. . . of bad policy. That’s what Michael Woodford thinks, and I agree. Not all recessions. In 2001 economists didn’t even see a recession coming until about September, and the recession was over by November. I’m talking about severe recessions, those where there is the feeling of going over the crest in a roller coaster, then that “uh-oh moment,” followed by a sickening plunge. Like 1920-21, 1929-30, 1937-38, 1981-82, 2008-09. Can policy address the problem once it has occurred? Yes and no. Technically it can, but it is very unlikely to work in practice, precisely because it is very unlikely to be tried.
The markets are pretty smart, and when they perceive one of those uh-oh moments, they are usually correct. I mean all markets, BTW, not just the stock market, which often sees ghosts that aren’t there. If stocks, bonds, commercial RE and commodities all signal a big drop in NGDP, it’s almost certainly on the way. We’ve all seen the NGDP “downshift” graph that Beckworth, DeLong, Yglesias, Woolsey, Hendrickson, et al, keep showing. The one with no trend reversion. That’s what markets gradually realized in late 2008.
In a strange way this relates to Paul Krugman’s liquidity trap argument. His strongest argument is that conventional monetary stimulus is ineffective at the zero bound. Since conventional monetary stimulus is cutting nominal short term rates, no one can really contest this part of Krugman’s argument. His more controversial argument is that while there are some unconventional things that a central bank could do, they are not likely to do those unconventional things. In a sense that’s right, if they were likely to do those things the asset markets never would have crashed in the first place. Woodford showed that current AD is strongly influenced by expected future AD. But of course this is equally true of fiscal stimulus. The sickening plunge in asset prices and economic activity from August 2008 to March 2009 was an implied prediction that (take your pick) fiscal stimulus doesn’t work very well, or would not be done in large enough amounts (probably some of both.)
I doubt that a quasi-monetarist policy regime (say targeting NGDP expectations) would be effective in future severe recessions. Why not? Because if the regime was expected to be quasi-monetarist then the deep slump should never have happened. Alternatively, if it did happen then markets would presumably be forecasting that there would be no NGDP targeting. Only in the case where policy was quasi-monetarist, but not understood by markets to be quasi-monetarist, would this policy actually be adopted and work. By how likely is that? I keep coming back to 1933 because it’s a rare example of a huge stimulus surprise, although there are some smaller examples like QE2. In the real world policymakers are rarely able to surprise markets. Investors understand the policy regime, and draw the relevant conclusions. When they become pessimistic about policy, their fears are generally confirmed. We need to stop thinking about deep slumps as a sort of random “problem” that needs to be “fixed.” They need to be prevented; if they aren’t, they probably won’t be fixed.
I’m not sure whether Krugman really understands this point, despite all his excellent work on “expectations traps.” Consider the following:
Now bear in mind that in order to make a commitment to inflation work, central bankers not only have to stand up to the pressure of inflation hawks — which is much harder when you’re having to testify to Congress than it is if you’re a Harvard professor — but, even harder, they need to convince investors that they’ll stand up to that pressure, not just for a year or two, but for an extended period.
Now, the thing about fiscal expansion is that people don’t have to believe in it: if the government goes out and builds a lot of bridges, that puts people to work whether they trust the government’s commitment to continue the process or not. In fact, to the extent that there’s some Ricardian effect out there, fiscal policy works better, not worse, if people don’t believe it will continue.
I don’t know enough macro theory to say this is completely wrong, but at a minimum it is very misleading. He’s right that monetary stimulus is only effective if it is expected to be somewhat permanent. That’s even true (to slightly lesser extent) when we aren’t in a liquidity trap. It’s always (mostly) about the expected future path of monetary policy. The public might expect future monetary policymakers to sabotage current stimulus, and the mere expectation of that future sabotage would prevent prices from rising today. But that’s also true of fiscal stimulus. Both fiscal and monetary stimulus raise prices by shifting AD to the right. If the central bank is composed of inflation hawks that don’t want inflation, then fiscal stimulus won’t raise future inflation because the public will expect future central banks to sabotage fiscal stimulus. Of course one can argue about whether this offset or sabotage would be as complete for fiscal stimulus as for monetary stimulus. Krugman clearly thinks wouldn’t be; I think it would be even worse, as monetary policymakers worried about long run credibility would be unlikely to sabotage their own announced stimulus policy. But one certainly cannot pretend that it applies only to one type of stimulus. And it’s not just my model, in Krugman’s expectations trap model it is extremely important that future monetary policymakers are expected to behave as we’d like them to behave. Which once again suggests that we desperately need NGDP targeting, level targeting. That’s how you get the right expectations. If you do that, fiscal stimulus might work. But of course if you do that then fiscal stimulus wouldn’t be needed in the first place.
What sort of policy is best during a severe recession? The sort of policy that would have prevented it in the first place. In late 2008 we had a severe slump precisely because markets (correctly) predicted that the Fed would not take the steps necessary to prevent NGDP from falling, and staying on a lower trajectory. That’s why pessimists like Krugman are often right. A Fed that would provide effective stimulus in a deep slump is one that would have prevented the deep slump in the first place. We don’t have that sort of Fed; now it’s all about minimizing the damage, and educating policymakers so that we are better prepared for the next financial tsunami.
Leave a Reply