the Great Recession. But that doesn't make the Keynesian theory true. The real question is: What caused AD to fall sharply. The Keynesian model suggests that the problem is the inherent instability of capitalism, especially the propensity to invest. That may be a useful theory under the gold standard, where the money supply can be thought of as stable. But it's not a useful theory under a fiat money system with monetary offset. The Fed is supposed to offset shocks to velocity, and in the vast majority of cases it does so.

After the Soviet Union collapsed there was an increasing demand for US currency notes. If the Fed had failed to accommodate that demand then money would have become tighter, triggering a depression. No one would have blamed Russian hoarding of US dollars, nor should they have done so. The Fed would be expected to meet that extra demand for liquidity. Similarly, they should have met the extra demand for liquidity after the housing bubble burst, but instead they did just the opposite during mid-2007 to mid-2008.

The Keynesian model is wrong under a fiat money system, because the cause of recessions is unstable monetary policy, not the inherent instability of capitalism. And that's true even though the Keynesians are right about declining AD being the proximate cause of the recession, and even about some of the factors that caused monetary policy to be thrown off course, such as a decline in housing investment after the "bubble" burst.

I think Tyler is wrong in claiming that each view offers something valuable. Either their views overlap (the importance of AD shocks), or their views directly contradict and can't both be right (i.e. the cause of falling AD was the inherent instability of capitalism, vs. the view that the cause was bad monetary policy.)

4. The one area where I slightly disagree with Tyler is his claim that the Austrians de-emphasize AD, and prefer to let the market sort things out on its own. Maybe that's correct, but I have trouble seeing how. If Austrians believe that excessively expansionary Fed policy led to an unsustainable boom with lots of bad investment, then they clearly believe it's not enough to let the market sort things out, you need a stable monetary regime. (Which may or may not involve the Fed.) That's actually similar to the monetarist view.

And of course many monetarists agree with the Austrians that government credit policies aimed at promoting housing were very misguided. I believe that Austrianism is wrong as a business cycle theory because the issues they point to (while correct) don't seem powerful enough to cause a sizable recession.

To summarize, I don't like the way the video contrasts one wise man with four blind men (not surprisingly, as I am one of the blind men.) I believe it's possible to believe strongly in one view (monetarism in my case) while being completely aware of the other perspectives, and even agreeing that these factors play a role in the economy.

My reasons for rejecting these alternative views differ from one case to another. In the case of Austrianism and RBC theory, I believe the factors cited are simply too weak to explain the Great Recession. They are grabbing the elephant's tail, not its body. In the case of Keynesianism, I see the theory as being non-useful, because while it correctly notes the importance of AD deficiency, it doesn't correctly diagnose the reason for that deficiency--unstable monetary policy.

BTW, there is no such thing as passive and active monetary policies. Policies that are passive in one dimension (say interest rates) are active in another (say money supply.) So I'm not saying the Fed should have rescued the economy, I'm saying they should have refrained from destabilizing the economy."