Scott Sumner on Money and the Fed

Episode Summary

Executive Summary: Scott Sumner argues the 2008-09 crisis was driven mainly by a collapse in nominal GDP caused by overly passive Federal Reserve policy, not just by the financial crisis itself. He says low nominal spending worsened debt burdens, amplified the subprime and European crises, and explains the weak recovery. He advocates nominal GDP targeting, possibly via futures markets, and criticizes fiscal stimulus as largely offset by monetary policy.

Main Topics: Nominal GDP as the key macro variable (Priority: 5/5): Sumner argues that monetary policy primarily affects nominal spending/income, which drives the business cycle, while long-run real growth depends on productivity, incentives, and structure rather than money. Why the 2008-09 recession deepened (Priority: 5/5): He says the collapse in nominal GDP during late 2008 and 2009 was the core macro failure. Financial panic mattered, but as a symptom and amplifier of insufficient nominal demand rather than the root cause. Interest on reserves and excess reserves (Priority: 5/5): Sumner claims the Fed’s emergency liquidity injections were neutralized by paying interest on reserves, which encouraged banks to hold excess reserves instead of expanding lending or spending. Zero lower bound and weak recovery (Priority: 4/5): He argues that once interest rates hit zero, conventional rate cuts stop working, and without a stronger nominal target the economy remains stuck in slow nominal growth and weak real growth. Fiscal stimulus versus monetary policy (Priority: 4/5): Sumner says fiscal stimulus is often overestimated because the Fed adjusts around it; if fiscal policy raises demand, the Fed tends to do less QE or easing, largely offsetting the effect. Nominal GDP targeting and market-based implementation (Priority: 5/5): He proposes targeting a 4% long-run path with temporary catch-up growth and using nominal GDP futures contracts to let markets help steer policy, rather than relying on ad hoc Fed tactics. Lessons from history and central banking (Priority: 4/5): He compares the Great Depression, Japan, and Europe to show that once central banks enter low-rate environments, they often remain too timid or reverse course too early.

Key Arguments: Monetary policy can control nominal variables like nominal GDP, even if it cannot permanently raise real long-run growth. The recession’s severity is best explained by the sharp fall in nominal GDP, which directly worsened debt burdens and slowed recovery. Financial crises are often symptoms of prior monetary contraction, because falling nominal income makes loans harder to service. The Fed’s late-2008 actions were partly offset by interest on reserves, making policy effectively passive despite a large increase in the monetary base. The Fed focused too much on current inflation and too little on market expectations such as TIPS-implied inflation. Once rates are near zero, simply injecting money may not work unless the public expects a permanently higher nominal path. Fiscal stimulus is weak because the Fed’s reaction function tends to neutralize it when it succeeds. A better policy would be nominal GDP targeting, ideally with futures-market-based implementation that credibly commits to a growth path.

Data Points: Nominal GDP growth pre-crisis: about 5% per year - Sumner says this was the normal expected path before the recession and the basis for wage and debt contracts. Nominal GDP collapse: fell about 4% from mid-2008 to mid-2009 - He says the decline was 9% below trend expectations and helped trigger debt stress and recession. Inflation expectation from TIPS: about 1.2% per year over five years - He cites market-based expectations after Lehman as showing inflation was below the Fed’s implicit target. Fed target rate after Lehman: 2% - He notes the Fed did not cut rates immediately after Lehman failed, which he sees as evidence of passivity. Early interest on reserves: around 1% at times - He says the Fed initially paid banks interest on reserves to prevent rates from falling to zero too soon. Current interest on reserves: about 0.25% - Used to argue the subsidy is smaller now but still above some alternative safe returns. Excess reserves: over $1 trillion, possibly around $2 trillion - He emphasizes the unprecedented scale of reserves parked at the Fed instead of entering circulation. Required reserves: around $50-$60 billion - Contrasted with excess reserves to show how unusual the post-crisis balance sheet became. Fed subsidy to banks: about $5 billion per year at 0.25%; about $20 billion at 1% - He frames this as potentially meaningful for some banks even if small relative to the whole system. Early 1980s recovery nominal GDP growth: about 11% annual rate for six quarters - Used as a comparison showing how faster nominal growth supported a rapid recovery. Current recovery nominal GDP growth: about 4% to 4.5% - He says this is too slow to generate strong real growth and rapid job creation. Typical post-crisis real growth: around 3% - He argues low inflation plus weak nominal growth leaves only mediocre real expansion. Late 1920s deflation: about 1% per year - Cited as mild, expected deflation that did not prevent strong real GDP growth. Original U.S. stimulus package: $787 billion, later cited as $825 billion - Referenced in the discussion of fiscal stimulus and its likely offset by monetary policy.

Pivotal Quotes: "I see monetary policy as driving nominal spending in the economy or nominal income." — Scott Sumner: Core framing of his macroeconomic view at the start of the interview. "Almost all of this new money that the Fed injected in the economy went into the banking system and sort of sat there as what's called excess reserves." — Scott Sumner: Explains why large Fed asset/liquidity actions did not translate into strong spending. "What continues to amaze me is this. Japan's current strategy of massive, unsustainable deficit spending... Meanwhile, further steps on monetary policy... are rejected as dangerously radical." — Paul Krugman (quoted by Russ Roberts): Used by Sumner to show that his pro-monetary-policy view once resembled the orthodox position.

Implications: Listeners should see recessions through nominal spending, not only financial-sector stress. The episode argues for credible monetary commitments—especially nominal GDP targeting—over reliance on fiscal stimulus when rates are near zero.