It's funny how history repeats itself, but it's also depressing. For a long time after the Great Depression, economists and historians postulated many different causes behind it. In 1963, Milton Friedman and Anna Schwartz published A Monetary History of the United States, 1867-1960. In it, they convincingly demonstrated that the Federal Reserve could have prevented the Great Depression if it had adopted a more expansionary monetary policy, a view that later became the consensus among economists.
Today, we are in the same position. The Fed could restore the economy to full employment, ending the needless suffering among millions of unemployed workers and return idle capacity to productive use. Economists from the left and right, libertarian Scott Sumner of Bentley University has been chief among them, have been uniting around a regime change for monetary policy: targeting nominal income. Other prominent economists such as David Beckworth, Christina Romer, Paul Krugman, and Brad Delong have jumped on the bandwagon.
Why do we need regime change? The Fed is and is not out of ammo. The Fed typically influences economic activity through interest rates, but already cut rates to zero in 2009 and has kept them there ever since. But since interest rates have a zero lower bound, the Fed can no longer use conventional monetary policy to restore the economy to full employment. However, the Fed can and has engaged in unconventional monetary policy, such as Quantitative Easing, and essentially has an unlimited ability to create as much money as it wants.
Why didn't Quantitative Easing work? The Fed's strategy of incremental change was flawed from the get go. When interest rates are at the zero lower bound, the only way to get the economy going is by changing expectations. When the Fed did its rounds of quantitative easing, it announced the quantity of money it would inject, instead of setting an explicit income, GDP, or inflation target. Unsurprisingly, QE did little to change expectations of nominal income growth or inflation.
Why is a nominal income target our best option? A nominal income target best captures the Fed's dual mandate to promote maximum employment and price stability. Consider a nominal income target of 5 percent. Even if the economy doesn't experience any real growth, inflation is limited to 5 percent. However, a nominal income target would provide individuals with reasonable expectations about the future, so that they can make plans more easily and with less uncertainty, so continuous real growth is likely.
In 2002, Ben Bernanke gave a speech at a conference in honor of Milton Friedman on his 90th birthday. Closing his speech, he said, "Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."
It's funny how history repeats itself, but it's also depressing.
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