To the editors:

Henri Lepage has written a provocative review of Mervyn King’s new book, The End of Alchemy: Money, Banking, and the Future of the Global Economy. Lepage discusses a wide variety of differing perspectives, which have been developed over the past decade. So, what happened to the broad consensus among macroeconomists during the so-called “Great Moderation” (1984–2007)?

Perhaps the splintering of the New Keynesian consensus reflects an unusually high level of confusion about monetary policy. Broadly speaking, the world has seen more than 30 years of interest rates trending downwards. This pattern has been widely interpreted as reflecting an increasingly “easy” or expansionary monetary policy by the major central banks. And yet both inflation and nominal GDP growth have also declined sharply, which seems perplexing if central bank policy really has been extraordinarily accommodative. No wonder heterodox views are suddenly in vogue.

There are two schools of thought that would question the “and yet” in the previous paragraph. Both market monetarists and NeoFisherians claim that conventional economists have things backwards, that slowing nominal GDP growth and/or inflation is the cause of the lower rates, and that monetary policy has actually been increasingly contractionary in recent decades.

This is hardly a new idea. Back in 1997, Milton Friedman suggested that near zero interest rates in Japan were a sign that money had been tight: “Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.”¹

In 2003, Ben Bernanke referred to Friedman’s views and then went even further, suggesting that neither interest rates nor money supply growth were proper indicators of monetary policy. Instead, nominal GDP growth and inflation were the best ways to measure the stance of policy. (Ironically, Bernanke seemed to forget these views after he became Chair of the Federal Reserve in 2006.)

When viewed from this perspective, there are actually two fault lines in modern monetary economics, which lead to four rather distinct schools of thought. At the risk of oversimplifying slightly, both dovish Keynesians and more hawkish economists at the Bank of International Settlements (BIS) tend to view low interest rates as an expansionary monetary policy. In contrast, both market monetarists and NeoFisherians tend to see low rates of interest as a sign that policy has been contractionary, particularly if accompanied by very low inflation.

When viewed from a hawkish or dovish perspective, however, the fault lines are quite different. Both Keynesians and market monetarists believed that additional monetary stimulus was appropriate during the recovery from the Great Recession. In contrast, economists at the BIS worried that additional monetary stimulus could lead to asset price bubbles, while NeoFisherians actually approved of the low rates of inflation and saw no need to push prices higher.

The market monetarist view follows in the tradition of Milton Friedman, who argued that injecting new money into the economy will depress interest rates in the very short term, but then cause rates to move higher in the medium to long term, as income growth and inflation expectations both increase. That is why Friedman used the past tense when saying that low rates were a sign that money has been tight. A common mistake is to assume that short term means “right now” and that long term means “in the future.” Not so, right now we experience the interest rates that reflect the long-term effects of earlier central bank decisions.

Friedman believed (correctly, in my view) that most economists were not sufficiently aware of this distinction. He pointed out that this is not the first time that economists have been confused on this point:

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.²

Market monetarists do not just believe that monetary policy has been widely misinterpreted, they think this confusion actually contributed to the Great Recession, and the slow recovery. Consider the decisions made by the European Central Bank in the spring of 2011. The European Central Bank (ECB) tightened policy by twice raising their target interest rate, a policy that presumably would meet with approval by economists sympathetic to the BIS view. Market monetarists worried that the tightening would slow nominal GDP growth, and actually lead to lower interest rates in the long run.

And that is exactly what happened. Eurozone nominal GDP stopped growing for a couple of years, and the eurozone economy slid into a double-dip recession. As a result, eurozone interest rates are now considerably lower than rates in the U.S., just the opposite of the situation in 2011. It would be hard to find a more perfect example of Friedman’s claim that low rates today reflect a previously enacted tight money policy.

The 2011 ECB policy did not just lead to a recession in the eurozone, it also contributed to an intensification of the eurozone debt crisis, which is exactly what economic theory would predict. After all, nominal GDP represents the resources that individuals, businesses and governments have available to repay nominal debts.

In retrospect, even the Great Recession of 2007–2009 can be partly attributed to excessively tight money, if one accepts Bernanke’s 2003 claim that nominal gross domestic product (NGDP) growth and inflation are the proper measures of the stance of policy (not interest rates or the money supply). If so, then perhaps we have been misdiagnosing the financial crisis.

If excessively tight money caused NGDP to fall sharply in 2008–2009, then this could have dramatically intensified the ongoing banking crisis, which was relatively mild until the economy fell into recession. Instead of the financial crisis causing the deep slump, the market monetarist perspective suggests that the crisis was to a great extent caused by the Great Recession. If this seems a bit far-fetched, consider that during 2011 the Fed decided not to follow the ECB tight money policy. Not only did the US avoid a double dip recession (despite enacting as much fiscal austerity as in eurozone), it also avoided a renewal of the debt crisis. At least in 2011, causation almost certainly went from monetary policy to nominal income to debt distress.

This perspective may appear counterintuitive for many readers. However each component of the market monetarist explanation is consistent with mainstream monetary theory, circa 2007. As Friedman noted in 1997, economists repeatedly tend to forget that low interest rates do not mean easy money, because that fact is so counterintuitive. Even to me, it certainly looked like the banking crisis of 2008 caused the Great Recession, and that monetary policy was not particularly contractionary. There is a famous anecdote that beautifully illustrates this problem:

“Tell me,” the great twentieth-century philosopher Ludwig Wittgenstein once asked a friend, “why do people always say it was natural for man to assume that the sun went around the Earth rather than that the Earth was rotating?” His friend replied, “Well, obviously because it just looks as though the Sun is going around the Earth.” Wittgenstein responded, “Well, what would it have looked like if it had looked as though the Earth was rotating?”³

Market monetarists face the challenge of getting people to look at monetary policy as if the long term effect were what we usually observed. In that case, a period of near-zero interest rates, falling inflation and output, as well as financial distress, looks like the effects of an excessively contractionary monetary policy.

A similar misdiagnosis occurred in the 1930s. At the time, the Great Depression was widely believed to have been caused by a global financial crisis, and that monetary policy was expansionary but ineffective. Today, excessively tight money is viewed as the primary cause of the Great Depression, and the financial crisis is seen as a symptom, albeit one that worsened the slump. It will be interesting to see how long before the consensus view of the Great Recession is similarly revised.

Scott Sumner

Henri Lepage replies:

Scott Sumner is one of the new stars in the pantheon of living American economists appearing around the events of 2007–2009.⁴ He is professor at Bentley University (a private university in the suburbs of Boston) and program director of the Mercatus Center at George Mason University. He is also a web activist, whose blog “The Money Illusion” rivals, in its success, those of personalities like Paul Krugman and Ben Bernanke.⁵ He is primarily known for his work suggesting that responsibility for the crisis lies with the errors of monetary policy unwittingly committed by the central bank, and which advises a change of strategy, namely to adopt as the main target of its activity the nominal growth of the gross national product, rather than continue to focus primarily on interest rates. As such, he is one of those who have been most influential in the decision by the U.S. monetary authorities to embark on the adventure of quantitative easing. I do not know him personally, so it was with some surprise, and a sincere feeling of gratitude, that I discovered that he had responded to my essay.

I have nothing specific to add to his letter. I am very grateful to him for having provided a full letter that explains, extraordinarily concisely, what characterizes the thought of the New Monetarists and how their diagnosis differs from that of some of their colleagues.

I will content myself with merely underlining the importance of what he has written about the misunderstanding, denounced by Milton Friedman, of how to interpret interest rates, which I understand in the following way: we have long seen unusually low interest rates persisting in a situation characterized by sub-normal growth of production, reflected in NGDP. The lesson to be drawn is not that we are in a situation of monetary stimulus which will logically lead to an upturn in activity, but that these rates are, in fact, the legacy of an earlier situation, neglected, of a monetary austerity that degraded expectations of future growth and is thus responsible for the low growth of today and tomorrow (if nothing is done to correct those expectations). In other words, it is a complete inversion of the usual interpretation of economic indices, which explains the unwitting errors of the central banks in continuing to rely on the indications of their traditional methods of analysis.

This alone makes it worthwhile to read Sumner’s letter with care.