Monetary Policymakers don´t lack the tools, they lack the will!

From Larry Summers:

Global economy: The case for expansion: …The problem of secular stagnation — the inability of the industrial world to grow at satisfactory rates even with very loose monetary policies — is growing worse in the wake of problems in most big emerging markets, starting with China. … Industrialised economies that are barely running above stall speed can ill-afford a negative global shock. Policymakers badly underestimate the risks… If a recession were to occur, monetary policymakers lack the tools to respond. …

This is no time for complacency. The idea that slow growth is only a temporary consequence of the 2008 financial crisis is absurd. …

Long-term low interest rates radically alter how we should think about fiscal policy. Just as homeowners can afford larger mortgages when rates are low, government can also sustain higher deficits. …

First off: the level of interest rates do not define the stance of monetary policy. This and reasoning from a price (or quantity) change are the most common conceptual errors made by economists of all stripes, including Prizewinners!

Even those like Bernanke, who know best, having stated very clearly in 2003 that interest rates are not a good indicator of the monetary policy stance, saying we should look at NGDP (or inflation, but let us leave that one aside, not only because it is far below “target” everywhere that counts).

The chart indicates that for a significant fraction of “industrialized economies”, monetary policy has been “tight”, certainly not “very loose”!

Lack of will

Prior to the crisis, nominal spending growth was the same in the US and UK (around 5.4%) and much lower in the EZ (4.2%).

Note that after the initial pullback from the deep recession, the ECB under Trichet pulled the brakes hard in early 2011, throwing the EZ economy back into hell. Meanwhile, in tandem, the US and UK said “that´s enough nominal spending growth” (4%). No wander inflation languishes (as does real growth and employment).

Why did all those central banks, the ECB more radically, put a premature stop to the recovery? The obvious answer is fear of breaching their inflation target, even for a “moment”!

In that they sorely lacked what came to be called a “Volcker moment” (or, to paraphrase FDR, a “Volckerian Resolve”). Ironically, or maybe not, the country that has been in hell for longer, Japan, is now trying to get back to savoring some “worldly goods”. Let´s hope the others “get smart” more quickly!

On October 6 1979, the Fed made an announcement (HT David Andolfatto):

Lack of will_1

We know that didn´t cut it. Inflation was only brought down permanently when NGDP growth was adjusted down:

Lack of will_2

Now the Fed (and others) have to adjust NGDP growth up. But please, not through more government (which Japan´s experience also shows doesn´t have lasting effects).

“Secular Stagnation! Larry Summers is wrong”

Roger Farmer posts: “Secular Stagnation! Larry Summers is right

Larry Summers has once again been advancing the secular stagnation hypothesis. David Andolfatto responds with this tweet which plots GDP per person in the United States since the late nineteenth century. I’m with Larry on this one.

Why does this matter and what does it have to do with secular stagnation? Those who would deny the secular stagnation hypothesis want you to believe that the economy has a very strong tendency to revert to a mean growth path which is independent of shocks. Leave the economy to itself, and the recuperative powers of the market will restore us to the social optimum. The secular stagnationists, and I am one of them, disagree.

We believe that, in the absence of corrective policies by the central bank or the treasury, the economy will never recover after a shock. The unemployment rate will not revert to its social optimum and, associated with that fact, the economy will never revert to its optimum growth path. After a shock, the data do not revert to the same trend that they followed before the shock hit.

GDP per person has a unit root. That is accepted by everyone who has studied these data. The interesting question is why?

If, as Robert Gordon believes, it is caused by random technology shifts then there is not much that monetary policy or macro prudential policies can do about it. If, as I believe, it is caused by random movements from one inefficient equilibrium to another, we should be thinking very hard about how to design a monetary/macro-prudential policy that keeps the economic train on the tracks.

I´m closer to Andolfatto. Furthermore, Farmer´s allegation that “a unit root in GDP per person is accepted by everyone is false! He links to a Cochrane 1988 paper. These two links (here and here) indicate “everyone” is not really everyone!

The chart below takes the post WWII years. I estimate the trend from 1950 to 1994 and project for the next 20 years. GDP per person remains on trend up to 2007, after which it drops AND stays down.

Farmer SS_1

During the late 1960s and throughout the 1970s, the economy was buffeted by significant demand (fiscal) and real (oil) shocks. Monetary policy was lousy (the reason behind the period getting named “Great Inflation”). Nevertheless, the chart indicates that real GDP per person always reverted to trend, contrary to what Farmer presumes.

During the “Great Moderation”, output per person hugged very closely to the trend, with little oscillation. That was broken in 2008 and for the past 7 years GDP per person has evolved far below trend. It´s not really a “Great Stagnation”, but a “depression” (even if it´s not “Great”).

I agree with Farmer that we should “thinking very hard about how to design a monetary policy that keeps the economic train on the tracks”. Market Monetarist´s suggestion is that monetary policy should strive to obtain nominal stability, in other words, keep NGDP evolving close to a level trend path.

The NGDP growth chart illustrates

Farmer SS_2

Update: Jérémie Cohen Setton at Bruegel has a take:

What’s at stake: The question of whether capitalist economies are self-correcting and will eventually revert to mean growth has received renewed interest given the underperformance of most economies six years after the onset of the Great Recessions. While the idea of persistent high unemployment was central to Keynes’ General Theory, it was quickly abandoned by the neoclassical synthesis.

Tyler Cowen writes that the most crucial issue is whether economies will return to normal conditions of steady growth, or whether we are witnessing a fundamental transformation, unveiled in bits and pieces. One relatively optimistic view is that observed deficiencies — like slow growth in real wages and the overall economy, persistently low interest rates and low levels of labor participation — are merely temporary.  Another commonly heard view is that we made the mistake of letting the last recession linger too long, allowing some of its features to become entrenched.