Growth is to be avoided at all costs!

That´s the sort of reasoning a depression can bring about! In “How a Surprise Upturn in U.S. Growth Could Trigger the Next Recession”, we read:

Could the cause of the next U.S. recession be too much growth? That is one risk of an unprecedented environment in which investors are betting heavily on a perpetually weak economic expansion.

If markets are wrong–and the economy surges instead of sputters–the bad bets could roil the financial system, some economists are increasingly warning.

“Ironically, one can think of a scenario where a stronger-than-expected expansion leads to financial trouble, which in turn puts into question the expansion itself,” said former International Monetary Fund chief economist Olivier Blanchard.

Mr. Blanchard is the latest prominent economist to warn that a surprise upturn in growth may force the Federal Reserve to raise rates faster than investors expect. A jump in borrowing costs could catch many off guard, given that much of their portfolios are based on lower rates.

“If the economy were to pick up faster than markets think, which I think has substantial probability, it could lead to some financial turmoil,” Mr. Blanchard, now a senior fellow at the Peterson Institute for International Economics, said in an interview.


“When the Brexit smoke clears, if, as I expect, it clears, then the Fed should tighten,” said Mr. Blanchard. And given that it takes roughly a year for interest rates to have a substantial effect on the economy, that means the Fed can’t wait too long to raise the cost of borrowing to temper inflation.

“You have to anticipate,” he said. “If I was at the Fed, I would be slightly on the hawkish side.”

The economy is being smothered by the Fed. In that case all the risk is on the downside. Higher growth is a chimera!

What´s the story? Slow growth reflects Policy incompetence or is it a “fact of life in the post-crisis world”?

To Blanchard, it´s the latter:

Once the acute phases of the financial and euro crises were over, it was clear that it would take time for advanced economies to recover. The history of past financial crises gave a clear warning that recovery would typically be long and painful.

Today, the scars are largely healed but growth is still slow. Before the crisis, any economist would have predicted that an economy with interest rates close to zero and no other major brakes on demand would see high growth rates and quickly overheat. Yet this is not what we have seen. The reason, I believe, must be found in mediocre medium term prospects, which in turn affect current demand and growth.

Low potential growth is bad news for the medium term. But it may explain what is happening today. A main finding of a paper that Eugenio Cerutti, Lawrence Summers and I wrote in 2015 was that, over the past 40 years, recessions in advanced countries have been associated surprisingly often with lower growth following the recession.

Let´s examine this last point – fundamental for his “fact of life” argument – for the case of the US.

The chart shows clearly that since the mid-80s and up to 2006, real growth was much more stable. The two recessions over the period were much shallower than average. In other words, “boom & busts” were much more contained, with growth keeping close to the long term average value.

What´s the story_1

This is not exactly an original view. The same mistake was made following the 1990/91 recession, the first during the Great Moderation.

In the summer 1992 issue of Challenge Magazine, Robert Brusca, at the time chief-economist at The Nikko Securities Co., wrote a long piece entitled Recession or Recovery? This is a good example of the often committed mistake of gauging the present (and forecasting future developments) using old barometers. He writes: “… by all historical standards there should be a strong recovery (following the 1990/91 recession). But the economy is now so uncertain, we could be in for a triple-dip recession rather than a recovery…” and there follows several pages of comparative statistics on the behavior of all kinds of economic variables following a recession, with the conclusion being that since the economy had not yet shown the strong rebound that historically follows a recession, his view was that the recession had not yet ended, “appearing to be the longest since the Great Depression” (at about the time the article was published, the official date for the end of the recession was put at March 1991).

In the Fall 1992 issue of The Federal Reserve Bank of Minneapolis Quarterly Review, David Runkle (a senior economist in the research department) wrote: “… the current recovery is the weakest in the post war period in all measures of economic activity. This means that the current recovery is most appropriately viewed as a continuation of a long period of below average growth”.

Now, the recovery from the 2007/09 recession has been very slow, indeed. But let´s not make the mistake of saying this is “a fact of life”!

I favor the “policy incompetence” argument. The charts illustrate.

While the Fed was correcting for the monetary policy mistake of letting nominal spending (NGDP) growth fall causing the 2001 recession, the economy was impacted by the first leg of the oil price shock (yellow band). In the case of a negative supply shock you expect a reduction in real growth (and some increase in inflation). The best that the Fed can do is to keep NGDP growth stable. This is what Greenspan did.

What´s the story_2

As soon as Bernanke takes over, nominal spending growth begins to falter. Real growth falls some more. When the second leg of the oil shock hits (green band), the Fed´s “inflation concern” additionally constrains NGDP growth and so increases the fall in real growth. When NGDP tanks after mid-08, both real growth and oil prices tumble.

This was surprising because 10 years earlier, in 1997, Bernanke had stated the “blueprint” for monetary policy in the event of an oil shock, concluding:

Substantively, our results suggest that an important part of the effect of oil price shocks on the economy results not from the change in oil prices, per se, but from the resulting tightening of monetary policy. This finding may help to explain the apparently large effects of oil price changes found by Hamilton and many others.

Either he forgot about it, or weak leadership made him sound “unconvincing” to the majority of the Board!

Oil prices rebound when nominal spending picks up in mid-09, following the introduction of QE1 ending the recession.

But, as the pink band shows, the recovery was “aborted” before nominal spending had picked up sufficient speed to bring the economy nearer the previous levels.  This is illustrated in the pair of charts below, which clearly illustrates how the “slow growth fact of life” came into being!

What´s the story_3

This echoes Runkle´s conclusion from 1992:

This means that the current recovery is most appropriately viewed as a continuation of a long period of below average growth”

It did not have to end this way!

The lack of imagination is pervasive!

Gavyn Davies summarizes:

The great financial crash of 2008 was expected to lead to a fundamental re-thinking of macro-economics, perhaps leading to a profound shift in the mainstream approach to fiscal, monetary and international policy. That is what happened after the 1929 crash and the Great Depression, though it was not until 1936 that the outline of the new orthodoxy appeared in the shape of Keynes’ General Theory. It was another decade or more before a simplified version of Keynes was routinely taught in American university economics classes. The wheels of intellectual change, though profound in retrospect, can grind fairly slowly.

Seven years after 2008 crash, there is relatively little sign of a major transformation in the mainstream macro-economic theory that is used, for example, by most central banks. The “DSGE” (mainly New Keynesian) framework remains the basic workhorse, even though it singularly failed to predict the crash. Economists have been busy adding a more realistic financial sector to the structure of the model [1], but labour and product markets, the heart of the productive economy, remain largely untouched.

What about macro-economic policy? Here major changes have already been implemented, notably in banking regulation, macro-prudential policy and most importantly the use of the central bank balance sheet as an independent instrument of monetary policy. In these areas, policy-makers have acted well in advance of macro-economic researchers, who have been struggling to catch up.

The IMF has tracked this process well, and it has just held its third post-2008 conference on Rethinking Macro Policy under the leadership of chief economist Olivier Blanchard. Olivier has summarised the conference (here and here) but so far it has it not been much discussed by macro investors.

I have therefore taken the liberty of organising Olivier’s summary and the conference material into the three tables below. Although highly simplified, the tables represent a snapshot of the current “state of the art” in macro policy, at least as seen by today’s mainstream luminaries of the subject.

And concludes:

In conclusion, what should we expect from macro-policy makers in future, assuming the economic back-drop remains relatively benign? Probably, more of the same: broadly stable central bank balance sheets, very slow declines in public debt ratios and a gradual return to using interest rates as the main weapon of monetary policy. A more rapid return to pre-2008 norms for fiscal and central bank balance sheets is somewhat unlikely.

To call the economic back-drop benign is a stretch; but while that remains the conventional thinking, Summer´s “Great Stagnation” thesis will continue to be ‘celebrated’!

Why can´t they see that the “GS” is the exact opposite of the “Great Inflation”? Interestingly, while the “GI” was going on, the prevalent thought was also that monetary policy couldn´t do much to abate it!

Continued negation of monetary policy IMF version

Blanchard, the IMF´s Chief-Economist writes:

Turning finally to policy recommendations.  Given the diversity of situations, it is obvious that policy advice must be country-specific. Even so, some general principles continue to hold. Measures to sustain growth both in the short and the longer term continue to be of the essence. With the introduction of quantitative easing in the euro area, monetary policy in advanced economies has largely accomplished what it can.

No, it has only gone as far as it wants, which is not far enough!

An extreme example:

The charts indicate that Greece at the present time has a great depression which is proportionally almost equal to the depths of the US great depression in early 1933. At this point in the cycle, however, the change in the monetary policy regime by FDR in March 1933 had allowed the US to show a significant recovery. The most favorable reading for Greece is that the depression has stagnated!

MP Negation