The Great Recession was the bastard child of the Great Moderation!

Olivier Blanchard wants the economy to keep away from “dark corners”:

From the early 1980s on, most advanced economies experienced what has been dubbed the “Great Moderation,” a steady decrease in the variability of output and its major components—such as consumption and investment. There were, and are still, disagreements about what caused this moderation. Central banks would like to take the credit for it, and it is indeed likely that some of the decline was due to better monetary policy, which resulted in lower and less variable inflation. Others have argued that luck, unusually small shocks hitting the economy, explained much of the decrease. Whatever caused the Great Moderation, for a quarter century the benign, linear view of fluctuations looked fine. (This was the mainstream view. Some researchers did not accept that premise. The late Frank Hahn, a well-known economist who taught at Cambridge University, kept reminding me of his detestation of linear models, including mine, which he called “Mickey Mouse” models.)

The Great Moderation had fooled not only macroeconomists. Financial institutions and regulators also underestimated risks. The result was a financial structure that was increasingly exposed to potential shocks. In other words, the global economy operated closer and closer to the dark corners without economists, policymakers, and financial institutions realizing it.

Macroeconomic policy also has an essential role to play. If nominal rates had been higher before the crisis, monetary policy’s margin to maneuver would have been larger. If inflation and nominal interest rates had been, say, 2 percentage points higher before the crisis, central banks would have been able to decrease real interest rates by 2 more percentage points before hitting the zero lower bound on nominal interest rates.

And concludes:

The crisis has been immensely painful. But one of its silver linings has been to jolt macroeconomics and macroeconomic policy. The main policy lesson is a simple one: Stay away from dark corners.

Blanchard insists in saying that if nominal rates/inflation had been higher before the crisis, monetary policy´s margin of maneuver would have been larger. Implicitly, he assumes monetary policy is interest rate policy. Few see that the Great Moderation was all about Nominal Stability, under the purview of the Fed. It was nominal stability, in the guise of a stable growth of spending along a level trend path that helped keep the economy away from “dark corners”. In other words, it was not the “nature” of the shocks that changed, but how “good policy” was “good” exactly because it was managed in such a way as to contain the propagation of the shocks (avoid the “dark corners”).

Bernanke´s Fed sacrificed nominal stability in the altar of inflation targeting. The result, as Brad Delong has just defined, was a “Greater Depression”!

Dark Corners


Remembering Prosperity (In A Forgotten Time)

A guest post by Benjamin Cole

Given the rampant defeatism in modern economy policy circles, I thought I would re-visit an era of robust growth in the United States: The late 1970s.


But the 1970s were one, long ugly bout of stagflation in the United States, right?

And not only! The 1970s featured ugly clothes, strange hairdos, a squalid and losing war in Vietnam, and soaring crime in the US cities. While U.S. automakers made garish vehicles that fell apart, the serial liar Richard Nixon Watergated the  Presidency, where he was succeeded by the mushy wimp Jimmy Carter.

It is a decade Americans prefer to forget, except for maybe the disco dancing. But relying on memories and anecdotes can be treacherous.

How about this: From 1976 through 1979 the U.S. economy expanded (and in real terms) by 20 percent, after the two-year recession for 1974-1975. These are the stats:

Year      Real GDP Growth %

1976       5.4

1977       4.6

1978       5.6

1979       3.1

That four-year recovery is not stagnation; it was a honking great economic expansion. And it coincides with President Jimmy Carter’s watch, the man remembered for his pious pleas that Americans live on less in chilly houses, due to oil shortages.

Except while Carter sermonized, the economy roared. The number employed in the United States rose from 88.8 million to 98.8 million in the four years, an 11 percent jump for the Carter Administration.

The Price was Prices?

Of course, I have left out part of the late 1970s picture: The hobgoblin inflation. Especially as measured by the consumer price index (CPI), a series that then tended to overstate inflation. Be that as it may, by 1979 the CPI topped an 11 percent annual increase.

The Federal Reserve Board chiefs of the day were Arthur Burns (1970-78) and then William Miller (1978-79), the latter a man nearly erased from Federal Reserve histories. Today, Burns and Miller routinely get blamed for “runaway inflation.”

Today, no one ever says the pair of central bankers “oversaw a 20 percent expansion in real GDP to finish out the last four years of the 1970s.”

Blame Burns and Miller deserve—but only so much. In fact, inflation barely reached double-digits in the late 1970s, a long way from Zimbabwe or the Weimar Republic horror stories. Inflation was probably too high for comfort in the late 1970s, but it was not so high for the time and place.

The Forgotten Context

Back in the 1970s, a 5 percent rate of inflation was considered okay; as we have seen in this space, both the Nixon and Reagan Administrations pushed the Fed to ease when inflation was in that range. Even the towering inflation-fighter and Fed Chairman Paul Volcker (1979-87) cooled his guns when inflation retreated to 4 percent.

Yes, Volcker relented when inflation was double the rate that today sends Fed officials cowering.

So, to be fair to the invisible man Fed Chief Miller, he presided over a rate of inflation that was up 5 percent from what had been deemed acceptable, or was double the then-acceptable rate. It is key to remember that inflation did not rise from 1 percent to 10 percent on Miller’s watch, but more from the mid-single digits to bottom of the double digits.

Miller also operated in an economy much more prone to inflation than today. The top marginal tax rate was 70 percent, unions were still a force in the private sector, and international trade was growing but far from levels reached in the 2000s. Transportation, telecommunications and finance were heavily regulated. It was the pre-Internet age, with all the transactions costs of that era. COLA contracts were common.

And Today?

What inflation pain would it be worth it to obtain a 20 percent expansion of real GDP in the United States—and to create 15 million jobs? What if policymakers had to accept an increase in inflation to, say, the 5 percent to 6 percent range?

Our not-so-long central-bank ancestors would sneer at our timidity. They thought inflation in the 5 percent range was the norm. They would put the money-printing press needle in the “Red Zone Hot” and take a long weekend.

Moreover, is not clear the United States would get up to 5 percent inflation, even in a robust boom. The traditional model of inflation assumes that an increase in the money supply (assuming static velocity) will boost demand, leading to an increase in output. Competition keeps a lid on prices. Only after output reaches full capacity do sellers ration by price, and then inflation results. In real life, not so clean, but that is the general idea.

But what of an economy (the United States) that sources globally? Can the U.S. economy really cause global supply lines to reach demand-pull inflation? If Ford raises prices, do Kia and Toyota and BMW?

Sadly, our central bankers do not even want to find out what level of demand prompts inflation. They think 2 percent inflation is the monetary River Rubicon—and so our Fed is evidently targeting 1.5 percent inflation, as an average. Other prominent monetary thinkers call for zero inflation, or even deflation.

For me, that says we are in the Economic Dark Ages. What is nearly certain is the United States will never see a robust 1976-1979 type recovery, as long as the Federal Reserve is so obsessed with inflation.

Maybe forgotten Fed Chief William Miller was not that bad.  And disco was great.

“Distorted Mirrors”

In a just released book – Hall of Mirrors: The Great Depression, The Great Recession, and the Uses-and Misuses-of HistoryBarry Eichengreen argues that:

There have been two global financial crises in the past century: the Great Depression of the 1930s and the Great Recession that began in 2008. Both featured loose credit, precarious real estate and stock market bubbles, suspicious banking practices, an inflexible monetary system, and global imbalances; both had devastating economic consequences. In both cases, people in the prosperous decade preceding the crash believed they were living in a post-volatility economy, one that had tamed the cycle of boom and bust. When the global financial system began to totter in 2008, policymakers were able to draw on the lessons of the Great Depression in order to prevent a repeat, but their response was still inadequate to prevent massive economic turmoil on a global scale.

In Hall of Mirrors, renowned economist Barry Eichengreen provides the first book-length analysis of the two crises and their aftermaths. Weaving together the narratives of the 30s and recent years, he shows how fear of another Depression greatly informed the policy response after the Lehman Brothers collapse, with both positive and negative results. On the positive side, institutions took the opposite paths that they had during the Depression; government increased spending and cut taxes, and central banks reduced interest rates, flooded the market with liquidity, and coordinated international cooperation. This in large part prevented the bank failures, 25% unemployment rate, and other disasters that characterized the Great Depression. But they all too often hewed too closely and too literally to the lessons of the Depression, seeing it as a mirror rather than focusing on the core differences. Moreover, in their haste to differentiate themselves from their forbears, today’s policymakers neglected the constructive but ultimately futile steps that the Federal Reserve took in the 1930s. While the rapidly constructed policies of late 2008 did succeed in staving off catastrophe in the years after, policymakers, institutions, and society as a whole were too eager to get back to normal, even when that meant stunting the recovery via harsh austerity policies and eschewing necessary long-term reforms. The result was a grindingly slow recovery in the US and a devastating recession in Europe.

The steps taken by the Federal Reserve (read FDR) in March 1933 (de-linking from gold) were certainly not futile. NIRA (also FDR) seems to have been counterproductive. And the tightening of monetary policy (increase in required reserves by the Fed and gold inflow sterilization by the Treasury) in 1937-38 caused grave damage!




Slaves to the misguided Phillips Curve

From a Janet Yellen speech in 2007:

The Phillips curve is a core component of every realistic macroeconomic model. It plays a critical role in policy determination, because its characteristics importantly influence the short- and long-run tradeoffs that central banks face as they strive to achieve price stability and, in the Federal Reserve’s case, maximum sustainable employment—our second, congressionally mandated goal.

In her speech – Labor Market Dynamics and Monetary Policy –at the Jackson Hole gathering she says:

In my remarks this morning, I will review a number of developments related to the functioning of the labor market that have made it more difficult to judge the remaining degree of slack. Differing interpretations of these developments affect judgments concerning the appropriate path of monetary policy. Before turning to the specifics, however, I would like to provide some context concerning the role of the labor market in shaping monetary policy over the past several years. During that time, the FOMC has maintained a highly accommodative monetary policy(!) in pursuit of its congressionally mandated goals of maximum employment and stable prices. The Committee judged such a stance appropriate because inflation has fallen short of our 2 percent objective while the labor market, until recently, operated very far from any reasonable definition of maximum employment.


One convenient way to summarize the information contained in a large number of indicators is through the use of so-called factor models. Following this methodology, Federal Reserve Board staff developed a labor market conditions index from 19 labor market indicators, including four I just discussed. This broadly based metric supports the conclusion that the labor market has improved significantly over the past year, but it also suggests that the decline in the unemployment rate over this period somewhat overstates the improvement in overall labor market conditions.

The set of charts below shows how unreliable the labor market indicator is for the behavior of inflation and also that monetary policy has been nowhere near accommodative (let alone “highly”). The bottom chart indicates that the NGDP gap has lost all meaning after late 2009 – an indication that the trend level of spending has, in reality, become much lower than previously – implying that the economy is stuck at a depressed level with much lower labor participation rate and level of employment  than otherwise would be the case but also with a below target rate of inflation.





Is RBC Theory winning out?

Commenting on a paper presented at the Jackson Hole gathering, Benyamin Appelbaum writes:

The paper, presented Friday morning at the annual gathering of economists and central bankers at Jackson Hole, Wyo., argues that the share of Americans with jobs has declined because the labor market has stagnated in recent decades — fewer people losing or leaving jobs, fewer people landing new ones. This dearth of creative destruction, the authors argue, is the result of long-term trends including a slowdown in small business creation and the rise of occupational licensing.

“These results,” wrote the economists Stephen J. Davis, of the University of Chicago, and John Haltiwanger, of the University of Maryland, “suggest the U.S. economy faced serious impediments to high employment rates well before the Great Recession, and that sustained high employment is unlikely to return without restoring labor market fluidity.”

At the end:

In the view of Mr. Davis and Mr. Haltiwanger, the recession just made a bad situation worse.

The economy clearly had problems before the crisis. Indeed, those problems contributed to the crisis.

But economists and policy makers will have to reconcile the assertion that these trends were the dominant factors with the reality that the employment rate rose in the years before the recession, then dropped sharply during the recession.

The new paper, like others of its genre, basically requires belief in a big coincidence: that a short-term catastrophe happened to coincide with the intensification of long-term trends — that the economy crashed at the moment that it was already beginning a gradual descent.

Tyler Cowen commented on Benyamin Appelbaum last paragraph saying:

I view this somewhat differently.  Very often trends accumulate, often without much notice, and then a cyclical event causes that trend to explode into full view.  Such a coincidence of cycle and trend is very often no accident and in fact the two are closely related.

Let’s say, as seems to be the case, that wages stagnated, labor market mobility slowed down, and non-outsourcing productivity was slow during 2000-2007 (or maybe longer).  Those are all long-term economic trends and they are all bad news.

During 2000-2007 most Americans acted as if were are on a good trend line when in fact they were on a less favorable trend line.  This influenced spending decisions, borrowing decisions, real estate decisions, and so on.  People overextended themselves and they also created unsustainable bubbles.  Sooner or later the debt cannot be rolled over, the bubbles pop, the crash ensues, AD falls, and so on.  This often takes the form of a discrete cyclical event, as indeed it did in 2008.

One point — still neglected in much of today’s macroeconomic discourse — is that the mis-estimated trend was a major factor behind the cyclical event.  But there is yet more to say about this interrelationship between cycle and trend.

The arrival of the cyclical event, in due time, makes the negative underlying trend more visible.  At first people blame everything on the cycle/crash, but a look at the slow recovery, combined with a study of pre-crash economic problems, shows more has been going on.

Which reminded me of the RBC view that:

…the old view that long term (“potential”) growth was something smooth and slowly changing that could be analyzed separately from cycles (the ups and downs of everyday life) is probably not true. The economy should be viewed as an optimizing dynamic system constantly buffeted by shocks. In this sense, what is popularly called cycle is nothing more than the manifestation of the economy’s search of its new equilibrium growth path. If that happens to be below what many conventionally define as potential, it does not follow that the economy has somehow to rise back to it.

I don´t buy Tyler Cowen´s arguments. To me they are mostly rationalizations!

Two illustrations:


Richard “Easy Money” Nixon Shames Barack “Know Nothing” Obama! Tapes Reveal Nixon Wanted Easy Money, and to Pack the Federal Reserve with Monetary Expansionists

A guest post by Benjamin Cole

The astounding and revelatory conversation between President Richard Nixon and Fed Chairman Arthur Burns was caught on tape on March 19, 1971, in the famed White House Oval Office.

Nixon: Arthur, the main thing is next year [1972, election year]…let’s don’t let it [unemployment] get any higher. I hope we can—

Burns: That’s what I have my eye on.

Nixon: Yeah. But I think we really got to think of goosing it.

Burns: Yes.

Nixon: Shall we say late summer and fall this year in order to affect next year?”

Burns: Exactly.

The conversation above is captured in a fun, new book, Chasing Shadows, by Ken Hughes. BTW, inflation then was just under 5 percent, on the CPI.

But that’s not all—Nixon reveals himself a shrewd monetarist of the populist stripe, far more aware of the role of the Federal Reserve in the nation’s prosperity than President Obama.

The following Nixonian monologue refers to finding someone to sit on the Fed board, to fill an empty seat.

“I’ve told [Treasury Secretary John B] Connally to find the easiest money man he can find in the country and one that will do exactly what Connally wants and one that will speak up to Burns…Connally is searching the goddamned hills of Texas, California, Ohio,” Nixon said to his aides. “We’ll get a populist spender on the board one way or another.”

There is another small, and forgotten part of the Nixon Legacy: He flirted with an idea to radically expand the Federal Reserve Board, so as to “pack” it with easier money types—Nixon felt even the compliant Burns was not expansionist enough.

The UPI reported on July 28, 1971 that, “President Nixon is considering a proposal to double the size of the Federal Reserve Board, it was learned today. The suggestion, if put before Congress, could touch off a controversy rivaling President Franklin D. Roosevelt’s attempt to ‘pack’ the Supreme Court.”

Tapes show Nixon even dickered with a pay raise for Burns, in seeking Burns’ obedience on easy money.

Melancholy Money and Obama The Milquetoast

Of course, these insights into Nixon remind one of the Ronald Reagan Presidency, in which the Reagnauts were so furious with then-Fed Chairman Paul Volcker’s tightness that they floated a proposal to move the Fed into the Treasury Department, where it would answer to Treasury Secretary Don Regan.

Next to Nixon and Reagan, Obama looks like a Milquetoast-y effete, meekly tolerating the Fed in its inflation-phobic policies, even as the central bank asphyxiates the economy.

Did Obama ever demand of the Fed, “Why are we consistently below the “average” 2 percent inflation target, when the economy is sputtering?” Nor did Obama ever float proposals to pack the Fed or shift control over monetary policy to the Treasury Department.

The other melancholy part of these Nixonian revelations is the reminder that the right-wing was not always insensately addicted to tight-money rhetoric.

Today, it is impossible to imagine a GOP President strong-arming to the Fed to ease up, or for any right-wing economist with “street cred” to call for easier money. (A reader here recently opined that some right-wing economists call for Market Monetarism, but everyone knows they are not “real” right-wingers. To be for monetary tightness, or even deflation and the gold standard, are the current defining attributes of true right-wing economist).

Excellent writer Ken Hughes’ Chasing Shadows book is, properly enough, more devoted to Nixon’s skullduggery and evasions than his monetary policy.

But the book and its brief addresses of monetary policy are wonderful reminders that Nixon ever escapes easy definition, and that a peevish fixation with tight money and inflation was not always a right-wing predilection—nor the default position of the Federal Reserve.

Snippet of a conversation at Houston Airport

I really couldn´t believe my ears when I heard these two African American airport employees having the following conversation in the train linking terminals at Houston Airport:

“…the problem is that money is slow, it is not circulating as much as it should and so blocking spending…”

Pity I had to leave at the next terminal while they continued on. I would have suggested the speaker started reading MM blogs. But maybe he already does!

They should have been invited to JH!

The Great Conundrum faced by “Righty-Tighties”

A guest post by Benjamin Cole

That tight money is sacred is an axiom of right-wing politics today.

The second and related axiom is that monetary policy is currently, and always, too loose.

The third derivative axiom is that low interest rates turn otherwise gimlet-eyed private-sector investors and corporate chieftains into wanton bubble-chasers.

There is a confounding problem with this trifecta of potential central bank sins: As Milton Friedman said, low interest rates are the result of tight money. You can’t get down into the low single digits by printing a lot of money. And you can’t get to zero lower bound and zero inflation without some monetary asphyxiation.

So, if a central bank runs tight money long enough, it will get to…yes, the evil of low interest rates, those low single-digit vigorish IOUs that drive business decision-makers bananas.

Thus, the great good of tight money begets the great evil of low interest rates.

The Paradoxical Oddity

Paradoxically enough, if the U.S. Federal Reserve really wants higher nominal and real interest rates, they will have to loosen, and for a long time. Fed Chief Janet Yellen would have to run an aggressive QE program for a few more years, over the increasingly hysterical objections of the monomaniacal inflation-phobiacs on the FOMC board.

Not likely, eh?

If lenders and bond-buyers came to fear erratic or higher rates of inflation, they would charge an inflation-fear premium. Then the righty-tighties could embrace  higher nominal and real interest rates. And if demand for capital was strong enough—thanks to robust economic growth—there might actually be the rationing of credit by price, meaning higher interest rates.

But the preceding scenario is, I am sad to say, mostly fantasy. As it stands now, interest rates might actually go lower. How?

Long-term inflationary expectations—as in 10 years out—are under 2 percent, according to the Cleveland Fed. Not only that, there is a global glut of capital—see the recent Bain & Co. report, A World Awash in Money. The International Monetary Fund’s 2014 report is the obverse of the Bain study; the IMF says we will see weak demand for capital and thus low interest rates for a long time.

So, add a savings glut to dead inflation fears and weak demand for capital and you get…low nominal and real interest rates. Going lower? Maybe. That is the reality in Europe and the risk in the United States.

Musing About Unresolved Problems

Still, I am not sure even an aggressive, expansionist Fed could bring higher nominal and real rates, or even much inflation, although we might have live through years of prosperity to find out.

The unresolved problem is 50-percent savings rates in China; high savings rates in Japan; gigantic and growing sovereign wealth funds; private and public pension plans the world over obligated to build assets; insurance companies under requirements to build balances to match liabilities and a new global upper class able to save. Russian klepto-crats, Chinese cronyists and Mideast oil moguls assemble towers of capital, regardless of interest rates.

The amount of demand for capital it would take to raise interest rates may not be possible. The market may be sending a signal that capital is abundant, and get used to it. This is the new normal.

And inflation? Well, the supply-side in the United States has gone global. In the old days we thought boosting demand through monetary expansion would first bring on new supply, then higher prices, as sellers rationed supply by price. Now, when there is a boost in demand in the United States, global suppliers of goods, services and capital are at the ready and pour in.

How does price allocate a glut of goods, services and capital?

To get to higher interest rates and inflation, we may have to endure years and years of prosperity. And even that may not work. I think we should try anyway.

PS: Just so my right-wing friends know—the left-wing solutions of higher taxes, bigger deficits and more social welfare are awful also…

Barry Eichengreen & Secular Stagnation

VoxEu has an e-book discussing Larry Summer´s “invention”: “Secular Stagnation”. In his essay, BE concludes:

So is there a secular stagnation problem? Yes, there are reasons to worry that the US’s growth rate over the next 10 or 20 years will disappoint by the standards of the 20th century. But this is not inevitable. It will not be because all the great inventions have been made or because there is a dearth of attractive investment projects and an overabundance of savings.

If the US experiences secular stagnation, the condition will be self-inflicted. It will reflect the country’s failure to address its infrastructure, education and training needs. It will reflect its failure to take steps to repair the damage caused by the Great Recession and support aggregate demand in an effort to bring the long-term unemployed back into the labour market. These are concrete policy problems with concrete policy solutions. It is important not to accept secular stagnation, but instead to take steps to avoid it.

David Beckworth, Ryan Avent and I mostly agree with Eichengreen.