The Midas Paradox: Financial Markets, Government Policy Shocks and the Great Depression

"Scott Sumner was a much overlooked monetary thinker until 2008. This goes back to my student days, when Scott was a young professor. He wrote some very interesting work on monetary policy rules. Scott’s personal history as an academic is interesting in relation to the history of monetary policy, particularly in the US, because Scott and Robert Hetzel, who we’ll come to in the final book, both did some work that was very similar. I read both of them when I was in university in the early 1990s. I’m very happy to call both of them very good friends today. They both wrote on monetary policy rules and how we could have better rules that could stabilise either nominal demand in the economy or the price level. What happened in the early 1990s was that those kinds of policies were, in a broad sense, adopted. The monetary machine was working fine and nobody was interested in monetary policy. What Sumner had been writing about in his career as a young professor was solved quite fast. But then he started to teach monetary history and was writing on it, and worked on this book, the Midas Paradox , for many years. Up until the crisis, he had not been a public person. He was just an economics professor. But, when 2008 happened, he said, ‘Well, this is a monetary crisis.’ And Robert Hetzel, who was an economist at the Federal Reserve, said the same thing. And I was sitting in Copenhagen saying, ‘Well, this is a monetary crisis.’ Sumner and Hetzel were both graduates and PhDs from Chicago, where Friedman had taught. I see myself as a Chicagoan, even though I was educated at the University of Copenhagen, because all I read was Milton Friedman. We all came to the same kinds of conclusions in 2008-9. What we all realised was that when we went back to Milton Friedman and looked at the money supply numbers, something was missing because, just looking at the money base, you could see that it was going up. That led a lot of people to conclude that we would have very strong inflation. But the markets were telling us a different story. Commodity prices and the stock market were plummeting, the dollar was strengthening. In the Treasury bond market inflation-indexed government bonds suggested the market was expecting inflation to fall from around 2% to negative inflation. The markets were telling us that we were not easing monetary policy, but actually going through a period of monetary contraction. Sumner was the one who, in 2008, pointed out most forcefully what was happening on his blog The Money Illusion . The thinking that came out of this was that monetary stability, and hence economic stability, is about the supply and demand for money and we can observe that in financial markets. They tell us something about it. It’s one thing to observe the money base, but it’s harder to observe money demand and the relation between the two things. If commodity prices and wages are sticky, monetary disequilibrium will not show up there immediately. But it will show up in financial markets. That is the insight of my two last books, Scott Sumner’s book and Robert Hetzel’s. They both argue that we have a way to understand monetary policy or to read monetary policy by observing financial markets. 2008 interrupted Scott Summer’s work on the book he had been working for many years. The book had been rejected by numerous publishers—nobody found Scott’s stories about the Great Depression interesting. 2008 changed that. The story Scott tells is really a contribution to how to conduct monetary research and economic history research. It’s a wonderful book, not only in the way that it describes what happened during the Great Depression, but because it also teaches us a new method of understanding the world. That method is ‘market monetarism’, a term I coined in a working paper in 2011 or 2010, but which Scott has embraced wholeheartedly. At the core of market monetarism is the old-style monetarism of Milton Friedman and Anna Schwartz, combined with the insight of Leland Yeager, that the demand and the supply of money is important; and that by reading what the markets are telling us we can understand that better than by purely looking at money supply numbers. “Because a lot of the economic theory that has been developed over the years is US-centric, we teach economics students about a large, closed economy” Milton Friedman used to say that monetary policy works with long and variable lags, that we do something today and then economic variables change later on. And the way things change depends on the economic regime, price rigidity, wage rigidity, what kind of institutional frameworks we have, expectations and so forth. But Scott Sumner says that monetary policy works with long and variable leads. What does he mean by that? Obviously that isn’t completely right. Monetary policy does not work before it’s been implemented. But the question is, how is it implemented? When do we implement it? You can explain what he means as follows. If today, as Federal Reserve Chairman, I announce that in three months I’m going to triple the money base, when will that have an impact on the monetary economy? If we take Schwartz and Milton Friedman’s work on monetary history , we wouldn’t see anything in the money supply numbers before we actually triple the money supply three months later. But financial markets move immediately. So the real macroeconomic impact of that announcement would happen immediately. Even before we start printing the dollars, there is an impact. That is a great insight—one, of course, that Milton Friedman understood. But that insight is regime-dependent, because the regime in which we operate shapes all of the economic agents’ actions. This book came out in 2015 and was many years in the making. Scott wanted to get it perfectly right. He created this method by which a monetary policy action is many things. His primary source was the New York Times , which has a wonderful archive of news articles going back to the Great Depression years. He said that monetary actions would be revealed in market movements. He looked at what happened to commodity prices, to the price of gold and to the stock market. Textbooks say that if we tighten monetary policy—meaning we contract the money supply relative to the demand for money—then stock prices and commodity prices will go down and the yield curve will flatten—that is the longer term, longer horizon, longer maturity yields will drop relative to shorter maturity yields, and so forth. Sumner asked what this news archive would have to say about major movements in the markets. What did the Federal Reserve or the US Treasury Department say at various points (the Treasury Department was a monetary actor because they were determining the exchange rate policy)? So, both the Roosevelt administration and the Federal Reserve could conduct monetary policy. The introduction of new reserve requirements was the kind of thing you could read in newspaper articles. Support Five Books Five Books interviews are expensive to produce. If you're enjoying this interview, please support us by donating a small amount . Another thing Sumner did was to say that there are three phases of the Great Depression. There’s the period from 1929 to 1933, a deflationary depression with a monetary contraction. Roosevelt is elected US president in November of 1932. And then there is the devaluation of the dollar in April of 1933. He’s not very far into his presidency when he eases monetary policy tremendously. The second phase is essentially all of the Roosevelt administration’s horrendous policy mistakes. Those policy mistakes were particularly related to the fact that Roosevelt’s economic advisors believed that labour unions were too weak, that deflationary pressures were essentially a result of this crisis of capitalism, and that you needed to strengthen labour unions . So they passed the National Industrial Recovery Act, which was essentially a move for the cartelisation and unionisation of the US economy. One could say that this was not very unlike the kind of economic thinking of the Mussolini government in Italy, essentially corporatist—some would say a fascist—economic policy, where you have strong unions and strong big business coordinating their actions with a strong government to set prices. This maintained private enterprise, but in a way that was a break from what you had seen up to then in the US. It meant that salaries were pushed above levels of productivity. If you look at the stock market in the US at this point, it stalls. You have the initial impact of the monetary easing, but then the US economy is whacked by the National Industrial Recovery Act. Then, in 1935, the National Industrial Recovery Act is overruled by the US Supreme Court as unconstitutional. And you can see the reaction in the financial markets. The stock market shoots up and immediately after that the US economy continues on its path of recovery. Only later on does it run into trouble again, when the Roosevelt administration in 1937 starts to fear inflation. Scott Sumner has a good discussion of that, the so-called recession in the depression that happens in 1937-38. I think there’s great agreement among economists that the Federal Reserve and the Roosevelt administration moved too fast to tighten monetary policy because of those overblown inflation fears. There’s been lots of discussion about what caused this. What Scott Sumner shows is that dollar policy was quite important and that monetary policy in that exact period works with long and variable leads. The Roosevelt administration’s continued voicing of concerns about inflation was telling financial markets that they would tighten monetary policy soon. And if you know that the dollar will be revalued, what will you do? You will start to hoard dollars. And as you do that the demand for money goes up relative to the supply of money. And then that creates the recession in the depression of ’37. And Scott Sumner shows that in a beautiful way, discussing and going through those New York Times articles, telling us exactly what the administration was saying. Before they took actual actions, by speaking, by voicing their concerns about inflation, they were actually implementing monetary policy. Sometimes policy works before it is actually implemented, or even announced. Obviously, central bankers know this very well today. But that was less the case in the 1930s. I also think Sumner shows us something that’s missing. When we look at macroeconomic research, and also macroeconomic historical research, we build econometric models where we look at macroeconomic data, and estimate what happens to consumption through the money supply, and to interest rates, and how that all fits together. That’s one kind of model. Then we have simulations, we simulate something, there’s a shock, and we can incorporate rational expectations and forward looking behaviour. What economist haven’t taken much time over is the empirical study of expectations, those we can read directly from financial markets. That kind of thinking, I learned from Scott Sumner. It would be wrong to say that I learned it from reading The Midas Paradox , because I read Scott early on in the 1990s, and have known him for many years now. But it combines that thinking about money with the really deep economic and historical thinking. That’s the beauty of the book."