"If money isn't loosened up, this sucker could go down" - George W. Bush warned in September 2008

Saturday, December 18, 2010

Monetary policy and Minsky cycles

1. It is impossible to understand the Great Recession without invoking Minsky's cycle theory.

2. Minsky cycle creates the least damage if Minsky recession takes place in the context of stable NGDP growth. Minsky crash creates collateral damage if there is a downward deviation from the NGDP trend.

3. We observe the asymmetry of Minsky booms and Minsky crashes. Traditional monetary policy is a very powerful AD fine-tuning tool during the Minsky boom, on the other hand, monetary policy is prone to crashes and mistakes during the Minsky bust.

4. Monetary authorities usually operate some kind of peg, this peg may crash or lose credibility when the Minsky moment arrives. During the Great Depression, the dollar gold peg lost credibility, and the AD was too low until the Roosevelt devaluation. These days the Fed is operating a crawling fed funds rate peg, this peg has crashed after the bankruptcy of Lehman, and the AD was too low during the crash. During the collapse of the fed funds rate peg, we had the flight to liquidity problem, not the flight to safety problem, so the root cause of low AD was monetary, not Minskyite. The fed funds rate peg was restored in late October 2008.

5. When the monetary peg is restored, it is important that it is restored at the levels where it promotes the speedy recovery. Roosevelt repegged the dollar at the level that generated a fast recovery, on the other hand, the federal funds rate was too high when the fed funds rate peg was restored in late October 2008. Scott Sumner's NGDP expectations peg is useful in this regard. If the NGDP expectations peg crashes, most likely it will be restored at the previous NGDP trend.

6. If the neutral short term risk free interest rate drops below zero during the Minsky bust, the risk of monetary policy mistakes increases. Monetary tools that bring the neutral interest rate back into the positive territory need to be aggressively employed. There are three such tools - higher inflation targets, quantitative easing, credit easing.

7. Higher inflation targets are undesirable, as credibility of monetary policy is diminished during normal times. NGDP path targeting removes the need to change the goals of the monetary policy during the Minsky cycle.

8. Quantitative easing is powerful only until the term risk premium is lowered to zero. After that, it loses the direct effect and only signalling effect remains. The power of quantitative easing is limited, so Bernanke did not use this tool until March 2009.

9. Credit easing is the most powerful non-traditional monetary tool. Bernanke started using it in 2007. However, the extensive use of credit easing increases the risk of Fed's insolvency, it also creates various legal, technical and political problems. Credit easing programs were not expanded to the extent needed to stabilize AD. Bernanke has indicated that additional fiscal stimulus is needed to increase AD.

10. Measures that increase the use of credit easing would be helpful. Larger Fed's capital base could reduce the risk of Fed's insolvency. Development of broad short term credit market indexes could help us design credit easing programs that are not discriminatory and thus more attractive politically.

11. NGDP path pegging is the policy that could prevent the collateral damage caused by the Minsky crash. NGDP path peg gives us a speedy recovery when monetary policy temporarily loses credibility. NGDP path provides a good focal point for the coordination of monetary and fiscal policies when the zero interest rate constraint is binding.

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