Was Mishkin the Benjamin Strong of 2008? By Scott Sumner

Benjamin Strong headed the Fed during the Roaring 20s, and used countercyclical monetary policy to try to stabilize prices and output (which is roughly equivalent to NGDP targeting.) He died in 1928 and the new leaders of the Fed switched their attention to popping the stock market “bubble.” They succeeded. Stocks dropped nearly 90% between the 1929 peak and the 1932 trough. Some of the very greatest monetary economists of the 20th century (Fisher, Hawtrey, Friedman) suggested that his death might have contributed to the Great Depression.

I use Frederic Mishkin’s monetary economics textbook, which is the number one text in its field. I’ve often argued that the Great Recession would have been far milder if only the Fed had utilized the ideas in Mishkin’s text. Interestingly, Mishkin served on the Fed’s Board of Governors in 2008, retiring just before the fateful September meeting, where the Fed blew it.

Ravi Varghese has written an excellent post, pointing to 4 very prescient comments that Mishkin made in his final meeting, on August 5, 2008. I’d like to focus on this one:

First of all, let me talk about the issue of focusing too much on the federal funds rate as indicating the stance of monetary policy. This is something that’s very dear to my heart. I have a chapter in my textbook that deals with this whole issue and talks about the very deep mistakes that have been made in monetary policy because of exactly that focus on the short-term interest rate as indicating the stance of monetary policy. In particular, when you think about the stance of monetary policy, you should look at all asset prices, which means look at all interest rates. All asset prices have a very important effect on aggregate demand. Also you should look at credit market August 5, 2008 conditions because some things are actually not reflected in market prices but are still very important. If you don’t do that, you can make horrendous mistakes. The Great Depression is a classic example of when they made two mistakes in looking at the policy interest rate. One is that they didn’t understand the difference between real and nominal interest rates. That mistake I’m not worried about here. People fully understand that. But it is an example when nominal rates went down, but only on default-free Treasury securities; in fact, they skyrocketed on other ones. The stance of monetary policy was incredibly tight during the Great Depression, and we had a disaster. The Japanese made the same mistake, and I just very much hope that this Committee does not make this mistake because I have to tell you that the situation is scary to me. I’m holding two houses right now. I’m very nervous.

Until late 2008 I thought this was the general view. After all, it’s obviously correct, and it’s emphasized in the number one monetary text, written by a respected moderate economist. I had never heard any serious person contest this view. Then in late 2008 all asset markets crashed except risk free conventional Treasuries, clearly indicating ultra-tight money, and yet 99% of economists, including all of the remaining FOMC, seemed to believe that monetary policy was extraordinarily accommodative. It made my head spin. In retrospect Mishkin must have sensed the profession (and FOMC) moving away from him, why else issue that warning in his very final statement?

The remark was prefaced by this comment:

What I’d like to spend some time on–because I feel this is sort of my swan song, but maybe because I’m a classy guy, I’ll call this my “valedictory remarks”–are three concerns that I have for this Committee going forward.

Put it right up there with Eisenhower’s farewell address warning about the military industrial complex, or George Washington warning about getting entangled in foreign wars.

Unfortunately in the end I can’t honestly conclude that Mishkin staying on would have made any difference. Maybe Mishkin doesn’t even agree with me on this issue. Or if he does, he doesn’t seem like the sort of person to show “Strong” leadership. His text has been gradually changed since 2008, with each change moving it closer to (erroneous) conventional wisdom, and further from the truth. His discussion of the events of late 2008 is quite conventional, and completely at odds with the 4 key lessons on monetary policy that immediately follow. And even those lessons have been changed. Monetary policy is no longer “highly effective” at the zero bound, merely “effective.” A homework problem implying that a policy of interest on reserves is contractionary was mysteriously removed, right after the Fed adopted IOR at the very worst possible time—October 6, 2008.

The other problem is that Bernanke also said many wise things before the crisis of late 2008. He said low rates and a bloated money supply don’t imply that money is easy–you need to look at inflation and NGDP growth. Indeed Bernanke adeptly steered the Fed through the severe crisis of January 2008. Yet in the end the crisis of late 2008 was simply too much to handle for a monetary policy establishment that relied on outdated New Keynesian models and policy apparatus, models that focus on interest rates as a policy instrument.

Lessons have been learned, and the Fed will do better the next time. Indeed policy is already improving, and not just in the US—Britain and Japan are also doing better. But big conservative institutions adapt very slowly. It is fun to search the minutes for heroes and villains, but that’s now how things work in the real world.

I’m not even sure that Benjamin Strong would have been a strong enough leader.

PS. Read Ravi’s excellent post. Mishkin does deserve credit for a number of very wise and prescient remarks at his final meeting. He was an excellent FOMC member. Going forward we need a policy regime that will work OK even if there are a number of mediocre FOMC members. A system that will work well even if the FOMC contains people who think that printing money never solved any problem, but are experts on pop music references. That system would be NGDP targeting, level targeting.

PPS. Another difference: Mishkin’s merely retired from the Fed, Strong died.