Blog cafe : Economists got it wrong

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: Last night Mrs. Businomics and I were doing things we hardly ever do. I was admitting that I had been wrong. She was agreeing with me.

The subject: we economists have been wrong about monetary policy and asset bubbles

Back in the old, old days, like the 1980s, we had all become monetarists. Professor Friedman taught that money supply growth rates should be stable and low. Then financial deregulation, sweep accounts, and other innovations made the money supply numbers hard to interpret. So we economists looked at inflation, and the gap between actual output and potential output, to assess whether the Fed was being loose or tight with monetary policy.

Greenspan kept rates extremely low from 2002 to 2004, and very low in 2005. We weren’t seeing inflation, and output didn’t seem to be surging excessively, so it seemed that the Fed was not too loose with money.

The easy money of the early 2000s did not lead to above-trend consumer spending; it led to above-trend buying of houses. Some of that buying led to construction of new houses, but a great portion of the effect was to induce a run-up of homes prices. Easy money WAS leading to inflation, just not inflation of consumer goods, but rather housing inflation. Thus the housing boom, which resulted in the oversupply of housing, the over-optimism about sub-prime home loans, and the subsequent financial crisis. OK, we economists have learned our lesson. Monetary policy must be conducted with an eye to both consumer price inflation and asset inflation.