It’s ‘Handle’:

Any proposed answer to the question of “What really caused the Great Depression” is inevitably pregnant with policy implications, and so is unavoidably incredibly politically charged. That’s one of the reasons so many top economists are so keen on studying it. Big names like Keynes, Hayek, Friedman, and Bernanke, just to name a few.

[more below the fold]

In order to answer the question you have to present, explicitly or implicitly, some kind of model of “How The Macroeconomy Really Works”. That model then inescapably implies some kind of governmental strategy for “What Must Be Done” to maximize production and stabilize and optimize the growth path, and most especially, how to prevent – or otherwise minimize the pain of – any downturn or disturbance.

But there is a huge amount at stake in whatever that recommended strategy turns out to be, because it may lend support to, or otherwise be inconsistent with, one’s personal preferences for a political agenda. Just like in US politics, there tend to be two big factions, either insistent or skeptical of the benefit of government management of the marketplace and of major state interventions.

I don’t think it’s very controversial to say that these huge political stakes have a very corrupting influence on which model of the Macroeconomy (and thus, the compatible explanation for The Great Depression), one favors. The only controversial part is which faction is being pure and innocent and scientific, and which is being vile and corrupt. It’s also possible to think almost everyone is corrupt or otherwise wrong, but then your team is tiny, and apparently social networking is critically important in the upper echelons of the field and in terms of having your ideas taken seriously.

Ok. As you might now expect, Scott Sumner’s explanation of the Great Depression is consistent with his Market Monetarist model of “How The Macroeconomy Really Works” and thus also lends support to his proposal for NGDP-futures level targeting as the optimal government economy-stabilizing management regime.

But you can’t propose such a model and implicit suggestion for a management regime without also passing the fundamental test of credibility and plausibility in the profession, which is to test it against the universal yard-stick of how well it accounts for The Great Depression.

And that’s what The Midas Paradox does for the Market Monetarists and the NGDPLT proposal. Sumner wanted it to be “The Midas Curse”, just like the myth, and indeed that would have been a better and more apt title. Midas for gold, Curse for being harmed by an excess of the thing you wanted (in this case, deflation caused by hoarding). But it was hard enough to find a publisher for this book, and they wanted paradox and they got it, and anyway it’s close enough.

Central to the Market Monetarist perspective on things is the Efficient Market Hypothesis (EMH) and the role of expectations in terms of the trends in total income (NGDP) and inflation, and the fact that the best guess as to these expectations is embedded in market prices.

Concordantly, sudden, major, and durable shifts in those market prices in apparent response to new, surprising, widely publicized information about international events, market conditions, or new government policies, embed information about the expectations regarding the likely impact of those contingencies. Yes, there is a lot of ordinary market volatility, but with a large enough sample you should be able to extract a signal from the noise if there is one there.

As a proxy for ‘new surprising information’, Sumner used economically-relevant articles reported in the New York Times, which, given the dominant way and speed in which information was disseminated to all market participants at the time, is a reasonable-enough source.

Sumner’s thesis is that there is indeed a good signal there, in which real news is highly consistent with near-immediate shifts in market prices, which embed that information about expectations, which are, in turn, well-correlated with future production. The most important market price was gold, because of the various different gold monetary standards at play at different places and time during that historical period. Expectations about future Macroeconomic trends and prices made it individually rational for individuals and governments to alternately hoard or divest themselves of gold, and, Sumner demonstrates, these swings were critically important drivers of Macroeconomic conditions.

He goes on to argue that this does a much better job explaining the dramatic twists and turns of The Great Depression than the rival macroeconomic theories. (For a great narrative account of what these twists and turns, booms and busts, felt like to an ordinary citizen, I highly recommend Benjamin Roth’s “The Great Depression: A Diary”)

And since this rival Macroeconomic theory does such a better job meeting the ‘gold standard’ of explaining The Great Depression, then the model deserves to be upgraded in status and credibility (with the other ones, dominant before the GFC, deserving severe downgrades). And consequentially, the proposed Market Monetarist regime of NDGPLT based on that model should be embraced by central bankers in developed countries in favor of the Taylor-Rule / inflation-targeting model, which arguable didn’t ‘work’ and still isn’t ‘working’ and so ought to be abandoned.

Obviously there is a lot of controversy about those assessments, but those controversies cannot be easily resolved because of the weak epistemic status of Macroeconomic theories, in which controlled experiments to test theories are practically impossible. The best one can do is create an interpretive framework and observe it is seems to do better or worse than others in producing estimate that are consistent with major past crises as well as current events.

Sumner argues that his interpretive framework is superior, and this book is the “consistency with the most significant past event” pillar of that argument.