The “Longest Depression”

In “Future Economists Will Probably Call This Decade the ‘Longest Depression”, Brad DeLong writes:

Back before 2008, I used to teach my students that during a disturbance in the business cycle, we’d be 40 percent of the way back to normal in a year. The long-run trend of economic growth, I would say, was barely affected by short-run business cycle disturbances. There would always be short-run bubbles and panics and inflations and recessions. They would press production and employment away from its long-run trend — perhaps by as much as 5 percent. But they would be transitory.

The charts illustrate DeLongs conjecture, both from a very long-run perspective and for the past 60 years.

DeLongs Conjecture

Even during the Great Depression, by this time improvement was palpable.

And boy, let´s not cry, like Stiglitz, “fiscal foul” or “growing inequality” for the “Great Malaise”:

The problems we face now, Stiglitz points out, include “a deficiency of aggregate demand, brought on by a combination of growing inequality and a mindless wave of fiscal austerity.”

It´s really mostly about very bad monetary policy!

John Taylor was wrong, but so is DeLong

Brad DeLong writes “The Trouble With Interest Rates”, where he strongly and rightly critiques views of John Taylor and concludes:

There is indeed something wrong with today’s interest rates. Why such low rates are appropriate for the economy and for how long they will continue to be appropriate are deep and unsettled questions; they call attention to what MIT’s Olivier Blanchard calls the “dark corners” of economics, where research has so far shed too little light.

What Taylor and his ilk fail to understand is that the reason interest rates are wrong has little to do with the policies put in place by central bankers and everything to do with the situation that policymakers confront.

However, what DeLong fails to realize is that the “situation that policymakers confront” is closely tied to the policies that the central bankers put in place previously!

In the linked Blanchard article, written on December 1 2008, we read:

Third, governments must counteract the sharp drop in consumption and investment demand. In the absence of strong policies, it is too easy to think of scary scenarios in which depressed output and troubles in the financial system feed on each other, leading to further large drops in output. It is thus essential for governments to make clear that they will do everything to eliminate this downside risk.

Can they credibly do it? The answer is yes. With interest rates already low, the room for monetary policy is limited. But the room for fiscal policy is wider, so governments must do two things urgently. First, in countries in which there is fiscal space, they must announce credible fiscal expansions; we – the IMF – believe that, as a whole, a global fiscal expansion about 2% of world GDP is both feasible and appropriate.

Coincidentally, as Blanchard had just finished typing his words, the next day the Fed announced:

that it will extend three liquidity facilities, the Primary Dealer Credit Facility (PDCF), the Asset-Backed Commercial Paper Money Market Fund Liquidity Facility (AMLF), and the Term Securities Lending Facility (TSLF) through April 30, 2009.

I call that QE0 and in fact, according to our proprietary MAST Index, it marked the end of the financial panic!

What´s wrong with Interest Rates_1

Also coincidentally, soon after, on February 17, President Obama

signs into law the “American Recovery and Reinvestment Act of 2009”, which includes a variety of spending measures and tax cuts intended to promote economic recovery.

Even more coincidentally, the deficit quickly goes to the 2% of GDP suggested by Blanchard, and remains at that level for the next three years.

What´s wrong with Interest Rates_2

The panic ended and fiscal stimulus was introduced, but the real economy only began to improve when monetary policy, gauged by NGDP growth turned! Note that the removal of fiscal stimulus, which began in mid-2012, did not affect the NGDP growth-determined pace of the recovery.

What´s wrong with Interest Rates_3

Initially, going into the crisis, monetary policy was very tight. During the past five years, it has remained tight, even if much less so.

Note: The Market Advised Sentiment Tracker (MAST) tracks the coordinated movements of a basket of financial market prices. As such it will respond to rumors, statements by Fed officials or any unexpected asset price move. It is a proprietary index of NGDPAdvisers, a macro consultancy that will begin activities early next year.

Krugman´s answer to DeLong: We´re in a “Postmodern Economy”!

Krugman responds to DeLong´s “Backward Induction Unraveling”:

One more thing: Brad says that we came into the crisis expecting business cycles and possible liquidity-trap phases to be short. What do you mean we, white man? Again, we had the example of Japan — and even aside from Rheinhart-Rogoff, it was obvious that Postmodern business cycles were different, with prolonged jobless recoveries.

In the end, while the post-2008 slump has gone on much longer than even I expected (thanks in part to terrible fiscal policy), and the downward stickiness of wages and prices has been more marked than I imagined, overall the model those of us who paid attention to Japan deployed has done pretty well — and it’s kind of shocking how few of those who got everything wrong are willing to learn from their failure and our success.

He should have read my answer to him 4 years ago – THERE´S NOTHING “POSTMODERN” ABOUT THIS RECESSION, IT´S A FED ENGINEERED DEPRESSION where I conclude:

By calling this a “postmodern” recession, Krugman is likely saying that the only way-out is through fiscal policy. But that has been tried (according to Krugman the dosage was not big enough) and the collateral effects have been pretty damning.

What all this discussion does is to allow the Fed to stay on the sidelines. After all, it had not much to do with anything that´s been happening. It´s “Postmodern”!

(Note: Postmodernism is a philosophical movement… it holds realities to be plural and relative, and dependent on who the interested parties are and what their interests consist of.)

Let´s put up some images. The first set shows that the both the intensity of the drop in employment and the speed of increase are associated with what happens to aggregate nominal spending (NGDP), something the Fed closely controls, irrespective of where the interest rate happens to be.

Postmodernism fallacy_1

Note that things are much more subdued after the Volcker adjustment phase (1981-85). What follows is the “Great Moderation”, when NGDP grows at around 5.5% along a stable level trend.

For example, after the 2001 recession, which was quite shallow in terms of RGDP growth (never becaming negative), NGDP growth lingers for some time below the 5.5% rate of growth. Therefore, employment behavior looks like the base of a wide (shallow) bowl (“jobless recovery”)

The present cycle is another animal altogether. The Fed never had its heart in pulling nominal spending up to a reasonable level, keeping its growth stable at “slow speed”. Employment takes a deep dive and comes back at a speed consistent with the low spending growth.

The next set shows the behavior of inflation over the same periods. The pattern is easy to see. The Volcker adjustment is successful in bringing inflation down. Later, Greenspan places it on (or close to) the 2% “target”, mostly by keeping spending growth close to the trend level path. Then, Bernanke comes along and apparently decides that´s “way too high”. To keep inflation “lower than low” the Fed pulls the hand brake to slowdown nominal spending growth.

Postmodernism fallacy_2

The last set illustrates nominal and real growth over the episodes. When you look at the bottom right image, you get the hang of why thinks are so glum.

Postmodernism fallacy_3

The “novelty” of the situation depicted in the bottom right image of all the charts is what explains why people’s expectations of the length of the what Krugman calls the “liquidity-trap” phase were “miles off”, and why DeLong says “backward induction unraveled”.

Unfortunately, very few fingers point at the Fed!