Academics and policymakers have been discussing for years about “The conduct of monetary policy in a low inflation environment”. The first conclusion that should have been reached was “ditch IT”. Obviously, given the protracted discussion, IT was not robust.
So now that academics and policymakers had to eat crow, the solution becomes “contingent commitments”, much like after the Asia crisis in 1997 the buzzword became “reform of the international financial architecture”. A lot of good that did!
In the spirit of proposing new “buzzwords, Larry Summers wrote an oped based on his paper with Brad DeLong:
On even a pessimistic reading of the economy’s potential, unemployment remains 2 percentage points above normal levels; employment, 5 million jobs below potential, and GDP, close to $1 trillion short of potential. Even with the economy creating 300,000 jobs a month and growing at 4 percent, it would take several years to re-attain normal conditions. So a lurch back this year toward the kind of policies that are appropriate in normal times would be quite premature.
Indeed, recent research on what economists label hysteresis effects suggests that slowing could have highly adverse consequences. Brad Delong and I argue in a recent paper that it is even possible premature and excessive movements toward fiscal contraction, by shrinking the economy, risk exacerbating long-run budget problems.
How then to respond to valid concerns about fiscal sustainability, excessive credit creation and the eventual return to normality in a world where policy credibility is essential? The right approach is policies that commit to normalizing conditions but only when certain thresholds are crossed. The Federal Reserve might commit to maintain the current Fed funds rate until some threshold with respect to unemployment or expected inflation is crossed. Commitments to fund infrastructure over many years might include a financing mechanism such as a gasoline tax that would be triggered when some level of employment or output growth has been achieved. Tax reform could phase in new rates in pace with the rising economic performance.
Contingent commitments have the virtue of providing clarity to households and businesses as to how policy will play out, and in areas where legislation is necessary, eliminating political uncertainty. They allow policymakers to project a simultaneous commitment to near-term expansion and medium-term prudence — exactly what we require right now. An element of contingency in policy is always there in a volatile world. Recognizing it explicitly is the way to provide confidence and protect credibility in a world whose future no one can gauge with precision.
“Contingent commitments” are vague and instead of “providing clarity”, they sow confusion. The contingencies to which the commitments are tied may just not be credible, and even if they are there can be a combination of “realizations” that leave agents in great doubt about the actions policymakers will deem appropriate.
So instead of appealing to the negative consequences of a protracted economic slowdown and proposing “voodooesquelike” “self-financing deficits”, academics should stop bickering about the temporary impotency of monetary policy and the mystic wonders of expansionary fiscal policy and quickly come to a consensus on the most effective way to get the economy “back on track”. Deep down they know how to do it, but “papers have to be written”!