This is the second installment of our interview series “Where is the General Theory of the 21st Century?“.
In this second installment, we continue our discussion with Prof. Scott Sumner, the Ralph G. Hawtrey Chair of Monetary Policy at the Mercatus Center at George Mason University, where he is the director of the Program on Monetary Policy.
In this interview, Prof. Sumner talked about his view on why there is no “Keynesian Revolution” in macroeconomics after the Great Recession and what is Market Monetarism. You can also read the Part I of the interview, where Prof. Sumner discussed the findings from his new book, The Midas Paradox and his views on what caused the Great Depression.
Q: So do you think there is a second “Keynesian Revolution”, what I mean is, are there any huge changes in macroeconomics academic going on after the Great Recession?
S: Well, I think it is sort of going back to old Keynesian ideas. Some of the popular ideas talked about by Paul Krugman, Larry Summers, and other more famous Keynesians. Some of these ideas are really bringing back Keynes’ ideas from the 1930s.
As far as new ideas, I am not certain. There is a lot of work on liquidity traps, and financial crises, some economists are trying to put the financial system into macroeconomics models, so we can better understand what happens when there is a banking crisis. But I think it is too soon to say how that is going to work out. I don’t think there has been any single new model that has emerged that has really been dramatic and revolutionary like Keynes’s was in the 1930s. So I am still not certain we have any dramatic new ideas coming out of this. Maybe in ten years we will look back and find someone working right now was doing something very important. But I just don’t see it.
I think it is mostly people trying to explain what happened by going back to old ideas and using them again, even ideas that have been forgotten.
Q: The Great Recession is supposed to be the closest experience to the Great Depression. Why, even after 8 years, we still don’t have another breakthrough? What is happening in the academia?
S: Obviously I have my own point of view. I am called a Market Monetarist. So I think that’s the right answer.
But if you ask me why don’t other people agree with me, I think the main problem is that the macroeconomy is so complicated, that different people can focus on different aspects of the problem. So even people that are well-intentioned and smart, and trying to get an answer, may disagree because someone will just look at the banking situation and say, “I think the financial system is the key.”
For me, I look at monetary policy and I said, “I think Federal Reserve policy and European Central Bank policy, those are the keys.” Someone else would say, “I think government spending and fiscal policy are the keys.” Because of such a large, complicated macroeconomy, so many things inter-relating, it’s really hard to prove any single theory over any other theory. It’s a very complicated, messy situation.
Maybe I should use the analogy of politics. People disagree on politics, partly because the world is such a complicated place, it is very difficult to know which presidential candidate would be the best until you actually see them in action. And people focus on different aspects. I think economics is a lot like politics in that way. We are looking at a very complex system. You try to simplify with models, try to focus on what you think is the key aspect of the problem. I concluded monetary policy is the key to the business cycle.
But other people just see other factors as being key. I do understand why that is. At first glance of look, it actually looks like the banking system was more important than the Fed. So I have difficulty at first getting people to pay attention to my opinion because it didn’t look like Fed policy was the problem.
Q: Is this a good thing? To me, as an outsider, I found that macroeconomics seems to be chasing its own tail. I have learned a lot of old ideas like Secular Stagnation, Natural rates, Liquidity Trap, but I can hardly present any new theories to anyone.
S: I know. I think the problem here is that in some way economics is more like an art than a science. So in movies and TVs, they run out of new ideas, they start using old movie ideas and simply remaking movies.
I think in economics there is only a certain number of ways that you can reasonably model the macroeconomic problem. You can say there is the supply-side view, the demand-side, Keynesian, Monetarist, etc. So you can’t just say, “let’s come up with a dramatic new theory that nobody has ever thought before.” You can’t just make it happen because people have been thinking very hard about the macroeconomy for decades and decades, more than a hundred years. People have been thinking very hard about the problem. There are only so many reasonable ways of thinking about what went wrong in the Great Depression or the Great Recession. So I think inevitably you get to a point where, instead of inventing new theories, you sort of bring back old ones and maybe trying to improve them.
You are right, we are not really coming up with any dramatic new ideas. But again I do think we are making some progress. My views are based on some of the ideas of Fisher and Hawtrey in the 1920s, but I think my ideas have also improved a bit on theirs. We understand some issues better because we have more data to look at.
Q: What is Market Monetarism? How do Market Monetarists explain the slow recovery of the Great Recession?
S: Unfortunately, this is a little bit like in my book where the answer is complicated. It was very similar to the Great Depression in which there were both supply and demand side problems.
In both cases, the initial downturn was caused by a drop in aggregate demand. So my starting point is a big drop in spending. Then if you ask about the slow recovery, I think is partly a supply-side problem in the economy. I think that the long-run trend rate of growth in America, and in other countries also, are slowing down. So there are two parts. We have a deep recession and a slow recovery.
Market monetarists focus mostly on the demand side, which is what caused the deep recession. I think the demand side also partly explains the slow recovery. I would argue that you should first look at nominal GDP, which is where demand comes in. Put it in another way, that is the total spending in dollar terms.
Essentially, the monetary policy failed in its job to keep nominal GDP growing at a reasonable rate. A reasonable rate would be at least 3%. The average had been 5% over two previous decades. That’s a failure of monetary policy, an excessively tight monetary policy.
Of course, that differs from the view of most other people who think that monetary policy was easy. The market monetarists say that it is wrong to look at the interest rate or even the QE as the measure of monetary policy. Instead, you want to look at the result: did nominal GDP grow fast enough? If it did not, then money was too tight whatever else was happening at the time.
We believe the key mistake was made in 2008 when the equilibrium interest rate, the one that will keep the economy stable, was falling very fast. The Fed did not cut interest rates fast enough. Because the Fed didn’t cut interest rates fast enough, spending started to slow dramatically in the second half of 2008. For instance, two days after the Lehman Brothers failed in September 2008, the Fed refused to cut interest rates from two percent at the meeting. They should have probably cut it very dramatically at that meeting, or even before that in fact. So we believe that monetary policy failed to be expansionary enough.
The term “market” in market monetarism refers to the fact that we disagree with the old monetarists. We favor using market expectations to guide monetary policy. Instead of the Fed just sitting down and thinking about the question “what do we think is best?” by themselves, they should set monetary policy at a level which the market believes that will lead to a fast enough NGDP growth. If you have a target of say 5%, you should always set interest rates or the money supply at a level where you expect to get 5% NGDP growth. The markets should guide monetary policy.
Q: Then in your view, why is inflation still so low around the world right now?
S: I think most central banks are doing roughly the same kind of policies, and they are having difficulty operating in a low inflation environment, where the interest rate is zero. They tend to set policy too contractionary, and that is especially true in Japan and Europe.
In the United States, we have recently raised the target interest rate. So I believe it’s a mistake to think that the US is just stuck with low inflation. The reason the Fed raised interest rate is they are worried about inflation eventually going above 2%. They believe that inflation will be 2% in a couple of years. Within the US, the question is whether the Fed is right or wrong. The Fed does have control over inflation, they are adjusting interest rates upward now, and may move again in July. They can control inflation. If they fall short, it’s not because they are not able to, it’s because they made a mistake in raising the interest rate target. If they fall short in two years, that would be the reason.
It is a whole lot different in Japan where they are stuck in zero. There I would say is the unwillingness to use the more aggressive unconventional tools that I recommended. You can use QE more aggressively, or set a level target instead of growth rate target. So when you are at zero, I support use of more aggressive policy tools.
But the Fed is already back to raising the interest rate, so they are back to standard monetary policy, and if they fall short, it’s not because they are unable to raise inflation, but rather because they made a mistake in raising the interest rate.
Q: Can you tell us more about your proposal on the NGDP level targeting futures market?
S: Way back in the 80s, I started thinking about this. I knew about the gold standard, and the problem with the gold standard is that you can stabilize the price of gold but then other prices go up and down, so it isn’t necessarily the best thing to stabilize.
So then I started to think about how we could stabilize the whole price level, sort of like the gold standard but have it be a basket of all goods and services in the CPI, and try to do the same sort of thing as the gold standard, but for the consumer price index. But then I thought, you can’t buy and sell all goods like cars and TVs in the way you could with gold under the gold standard. So instead you buy and sell a futures contract, tied to the CPI. It would be kind of like the gold standard, but for all goods, not just for gold.
So my initial thought was to use the futures contract idea for stabilizing the price level, but as I began to realize that the macroeconomy did better with nominal GDP stability than a price stability, I just took that idea and converted it from the CPI over to NGDP. So if you want to know how I got here, I started with the gold standard idea, then I went to the CPI, which is like a broader version of the gold standard, and then I went to nominal GDP.
So then I did a little bit of research on how that could work, how it can actually be implemented, how it will affect the money supply, and it could work automatically so that the Fed wouldn’t have to make any decisions. Essentially the market makes decisions.
I have a paper in Mercatus discussing all my views on the details and the specific ways of implementing it. I am still working on modifications to make it more practical or less controversial for the central bank. It’s a controversial idea right now. So now I am working on proposals that would gradually phase it in over time, a little bit at a time. We would see how it works a little bit at a time, before going completely to an automatic system.
Q: So under this plan, would the monetary policy-making process be more rule-based?
S: Yes, I consider it as very rule-based policy, and it is the kind of rule I like.
Other rules, like the Taylor Rule, adjust the interest rate according to a formula that they have derived from models of the economy. The formula said this or that interest rate should lead to good results, and the good results are successful inflation targeting, and so on.
The market monetarists say that instead of having just a model that you come up with, which could be correct or could be incorrect, the most efficient policy is to use the market forecast. And the market is going to look at many, many different models, and give a sort of consensus view of what the best result is, not any single model. There is a book called The Wisdom of Crowds, which explains the idea that averaging the opinion of many people is often more accurate than any single opinion. So essentially, if the market thinks there is too much nominal GDP growth, they started to buy contracts to profit from high future nominal GDP, and those purchases automatically reduce the money supply until expectations come back on target. So it works very automatically.
Q: So it would be kind of a perfect guide to monetary policy?
S: I always say that you never reach perfection, so someday someone would come along with something better than me. But I don’t think that’s a problem, as long as you are making things better each time, that’s progress.
Even as bad as the Great Recession was, we made progress over the Great Depression, we didn’t make mistakes quite as foolish as the last time. So I think that all we can hope for is to make policy better and better over time. But there will always be new things that pop up and probably a little adjustment to the model to reflect those.