Things I Won’t Have Time to Say: Rethinking Macro Policy III Conference, Washington D.C., April 15-16

Rethinking Macro Policy III: Progress or Confusion?

Things I am almost surely not going to have time to say I:

It could have turned out very differently.

It could have been–as those of us who more-or-less hooted Raghu Rajan down at Jackson Hole in August 2005 wrongly thought—-that the money-center universal banks did understand their derivatives books; that asset-price innovation variances did drift up or down with time relatively slowly; that the weak point in the global economy in the mid 2000s was the global imbalance of the US trade deficit, and the possibility that some large bad actor had been selling unhedged dollar puts on a very large scale–not the subprime mortgages on houses built in the desert between Los Angeles and Albuquerque, and the use of securities based on those subprime mortgages as core banking reserves.

It could have been that, after the financial crisis, trust in financial intermediaries would rebuild itself quickly. It was not certain ex ante that trust would remain nonexistent, giving rise to our extraordinary, ludicrous, bizarre, and apparently permanent upward spike in liquidity preference.

It could have been that the North Atlantic’s central banks, even stuck at the zero lower bound on short-term safe nominal interest rates, would have been able to nail market expectations. Markets could have been confident of a rapid return to normalcy in the path of nominal demand. That would have provided cash holders with powerful incentives to spend on real assets. That would have created not the L but rather the U or even the V-shaped recovery that we all wish we had and had had.

It could have been the case that fiscal expansion–even at the zero short-term safe interest-rate nominal bound, even for reserve-currency printing sovereigns–would have proven ineffective, or even counterproductive. It was Karl Smith pointed out to me that in the guts of even the IS-LM model, a principal channel through which fiscal policy expands I+G is via reducing the perceived average riskiness of debt, and thus getting households to hold more debt. It is not guaranteed that a sovereign that issues more debt thereby necessarily reduces the perceived riskiness of the average piece of debt.

But we all go to the blackboard with the economy behalf, rather then the economy we used to think we had.

If Paul Krugman were here, he would say that if he has had an analytical edge since 1995, it was because he stopped taking macro after his class with Jim Tobin, and since 1995 we have been living in Jim Tobin’s world. I will say that if I have had an analytical edge, it would be because my Econ 2410 teacher, Olivier Blanchard, made us spend weeks–it seemed then like months–decoding Lloyd Metzler’s paper, “Wealth, Saving, and the Rate of Interest”, from the early 1950s.

If you had asked me back in 2005 whether the world could possibly turn out to be as “Old Keynesian” as it has turned out to be over the past decade, I would have said: No.

Suppose you had told me back in 2005 that the Federal Reserve was going to take the size of its balance sheet north of $4 trillion in the forthcoming decade. I would have immediately leveraged up as far as I possibly could on nominal debt. I would then have sat back and waited for the inflation to make me rich.

Now there are two possible ways we can respond given how the world has surprised us over the past decade.

We can turn our excellent brains to constructing increasingly implausible rationalizations for why what we thought in 2005 was right after all.

Or we can mark our beliefs to market.

I strongly recommend the second.

That is all I am going to say about fiscal policy in the short run–with the note that these days the “short run” is not the two or three years I used to teach my undergraduates, but rather a period of time that is uncertainly and terrifyingly long.

Sent from my iPhone