Noah Smith has a new post discussing the current fad of looking for alternatives to the rational expectations model. The motivation seems to be that we need to explain the collapse of bubble expectations and the rise in the propensity to save (although not actual saving?) during the 2008 recession. I understand why people want to do this, but it would be a very big mistake.
I’ve always thought that it was patently obvious that the Fed caused the Great Recession with a tight money policy that allowed NGDP expectations to collapse in late 2008. But other people apparently don’t see it as being at all obvious. They look for alternative explanations. And yet when you ask them why, they tend to give these really lame “concrete steppes” explanations, such as, “The Fed didn’t raise interest rates on the eve of the Great Recession, so how can you claim that tight money caused the recession?” Or they show themselves to be completely ignorant of actual Fed policy, and claim that the fed funds target was at zero when NGDP expectations collapsed in 2008. It wasn’t.
Fortunately, neither of those apply to the ECB, which had positive target interest rates throughout 2007-2012, and which took “concrete steppes” in both 2008 and 2011, tightening money and triggering not one but two plunges in NGDP growth, which led to two recessions. If there has ever been a more perfect example of the monetary policy/AS/AD model that we teach in our textbooks, I’d like to see it. (OK, maybe 1929-32.) And yet last time I did one of these rants almost no economists were blaming the ECB’s tight money policy for the double dip recession.
Now, I’m seeing progress. I’m seeing more and more mainstream economists accept the MM claim that the monetary tightening of 2011 caused the second dip in Europe. In a few more years economists will realize that the ECB tightening of 2008 (which was also “concrete”) caused the 2008 recession as well.
Then economists may begin to notice that the 2008-09 recession in the US was oddly similar to the eurozone recession, which was clearly caused by tight money. The only (minor) difference was that in the US it was “passive tightening”, if the fed funds rate is your preferred policy indicator.
A few economists don’t buy the “nominal shocks have real effects due to sticky wages and prices” model of demand side business cycles. I don’t agree with them, but it’s fine if people like John Cochrane don’t accept my claim that the ECB didn’t caused the eurozone depression. But as for the rest, the overwhelming majority who think nominal shocks do matter, I’m mystified. Take the AS/AD model that you see in McConnell, Mankiw, Krugman, Cowen and Tabarrok, Hubbard, or any of the other textbooks. Why do we even teach this model if confronted with an almost perfect example of a depression caused by tight money, we simply don’t believe it?
I was inspired to do this post by an excellent recent paper on the eurozone depression, by David Beckworth.