Some “bygones” should not be “left alone”

Recently Lars put up a controversial post in which he concludes:

Recognizing a 4% NGDP level target from the present level of NGDP in my view should be rather uncontroversial as this de facto has been the policy the Fed has been following over the past five years anyway. Furthermore, it could easily be argued as compatible with the Fed’s (quasi) official 2% inflation target (assuming potential real GDP growth is around 2%).

Scott Sumner had a critical response and Lars wrote a rejoinder.

What Lars is in effect saying is that we should learn to live (and enjoy) the “New Normal”, “Great Stagnation” or “Lesser Depression” that has become fashionable and let bygones be bygones.

I´ll grant that the previous (“Great Moderation”) trend level may be unachievable. Too many mistakes along too many years may have put a big dent in the level of potential output. But I believe a gap relative to a feasible NGDP level remains and should be closed.

The chart illustrates the argument:


In 2001 Greenspan´s Fed bungled and allowed spending to fall below the trend level. After bringing the FF rate all the way down to 1%, without much effect, in mid-2003 the Fed adopted Forward Guidance. This was successful in taking spending back up to the trend path. When  Greenspan left in January 2006 NGDP was very close to it.

Soon after taking over at the Fed, Bernanke allows NGDP growth to fall to near 4%, distancing itself from the “GM” trend level (note: this wouldn´t be at all positive for the housing market, with house prices beginning to fall at the same time).

In 2008 Bernanke lets the “shoe drop”, creating havoc. Note that now we are back on the trend level that the economy had dropped to in 2001-02, from which it had climbed with forward guidance.

What I´m arguing is that the big mistake of 2008 (“shoe drop”) should not be allowed to fall into the “bygone be bygone” category. Back in 2006 Bernanke appears to have “favored” a lower growth trend path, with NGDP growing close to 4%. NGDP is back to growing 4% but the level is clearly off. And don´t think the gap is a triffle. It´s worth about 1.7 trillion dollars!

PS As to the title of Lars´rejoinder post: “Certainly not perfect, but Fed policy is not worse than during the Great Moderation (an answer to Scott Sumner)“, it is wrong because, clearly, in 2003-05 the Fed tried (and essentially succeeded) to regain the trend level path. Now, it has done absolutely nothing to recoup the “shoe that dropped”!

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