Wednesday, November 26, 2014

The Long Short Run

BERKELEY – Before 2008, I taught my students that the United States was a flexible economy. It had employers who were willing to gamble and hire when they saw unemployed workers who would be productive; and it had workers who were willing to move to opportunity, or to try something new in order to get a job. As bosses and entrepreneurial workers took a chance, supply would create its own demand.

Yes, I used to say, adverse shocks to spending could indeed create mass unemployment and idle capacity, but their effects would be limited to one, two, or at most three years. And each year after the initial downturn had ended, the US economy would recover roughly 40% of the ground between its current situation and its full employment potential.

The domain of the Keynesian (and monetarist) short run, I said, was 0-2 years. When analyzing events at a horizon of 3-7 years, one could safely assume a “classical” model: the economy would return to full employment, while changes in policy and in the economic environment would alter the distribution but not the level of spending, production, and employment. Beyond seven years was the domain of economic growth and economic institutions.

All of this is now revealed as wrong, at least for today, if not in the past or the future. Japan since the start of the 1990’s provides strong evidence that the short run can last for decades, and then be followed not by a return to the old normal, but by a transition to a new normal in which the Keynesian short run of economic depression casts a long shadow. What we have seen since 2008 is that Japan is not an exception.

The default framework for thinking about these questions is a very old one: the market-and-natural-interest-rate framework of Knut Wicksell’s Geldzins und Guterpreis (“Interest and Prices”). In every economy, the argument goes, there is a market interest rate determined by the financial system, and there is a natural interest rate – the value at which desired savings at full employment equal desired investment at full employment, and at which the economy as a whole desires neither to leverage nor to deleverage.

If the economy as a whole desires to leverage up, the result is an inflationary boom. If the economy as a whole desires to deleverage, a depression ensues. It is then the central bank’s job to intervene in the banking system in order to push the market interest rate to the natural interest rate, thereby balancing the economy at full employment without excess inflation.

The problem now is that the natural interest rate – that is, the liquid safe nominal interest rate on short-term US Treasury securities – is less than zero. Thus, the central bank cannot push the market interest rate there. Until something happens to raise the natural interest rate, we are stuck with a depressed economy.

Some blame a global savings glut for this state of affairs, and call for less thrift. But if we were at full employment, we would recognize that the world still has mammoth growth opportunities, and to sacrifice future growth for current well-being is a second-best choice.

Others blame a global investment shortfall driven by a lack of technological opportunities. But, given that this view is expressed in every deep depression, it appears to be an effect of economic stagnation, rather than a cause of it.

Still others say that the problem would resolve itself, at least in the US, if the target for annual inflation were raised from 2% to 5%, because a loss of so much of the real purchasing power that people hoard in cash would induce the needed boost in real investment. I think they are probably right, but former central bankers like Paul Volcker and Alan Greenspan would warn that a 5% inflation target is ultimately unsustainable. People can be happy with a stable 2% target (which is too low to notice), but 5% annual inflation would eventually become 10%, and 10% would eventually become 20%, and then the US would face another deep recession, like in 1982, or even more unpleasant alternatives.

Finally, according to a fourth group of economists, centered around Ricardo Caballero of MIT, the problem is a global shortage of safe assets. This view translates into policies aimed at better mobilizing society’s financial risk-bearing capacity, and that use the public sector to outwit the forces of time and ignorance that curb willingness to engage in risky investments.

So we have four theories, all advocated by smart, thoughtful, and hard-working economists. In a better world, sophisticated debate in a vibrant public sphere would inform economic policy. In the world as it is, we are all Japan in the early 1990’s, looking ahead to two or more decades of lost economic growth.

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    1. CommentedHerbert Walter

      At the current range, the oil price depresses US annual GDP growth by no less than 1.5% compared to where it would be if the price was still the same as ten years ago. Neo-Keynesians do not acknowledge this colossal supply-side shock that persists despite the shale boom. It is entirely irrational to push global aggregate still higher under these circumstances as the Neo-Keynesians argue.

      The deleveraging narrative is completely beside the point. The world as a whole has obviously not been deleveraging. It has reached one all-time debt record after another.

    2. CommentedSami Al-Suwailem

      The claim that natural interest rate is the same as nominal interest on short-term US Treasuries is not true. This is not the definition Wicksell provided for natural interest rate. Wicksell defines it as the rate on real capital (see p. xxv of his book).

    3. CommentedPaul A. Myers

      In a period of exceedingly low interest rates, borrowing $1 trillion and investing it in public infrastructure would have many beneficial effects, both short and long. The investments would improve both competitiveness and comparative advantage, would put upwards pressure on median real wages, would enhance future productivity growth of private sector workers, and would provide a pulse of immediate demand which would increase the upwards slope of future demand.
      We are where we are because the Congress, and to some extent the Obama administration, refused to seriously consider the "best way" forward, but rather choose to chase after small dollar panacea solutions. In a very large economy, if you want to jump start growth in a deep recession, you have to move some very large numbers. The establishment in Washington failed to understand this, and accordingly they failed to focus on a somewhat obvious solution hiding in plain sight.
      What we had in 2009 and 2010 with Larry Summers in the White House was the McGeorge Bundy of economic policy. So of course we wound up in a swamp (just as McGeorge Bundy advised LBJ to jump into Vietnam with a half million troops).

    4. CommentedG. A. Pakela

      I disagree with Professor DeLong's response below that there is a demand side problem. In fact, the problem is on the supply-side. Too many individuals find themselves unemployed, and job opportunities are scarce and highly competitive. The only way to sop up all of these unemployed resources is for firms to make incremental investments that would create demand for more labor. Investor sentiment, both among large firms and the hundreds of thousands of small businesses, needs to perk up. Isn't that what "animal spirits" is really about, an almost irrational swing in mass emotion on the part of active investors and entrepreneurs? As new business gives rise to increased employment, the demand-side of the economy will kick in and make the recovery more normal and self-sustaining. Playing with inflation targets is an interesting theory, but it has never been attempted in the current context. Perhaps we'll see whether it works for the Japanese.

        CommentedTomas Kurian

        And why on Earth they would invest more, when current capacity is already underutilized ?
        When thinking whether we have demand side or supply side problem, you have only to judge production capacity utilization.

        Are factories working on 100% capacity ?

        Far from that. They are working 4 days, sending workers on part time leave, factories are closing down as nobody have money to buy.

        Answer is simple - it is Demand side problem.

    5. CommentedMarc Laventurier

      It's always amusing to see conventional market (meaning capitalist) economists resort to the idea of using incremental inflation to flush out savings into investment which would create demand where it did not more naturally arise, all in pursuit of nominal growth (meaning profit). Maybe, someday, polities will evolve an opposable thumb, capable of more than mere grasping, and the theorists who regard populations as livestock to be herded will meet the fate of the losing simian tribe depicted toward the beginning of Kubrick's 2001, the big bone wielded representing democracy.

        Portrait of J. Bradford DeLong

        CommentedJ. Bradford DeLong

        Marc, did you read what I wrote? I think that a higher inflation target is worth trying, but I am skeptical about whether it will work--and I think there are good reasons to be skeptical about whether it will work...

    6. CommentedProcyon Mukherjee

      As usual an excellent piece where competing ideas are pitching for a view that could take us out of the current steadfastness where on one hand we have reached the lowest end of the ‘lower bound’ and on the other hand we do not know whether prolonging the monetary release at the current drip-feed rate is a good idea. The supply side, as usual, cannot be propped up any better, while demand needs new innovation, the pace of which had slowed down in the developed world.

      This leaves a sobering thought how incipient is the nature of the capital movement to the zones of depravity, where demand is yet to take off, where even running water is a rarity, or the electrification or permanent roads are in want that would drive down costs that are taken away from the farmer by the ‘middleman’ in the supply chain. These are not great Nobel Prize winning thoughts, but simple things that needs Capital to be released with a touch of uncertainty but surely would sow the seeds of long term demand creation, the likes of which would make current investments in liquid assets sound like a pale overture; capitalists ignore this alternate path at their own peril, strangely, while the politicians do too little other than lip service. There is no interactive complexity in this but the absence of cooperative virtue, something which this generation has lost the touch of.

    7. Portrait of Michael Heller

      CommentedMichael Heller

      I suggest you have left out the fifth theory of economics, the most important one, unless perhaps you intended (rather misleadingly) to subsume it under the technologically-determined bottlenecks theory. The missing theory I refer to is the neoliberal one, namely the one that identifies the problem as the decay phase of prolonged state activism (with symptoms ranging from debt-fuelled over-spending and rampant discriminatory welfare, to political cronyism and business rent-seeking), and which identifies the remedy on the supply side as deregulation, reregulation, privatisation of many state assets (think of Japan's over-indebted state which has assets of Y600 trillion, including Y260 in cash, securities and loans, which cry out for selective but radical privatisation to spur good incentives --, and, more generally, all the other tried and tested measures that work *directly* on the supply side to restore that precious *flexibility* whose tragic absence you so correctly identified in paragraph one. To my knowledge Japan has never tried the neoliberal recipe, despite the fact that some of its best economists support it. Compared with the kingly neoliberal theory, the rest, as they say in fairy tales, are nought but hocus pocus and humbug. The longer one delays the necessary reform, and the longer one follows the Japan example, the more difficult it is to clamber out of the hole without starting a Third World War in order to do so.

        CommentedDon Johnson

        I was gratified to finally see my thoughts represented by Mr. Michael Heller. Deregulation and a steady and slow move away from Guaranteed Federal Bailouts(for unions, banks, car manufacturers, gse's of all shapes and sizes, Big Oil, Big Sugar, Big Biz, etc.) would be a good start to solving our problems. Of course, I realize this will never happen. Why would politicians give up their power of rewarding and punishing to extort contributions from rich folks? Ain't ever gonna happen. Much as dumping 6 or 7 trillion into the economy might kickstart things but also ain't gonna happen. That money would look a whole lot better fattening up campaign coffers or porking up home district's slush funds. So who gets it? Wall Street. Hey I'm not complaining it's keeping my pension and my parents retirement funds from evaporating but how sustainable is all this monetary easing? What happens when the music stops and how many chairs are going to be left for us middle class working little people? I worry.

        Are we truly not in Stagflation? My understanding is that unemployment is really much higher then government statistics say it is. As for inflation, well, I know my paycheck doesn't go near as far as it used to with higher gas and food prices, higher insurance premiums and out of control fees and taxes and surcharges and what not. Usually not too difficult to trace things back to none-too-well thought out government regulation policies. Don't even get me started on the EPA. I may not be for subsidizing Big Oil but I'm really, really not for strangling Big Coal. Thank goodness for cheap natural gas and the success of fracking. Without these we really would be in the ash heap.

        Portrait of J. Bradford DeLong

        CommentedJ. Bradford DeLong

        If our principal problems were on the supply side, we would see--as we say in the 1970s--stagflation: high unemployment and rising inflation. We don't. The fact that we don't is what makes practically everybody I find worth reading conclude that our principal problems are on the demand side--and that we should solve those first and then see where we are...

        CommentedTim Chambers

        To every man with a hammer every problem looks like a nail. The supply side was supposed to be the thing that fixed the economy back in the 1980s, but what really fixed the economy was the development of the PC and the ecosystem it spawned. But it still only gave us an average of less than three percent growth.

        The problem isn't on the supply side now, the problem is with demand. The demand is all in the emerging markets because the developed markets are sated. Without a new product like the PC, the developed world is in for years of economic stagnation and misery that can only be alleviated with punitive taxes on wealth and financial transactions.