Sunday, November 23, 2014

Grand Mal Economics

BERKELEY – Across the North Atlantic region, central bankers and governments seem, for the most part, helpless in restoring full employment to their economies. Europe has slipped back into recession without ever really recovering from the financial/sovereign-debt crisis that began in 2008. The United States’ economy is currently growing at 1.5% per year (about a full percentage point less than potential), and growth may slow, owing to a small fiscal contraction this year.

Industrial market economies have been suffering from periodic financial crises, followed by high unemployment, at least since the Panic of 1825 nearly caused the Bank of England to collapse. Such episodes are bad for everybody – workers who lose their jobs, entrepreneurs and equity holders who lose their profits, governments that lose their tax revenue, and bondholders who suffer the consequences of bankruptcy – and we have had nearly two centuries to figure out how to deal with them. So why have governments and central banks failed?

There are three reasons why the authorities might fail to restore full employment rapidly after a downturn. For starters, unanchored inflation expectations and structural difficulties might mean that efforts to boost demand show up almost entirely in faster price growth and only minimally in higher employment. That was the problem in the 1970’s, but it is not the problem now.

The second reason might be that even with anchored inflation expectations (and thus price stability), policymakers do not know how to keep them anchored while boosting the flow of spending in the economy.

And here I stop, flummoxed. At least as I read the history, by 1829, Western Europe’s technocratic economists had figured out why these periodic grand mal economic seizures occurred. That year, Jean-Baptiste Say published his Cours Complet d’Economie Politique Pratique, admitting that Thomas Malthus had been at least half right in arguing that an economy could suffer for years from a “general glut” of commodities, with nearly everybody trying to reduce spending below income – in today’s jargon, to deleverage. And, because one person’s spending is another’s income, universal deleveraging produces only depression and high unemployment.

Over the following century, economists like John Stuart Mill, Walter Bagehot, Irving Fisher, Knut Wicksell, and John Maynard Keynes devised a list of steps to take in order to avoid or cure a depression.

1. Don’t go there in the first place: avoid whatever it is – whether external pressure under the gold standard, asset-price bubbles, or leverage-and-panic cycles such as that of 2003-2009 – that creates the desire to deleverage.

2. If you do find yourself there, stop the desire to deleverage by having the central bank buy bonds for cash, thereby pushing down interest rates, so that holding debt becomes more attractive than holding cash.

3. If you still find yourself there, stop the desire to deleverage by having the Treasury guarantee risky assets, or issue safe ones, in order to raise the quality of debt in the market; this, too, will make holding debt more attractive.

4. If that fails, stop the desire to deleverage by promising to print more money in the future, which would raise the rate of inflation and make holding cash less attractive than spending it.

5. In the worst case, have the government step in, borrow money, and buy stuff, thereby rebalancing the economy as the private sector deleverages.

There are many subtleties in how governments and central banks should attempt to accomplish these steps. And, indeed, the North Atlantic region’s governments and central banks have tried to some degree. But it is clear that they have not tried enough: the “stop” signal of unanchored inflation expectations, accelerating price growth, and spiking long-term interest rates – all of which tell us that we have reached the structural and expectational limits of expansionary policy – has not yet been flashed.

So we remain far short of full employment for the third reason. The issue is not that governments and central banks cannot restore employment, or do not know how; it is that governments and central banks will not take expansionary policy steps on a large enough scale to restore full employment rapidly.

And here I reflect on the 1930’s, and on how historical events recur, appearing first as tragedy and then, pace Karl Marx, as yet another tragedy. Keynes begged the policymakers of his time to ignore the “austere and puritanical souls” who argue for “what they politely call a ‘prolonged liquidation’ to put us right,” and professed that he could “not understand how universal bankruptcy can do any good or bring us nearer to prosperity.”

Today’s policymakers, so eager to draw a bold line under expansionary measures, should pause and consider the same question.

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    1. Portrait of Asgeir B. Torfason

      CommentedAsgeir B. Torfason

      Can it be that a new near collapse of a central bank is what is needed to cure the grand mal? In fact we have one recent example, from 2008, when the central bank of Iceland collapsed after having supported the banks too much. There are lessons from it that might be useful for other countries in the North Atlantic region, even though they have not as big banking system, proportionally, as the the small island in the middle of the North Atlantic.

    2. CommentedAvraam Dectis

      The vast majority of reputable economists agree with Professor DeLong.

      Given that, why do we have such policy ineptitude?

      The answer is that politicians run for office and economists sit comfortably in academia.

      If Krugman, DeLong and all the others , and there are quite a few, ran for office, enough would be elected to get decent policy change.

      Any economist with the throw weight to get a Nobel or appear here should be running for Senator or President. The lesser lights should be running for Congress.

      It is an easy thing to enter a Congressional primary. Just do it.

      Avraam J. Dectis

    3. Commentedprashanth kamath

      "The United States’ economy is currently growing at 1.5% per year (about a full percentage point less than potential)"

      - Sorry Mr. DeLong, Economy seems to disagree with you by growing 1.5% less than you expect it to grow.

      "Over the following century, economists like John Stuart Mill, Walter Bagehot, Irving Fisher, Knut Wicksell, and John Maynard Keynes devised a list of steps to take in order to avoid or cure a depression."

      - Has it occurred to Keynesians that at zero interest rate, value of any risk free investment with any rate of return is theoretically infinite; so assets can suck in all the liquidity - which is supposed to have driven goods and services sectors?

    4. Commentedradek tanski

      Hey ... but maybe it's actually the repeated interventions from government to lower interest rates, print money, and guarantee and protect the "good guys" which makes increasingly unstable deleveraging cycles necessary in the first place? Just saying.

      Maybe these pro gov intervention economists are looking for some taxpayer payola for their academic tenure.

      Maybe if the banks, who have the most to lose and and had the most interest in preventing their money being lost, were allowed to decide interest rates, and not forced to buy junk gov deficit spending, then maybe this wouldn't happen.

      Maybe you just can't outsmart the economy but trying out new tricks to get something for nothing.

        Portrait of J. Bradford DeLong

        CommentedJ. Bradford DeLong

        I have never been able to make such stories work, quantitatively. I would be interested in a pointer to others who have been trying and succeeding better than I have been...

    5. CommentedProcyon Mukherjee

      The best example of 'prolonged liquidation' is Japan, where for almost a decade monetary policy has stayed near zero lower bound, thus making debt more attractive than money; the zooming of debt to GDP ratio, while it was zooming had no direct correlation with job growth while prices have stayed dampened throughout. If this is a successful model to emulate, then so be it, specially when demographics would further come in the way of providing solutions, as is the case with Japan.

      We have seen how monetary transmission beyond a point has its limits to move into goods and services that create jobs; rather it moves to inflate some assets at the cost of the other; a retraction or contraction or the dozing amount makes this movement oscillatory.