Paul Romer recently lamented on the current crisis in macroeconomics. The money quote to excusing the pun was that:
Macroeconomic theorists dismiss mere facts by feigning an obtuse ignorance about such simple assertions as “tight monetary policy can cause a recession.”
Stanley Fischer, Deputy Governor of the Federal Reserve, is one such theorist Romer had in mind. His recent speech on Low Interest Rates is faintly astonishing in not once suggesting that low interest rates might be caused by tight monetary policy.
As usual, with the central bank-sponsored macroeconomic groupthink everything is to blame for persistently low interest rates except the central bank.
Knut Wicksell, the great Swedish economist, emphasized the concept of an equilibrium level of interest rates in his influential work. In his 1898 book, Interest and Prices, he wrote that “there is a certain level of the average rate of interest which is such that the general level of prices has no tendency to move either upwards or downwards.” In modern language, this level of the interest rate is usually referred to as the natural rate of interest.
But I am inclined to think, so what? There may well be a natural level of interest but what causes what? Does the natural level of interest cause the price level, or does the price level cause the natural level of interest?
Fischer asserts that the low level of the natural rate of interest has somehow caused the low level of inflation and low market rates. Cute, that. It’s “natural” so there’s nothing than can be done.
Fischer recognises that the natural rate is not easily observable, but so what? He hasn’t demonstrated it causes anything in particular. The essence of the Romer critique of macro is that it signally fails to get causes right, or even really think about them at all.
It builds simple models to show stuff, but the results are in the assumptions rather than in reality:
Laubach and Williams estimated the natural rate in a small-scale Keynesian model where inflation responds to the gap between actual and potential gross domestic product (GDP) and economic activity is determined by a simple equation that links deviations of actual from potential GDP to the gap between actual and natural interest rates. In their model, as in Wicksell’s framework, inflation generally will rise if the interest rate is low relative to the natural rate and fall if the interest rate is high relative to the natural rate. Their empirical results point to the growth rate of potential GDP as an important determinant of the natural rate of interest …
“A small-scale Keynesian model where inflation [is assumed] to be the result of ….”. There we go again.
We then get the usual litany of possible reasons for low growth:
- slower technological innovation
- excess saving
- “trauma” or economic uncertainty after the Great Recession
- the mysterious “secular stagnation”
And then he almost seems to suggest that tight money has helped the economy somehow, that is one possible interpretation of “sound monetary policies” here:
First, transparent and sound monetary policies here and abroad have helped mitigate downside risks and improve economic conditions, likely boosting confidence in the sustainability of the recovery. Without them, we probably would have had a more pronounced increase in precautionary saving and a deeper decline in fixed investment, which together would have put additional downward pressure on the natural rate of interest and, more important, further damaged the economy’s growth potential.
And then we get the usual rubbish about monetary policy having done all it can:
But, second, the virtues of sound monetary policy notwithstanding, we must not forget, as former Fed Chairman Ben Bernanke reminded us on numerous occasions, that “monetary policy is not a panacea.”
At least he is being honest about the monetary policy that has been followed. Sound (aka tight) monetary policy in a high inflation environment is a good thing. “Sound” monetary policy in a lowflation environment will make it worse. I hate to be ageist, being quite old myself, but this backslapping about sound monetary policy in entirely the wrong monetary environment makes him seem like he is living still in the 1970s, while in fact just being incredibly dim.