Monetary Policy and Mussaism: We Economists Were Wrong

By Bill Conerly, Businomics, Conerly Consulting,

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.  Then I went to read some blogs and I found Brad DeLong saying exactly what I had been thinking, which is also fairly unusual.  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.

Chairman Greenspan kept interest rates extremely low from 2002 through 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.

A few folks worried about asset bubbles being nurtured by easy money.  DeLong cites Michael Mussa, former research director at the International Monetary Fund, and calls this view “Mussaism.”  The view actually goes back to much older theories (Don Patinkin for you economists) that can be thought of this way:  folks have three types of assets: money, investment assets, and consumption assets.  If you increase the money supply through easy monetary policy, then people try to get into asset allocation balance again, by selling money (also called “spending”) and buying the other assets.  When they are buying consumption goods, we worry about inflation.

Well, 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.  Man, I loved Alan Greenspan, but it turns out that he is to blame for today’s problems.

With this view, we have a better understanding of what happened during the easy money period of the late 1990s, with the high-tech stock price boom.

We don’t yet have a consensus among economists on this.  The theoretical guys will write equations, then the empirical guys will test them with data.  But this feels right in MY gut.

OK, we economists have learned our lesson.  Monetary policy must be conducted with an eye to both consumer price inflation and asset inflation.  This lesson does not mean that we economists are stupid, just that we still have some stuff to learn.  Now, lesson learned.

Going forward, once we can get past the current recession, look for monetary policy to be more cautious.  Look for a greater willingness to tolerate small recessions.  Look for an avoidance of easy money, and thus an avoidance of this mistake.

I hate to sound like we’re just making this up as we go along, but that’s what I see.  We in the economics profession learned a lot from the Great Depression.  Even in the current crisis, we’re avoiding the dreadful mistakes of the 1930s.

We learned a lot from the inflation of the 1960s and 1970s.  We’ve avoided that mistake ever since.

Now we have a new lesson, and we’ve learned it.  Monetary policy won’t be error free in the future, but I’m highly confident that we economists … will learn from our future mistakes.


Bill Conerly is principal of Conerly Consulting LLC, chief economist of, and was previously Senior Vice President at First Interstate Bank. Bill Conerly writes up-to-date comments on the economy on his blog called “Businomics” and produces a monthly audio magazine available on CD. Conerly is author of “Businomics™: From the Headlines to Your Bottom Line: How to Profit in Any Economic Cycle”, which connects the dots between the economic news and business decisions.

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