Here’s Matt Yglesias:
If you look at the last two bits of big-time macro stabilization failure in the west—the Great Depression and the inflation of the 1970s—you got what I’d call a change of regime as a result. The Depression discredited the gold standard and a whole set of related notions. The Great Inflation discredited ideas about the Phillips Curve (note interestingly that Keynes himself warned about this). So now we’re here again mired in failure and we’re getting … what?
Very good point (although he’s far too kind to Keynes.) Matt continues:
We had, until recently, the Great Moderation Consensus that automatic fiscal stabilizers are a good thing and then beyond that the Federal Reserve has the ability to stabilize the macroeconomy by fiddling with interest rates. Well now here we are and the Federal Reserve can’t stabilize the macroeconomy by fiddling with interest rates. That calls for the creation of a new regime. But it’s clear that despite a few stabs in the direction of Quantitative Easing and communications management that Ben Bernanke isn’t going to give it to us. It’s not simply that the current recession isn’t being brought to a rapid end, it’s that nothing whatsoever is being done about the underlying weaknesses in the American economic system that it revealed.
It’s too soon to throw in the towel. In the spring of 1940 the US unemployment rate was quite high—and we’d been in depression for more than 10 years. Neither government officials nor academics had any good ideas about how to bring the rate down. (Then Germany invaded Western Europe.) In the 1970s we were well into the Great Inflation, and still clueless about how to deal with it. So there is still time. Yglesias continues:
This is a really big deal. It means that either we need to discover a new paradigm for stabilizing aggregate demand, or else we need a whole new way of thinking about economic policy choices that doesn’t assume the economy will operate at nearly full employment over the long-term. New paradigms for demand management seem to strike a lot of America’s policy elite as uncomfortably radical, but if you think about it the implications of the other option are much more radical.
We’ve been here before. In the early1930s the conservative establishment would not accept monetary stimulus, so we ended up with much more radical and less effective programs like the tariffs, the WPA and the NIRA. In the 1970s the liberal establishment would not accept monetary contraction, so we ended up with much more radical and less effective programs like wage/price controls. Matt’s right that in an environment without demand stabilization it becomes much harder to dismiss radical ideas.
The good news is that we did eventually learn from the 1930s and 1970s. So there’s still hope.
The bad news is that in some respects I think it’s even worse than Yglesias suggests. This is the first recession in my entire life where nominal interest rates fell to near zero. And yet I wouldn’t be at all surprised if this occurred in every single future recession during my lifetime. In my view, Japan is the future of the global economy. Not the deflation (I think the Fed will be able to keep inflation close to 2%) but the low real interest rates. In retrospect the 2001 recession (when rates fell to 1%) was the canary in the coal mine. Nominal rates will probably be unusually low from this point forward. Global saving will increase dramatically as Asian countries get richer (remember that most people are Asians) and slowing population growth outside of Africa will dramatically reduce the demand for investment funds.
Need I say something about the S=I identity?
Yglesias says this recession has exposed flaws in the dominant interest rate targeting approach to monetary policy. That’s true. The interest rate establishment in economics is hoping that this is just a nightmare that will pass away over time. They are as attached to interest rates as their grandfathers were to the gold standard. But what if this is the new normal?
It’s likely that rates will rise as we recover. But if I’m right about future recessions, we’ll be facing the same problem over and over again. We’re committed to a policy regime that totally freezes up at the moment we need it most. We market monetarists are standing on the sidelines willing and able to offer advice, just as soon as policymakers realize that the zero rate bound is quite likely to occur in future recessions.
We don’t necessarily have to adopt NGDP level targeting, or NGDP futures contracts, but we certainly do need to move away from a monetary theory and policy apparatus based on the notion that interest rates are the be-all and end-all of monetary policy.
HT: Marcus Nunes