Washington Center for Equitable Growth
Liveblogging World War II: April 1, 1944

April 1 Weblogging: Department of "Huh?!": Never in History, So Far as I Am Aware, Has There Ever Been a "Credit Crunch" in Which Production Fell and Prices Rose...

Someone who sends me ill sends me a piece from John Cochrane for April Fools day. It convinces me that he does not know what a credit crunch is:

: If we just had a credit crunch, we would expect to see stagflation--lower quantities sold, but upward pressure on prices. A credit crunch, like a broken refinery is a “supply shock.”….

[P]eople want to hold more of both money and government debt--and don’t particularly care which. Trying to get it, we are trying to buy less of both consumption and investment goods…. What do to? In this analysis, monetary policy is impotent, but not for the usual reason that interest rates are nearly zero. The Fed can arbitrarily exchange Treasury debt for money, and increase the money supply as much as we like. But nobody cares if it does so, since the “flight to liquidity” is equally towards all forms of Government debt.  If we want more fruit and less cheese, putting more apples and less oranges in the fruit basket won’t help.

The first paragraph is remarkable.

The first two sentences of the second paragraph are correct.

But the rest of the second paragraph is wrong.

The conventional explanation of how expansionary monetary policy works is that buying government debt for cash makes money--held for transactions motives--abundant, and so people raise their spending to try to get rid of abundant money. The conventional explanation is that monetary policy is impotent when interest rates are near zero because then people are holding money for both transactions- and savings-vehicle motives. Because buying bonds for cash does not shrink the supply of safe savings vehicles it does not make money abundant--and so people have no reason to raise their spending. To say:

the 'flight to liquidity' is equally towards all forms of Government debt. If we want more fruit and less cheese, putting more apples and less oranges in the fruit basket won’t help...

is not to provide an alternative to but rather to repeat the usual explanation for why conventional monetary police is impotent at the zero nominal lower bound.

Again and again, whenever I read John Cochrane, I find myself forced to choose between two alternatives:

  1. Cochrane simply has not done his homework, and does not understand what he is writing. We have yet another example right here: Cochrane's twin claims that a credit crunch is a supply shock which raises prices, or that he has an alternative to the usual reason for the ineffectiveness of monetary policy at the ZLB.

  2. Conchrane knows damned well that what he calls his "alternative"--that CMP at the ZLB does not affect spending decisions because it involves swapping two assets with an infinite elasticity of substitution--is the same as the "usual reason"--that CMB at the ZLB does not affect spending decisions because it cannot lower interest rates further. But, for political reasons, Cochrane wants to make his readers believe that his adversaries think something different than they do and do not know what they are talking about.

Is there a tertium quid here? If there is, please tell me what it could be...

Please help me out here.