I saw this in the Journal of Economic Perspectives, under recommended reading:
Claudio Borio asks “The Financial Cycle and Macroeconomics: What Have We Learnt?” “The financial crisis that engulfed mature economies in the late 2000s has Learnt?” “The financial crisis that engulfed mature economies in the late 2000s has prompted much soul searching. Economists are now trying hard to incorporate financial factors into standard macroeconomic models. However, the prevailing, in fact almost exclusive, strategy is a conservative one. It is to graft additional so-called financial “frictions” on otherwise fully well behaved equilibrium macroeconomic models . . . The main thesis is that macroeconomics without the financial cycle is like Hamlet without the Prince. In the environment that has prevailed for at least three decades now, just as in the one that prevailed in the pre-WW2 years, it is simply not possible to understand business fluctuations and their policy challenges without understanding the financial cycle.” Bank of International Setttlements, Working Paper #395, December 2012. At http://www.bis.org/publ/work395.pdf.
First a bit of history. In the 1920s the standard view among elite macroeconomists was that the business cycle was a “dance of the dollar,” to use Irving Fisher’s metaphor. Then came the 1930s, and monetary policy got pushed to the sidelines. This oversight eventually led to a series of mistakes which culminated in the Great Inflation. Only then was money rediscovered, and AD brought back under control.
I’m begging the economics profession to avoid another long and fruitless detour into non-monetary theories of the business cycle, although even as I type these words I know I will fail. The average reader will be far more impressed by Brad DeLong’s long and thoughtful post, than this puny post.
There is nothing in the slightest way mysterious about the current recession. If in 2007 you told the world’s elite macroeconomists what the path of NGDP would look like over the next 6 years, most of them would have predicted a deep recession and slow recovery in the US, and a deep recession, slow recovery, and then double-dip recession in the eurozone. And that’s exactly what happened. Adding finance won’t improve that story one iota.
Let me anticipate some objections:
1. But why did NGDP fall so sharply? Because a failure of monetary policy. No one denies that the banking crisis played a role in that failure, but it wasn’t a necessary role. There is no evidence that central banks lose control of NGDP during a financial crisis. Look at 1933. You can make a slightly stronger argument that they lose control at the zero bound (a completely different argument, BTW) but even that is wrong. There is no case in recorded history of a fiat money central bank trying to inflate and failing. When Brad DeLong asked Bernanke why not 3% inflation, Bernanke didn’t say; “can’t do it.” He said it’s a bad idea. The Fed also thinks NGDPLT is a bad idea. The idea that the ECB is out of ammo doesn’t even pass the laugh test, as they’ve repeated raised interest rates during the recession, driving eurozone unemployment ever higher. Elite macroeconomists continue to publish papers that are meaningless if the BoJ is able to sharply depreciate their currency, and yet they’ve just showed that they are capable of sharply depreciating their currency. That’s not supposed to happen, if you believe that central banks are incapable of debasing their fiat currencies.
2. ”There are lots of structural problems.” Of course, there always are structural problems, but then why isn’t unemployment in the US much higher than 7.6%? We have roughly the unemployment rate you’d expect from the demand shock alone. So unless demand shocks miraculously don’t cause unemployment when you have structural problems, the unemployment rate should be far higher if structural problem were capable of explaining an extra 2.6% unemployment. (And this skepticism about the importance of structural problems comes from a conservative economist who has argued the extended UI benefits added about 0.5% to 1.0% to the unemployment rate at the peak, not a 100% demand-sider with his head in the sand about supply-side issues.)
Is there really any harm in adding finance, to make the models a bit more realistic? Damn right there is. It will cause us to make the exact same mistake we made in late 2008, trying to fix the banking system while ignoring the huge slide in NGDP expectations, until it is too late. If you don’t correctly diagnose the crisis, how are you going to get effective solutions?
Economists are too blinded by framing effects—it looked like finance was the root cause of the recession. But debt doesn’t make workers want to work less, it makes them want to consume less. There is a difference. We need economists to look through these framing effects, and see that the standard model that demand shocks cause high unemployment worked fine; it’s our policymakers who failed us.
I never thought I’d say this, but macroeconomists just aren’t autistic enough.
And where has the University of Chicago been? Who is carrying on the tradition of Milton Friedman? He taught us to look beyond the financial crises of the 1930s, into the root cause of the Great Depression. It’s all about M*V. Do we have to learn that lesson all over again?
In some ways this recent crisis was even more inexcusable, as those poor fools in the 1930s didn’t have a Monetary History of the US telling them what went wrong 8o years earlier. We did, and still had an excessively tight monetary policy.
Hamlet without the prince? Sounds kind of interesting, in a post-modern sort of way. Maybe Gus van Zant could direct.
HT: Timothy Taylor
PS. I’ve been asked about the recent Japan debate. I agree with Nick Rowe:
In other words, I have deliberately set up a case in which Richard Koo would be right (maybe for the wrong reasons, but let that pass). I have deliberately made worst-case assumptions so that the higher interest rates caused by loosening monetary policy creating economic recovery would cause Japan to default on its debt, either literally or via very high inflation.
Does this mean that “Japan cannot afford recovery”?
No. It means that Japan is already dead. It just doesn’t know it yet.
Sure, the Bank of Japan could abandon Abenomics, tighten monetary policy, reduce the inflation target, squash all hopes of recovery, and bring nominal interest rates back down again. But if the past is any guide to the future, this means the debt/NGDP ratio will keep on growing. Because Japan will be scared to tighten fiscal policy in a recession when the Bank of Japan won’t offset that tightening by loosening monetary policy. Which means that recovery, when it does finally come, will cause an even bigger default, because the debt/NGDP ratio will be even bigger.
And recovery will come eventually, one way or another. If not by happenstance, then because there is a limit to the debt/NGDP ratio that the young generation in an OLG economy will be willing to buy from the old.
If Japan is already past the point of no return, then recovery will mean default. But delaying recovery will simply mean an even bigger default.
Now I’m going to cry over spilt milk, and ask: why oh why didn’t they do Abenomics earlier, before the debt/NGDP ratio had grown so big? What was all this talk about “balance sheet recessions”, where monetary policy was impotent to increase Aggregate Demand, so fiscal policy had to be used to prevent AD from falling? And how did we suddenly switch from “monetary policy is impotent” to “monetary policy is very dangerous because it will increase AD which will only cause inflation and higher interest rates which will cause default because loose fiscal policy has made the debt/GDP ratio so big”?
In my view Japan isn’t dead, although I certainly admit it might be. The real question is why people continue to insist that monetary policy is ineffective at the zero bound, even as Japan shows it is effective. Nick and I told Japan what to do back in 2009 (and Bernanke even earlier)—why did it take them so long? And why hasn’t the ECB moved yet?