Lessons From the Past

Studying pre-modern economic history and economic trends can teach a lot. You can take many different perspectives, especially when studying the first invention of money, the Roman period (specifically the 3rd-century crisis), and the High Medieval economy.

Years ago, while studying pre-modern economic history for the first time, I wondered how money was invented. Until then, like most people, I used to think that money arose with the state. It didn’t take long to see that I was wrong. Of course, the governments monopolized money earlier in history. However, this does not imply that money is always monopolized. Rather, states created monopolies by force. When rulers established their mints, they banned private mints and used their coins as both a symbol of their power and a source of profit. At the end of the 7th century BC, the money was already monopolized in the Greek world. Nevertheless, money has not always been under government monopoly. Free banking has been experienced in many different regions of the world, although it takes a shorter time compared to state monopolies. In some countries in the past, money was not under the monopoly of the government specific periods(see Selgin’s famous book).

Likewise, the Black Plague is also quite informative if you want to compare it to the recession we’re in. The Black Plague killed 1/3 of Europe’s population. Demand for almost every commodity fell, and demand curves shifted to the left. The supply curves also shifted to the left, so relative prices remained the same. However, the Black Plague probably had little or no impact on aggregate demand. How can this be? There were far fewer people in the world than in the previous situation, and the demand for almost every commodity declined. Why has the total demand not decreased?

The “price” in the AS/AD diagram indicates the nominal price level, not the relative price of a single good. The Black Plague didn’t kill the money, which is probably why the supply of (commodity) money has not changed. The plague may have lowered AD by decreasing velocity, but that doesn’t matter much. We know that the Black Plague raised the price level in Europe, which declined the real GDP(On the other hand, the AD curve probably didn’t change much in response to the plague).

Generally, people tend to be concerned with “aggregate demand” and “quantity of goods and services purchased.” Even if there is no change in aggregate demand, the amount of goods people buy from stores will tend to decrease when the AS falls. But this is only a decrease in the equilibrium, not AD. What determines AD is monetary policy.

A similar situation is true in the Covid-19 recession. The pandemic disrupted supply chains and shifted AS to the left. However, this did not cause a direct reduction in aggregate demand (AD). Instead, prices rose and real GDP fell. I agree that this recession is unique in a way (not in terms of shocks) and it is clear that Keynesian models cannot explain this situation.

Consider unemployment rates. During the recovery from the Great Recession, it took a decade for the unemployment rate to fall normal level, from 10% in 2009 to 3.5% in 2019. In contrast, the unemployment rate, which was 14.7% in April 2020, fell below 9% in August.

If you’re not too surprised about the current decline, I have to remind you that Lars Christensen predicted in May that the unemployment rate will fall 6% in November. Indeed, everyone found this prediction out-of-touch from reality. He insisted that disasters were recovering very quickly, unlike financial crises. Christensen’s view is no longer so exceptional. More importantly, he will be proven right.

Likewise, when market monetarists like me claimed that tight money was the problem in the Great Recession, we encountered massive resistance.
Some economists argued that the problem is real, not nominal. The financial crisis was a real shock, and recovery had to be slow. However, it would not be an exaggeration to say that they did not learn much from US economic history. Indeed, the US had experienced quite fast recoveries after many financial recessions.

Other economists, while sympathetic to the Market Monetarists’ statements, believed the Fed had nothing more to do. Today we know there were lots more things the Fed could have done:

  1. Do much more QE.
  2. Don’t pay interest on reserves.
  3. Switch to NGDP level targeting(or, at least price level targeting).

As I wrote earlier, I interpret the Fed’s change of strategy as an implicit admission of their erring during the 2010s. If more were done in 2009, it would certainly have been much faster, although I’m not sure the recovery would be as rapid as it is current recovery.

All of this suggests that perhaps the Fed is learning from the past. Not all of the changes I was hoping for have happened, as the Fed seems to be making quite conservative changes. Still, the Fed’s admission that they were wrong in the 2010s is at least a start.

Market monetarist ideas on the Great Recession are looking increasingly more persuasive. If Christensen is right (and probably is), this will be written as a major victory for market monetarism.

P. Q: Monetary policy still seems a bit too tight, but due to Covid-19 it is too early to be sure.

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Superb post.