Y2Care about Monetary Rules
Y2K as a natural experiment in macroeconomics
In macroeconomics, there is almost no such thing as a controlled experiment. Unlike in physics, where one could construct a trebuchet and determine the optimal intial angle of elevation for a given projectile, in economics, one can't build an entire economy and test the effects, say, of capital gains tax cuts on real output.
Macroeconomic models are far more complex than what's needed for physics, in most cases -- instead of gravity and drag coefficients, you need all sorts of parameters, not all of them known, many of them difficult to measure with certainty, and the model itself is uncertain.
In most cases, real-world economies tend not to volunteer themselves as subjects for experimentation. Policy error, moreover, would be tremendously costly.
And yet, from time to time, stable conditions exist in the real world, and a single macroeconomic policy changes -- thus creating what economists call a "natural experiment." Sure, the experimental conditions may not be perfectly controlled -- but the real-world test informs in a way that economic modeling cannot. Economist hunt eagerly for such instances through the historical record -- the Romers' paper on tax policy in the interwar era (highly recommended reading) is one such example, using the US as "a laboratory for investigating the incentive effects of changes in marginal income tax rates."
The Y2K scare is, in my opinion, an overlooked natural experiment with tremendous potential for economic inquiry. (There was only one paper, a NY-FRB staff report from 2003, which I could find which used Y2K as something resembling a test case.) It meets the essential experimental controls: a stable macroeconomy, a very limited nature of a policy shock. What's best about it, in fact, is that the real shock of Y2K was fully anticipated, but did not happen -- it allows us to study the preemptive policy response in near-total isolation.
But first, this is why it's not complete isolation. In the run-up to Y2K, when the operation of the financial system seemed in doubt, there was an exogenous increase in the desire to hold cash rather than in bonds, and in currency rather than in electronic deposits. There was also an increase in the overnight risk premium for banks. And I think last, one could argue there was some investment -- see the John Quiggin paper, replacing computers and related equipment -- which would have otherwise not occurred. All of those are important, but this is really as good as it gets.
Y2K was, in effect, a monetary policy experiment. The Fed planned for the worst. To calm financial markets, the Fed increased bank reserves, expanding the monetary base and doubling excess reserves; it also printed a whole lot of dollars. It did this promising that it would fully stabilize nominal aggregate demand in the event of a real shock; and that in the absence of a shock, it would fully pull back on the expansion of the money supply and monetary base.As we can see in the graphs above, which map a year from July 1999, there was a large-magnitude change in all of these monetary measures, also very cleanly separated from the secular trend -- it's not hard, in other words, to distinguish signal from noise.
And I was thinking that I should show you a graph of prices during this time, or in real output, or in interest rates, or in anything -- but there is nothing. Y2K, obviously, didn't happen, but there was no consequence of the monetary expansion seen in the data other than in monetary measures. That's amazing because, while economists have known since the 1980s that an increase in the money supply matters to prices only in the long run, Y2K lets us see the strength of expectations set by a central bank rule (the rule, in this case, is the bank's ad-hoc promise to stabilize nominal aggregate demand) and thus the power of expectational channels in monetary policy.
This matters today. As in Y2K, the Fed has taken dramatic action -- expanding the monetary base and money supply, first to calm financial turmoil and then in attempted quantitative easing, and the result has been the creation of far more excess reserves than in Y2K. What Y2K gives us is the extreme case of how a policy shock based in rules and expectations ends up working; the fact that the circumstances are so similar to today, except for the lack of such a rule, tells us that markets are expecting an eventual drawdown of the monetary base (obviously). Markets do reflect, but in a much more muted capacity, the monetary expansion -- interest rates have fallen across the board, inflation breakevens are seen some lift -- but we aren't using the expectational channel at all today. Markets do not expect nominal AD stability, and the rule-less monetary easing has been underwhelming if not ineffective.
Y2K tells us that there's another way.