The Latin phrase Nemo judex in causa sua can be roughly translated as: No man can judge his own cause.
This ancient maxim is a bedrock principle of English common law. In this post I’ll argue that violation of this principle has caused great damage to the field of macroeconomics. Macroeconomists have sat in judgment of their own decisions, and failed to reach an accurate assessment. Here’s my hypothesis:
In areas when economists play a major role in policymaking the economics profession will fail to provide a fair and balanced appraisal of the extent to which bad outcomes are due to policy mistakes and the extent to which bad outcomes are due to exogenous shocks.
To be clear, I’m not suggesting that economists are doing anything illegal, or even unethical. Rather, I’ll argue that in the normal course of “doing macroeconomics”, the profession ends up sitting in judgment of their own decisions, and almost inevitably a certain bias seeps into the way they evaluate the effects of policy. That has led to important blind spots in our understanding of contemporary macroeconomic events.
Here are some specific claims:
1. Economists (broadly defined to include key monetary policymakers without an economics degree) have great influence over the course of monetary policy. Monetary policy tends to mostly (not entirely) reflect the consensus view of economists.
2. Economists are unlikely to reach the conclusion that their policy views were wrong. Instead, they will blame any resulting macroeconomic problems on various “shocks”, even when the evidence strongly points to a failure of monetary policy.
3. In contrast, economists will be willing to criticize the policy decisions made by earlier generations of policymakers, or the policy decisions of economists in other countries.
Here is some evidence:
1. At the time, most economists did not believe that a Fed tight money policy was a major cause of the Great Depression. Today, that is a widely held view among economists, even Fed economists.
2. At the time, most economists did not believe that a Fed easy money policy was the cause of the Great Inflation of 1966-81. Today, that is a widely held view among economists, even Fed economists.
3. Many western economists were highly critical of Japanese monetary policy during the late 1990s and early 2000s, despite the fact that Japan had cut interest rates to zero and done some QE.
4. These same economists tended to be much less critical of Fed policy during 2008-09, despite conditions being quite similar to the Japanese case.
5. In the case of the recent high inflation, American economists focused most of their blame on supply side problems and excessive fiscal stimulus.
I believe that American economists were also more likely to blame the ECB’s tight money policy for the eurozone’s double dip recession in 2011, whereas European economists were more likely to point to the debt crisis. (I’m less confident on this point than the other five—please correct me if I’m wrong.)
Here is some evidence for the claim about Japan.
In 2003, Princeton economist Lars Svensson published a paper offering a “foolproof” way out of its liquidity trap and deflation. The term foolproof suggests that even a fool could accomplish this task. But the Japanese failed to do this, so what are we to infer?
In 1999, Paul Krugman had this to say about Japanese policy:
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. 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.
Will somebody please explain this to me?
In 1999, Ben Bernanke published a paper entitled: “Japanese Monetary Policy: A Case of Self-Induced Paralysis?* In a nutshell, the answer he provided was “yes”:
I tend to agree with the conventional wisdom that attributes much of Japan’s current dilemma to exceptionally poor monetary policy-making over the past fifteen years . . .
I do not deny that important structural problems, in the financial system and elsewhere, are helping to constrain Japanese growth. But I also believe that there is compelling evidence that the Japanese economy is also suffering today from an aggregate demand deficiency. If monetary policy could deliver increased nominal spending, some of the difficult structural problems that Japan faces would no longer seem so difficult.”
Japan had suffered a real estate and banking crisis, followed by recession and near-zero interest rates. In 2008-09, the US faced a quite similar situation. But this time most of our economists failed to blame the central bank for the severe decline in “nominal spending”. Instead, the problem was attributed to various “shocks”, and the central bank was excused because there was a feeling that they had done all they could.
In fact, the Fed failed to do the specific things that we recommended the Japanese do. The Fed did not do level targeting. The Fed did not do a “whatever it takes” approach to QE. Instead, the Fed warned of various vague costs and risks associated with open ended QE, concerns that were brushed aside when advice was given to the Japanese.
The underlying problem is that the Fed’s policy was close to the consensus view of American economists, and no one likes to admit that they were wrong.
The case of the recent inflation is a bit more ambiguous. Many economists did suggest that the Fed waited a bit too long to raise rates. Even in this case, however, you find very few economists plainly stating that the Fed caused the high inflation of 2021-23 with a recklessly expansionary monetary policy. Instead, the overwhelming majority of the attention has focused on two other factors—supply problems due to Covid/Ukraine, and overly expansionary fiscal stimulus. In my view, economists have put about 50% of the blame on supply problems, 40% on excessive fiscal stimulus, and at most 10% on Fed stimulus.
In fact, almost 100% of the cumulative inflation since 2019 is due to monetary policy. Full stop. It’s the Fed’s job to take fiscal stimulus into account and offset it so that aggregate demand grows at a rate consistent with its dual mandate. Although the Fed doesn’t have to offset supply shock inflation (due to its dual mandate), those effects have mostly unwound over the past year. While some of the inflation of late 2021 and early 2022 was supply side, over the longer run the rate of excess inflation (inflation above 2%) is almost identical to the amount of excess NGDP growth (nominal growth above 4%.) Real GDP growth over the past 4 years has been about 2%, slightly above the Fed’s estimate of trend RGDP growth (which is 1.8%). So the cumulative excess inflation since 2019 is almost all demand side.
The Fed created the high inflation of 2021-23, and now Powell is being lionized by the profession for creating a soft landing. Powell has done a good job of fixing the problem (so far), but it’s a problem that was almost entirely created by the Fed.
In my view, this is a fatal flaw with modern macroeconomics. Because monetary policy reflects the consensus views of economists, we cannot expect our economists to accurately diagnose the causes of policy failures. At best you’ll get a few heterodox economists pointing to the role played by Fed policy, people like Robert Hetzel and Tim Congdon.
How can this problem be solved? We need a policy regime where policy failures are able to be clearly identified. I thought FAIT would be such a regime, but the Fed spoiled it by later deciding that average didn’t mean average. We need a clear and specific target path for NGDP, and a promise to return to that path when the economy deviates from stable growth in nominal spending. Only then will it become apparent who deserves blame for policy failures.
BTW, I’m not saying policy must immediately return to the trend line. NGDP data can be noisy, and during periods like Covid it makes sense to allow a year or two to return to trend. But policy must commit to a long run trend line if we are to avoid repeating the mistakes of 2008-09 and 2021-22.
PS. In fairness, Paul Krugman did argue (correctly) that the Fed should be more aggressive during the post-2009 recovery. That was a minority view. But in my view he overlooked the role of tight money in the 2008 recession, which he attributed to exogenous shocks.
PS. Merry Christmas!
