Tyler Cowen: belief

Transcript context

…I see what you’re saying, but I think that, in a way, your instincts that it’s almost tautological reflect the fact that you sort of buy into what I’m saying about the interrelationship between real and nominal shocks. We both know that they’re not necessarily at all closely correlated, right? In 2008 and 2009, Zimbabwe had a recession and a hyperinflation at the same time. Their nominal and real economies are going in dramatically different directions. We also know that real and nominal variables are radically different variables. When our instincts tell us that there’s something tautological about the correlation between real and nominal GDP in the United States, it’s because our instincts have recognized the fact that, in fact, most of the US business cycle is due to nominal shocks interacting with sticky wages. If that hypothesis is true, that model of the business cycle is true for the United States but not for Zimbabwe, then what it’s telling us is that if we can control nominal GDP growth, probably the path of real GDP will also be more stable. Now, it’s possible that we do succeed in stabilizing nominal GDP growth, and we find out it doesn’t help. But there’s an awful lot of circumstantial evidence to support my claim, because we observe, for instance, in the United States that when nominal GDP is more volatile, so is real GDP. That’s one thing we know. We also know that some of the volatility of nominal GDP comes from very clear monetary policy mistakes that have been made at various periods of time that can be clearly identified. When we see this show up in similar movements in real output, there’s just a strong presumption that there’s a causal relationship there. Financial markets also seem to treat it like there’s a causal relationship. Financial market responses to Federal Reserve policy shocks seem to reflect a view in the financial markets that these things are important for the real economy. I think my view would be, when you get a very bad recession, it’s typically the combination of negative nominal shocks and significant negative real shocks, often to credit markets. The negative real shocks are not just an epiphenomenon or result of the nominal problem mixed with sticky wages. You have both happening, and the credit market problems don’t just go away if you do your nominal job. Then you get back to these situations where you’ll need a fairly high rate of price inflation to stabilize the growth path of nominal GDP. You just think credit market shocks are not that important? Like what Charles Kindleberger wrote, you wouldn’t really agree with that economic history? Or how should I frame your view here? Yes, I think the financial market problems are mostly a symptom. Here’s another example I could give you: At the beginning of the 2008 recession, the view in Europe was that America was paying a price for our reckless cowboy capitalism, deregulation of banking, less stable financial system than in Europe. There was almost a little bit of gloating in some quarters in Europe at that time. Now, we now know that the Great Recession ended up being much worse in Europe than the United States. Let’s say the standard view is correct, that the Great Recession was caused by the American housing bubble combined with the banking crisis. The recession should have been much worse in the United States. We’re the ones that had the big subprime crisis. That was what was expected in early 2008. The recession was going to be much worse in the US than in Europe. Here’s one difference: Monetary policy in Europe was clearly tighter throughout 2008 than the US. The ECB was much more hawkish than the Bernanke Fed. That led to the recession being more severe in Europe. In addition, two years later, in 2011, the Europeans got spooked by rising commodity prices and a pickup in inflation, which was a little bit misleading because nominal growth was very weak still. They tightened monetary policy twice in early 2011. They had a double-dip recession. The financial problems ended up being more severe in Europe than the United States. They were more severe because the path of nominal GDP was much more unfavorable in Europe compared to the United States, even though the United States did not do particularly well. I think that, again and again, when you look at these cases where there’s some sort of monetary policy mistake — America in 1929, Argentina in the late 1990s — you see the monetary policy mistake occurring first, in an otherwise healthy economy; then you see the financial crisis developing as nominal GDP is falling sharply. There are other occasions, like 2008, where the financial distress occurs first. This is why I believe it gets misdiagnosed. Because the financial distress occurs first, people think that everything that happened afterwards was an implication of just a worsening financial crisis, whereas what actually happened is the financial crisis causes changes in the equilibrium interest rate that the Fed misjudges. Policy gets off course. Because it’s off course, aggregate demand falls sharply. That is the factor that actually worsens the financial crisis as you get deeper into the process.…

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