Let me point out that, to the extent one recognizes even the possibility of hysteresis or superhystesis, obvious optimal control policy when you approach the zero lower bound is to dial up current monetary expansion to the max and call for more fiscal expansion as well. The long-run damage from not generating a V-shaped recovery in the short-run is then immense, and you always dial policy down to be less expansionary should it look like you were about to overshoot. Yet such arguments had no purchase in the Bernanke Fed or the Geithner Treasury, and little inside the Obama White House.
I must confess that I have never understood why people ever thought it reasonable to believe that the pace of potential output growth was the same in a low pressure as an high-pressure economy. And, indeed, it is not:
Larry Summers: Advanced Economies Are so Sick We Need a New Way to Think About Them: “There appear to be more cases where recessions reduce the subsequent growth of output…
…than where output returns to trend. In other words ‘super hysteresis,’ to use Larry Ball’s term, is more frequent than ‘no hysteresis.’… We look at… recessions with different precursors. We find that even recessions that are associated with disinflationary monetary policies or the drying up of credit have substantial long-run output effects–suggesting the presence of hysteresis effects…. [Moreover,] fiscal policy changes have large continuing effects on levels of output suggesting the importance of hysteresis…
But we knew all this back in 1936, no? John Maynard Keynes:
John Maynard Keynes (1936): The General Theory of Employment, Interest and Money, chapter 24: “The enlargement of the functions of government…
…[is] the only practicable means of avoiding the destruction of existing economic forms in their entirety and as the condition of the successful functioning of individual initiative…. If effective demand is deficient, not only is [there] the public scandal of wasted resources… but the individual enterpriser… is operating with the odds loaded against him… many zeros, so that the players as a whole will lose if they have the energy and hope to deal all the cards. Hitherto the increment of the world’s wealth has fallen short of the aggregate of positive individual savings; and the difference has been made up by the losses of those whose courage and initiative have not been supplemented by exceptional skill or unusual good fortune. But if effective demand is adequate, average skill and average good fortune will be enough…
Only in a high-pressure economy, Keynes says, will the “increment of wealth”–the value of productive capital and organizations created–match “the aggregate of positive individual savings”–the amount of resources devoted to trying to boost productive capacity. In a low-pressure economy, a lot of investments that could pay off from a tastes-and-technologies standpoint won’t because of slack demand, and so perfectly-productive factories and organizations will be scrapped and shut down.
And we have to add on to this the perspective, derived from Granovetter, that a great deal of the societal resource-allocation capital of the labor market is the social network of loose ties generated that nobody gets paid for, and is thus a spillover; the perspective, derived from Saxenian, that a great deal of the societal resource-allocation capital of the value chain is the social network of overlapping communities of engineering practice generated that nobody gets paid for, and is thus a spillover; and the perspective derived from Hayek that a great deal of the societal resource-allocation capital of the price system is the revelation by market prices of societal scarcities and values that nobody could calculate on their own, and that nobody gets paid for generating, and is thus a spillover. Externalities all over the place here!
The question is: why did people ever assume otherwise? Yes, a linear Phillips Curve is simple to work with. Yes, the assumption that the rate of inflation expected next year is simply actual inflation last year seems like a not unreasonable rule-of-thumb. But you have to put very great weight on both–weight that the past decade has conclusively proven they cannot bear–to even conclude the business cycles are fluctuations around rather than falls below sustainable levels of production. And you are still absolutely nowheresville with respect to the invariance of potential growth to cyclical conditions.
