Must-Read: Simon Wren-Lewis: A Self-Fulfilling Expectations-Led Recession?

Must-Read: Simon Wren-Lewis: A Self-Fulfilling Expectations-Led Recession?: “I acknowledge that macro rightly got a lot of stick by largely ignoring the role of finance…

…but I also point out that the poor recovery has involved a vindication of the core macro model: austerity is a bad idea at the ZLB, QE was not inflationary and interest rates on government debt did not rise but fell…. I end by showing them this chart:

There has been no recovery from the Great Recession…. A mechanical way to explain what has happened is to bend the trend: to suggest that technical progress has been slowing down for some time. This inevitably means that the pre-crisis period is transformed into a boom. I have been highly skeptical… traditional ideas about what inflation would do in a boom….

Suppose that firms and consumers came to believe that the output gap was currently zero when it is not…. Suppose also that unemployed workers priced themselves into jobs by cutting their (real) wage or disappearing by no longer looking for work…. How do we know that we are suffering from demand deficiency? The traditional answer in macroeconomics is nominal deflation: falling wages and prices. But because workers have already priced themselves into jobs, nothing more will come from the wages route. So why would firms cut prices?…

The accelerator remains a very successful empirical model of investment…. But if beliefs are such that the market is not going to expand that much, because firms believe the economy is ‘at trend’ and trend growth has now become pretty small, then the need to invest to meet an expanding market largely goes away…. It is this possibility which is the reason that I have always argued central banks and governments should have been much more ambitious about demand stimulation after the Great Recession. As I and others have pointed out, you do not have to attach a very high probability to the scenario that demand will create supply before it justifies a policy of ‘testing the water’ by letting the economy run hot. Every time I look at the data above, I ask whether we have brought this on ourselves by a combination of destructive austerity and timidity.