0:36 Intro. [Recording date: December 21, 2011.] Broad topic, my ignorance: I have trouble figuring out what's going on in the area of money and monetary policy. You seem to understand it, so I'm coming back to you to ask some of the same questions I've been asking for a while to see if I can get a little bit smarter. Let's start with a little bit of a review. In your perspective, what does monetary policy have to do with the mess that we are in right now? Basically, I see monetary policy as driving nominal spending in the economy, nominal income. By nominal you mean just the dollar value, rather than corrected for inflation? Right. So, if your listeners were to imagine their own income, and then add up everyone else's income in the entire United States, that would be total nominal income. And so that's the variable that I think is the key to the business cycle. Now, I don't think it's a key to long term economic growth. In fact, I don't think it really even matters much in that area. But in terms of the business cycle, I think fluctuations in nominal income or spending are really the key. I want to stop you there again. So, when you said it doesn't matter in the long run--you mean, for example, if we doubled nominal income, our wages doubling, but we didn't produce anything more, we'd have twice as much measured income, but we wouldn't be any richer. Right. Prices double, and then your real power of purchasing would be unchanged. So, that's an example of where the government could affect, say, nominal income as a whole, but in that example, we wouldn't be any better off. I think in most people's minds, this is one of the great sources of confusion in macroeconomics. "Well, but I'd have to double the income." Famous Mark Twain passage. People have trouble perceiving that your income--it depends what it can buy. If you can't buy any more, you are not any richer. Right. And I think one of the big confusions in macro is that people confuse two issues, the real and the nominal. So, some people talk about what can the Federal Reserve (Fed) do? There's one question which is: Can the Fed boost nominal spending or nominal income? And there's the second question, which is: Would more nominal income boost real output? And those are two very distinct questions. I think most economists believe that at least in the long run, monetary policy can target nominal variables or control them in some sense by controlling the quantity of money. There's somewhat more disagreement about how that plays out in terms of real variables--whether they are affected in the short run or not at all or over a fairly extensive period of time. But, when you see a lot of the debates about Fed policy, you see people mixing and confusing the two issues. What does it mean to say the Fed is out of ammunition or not able to do anything? Are you talking about nominal spending or are you talking about real output? Two very different questions. A good example would be Zimbabwe, which produced spectacular growth in nominal spending, but almost all through inflation, so there was no growth in real output. To the point where inflation was sufficiently high that real output would fall because the normal channels of exchange were so uncertain. Exactly. And of course, they had other supply side problems, too. So, that's one issue. My view is that there really should not be a serious debate about whether monetary policy can drive nominal variables. It's just a question of how determined the Central Bank is. They can print almost unlimited amounts of money. I think the real debate, in my mind, is: What is the proper path of nominal spending or inflation or whatever nominal variable you wish to target--could be the money supply, as Milton Friedman proposed. There's going to be some nominal variable that's going to be the anchor for the monetary system. Another example is the gold standard, where it was anchored to a fixed nominal price of gold for many years. So, you have a monetary policy that in some sense determines nominal aggregates--and I happen to think nominal income is the best one to stabilize. And then the second question is: If you do that, what sort of real outcomes in the economy do you get? And that's where I distinguish between the business cycle and long-run growth. I think monetary policy can help smooth out the business cycle by having a stable path of nominal income growth, but it can't speed up the real growth in the economy. That's due to structural factors, government policies, incentives, all sorts of productivity, etc.

5:47 So, what went wrong, do you believe--there's two parts to this question. What went wrong to get us into the mess, and what has gone wrong with getting us out with respect to monetary policy? We debate in the policy sphere about every aspect of policy. We debate fiscal policy, we debate monetary policy, the structural things, side-issues about what to do with the housing market. But basically you focus a lot on monetary policy. So, what went wrong with monetary policy, both to get us here and to fail to get us out? First of all, if you just look at the path of nominal GDP over the last 5 years and knew nothing about the rest of the economy--you didn't know there was subprime bubble and crash and banking crisis and all that stuff, you didn't know who was elected President in 2008--you would predict a fairly severe recession, just based on the path of nominal GDP. In 2009 it fell at the fastest rate since the Great Depression, and it's grown very slowly since, much more slowly than in a normal recovery. So, that's one level of causation. But then of course people will say: But that doesn't really explain anything. Why did that happen? When we have a recession, isn't nominal income going to go down? No. For instance, in 1974 we had a very severe recession, and nominal income rose fairly briskly because we had high inflation. That was the famous oil shock case. So, real Gross Domestic Product (GDP) falling is actually the definition of a recession. So, if I were talking about real GDP I would have just stated a tautology. But nominal GDP, I do think there is a causal relationship between a fall in nominal GDP, which as I say I think is controllable by the Fed, and the impact on real output. And then the next question is: What caused GDP to fall? Certainly the Fed probably didn't want this to happen. There I think it's kind of a complicated story where parts of it have to do with the financial crisis sort of unintentionally made monetary policy more contractionary than the Fed wished or desired. And second, in late 2008 the financial crisis was a big distraction, so I think the Fed wasn't really focusing on the fact that its monetary policy stance was inadequate to promote nominal growth. And another thing is I think there is a tendency to confuse symptoms and causes. When you have a severe crisis, all sorts of things happen to an economy that look like causes that might very well be symptoms. For instance, almost every crash in nominal spending is associated with a financial crisis of one sort or another, throughout history. And there is a tendency at the time for people to blame the problems on the financial crisis because that's much more visible than the fall in nominal spending. So, that was the original view of the Great Depression--that it was caused by financial problems. Later, Milton Friedman and Anna Schwartz started to convince economists that it was actually monetary policy failure. I could point to examples like Argentina about 10 years ago where their deflation and all of nominal GDP led to the severe financial crisis. And then of course more recently--well, what's interesting about the current situation is you had, in both the United States and Europe, very real problems that had nothing to do with monetary policy. In the United States, it was our subprime fiasco. And in Europe it was fiscal policies, especially in places like Greece. So, those are outside of the story I'm telling. But what happened was that when nominal GDP fell in both places, each of those crises spread and became much larger than the original problem. So, you so of started with some bad loans made for a variety of reasons, and then you had this fall in nominal GDP. And instead of just having a subprime crisis in America, we had a huge debt crisis that spread into commercial loans, and municipal loans, and sorts of other things. And then in Europe instead of there being a Greek debt crisis, there became a Eurozone debt crisis because of the fall in nominal GDP. So people view the financial crisis as the problem, whereas I see it more as a symptom of a deeper problem, which is inadequate nominal income, which makes it tougher to repay loans. After all, most loans are nominal loans. They are not indexed to inflation. So, when nominal spending falls, it's much harder for people or governments to repay loans.

10:44 Let's digress about that for a minute. My presumption remains, after many conversations, some on this program, that the real danger of deflation is a simple danger. It's not as frightening in and of itself as people make it out to be. The reason it's dangerous is that it's rare. It's often unexpected. And if I have made a promise to repay you $1000, which is as you say a nominal promise--meaning it's just a certain amount of money, that's all we mean by "nominal," it just means dollars, some absolute numbers--so if I promised to repay you $1000, if there is a deflation and I have trouble and my wages fall for example, all of a sudden my ability to repay that has changed. And you are expecting to get that money and do something with it. I might not be able to keep that promise. However, if we had expected deflation then we would have had a different interest rate implicit in that loan and things would have been very different. So, it's unexpected deflation that can lead to contractionary problems as people struggle. I think that's right. But let me just make one little addendum there. A good example was in the late 1920s when we had a little bit of deflation--maybe 1% or something per year. I'm not sure the exact number. But real GDP was growing strongly, so people's nominal incomes were going up maybe 3% a year, something like that. Because monetary policy was relatively neutral, you are saying. Relatively neutral. So, people sort of expected back in those days that there might be a little bit of deflation. So that didn't really create any problems for the economy. It did very well in the late 1920s, until the end of 1929. But what tends to happen is that when you get a severe deflation, it's almost always unanticipated. So, in the 1930s, we had this big drop in prices. And the reason why it's almost always unanticipated is: It's hard to have anticipated deflation at a rapid rate, because that would do is make the real return from holding cash become very high; and that's not like just an equilibrium solution to an economy. It's sometimes called a liquidity trap. So, if you had 10%/year deflation, people holding cash would earn a real rate of return of 10% on just sitting on cash in their wallets. And the economy isn't really capable of generating that kind of real rate of return on a safe asset like cash. So, instead you get a liquidity trap developed. What do you mean by that? I don't really mean "trap" in the sense most people use it. I don't think it's a barrier to expansionary monetary policy. All I mean is that you get a situation where people sort of hoard currency, and interest rates on other assets, like government bonds, fall close to zero. But that sort of environment--because that's not an equilibrium condition for the economy, to have that sort of real interest rate on cash, what would tend to happen is if you tried to run a deflation that was very rapid, you'd probably end up in a depression, for various reasons. But mild deflation which still allows for a positive interest rate is still a feasible solution, and we saw that in the late 1920s. Now, in our modern world unfortunately we are expecting not a 1920s situation but a positive rate of inflation and also positive real GDP growth. So, most people are probably expecting about 5% nominal growth, and they made their plans on that basis. They made wage contracts, signed debt contracts on those expectations, and when they didn't pan out--nominal income fell about 4% from mid-2008 to mid-2009, that fall was 9% below what people expected based on trends. So that really made it a lot harder to repay debt, and it pushed a lot of marginal debts over the line into problem debts. It still is true that much of the debt problem was bad decisions, but the amount of actual distress you have depends also on the ability of people to service those debts, which is national income basically.

15:12 I want to come back to this parallel between our subprime crisis and the European crisis and how people see them as two different things, and you see them both being exacerbated, made worst dramatically by a failure of monetary policy. We'll come back to that. Let's stick with your observation a few minutes ago. You said the Fed, very focused in 2008 on the financial crisis, for whatever reason failed to note or failed to respond to this drop in nominal income and dropped the ball, made things worse. So, as a casual observer, I would be puzzled by that; and here's the obvious question. Help me understand it. Around that time, the Fed was doing some of the most aggressive monetary interventions of our lifetime. They were injecting a trillion, two trillion--I don't remember the numbers, you probably do--trillions of dollars in what's called high-powered money. That is not like literally printing money and dropping it from a helicopter, but entering it into its books; buying up assets from various banks and entering it into the books of those banks. Reserves, which they would now be free to lend. So, you are suggesting that the Fed was being negligent in being insufficiently aggressive and having too tight a monetary policy. But on the surface, it's the most aggressive, expansionary monetary policy in recent history--maybe ever. So, reconcile those two broad points. Let's be clear what we are talking about here. You are presenting what would be the liquidity trap view, that they pushed all this money out there and it didn't do anything. I'm not presenting anything. All I know is you look at the balance sheet. I have a mild horse in this race; we'll get to my horses later. Let me put it this way: I'm characterizing your view . In other words, there are two issues here. One is, would more nominal spending boost real spending; and the other is, would expansionary monetary policy boost nominal spending. And we just know from the data that we haven't gotten a lot of nominal spending in the last three years. So, the real question is why haven't we gotten much nominal spending given this big increase in the monetary base. And I think there are several reasons for that--probably three reasons I could cite. One reason is when they started doing this in late 2008, they simultaneously instituted a program called Interest on Reserves. They'd never done this before--paying banks interest on the reserves the banks held. And so what actually happened is almost all of this new money the Fed injected into the economy went into the banking system and sort of sat there as what's called excess reserves. Meaning cash that sits on the bank balance sheet but they are not doing anything with it other than collecting interest from the Fed. The Fed requires that they keep a certain minimum amount, and they are well above that minimum. Most banks. Usually what happens is required reserves would be like $50 billion, say, and excess reserves might be $1-2 billion. Now we have required reserves still being around $50-60 billion, across the whole system, but the excess reserves have gone into the trillions. Or maybe between $1-2 trillion. And that's from $1 billion or $2 billion. So, we're seeing an increase of a thousand fold, order of magnitude increase in excess reserves. It's almost all gone into the excess reserves category. I think there are two reasons for that. One is that the Fed started paying interest on reserves. Now, this might really surprise you, because people don't really remember it this way, but during the big crash in nominal GDP, which basically took place in the second half of 2008, the Fed's interest rate target was not yet at 0. It was running around 1-2%. And the Fed decided they wanted to put a lot of money into the banking system, a lot of liquidity to sort of bail out the banks, prevent the system from freezing up; but they didn't want a highly expansionary monetary policy. So, the reason they started paying interest on reserves, surprisingly, was to prevent interest rates from falling to zero sooner than they actually did. Now, in the end, in the middle of December, interest rates were finally cut close to zero. But during that big injection of money in the middle of 2008, the Fed specifically wanted it to stay in excess reserves and paid banks interest on that in the hopes that it would stay there and prevent interest rates from falling too fast. In other words, the policy was basically contractionary in its intent. And that's pretty generally accepted. Now, it was offset by the fact that a lot of money went in there. It didn't do anything. A term we use in monetary economics is that it was sterilized. It was made so that it didn't really have any effect. They paid banks to just sit on the money. Hang on. We are getting close to getting rid of some of my ignorance, because this is one of the deepest and strangest parts of this whole episode. Currently, banks are earning about a quarter of a percent on those excess reserves. Yes. And those who sneer at the implications of paying interest on those reserves say, well, a quarter of a percent on $2 trillion. Say, between $1 trillion and $2 trillion. People say that's such a small amount of money. But of course it was higher initially, as you point out. It was close to 1% initially. They changed it several times in late 2008, but it was somewhere around 1%. The other thing you have to look at. I'm not sure that right now that's a big problem, but even a quarter point is more than banks can earn on, say, Treasury Bills or certain alternative investments. You have to look not just at the amount that is paid but also at the banks' alternatives for other safe investments.

22:20 All right, but so here's the question. You state it as if it were fact when you say why the Fed did this. We don't really know what's going on in the mind of the decision makers at the Fed. Ben Bernanke's the most prominent, but there are other people with influence. It's somewhat of an emergent decision. It's deeply puzzling, why at a time when the American economy, when unemployment stinks, when the economy is recovering at a tepid pace, very disappointing to everybody across the political spectrum--why would the Federal Reserve discourage its activity from having an impact? It does nothing. Let me state it in a way that's not at all controversial, and give you something that's in the public record. Two days after Lehman Brothers failed in September, the economy was clearly worsening. The Fed had a meeting and they decided not to cut interest rates. They left their target at 2%. Here's my question. If in the fall of 2008, the Fed was doing all it can to revive the economy, why would it not have cut the Fed target from 2% to say, 1.75%, 1.5%, 1.25%, 1%, .75%? This is certainly what I favored at the time. I think we compress history in our minds, and we remember the Fed getting more aggressive in early 2009 when it started the first quantitative easing program. But I think we tend to forget that in the last half of 2008, when the actual collapse in nominal GDP occurred, the Fed was actually pretty passive. After Lehman Brothers failed they issued a statement saying that "we see the risks of inflation and recession as being equally balanced." In other words, from their point of view, the economy was right on target, but there was some risk that there would be too much spending in 2009, and some risk that there would be too little spending in 2009. Those risks were balanced, so they said: On balance, we're not going to cut interest rates. At the same time they wanted to push a lot of money into the banking system. Other things equal, that's clearly expansionary. My point about interest on reserves is that it essentially neutralized that injection. The injection of all the money was expansionary; then the decision to pay interest on reserves sort of tied up the money and made it non-expansionary. So, if you net the two out, it's simply a passive stance by the Fed. So, I've suggested--it's a depressing suggestion--that the policy of paying interest on those reserves was simply a back door subsidy to the banking system. Again, people say: Well, it's only $5 billion at the current rate--$2 trillion in reserves at a quarter percent is about $5 billion. At 1% it's about $20 billion. And you can argue whether $20 billion is a lot or a little bit of money. I think for some banks it was a great deal of money. You can't just look at the entire system and say: Well, for the overall system it's a trivial subsidy. I think for certain banks it may have been the difference between survival or not. That's certainly possible. That's the empirical question I'd want to investigate. It's possible they had these twin objectives--they wanted to put money in there to help the banks, and they wanted to not have interest rates fall to zero. As you probably know, if you inject a lot of money into the system, the free market interest rate will tend to fall, normally, because you are increasing the supply of money, so that depresses interest rates through the liquidity effect. That's how monetary policy normally operates. So, this huge injection, late 2008, normally would have pushed interest rates immediately to zero if the Fed had not done the interest on reserves. So, why did--let's give the Fed the benefit of the doubt--why was that an unattractive outcome for them? To push interest rates to zero right away? Yes. As I said, believe it or not, they said that the risks of inflation and recession were equally balanced. They were sort of looking through the rear view mirror. Inflation had been high in the previous 12 months, but the futures markets, or more specifically what's called the TIPs spreads, which is the difference between interest rates on regular bonds and indexed bonds, those financial market indicators showed that investors expected about 1.2% inflation per year over the next 5 years. Very low. That's below the Fed's implicit 2% target. So, I've argued that actually the Fed should have worried about inflation being too low, not too high. But they were sort of like driving a car by looking in the rear view mirror, and trying to notice when it was going off the road; and they weren't looking at the market indicators, looking down the line to see where the economy was headed. And if they had done so, they would have seen that inflation was probably going to come in below target. Now, let me hasten to add--these are just futures indicators. They are often incorrect. It just so happens that the one I cited the day after the meeting the day that Lehman failed did turn out to be fairly accurate--we've run about 1.2% inflation on average since that meeting. Although it's been highly volatile. Deflation in 2009 and much higher inflation in 2011. But on average we've had about 1.2% inflation over the last 3 years. That was one of their mistakes, to have a backward looking policy and not take market indicators into account. I think if they'd done so they would have been more aggressive. I think if they could go back in a time machine, seeing what's happened I think they now realize they made a mistake in late 2008; and some of the aggressive moves they've done which have not had much effect, which I'll get to in a moment, would have been more helpful back then. The problem we are in now is once interest rates get near zero, even eliminating interest on reserves may not be enough to get the money circulating in the economy. Because with interest rates near zero there is almost no opportunity cost for banks to just sit on money. What you really need then is a more aggressive policy of targeting some variable, like inflation or nominal GDP, at a level that will raise expectations of future nominal growth and make the price of assets go up and the demand for credit go up and boost spending in the economy. And the Fed is unwilling to do that. So, they've missed their chance to play around with conventional policies like cutting interest rates, which they could have done after Lehman failed. Now they are in a more difficult, unconventional world where they can't cut interest rates any more because they are near zero; and they are simply afraid of using, for whatever reason, unconventional policies that would be effective. Although they've tried some ineffective unconventional policies. Let me be more precise--not completely ineffective, but not effective enough. I would say that all the things they've done probably have prevented the economy from being in a deeper depression right now--I'll concede that--but not enough to promote a rapid recovery like we saw from the 1980s recession, for example. Which was also a fairly large one. Another deep recession. And that one had a very fast recovery, along with very fast nominal GDP growth. Again, to me in a way there's no mystery about the weak recovery. If people say: Where are the jobs? There's no jobs because GDP growth is slow in real terms. Why is real GDP growth slow? No mystery there either--nominal GDP growth is very slow. So, in the 1983-1984 recovery, nominal GDP growth averaged about 11% annual rate for six quarters. In this recovery, it's been a little over 4, 4-4.5%. What does that mean? It means that in a world of low inflation, you are only getting about 3% real growth, which is barely above trend. And that's why we've had such a small reduction in the unemployment rate. We're growing in this recovery over the last few years just barely above trend.

31:18 But all of this presumes that somebody's in charge of nominal income and nominal spending. If we went back to that 1983-84 recession, can you point to things that the Fed did rather than things that just turned out that way? Well, they had an easier job, because all they really needed to do was just cut interest rates to promote a more rapid recovery, and they did that aggressively. They started high. Now, in our situation--and by the way, it's not just the Fed. What I found looking around the world today or looking back through history, is every single time, I believe, that countries get into this zero-rate situation, monetary policy tends to be less expansionary than expected. You tend to stay in this slow nominal growth phase for often an extended period of time, and we went to low interest rates in the early 1930s and they stayed that way almost all the way into the early 1950s. Japan went to near-zero interest rates some time around the mid-1990s and they are still there. Europe and the United States have gone into a low-interest rate environment in the last three years and are basically still there. And even more interesting is the fact that twice in Japan and twice in Europe they tried to escape from it by raising rates, and they did so prematurely; and each of those four occasions, the Central Bank had to do an embarrassing about-face very quickly and cut them right back down. It occurred in Japan in 2000, in 2006 where they raised rates--the economy slowed and they quickly had to cut them again. And in Europe, the European Central Bank raised rates in mid-2008 and then had to cut them soon after; and they did it just this year in April, I believe they raised rates from about 1 to 1.5%; and then the European economy slowed in the latter part of this year and the European Central Bank has recently cut them right back down. So, those are four very embarrassing about-faces for central banks, all because they were anxious to get out of the zero-rate trap but hadn't created the robust nominal growth that would support higher interest rates. So, they did it prematurely, essentially. But where's the cause and effect? If you ask a person, somebody running a business, and say: Interest rates are really low. This is your chance to go out there and really do some great projects. Why isn't that happening? The standard answer you hear is: Banks are uneasy about lending because the future is uncertain, and businesses are uneasy about investing, because the future is uncertain, and that's why interest rates are low. Is that true? Excuse me--that's why we don't see a lot of investment. It depends on what you mean by uncertain. There's kind of two arguments on this, the liberal argument and the conservative argument. And they are both probably true to some extent. The liberal argument is that the low interest rates haven't helped because there's not much demand in the economy. Not much spending. So companies are operating factories at, say, 75% of potential; they don't need to borrow to expand their plant, equipment because there's not much demand for their goods. Or, in the housing market, sure there are low interest rates, but since house prices keep falling why would someone want to buy a house now? So, there's not much demand for credit. And so the interest rates reflect a weak economy. The conservative argument is that a lot of bad government policies scare businesses, deter investments--taxes, regulation, and so on. And that may be true, and I think it is true to some extent. But the liberal argument here is really all you need. I don't think it's a complete explanation of the recession, and I've argued to some extent against liberals on some issues like unemployment insurance and other things that I think are increasing the structural rate of unemployment in the economy. But on balance I think that when you have very weak nominal spending, the free market interest rate will tend to fall to zero even in an economy that doesn't have a lot of structural weaknesses. It's not an assumption you need to explain what's going on here.

35:49 But then what's the implication of what we ought to be doing? The left-of-center approach is, say: We just need to spend more. We need to get nominal income up--they agree with you. Nominal income has been falling or is not rising at a fast enough rate, so something needs to fill that gap by spending more money. That's their standard argument. Why are they wrong? They are arguing for government spending, which I think first of all won't really help very much. And second, monetary stimulus. The best way and probably the only way to promote faster nominal GDP growth is to get a more expansionary monetary policy. So, I think the mistake on the left is to put too much faith in fiscal stimulus. Fiscal stimulus is relatively weak, and it also tends to be offset or neutralized by monetary policy. But let's say monetary policy stayed as it is; the President and the Congress got the Keynesian religion; they listened to Paul Krugman and they increase government spending in the United States by over a trillion dollars this year, which is what many people are advocating who are Keynesians. They argue interest rates are too low; the Fed has no bullets left. So, they can't lower the interest rate any more; so the best thing to do is have government spend. Government spending a trillion dollars--isn't that going to increase nominal income? Here's the tricky part: When you said, let's leave monetary policy as it is, you slid over a very subtle and complicated question, and that is: What is monetary policy? And I find when I talk to people, everybody I talk to seems to have a clear and definite idea in their mind about what we mean by holding monetary policy constant. But they don't equate with each other. So, for some people that means the Fed keeping the money supply constant. For others it means keeping interest rates constant. Which is a very different policy. And I think both of those are wrong because it's not what the Fed is actually doing. What the Fed is actually doing is adjusting monetary policy to conditions in the aggregate economy. So, they'll do some quantitative easing (QE), then they'll back off; they'll do some more. Or Operation Twist. Or they'll promise to keep interest rates low for two years. And these policies are not highly effective, but they are probably effective in slightly nudging the economy a little bit faster, a little bit slower. So, what the Fed is doing is these on and off policies as it reads the incoming economic data. If the data gets stronger, the Fed does less. When the data gets weaker, the Fed does more. What that means is fiscal stimulus does succeed in promoting a little bit faster growth; the Fed will react by doing less quantitative easing and other policies of that sort; and it will very likely neutralize most of the effect of the fiscal stimulus. Now, I'm not trying to stake out an extreme position here. If the Federal government did an enormous amount of fiscal stimulus, yes, I think it would boost nominal GDP. Whether it would be a good idea would be another question. But obviously, if you took it to the extreme like the spending in WWII, it would definitely boost measured GDP in the economy. But for the amounts that are politically realistic, I really don't think--let me put it this way: The original stimulus bill was originally around $800 billion, in 2009. Ended up being $825 billion. I think it was a mixture of spending and some tax rebates. About 1/3 each--1/3 tax rebate, 2/3 spending, and of that 2/3, 1/3 on payments to the states and 1/3 on various so-called expansionary activities of various kinds. And that was done in early 2009. About the same time the Fed was getting very worried about the economy. It wasn't "done" in 2009. The legislation authorizing it was enacted. It took a while to spend it; it spent out over 2 or 3 years. Right. But importantly, by the way, a lot of modern theories say the effect on demand should come with expectations; so it should start even when the program is not enacted. You've got that program, then. The standard way of looking at it is to assume the Fed is just this passive bystander. But everything we know about Ben Bernanke, throughout his career, tells us very clearly he had no intention of allowing a Great Depression II on his watch. He's a scholar of the Great Depression. He passionately believes the Fed blew it by not being more aggressive. He's also insisted all along the Fed has lots of ammunition they haven't used. He's talked about things they could do, things he recommended the Japanese do that he hasn't done yet. So, the Fed has a lot of ammunition left including the most powerful tools, which they haven't pulled out yet. Which are? Setting a higher inflation or nominal GDP target is the most powerful one probably. If they could. That would be politically controversial, especially if they did it in terms of inflation. I prefer nominal GDP. But here's my point: Suppose Obama did nothing in 2009. There's no way the Fed would have just sat back passively and watched the economy collapse. What would have happened is with less fiscal stimulus there would have been a lot more monetary stimulus. I don't know exactly what it would look like. I'm not saying it would have exactly made up for the lack of fiscal stimulus, but my point is this: Any estimate of the effects of fiscal stimulus are probably really wildly exaggerated by not taking into account the reaction function of the monetary policy makers. And that's the big flaw in the way we think about fiscal stimulus. And no matter how many times I make this point, I find it's very hard for people to absorb it. They want to think in terms of other things equal--like, okay, there's the monetary policy; now let's see what fiscal policy can do. It doesn't work that way. If fiscal policy does more, monetary policy will do less. That's how things work.

42:21 I agree with your idea--I've always felt it's an interesting psychological insight--that the greatest living scholar of the Great Depression is Ben Bernanke. Nothing could be more embarrassing than for his legacy to be that he allowed it to happen under his watch. For one thing he's a great scholar of the Great Depression. For another, there's this famous conference where he, in the presence of Milton Friedman, who is not with us any longer and who I'd argue would be the number 1 scholar of all time, but fine, Ben Bernanke's second but now he's first because Milton's gone--but at that conference while Milton was still here, Ben Bernanke said: Don't worry, Milton, we won't let it happen again. Now, as you said earlier, maybe he's achieved that level. He did enough to avoid a Great Depression. He didn't do enough to avoid a Great Recession. But why would he even get this close? Why would he, when he saw that that $787, now $825 billion of stimulus wasn't doing very much, why would he counteract it? You are suggesting he counteracted it, and that's why it had no effect. Is that what you are saying? Yes. The way I would put this is: He didn't go out and say: Aha, I'm going to go out and counteract this now. If you asked him, he would deny counteracting it. No doubt. In his own mind he would not believe that he did that. But I believe that if you really think through the logical implications of what the Fed would have done in the absence of fiscal stimulus, that in essence it was sabotaged. I know that's a very counterintuitive and controversial statement, and almost nobody agrees with me. But I think that's because they are not thinking about the issue clearly enough. It's not that the Fed would ever set out to hurt the economy intentionally or anything of that sort. I happen to believe the Fed underestimated the amount of stimulus that was needed. If there had been no fiscal stimulus, their estimate of what was needed on the monetary side would have been substantially higher, and that's the logical point I'm making. Now, if you word it in a certain way, it sounds very appalling, like the Fed is sabotaging fiscal stimulus; and that's not it at all. But that's really kind of what it amounts to when you think about it logically. Let me give you an example of how the way we're thinking about these issues is so unlike the orthodox view. Can I take one minute to read a quotation--and I bet you cannot guess who said this, in 1999. This is about Japan. What continues to amaze me is this: Japan's current strategy of massive, unsustainable deficit spending in the hopes that this will somehow generate a self-sustained recovery is currently regarded as the orthodox, sensible thing to do - even though it can be justified only by exotic stories about multiple equilibria, the sort of thing you would imagine only a professor could believe. So, this is my view, interjecting. Continuing: Meanwhile further steps on monetary policy - the sort of thing you would advocate if you believed in a more conventional, boring model, one in which the problem is simply a question of the savings-investment balance - are rejected as dangerously radical and unbecoming of a dignified economy. So, he's amazed that people are suggesting that Japan do deficit spending when they already have this big debt and asking why aren't we doing the conventional monetary stimulus. Now do you know who said this in 1999? I'm going to guess it's Ben Bernanke from the way you are talking. No. Paul Krugman. That was my second guess! So, here's Paul Krugman saying exactly what I'm saying now, and I feel like my view of monetary and fiscal policy was the standard view, and in a sense the only reason we're even having this conversation right now is that in some strange way, the conventional view became very unconventional in 2008 and 2009. As you probably know, I'm not a particularly well known economist, at least prior to getting into blogging; and so the only reason we're having this interview is once I started blogging, I found that my view, which I thought was the conventional view, was in fact a fairly radical view and it got a lot of attention. A lot of people sort of thought of it as a very provocative, unconventional view. This is what I find so strange about what is going on. We have this situation where the standard view somehow twisted around from being monetary policy as the natural way of preventing a depression, which is the story that came out of the Great Depression, supposedly, to the view that it's actually fiscal policy that needs to do this. Now, some people will say it's different now because we're in a liquidity trap; but Japan had zero interest rates in 1999, roughly, when Paul Krugman made this statement. It's not really different. I'll just read you one really quick quotation out of the number 1 textbook in money: Monetary policy can be highly effective in reviving a weak economy even if short-term interest rates are already near zero. So, that's what we are teaching our students, right out of the number 1 textbook; and I found in late 2008 almost none of my colleagues believed this. They were all saying: Monetary policy can't do anything right now; we have to use fiscal stimulus. What textbook is that? Frederic Mishkin, Money and Banking.

48:03 So, one thing that Krugman's been saying a lot lately is that people who worried--this would be me, and others--that the injection of $2 trillion or so of reserves into the banking system is going to cause inflation--look how stupid they were. They were crazy. They were wrong. It didn't happen. When people ask me why didn't it happen, I quote Allan Meltzer. He said, on this program maybe two years ago: That's because they are not spending it. Then you come to the question of it's not in the economy; of course it didn't cause inflation. They are sitting on it. So, the question I think it comes down to is I think Krugman would justify his current position by saying: It's true that in theory monetary policy could do something, but when the banks aren't going to spend the money you give them, then you are stuck and the government has to step in. And you are suggesting that that's partly because of the bad policy on the part of the Fed of paying interest on reserves, and partly because of other things. Here's one other point he would make, and where I partly agree with him. He would say: What Japan really needed to do was to set a higher inflation target. That is, create expectations on the part of folks. To lower the real interest rate. So, if the nominal interest rate is stuck at zero--let's say you have a 4% inflation. I think that's the number Krugman recommended. Then the real interest rate becomes -4%. In other words, it doesn't really cost anything to borrow money because you are paying it back with cheaper dollars in the future. This is something Ben Bernanke recommended the Japanese do as well. Do what? Raise their inflation target. To 4% rather than its current appearance of zero. I don't know that he mentioned the number 4, but to do what's called level targeting, which means make up for the deflation. So, Japan has had some mild deflation, and what Bernanke said was they should have some inflation now to sort of catch up for the previous fall in prices. I can't remember the number, but I think it may have been numbers like 3-4% mentioned in his article. This is something he wrote I think in the early 2000s. But interestingly he's rejected that for the United States and his argument is that we don't have outright deflation like Japan, so that's the reason he's able to reconcile these positions. It's hard to know. Given the way that the Department of Labor calculates housing prices into the Consumer Price Index (CPI), they've made some arbitrary choices; they might be right; it's a bizarre method; I'm sure the measurement of it is flawed. They have all kinds of problems with quality control, holding quality constant. One quick example that's really striking: According to official CPI data over the last 5 years, housing costs are up about 7.5%, total. That's a little weird. According to the Case-Shiller index, they are down like 32%. That's a 40% discrepancy between Case-Shiller and the CPI on housing, and housing is like a third of the CPI, roughly. In other words, I'm not trying to argue that we are really in deflation this year. This particular year, probably inflation is a little bit positive. But what I would argue is that in general the CPI is unreliable, and that's why I tend to focus on nominal GDP. And if you look at nominal GDP, it's just unambiguous. Instead of the normal 5% a year growth in nominal GDP, for the last 3 years it's been going up about on average I think 1-1.5% a year. And that's barely above population growth. So, basically what we are doing is we are not providing enough income, where we could have a fast recovery even if our economy was perfect. In other words, even if we had none of these flaws that you and I don't like about the regulatory system, the tax system, and everything. It's very unlikely that this amount of income will allow for a fast recovery, because to get a fast recovery we'd have to have rapid deflation, and you just don't tend to see fast recoveries during periods of rapid deflation. At least in a modern economy where probably wages are stickier than they used to be.

52:30 So, let's have a little fun. Let's suppose on December 31, Ben Bernanke writes a letter to President Obama and he says: I've always wanted to spend more time with my family, so I'm resigning. And to the surprise of many, the President, desperate for a healthy economy over the next 9 months, 10 months, for obvious reasons, puts in place Scott Sumner of Bentley University; he's approved, and on January 1st he takes control of the Fed's Chair. What would you do? What might you do? What would be your announcements and actions that you would think be the best in this situation? That's a good question. I'll give you a week if you want, but we are recording it now. You've got ten days, but let's pretend it's now. I can give you a quick answer, but it may not be a simple answer. First of all, any Fed policy has to be a strategy. It can't be just a tactic for the moment. So, I can't really know what's best for right now unless I know what the long term trajectory is. If I had to choose, I might just default to what the Fed was doing prior to the recession, which was promoting about 5% nominal GDP growth, maybe a little bit lower. Maybe 4%. That would be the long-term target. How do you get to a target like that? What would be your actions or words? Okay, but the second part is I think we need a little bit of catch up in the next two years because we are so far below trend. I don't think we should try to go all the way back up to the old trend line. I'd like to see us promote maybe 6-7% growth for the next couple of years, and then whatever we decide on. Let's say I pick 4% thereafter. Now, how do we get there? The ideal policy would be to create nominal GDP futures contracts. And peg the price of them. That is, issue enough money until the market expected nominal GDP to grow that fast. So, you would just keep injecting money until you got the nominal GDP futures contract showing the amount of growth that the goal of the policy was. How would you do that? How would you inject a sufficient amount of money given that the past injections have had no effect? First, if you want to make them more effective, you'd stop paying interest on reserves. That's a start. Now, let's suppose banks continue to sit on the money even at zero interest rates. You could always make the interest on reserves negative. You could charge them. That would be a fairly radical move. Now, I happen to think that's not necessary. That's a fairly radical option. That doesn't seem so radical. Well, it would probably for instance destroy the money market mutual fund industry, because people would be better off keeping money in safes in their house at zero interest--cash--than they would sitting in money market mutual funds at negative interest rates. I don't know if you see what I'm saying. I don't. There would be some distortions to the financial system. That would be really bad. I would prefer that instead of going to negative interest on reserves that the first option would be to simply buy as many assets as necessary. The Fed hasn't even scratched the surface for what they could buy. There's a lot of assets out there. But I think the more important point is that people tend to look at this problem backwards. What the Fed has been doing is injecting money and promising that they'll pull the money out again before we get a lot of inflation. Or anything of that sort. Mop it up. So, it's a temporary currency injection. Those are not going to boost GDP very much, or spending or inflation. To have an effect, it has to be more permanent. So, what the target does is it tells you the Fed is going to leave enough money out there permanently to try to hit this track that you've laid out, this trajectory that you are targeting for nominal income. Again, the optimal solution in my mind would be for the markets to determine how much money and what interest rates for this futures contract technique. Essentially the Fed just targets the price of the futures contract and passively adjusts the money supply as needed to make that target price stick. In other words, the analogy would be like the gold standard, except instead of pegging the price of gold, you'd be pegging the price of nominal GDP futures. In both systems the quantity of money in circulation is determined by how much the public wants to hold, given that trajectory for nominal GDP. Now, people will say: What if no amount of money gets you there? You can't really seriously argue that because in the reductio ad absurdum, the Fed would buy up all of planet Earth. And pay for it with currency. Obviously that's not an equilibrium outcome. Long before you got to that point, inflation expectations would start rising and you'd have to stop the injection. I would even go further, though. I would predict that if my policy were put into effect, the monetary base--that's the money created by the Fed--would actually go down. In other words, we have plenty of money in circulation right now. Too much to hit that target. The reason we are not having faster growth is that there is too much demand for money, partly because of the interest on reserves and partly because of the low expected nominal GDP growth. If we had a robust, more expansionary policy people and banks wouldn't want to be sitting on reserves. They would move the money into places where they could earn higher rates of return. And it would turn out we could actually need much less currency to achieve our target than we currently have in circulation. Or base money, to be precise. When I talk about the monetary base I mean including both money in the banks that they are sitting on--the so-called excess reserves--and also the cash in circulation. That you and I hold. What would happen is the banks would probably stop sitting on all those excess reserves. The public certainly doesn't want to hold $3 trillion in cash. So, what would happen is at some point the Fed would have to pull some of that money out of circulation that was injected during the emergency, because in a healthy economy you simply don't have that much demand for liquidity. So, I'm not really worried that the Fed wouldn't be able to buy enough assets to make that happen. I would expect once they started buying assets, expectations would increase sharply, and that very quickly they would have to reverse course and start pulling money out of circulation.