I think that the basic approach is now stable. I might have a draft completed by the end of October. It is now a drama in four acts (have I said that before?). I have no idea how it will work for readers, but if I try appealing to an imaginary reader, I can’t write the book at all. As Ricky Nelson sang, “you can’t please everyone, so, you’ve got to please yourself.”
The “drama” approach allows me to speak favorably of points of view that I do not really share. I make a case for DSGE models. I try to make Scott Sumner’s case. Below the fold are some excerpts from the current version of the book.
ASK: Why should I bother with DSGE?
OB: Because it has passed the market test. Everyone uses it.
ASK: To me, the market looks more like a cartel which produces a lousy product.
OB: You would prefer to go back to doing macroeconomics without microfoundations?
ASK: I do not agree that we can equate solving a stylized dynamic optimization problem with having microfoundations. Putting a dynamic optimization equation in the midst of what is otherwise an ad hoc model and calling it microfounded is like putting a Rolls Royce engine in a rusted-out hulk with no wheels and calling it a luxury car.
OB: Are you saying that the way to turn it into a luxury car is to get rid of the Rolls Royce engine?
ASK: I am saying that we should drop the pretense that we are doing physics and instead admit that we are dealing in narrative. Put it this way. Suppose I give you a choice between betting $1000 on two groups trying to achieve a goal. One group consists of rocket scientists trying to land a spacecraft on the moon. The other group consists of economists enacting monetary and fiscal policy to try to hit an employment target one year from now. Which group would you bet on?
OB: I admit that I would bet on the rocket scientists.
ASK: Right. No matter how much economists try to dress up as rocket scientists, macroeconomics is not rocket science. Why is that? Many laymen would say, “Because macroeconomics deals with human beings, not with physical bodies.”
OB: But that does not mean that you should not use mathematics. It just means that the math can turn out to be more complex.
ASK: But when a rocket scientist works with equations, those are equations that have been verified and tested in the real world. The equations in DSGE models are arbitrary conventions. They have not been evaluated to see whether they really apply.
OB: We use microeconomic models that assume rational agents along with other assumptions, and those models work. Is it not logical to use the same assumption in macroeconomics?
…
Market Monetarist: Actually, my views are what I took to be the mainstream consensus before the financial crisis. The way I look at it, many of my fellow economists, like the Liberal and Conservative that you interviewed, have abandoned the views that held sway for two decades and gave us the Great Moderation. All of the trouble that we are in now can be blamed on bad monetary policy. The problem is not that monetary policy was too loose before the crisis, as the mainstream Conservative and the Austrians would say. The problem is that monetary policy became too tight during the summer and fall of 2008.
Moderator: I want to go back to my three questions. Was the financial crisis a macroeconomic event? Did the financial crisis cause the economic downturn? And were the policies appropriate?
Market Monetarist: The financial crisis was a macroeconomic event in that the markets recognized that we were in a tight-money episode. This caused a drop in the value of financial assets, and that in turns put banks in precarious positions.
Moderator: But the Fed lowered interest rates and expanded its balance sheet during the crisis. Doesn’t that show that monetary policy was expansionary?
Market Monetarist: Not at all. Interest rates are a price, determined by supply and demand factors. You cannot know that interest rates are falling because the Fed is supplying more money or because the economy is weakening. In 2008, it was clearly the latter. As for the Fed balance sheet, the Fed accompanied its new asset purchase programs with a policy of paying interest on reserves. Thus, it encouraged banks to hold reserves idle, rather than lend them out. So the net effect on the money supply was ambiguous at best. In any elementary model of the money market, raising the interest rate paid on reserves is contractionary.
The best indicator of monetary policy is the level of nominal GDP, or NGDP for short. Of course, since monetary policy affects the economy with a lag, you want the Fed to focus on future NGDP. Ideally, we would have a market forecast, based on an NGDP futures contract. The name “market monetarism” comes from this idea that you would use a market indicator of future NGDP to fix monetary policy. Unfortunately, there is no NGDP futures contract, but there are plenty of indicators out there that would allow you to get a pretty good idea of the market estimate of NGDP growth over the next two years. And those indicators would have told you September of 2008 that we were suffering from a monetary contraction.
Moderator: Are you seriously arguing that it was a monetary contraction that caused the problems at Freddie, Fannie, Lehman….?
Market Monetarist: Not necessarily. But the failure of those three companies was not enough to wreck the economy. Even the failure of another large bank would not have been enough, as long as the Fed supplied enough money to keep NGDP growing at a normal rate of 5 percent per year or so, which is consistent with normal inflation of 2 percent plus normal real growth of 3 percent. Look at this table, which shows the percent growth of GDP from four quarters ago.
Quarter
Percent change in Nominal GDP from four quarters earlier
2007-Q3
4.8
2007-Q4
4.4
2008-Q1
3.1
2008-Q2
2.7
2008-Q3
1.9
2008-Q4
-1
2009-Q1
-2
2009-Q2
-3.2
2009-Q3
-3.1
2009-Q4
0.1So in the second half of 2007, the economy is doing ok, although it is far from overheated. But the first half of 2008 is really terrible.
Moderator: And the Fed is lowering the Fed funds rate, from 5-1/4 percent in the first half of 2007 to just over 3 percent in the first quarter of 2008 and down to 2 percent in the second quarter.
Market Monetarist: But that’s obviously not enough, as you can tell from how NGDP is performing. Moreover, the Fed funds rate stays at 2 percent in the third quarter of 2008, even though you have all of these indicators saying that the economy is in trouble.
Moderator: But then the Fed drops in the interest rate essentially to zero by the end of the year. At that point, wasn’t the Fed pretty much out of ammunition?
Market Monetarist: Not at all. Remember that they were paying interest on reserves. They could have stopped doing that. They could even have charged a penalty on excess reserves. They were already buying mortgage-backed securities and other assets, and they could have bought more securities, or foreign currencies. My point is that they didn’t lack the tools to raise nominal GDP growth. They lacked the will. And so, if you go back to the table, by the latter half of 2009 nominal GDP is actually down 3 percent from a year ago, when it should be 5 percent higher than a year ago. If you think in terms of levels, as I believe you should, then the cumulative shortfall is actually greater—NGDP was more than 10 percent below what it should have been.
Moderator: In our earlier panel, both the mainstream liberal and the mainstream conservative economists said that they thought that the financial crisis caused the recession. I gather that you do not agree.
Market Monetarist. Correct. It was contractionary Fed policy that caused the recession.