December 7, 2008
Macroeconomic Policy and the Current Depression
Macroeconomic Policy and the Current Depression--Posner
Macroeconomic Policy and the Current Depression—Posner
I am not a macroeconomist, but given the strange, perhaps embarrassed silence of so many macroeconomists, mentioned by Becker, I feel less daunted by my lack of expertise than I ordinarily would be.
As Becker explains, the focus of central banks, such as the Federal Reserve Board, has been on maintaining price stability by reducing interest rates when economic growth is too sluggish and raising them when it is too fast. The first response encourages economic activity when needed and the second limits inflation. But control of interest rates cannot prevent depressions, including severe depressions. Nor can fiscal policy--government spending and taxing.
There appear to be three types of depression (why that word has been displaced by "recession" eludes me--who is supposed to be fooled by such a euphemism?). In one, the least interesting and usually the least serious, some unanticipated shock, external to the ordinary workings of the market, disrupts the market equilibrium; the oil-price surges of the early and then the late 1970s are illustrative. The second, illustrated by the depression of the early 1980s, in which unemployment exceeded 10 percent for a time during 1982, is the induced depression: the Federal Reserve Board broke what was becoming a chronic high rate of inflation by an unexpectedly steep increase in interest rates, which shocked the economy. In neither type of depression is anyone at fault, and the second was downright beneficial to the economy.
In the third and most interesting type of depression, illustrated by both the depression of the 1930s and the current depression, the cause is the bursting of an investment bubble. There was a stock market bubble in the 1920s fueled by buying stock with money loaned by banks. That was risky lending and as a result the bursting of the stock market bubble in 1929 resulted in bank insolvencies. The severity of the depression may have been due to the Federal Reserve Board's failure to bail out the banks, but the depression itself was due to the stock bubble's bursting and precipitating bank insolvencies. There was a lesser stock market bubble, in stocks of high-tech companies, in the late 1990s, but its bursting had a small effect on the economy as a whole.
The current depression is similarly the consequence, but a very grave one, of the bursting of a bubble. The bubble started in housing, but extended to commercial real estate and other sectors of the economy as well. Very low interest rates, imaginative marketing of houses (and of mortgages on houses) and other goods, and the deregulation of the banking industry spurred highly speculative investing; and the eventual bursting of the bubble, as in 1929, precipitated widespread bank insolvencies and a rapid and steep decline in the stock market, though this time the insolvencies preceded and precipitated the stock decline, rather than vice versa.
An article by Massimo Guidolin and Elizabeth A. La Jeunesse published a year ago in the Review of the St. Louis Federal Reserve Bank noted that the personal savings rate of Americans had actually turned negative, meaning that people were spending more than they were earning. And now such savings as people had, being heavily invested in the stock market, have become depleted by the drop in the stock market. As a result of their inadequate savings, people who lose their jobs or cannot sell the houses they no longer can afford are limited in their ability to reallocate savings to consumption, as they had done in previous, milder depressions. So consumption has fallen steeply, precipitating layoffs that have further reduced consumption (because the unemployed have lower incomes), creating the downward spiral that the economy finds itself in at this writing. And the timing could not be worse: during a presidential transition, with the lame-duck President seeming uninterested in and uninformed about economic matters, with economic officials whose stumbling responses to the gathering financial crisis have undermined their credibility, and with the crisis accelerating during the Christmas shopping system, which normally accounts for as much as 40 percent of annual retail sales. The buying binge financed by the heavy borrowing during the bubble have left consumers awash in consumer durables, so it is easy for them to postpone buying. Moreover, consumer durables are more durable than they used to be, so that replacement can be deferred longer than used to be possible.
If this diagnosis is correct, then the public-works expenditure program that President-elect Obama is proposing, though anathema to economic libertarians, resisted by the Bush Administration, and bound to be wasteful, as all such programs are, may be the most sensible response to the depression and one clearly superior to a tax cut. A tax cut or rebate, like the bank bailout, is unlikely, unless very large or credibly promised to be permanent, to stimulate consumption greatly; most of the money is likely to be used to rebuild savings or, in the case of the banks, to rebuild their equity cushion so that they can make loans, bound to be risky in a depressed economy, without courting bankruptcy. In other words, to stimulate economic activity the government will have to step in and "consume," in lieu of reluctant or impoverished consumers by spending money on road repair and other public goods. A critical variable, however, is the length of time it will take for public-works projects actually to be begun. American government tends to be extremely sluggish.
Central Bank Confidence in Taming the Business Cycle: A Grand Illusion? Becker
For many years economists and central bankers have congratulated themselves on the remarkable stability of US economy. Since the early 1980s, inflation has been under excellent control, and business cycle fluctuations in real GDP have been modest. For example, in no year since 1955 was US average unemployment as high as 10 percent. The highest annual rate was 9.7 percent in1982 during the recession then, and the next highest was 8.5 percent during the recession related to the first oil price boom. Moreover, many economists attributed the quite high average rate growth rate of American GDP in large part to the low rate of inflation and the stability of the economy.
Stable prices and mild business cycles were in turn explained not only by the underlying strength of the American economy, but also in an important way by policies learned by the Fed and other major central banks. Inflation targeting explicitly guided the European Central Bank, the New Zealand Bank, and a number of other central banks. It was also important to the Fed. Through such targeting, central banks would raise their interest rates and tighten up access to credit when inflation exceeded say 2 per cent. Inflation has been remarkably mild for the past quarter century. Japan experienced deflation, not inflation during its stagnant 1990s.
To control real business cycles, central banks relied on formal or informal versions of generalized inflation targeting to include real output changes. In these Taylor-type rules, central banks responded not only to inflation rates, but also to slowdowns in the growth of GDP relative to what was estimated as their long-term trend values. When the growth rate slowed relative to trend, central banks would loosen up their interest rates and access to credit. They would tighten when growth rates were above trend values. By "leaning against the wind" in this fashion, steps were taken to dampen the magnitude of fluctuations in real output.
In light of the severity of the recession that the world economy is now experiencing, for example in the US, Europe, and the UK, can this widespread confidence in our knowledge of how to tame the business cycle through central bank policy be called "a Grand Illusion"? In answering this question, one does have to recognize that the Fed and other central banks learned major lessons from the Great Depression about the value of loosening its purse strings when times were bad. And no one can deny that the past 25 years was a remarkable, and perhaps unprecedented, good run for the American, British, Chinese, Indian, and the world economy.
Clearly, however, central bankers and we economists were unprepared for the magnitude of the present financial crisis, and even less for its large effects on the real economy through the drying up of credit for mortgages and business investments. This recession is still ongoing, but it appears as if it will be the most severe recession since 1982, when American unemployment peaked in some months at about 10.5 percent. One year into the recession according to the NBER dating, unemployment has reached 6.7 percent, and it is still rising at a fast pace.
Central banks, especially the Fed, did respond rather rapidly to the unfolding of the financial crisis, even before it had a large impact on the economy. The Fed employed all the weapons in its traditional arsenal, such as lowering interest rates and easing access to the discount window. It also innovated beyond traditional approaches by allowing investment banks access to its credit, and by helping to arrange for the takeover or elimination of weak investment banks, such as Bears Stern and Lehman brothers.
In contrast to the Fed, the US Treasury took a series of actions with dubious merit, including bailouts and a fiscal stimulus, that had few consistent principles. The latest as reported in the NY Times and Wall Street Journal is to use Fannie Mae and Freddie Mac to encourage banks to drop mortgages to 4.5 percent in order to raise housing prices and encourage home building. Yet Freddie and Fannie and their government guarantees contributed to the housing mess by encouraging excessive building of residential dwellings. Any effect of this proposed price ceiling on housing prices on mortgage rates would be small, but the damage to adjustments in the housing market would be major. The goal of policy should be to reduce, not increase, the power and distortions caused by these two institutions.
In any case, the Fed and Treasury's actions combined obviously were not sufficient to greatly contain the damage to the real sector. The retreat from risk has been so large that treasury bills and bonds are selling at very low interest rates, other measures of risk are way up, and lenders are reluctant to lend, even when expected rates of return on their investments are high. Not surprisingly, the confidence of central bankers and economists that we have learned how to moderate greatly the real business cycle has been shattered. It is revealing how many leading macroeconomists have been silent during the unfolding of this crisis. Perhaps the prudent approach is to go back to the drawing board before offering an interpretation of what happened, and how to combat it.
Despite the seriousness of the present crisis, we should not forget that the past quarter century has been a great period of growth and stability for most of the world. Hundreds of millions of men, women, and children were pulled out of extreme poverty in China, India, and elsewhere by the rapid growth of their economies, due in considerable measure to the steep expansion in world trade, and the stability of the world economy. Even with two years of a rather deep world recession added in, the period since the early 1980s would look good by historical standards.
True, as I argued in prior posts on our blog, additional regulations of financial institutions are desirable, and the Fed has to think deeply about how to expand its arsenal of weapons. Yet it would be a major mistake to seriously hamper a worldwide competitive market engine that has brought so many benefits to the world's population.