Market monetarists like myself have criticized the “wait and see” approach used by many macroeconomists. This refers to the tendency of economists to watch how the economy plays out over time, after a new policy initiative. This technique is not reliable, as the economy is constantly being buffeted by all sorts of shocks, and it’s not easy to isolate the impact of any one shock. Instead, the immediate impact of policy announcements on market forecasts provides the best indication of whether stabilization policy is on target or off course.
In 1933, FDR gradually depreciated the dollar in order to boost prices and output. As the year progressed, opposition to the program increased. Even Keynes (who initially supported the policy) called for a halt in the dollar depreciation policy toward the end of 1933. FDR’s critics made the mistake of assuming that we needed to “wait and see” how the policy would impact the economy.
In fact, FDR should have depreciated the dollar even further. One economist who did understand this was George Warren, the FDR advisor who had advocated the policy. In my book on the Great Depression, I drew some parallels between this episode and modern policy errors:
The distinction between flexible (commodity) prices and a sticky overall price level is crucial to any understanding of Roosevelt’s policy. For instance, when Roosevelt decided to formally devalue the dollar in January 1934, many prominent economists such as E.W. Kemmerer predicted runaway inflation. Prices did rise modestly but remained well below pre-Depression levels throughout the 1930s. Pearson, Myers, and Gans quote Warren’s notes to the effect that when the summer of 1934 arrived without substantial increases in commodity prices:
The President (a) wanted more inflation and (b) assumed or had been led to believe that there was a long lag in the effect of depreciation. He did not understand—as many others did not then and do not now—the principle that commodity prices respond immediately to changes in the price of gold. (1957, p. 5664)
Warren understood that commodity markets in late January 1934 had already priced in the anticipated impact of the devaluation, and that commodity price indices were signaling that a gold price of $35/ounce was not nearly sufficient to produce the desired reflation. Most modern macroeconomists continue to make this mistake, taking a “wait and see” attitude toward initiatives such as “quantitative easing,” whereas the inflation expectations embedded in the Treasury Inflation-Protected Securities (TIPS) markets provided immediate evidence that the policy was nowhere near sufficient.
During 2009-10, many conservatives wrongly predicted that QE would be highly inflationary, and in 2012 many Keynesians wrongly predicted that the 2013 fiscal austerity would be highly contractionary. Both groups could have avoided their errors by looking at market forecasts.
The majority of economic historians seem to view George Warren as a bit of a crackpot. In fact, he was well ahead of the profession, and still is.
In macroeconomics, there’s (almost) nothing new under the sun, including market monetarism.