Christina Romer does the Five Books interview and one of her recommended reads is a famous article by Peter Temin and Barry Wigmore titled “The End of One Big Deflation.” This is a great choice since it shows that even in a “balance sheet recession” facing a binding zero percent lower bound, monetary policy can still be very effective by managing expectations. The key is to radically shift expectations. Here is Romer discussing the implications of this article for today:
What we learned from the Temin and Wigmore paper is that one way out of a recession at the zero lower bound is by changing expectations. To do that, often what is needed is a very strong change in policy – something economists call a “regime shift”. The most effective way to shake an economy out of a terrible downturn when we’re at the zero lower bound is an aggressive change in policy that makes people wake up, say “this is a new day” and change their expectations. What the Fed has done since early 2009 is much more of an incremental change.
In other words, the Fed has failed to appropriately manage expectations and so we are stuck in a slump. And I am not convinced that it is now doing any better with its new long-run forecasts of the federal funds rate. So what in the current environment would rise to the level of a “regime shift”? What would change expectations enough to catalyze a broad-based recovery in aggregate demand? Here is Romer’s answer:
I think that what the Fed needs instead is a regime shift. A number of economists have suggested that the Fed adopt a new framework for monetary policy, like targeting a path for nominal GDP. If the Fed adopted such a nominal GDP target, they would start in some normal year before the crisis and say nominal GDP should have grown at a steady rate since then. Compared with that baseline, nominal GDP is dramatically lower today. Pledging to get back to the pre-crisis path for nominal GDP would commit the Fed to much more aggressive policy – perhaps more quantitative easing and deliberate actions to talk down the dollar. Such a strong change in the policy framework could have a dramatic effect on expectations, and hence on the behavior of consumers and businesses.
Such a regime shift would require Bernanke to man up and have his own Volker moment, as previously noted by Romer. It would be a huge change and that is the point. A big shock to public expectations, one that would meaningfully change the expected path of future aggregate nominal spending, could be created by a public commitment to a nominal GDP level target. This is just the medicine the U.S. economy needs right now.