This morning a lot of people are not happy campers:



















I confess that last August I thought that Ms. Market had overreacted.


I thought that the political costs to being the people on whose watch the Euro had crashed were so great that the administrators of Europe would take steps to make sure that it did not happen on their watch. I thought that Germany would guarantee a facility which would then borrow at 2.5% and buy peripheral eurobonds yielding 5%. I thought the facility would then make a ton of money as the ECB reflated the continent, and changed its inflation target from 1% for the eurozone as a whole to 2% for Germany (which means 3% or more for the eurozone as a whole).


Silly me.


And I confess that last August I was focused on risks to the U.S. recovery from domestic sources.


It seemed to me very clear that the Fed and the Treasury would announce that they would take steps and would in fact take steps to neutralize and offset any effects of the eurocrisis on aggregate demand in the U.S. That seemed a much smaller danger than that right-wing political pressure interested in choking off recovery would push the Fed into a much-too-austere monetary posture.


Silly me.


I do not (yet) know how much eurorisk is on the balance sheets of U.S.-relevant banks and shadow banks. I do not know what the tail of the distribution looks like. I do not know if we wind up in the tail how much of their eurorisk banks and shadow banks will be able to dump onto new entrants to the market who see a long-term bullish bet on Europe as an attractive one. I do not know if we wind up in the tail how much of American business will not be financed over the next year as banks feel constrained by their eurorisk.


I do not know what facilities the Fed and the Treasury have planned and have started setting up to deal with getting eurorisk off of Ms. Market's diminished risk-bearing capacity if we wind up in the tail. And I really ought to know this by now. In fact, everybody should know this by now: the argument that the Treasury and the Fed should not reveal their contingency plans because it would spook the markets is at least two-months past its sell-by date.

So I am sitting here peacefully at my office desk, when across my screen flow the words of Scott Sumner, who writes:



The IS-LM model led economic historians to argue money was easy in 1929-30, because rates fell sharply.  It led modern Keynesians to assume that money was easy in 2008, because rates fell sharply...



Well, I would say that not just "modern Keynesians" but a lot of people believed that monetary policy was expansionary in 2008.


They believed so not just because (safe) nominal (and real) interest rates were falling, but because the money supply was expanding. Indeed, since 2007 the Federal Reserve has tripled the monetary base:





This episode of monetary expansion is surely the largest monetary expansion in the United States in a long, long time:





If expanding the monetary base to three times its previous size is not "expansionary", what could possibly be?


And I see that Scott Sumner is joined by Matt Rognlie, who writes:



historically low inflation expectations and below-potential output are prima facie evidence that real interest rates are too high. That’s what every macro model tells us is associated with contractionary policy by the Fed.... [T]he fundamental, overriding dilemma is getting the price (in this case, the interest rate) right.... [O]nce we recognize that the fundamental problem is monetary, the issues become much clearer. The Fed’s failure to use all the tools at its disposal--in particular, its failure to make a conditional commitment like the one proposed by Chicago Fed President Charles Evans--is by far the most serious failure of economic policy today…



"Wait a minute!" you say. "The ten-year nominal Treasury bond rate has fallen 325 basis points since 2007. The three-month Treasury bill rate has fallen by 500 basis points since 2007. And this is not a case in which apparently low nominal interest rates are really high real interest rates because of expected deflation: expected inflation has fallen by only about a third as much as nominal interest rates have fallen. The real interest rate on ten-year Treasury bonds has fallen from 2.5% per annum in 2007 to zero today:





"And Matt wants us to believe that this pushing-up of the present value of a real dollar of cash flow ten years in the future by more than one-quarter--this more than doubling of the present value of a real dollar of cash flow thirty years in the future--this tripling of the monetary base--is contractionary? What is going on here?!"


What Sumner (and Rognlie) should say, I think--in order to avoid confusing readers who try to wrap their minds around the idea that a large monetary expansion is contractionary--is that monetary policy was expansionary but the expansion was not large enough to cope with the macroeconomic problem.


But for some reason they don't want to say this.


They want to say that the expansion of the monetary base and the money stock was contractionary. They want to say that an easing of the difficulty people have borrowing cash is restrictive of people's access to money. They want want to say that a loosening of the conditions required for something to be a positive NPV investment project is a tightening of those conditions. They are taking words that had clear meanings--expanding the monetary base, easing the difficulty of borrowing, loosening required conditions for investment to be profitable--and claiming that they mean the opposite because these policy moves were not large enough to prevent the steep fall in nominal GDP.


I think both of their arguments would become much, much easier and clearer and coherent--and, I think, stronger--if they would only allow themselves to draw an IS-LM diagram.





The financial crisis--the collapse of trust in the competence of bankers, the impairment of the capital of banks, the loss of housing values, the reduction in risk tolerance--was a massive shock that pushed the IS curve far to the left. Had the Federal Reserve kept "monetary conditions" unchanged--had it engaged in contractionary open market operations and shrunk the money stock in order to keep interest rates at their 2007 levels--we would have had another Great Depression. Fortunately, the Federal Reserve did not do that. It expanded the monetary base and the money supply, and kept on expanding even after the short-term safe nominal interest rate had hit the zero nominal lower bound. But these expansionary policies--while they greatly moderated the size of the Lesser Depression--were not enough to offset the negative IS shock of the financial crisis.


The problem is that we need much more monetary expansion (or fiscal expansion, or something) than we have, given the damage done by the financial crisis. We need to push the real interest rate substantially below zero to get the economy back to full employment. We need enough monetary expansion to drive expectations of inflation up so that the relevant interest rate once again matches the supply of to the demand for the flow-of-funds through financial markets at full employment.


The IS-LM framework has the virtue of not forcing you to say things like the things Rognlie and Sumner do: that the Lesser Depression struck in late 2008 because monetary policy turned contractionary, and because the Federal Reserve tightened. That simply leads--in my view at least--to a lot of confusion.

We are live at the Huffington Post:


When I first learned in 2009 that Ron Suskind's next book was going to be about the making of a economic policy in the Obama administration, I looked forward to it. Previous books about the making of economic policy had degenerated into unseemly hagiography (cough Robert Woodward's Maestro cough) or into pure gotcha books (cough Robert Woodward's The Agenda cough). It seemed to me that Ron Suskind had done considerably better than "gotcha" books -- or had written "gotcha" books that also had immense extra value added -- on the Bush-era national security apparatus.


I thought he would do equally well on economic policy.


I thought the Obama economic-policy team was first rate. All five of the principals, Benjamin Bernanke, Timothy Geithner, Lawrence Summers, Christina Romer, and Peter Orszag, seemed to me among the very best candidates in the world for senior economic policymaking jobs in an American administration.


And they were all my friends, or at least we were friendly. I did think that some of them were in the wrong jobs. Lawrence Summers made much more sense to me as Treasury Secretary than as NEC chair. Timothy Geithner seemed to me much better suited to be NEC Chair than to manage a large department with line authority.


Nevertheless, even though the economic situation was horrible, the economic policy team looked good to me. I looked forward to a Suskind book that would tell of success: smart and serious people who knew what they were doing fighting about substance, presenting the president with good options, him choosing the best one, and the course of the economy during the Obama administration being if not great at least better than we all feared after the bankruptcy of Lehman Brothers.


And there is a perspective from which Obama administration economic policy has been a considerable success. The banking system collapse was averted. The spike of the unemployment rate to 15% or higher was averted. Obama passed a pretty good financial regulatory reform. Obama passed a pretty good health-care financing reform. Obama passed the largest quick fiscal expansion he could get through congress (using the Reconciliation process would have taken months and months longer). We are left with a jobless recovery, and with crippled mortgage finance and construction, and a ticking bomb in Europe. But, one could say that things could have been much worse--and would have been much worse had Republicans controlled any substantial share of economic policy or been more effective at blocking Obama initiatives.


And of the successes of Obama administration economic policy perhaps the greatest success was the successful implementation of the "stress tests" of the banking system by Tim Geithner and his Treasury Department in the spring of 2009. The panic and the downturn could not be halted until finance became convinced once again that the key highly-leveraged money-center banks were well-capitalized. The government's TARP authority was not large enough to do the job. Somehow, private investors had to be convinced that investing in the banks was a good idea. The stress tests did that, and played a role in restoring confidence in 2009 somewhat akin (albeit on a smaller scale) to Roosevelt's abandoning the gold standard in 1933. It was a major achievement, well-executed--especially given that Tim Geithner was then "home alone" at the Treasury without confirmed deputies.


But this is not the only perspective from which to view Obama administration economic policy.


Since the spring of 2009 I have became more and more alarmed by the economic policy choices made by the Obama administration. A new administration needs to (1) forecast what is most likely to happen, and (2) design and implement policies that will deal with what is likely to happen, The Obama administration did that. I think that some of its initial policies were wrong, but given the press of events I would give the administration moderately high marks for the policies it designed and implemented up through, say, April 2009.


Thereafter, however, things to me seemed to gradually fall apart. An administration has a third task it needs to carry out: (3) think hard about the risks--what if the administration has misjudged the situation? what if more things go wrong?--figure out what it needs to do to buy insurance against those risks, and do those things as well.


It needs to ask itself:



What if we are wrong in our estimation of the situation--what might the world then look like three years from now? 

What if more things go wrong in the next year or two--what might the world then look like three years from now?

In those possible scenarios, what will we wish then that we had done today to prepare the way for dealing with the situation?



The major risks that confronted the Obama administration-to-be in the fall of 2008 and the winter-spring of 2009 that are relevant here were:



That the moderate Republicans in the Congress would, rather than engaging in normal American governance, join their colleagues out of party loyalty and help them wage a scorched-earth war against all administration policies--even their own Republican policies--following the Gingrich playbook that the road to victory in the next election is to make the Democratic President be and appear to be a failure.

That the Federal Reserve would ignore half of its dual mandate, and be satisfied with policies that avoided deflation now matter what unemployment rate or capacity utilization rate those policies brought. 


That the recovery that would follow once the recession was over would be a slow, hesitant, "jobless" recovery. 

That the initial shock to the financial system and downturn would be much larger than anticipated as of early December 2008. 

That mortgage finance might not resolve itself, and that construction might remain deeply depressed for a very long time.

That government attempts to support weak banking systems would set off a wave of sovereign debt crises that would then deepen the global downturn.

That repeated waves of expansionary policies might set off a dollar, sovereign debt, and inflation crisis inside the United States.



To deal with all of these, Obama needed to staff his administration up--to choose and nominate officials and, if the Senate did not confirm them in a timely fashion, recess-appoint them.


To deal with the first of these seven, the Obama administration needed to set up the Budget Act Reconciliation process and to husband executive branch authority so that it could conduct large-scale expansionary economic policy via Reconciliation and loan guarantees and quantitative easing if Republicans filibustered and the economy was still in the dumps in 2010 and 2011. To deal with the second, the Obama administration needed to rapidly nominate and get confirmed Federal Reserve governors and a Federal Reserve Chair who would take the Federal Reserve's dual mandate very seriously indeed if unemployment was above 9% and stable or rising in 2010 and 2011.


To deal with (3) and (4) the administration needed to prepare the ground by doing more of what it had done to buy insurance against (1) and (2)--by warning at every opportunity that the first round of expansionary policies 
might not be enough, by preparing the ground via Reconciliation and by husbanding executive branch authority, and by making sure not to abandon the fight against unemployment for the fight for long-run fiscal stability until the recovery was well-established--lest the administration wind up in 2010 and 2011 with a jobless recovery and few remaining tools to expand demand.


To deal with (5), the administration needed to prepare the ground for using Fannie Mae and Freddie Mac to essentially nationalize, refinance, and work out mortgages nationwide, should it turn out in 2010 or 2011 that the recovery was not strong or sustained.


To deal with (6), it would have been wise on day 1 to promote the IMF to the role of global technocratic crisis manager, and to get commitments from major credit-worthy economies that they would back the IMF with sufficient resources for it to actually handle the situation. should the mortgage-induced banking crisis of 2008-9 set off sovereign debt crisis in 2010-11.


I wasn't a genius to see these as the risks. They were, at least in the circles in which I moved, obvious.


Yet the only risk that the Obama administration has appeared to even think about guarding against is (7)--which is the one risk that has not come home to roost big time.


For me the big question since the summer of 2009 has been: Why? Why didn't the Obama administration make any significant effort to purchase insurance against risks (1) through (6)? Those were the questions that I hoped Ron Suskind's book would answer for me.


And, alas, it does not do much to do so. Instead, it falls into the Woodward The Agenda trap: it is a story of strong and colorful personalities knifing each other in internal bureaucratic bar fights, with little sense of what the substantive policy arguments were, of the arguments' merits and demerits, and of the stakes.


Moreover, the book falls victim to the Teddy White disease: a reporter taking the time-colored recollections of 
individuals and turning them into a third-person omniscient capital "T" Truth, giving the narrative an authority it does not deserve.


This is further compounded by Suskind's having the implicit viewpoint of the third-person omniscient narrator jump away from one source to another, sometimes seemingly at random, sometimes when the first source tells a version of the story that Suskind does not want to highlight. This causes errors. References to seventeenth-century muzzle-loading musketry technology become in Suskind's retelling references to twenty-first century pornography. People who steamrolled the entire Democr[…]