Scott Sumner on Monetary Policy

Episode Summary

Executive Summary: Scott Sumner argues the 2008–09 crisis was worsened mainly by a sharp post-August 2008 monetary-policy failure: the Fed allowed nominal GDP and velocity to collapse, despite low rates and a larger monetary base. He favors rules-based, forward-looking targeting of nominal GDP expectations, not discretionary interest-rate policy or fiscal stimulus.

Main Topics: Monetary policy as the key driver of the downturn (Priority: 5/5): Sumner contends the decisive mistake was the Fed’s failure to offset falling velocity after August 2008, turning the crisis from a subprime-and-banking shock into a broad recession. Why low interest rates and a bigger monetary base were misleading (Priority: 5/5): He argues that interest rates, the monetary base, and reserves are poor indicators of policy stance when banks hoard reserves and the Fed pays interest on them. Nominal GDP and aggregate demand as the right target (Priority: 5/5): Sumner prefers nominal GDP because it captures total dollar spending and better reflects macroeconomic shocks than CPI or interest rates. Monetarist vs. Keynesian explanations (Priority: 4/5): He says monetarists and Keynesians both identify insufficient nominal spending, but differ on causation and the efficacy of monetary policy. Policy tools: zero rates, reserve payments, QE, and expectations (Priority: 4/5): He outlines a sequence of actions the Fed could have used—stop paying interest on reserves, conduct QE, and set an explicit target to shape expectations. Rules over discretion: Taylor rule, Friedman, and NGDP futures (Priority: 4/5): Sumner supports non-discretionary policy rules but prefers forward-looking NGDP targeting, potentially via an NGDP futures market, over backward-looking interest-rate rules. Secondary deflation, debt, and the spread of the crisis (Priority: 4/5): He links falling nominal income to greater debt defaults and a broader collapse beyond the original subprime problem, echoing Austrian ‘secondary deflation.’

Key Arguments: The recession deepened because the Fed let nominal GDP fall sharply below trend after mid-2008, rather than because it lacked tools. Low interest rates are not reliable evidence of easy money; they can coexist with tight policy, as in the Great Depression, Japan, and late 2008. Paying interest on reserves encouraged banks to hoard liquidity, blunting the expansionary effect of reserve creation. The core macro problem is not money supply alone but expected nominal spending; policy should target the forecast of nominal GDP or inflation. A stable nominal GDP growth path would reduce both inflation surprises and business-cycle instability. Keynesian and monetarist frameworks both emphasize a shortfall in nominal spending, but monetarists place more blame on central-bank errors. Inflation and deflation matter most when they are unexpected; anticipated price changes are largely neutralized through contracts and interest rates. The post-2008 collapse worsened debt burdens, triggered more defaults, and spread the crisis beyond subprime mortgages to the wider economy. A rules-based regime, possibly with an NGDP futures market, would be superior to discretionary, backward-looking rate setting. Monetary policy can be very powerful—powerful enough to cause hyperinflation if misused—so it should be constrained by explicit targets.

Data Points: Date of episode: October 30, 2009 - The conversation took place in the aftermath of the 2008 financial crisis and early recovery. Normal nominal GDP growth trend: about 5% per year - Sumner uses this as the approximate historical trend the Fed should have maintained. Post-mid-2008 nominal GDP change: fell about 2.5% over the next year - He cites this as evidence of severe monetary contraction. Gap from trend by mid-2009: about 8% below where it should be - He argues nominal GDP was far below the continuation of the pre-crisis trend. Fed funds target in late 2008: 2% - Sumner says the Fed wanted to keep rates above zero and paid interest on reserves to maintain control. Federal funds rate later: close to zero / quarter of a percent - Used to argue that near-zero rates do not prove policy was expansionary. Monetary base: almost doubled late in 2008 - Sumner says this was offset by reserve hoarding and interest on reserves. Interest on reserves started: October 2008 - He identifies this as a major reason excess reserves surged. Headline inflation peak: 5% - Mid-2008 oil-price spike made the Fed more worried about inflation. Core inflation housing weight: almost 40% - He criticizes CPI housing measures for obscuring current market conditions. Historical comparison: 1982 inflation still 4% - He notes recession occurred even with positive inflation because it was far below expected inflation. Inflation expectations reference: expected 10% vs actual 4% in 1982 - Used to illustrate how unexpected disinflation causes recession. Estimated banking-system losses: rose as high as $4 trillion - Sumner says falling nominal GDP amplified losses beyond initial subprime estimates. Original subprime losses: perhaps a half a trillion to $1 trillion - He contrasts initial losses with later crisis amplification. Target inflation example: 2% inflation with 3% real growth = 5% nominal GDP growth - He uses this as a practical nominal GDP target example. Alternative nominal GDP target: 3% nominal growth - He says this could imply 0% inflation and 3% real growth in the long run.

Pivotal Quotes: "the economy slowed down a little bit for a year up until about August 2008... And then I think where people went wrong is that they underestimated how much of an error monetary policy made after about August 2008." — Scott Sumner: His central claim about the timing and cause of the recession’s worsening. "the Fed adopted a very contractionary policy relative to what was needed to offset the fall in velocity." — Scott Sumner: His core diagnosis of the policy failure. "they should have been looking forward down the road and trying to steer towards where they're targeting the economy." — Scott Sumner: His criticism of the Fed’s backward-looking approach.

Implications: Listeners should see recessions as often driven by nominal-spending collapses and policy mistakes, not just real shocks. Sumner’s view implies central banks should adopt explicit, forward-looking rules—especially NGDP targeting—to prevent future deep downturns.