Must-Read: Lawrence Summers: Global Economy: The Case for Expansion

Must-Read: Uncertainty about what the correct model of the economy is and a strongly asymmetric loss function do not simply apply to the question of whether the Federal Reserve should start a tightening cycle now or delay for a year and reevaluate then. It also applies to the question of whether fiscal policy–with its substance-free love of austerity–is fundamentally, tragically, and potentially catastrophically misguided:

Lawrence Summers: Global Economy: The Case for Expansion: “The inability of the industrial world to grow at satisfactory rates even with very loose monetary policies…

…problems in most big emerging markets, starting with China… the spectre of a vicious global cycle…. The risk of deflation is higher than that of inflation… we cannot rely on the self-restoring features of market economies… hysteresis–where recessions are not just costly but stunt the growth of future output–appear far stronger…. Bond markets… are [saying:] risks tilt heavily towards inflation… below… targets… [despite expected] monetary policy… looser than the Federal Reserve expects… [plus] extraordinarily low real interest rates….

If I am wrong about [the need for] expansionary fiscal policy, the risks are that inflation will accelerate too rapidly, economies will overheat and too much capital will flow to developing countries. These outcomes seem remote. But even if they materialise, standard approaches can be used to combat them. If I am right and policy proceeds along the current path, the risk is that the global economy will fall into a trap not unlike the one Japan has been in for 25 years…. What is conventionally regarded as imprudent offers the only prudent way forward.

If the world undertook a large, coordinated fiscal expansion, five years from now we might regret it: we might be trying to reduce an uncomfortably-high inflation rate via tight monetary policy and relatively-high interest rates, and worrying about the long-term sustainability of government debt given that, finally, r>g. But those are problems we can handle, and those are problems of a world near full employment with ample incentives to invest in physical capital, organizational business models, and new technology.

If the world does not undertake a large, coordinated fiscal expansion, five years from now we might regret it: having failed to do anything to claw the global economy off the lee shore of the zero lower bound in 2015-6, the next adverse shock would leave the world mired in a depression as deep as 2008-9 with no available monetary policy tools to fight it.

In a world of uncertainty about the right model, the correct policy choice is obvious.

Yet the center of the Fed–both FOMC participants and staff alike–say things like: “You cannot make policy without a forecast.” And they go on to say that they will take the next policy step as if the forecast is accurate, and reevaluate only as outcomes differ from expectations. This seems to me to be an elementary mistake: in finance, after all, those who neglect optionality get taken to the cleaners by those who see it and use it.

And it is not as if the Federal Reserve’s current forecast–for rising PCE inflation crossing 2%/year in less than two years–even looks to me like the right forecast: is this a pattern that you think will generate wage growth high enough to sustain 2%/year-plus PCE inflation in two years?

A kink in the Phillips curve Equitable Growth

October 28, 2015


Brad DeLong
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