If we used cows as money, we would probably teach our students courses on "Money and Milk Yields". If an outbreak of foot and mouth disease had caused a recession, macroeconomists would feel they needed to pay much more attention to veterinarians.

Milk yields matter. Foot and mouth disease is a problem. But these are fundamentally microeconomic problems. There is no inherent connection between milk yields and money, or foot and mouth disease and recessions. There is only a connection if our monetary practices make a connection where there needn't be one.

We use paper, ink, and electrons as money. Since those are all quite plentiful, we are free to make whatever connections we like with our money. We can target the price of cows, if we like. So money would be paper cows. And if we did that, we would still teach courses on money and milk yields, and worry about recessions caused by foot and mouth disease. But we don't have to do that. We could target something else instead.

It is presumably not a coincidence that a global financial crisis coincided with the beginning of a global recession. There was a connection between money and finance. But does there have to be that connection? Or was it simply a contingent fact based on our particular monetary practices?

Assume, just for the sake of argument, that it was as impossible for central banks to have prevented the financial crisis as it would have been impossible for central banks to prevent an outbreak of foot and mouth disease. Given the financial crisis, was recession inevitable? Could central banks have prevented a recession, not by preventing a financial crisis, but despite a financial crisis?

I want us to take Scott Sumner's challenge seriously.

"There is nothing in the slightest way mysterious about the current
recession.  If in 2007 you told the world’s elite macroeconomists what
the path of NGDP would look like over the next 6 years, most of them
would have predicted a deep recession and slow recovery in the US, and a
deep recession, slow recovery, and then double-dip recession in the
eurozone.  And that’s exactly what happened.  Adding finance won’t
improve that story one iota."

I know Scott believes that the financial crisis was much worsened by the recession that central banks could have prevented, but I want to set that aside. Assume a lot of people in finance made a lot of stupid decisions and the financial system is so unstable that there would have been a big global financial crisis whether or not the global economy went into recession. Could central banks still have prevented the recession, despite the financial crisis, if they had done something different?

I think that someone who answers "No, the recession was inevitable, given the financial crisis" must believe one of two things:

1. Given the financial crisis, it was impossible for central banks to have prevented the fall in NGDP relative to trend.

Or,

2. Given the financial crisis, even if central banks had prevented the fall in NGDP relative to trend, real GDP would still have fallen by the same amount, and so by definition the only effect would have been higher inflation.

Which is it? 1 or 2?

In my opinion 1 is implausible. For example, if central banks had been targeting NGDP for the previous 20 years, and had gained credibility for keeping NGDP on trend, so that people confidently expected that any deviations of NGDP from trend would be temporary, because the central bank would bring NGDP back to trend, that in itself would act as a powerful automatic stabliser bringing NGDP back to trend sooner than if people did not have those expectations.

Central banks like the Bank of Canada have been very successful in creating expectations that inflation would soon return to the 2% target. And those expectations have helped keep actual inflation close to the 2% target. If instead they had been targeting NGDP for the last 20 years, why couldn't they have been equally successful in creating expectations that NGDP would soon return to the trend path? And why wouldn't those expectations have helped keep actual NGDP close to the trend path? If people and firms don't expect NGDP to fall, they won't cut their spending as much in a way that causes actual NGDP to fall.

In my opinion 2 is implausible too. If I thought that nominal prices were perfectly flexible then I would believe 2. But I would have a very hard time convincing myself that the big drops in output and employment, and the big rise in unemployment, were simply the result of a supply shock caused by the financial crisis.

The Eurozone aside (which still looks to me like a disaster waiting to happen) things are looking a lot better than they were. The fear I felt five years ago is mostly gone. But when I see that fear replaced by complacency, and an apparent willingness to stick to much the same monetary policies that we had before the recession, I almost wish that fear would return.

Have we learned nothing? Or nothing that matters for monetary policy? Are we still just going to keep on targeting 2% inflation? Is this really the best we can do?

I don't think so.