If you woke up one morning and found that your investment adviser had absconded with your pension, how would you react? Suppose your house burned down; how would you react? Wouldn’t it be rational to respond to a big loss in wealth by buckling down and working harder? Would you consider it a good time to take a long vacation?
Here’s David Andolfatto discussing a recent paper by Jim Bullard, of the St. Louis Fed:
I think that Bullard makes a persuasive case that the amount of household wealth evaporated along with the crash in house prices should likely be viewed as a “permanent” (highly persistent) negative wealth shock. Standard theory (and common sense) suggests a corresponding permanent decline in consumer spending (with consumption growing along its original growth path). The implication is that the so-called “output gap” (the difference between actual and “trend” GDP) may be greatly overstated by conventional measures.
Maybe I’m missing something, but I completely fail to see any connection between the final paragraph of that sentence and the previous two sentences. Yes, you’d want to reduce consumption, although for “PSST” reasons you’d want to do so quite gradually. And you’d want to produce more investment goods and exports, as consumption gradually declined. And you’d want to work longer hours. And the extra labor and investment would raise the growth rate of the economy. But why would you want to produce less output just because wealth fell? That makes no sense to me.
Don’t get me wrong, I’m sure I’m missing something blindingly obvious, as Jim Bullard, David Andolfatto and Tyler Cowen (who also links to this argument) are very bright people. It’s just that I don’t see the argument. And the argument is stated in such a way that it seems like one of those “needs no explanation” points. As if the fall in wealth would obviously reduce consumption (I agree) and obviously that fall in consumption would reduce output. But why?
I’ll look for an explanation in the comment section. But don’t tell me “it reduces AD, stupid,” because they are explicitly arguing that it reduces the potential level of output. I could sort of buy the AD argument, although I’d ask why monetary stimulus couldn’t fix the problem. Andolfatto continues:
The view that one takes here is likely to influence what one thinks about monetary policy. The conventional view seems to support the Fed’s current policy of keeping its policy rate close to zero far into the future. In his speech, Bullard worries that this may not be the appropriate policy if, in fact, potential GDP has experienced a level shift down (or, what amounts to the same thing, if conventional measures treat the “bubble period” as the economy being at, and not above, potential). Among other things, he [Bullard] says:
But the near-zero rate policy has its own costs. If we were proposing to remain near-zero for a few quarters, or even a year or two, one might argue that such a policy matches up well with the short-term business cycle dynamics of the U.S. economy. But a near-zero rate policy stretching over many years can begin to distort fundamental decision-making in the economy in ways that may be destructive to longer-run economic growth.Precisely how such a policy “distorts fundamental decision-making” needs to be spelled out more clearly (though he does offer a couple of examples that hinge on a presumed ability on the part of the Fed to influence long-term real interest rates). I am sure that many of you have your own favorite examples.
I think Andolfatto’s being way too kind with “needs to be spelled out more clearly.” From mid-2008 to mid-2009 we saw the Fed let NGDP plunge 9% below trend. That was the main cause of the wealth crash in America, not the subprime bubble. If falling wealth is the problem (which I doubt) then more monetary stimulus is the solution. We shouldn’t be basing monetary policy on guesses about where the “potential output” is, no one knows where it is. We should have steady 5% NGDP growth, level targeting, because all the supposed “welfare costs of inflation” are actually welfare costs of unstable NGDP growth.
Milton Friedman said ultra-low interest rates are a sign that money has been very tight. Of course he’s right, but I don’t sense that there’s anyone at the Fed that understands this. They seem to think their zero rate policy is a sign of “easy money,” and indeed might be distorting the economy by being too easy. If near-zero rates are easy money, then the only two cases of even easier money in all of world history would be the Great Depression and the Great Japanese Deflation.
Yes, we’d all be much better off if interest rates were much higher now, as long as those higher rates were produced by a Fed that kept NGDP growing at 5% after 2008, which would have made both the wealth crash and the recession much milder. But there are always two ways to raise rates, easier money or tighter money. My big fear is that the Fed will mistakenly choose the latter course. It was tried twice in Japan at the zero bound (2000 and 2006) and once in Europe (April 2011), and all three times failed abysmally. Yes, by all means let’s have higher rates, but as a result of an expansionary monetary policy that boosts NGDP growth, wealth, consumption, and RGDP.
The Fed let NGDP fall in 2009 at the sharpest rate since 1938. That’s their policy failure. Their failure to fulfill their dual mandate. Mainstream macro theory says a sudden fall in NGDP will have a devastating effect on both the real economy and the financial system. It’s distressing to see top Fed officials suggest this isn’t the problem, that “potential output” mysterious declined at the same moment.