Scott Sumner: evaluation

Transcript context

…Can’t credit markets break down on their own? Say, today, a large private equity firm turned out to be more leveraged than it seems at the moment, and they became insolvent, and that would be a macroeconomic crisis. I certainly would agree it would be a good idea to stabilize the expected growth path of nominal GDP, but is any kind of credit market intervention needed? Again, Congress is not going to do it well. We know that. What should monetary policy do? Here, if I told you what it — I’ll tell you in a moment what it should do. Some people would interpret my answer as a bailout. I don’t think it is a bailout. Let me explain. Let’s say there’s a large institution that fails, and it potentially has ripple effects on other parts of the financial system. That’s essentially going to lower the equilibrium interest rate in the economy. The Fed, in order to stabilize nominal GDP growth, might have to cut interest rates sharply, and might have to do some QE or whatever, merely to stabilize the path of nominal GDP growth, given that shock. If they do that, then the ripple effects from the original crisis become far smaller. I think what happens when people look back at previous financial crises that seem to spread on their own, what they’re missing is the role of the effect on the macroeconomy. When there is a banking crisis that starts in one place and spreads, the initial crisis might have been due to mistakes made by that individual bank, but the spread across the financial system is usually because the policymakers allowed nominal GDP to fall sharply. Any sort of decline in nominal GDP that occurs for any reason will tend to make financial crises worse. We saw this in Argentina in the early 2000s. Even in the Great Depression in the United States, when we look back on it, we think of it as like a financial crisis causing a Great Depression. That’s not actually what happened. The Great Depression in the US began in late 1929. The banking system didn’t get into any kind of serious trouble until more than a year later, when the depression was already quite deep. The causation clearly ran from falling nominal spending to financial distress. That shouldn’t be surprising at all, because nominal GDP is the key variable determining the health of the financial system, given that almost all of our financial contracts are nominal contracts. Think of the total nominal income in the economy as the resources that people, companies, and even governments have to repay their debts. If that falls sharply, you will have a lot of financial distress. On the other hand, if there’s a financial crisis, and that lowers the equilibrium interest rate, and policymakers don’t respond appropriately, nominal GDP will fall, the crisis will get worse, and it’ll look to the average person like the crisis is just building on itself. An analogy I sometimes use is like a cold that turns into pneumonia. It starts as one illness. It might seem to a person like it’s just a bad cold, but actually the nature of the illness has changed. This is what often happens in these periods of financial crisis combined with falling nominal GDP. It starts with one type of problem, financial distress, and it turns into a very different type of crisis when nominal GDP falls sharply, because of all these nominal debt contracts. If the Fed had listened to you during the great financial crisis, what would have been the rate of price inflation in 2009, roughly?…

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