Over at Project Syndicate: An Even More Dismal Science

Over at Project Syndicate: For the past twenty-five years those of my elders whom I regard as the barons of policy-relevant academic macroeconomics–at least the reality-based and sane barons–have been asking themselves fundamental questions. The first question was whether the business-cycle pattern of the post-World War II generation of full employment, a bias toward moderate inflation, and rapid growth had in fact come to an end. The second question was how best to think about the business cycle after the end of the post-WWII era’s “Thirty Glorious Years.” READ MOAR

First out of gate, in 1991, was Larry Summers, with his “How Should Long-Term Monetary Policy Be Determined?” Summers was not certain that the economic policy régime and economic reality had changed. Thus his first goal was to stengthen the technocratic independence of the central bank. “Institutions should do the work of rules”. And attention should be devoted to “strengthening the[ir] independence”. While politicians should and could set goals, technocrats could carry them out better than politicians micromanaging or politicians prescribing rules that would inevitably fail in unexpected circumstances. That would guard against a repetition of the inflationary disturbances of the 1970s. His second goal, however, was to convince the technocrats he hoped to see running central banks that a 2-3%/year inflation rate should be the goal. He did “not see evidence that [inflation] instability results at [such a] low rate.” He saw “forgo[ing] that opportunity under a zero inflation rate” of achieving the right real interest rate if the “real rate of interest should be negative… at certain times” as very expensive. And the expense was amplified by three considerations: The first was that the presence of money illusion and downward nominal rigidities in labor and debt contracts. The second was that the productivity slowdown made wage growth more likely to bump up against zero. And the third was that the combination of the productivity slowdown and the demographic transition made interest rate more likely to bump up against zero.

Second was Paul Krugman in 1998, with his book The Return of Depression Economics2 and his paper “It’s Baaack: Japan’s Slump and the Return of the Liquidity Trap.3 Krugman argued powerfully that central banks had succeeded in anchored inflation and inflation expectations to a low level. Thus, he believed, the global economy–or at least the North Atlantic economy–had returned to an earlier pattern. The pattern was the pre-World War II pattern of “depression economics”. And in it shortages of aggregate demand, risks of deflation, financial crises, and liquidity traps would become important and perhaps dominant features.

Summers believed that technocratic central banks under loose political reins could guard against both the inflationary dysfunctions of the 1970s and the depression-prone dysfunctions of the pre-WWII era. Krugman believed that hope was vain, and that the régime of depression economics had returned. And at the third point of the triangle was Ken Rogoff. Ever since his 1998 Brookings Institution comment on Paul Krugman he has found himself “not quite buy the view that short- and medium-term full-employment real interest rates… are negative. And even if they are… the right policy is probably to raise the real interest rate through expansionary fiscal policy… free[ing] monetary policy from its supposed liquidity trap.” He has viewed what Krugman sees as a long-term vulnerability to “depression economics” as, rather, the temporary consequences of failures to properly regulate and curb debt accumulation. It is such debt accumulation cycles which cause the problems by inevitably ending in a great deal of underwater loans in and economy. And then they can and must be cured only by painful deleveraging accompanied by heterodox government-enforced debt writedowns.

And the other barons–Joe Stiglitz, Ben Bernanke, Marty Feldstein, and many others–have not so much staked out their own positions as remain in some Schroedingerian superposition. Sometimes they argue as if we still lived in the 1953-1986 world in which central bankers like William McChesney Martin, Arthur Burns, and Paul Volcker operated. Sometimes they sound like Krugman, Summers, or Rogoff.

So what can we say about this debate, which has now been ongoing for twenty-five years?

Most importantly, we can say that the answer to the first question–whether the business-cycle pattern of the first post-World War II generation has come to an end–is: “yes, definitely.” The models and approaches developed to understand the small size of the post-WWII generation’s cycle and its bias toward moderate inflation are worse than useless for today. Second, Summers has more-or-less abandoned his 1991 belief that central banks can and will and perhaps even should interpret “price stability” flexibly enough to keep the return of depression economics away. In his view, with which I concur, more of the risk-bearing and long-term investment-planning and investing role in society needs to be taken over by governments. And we strongly believe that at least those governments with exorbitant privilege that issue the world’s reserve currencies can take on this role without any substantial chance of so-loading future taxpayers with inordinate debt burdens. Rogoff, by contrast, continues to hold to the rather Minskyite position that has underpinned his thinking since at least 1998: that successful macroeconomic performance requires regulating finance and curbing debt accumulation in the boom.

The triangle of positions has thus collapsed to a line. Perhaps central banks could have managed to attain the technocratic utopia of macroeconomic business-cycle management Summers hoped for back in 1991. But they have failed to do. And few if any seem to have good ideas as to what institutional changes could provide them with both the will and the power to a accomplish that mission.

And the line reflects different positions not so much on the situation but on whether macroeconomic management can provide a cure. Summers and Krugman now both believe that more expansionary fiscal policies could accomplish a great deal of good. Rogoff still believes that attempting to cure an overhang of bad underwater private debt via issuing mountains of government debt currently judged safe is too dangerous–for when the private debt was issued it too was regarded as safe.

It is a far cry from the optimism of the Great Moderation era.