Post-modern recessions

Classical recessions were often caused by shocks that reduced the natural rate of interest.  As market interest rates fell (there was no Fed), the demand for gold increased.  Because gold was the medium of account, this was a negative demand shock.

Modern recessions occurred because the Fed struggled to control inflation, as we gradually moved to a fiat money system after the Depression.  Inflation would rise too high, and this would cause the Fed to tighten.

I recall that Paul Krugman once did a post suggesting that the most recent recessions were not caused by the Fed, but rather were caused by factors such as bubbles and investment/financial instability.  The recessions of 1991, and especially 2001 and 2008, were not preceded by particularly high inflation expectations, which were well anchored by Taylor Rule-type policies. Thus these recent recessions (in his view) were not triggered by tight money policies aimed at reducing inflation, as had been the case in 1982, 1980, 1974, 1970, etc.

I suspect that the post-modern recessions are indeed a bit different, but not quite in the way that Krugman suggests.  Although I don’t think interest rates are a useful way of thinking about monetary policy, I’ll use them in this post.  (If I just talked about slowdowns in NGDP growth it would not convince any Keynesians.)

In the New Keynesian model, a tight money policy occurs when the Fed’s target rate is set above the natural rate of interest. In 1981, that meant the Fed had to raise its interest rate target sharply, to make sure that nominal interest rates rose well above the already high inflation expectations, high enough to sharply reduce aggregate demand.  In contrast, interest rates were cut in 2007, despite a strong economy and low unemployment.  The natural interest rate started falling in 2007 as the real estate sector contracted.

In a deeper sense, however, the post modern recessions are no different than pre-1990 recessions.  They still involve the Fed setting its fed funds target above the natural rate.  The difference is that in recent recessions this has occurred via a fall in the natural rate of interest, whereas in 1981 it occurred through a sharp rise in the market rate of interest.

You might say that we used to have errors of commission, whereas now we have errors of omission.  But that only makes sense if you accept the notion that interest rates represent monetary policy.  But they don’t. Every major macro school of thought suggests that something other than interest rates represent the stance of monetary policy.  Monetarists cite M2, Mundell might cite exchange rates, New Keynesians cite the spread between market rates and the natural rate.  No competent economist believes that market interest rates represent the stance of monetary policy.

Thus in the end, Krugman’s distinction doesn’t really make any sense.  It’s always the same—recessions are triggered by the Fed setting market interest rates above the natural interest rate.  Since 1982, the natural rate of interest (real and nominal) has been trending downwards.  This was an unexpected event that very few people forecast.  (I certainly did not.) The Fed would occasionally end up behind the curve in terms of noticing the decline in the natural rate.  The FOMC would only realize its error when NGDP growth fell well below their desired rate.  Then they’d try to ease policy, but initially they’d underestimate how much they needed to cut rates in order to get the proper amount of stimulus.  The natural rate was lower than they assumed.  Hence slow recoveries.

My hunch is that we are coming to the end of this long downtrend in the natural rate of interest.  That means that future recessions will be caused by some other type of cognitive error.  That’s also why I expect this to be the longest economic expansion in US history.  But that’s not very impressive when you have such a weak recovery.  Much more impressive would be the longest consecutive streak of boom years.  Now that would Make America Great Again!



29 Responses to “Post-modern recessions”

  1. Gravatar of Mike Tubbs Mike Tubbs
    27. June 2017 at 14:07


    I’m not sure about the future of the Wicksellian natural rate. If you take seriously this demographic story by Eggertsson, Mehotra, and Robbins then maybe we shouldn’t be so optimistic.

    I mostly agree that the root cause of all financial crisis is the relative position of the nominal rate and the Wicksellian rate. However, I would add that the entire future path of short rates relative to a natural rate is more important in the NK model. It explains why without a plt or a ngdpplt monetary policy can become inept at the zlb. It’s a very clever trick by NK to get around the zlb constraint in their model, but a completely unnecessary one if they would stop using interest rates.

    This could be a nice side effect of a low natural rate world. Maybe it would cause CB’s to reconsider the interest rate paradigm. (very optimistic)

    Thanks for the post!

  2. Gravatar of Benjamin Cole Benjamin Cole
    27. June 2017 at 15:56

    Excellent blogging.

    If Japan is instructive, the secular downward drift in interest rates and inflation in the western developed nations still has another leg to go.

    As Scott Sumner said, few predicted the near 40-year secular downtrend in interest rates and inflation. Today few are predicting that we will follow Japan to even lower interest rates, inflation and economic growth.

    So why change orthodox macroeconomics now?

  3. Gravatar of Benjamin Cole Benjamin Cole
    27. June 2017 at 16:00

    Add on: actually Scott Sumner was being a little kind to the macroeconomics profession. All through the 40-year decline in interest rates and inflation, the mainstream economics profession predicted that higher interest rates and inflation were pending.

  4. Gravatar of Kevin Erdmann Kevin Erdmann
    27. June 2017 at 16:15

    Ben, a lot of people have fixed that problem by pretending that we have had high inflation for the past 40 years. It’s just only been in asset markets, so the story goes.

  5. Gravatar of H_WASSHOI H_WASSHOI
    27. June 2017 at 16:26


    >we are coming to the end of this long downtrend in the natural rate of interest.

    Why do you think so? Growing emerging markets?
    (logistic equation?)

  6. Gravatar of Major.Freedom Major.Freedom
    27. June 2017 at 17:04

    “Classical recessions were often caused by shocks that reduced the natural rate of interest”

    The “natural” predicate here is a misnomer. There is nothing natural about it, since it is not the rate that would prevail in a natural order of society. It is an artificial rate, caused by ultimately violent intervention in what otherwise would be a natural order.

    There is nothing natural about prices having to increase at a certain predefined rate established by people who threaten other people’s liberty with thugs with guns.

    The natural rate of interest does not change because of anything central banks do. The rate referred to as “natural” is in fact the Fed chasing otis own tail. The word “natural” here is purposefully used so as to provide some modicum of legitimacy to it where there otherwise would to be any in an actual natural order of society.

    The true natural rate of interest is actually a complex series of rates, established on the basis of how much value people attribute to present goods relative to future goods. The more highly valued are present goods, the higher ceteris paribus will rates become, as the cost of sacrificing present consumption becomes higher and higher. In dollar terms, when consumption goes up relative to investment, it lowers business costs because there is less spending on capital and labor. But with the spending on consumption, total revenues become larger relative to total costs. That means higher rates of profit in dollar terms, and when profits are higher in dollar terms, people borrow from each other at higher rates. This is the actual cause of the level of natural interest rates. Inflation and credit expansion just messes it all up.

  7. Gravatar of Benjamin Cole Benjamin Cole
    27. June 2017 at 18:32

    Kevin Erdmann: Add on, if the US restricts the supply of housing enough, we may get some inflation, as measured.

    So the US inflation rate, as measured, will not decrease to that of Japan’s, where property development is robust.

    Demographers say another 55 million people will be living in the U.S. in just 23 years more, or about one more person for every five now.

    So the solution to low inflation and interest rates is tighter money, the creation of more labor surpluses, and continued crimps in housing production.

    kemo sabe?

  8. Gravatar of Kevin Erdmann Kevin Erdmann
    27. June 2017 at 20:11

    If that is the road we go down, there isn’t any doubt they’ll still be blaming the Fed for holding rated too low, is there?

  9. Gravatar of Brent Buckner Brent Buckner
    28. June 2017 at 01:02

    I have some trouble with your phrase “the Fed setting market interest rates”.

  10. Gravatar of Anonymous Anonymous
    28. June 2017 at 03:15

    There is an importance difference based on the rhetoric of the fed ‘causing’ recessions. If we accept everything you’ve written above, and the notion that the fed could prevent all recessions, wouldn’t the Krugman point of view be that the FED is not effectively preventing recessions caused by financial sector foibles, whereas as you think the FED is literally causing recessions?

    To use a soccer analogy, from Krugman’s alleged point of view, you are blaming the goal keeper for the goals scored against their team, because the goalkeeper could have potentially stopped them, whereas I guess from your point of view, the goalie is scoring own-goals. Is that a fair characerisation?

  11. Gravatar of Carl Carl
    28. June 2017 at 08:06

    Why do you see the downward trend of the natural rate stopping? Accelerating automation?

  12. Gravatar of Patrick Sullivan Patrick Sullivan
    28. June 2017 at 09:17

    Until economists recognize that interest rates are NOT ‘the prices of money,’ it’s hopeless to cure monetary policy. Anyway, the fun news in economics is micro;

    When the Left has lost Noah Smith, it’s time to hang it up on minimum wages. Even ignoring the reporting from the Seattle Times and Vox, which must have been equally distasteful to swallow.

    For one thing, it reveals a new and disturbing channel by which minimum wages could hurt the very workers they’re designed to help — reduced working hours. In the past, if an American worker had a job, that generally meant a guaranteed number of working hours per week, even if the job wasn’t full-time. But in recent years that has no longer been the case. A 2015 report by the Economic Policy Institute found that 10 percent of the workforce now has irregular or on-call work shifts. This irregularity is concentrated among low earners in service industries like the restaurant industry.

    Non-guaranteed working hours give employers a new way to defray the higher costs imposed by a minimum wage hike. Instead of laying off workers, bosses can just call lots of their existing workforce in for fewer hours each week. Nobody will show up on the unemployment rolls, but workers’ incomes will drop all the same.

    The University of Washington study raises the possibility that this has been happening a lot more than minimum-wage researchers have realized. Lots of the papers that find zero employment effects might be missing a drop in working hours. Because detailed data on hours is relatively rare, it will take some time for other research teams to follow up on this new angle.

    Meanwhile, policy is moving fast. Even before the results of recent studies are fully digested, Seattle will raise its minimum wage again. The entire state of California will soon follow. And “Fight for 15” advocates want to extend the $15 minimum wage to the entire country, even to rural and poor regions where employers will have a much harder time paying that amount.

  13. Gravatar of Patrick Sullivan Patrick Sullivan
    28. June 2017 at 09:21

    Here’s the actual Vigdor, et al, paper from NBER;

    It’s like watching Mozart compose a symphony note by note. Just devastating to all the clowns claiming ‘research shows’ that raising minimum wages doesn’t hurt employment.

  14. Gravatar of Patrick Sullivan Patrick Sullivan
    28. June 2017 at 09:31

    Megan McArdle does a good job ‘splainin’ too;

    Now the question has acquired a little sizzle. UW is not the only school studying Seattle’s experiment, and last week a report came out from UC Berkeley, focused specifically on food services. Last week, that study reported: “Our results show that wages in food services did increase — indicating the policy achieved its goal. … Employment in food service, however, was not affected, even among the limited-service restaurants, many of them franchisees, for whom the policy was most binding.”

    Seattle Mayor Ed Murray seemed ecstatic at the news; as Michael Saltsman noted at the time, he “conveniently had an infographic designed and ready to go for the study’s release. His office excitedly tweeted that the policy had ‘raised food workers’ pay, without negative impact on employment,’ linking to an uploaded study version on the Mayor’s personal .gov website rather than a University domain.”

    This morning’s data gives ammunition to the mayor’s opposition. The University of Washington released its second study, this one covering the increase from $11 an hour to $13. And this study found huge effects: For every 1 percent increase in their hourly wage, low-wage workers saw a 3 percent reduction in the number of hours worked. As a result, they lost about $125 in earnings a month, clawing back the entire gain from the earlier hike and more.

    Mayor Murray did not have an infographic ready to go for this study. Instead, he simply retweeted the infographic from the old one.

    This is hardly the first time we’ve had dueling studies on the minimum wage; indeed, by this point, the dueling is so common that the minimum wage practically has its own rules of engagement. But it’s pretty rare for a city to fund one study and then try to rebut it with another. Worse still for the citizens of Seattle, a read of the new paper suggests that this rebuttal won’t work.

    Btw, Megan should have identified that Berkeley study as the work of notorious, and unreconstructed, Marxist Michael Reich. Who was the founder of the Union for Radical Political Economics (URPE).

  15. Gravatar of flow5 flow5
    28. June 2017 at 09:44

    “With core inflation currently running at approximately 1.5 percent, the Fed is less than two hikes away from the neutral rate in nominal terms.”

  16. Gravatar of flow5 flow5
    28. June 2017 at 09:48

    Rates and spreads are meaningless. The FRB-NY’s trading desk can’t get their O/N reverse repo positioning right (demand for reserves).

    Maybe trades should be based on the number of participating counterparties. I.e., there was a “problem” with short-term rates. The one month rate fell from .9% to .76% from the 14th to the 23rd (reflecting Yellen’s rate hike’s impact on the economy). The tightening initially caused stocks to fall. The revesal, the subsequent easing, is stoking them.

  17. Gravatar of flow5 flow5
    28. June 2017 at 10:22

    This is a 4th of July sponsored rally (long weekend & month-end commercial bank, & Central bank squaring). It represents the injection of reserves and depositing / transfer of funds from the Treasury’s General Fund account, etc.

    I.e., anyone using interest rates as a guide to monetary policy actions will be fooled.

  18. Gravatar of Matthew D McOsker Matthew D McOsker
    28. June 2017 at 12:38

    The last 2 recessions circa 2000 and 2008 ignored certain things:
    1) Balance of trade (namely deficit)
    2) Fiscal flows relative to balance of trade, and credit
    3) Banking instabilities around 2008 – many ignore the banking system and credit entirely including it seems the Fed

    Agree with Patrick above, but I would say interest rates are the price of credit, and opportunity cost used in many financial calcs

  19. Gravatar of Matthew Waters Matthew Waters
    28. June 2017 at 15:19

    There is confusion over low nominal rates and low real rates. The NBER paper above talks extensively about the ZLB, which is confusing. Low real rates make the ZLB more likely if inflation is low, but the ZLB can be separate from real rates.

    On real rates, ultimately supply of loanable capital and credit-worthy demand for the capital determine the real rates. IMO, most of the explanation for low real rates is:

    1. Changing balance away from number of people of prime, lendable age. Those 20’s through 40’s may take out more debt. Demographics also lead to replacing capital above depreciation for higher future demand.

    2. Wealth and income inequality, which I think is obvious. The very wealthy and endowments only have the option to consume or invest. They’re generally loathe to spend the money.

    3. Investment in poor asset classes. This is hard to define exactly, but I see junk bonds in 80’s, tech stocks in 90’s, and subprime loans in 00’s all soaking up investment. If there is a fixed amount of credit-worthy borrowers but investors start to think non-credit-worthy borrowers should get money, interest rates go up.

    Given all this, the case for negative real rates is compelling aside from challenges of productivity. In the end, negative real rates may just not matter. The Fed can still meet inflation and employment targets. Productivity can still increase in the future. Savers will lose real spending power and borrowers gain real spending power, but that’s zero-sum. The Fed can’t fix real interest rates as much as Seattle can fix low wages.

  20. Gravatar of Benjamin Cole Benjamin Cole
    28. June 2017 at 18:05

    As I am banned from commenting on Econlog, I comment here on Scott Sumner’s recent and thoughtful post on construction and productivity.

    It is true, and admirable, that people produce more with less labor due to increasing productivity.

    But remember, every manufacturing job creates multiples in related work, such as warehousing and transportation, administration, building maintenance, real estate, etc.

    One might even posit that eventually some portions of R&D and finance tag along with manufacturing. The Silicon Valley was started in high-tech manufacturing, and the R&D and financing followed. Eventually, we may see the R&D and financing gravitate offshore closer to the manufacturing. Certainly, the Silicon Valley crowd constantly threatens to offshore R&D unless we import cheap labor.

    It is indisputable that income flows into regions that are net exporters of goods and services.

    The richest big city on the planet in 1960? Detroit.

    There is something glib about the “manufacturing doesn’t matter” approach to macroeconomics. Mostly, and empirically, it just does not seem to work.

    Tyler Cowen points out that young American males make 31% less today than in 1969. Homeownership rates among the young are plunging. (Property zoning is probably the biggest issue of the day.)

    Real median full-time weekly earnings males 16+ in the US are down from 1979.

    We are getting to 40 years of downward-sideways drift, and now our central bank says there are too many people working in the United States.

    (The San Francisco Fed: “The (national) labor market has further strengthened and appears to be at or even beyond full employment.“

    This is not success.

    China is booming, and the entire Far East has boomed on the export model, with variations of mercantilism.

    More young Chinese own their own homes than young Americans.

    Theories are fine, and as the French economist said, “Is what I say true in fact, or more importantly, is it true in theory?”

    But jeez, at what point do we say “This just ain’t working, Jack.”

  21. Gravatar of Philo Philo
    29. June 2017 at 09:25

    @ Ben Cole:

    You wrote: “It is indisputable that income flows into regions that are net exporters of goods and services. The richest big city on the planet in 1960? Detroit.” But wasn’t this sort of mercantilist thinking refuted long ago?

  22. Gravatar of ssumner ssumner
    29. June 2017 at 12:13

    Mike, You might be interested in my new Econlog post, which should appear later this afternoon.

    Wasshoi and Carl, I don’t really have any good reason for this prediction. When I don’t know what to expect, I predict more of the same. That would mean more of the current i-rate, in this case.

    Brett, I was referring to the rate at which banks lend money to each other. The Fed targets that rate.

    Anonymous, I don’t follow the soccer example, but I’d say I’m blaming the Fed for not doing what Congress instructed it to do.

    Ben, You said:

    “China is booming, and the entire Far East has boomed on the export model, with variations of mercantilism.”

    As I’ve explained to you many times, this is simply false.

  23. Gravatar of Steve F Steve F
    29. June 2017 at 20:07

    Scott, as you’ve noted in the past, the monetary base uncharacteristically did not grow during virtually all of 2007. During this time, the Fed lowered the nominal rate by about 125 basis points. If we show this on a money market graph (nominal interest rate on y axis and quantity of money on x axis), this would mean that when the Fed set the nominal rate lower without increasing the money supply, the nominal rate is below the equilibrium point, resulting in greater quantity of money demanded than quantity of money supplied and thus a shortage of money. Going off the statement in your opening paragraph, “As market interest rates fell (there was no Fed), the demand for gold increased. Because gold was the medium of account, this was a negative demand shock,” this suggests than in the scenario I described in the money market, the demand curve for money would shift leftward, resulting in a leftward shift in the AD curve on an AS/AD diagram.

    Is this correct? If not, what am I getting wrong?

  24. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    29. June 2017 at 20:57

    ‘If not, what am I getting wrong?’

    Interest rates are NOT ‘the price money.’

  25. Gravatar of Postkey Postkey
    30. June 2017 at 01:01

    “The funny thing is: they haven’t. In fact, among the more than 10,000 research articles produced by the major central banks in the two decades prior to the 2008 crisis, none explored the correlation or causation between nominal interest rates and nominal GDP growth. Fortunately, this task is not very demanding, and once we conduct such an examination, we conclude that, in actual fact, there is no evidence to back these assertions whatsoever. To the contrary, empirical evidence shows that the central banking narrative on interest rates is diametrically opposed to the observable facts in two dimensions: instead of the proclaimed negative correlation, interest rates and economic growth are positively correlated. Secondly, the timing shows that interest rates do not move ahead of growth, but instead are either coincidental or even follow it.”

  26. Gravatar of Brent Buckner Brent Buckner
    30. June 2017 at 04:02

    Dr. Sumner: thank you for your elaboration.

    In present circumstances we see the Fed not achieving its target rate zone for the Reverse Repo Program so I’m particularly sensitive to the word “setting”.

  27. Gravatar of ssumner ssumner
    30. June 2017 at 14:15

    Steve, No, it’s not disequilibrium on the money S&D graph, it’s a decline in the demand for money.

    Postkey, Yup.

    Brent, Perhaps “influencing” is better.

  28. Gravatar of Larry Larry
    30. June 2017 at 22:15

    Accepting the fact that post-modern recessions are caused by falls in the natural rate, what caused that rate to crash in the GR? Real estate? That has crashed before without requiring unnatural acts by the Fed. What is definitively different now?

  29. Gravatar of ssumner ssumner
    2. July 2017 at 12:48

    Larry, I think both of your assumptions are wrong. The real estate crash was an order of magnitude larger than any other (American) real estate crash in recorded history.

    That’s not to say real estate is the only factor, there are lots of other factors, such as slowing population growth in developed countries, high Asian savings rates, etc.

    And the Fed did not engage in any unnatural acts. The cut in its interest rate target was pretty typical for a recession, they just started from a lower level than usual, and hence got to zero.

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