The Great Debate©: Is Fed Policy Too Tight?

The following is a proposition by Scott Sumner (professor of economics at Bentley University) that the QE programs by the U.S. Federal Reserve and other central bank actions have actually been “highly contractionary” and a rebuttal by L. Randall Wray (professor of economics at the University of Missouri Kansas City).

Monetary Policy has not been Ultra-loose

by Scott Sumner, The Economist

RICHARD DOBBS and Susan Lund have written a report evaluating the impact of QE:

The European Central Bank’s surprise cut to its interest rate last Thursday is just the latest evidence that the lengthy era of ultra-loose monetary policies is still firmly in place. Since the start of the crisis in 2007, the four central banks of the United States, the United Kingdom, the Eurozone, and Japan have injected a $4.7 trillion tidal wave of liquidity into their economies, pushing interest rates to very low levels.

Actually, monetary policy has been highly contractionary since 2008. Yes, interest rates are quite low, and a lot of money has been injected in the economy. But that was also true in the 1930s in the US and in the early 2000s in Japan. It does not indicate easy money, as Ben Bernanke noted 10 years ago:

The imperfect reliability of money growth as an indicator of monetary policy is unfortunate, because we don’t really have anything satisfactory to replace it. As emphasized by Friedman…nominal interest rates are not good indicators of the stance of policy…The real short-term interest rate…is also imperfect…Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation.

If one uses nominal GDP growth as the criterion, then since 2008 monetary policy has been tighter than any period since the early 1930s. Indeed this is even true if you average NGDP growth and inflation. Unfortunately, Dobbs and Lund are expressing the majority view; indeed, even Ben Bernanke now considers monetary policy to be highly accommodative, despite his 2003 statement.

Some might argue that this is just a question of semantics. Who cares whether monetary policy is called “easy” or “tight”? Here’s the problem. If you misdiagnose the stance of monetary policy, you are almost certain to misdiagnose the impact. Dobbs and Lund ask why lower interest rates have not spurred more investment. In fact, economic theory does not predict that lower interest rates will encourage more investment, just as economic theory does not predict that low prices will be associated with higher consumption. Never reason from a price change.

Read the rest of this article at The Economist.

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The Circular Logic Behind Scott Sumner’s Claim That the Fed’s Policy is Contractionary

by L. Randall Wray, New Economic Perspectives

OK, I’m flabbergasted.

I came across, and commented on, a piece by Scott Sumner a few days ago. (DID SCOTT SUMNER FIND MMT’S ACHILLES’ HEEL? ) He claimed he had proof MMT is wrong: if the Fed doubles the base then ipso facto nominal GDP must double and ipso facto MMT is wrong. Well, the Fed tripled the base and nominal GDP didn’t budge. In any case, even if that had worked, it is not evidence against MMT. All Sumner did was to string together a series of non-sequiturs.

Sumner’s also behind an inane proposal that the Fed ought to use its demonstrated impotence to target nominal GDP. Right. I wish the Chairman would reduce the earth’s wobble instead.

A reader thought I’d been too hard on him. But in his latest piece, he’s removed all doubt. What puzzles me is that some people seem to take this seriously. I don’t get it.

He argues that with ZIRP and successive rounds of QE the Fed has not been running easy policy, but instead has subjected the economy to extremely tight policy. You see, zero interest rates, trillions of dollars of excess reserves, and goosing Wall Street by over-paying for all the toxic waste that big banks want to unload is NOT easy policy—it is contractionary.

Actually, monetary policy has been highly contractionary since 2008. Yes, interest rates are quite low, and a lot of money has been injected in the economy. But that was also true in the 1930s in the US and in the early 2000s in Japan. It does not indicate easy money…

How does Sumner know? Well, because GDP growth is low. If monetary policy were easy, GDP growth would be high. Indeed, the low interest rates are NOT due to easy monetary policy, but rather result from low GDP growth.

If one uses nominal GDP growth as the criterion, then since 2008 monetary policy has been tighter than any period since the early 1930s. Indeed this is even true if you average NGDP growth and inflation…. The highly contractionary monetary policy of the last five years has dramatically reduced nominal GDP growth, and this has caused much lower interest rates.

Yes, and black is white, and white is black, and down is up and up is down in Sumner’s world. You see, if you use nominal GDP growth as an indicator of the monetary policy stance since Wall Street destroyed the economy back in 2008, then it is tight.

Sumner’s argument utilizes a tight circular logic: the Fed must have caused the recession because GDP fell, and the Fed must have had tight policy since the recession because GDP growth has been sluggish. We will know when policy loosens because GDP growth will accelerate. Until then, blame the Fed.


Now, I’m a skeptic about the Fed’s ability to affect GDP—one way or the other—but at least I understand what tool the Fed has to try to affect it: the overnight interest rate. That rate is NOT determined by nominal GDP growth, although the Fed does react to growth. Low nominal GDP growth usually induces the Fed to lower the overnight rate. The GFC pushed the Fed to go all the way to ZIRP.

On conventional thinking, that’s all the Fed can do—it shot its wad. Chairman Bernanke (wrongly) thought he had more ammunition, hence, he adopted unconventional policy with QE injecting trillions of dollars of excess reserves into banks. As anyone who understands MMT or even endogenous money predicted, the effect of that would be close to nada: ZIRP+QE=Zilch.

(MMTers believe there is a slightly negative bias resulting from lower rates, as Treasury interest spending is somewhat lower than it would have been; further, substituting reserves on bank balance sheets for higher earning Treasuries acts like a small bank tax—which probably is not good for bank lending.)

But no one schooled in economics thinks that nominal GDP growth determines the policy interest rate in a causal sense.

Except Sumner, who apparently believes that low nominal GDP growth causes low interest rates.  But even that claim is not quite enough for some new blogosphere branch of “economics” that is called Market Monetarism (MM). (Note: Even its adherents seem to admit that its arguments have never been held up to any kind of scholarly scrutiny.) Nay, not only has the Fed delayed recovery by adopting extremely tight policy since 2008, the Fed—not Wall Street—actually caused the crash in 2008.

It was not a Global Financial Crisis, but rather, it was a decline in—you betcha—nominal GDP growth that caused the crisis. And who should we blame?  Why, the Fed, of course, which caused the economic downturn by pushing nominal GDP growth to negative territory.  Since, of course, the Fed controls nominal GDP growth through its policy. Whatever that policy is—not interest rates since those are determined by—you betcha, again—nominal GDP growth.

A nice, neat, impenetrable circular argument.

They call it the “monetary disorder view”: The Fed’s tight policy caused the recession, and its tight policy prevents recovery. It’s the Fed coming and going. You see, it is not that the Fed is impotent, but rather that the Fed is super-duper potent.

And for some reason, the Fed is hell-bent on dragging the US economy through the mud. So, don’t you believe Uncle Ben when he says the Fed is doing all it can do to get the economy back on track. Actually, the Fed caused the recession and persists in ultra-tight policy in order to keep us in recession.

And, yes, the Fed keeps the planet wobbling, too.

I can remember when the main critique of the Fed was that it was always hell-bent on causing inflation by pumping too much money into the economy. Now the claim is that the Fed is biased toward running extremely tight policy.

Market Monetarism appears to be based on two Godfathers. The first is Uncle Milty Friedman, hence “Monetarist”. Friedman claimed that the Fed controls the money supply, which determines inflation. All “real” variables are determined by “real” things, leaving money to determine the “non-real” nominal stuff. Aside from short-term temporary fooling, all the Fed does is to determine the rate of inflation. And hence, inflation is always and everywhere the fault of excess money. Who do you blame? The Fed.

To get there, Friedman had to rely on magic: somehow the Fed controls the money supply through control over reserves. And somehow a rise of the money stock causes the flow of spending to rise above capacity, causing inflation. No one believes that magic any more. The so-called deposit multiplier is deader than door-nails and door-knobs. Trillions of reserves don’t generate trillions of deposits nor trillions of dollars of spending; hence, no inflation.

Everyone who understands anything about central banking now accepts that the Fed only controls the overnight interest rate—which is a very weak handle to try to control “the money supply” or spending and inflation—or the earth’s wobble or just about anything else that you might care about. As I’ve argued, we do not really even know if raising that rate will encourage or discourage lending, borrowing, and spending. At best, you’ve got impotence when you most need vigorous virility. And that’s why the Monetarist Bernanke turned to the QE fire hose to spray trillions of reserves at banks. To no avail.

So to resurrect Monetarism, the Market Monetarists adopted another Godfather, Knut Wicksell. He was an interesting fellow, but as I said, once you got Keynes you certainly don’t go back to Wicksell for monetary theory. The erroneous idea is that “real variables” grind out “real interest rates”.  Supposedly, the interplay of thrift (from whence comes the supply of some scarce resource called loanable funds) and productivity (that generates a demand for scarce loanable funds) determines a real rate, quite apart from the nominal rate determined by the central bank.  According to Wicksell, when the “market rate” exceeds the “real rate” you get recession, while a market rate below the real rate gives you inflationary expansion. All of these “real” variables are unobservables — hidden behind the magician’s cloak.

That notion of a divergence between the “real” rate and the “market rate” is what puts the Market into Market Monetarism.  And it is that Wicksellian magic that is behind Sumner’s cryptic argument:

The highly contractionary monetary policy of the last five years has dramatically reduced nominal GDP growth, and this has caused much lower interest rates. In supply and demand terms, the investment schedule or the demand for loanable funds schedule has shifted to the left, depressing interest rates and also the quantity of money borrowed. If this had been caused by an easy money policy, then the low interest rates would be associated with higher levels of borrowing and investment.

The Fed caused investment to collapse—which lowered GDP as we moved into the Great Recession—and as the demand for loanable funds fell, they became less scarce, causing interest rates to fall. It wasn’t the Fed that lowered rates, it was the decline in the demand for loanable funds.

Why did that happen? Because monetary policy was too tight. How do we know? Well, we cannot look to either monetary aggregates (A.K.A. money supply or base—the Friedmanian Monetarist view) or to interest rates (everybody else). We must look at GDP. Faltering GDP growth is evidence that monetary policy is too tight. Sumner again:

As a general rule higher interest rates are associated with robust economic growth (nominal) and low rates reflect weak growth. It’s a mistake to evaluate the impact of interest rates on the economy. What economists need to do is evaluate the impact of the factors that cause interest rates to change. Especially nominal GDP growth.

As Ronnie Reagan said,

“There you go again”.

If the Fed does not implement money policy by controlling the money supply (Friedman) or the overnight interest rate (Everybody else), then how does it do it? Well, by the Expectations Fairy. Here’s Sumner:

Monetary aggregates are neither good indicators of the stance of monetary policy, nor good policy targets. Rather than assume current changes in (the money supply) affect future (aggregate demand) with long and variable lags, I assume current changes in the expected future path of (the money supply) affect current (aggregate demand), with almost no lag at all.

It is the expectation that future money supply growth will be below future demand for money supply that causes an immediate collapse in aggregate demand. That’s how the “market” modifies old-style “monetarism” to give us the new whiz-bang Market Monetarism.

So, the crash in 2008 was caused by the market’s belief that the Fed was going to engineer a reduction in the future growth of the money supply. However, that reduction would not be accomplished by actually reducing money supply growth (which the Fed cannot accomplish) nor by raising interest rates (which are determined by GDP growth).

No, the Fed would lower future growth of the money supply by whispering into the Expectation Fairy’s ear that it would tighten policy, and that would then lower GDP growth today—which would lower rates now. Hence, the low rates are actually evidence that policy is tight, not loose.

It is evidence that that Expectation Fairy is flitting about, warning every one of the Fed’s intention to lower GDP growth. As Sumner likes to say, monetary policy operates with “long and variable leads” (that’s the Fairy’s whispers) and affects aggregate demand “with almost no lag at all”. If we could just get that Expectation Fairy to start whispering about future monetary ease, then GDP growth would rise and interest rates would rise—which would be evidence of easy money policy.

If you are following all of this, I feel your pain—as President Bubba used to say.

About Scott Sumner

Scott Sumner has taught economics at Bentley University for the past 30 years. He earned a BA in economics at Wisconsin and a PhD at Chicago.  Research has been in the field of monetary economics, particularly the role of the gold standard in the Great Depression.  He had just begun research on the relationship between cultural values and neoliberal reforms, when he was pulled back into monetary economics by the Great Financial Crisis.  In recent years Sumner has been writing at his blog The Money Illusion.

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One reply on “The Great Debate©: Is Fed Policy Too Tight?”

  1. Economists who focus entirely on monetary policy and the Fed will misunderstand the economy about say half the time.
    That is because they fail to look at fiscal policy and ignore basic economic identities and sectoral analysis..
    In the US in spite of Zirp and QE representing the easiest monetary settings in history, the Federal government has embarked on huge fiscal consolidation, and more is coming. The evidence is to look at the contraction in the Federal Deficit over the last 1 to 2 years, and to look at the sequester cuts and deficit forecasts for the next 12 to 18 months.
    That the US economy is growing at all is a wonder given the fiscal consolidation, both recently passed and forecast from the sequester..
    Scott Sumner’s analysis is, I believe,  misleading.

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