Monetary Policy Devils Are In The Details: Easy To Dismiss Ideas Too Quickly

During the last debate Senator Ted Cruz, Ben Carson, Mike Huckabee and Senator Rand Paul all waded into monetary policy, a hot topic since the 2008 crisis. Predictably, the last few days have seen a flurry of news articles attacking their views.

Some of these stories, such as Greg Ip’s, are quite thoughtful. But on balance they are too dismissive of legitimate policy issues.

One critique landed on the Politico Wrongometer, but it definitely shouldn’t have. After one candidate suggested monetary policy was too tight in 2008, the Wrongometer responded as follows:

"But what did the Fed do in 2008? It wasn’t tightening money. The Fed actually cut rates repeatedly in 2008. Some economists have argued policy makers didn’t cut rates fast enough given the economic conditions. But that’s only 'tightening' if you measure it against the demand for liquidity and market expectations. It doesn’t reflect the Fed’s actual policy moves."

One problem with this indictment is that the Fed should be held accountable for its policy decisions leading into 2008, not only those it implemented after the crisis hit. Another problem is the stubborn fascination with interest rate decreases and increases.

As David Beckworth points out, interest rate target cuts are not the only way the Fed can tighten. And we definitely shouldn’t relegate the Fed’s impact on liquidity to a secondary concern. The Fed is actually supposed to prevent economic collapse by providing system-wide liquidity.

By this standard, there’s a pretty good case for monetary policy being too tight leading up to – and through the beginning of – the 2008 crisis.

For instance, if we look at two widely accepted measures of aggregate demand, the Fed tripped up.

First, the growth rate of nominal gross domestic product (NGDP) started a downward trend in the last half of 2007 and turned negative in the first quarter of 2008. Second, growth in final sales of domestic product slowed dramatically at the beginning of 2008, and then turned negative at the end of the year.

Some will argue these are nontraditional measures of tightness, but the fact remains that the Fed is supposed to prevent the economy from tanking. Nonetheless, even more traditional measures make a good case that monetary policy was too tight.

For example, even though there was no dramatic decline in the monetary base from 2005 through August 2008, the monthly rate of growth was below the long-term average in 34 out of 44 months. And the rate turned negative in almost half of these months. Similarly, the rate of growth in the St. Louis Fed’s M1 Divisia index – an additional monetary aggregate – was below average in 38 of 44 months.

And even if we continue to flirt with interest rates, there’s a problem: the Fed started raising its target rate in the middle of 2004, and never lowered it again until September 2007. Over that period, the fed funds target rose from 1 percent all the way to 5.25 percent.

It’s not a simple matter of saying the Fed wasn’t too tight because it lowered its target rate in 2007. The long-term trend can still indicate the Fed held its target too high for too long.

The other policy that’s under attack – and it’s hardly the first time – is the gold standard. Several candidates suggested the gold standard was a good system, and they’re all getting flak for talking about gold. Politico reports that:

"Ted Cruz suggested a return to the gold standard, an idea widely rebuked by economists of all partisan stripes as a disaster that would make it impossible for a central bank to fight recessions and tie the value of the dollar to the availability of gold, a finite resource. The Great Depression ended in part because the United States dumped the gold standard."

The reporter is right. The idea is widely rebuked by many economists. But some actually recognize the gold standard was successful.

For example, in 2004 Ben Bernanke said the following:

"The gold standard appeared to be highly successful from about 1870 to the beginning of World War I in 1914. During the so-called 'classical' gold standard period, international trade and capital flows expanded markedly, and central banks experienced relatively few problems ensuring that their currencies retained their legal value. The gold standard was suspended during World War I, however, because of disruptions to trade and international capital flows and because countries needed more financial flexibility to finance their war efforts. (The United States remained technically on the gold standard throughout the war, but with many restrictions.)"

Even if we ignore all the subtleties in this passage – and we shouldn’t – we should at least stop to carefully examine the merits of the gold standard before dismissing it.

First of all, we have to be clear on what “the gold standard” refers to. For proponents of a true gold standard, that’s the “classical gold standard period,” which Bernanke refers to as highly successful. (Ralph Benko provides agreat rundown at The Pulse 2016.)

That system functioned well, at least in part, because it was self-regulating. For instance, any country with imports greater than its exports (a deficit) would soon see gold flow out of the country. This decline in the stock of base money would ultimately lead to a drop in prices in the deficit country, thus raising the attractiveness of its goods.

The deficit would eventually close as other countries imported those relatively less expensive goods. In other words, the deficit country would eventually start exporting more because its goods became relatively less expensive. Gold would then flow back into the deficit country and prices would soon rise.

We didn’t need a central bank to do anything under this self-regulating system, so we really didn’t need a central bank. (It’s at least worth considering that central bankers don’t like the gold standard for this very reason.)

In his speech, Bernanke also pointed out that the gold standard broke down in WWI because belligerent countries decided to print more paper money to pay for the war. So after WWI broke out, countries were not on the classical gold standard, they were on some managed version of the gold standard.

This managed version basically lasted through WWII. As noted by a recent Economist article, this interwar version of the gold standard was a mess. It’s certainly worth debating the success of even this system, but the Great Depression could not have ended because the U.S. dumped the gold standard because the gold standard itself – the self-regulating one – was already dead.

Government’s killed it so they could spend more money, and that’s one problem with the classical gold-standard that its advocates shouldn’t minimize.

Many who favor the gold standard recognize that it provided a nominal anchor as opposed to the discretionary fiat system we have now. Maybe the gold standard isn’t the best way to achieve that nominal anchor, but we shouldn’t just dismiss the whole notion. Especially not because economists say so.

-Norbert J. Michel is a research fellow specializing in financial regulation for The Heritage Foundation’s Thomas A. Roe Institute for Economic Policy Studies. He is also a co-author of Heritage’s "Opportunity for All; Favoritism to None".

About the Author

Norbert J. Michel, Ph.D. Research Fellow in Financial Regulations
Thomas A. Roe Institute for Economic Policy Studies

This piece was originally published by Forbes. See the original and read more at