My talk from August 31, 2011:
It is hard to talk about macro right now. It is hard, in large part, because virtually all of us macroeconomists have been wrong over the past four years. Thus the past four years is that it’s been a great process of unlearning. And, distressingly, we have not been unlearning old things and learning true new things. We have, instead, been unlearning relatively new things but not replacing them with new new things. Instead, we have been going back to still older things. And these older things now appear to be more true than we imagined a decade ago, or indeed more true--at least for our economy right now--than economists have thought them at any time since 1950.
One way to look at the 60 years before 2007 in macroeconomics is as a long intellectual twlight struggle in which Milton Freedman in the end beat John Maynard Keynes, and beat him decisively. There were three major questions in macroeconomics on which Friedman and Keynes differed, and by 2007 an overwhelming majority of macroeconomists agreed with Friedman.
The first question was: Could central banks technocratically and apolitically do the macroeconomic stabilization jobs by themselves, or did they require help and assistance from the more political branches of government? Could central banks all by themselves make Say's Law that supply creates its own demand true in practice even if it wasn’t true in theory? Milton Freedman said for 60 years that the answer was "yes". He pushed and pushed. And by 2007 nearly everybody agreed with him: there was little support for the view that shocks and depressions could be large enough in the modern world that central banks would need help from legislatures engaged in fiscal policy or Treasuries engaged in banking policy to maintain a steady flow of nominal aggregate demand.
The second question was: Would recovery on the labor market happen on its own even if the central bank did not manage to keep nominal aggregate demand on a steady track? Milton Friedman recommended leaning against the wind: keeping the growth of the money stock stable and in fact altering money stock growth to compensate for variations in monetary velocity. But what if it failed? Would the economy remain in depression, or would employment recovery in a fairly short time measured in years rather than Presidential terms? Here again by 2007 Friedman had the victory: the general consensus was that even in the absence of stimulative or countercylical stabilizing policy one could expect about 40% of the gap between the current employment-to-population ratio and one's estimate of its normal level was to be closed over the course of the year. Tthe labor market worked. It worked more slowly than we would like, perhaps. But, in the sense that if a very large number of workers searched for jobs they would find some even if there were not all that many vacancies at any point in time, it worked. You could count on substantial mean reversion in the employment-to-population ratio.
This victory carried as its corollary victory in the third question as well: Should stabilization policy be aggressive and turn into full employment policy? Here again Friedman said no: since the economy was returning to trend, the benefits from aggressive gap-closing were short-lived and the costs should you destabilize inflation expectations were high--you could quickly get yourself into a world of hurt. Therefore, the near-consensus was by 2007, be cautious with policy, because the downside to aggressive gap-closing if it went wrong was large, while the downside to excess caution was small because the market would fix itself.
The general view as of 2007 was summed up by a line from Chicago's Robert Lucas's presidential address to the American Economic Association: "the problem of depression prevention has been solved". The problem of maintaining price stability--in the sense of avoiding excursions into moderate inflation like we saw in the 1970s, and then on to high and hyperinflation--had also been solved or rather had been changed from an economic technocratic problem into a political problem. Thus the really live questions in the economics of the labor market were not macroeconomic ones, but instead questions that we would throw over the fence to our micro colleagues.
We would ask our micro colleagues why the NAIRU--the Non Accelerating Inflation Rate of Unemployment, the normal rate of unemployment at which supply seemed to balance demand and expectations were fulfilled--in the U.S. economy was 5% rather than 2%. Given the number of workers who change jobs without any spell of unemployment at all, the fact that the average worker in the American economy spends two and a half weeks unemployed every year seems quite a waste. It is true that you are more energized to look for a job when you’ve lost your old one and have no income--but all our theories of labor market networks suggest that it is not pounding the pavement but rather the weak ties to people you know that get you your job offers, and that kind of job search does not require that you already be unemployed to function. And we would ask our micro colleague why the unemployment rate in Europe stuck near 8% for a decade and a half after the recession of 1982. Was it really that they seriously messed up their social network and social insurance systems--something we could easily avoid? Or was there something else going wrong? And then there were the nasty questions we asked our micro colleagues of just what was happening to our income distribution? Could it possibly be that the slowdown in the speed in which Americans were adding to their formal education was producing this enormous widening of incomes, or was something else going on?
Those were the live questions. They were all micro questions.
Then comes 2007. 2007 was followed by 2008. And here we are in 2011, and:
(1) Virtually nobody believes that central bank technocratic interventions in the short-term money market can do the full stabilization policy job. A Treasury undertaking banking policy, a Federal Reserve undertaking non-standard monetary policy, a legislative branch undertaking fiscal policy have to play a major role. And that role is a political one. You are not just swapping one short-term government asset for another in transactions that are of concern only to financiers on Wall Street looking for basis points. You are instead making major interventions: deciding who will bear the risk on the economy, what kind of savings vehicles people will hold, how much liquidity is going to be provided to the system as a whole, how many banks are going to be rescued, how many losses are going to be socialized, how many profits are going to be privatized and so forth.
(2) Excess supply on the labor market not is registering at all, is not leading to any upward pressure on the rate of matching workers who want jobs with jobs that want workers. We have an awful lot of people who are answering the CPS survey by saying; "No, I don’t have a job, and yes, I have done something to look for one over the past four weeks". Your most basic economic matching model says: multiply the fraction of workers looking for jobs by the fraction of jobs looking for workers and that will b proportional to your job-finding rate. It isn't. The equilibrium-restoring forces in the labor market at the macro level appear to be much much weaker than I thought they were in 2007, appear much weaker than I would have believed back in 2007 that they possibly could be.
Erica Groshen at the New York Fed could say: "I told you so". We really should not be that surprised. Back before 1990 a typical recession involved the Federal Reserve fighting inflation by imposing a liquidity squeeze on the economy--raising interest rates, making a whole bunch of business models unprofitable, and so inducing businesses then fire their workers But after the excess supply in the labor market registered, wage increases stopped, and inflation expectations fell, the Federal Reserve would simply reverse course and return asset prices to their previous levels. Thus if you were a business it was easy to figure out what you should do after the macroeconomic storm had passed. Since asset prices and interest rates were back at their previous level, what you had been doing three years earlier before the recession would still be profitable. So all you had to do is reproduce your division of labor as it had been three years before.
However, starting with the savings and loan crisis of 1990 and then the dot com crash and now this current financial crisis we have recessions brought on not by Federal Reserve decisions to fight inflation, but rather by recognition that asset prices have gone significantly awry. This means that the post-recession configuration of asset prices will not be the pre-recession configuration. This means that businesses have to figure out how to reknit the division of labor in a new, profitable way rather than simply restoring the old pattern. Moreover, they have to reknit the division in a time of slack demand when nobody can tell exactly what business models will actually be profitable when the unemployment ratereturns to 5% again.
(3) The risks of doing too little now appear to be much larger than the risks of doing too much as far as gap-closing is concerned. Economists have searched for and by and large failed to find welfare losses from the errors of excessive aggregate demand in the 1970s. Economists don't have to search very far or very hard to find enormous welfare losses from the errors of deficient aggregate demand in the 2000s.
So given that most of what we macroeconomists were saying in 2007 was wrong, what, if anything, do we have to say today? Bear in mind that what turns out to have been wrong was pretty much everything that had been done since 1950. So go back to 1950--or perhaps all the way back to 1829, all the way back to classical economics and John Stuart Mill. Start with the classical economic point that recessions and depressions when all the agents in the economy collectively want to spend less than they earn, and they want to do so because they are unhappy with their holdings of financial assets. They sometimes cut back on their spending below the incomes as they try to build up their holdings of liquidity--because the money supply is too small. And the Federal Reserve can fix that. In fact, if that were our problem it would be over, because the Federal Reserve has stuffed the economy with unbelievable amounts of liquidity. That has helped the situation some, but it clearly has not done the job.
The problem, instead, appears to be that people are unhappy with the risk characteristics of the financial assets they hold (and owe). y People who own risky assets are unhappy, and would like to trade them for safe assets or simply to build up their holdings of safe assets. People who owe others are extremely unhappy and are desperate to cut back on their spending to build up their asset holdings. The current risky assets in the economy are worth very little to creditors--for creditors are not at all confident that they will ever be paid. But these assets weigh heavily on debtors.
The result is that, because the risk tolerance is not there, the economy as a whole seeks to spend less than it earns until it finds a way to build up its holdings of safe assets and shed its hodings of risky assets. It is not that the economy is short of liquidity: it is that it is short of savings vehicles--and short of the safe savings vehicles that people right now very much wish they had to hold. The collapse of the middle class's housing equity has done extraordinary things to the wealth cushion that the average American household thought it had available for emergencies and they desperately want to build up those savings vehicle.
Expansionary fiscal policy--government budget deficits--are one of the best ways to create safe savings vehicles. Perhaps the most amazing thing of the past four years is that we’ve increased the supply of Treasury securities held by the public from $4 trillion to $8 trillion, and the market is extremely happy to hold all of these extra Treasury securities and are holding them at very high prices out of their desperate desire to rebuild their balance sheets.
And thus I as a macroeconomist who can rely on macroeconomics as the discipline stood in 1950 or perhaps look at the situation and say that it still looks like there is a large unsatisfied demand for safe liquid savings vehicles out there, and that the right thing to do is for the treasury, the Federal Reserve and the legislative branch to satisfy this demand. We need additional non-standard expansionary monetary policy, additional expansionary fiscal policy pulling spending forward into the present and pushing taxes back into the future. We need additional banking policy to use government money to provide yet more loan guarantees--since the private sector seems to lack the appetite to bear risk, the government needs to. The problem is that at some point taking more risk onto the government’s books is going to crack the government status as a safe debtor in the world economy. But that is not, at the moment, the U.S. Iceland, Ireland, Greece, Portugal, Spain, Italy, and a bunch of others have no room for maneuver right now. But the moment at which financial market start to loose their confidence in the U.S. still appears to be very far off.
Thus the technocratic piece of macroeconomic advice is that we ought to be aggressively pursuing expansionary fiscal, monetary, and banking policy right now.
Unfortunately, for reasons I don’t understand, that position appears to have zero if not negative support inside both the legislative and the executive branch right now.
And on that note, even more depressing than Heather [Boushey], let me close...
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