TheMoneyIllusion » More evidence that the real problem was nominal: Last year David Glasner produced one of the strongest pieces of evidence in favor of the view that the current recession was caused by an AD shortfall. He found that beginning around 2008 stocks became highly correlated with TIPS spreads, suggesting the market was rooting for higher inflation, higher aggregate demand. Even Paul Krugman gave him a high five. Now Alexander David of the University of Calgary and Pietro Veronesi of the University of Chicago have a study….
[W]e should look at the late 1970s. Our estimates suggest that at that time investors faced large uncertainty about whether the U.S. would enter a persistent stagflation regime. Any consumer-price data that were above expectations were taken as an indication that the U.S. was transiting into such a regime, which brings about low growth and high inflation. The former makes stock prices decline, the latter makes long- term yields increase. Thus, data-driven fluctuations in investors’ beliefs about a stagflation regime pushed the prices of stocks and Treasuries to move together, and increased volatility for both.
In the recent Great Recession, the opposite occurred. The market now fears deflation, which is accompanied by low growth, as we know from the Great Depression. In this case, CPI data above expectations are great news for the economy, as investors interpret them as a signal that the bad deflation regime could be averted….
In late 2008 the markets were telling us that the Fed was making a tragic mistake by allowing NGDP expectations to plunge. But the economics profession didn’t listen, as they view stock investors as being irrational. Economists were obsessed with the notion that the real problem was banking distress, and that fixing banking would fix the problem. No, the real problem wasn’t banking, the real problem was nominal.