John Cochrane Misunderestimates the Fed

In my previous post, I criticized Ben Bernanke’s speech last week at the annual symposium on monetary policy at Jackson Hole, Wyoming. It turns out that the big event at the symposium was not Bernanke’s speech but a 98-page paper by Michael Woodford, of Columbia University. Woodford’s paper was important, because he is widely considered the world’s top monetary theorist, and he endorsed the idea proposed by the intrepid, indefatigable and indispensable Scott Sumner that the Fed stop targeting inflation and instead target a steady growth path of nominal GDP. That endorsement constitutes a rather stunning turn of events in which Sumner’s idea (OK, Scott didn’t invent the idea, but he made a big deal out of it when nobody else was paying any attention) has gone from being a fringe idea to the newly emerging orthodoxy in monetary economics.

John Cochrane, however, is definitely not with the program, registering his displeasure in a blog post earlier this week. In this post, I am going to challenge two assertions that Cochrane makes. These aren’t the only ones that could be challenged, but it’s getting late.  The first assertion is that inflation can never bring about an increase in output.

Mike [Woodford]’s enthusiasm for deliberate inflation is even more puzzling to me.  Mike uses the word “stimulus,” never differentiating between real and nominal stimulus. Surely, we don’t want to cook up some inflation just for its own sake — we want to cook up some inflation because we think it will goose output. But why? Why especially will increasing expected inflation help? Because that is the aim of all the policies under discussion here — promising to keep rates low even once inflation rises, adopting “nominal GDP targets,” helicopter drops, or similar policies such as raising the inflation target.

I don’t put much faith in Phillips curves to start with  — the idea that deliberate inflation raises output. I put less faith in the idea floating around Jackson hole that a little inflation will set us permanently back on the trend line, not just be a little sugar rush and then back to sclerosis.

But it’s a rare Phillips curve in which raising expected inflation is a good thing.  It just gives you more inflation, with if anything less output and employment.

Cochrane is simply asserting that expected inflation cannot increase output and employment. The theoretical basis for that proposition is an argument, generally attributed to Milton Friedman and Edward Phelps, but advanced by others before them, that an increase in inflation cannot generate a permanent increase in employment. The problem with that theoretical argument is that it is a comparative statics result, thus, by assumption, starting from an initial equilibrium with zero inflation and positing an increase in the inflation parameter. The Friedman-Phelps argument shows that a new equilibrium corresponding to the higher rate of inflation has the same level of output and employment as the initial zero-inflation equilibrium, so that derivatives of output and employment with respect to inflation are both zero. That comparative-statics exercise is fine, but it’s irrelevant to the situation we have been in since 2008. We are not starting from equilibrium; we are starting from a disequlibrium in which output and employment are well below their equilibrium levels. The question is whether an increase in inflation, starting from an under-employment disequilibrium, would increase output and employment. The Friedman/Phelps argument tells us exactly nothing about that issue.

And aside from the irrelevance of the theoretical argument on which Cochrane is relying to the question whether inflation can reduce unemployment when employment is below its equilibrium level – I am here positing that it is possible for employment to be persistently below its equilibrium level – there is also the clear historical evidence that in 1933 a sharp increase in the US price level, precipitated by FDR’s devaluation of the dollar, produced a spectacular increase in output and employment between April and July of 1933 — the fastest four-month expansion of output and employment, combined with a doubling of the Dow-Jones Industrial Average, in US history. The increase in the price level, since it was directly tied to a very public devaluation of the dollar, and an explicit policy objective, announced by FDR, of raising the US price level back to where it had been in 1926, could hardly have been unanticipated.

The second assertion made by Cochrane that I want to challenge is the following.

Nothing communicates like a graph. Here’s Mike [Woodford]’s, which will help me to explain the view:

The graph is nominal GDP and the trend through 2007 extrapolated. (Nominal GDP is price times quantity, so goes up with either inflation or larger real output.)

Now, let’s be clear what a nominal GDP target is and is and is not. Many people (and a few persistent commenters on this blog!) urge nominal GDP targeting by looking at a graph like this and saying “see, if the Fed had kept nominal GDP on trend, we wouldn’t have had  such a huge recession. Sure, part of it might have been more inflation, but surely part of a steady nominal GDP would have been less recession.” This is NOT what Mike is talking about.

Mike recognizes, as I do, that the Fed can do nothing more to raise nominal GDP today. Rates are at zero. The Fed has did [sic] what it could. The trend line was not achievable.

Nick Rowe, in his uniquely simple and elegant style, has identified the fallacy at work in Woodford’s and Cochrane’s view of monetary policy which views the short-term interest rate as the exclusive channel by which monetary policy can work. Thus, when you reach the zero lower bound, you (i.e., the central bank) have become impotent. That’s just wrong, as Nick demonstrates.

Rather than restate Nick’s argument, let me add some historical context. The discovery that the short-term interest rate set by the central bank is the primary tool of monetary policy was not made by Michael Woodford; it goes back to Henry Thornton, at least. It was a commonplace of nineteenth-century monetary orthodoxy. Except that in those days, the bank rate, as the English called it, was viewed as the instrument by which the Bank of England could control the level of its gold reserves, not the overall state of the economy, for which the Bank of England had no legal responsibility. It was Knut Wicksell who, at the end of the nineteenth century, first advocated using the bank rate as a tool for controlling the price level and thus the business cycle. J. M. Keynes and Dennis Robertson also advocated using the bank rate as an instrument for controlling the price level and the business cycle, but the most outspoken and emphatic exponent of using the bank rate as an instrument of macroeconomic control was Ralph Hawtrey. Keynes continued to advocate using the bank rate until the early 1930s, but he then began to advocate fiscal policy and public works spending as the primary weapon against unemployment. Hawtrey never wavered in his advocacy of the bank rate as a control mechanism, but even he acknowledged that could be circumstances under which reducing the bank rate might not be effective in stimulating the economy. Here’s how R. D. C. Black, in a biographical essay on Hawtrey, described Hawtrey’s position:

It was always a corollary of Hawtrey’s analysis that the economy, although lacking any automatic stabilizer, could nevertheless be effectively stabilized by the proper use of credit policy; it followed that fiscal policy in general and public works in particular constituted an unnecessary and inappropriate control mechanism. Yet Hawtrey was always prepared to admit that there could be circumstances in which no conceivable easing of credit would induce traders to borrow more and that in such a case government expenditure might be the only means of increasing employment.

This possibility of such a “credit deadlock” was admitted in all Hawtrey’s writings from Good and Bad Trade onwards, but treated as a most unlikely exceptional case. ln Capital and Emþloyment, however, he admitted “that unfortunately since 1930 it has come to plague the world, and has confronted us with problems which have threatened the fabric of civilisation with destruction.”

So indeed it had, and in the years that followed opinion, both academic and political, became increasingly convinced that the solution lay in the methods of stabilization by fiscal policy which followed from Keynes’s theories rather that in those of stabilization by credit policy which followed from Hawtrey’s.

However, a few paragraphs later, Black observes that Hawtrey understood that monetary policy could be effective even in a credit deadlock when reducing the bank rate would accomplish nothing.

Hawtrey was inclined to be sympathetic when Roosevelt adopted the so-called “Warren plan” and raised the domestic price of gold. Despairing of seeing effective international cooperation to raise and stabilize the world price level, Hawtrey now envisaged exchange depreciation as the only way in which a country like the United States could “break the credit deadlock by making some branches of economic activity remunerative.” Not unnaturally there were those, like Per Jacobsson of the Bank for International Settlements, who found it hard to reconcile this apparent enthusiasm for exchange depreciation with Hawtrey’s previous support for international stabilization schemes. To them his repiy was “the difference between what I now advocate and the programme of monetary stability is the difference between measures for treating a disease and measures for maintaining health when re-established. It is no use trying to stabilise a price ievel which leaves industry under-employed and working at a loss and makes half the debtors bankrupt.” Here, as always, Hawtrey was faithful to the logic of his system, which implied that if international central bank co-operation could not be achieved, each individual central bank must be free to pursue its own credit policy, without the constraint of fixed exchange rates.  [See my posts, “Hawtrey on Competitive Devaluations:  Bring It On, and “Hawtrey on the Short, but Sweet, 1933 Recovery.”]

Cochrane asserts that the Fed has no power to raise nominal income. Does he believe that the Fed is unable to depreciate the dollar relative to other currencies? If so, does he believe that the Fed is less able to control the exchange rate of the dollar in relation to, say, the euro than the Swiss National Bank is able to control the value of the Swiss franc in relation to the euro? Just by coincidence, I wrote about the Swiss National Bank exactly one year ago in a post I called “The Swiss Naitonal Bank Teaches Us a Lesson.”  The Swiss National Bank, faced with a huge demand for Swiss francs, was in imminent danger of presiding over a disastrous deflation caused by the rapid appreciation of the Swiss franc against the euro. The Swiss National Bank could not fight deflation by cutting its bank rate, so it announced that it would sell unlimited quantities of Swiss francs at an exchange rate of 1.20 francs per euro, thereby preventing the Swiss franc from appreciating against the euro, and preventing domestic deflation in Switzerland. The action confounded those who claimed that the Swiss National Bank was powerless to prevent the franc from appreciating against the euro.

If the Fed wants domestic prices to rise, it can debauch the dollar by selling unlimited quantities of dollars in exchange for other currencies at exchange rates below their current levels. This worked for the US under FDR in 1933, and it worked for the Swiss National Bank in 2011. It has worked countless times for other central banks. What I would like to know is why Cochrane thinks that today’s Fed is less capable of debauching the currency today than FDR was in 1933 or the Swiss National Bank was in 2011?


22 Responses to “John Cochrane Misunderestimates the Fed”

  1. 1 Saturos September 6, 2012 at 11:07 pm

    So did Hawtrey fundamentally take a “credit-view” of monetary policy, or not?


  2. 2 David C September 7, 2012 at 2:18 am

    I will comment that the Swiss experiment worked pretty well for a time, with the threat of buying Euros being enough, without requiring the SNB to actually buy very many. However, in the past few months, the SNB’s stock of Euros has really exploded. There isn’t really any technical reason they can’t keep buying indefinitely, but I am starting to see some political pressures that might ultimately create a limit.


  3. 3 Ritwik September 7, 2012 at 3:20 am


    He did. As did Thornton.

    Hawtrey belongs to the British central banking school of thought stemming from Thornton that has been comfortable both with the currency principle and the banking principle and always thought of the national currency as subservient to the international payments system. They set up the half-way house between Ricardo and Tooke. The American Fisher-Friedman style monetarism/QTM is not their playground.


    The difference between 1933 and now is real interest rates. The existence of a unit of account *superior* to the dollar meant that the dollar had something to de-value against. The past follies of central banks had meant that the real short rate was highly positive. But the world now lives on a dollar standard. It is not very clear what the dollar should devalue against. Also, the real short rate is negative. The monetary free lunch of 1933 is not available.

    The Fed could still de-value internationally, through outright purchases of a wide basket of foreign assets (this was Bernanke’s original proposal for Japan), thereby creating a virtual international basket reserve currency with a smaller dollar weight that the dollar can fall against. But it was to be willing to take losses on those assets if the need be.

    But SNB style pegs won’t do. SNB’s balance sheet has expanded monstrously and consumer price inflation is -0.5%, with wage inflation even lower. You can argue that it would have been further lower without the peg, but even if that is true, Switzerland is not experiencing reflation or an AD boost in any sustainable sense. What is happening instead is a massive rally in Swiss assets, including real estate. All the SNB has done is provided a subsidy to those fleeing from the Euro. Naturally, the wealth effects on consumption and production of these safe haven seekers is very low . Gradually, the deflationary forces will overcome and the SNB will have to double down (and purchase other currencies, not just Euro) to even maintain inflation at -1% or so. This is basically what happened in the US over 25 years, but in Switzerland it may take as less as 5.

    Unless,of course, there are direct fiscal transfers that raise the natural rate and push it to the territory where the bank rate can do its job again.


  4. 4 Nick Rowe September 7, 2012 at 4:09 am

    Thanks David!

    I had always wondered about the historical context of the interest rate view of monetary policy. (I can only write about fake alternate histories.) History does let us see that some aspects of the world we see as necessary are really only contingent.

    By the way, in my way of looking at it, viewing monetary policy as setting the price of gold would work even in a closed economy, because there is an industrial demand and supply of gold. When the central bank raises the price of gold, it devalues the dollar against real goods, not just against foreign currencies. So it would work even if all central banks did the same thing.


  5. 5 Marcus Nunes September 7, 2012 at 5:05 am

    Great Post. If only the likes of Cochrane (and even Woodford) would venture away a bit from their equations and step over to the “history laboratory”, both the debate and the policy adopted would be much better.


  6. 6 Phil Koop September 7, 2012 at 5:52 am

    What David C. said: the SNB has been unable to achieve its objectives via expectations and has actually had to go out and buy the euros. So that aspect of Nick’s simple and elegant story has been wrong. The revenge of the People of the Concrete Steps.


  7. 7 David C September 7, 2012 at 7:07 am

    Well, GDP for Switzerland was down 0.1% in the 2nd quarter, which is not too bad for a country whose economy depends so much on selling things to people in the EU. And the editorialist in this morning’s newspaper was wringing his hands because our unemployment rate rose from 2.7 to 2.8%. Actually, in the Canton where I live, the unemployment rate is less than 1%.

    So the SNB strategy seems to be working OK for now. Sustaining it politically is going to be the challenge.


  8. 8 Diego Espinosa September 7, 2012 at 8:46 am


    The more accurate gold standard analogy would be to look at late 1936: three years into a good recovery with moderate inflation, unemployment remained abnormally high. One could make the argument that the effect of tightening in that year supports the argument for loosening now. That is very different from saying 2012 is like 1932.


  9. 9 Max September 7, 2012 at 11:50 am

    Exchange rate intervention requires the cooperation (at least passive, and preferably active) of both central banks. It’s no solution if both countries want to devalue. I don’t understand the appeal of this idea.


  10. 11 W. Peden September 7, 2012 at 12:18 pm

    David Glasner,

    I was trying to remember where I’d read a very good blog post on what would happen in the event of a competitive devaluation. It turns out that it was right here!


  11. 12 John September 7, 2012 at 8:02 pm

    a few months ago Delong wrote about boiling frogs. That would be the only condition under which Cochrane could be right about inflation.

    Inflation alters expectations and has to produce some response. The obvious response will be to try to buy assets that will rise in value, but the only sellers will be those equally convinced that prices are going to drop, so the second order effective of that negative may well be positive


  12. 13 Tas von Gleichen September 8, 2012 at 2:55 pm

    That’s certainly a reasonable question to ask. It’s sad though that countries like switzerland have to go this fare. The action only shows have incapable the rest of Europe is.


  13. 14 David Glasner September 9, 2012 at 5:33 pm

    Saturos, Not exactly sure what you mean by “’credit-view’ of monetary policy.” Having said that, I think I pretty much agree with Ritwik’s response to you, except that I think that Fisher is closer to Hawtrey than to Friedman.

    David C, If the SNB is accumulating euros, they are not creating enough francs. They should be buying more Swiss assets, encouraging the Swiss to import more products from the EU or to export capital to the EU. But that would probably upset the Swiss exporters and import competers.

    Ritwik, The world may be on a dollar standard of sorts, but the exchange value of the dollar is fixed against very few currencies, so, as you go on to acknowledge, it is still within the power of the Fed to “intervene” in the markets by selling dollars and buying foreign currencies, driving the exchange value of the dollar down. I don’t see why the Fed should be deterred from taking actions to increase NGDP by the fear of taking a capital loss. As I said to David C, maintaining a peg against the euro is not sufficient to avoid deflation.

    Nick, You’re welcome. I agree with you about gold. Gold is a real commodity, that has a real value which is affected by central bank decisions.

    Marcus, Thank you. History is a great teacher. Hawtrey was a superb monetary historian. Even his greatest theoretical work, Currency and Credit, is packed with great historical material.

    Phil, The point is not that everyone should unquestioningly accept the central bank’s commitment. The point is for the central bank to subordinate its monetary policy to that commitment. If it does that, it can succeed even if its credibility is less than total.

    David C, Agreed.

    Diego, In my view, the high unemployment in 1936, at least in the US and probably to some extent in the UK, was the result of bad microeconomic policies, e.g., the NIRA.

    W. Peden, Serendipity in action.

    John, I missed Brad’s post.

    Tas, Yep, it’s a mess.


  14. 15 Blue Aurora September 11, 2012 at 11:26 am

    Once again, a phenomenal post on your part, David Glasner. However, I have a question for you.

    I’ve been trying to find good physical copies of Ralph Hawtrey’s works, and they are rather low in supply. Have you ever considered going to the University of Cambridge in the United Kingdom to edit Ralph Hawtrey’s works, and have them published, a la the CWJMK?

    I really think you ought to apply for a grant or something like this, and find some scholars interested in Ralph Hawtrey. Apart from the fact it would make Ralph Hawtrey’s work more available in quality editions, perhaps it could lead to an even greater revival in his work.


  15. 16 David Glasner September 12, 2012 at 7:39 pm

    Blue Aurora, Many thanks for your comment.

    As for your question, I have not really considered trying to edit Hawtrey’s works. Although I am a great fan of his, I do not think of myself as being a real expert on his work, having read only a handful of his over 20 books and only a very few of his 100 or more articles. But I do not dismiss your suggestion out of hand. Perhaps some such project will get underway in the future, but I suspect it would have to be undertaken by someone younger than I.


  1. 1 Links for 09-07-2012 | FavStocks Trackback on September 7, 2012 at 1:38 am
  2. 2 Brad DeLong: Every Time I Read David Glasner, I Think That the Academic Prestige Hierarchy of Economists Writing About Monetary Policy Is Badly Inverted Trackback on September 7, 2012 at 6:35 am
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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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