01 - Scott Sumner on *The Midas Paradox*, the Fed, and More

Episode Summary

Executive Summary: Scott Sumner argues that major macro downturns are best understood as failures of monetary policy, not mainly real-side shocks. He traces the Great Depression to gold-standard and Fed errors, defends FDR’s devaluation but criticizes wage hikes, and applies the same framework to 2008-09, blaming the Fed’s tightening, inflation fears, and policy regime for the slow recovery. He advocates nominal GDP level targeting over inflation targeting.

Main Topics: Sumner’s path into macroeconomics and monetarism (Priority: 4/5): Sumner explains that Friedman and Schwartz’s Monetary History of the United States shaped his early interest in macro, data, and monetary explanations of depressions, leading him toward rules-based thinking and eventually nominal GDP targeting. Nominal GDP targeting and market monetarism (Priority: 5/5): He describes his evolution from money-supply rules to nominal GDP targeting and argues the Fed should stabilize the market’s expected path of nominal spending, using market forecasts rather than the Fed’s internal forecast. The Great Depression as a monetary failure plus supply-side drag (Priority: 5/5): Sumner argues the Depression began with a collapse in nominal GDP caused by monetary mistakes and gold-standard dysfunction, then worsened after 1933 because of wage controls, unions, tariffs, and tax policy that slowed recovery. Gold standard breakdown and international gold hoarding (Priority: 5/5): He explains the interwar gold standard’s vague ‘rules of the game’ and says excessive demand for gold—especially by the U.S. and France—raised gold’s purchasing power, producing deflation and a collapse in spending. FDR’s devaluation and the interrupted 1933 recovery (Priority: 5/5): Sumner credits FDR’s devaluation of the dollar for the sharp 1933 rebound in industrial production, but says the recovery stalled when wage increases and labor-market interventions raised costs and reduced output. World War II, fiscal stimulus, and the limits of GDP as welfare (Priority: 3/5): He says wartime spending helped end the Depression mechanically, but warns that GDP rose through arms production while consumer welfare was distorted by rationing and conscription, implying monetary policy would have been a cheaper solution. The Great Recession, QE, and the case against inflation targeting (Priority: 5/5): Sumner argues the 2008 crisis was made severe by the Fed’s delayed response, interest on reserves, and concern over supply-driven inflation; he says QE mattered only insofar as it fit the broader policy regime and that nominal GDP targeting would have produced a faster recovery.

Key Arguments: The central cause of deep recessions is often a collapse in nominal spending, not just real shocks; economists and policymakers misdiagnose this in real time. The interwar gold standard failed because central banks, especially in the U.S. and France, hoarded gold and violated the informal ‘rules of the game,’ driving deflation. The Great Depression’s first phase was primarily a demand shock; its slow recovery was then hampered by supply-side policies such as wage fixing, union pressure, tariffs, and tax hikes. FDR’s devaluation of the dollar against gold was the key policy that sparked the 1933 recovery; monthly industrial production surged 57% from March to July 1933. Artificially raising wages during a depression is contractionary because higher labor costs reduce hiring and output; Sumner cites immediate negative effects in the data and market reactions. World War II ended the Depression in a mechanical sense, but that does not imply wartime fiscal stimulus is the best policy; monetary policy could have achieved the same nominal expansion more efficiently. In 2008, the Fed tightened at the wrong time: it introduced interest on reserves, worried about commodity-driven inflation, and failed to offset the collapse in the Vixellian natural rate caused by the housing bust. QE, forward guidance, and other tools are only effective if the Fed is committed to a strong regime such as nominal GDP level targeting; tentative QE alone is insufficient. Inflation targeting can mislead central banks because supply shocks raise inflation while demand collapses; nominal GDP targeting gives a better signal for policy. The Fed’s repeated undershooting of its inflation goal and acceptance of a lower nominal-spending path show that it wanted a weaker recovery than a level-targeting regime would allow.

Data Points: Nominal GDP decline during Great Depression: fell by about 50% - Between 1929 and 1933, cited as evidence of a massive negative demand shock Industrial production rebound in 1933: rose 57% - From March to July 1933 after FDR devalued the dollar Wage increase under FDR: 20% over two months - FDR’s executive-order wage push in July 1933, which Sumner says halted the recovery Union membership growth: doubled - Estimated increase in U.S. union membership between 1935 and 1937/38 after the Wagner Act Budget deficit reduction in 2013: about $500 billion - Fiscal tightening natural experiment during the post-crisis recovery Core PCE inflation since the crisis: about 1.5% average - Sumner’s evidence that the Fed preferred low inflation and tolerated undershooting its 2% target Fed inflation target: 2% - Used as the benchmark in the discussion of recovery and policy undershooting Period of strong 1933 recovery before wage shock: roughly 4 months - Recovering almost half the Depression’s industrial-production losses between March and July 1933 Late-2008 policy date: early October 2008 - Fed introduced interest on reserves, which Sumner views as contractionary Timeline of WWII-related turning points: 1939, spring 1940, December 1941 - German invasion of Poland, invasion of Western Europe, and Pearl Harbor are distinguished as different macroeconomic inflection points

Pivotal Quotes: "the profession tends to misdiagnose business cycles in real time" — Scott Sumner: On why recessions are often blamed on housing, finance, or other shocks instead of monetary policy "the Fed should do whatever it takes so that the market expects 5% nominal GDP growth" — Scott Sumner: Explaining market monetarism and the core idea behind targeting expectations rather than reacting late "this decision to raise wages 20% really delayed the recovery of the Great Depression substantially" — Scott Sumner: His critique of FDR-era wage policy and its effect on the 1933 recovery

Implications: The episode argues for a regime shift from inflation targeting to nominal GDP level targeting. For policymakers, the lesson is to ignore supply-shock inflation, prevent nominal-spending collapses, and use markets to anchor expectations—especially in downturns.