2-centuries-of-policy-mistakes

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I fanatically loved HBO’s Baltimore-based television drama, The Wire. It’s difficult to even imagine my pop-cultural brain without the presence of Omar Little, Stringer Bell, Bunk, and “McNutty.” When I started doing my sports radio show eight years ago, I scheduled interviews with as many of the actors as I could for no other reason than I wanted to breathe their air. Talking to Michael K. Williams about the method of Omar’s “long game” while he aggressively chewed on a sandwich will forever remain a career highlight. In every interview, I would always ask the same question: I wanted the cast to tell me whether working on this program was just another acting gig or if they all knew that they were doing something utterly unique in television history. When I asked this of Seth Gilliam, who played Officer Ellis Carver, he said, “It felt to us more like we were a movement, on a mission, in an army to bring awareness.” What really stoked me back then was the bracingly original political message that ran through The Wire compared to a typical Hollywood production. Most assembly-line entertainment is a variation on the shopworn theme of lone heroes confronting obstacles and then overcoming them. The connective thread of every Wire season, as described by show co-creator David Simon was that when individuals, no matter how heroic, fight to change entrenched power structures and bureaucracies—whether in the form of City Hall politics, police, or organized crime—the individual is going to lose.

That’s why I always shoved it to the back of my mind when my friends in Baltimore—I live about 45 minutes from the city—almost uniformly would tell me they either did not like or would not watch the show. People were hostile toward The Wire for a multiplicity of reasons. Some felt it was like gangster rap for a more sophisticated audience, glorifying black-on-black hyper-masculine street violence while selling itself as somehow more literate and ennobling to consume. My friend Mark once pissed me off fiercely when he told me that my favorite show was “NWA for people who read The New Yorker.”

My Baltimore friends who had seen the show also believed, given the police violence in their town, that The Wire’s view of Baltimore’s finest was almost comically kind. The one policeman who accidentally shoots someone (a fellow officer) not only isn’t prosecuted but gets reintroduced later in the series as a big-hearted public school teacher. And then other people just said to me that living in Baltimore was a struggle and the idea of anyone making commerce out of their pain was simply not their idea of entertainment.

I would casually dismiss these concerns, thinking people were being overly sensitive, overly critical, or just not “seeing” the brilliance in front of them. I also politically defended the show as one of the few spaces on television that, through its brilliant multiracial cast, looked at issues of crime, corruption, and urban blight in a systemic manner. The fact that it actually cared about the hopes, dreams, and lives of street criminals and not just cops felt more than radical. It felt revolutionary.

The events of the last two weeks, however, have changed my view of The Wire in a very fundamental way. I have spent most of my time listening to people in Baltimore speak about how this uprising came to be and why the anger runs so deep. I’ve been primarily speaking to black Baltimoreans in grassroots organizations who have, in a state of MSM invisibility, been building movements for years to fight poverty, end street violence, and challenge police brutality. This is humbling to admit, but this experience has made me reassess my favorite show, as if a very dim light bulb was being switched on above my head. I am now seeing what the The Wire was missing, despite its much lauded, painstaking verisimilitude: the voices of people organizing together for change. Everyone on The Wire seeks individual solutions for social problems: the lone cop, the lone criminal, the lone teacher, the lone newspaper reporter. Yes, it is certainly true that when entrenched bureaucracies battle individuals, individuals lose. But when bureaucracies battle social movements, the results can be quite different.

It is also impossible for me to separate David Simon’s view of people as either passive sheep or lone-wolf heroes from his comments about the events last week in Baltimore. Not his comments to “end the fucking drug war,” which are surely welcome, but his other public perspective.

With the fires in Baltimore just hours old, Simon wrote, “But now—in this moment—the anger and the selfishness and the brutality of those claiming the right to violence in Freddie Gray’s name needs to cease … This, now, in the streets, is an affront to that man’s memory and a dimunition of the absolute moral lesson that underlies his unnecessary death. If you can’t seek redress and demand reform without a brick in your hand, you risk losing this moment for all of us in Baltimore. Turn around. Go home. Please.”

It’s always cringe-worthy when a wealthy middle-aged white guy lectures young black people about who they are and what they should do. In other words, if you had said two weeks ago—in the battle of prominent Baltimore Caucasians—that Orioles Manager Buck Showalterwould represent himself better than David Simon, I think many would have been surprised. But his comments also revealed far more than was intended. The idea that David Simon, praised as someone with an ear to these Charm City streets like no one since H.L. Mencken, could look at what was happening in the Baltimore of 2015 and not see the social movements and organization beneath the anger, makes me wonder how much he truly “saw” when producing the show. That David Simon could tell people with bricks in their hand to “go home,” and have no direct words of condemnation for the violence displayed by the police made me remember my friend Dashon—from Baltimore—who told me he would never watchThe Wire because he believed it to be “copaganda,” since it was created not only by Simon but by longtime Baltimore police officer Ed Burns.

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Now, I cannot help but recall all my favorite Wire moments through a lens that has me wondering if the show was both too soft on the police and incredibly dismissive of people’s ability to organize for real change. In the season that took place in the public schools, where were the student organizers, the urban debaters, and teacher activists I’ve met this past month? In the season about unions, where were the black trade unionists like the UNITE/HERE marchers who were—in utterly unpublicized fashion—at the heart of last Saturday’s march? In the season about the drug war and “Hamsterdam,” where were the people actually fighting for legalization? In the stories about the police, where were the people who died at their hands? It all reveals the audacity—and frankly the luxury—of David Simon’s pessimism. Perhaps this pessimism, alongside the adrenalizing violence, created, asJamilah Lemieux put it in Ebony, a show steeped in the voyeurism of “Black pain and death” for a liberal white audience that “cried for Stringer Bell and a burned out CVS, but not Freddie Gray.”

I am not saying that art should conform to a utopian political vision of struggle like some dreck from the Stalinist culture mills. But I am asking a question that I wasn’t before: Why were those fighting for a better Baltimore invisible to David Simon? I don’t mean those fighting on behalf of Baltimore—the (often white) teachers, the social workers, and the good-natured cops who are at the heart of The Wire—but those fighting for their own liberation? Why was The Wire big on failed saviors and short on those trying to save themselves? And if these forces were invisible to David Simon, shouldn’t we dial down the praise of the show as this “Great American Novel of television” (Variety!) and instead see it for what it is: just a cop show? There’s no shame in that. I’ll even call it the greatest cop show ever, a cop show with insanely brilliant dialogue, indelible performances, and more three-dimensional roles for black actors than 99 percent of what comes out of Hollywood. But all the same—still just a cop show.

After reading stories like this, I think I’m done with cop shows for now. There’s a line from the Bible that says, “When I was a child, I spoke and thought and reasoned as a child. But when I grew up, I put away childish things.” In the wake of the Baltimore uprising, The Wire’s pessimism seems childish to me, and I’m going to put it away for a while. I could see myself revisiting it in the future, maybe amidst a more dreary political moment. But that moment isn’t now. Baltimore in 2015 shows that we can do more than just chronicle the indignities imposed by entrenched urban power structures—we can challenge them. David Simon should listen to the folks who are engaged in that collective project. As Cutty said, “The game done changed.”

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Three of the most important objectives for economic policy are:

  1. Achieving full employment
  2. Keeping inflation low and stable
  3. Maintaining financial stability

Larry Summers’ secular stagnation hypothesis holds that achieving these three goals simultaneously may prove very difficult. (See Larry’s statement of the case and a collection of short pieces on the subject by prominent economists.)

The term “secular stagnation” was coined by Alvin Hansen in his 1938 American Economic Association presidential address, “Economic Progress and Declining Population Growth.” Writing in the latter stages of the Great Depression, Hansen argued that, because of apparent slowdowns in population growth and the pace of technological advance, firms were unlikely to see much reason to invest in new capital goods. He concluded that tepid investment spending, together with subdued consumption by households, would likely prevent the attainment of full employment for many years.

Hansen proved quite wrong, of course, failing to anticipate the postwar economic boom (including both strong population growth—the baby boom—and rapid technological progress). However, Summers thinks that Hansen’s prediction was not wrong, just premature. For a number of reasons—including the contemporary decline in population growth, the reduced capital intensity of our leading industries (think Facebook versus steel-making), and the falling relative prices of capital goods—Larry sees Hansen’s prediction of limited investment in new capital goods and an economy that chronically fails to reach full employment as relevant today. If the returns to capital today are very low, then the real interest rate needed to achieve full employment (the equilibrium real interest rate) will likely also be very low, possibly negative. The recent pattern of slow economic growth, low inflation, and low real interest rates (see below) motivates and is consistent with the secular stagnation hypothesis.

Notice, by the way, that the secular stagnation story is about inadequate aggregate demand, not aggregate supply. Even if the economy’s potential output is growing, the Hansen-Summers hypothesis holds that depressed investment and consumption spending will prevent the economy from reaching that potential, except perhaps when a financial bubble (like the housing bubble of the 2000s) provides an additional push to spending. However, Summers argues that secular stagnation will ultimately reduce aggregate supply as well, as growth in the economy’s productive capacity is restrained by slow rates of capital formation and by the loss of workers’ skills caused by long-term unemployment.

The Fed cannot reduce market (nominal) interest rates below zero, and consequently—assuming it maintains its current 2 percent target for inflation—cannot reduce real interest rates (the market interest rate less inflation) below minus 2 percent. (I’ll ignore here the possibility that monetary tools like quantitative easing or slightly negative official interest rates might allow the Fed to get the real rate a bit below minus 2 percent.) Suppose that, because of secular stagnation, the economy’s equilibrium real interest rate is below minus 2 percent and likely to stay there. Then the Fed alone cannot achieve full employment unless it either (1) raises its inflation target, thereby giving itself room to drive the real interest rate further into negative territory by setting market rates at zero; or (2) accepts the recurrence of financial bubbles as a means of increasing consumer and business spending. It’s in this sense that the three economic goals with which I began—full employment, low inflation, and financial stability—are difficult to achieve simultaneously in an economy afflicted by secular stagnation.

Larry’s proposed solution to this dilemma is to turn to fiscal policy—specifically, to rely on public infrastructure spending to achieve full employment. I agree that increased infrastructure spending would be a good thing in today’s economy. But if we are really in a regime of persistent stagnation, more fiscal spending might not be an entirely satisfactory long-term response either, because the government’s debt is already very large by historical standards and because public investment too will eventually exhibit diminishing returns.

Does the U.S. economy face secular stagnation? I am skeptical, and the sources of my skepticism go beyond the fact that the U.S. economy looks to be well on the way to full employment today. First, as I pointed out as a participant on the IMF panel at which Larry first raised the secular stagnation argument, at real interest rates persistently as low as minus 2 percent it’s hard to imagine that there would be a permanent dearth of profitable investment projects. As Larry’s uncle Paul Samuelson taught me in graduate school at MIT, if the real interest rate were expected to be negative indefinitely, almost any investment is profitable. For example, at a negative (or even zero) interest rate, it would pay to level the Rocky Mountains to save even the small amount of fuel expended by trains and cars that currently must climb steep grades. It’s therefore questionable that the economy’s equilibrium real rate can really be negative for an extended period. (I concede that there are some counterarguments to this point; for example, because of credit risk or uncertainty, firms and households may have to pay positive interest rates to borrow even if the real return to safe assets is negative. Also, Eggertson and Mehrotra (2014) offers a model for how credit constraints can lead to persistent negative returns. Whether these counterarguments are quantitatively plausible remains to be seen.)

Second, I generally agree with the recent critique of secular stagnation by Jim Hamilton, Ethan Harris, Jan Hatzius, and Kenneth West. In particular, they take issue with Larry’s claim that we have never seen full employment during the past several decades without the presence of a financial bubble. They note that the bubble in tech stocks came very late in the boom of the 1990s, and they provide estimates to show that the positive effects of the housing bubble of the 2000’s on consumer demand were largely offset by other special factors, including the negative effects of the sharp increase in world oil prices and the drain on demand created by a trade deficit equal to 6 percent of US output. They argue that recent slow growth is likely due less to secular stagnation than to temporary “headwinds” that are already in the process of dissipating. During my time as Fed chairman I frequently cited the economic headwinds arising from the aftermath of the financial crisis on credit conditions; the slow recovery of housing; and restrictive fiscal policies at both the federal and the state and local levels (for example, see my August and November 2012 speeches.)

My greatest concern about Larry’s formulation, however, is the lack of attention to the international dimension. He focuses on factors affecting domestic capital investment and household spending. All else equal, however, the availability of profitable capital investments anywhere in the world should help defeat secular stagnation at home. The foreign exchange value of the dollar is one channel through which this could work: If US households and firms invest abroad, the resulting outflows of financial capital would be expected to weaken the dollar, which in turn would promote US exports. (For intuition about the link between foreign investment and exports, think of the simple case in which the foreign investment takes the form of exporting, piece by piece, a domestically produced factory for assembly abroad. In that simple case, the foreign investment and the exports are equal and simultaneous.) Increased exports would raise production and employment at home, helping the economy reach full employment. In short, in an open economy, secular stagnation requires that the returns to capital investment be permanently low everywhere, not just in the home economy. Of course, all else is not equal; financial capital does not flow as freely across borders as within countries, for example. But this line of thought opens up interesting alternatives to the secular stagnation hypothesis, as I’ll elaborate in my next post.

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To understand why this is so, it helps to introduce the concept of the equilibrium real interest rate (sometimes called the Wicksellian interest rate, after the late-nineteenth- and early twentieth-century Swedish economist Knut Wicksell). The equilibrium interest rate is the real interest rate consistent with full employment of labor and capital resources, perhaps after some period of adjustment. Many factors affect the equilibrium rate, which can and does change over time. In a rapidly growing, dynamic economy, we would expect the equilibrium interest rate to be high, all else equal, reflecting the high prospective return on capital investments. In a slowly growing or recessionary economy, the equilibrium real rate is likely to be low, since investment opportunities are limited and relatively unprofitable. Government spending and taxation policies also affect the equilibrium real rate: Large deficits will tend to increase the equilibrium real rate (again, all else equal), because government borrowing diverts savings away from private investment.

The real interest rate does not have to be consistent with full employment of labour. The real interest rate can be equivalent to the profit margin, or, average profit margin, of productive business.

When business profits are high, the economic incentive to borrow money rises. Consumers demand more of the good or service that can currently be supplied, therefore prices [and profits] reflect this. New entrants, attracted by the high profit margin enter the field, or, established business expands using borrowed capital. As more businesses enter profitable areas of business, demand for capital rises, which causes a rise in the cost of capital, unless savings increase [supply of capital] commensurate with the demand for capital.

If business profitability is lower than the cost of capital, business will not borrow. If the supply of capital should rise, then the cost of capital will fall. If the cost of capital falls below the profit margins of business, once again there will be a potential demand for capital.

Employment is a cost of production. Employers will hire labour to the point of marginal profit of labour. When that point is reached, no further labour will be engaged. Again, the higher the profitability of the business, the higher the marginal productivity of labour will be and the higher the employment in that business will be.

When the Federal Reserve sets interest rates and set them low as in ZIRP, the cost of capital is set below the profit margins of almost all productive business. No longer is capital allocated to business with the highest profit margins, which are the businesses with the highest consumer demand, capital is allocated to sub-optimal business with low consumer demand.

This ties up and increases the costs of raw materials used in production away from profitable business to marginal business. ZIRP is counter productive. ZIRP distorts the market. ZIRP prolongs the life of low profit businesses [businesses with low demand for their goods and services] and increases the costs of production of profitable businesses through increased competition [prices] in higher stages of production.

Bernanke misunderstands the effect of artificially created low interest rates by the Federal Reserve. The necessity of lowering interest rates in 2008 was caused by a liquidity crisis. A liquidity crisis is a result of fractional reserve lending, which in the 2008 crisis was driven largely through real property speculation.

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Interest rates around the world, both short-term and long-term, are exceptionally low these days. The U.S. government can borrow for ten years at a rate of about 1.9 percent, and for thirty years at about 2.5 percent. Rates in other industrial countries are even lower: For example, the yield on ten-year government bonds is now around 0.2 percent in Germany, 0.3 percent in Japan, and 1.6 percent in the United Kingdom. In Switzerland, the ten-year yield is currently slightly negative, meaning that lenders must pay the Swiss government to hold their money! The interest rates paid by businesses and households are relatively higher, primarily because of credit risk, but are still very low on an historical basis.

Low interest rates are not a short-term aberration, but part of a long-term trend. As the figure below shows, ten-year government bond yields in the United States were relatively low in the 1960s, rose to a peak above 15 percent in 1981, and have been declining ever since. That pattern is partly explained by the rise and fall of inflation, also shown in the figure. All else equal, investors demand higher yields when inflation is high to compensate them for the declining purchasing power of the dollars with which they expect to be repaid. But yields on inflation-protected bonds are also very low today; the real or inflation-adjusted return on lending to the U.S. government for five years is currently about minus 0.1 percent.

Why are interest rates so low? Will they remain low? What are the implications for the economy of low interest rates?

If you asked the person in the street, “Why are interest rates so low?”, he or she would likely answer that the Fed is keeping them low. That’s true only in a very narrow sense. The Fed does, of course, set the benchmark nominal short-term interest rate. The Fed’s policies are also the primary determinant of inflation and inflation expectations over the longer term, and inflation trends affect interest rates, as the figure above shows. But what matters most for the economy is the real, or inflation-adjusted, interest rate (the market, or nominal, interest rate minus the inflation rate). The real interest rate is most relevant for capital investment decisions, for example. The Fed’s ability to affect real rates of return, especially longer-term real rates, is transitory and limited. Except in the short run, real interest rates are determined by a wide range of economic factors, including prospects for economic growth—not by the Fed.

To understand why this is so, it helps to introduce the concept of the equilibrium real interest rate (sometimes called the Wicksellian interest rate, after the late-nineteenth- and early twentieth-century Swedish economist Knut Wicksell). The equilibrium interest rate is the real interest rate consistent with full employment of labor and capital resources, perhaps after some period of adjustment. Many factors affect the equilibrium rate, which can and does change over time. In a rapidly growing, dynamic economy, we would expect the equilibrium interest rate to be high, all else equal, reflecting the high prospective return on capital investments. In a slowly growing or recessionary economy, the equilibrium real rate is likely to be low, since investment opportunities are limited and relatively unprofitable. Government spending and taxation policies also affect the equilibrium real rate: Large deficits will tend to increase the equilibrium real rate (again, all else equal), because government borrowing diverts savings away from private investment.

If the Fed wants to see full employment of capital and labor resources (which, of course, it does), then its task amounts to using its influence over market interest rates to push those rates toward levels consistent with the equilibrium rate, or—more realistically—its best estimate of the equilibrium rate, which is not directly observable. If the Fed were to try to keep market rates persistently too high, relative to the equilibrium rate, the economy would slow (perhaps falling into recession), because capital investments (and other long-lived purchases, like consumer durables) are unattractive when the cost of borrowing set by the Fed exceeds the potential return on those investments. Similarly, if the Fed were to push market rates too low, below the levels consistent with the equilibrium rate, the economy would eventually overheat, leading to inflation—also an unsustainable and undesirable situation. The bottom line is that the state of the economy, not the Fed, ultimately determines the real rate of return attainable by savers and investors. The Fed influences market rates but not in an unconstrained way; if it seeks a healthy economy, then it must try to push market rates toward levels consistent with the underlying equilibrium rate.

This sounds very textbook-y, but failure to understand this point has led to some confused critiques of Fed policy. When I was chairman, more than one legislator accused me and my colleagues on the Fed’s policy-setting Federal Open Market Committee of “throwing seniors under the bus” (to use the words of one senator) by keeping interest rates low. The legislators were concerned about retirees living off their savings and able to obtain only very low rates of return on those savings.

I was concerned about those seniors as well. But if the goal was for retirees to enjoy sustainably higher real returns, then the Fed’s raising interest rates prematurely would have been exactly the wrong thing to do. In the weak (but recovering) economy of the past few years, all indications are that the equilibrium real interest rate has been exceptionally low, probably negative. A premature increase in interest rates engineered by the Fed would therefore have likely led after a short time to an economic slowdown and, consequently, lower returns on capital investments. The slowing economy in turn would have forced the Fed to capitulate and reduce market interest rates again. This is hardly a hypothetical scenario: In recent years, several major central banks have prematurely raised interest rates, only to be forced by a worsening economy to backpedal and retract the increases. Ultimately, the best way to improve the returns attainable by savers was to do what the Fed actually did: keep rates low (closer to the low equilibrium rate), so that the economy could recover and more quickly reach the point of producing healthier investment returns.

A similarly confused criticism often heard is that the Fed is somehow distorting financial markets and investment decisions by keeping interest rates “artificially low.” Contrary to what sometimes seems to be alleged, the Fed cannot somehow withdraw and leave interest rates to be determined by “the markets.” The Fed’s actions determine the money supply and thus short-term interest rates; it has no choice but to set the short-term interest rate somewhere. So where should that be? The best strategy for the Fed I can think of is to set rates at a level consistent with the healthy operation of the economy over the medium term, that is, at the (today, low) equilibrium rate. There is absolutely nothing artificial about that! Of course, it’s legitimate to argue about where the equilibrium rate actually is at a given time, a debate that Fed policymakers engage in at their every meeting. But that doesn’t seem to be the source of the criticism.

The state of the economy, not the Fed, is the ultimate determinant of the sustainable level of real returns. This helps explain why real interest rates are low throughout the industrialized world, not just in the United States. What features of the economic landscape are the ultimate sources of today’s low real rates? I’ll tackle that in later posts.

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How fast should the Federal Reserve tighten monetary policy? Should it tighten at all? I recently wrote about these issues but didn’t have the space to explore a fascinating aspect of the debate: the mostly forgotten 1937-38 recession. To many, it’s a cautionary tale against adopting tighter policies too soon. The latest to sound the alarm is Ray Dalio, the respected founder of Bridgewater Associates, a huge hedge fund group. His recent memo to clients inspired a Page 1 story in the Financial Times, headlined “Dalio warns Fed of 1937-style rate risk.”

At the time, it was called the “Roosevelt recession.” It “came as a surprise to most Americans,” writes historian Alan Brinkley in “The End of Reform: New Deal Liberalism in Recession and War.” Until the summer of 1937, the economy was growing briskly, and “many New Dealers were boasting that the Depression was over.” Although civilian unemployment was still high (10 percent in 1936), it was much lower than the peak (23 percent in 1932) and was declining rapidly.

Signs of economic revival abounded. In 1935, the steel industry was operating at 47 percent of capacity; by 1937, that was 80 percent. “Railroads put on extra trains” for July 4, wrote Business Week. “Mountain and seashore hotels packed them in.”

And then the recession hit. It was a doozy. At its low point, the economy’s output had dropped by 18 percent. Industrial production was down by 32 percent, and unemployment reached a peak of 20 percent, according to economist Allan Meltzer’s history of the Fed.

With hindsight, there’s widespread agreement that this stunning reversal was caused by government policies – though there’s disagreement over which ones.

An early villain was fiscal (a.k.a. budget) policy. Encouraged by the economy’s recovery and fearful of inflation – wholesale prices were rising, though not retail – Roosevelt decided that 1937 was a good year to redeem his promise to balance the budget. Although he failed, the budget deficit declined, driven down by the start of Social Security taxes (without offsetting benefit payments, which hadn’t yet begun) and the absence of a veterans’ bonus that had been paid in 1936.

On the facts, poor fiscal policy seems guilty, but some modern economists reject that verdict. By itself, the budget shift was too small to explain the economy’s dramatic change, they say.

Another culprit is the Federal Reserve, which between August 1936 and May 1937 doubled the amount of banks’ required reserves. (Reserves are funds that banks keep to meet depositors’ withdrawals.) This, it’s said, squeezed banks’ lending and money-creation. Again, modern scholarship objects. Banks already held high levels of reserves, so the new requirement had little impact, concludes an influential study by economists Charles Calomiris, Joseph Mason and David Wheelock.

A final explanation involves gold. Since 1934, the United States had been receiving large gold inflows – reflecting fears of political instability or war in Europe – that stimulated economic expansion. The reason was simple. When the gold arrived here, it had to be sold to the government for dollars. Those dollars were then spent or lent, giving the economy a boost. But in late 1936, the Treasury – again, to quash incipient inflation – decided to offset this boost by draining money from the economy. In economic jargon, the gold flows were “sterilized.”

This turned out to be a massive miscalculation. The sterilization created a “pronounced monetary shock,” argues a paper by Dartmouth economist Douglas Irwin. Growth in the money supply, which had been rapid, halted. Stock prices fell, and interest rates rose. After the Treasury reversed its policy on sterilization in 1938, the economy recovered.

Exactly what government policies caused the 1937-38 slump remains unclear. Perhaps all of them. It almost certainly was some mix. With hindsight, the recession seems to have been preventable. This is a lesson that ought to weigh heavily on the Fed as it ponders what to do next. Though tighter policies are inevitable, a fragile economy is vulnerable to too much or too soon.

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Based on the [quantity theory of money equation MV = PQ] holding the money velocity constant, if the money supply (M) increases at a faster rate than real economic output (Q), the price level (P) must increase to make up the difference. According to this view, inflation in the U.S. should have been about 31 percent per year between 2008 and 2013, when the money supply grew at an average pace of 33 percent per year and output grew at an average pace just below 2 percent. Why, then, has inflation remained persistently low (below 2 percent) during this period? …

During the first and second quarters of 2014, the velocity of the monetary base2 was at 4.4, its slowest pace on record. This means that every dollar in the monetary base was spent only 4.4 times in the economy during the past year, down from 17.2 just prior to the recession. This implies that the unprecedented monetary base increase driven by the Fed’s large money injections through its large-scale asset purchase programs has failed to cause at least a one-for-one proportional increase in nominal GDP. Thus, it is precisely the sharp decline in velocity that has offset the sharp increase in money supply, leading to the almost no change in nominal GDP (either P or Q).

5267109005_ac183b2699So why did the monetary base increase not cause a proportionate increase in either the general price level or GDP? The answer lies in the private sector’s dramatic increase in their willingness to hoard money instead of spend it. Such an unprecedented increase in money demand has slowed down the velocity of Money …

And why then would people suddenly decide to hoard money instead of spend it? A possible answer lies in the combination of two issues:

•A glooming economy after the financial crisis
•The dramatic decrease in interest rates that has forced investors to readjust their portfolios toward liquid money and away from interest-bearing assets such as government bonds.

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