Robert Hetzel

What's a neutral monetary policy?

The Federal Reserve Bank of Richmond alerted me to a newish paper from one of my favourite economists, Robert Hetzel, entitled "The Monetarist-Keynesian Debate and the Phillips Curve: Lessons from the Great Inflation"—needless to say it's highly interesting and informative. One bit in particular prompted me to write this screed on neutrality in central banking and monetary policy.

In the Keynesian tradition, cyclical fluctuations arise from real shocks in the form of discrete shifts in the degree of investor optimism and pessimism about the future large enough to overwhelm the stabilising properties of the price system and, by extension, to overwhelm the monetary stimulus evidenced by cyclically low interest rates.

In the quantity theory [monetarist] tradition, cyclical fluctations rise from central bank behaviour that frustrates the working of the price system through monetary shocks that require changes in individual relative prices to reach, on average, a new price level in a way uncoordinated by a common set of expectations.

In the real-business-cycle [new classical] tradition, cyclical fluctuations arise from productivity shocks passed on to the real economy through a well-functioning price system devoid of monetary non-neutralities and nominal price stickiness.

From each of these perspectives, we can derive some sort of definition of monetary/central bank neutrality, as well as an idea of what policy the central bank should operate. It strikes me that only one view is plausible, but before I make the case for that view, I will make the case for a particular theory of "meta-neutrality", i.e. a way that we should think about neutrality, whatever our perspective. I think this is something that everyone should be able to agree on, but I think that once we've agreed on it one view becomes inescapable.

Nothing is neutral with respect to everything. In one of my favourite ever essays, Scott Alexander makes a very similar point about "safe spaces" (nothing can be a safe space for everything—safe spaces for, e.g. a safe space for a disadvantaged group cannot also be a safe space for no-holds-barred rational discussion). In the same way, a monetary policy that is neutral with respect to real interest rates might conceivably have to achieve this by non-neutrality with respect to say, exchange rates. So the interesting question is what economic variables monetary policy must be neutral with respect to for us to call it "neutral" with no qualifiers.

But what we really want to be neutral to is the microeconomic working of the price system and markets generally, which is a bit more complex than any particular macroeconomic variable we could point to. One way around the question is by thinking about what might be non-neutral to the workings of the price system. One answer is: menu and shoe-leather costs, typically associated with high inflation, but more accurately linked to high aggregate demand (nominal GDP) growth.

Both impose restrictions on price adjustment, especially if they are unexpected and hence not "priced in".Menu costs will stop firms re-pricing things as often as would be optimal, impeding price adjustment, whileshoe-leather costs (from the high nominal interest rates associated with high inflation and high NGDP growth) will stop people from holding as much cash as they otherwise would, distorting their consumption decisions.

On the other side, unexpectedly low NGDP growth, combined with "money illusion" in borrowers ("sticky debts") and workers ("sticky wages"), could cause other microeconomic problems—markets won't clear until people's information, expectations and plans have adjusted, i.e. until people realise that the fall in prices/wages is not a relative price adjustment but a fall in overall prices/NGDP.

Overall this suggests we should call a policy neutral without qualifiers not when it is perfectly neutral (which is impossible) but when it is the "neutrality maximising policy". In the words of David Beckworth "neither too stimulative nor too contractionary and is pushing the economy toward its full potential" or in the words of Alan Greenspan one that "would keep the economy at its production potential over time".

That is, one that balances the distortionary costs of high (particularly unexpectedly high) NGDP growth with the costs of low (particularly unexpectedly low) NGDP growth. Empirically, menu cost and shoe leather problems have never been large in the USA and UK when NGDP is ticking along at about 5%. By contrast, NGDP growth less than 2.5% is almost always consonant with stagnation, while NGDP growth of less than zero always means a recession—much bigger costs. This suggests policy, far from being unprecedentedly easy in the lacklustre post-recession recovery, was if anything on the tight side of neutral.

Two crucial final points:

1. Identifying the conditions that we'd want to see in the macroeconomy for a (relatively) undistorted microeconomy does not mean endorsing a particular monetary arrangement or regime. Whether we have a central bank or not, we'd want stable NGDP growth.

2. This 5% level is contingent on society-wide expectations. If long-term expectations held by borrowers, lenders, firms, consumers and workers were for 0% NGDP growth (e.g. the 19th Century), then 0% NGDP growth would be more likely to be the neutrality-maximising monetary policy.

There was no British housing bubble

Marcus Nunes graphed the Housing Stock to Population ratio in the US recently, showing that housing reached something like a steady-state in the US from the mid-1980s onwards. As Philip Stephens says, “The constructing in US housing was exactly what was needed to maintain the housing-population ratio in the face of increased population growth. You cannot have an “unsustainable boom” without oversupply.”

This is what the UK looked like over this period (my thanks to Daniel Knowles for the data):


The long-term trend (black dotted line) is attributable to the tendency in recent decades to smaller households, but what’s interesting is that, not only was there no spike in the run-up to 2008, the growth of dwellings over population actually fell below the trend. This is not what we would expect to see if there had been a bubble in housing production.

Dwellings data is a little bit unreliable, though – splitting a house into two flats creates an extra dwelling – so it might be better to look at the amount of new houses that were actually built. Here’s a chart showing the number of residential construction permits granted over the past forty years:


And here’s the ratio of new residential construction permits over population across the same period:

These charts show that housing construction was actually well below historical levels in the 1990s and 2000s, both in absolute terms and relative to population. It is difficult to see how someone could claim that the 2008 bust was caused by too many resources flowing toward housing and subsequently needing time to reallocate if there was no bubble in housing to begin with.

What this suggests is that the Austrian story about the crisis may be wrong in the UK (and, if Nunes’s graphs are right, the US as well). The Hayek-Mises story of boom and bust is not just about rises in the price of housing: it is about malinvestments, or distortions to the structure of production, that come about when relative prices are distorted by credit expansion.

What did cause the crisis? Jeffrey Friedman has shown that bank regulation (most notably, the Basel accords) was one of the major factors that led to the financial crisis, and Robert Hetzel has outlined a convincing theory that central bankers’ tightening of monetary policy in early-to-mid 2008 was the overriding cause of the world’s economic collapse. There is also the possibility that financial investment in the housing market was a simple error.

I was once convinced that the Mises-Hayek story about the boom and bust was true, but the evidence does not seem to bear this out.

Update: A lot of people seem to be implying that Austrian Business Cycle Theory (ABCT) means: Easy money -> high prices ("bubble") -> bubble burst, people lose money. This is incorrect. ABCT relies on distortions to the structure of production (that is, the "real" economy) which have to be liquidated over a period of time following the point at which it becomes clear that they are not good investments. If a 'bubble' just meant that people had lost money it would not cause a long-running recession, it would just mean that overnight a lot of people had lost money (like a stock market crash). The reason the recession takes time according to the ABCT is that resources have been invested in a sector where price signals take a considerable amount of time to adjust after a credit-induced malinvestment bubble and so it takes a while for people to determine which investments are 'mal'.

In short: There may have been a price bubble in British housing market, but there was not the production bubble that ABCT predicts.

PS: I am interested in seeing these data for countries like Ireland and Spain, where the Austrian story may be more valid. It is also possible, as Anton Howes has pointed out, that a regional breakdown would show that there were bubble-like expansions in housing supply in certain parts of the UK, which the country-wide figures hide. If you have these data please let me know, either in the comments or by emailing me at