When economists lose their bearing…

It was when the gong announced the year 2009 had arrived. This happened during the AEA meeting on January 3-5. This NYT report on the meeting is enlightening:

SAN FRANCISCO — Frightened by the recession and the credit crisis that produced it, the nation’s mainstream economists are embracing public spending to repair the damage — even those who have long resisted a significant government role in a market system.

“We have spent so many years thinking that discretionary fiscal policy was a bad idea, that we have not figured out the right things to do to cure a recession that is scaring all of us,” said Alan J. Auerbach, an economist at the University of California, Berkeley, referring to the mix of public spending and tax cuts known as fiscal policy.

At about the same time, Brad DeLong wrote the same thing:

Economists who initially rejected the need for fiscal stimulus have warmed to the idea, too. Several months ago, Alan Viard, a Bush administration economist now at the American Enterprise Institute, thought the right size for a government spending bill was “probably zero.” He favored reliance on the Federal Reserve to slash interest rates and existing unemployment benefits to bolster the jobless. Now Viard shares the view that a stimulus package is needed, although he would prefer one limited primarily to tax cuts and direct benefits for victims of the recession, such as increased unemployment benefits. “Things have gotten so bad so quickly,” Viard said. “We have now lost 3.6 million jobs, a stunning loss. But what’s more horrifying is that half that loss has occurred in the last three months. This is a severe recession. There’s no doubt about it”…

The problem is that when you think out of fear you don´t think straight. The fear came from the quick and large drop in employment and increase in unemployment that took place in the last 6 months of 2008 (figure 1). In this setting, the “credit crisis” was a red herring that blinded most economists from thinking straight. This was further enhanced by the fact that monetary policy had become “ineffective” when short term rates dropped to “zero” by the end of 2008.

But all these things were really made worse by the seldom mentioned fact that the Fed allowed nominal spending (NGDP) to drop like a stone, something that was last seen in 1938 (figure 2)!

Just a little over two years on perceptions have changed dramatically. Many (maybe most) of those that championed fiscal “stimulus” in January 2009 are now in full force behind “austerity”:

There are many issues on which we don’t agree. Yet we find ourselves in remarkable unanimity about the long-run federal budget deficit: It is a severe threat that calls for serious and prompt attention.

In his NYT piece this weekend Mankiw brings the “future forward”:

The following is a presidential address to the nation — to be delivered in March 2026.

MY fellow Americans, I come to you today with a heavy heart. We have a crisis on our hands. It is one of our own making. And it is one that leaves us with no good choices.

But confusion still reigns. The Shadow Open Market Committee, a body that exists since 1973, convened on March 25. The Keynote speaker was Charles Plosser, a former “top gun” in the SOMC and now president of the Philadelphia Fed and FOMC voting member this year. The introduction to his speech is “biutiful”:

It is a pleasure to be here today with my old colleagues and friends. I spent the better part of 15 years as a member of the Shadow Open Market Committee and served as its co-chair with Anna Schwartz for part of that time. It was a valuable experience and I learned a great deal from our discussions and debates concerning policy.

When I accepted the position with the Federal Reserve Bank of Philadelphia in 2006, some of my colleagues thought that I had gone over to the dark side. I preferred to think of it as trying to help put the lessons of modern macroeconomics and monetary theory to work in the making of policy. That has turned out to be easier said than done for a number of reasons, not the least of which is the onset of the greatest financial crisis since the Great Depression. Some might think, based on temporal ordering or a test of Granger causality, that it was my arrival at the Fed that actually caused the crisis. Yet, we should be cautious in drawing conclusions about causation from such evidence. Personally, I prefer to think the crisis occurred despite my arrival at the Fed. But that is a story for another day

Michael Bordo, another SOMC member was forceful on the “prospects for inflation”:

The Great Recession of 2007-2009 is now over and the U.S. economy is expanding nicely as are most economies. The recovery from the recession reflects the operation of normal market forces and expansionary monetary policy by the Federal Reserve and other central banks. Many observers argue that the recovery in the U.S. is still anemic because the unemployment rate is still close to 9% and there is considerable economic slack. They argue that the Fed should continue on its expansionary track to insure that the recovery will be durable and strong.

The problem is that expansionary monetary policy by the Fed and by central banks around the world is creating incipient inflationary pressure which is already manifest in rising commodity prices and in headline inflation in both emerging and some advanced countries…

Arguing for “the other side” is former Fed Governor Laurence Meyer:

All of this has made some economists and lawmakers in the United States nervous. They fear that higher prices for commodities will translate into higher prices for all goods and services and that the Federal Reserve, by ignoring commodity prices, has become lax on inflation.

While the anxiety is understandable, the fears are misplaced. They result from a profound misunderstanding about whether food and energy prices today help predict overall inflation tomorrow.

And the biggest about face in all this confusion is provided by Kocherlakota. Only a few months ago he was ranting that unemployment was structural and there was nothing monetary policy could do about it (actually, if I remember well he advocated an increase in the FF rate). At a conference in Marseille on March 25th it is reported that:

Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said monetary policy stimulus, when done on a sufficient scale, could stop a bursting asset price bubble from causing an increase in unemployment.

“The bubble collapse has no impact on unemployment or output, given sufficiently accommodative monetary policy,” the bank president said, referring to an economic model in the text prepared for a speech today in Marseille.

He is clearly saying that if only the Fed had not let spending take a nose dive…

The surprising fact is that Bernanke is very much aware of the need to get spending back up (not just the growth rate but the LEVEL). According to Christy Romer:

I’m teaching a course this semester on macro policy from the Depression to today. One thing I had the class read was Ben Bernanke’s 2002 paper on self-induced paralysis in Japan and all the things they should’ve been doing. My reaction to it was, ‘I wish Ben would read this again.’ It was a shame to do a round of quantitative easing and put a number on it. Why not just do it until it helped the economy? That’s how you get the real expectations effect. So I would’ve made the quantitative easing bigger. If you look at the Fed futures market, people are expecting them to raise interest rates sooner than I think the Fed is likely to raise them. So I think something is going wrong with their communications policy. They could say we’re not going to raise the rate until X date. Those would be two concrete things that wouldn’t be difficult for them to do. More radically, they could go to a price-level target, which would allow inflation to be higher than the target for a few years in order to compensate for the past few years, when it’s been lower than the target.

I rest my case.

2 thoughts on “When economists lose their bearing…

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