People seem to be getting “desperate” about the “Great Recession” being a prolonged affair.
Or you could go with a simpler but more pessimistic explanation: both the level and growth rate of American potential output is much lower than we think. This would resolve all these puzzles: GDP growth of 2.5% is above, not at, trend, the output gap is closing, and it was probably smaller than we thought to begin with. That would explain why unemployment is falling so quickly, and why core inflation hasn’t fallen further. The excess supply of workers and products that ought to be holding back prices and wages is not as ample as we thought.
Felix Salmon (We lived in a “bubble for 40 years”!) adding to IP:
There’s a whole narrative in this chart. From 1970 through the beginning of the crisis in 2008, GDP grew at a pretty steady pace. But the amount of debt required to generate that output just got bigger and bigger — the rate of growth of the credit market was much faster than the rate of growth of GDP. In 1970, GDP was $1 trillion while the credit market was $1.6 trillion: a ratio of 1.6 to 1. By 2000, when GDP reached $10 trillion, the credit market had grown to $28.1 trillion: a ratio of 2.8 to 1. And by mid-2008, when GDP was $14.4 trillion, the credit market was $53.6 trillion. That’s a ratio of 3.7 to 1.
Tim Duy contests:
I still believe that primarily we are looking at an aggregate demand shortfall rather than a collapse of potential output, but would agree that only one thing is for sure: That we haven’t seen the end of this debate.
So does Mark Thoma:
Even a standard business cycle type AD shock will temporarily depress capacity and produce similar effects. Suppose that interest rates go up, taxes go up, government spending goes down, investment falls –pick your story — causing aggregate demand to fall. When, as a result, businesses lay people off, idle equipment, etc., productive capacity will fall. It can be cranked up again, and will be when the economy recovers, but rehiring labor and taking equipment out of mothballs takes time. In the interim the natural rate of output falls and, just as with a change in the preference for good A versus good B, a negative aggregate demand shock can cause “frictions” on the supply side that temporarily increase the natural rate of unemployment. And there are many other ways this can happen as well.
The point is that there can be short-run cyclical AS effects, and failing to account for these can lead to policy errors.
And Mathew O´Brien at The Atlantic calls a “pig by its name”:
Has the Great Recession Made Us Forever Poorer?
But that´s just “background” for the real purpose of this post which is to suggest – given the above – that a “restraining order” should be slapped on Mr. Andrew Sentance, formerly advisor to the Bank of England, forbidding him to entice “carnage”.
He was quoted in the FT/Alphaville:
The key to the ability of central banks to respond in this way is the stability of inflation expectations and underlying confidence in their ability to sustain stable prices in the medium term. But continuing to tolerate phases of relatively high inflation will raise questions about their commitment to price stability. In my view, a policy of “leaning against the wind” of high energy and commodity prices – by seeking to influence the exchange rate and expectations of price increases – is more likely to be successful in anchoring inflation expectations and sustaining central bank credibility.
And FT/Alphaville comments on that one, remembering Trichet´s views:
‘Leaning against the wind’ refers to the central bank tendency to cautiously raise interest rates even beyond the level necessary to maintain price stability, if and when an asset price boom is identified.
Here´s the ungated version of the full article by Andrew Sentance.
Sentance says, partially correctly:
Since the early 2000s, whenever we have seen a combination of strong growth in Asia and emerging markets and reasonably healthy growth in western economies, we have also experienced a burst of energy and commodity price inflation. The first occurred in 2003-5, the second in 2006-8, and the third in 2009-11. If, as many forecasts suggest, the world economy starts to gather momentum again as we move through this year, we are set for another phase of rising energy/commodity prices, carrying through into 2013 and possibly 2014. This is likely to push up inflation worldwide and may eventually be a threat to growth as living standards are squeezed.
It´s not “whenever” but almost continuously, that since the early 2000s “we have experienced a burst of energy and commodity price inflation” as the chart shows, associating that fact with China in the WTO (see here).
And the only time we didn´t, in 2008-09, was when the Fed (and ECB) decided that those “inflation pressures” emanating from commodity and oil prices should be “severely” contained. See chart.
The economy boat capsized and is still struggling to “right itself”. But Mr. Sentance is “intolerant” being eager to “turn it over” again. He even argues that that´s exactly what Germany did back during the oil shocks of the 1970s:
In the 1970s, the western central bank that took the inflationary threat from energy and commodity prices most seriously – the Bundesbank – emerged from that period of volatility with its reputation greatly enhanced. Others, including the UK, faced a long battle against high inflation and fared less well. Currently, the focus of the western central banks is on combating the aftermath of the financial crisis rather than the threat from energy and commodity prices. That judgment may have been right in 2008-9. But a renewed burst of commodity and energy price inflation could require a different policy approach.
But that´s not how it went down in Germany. As this post mentions, Adam Posen, a former colleague of Sentance at the BoE said about that episode:
The Bundesbank made public that it would take several years to bring inflation back to its target long-run inflation level, even though it would partially offset the shock immediately and inflation would rise. In fact, it took six years for German inflation to be brought back to 2.0 percent, and both the Deutsche Mark and the Bundesbank retained their counter-inflationary credibility.
And the “eastern” bank that at that time was quickest to bring inflation down on its knees was the BoJ. And look where all that “inflation phobia” got them 15 years later!
So yes, Mr. Sentance is a “menace” to society and should be “sentenced” and kept in solitaire!