Greg Mankiw was in the New York Times last week (May 7, 2011) admitting that “(a)fter more than a quarter-century as a professional economist” he has “a confession to make: There is a lot” he doesn’t know about his claimed principle area of expertise – “the ups and downs of the business cycle” – aka macroeconomics. I thought it was an interesting article because it raises a basic issue. The questions you ask reflect the framework you begin with. Some questions that are puzzling within a particular framework of analysis actually tell us that the framework is deficient rather than the questions being interesting. Anyway, in responses to his questions – here are some answers.
In his article – If You Have the Answers, Tell Me – he lists three uncertainties:
1. How long will it take for the economy’s wounds to heal?
2. How long will inflation expectations remain anchored?
3. How long will the bond market trust the United States?
I suppose after 25 years of writing within the New Keynesian mould where most of the workings of the monetary system are essentially abstracted from (denied) and teaching students in your textbook that the central bank controls the money supply and budget deficits are inflationary that you might be a little confused about what is going on at present.
If you then take into account that Mankiw and his ilk preached that the problem of the business cycle was largely solved by inflation targetting monetary policy and passive fiscal policy, I guess the crisis and its aftermath would be confounding.
The “Great Moderation” is a term used by mainstream economists to describe the fact that both GDP growth and inflation were less volatile in the period from the mid-1980s to the onset of the financial crisis.
They concluded that the “business cycle was dead” and that the main focus on policy should shift away from trying to manage aggregate demand so that economies provided enough jobs (why: because the self-regulating market would take care of that) and concentrate on freeing up markets and providing incentives for enterprise. This notion was called the “Great Moderation”.
The problem is that the Great Moderation was in fact a delusional period where central bankers were elevated to the level of gods and economists intensified their lobbying for financial and labour market deregulation.
The mainstream macroeconomists increasingly tried to claim in the 1990s and up until the recent crisis that they had “won” – been vindicated and those misguided Keynesian policies would never see the light of day again.
The arrogance and short-sightedness of this viewpoint is exemplified in the 2003 presidential address to the American Economic Association by Robert E. Lucas, Jnr of the University of Chicago:
My thesis in this lecture is that macroeconomics in this original sense has succeeded: Its central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades. There remain important gains in welfare from better fiscal policies, but I argue that these are gains from providing people with better incentives to work and to save, not from better fine tuning of spending flows. Taking U.S. performance over the past 50 years as a benchmark, the potential for welfare gains from better long-run, supply side policies exceeds by far the potential from further improvements in short-run demand management.
The Great Moderation became the norm in mainstream economics and further distracted them from seing what was really going on in financial markets which ultimately manifested as the global financial crisis.
Please read my blog – The Great Moderation myth – for more discussion on this point.
Mainstream economists started to concentrate on increasingly banal and crazy research programs and Mankiw’s work in this period was no exception.
His models were developed within the New Keynesian tradition which is in a line of models dominates teaching within universities but is mostly inapplicable to a fiat monetary system.
It is a concoction of classical theory of value and prices, late C19th marginal theory and monetary theory, and more recent add-ons to the free market models of the classics – the New Keynesian “frictions”. Gold Standard reasoning (or the convertibility that followed) is deeply embedded in the framework.
New Keynesian economics assumes a government budget constraint works as an ex ante financial constraint on governments analogous the textbook microeconomic consumer who faces a spending constraint dictated by known revenue and/or capacity to borrow. It then imposes on this fallacious construction a range of assumptions (read: assertions – assumptions can usually be empirically refuted) about the behaviour of individuals in the system and generally concludes, that even with frictions slowing up market adjustments, free market-like outcomes will prevail unless government distortions are imposed.
That body of analysis and teaching is a disgrace and would not prepare anyone to answer the three questions posed above in any coherent way.
Please read my blog – Mainstream macroeconomic fads – just a waste of time – for more discussion on this point.
But the “Great Moderation” overlooked that asset prices were increasingly not sending satisfactory signals to entrepreneurs interested in investing in real productive capacity and thus distorted the use of investment funds towards speculative financial assets.
Moreover, with aggregate policy now maintaining a buffer stock of unemployment to discipline the inflation process and fiscal policy behaving in a largely passive manner (to support the “inflation first” monetary policy ideology), economic growth became increasingly dependent on credit growth to drive mass consumption.
This reliance was also driven by the fact that the push for deregulation suppressed real wages relative to productivity growth thus redistributing real national income towards profits. That dynamic both placed more real income in the hands of the financial sector to engage in its casino-antics and meant that consumers had to borrow to continue to maintain growth in spending.
So while the economists were sitting around congratulating themselves while sipping chardonnay about how they had solved the problem of the business cycle, the build up of debt and the increasingly risky speculative behaviour was guaranteeing that the next crisis would be very significant – it was only a matter of time.
Mankiw and his fellow mainstream economists were oblivious to these developments. However, they were central to the body of work that Modern Monetary Theory (MMT) was offering – even as far back as the mid-1990s. We were warning about the early build up of debt and the generation of fiscal surpluses.
Please read my blog – The origins of the economic crisis – for more discussion on this point.
What the “Great Moderation” left us with was a major financial collapse leading to a collapse in private spending and the recession that ensued. Along the way it created a huge private debt burden and increasing income inequality.
So it is little wonder that Greg Mankiw is now admitting he hasn’t got much idea of what is happening at present.
Here are some pointers to help him answer his questions.
1. How long will it take for the economy’s wounds to heal?
Mankiw says that “(w)hen President Obama took office in 2009”:
… his economic team projected a quick recovery from the recession the nation was experiencing.
We can all agree that the “reality has turned out not nearly as rosy”. Growth is well below what was forecast which are now being downgraded not upgraded.
Unemployment is now entrenched at high levels and will remain at those levels for years at the rate things are going.
The US now has a long-term unemployment problem of the likes it has not seen before. It used to be said that one of the distinguishing features of the US relative to other advanced nations (particularly in Europe) is that the US never suffered lengthy periods of entrenched unemployment. Sure enough it experienced large swings in activity but the labour market recovered relatively quickly (compared to say Europe).
Now the sclerosis that has haunted Europe for many decades (largely because of the conservative nature of economic policy there) is bedevilling the US.
No surprise about that.
Mankiw compares the recovery in the 1981-82 US recession with that of the current period and says that “there is no doubt that the pace of this recovery will come nowhere close to matching the one achieved” in the 1981 episode.
The following Table is constructed from historical data available from the US Office of Management and Budget and shows the revenue and spending (and deficits) as a percentage of GDP for the periods: 1981-1984 and 2007-2010. The exact timing of the respective recessions is not perfect (given this is annual data) but it does give some impression of what happened.
In the 1981-82 episode, the fiscal response was more significant (and the loss of revenue less severe). The scale of the more recent recession has been clearly more intense and the fiscal response required was larger than in 1982. That did not occur and goes a long way to explaining why the recovery is tepid and drawn out.
The fact is that the attempts by the mainstream economists to reassert themselves in the popular debate after being caught out completely by the ferocity of the downturn has led to renewed calls for fiscal conservatism and the imposition of pro-cyclical responses by governments. The politics has overtaken the economics and governments are now withdrawing fiscal support at a time when private spending remains fragile.
So the combination of a timorous fiscal response – which appears to have been just enough to ward off a Great Depression 2 outcome – and the premature fiscal withdrawal – are largely the reason why the recovery is weak and teetering.
Mankiw worries about the rise in long-term joblessness and the loss of job skills associated with that. He says:
But because we are in uncharted waters, it is hard for anyone to be sure.
The mainstream economists consider long-term unemployment to be a supply-side problem. As a consequence they have focussed labour market policy on training and full employability rather than creating enough jobs – the OECD Jobs Study approach which only emphasised the “supply-side” and overlooked the fact that tight fiscal and monetary policy were suppressing the demand side.
The neo-liberal assertions were highly influential in the design of the 1994 OECD Job Study which influenced governments everywhere and led to the supply-side policy approach (and the abandonment of full employment). The principle claim was that long term unemployment possessed strong irreversibility properties. Irreversibility is sometimes referred to as hysteresis and suggests that the long term unemployed constitute a bottleneck to economic growth which can only be ameliorated through supply-side (rather than demand-side) policy initiatives.
The research that has studied this issue has found no evidence that there had been any major structural shifts in the relationship between long-term unemployment and total unemployment. The sharp rises in long-term unemployment occurred as a consequence of drawn out recessions.
All the dynamics of the long-term unemployment rate are demand-driven. They defy efforts to construct them as steady structural shifts driven by behavioural supply-side changes (say to welfare policy etc).
History shows that when economic growth is strong enough employers access both pools of unemployed – short-term and long-term. This is contrary to the claim by mainstream economists who typically consider long term unemployment to be highly obdurate in relation to the business cycle and thus a primary constraint on a person’s chances of getting a job.
Please read my blog – Long-term unemployment rising again – for more discussion on this point.
So the answer to long-term unemployment is to provide enough jobs. Where skills are lacking the research evidence is also fairly clear – effective on-the-job training is best achieved within a paid-work environment – that is, on the job actually working.
But for jobs to be created there has to be demand. That is the major problem in the US – insufficient public spending given the reluctance of the private sector to come to the party.
2. How long will inflation expectations remain anchored?
The fear of inflation is a familiar theme of the mainstream literature and has underpinned its concentration on inflation-first monetary policy and the eschewing of activist fiscal policy (at least net spending initiatives that aim to support demand).
It is clear that nominal contracts (which include prices) can be driven by inflationary expectations and that can be a self-fulfilling outcome.
Mankiw says that:
Fed policy makers are keeping interest rates low, despite soaring commodity prices. Why? Inflation expectations are “well anchored,” we are told, so there is no continuing problem with inflation. Rising gasoline prices are just a transitory blip.
They are probably right, but there is still reason to wonder.
I personally think that strains on energy resources will drive the price of petrol up over the next several years – I outlined my views on the shifting composition of energy demand in this blog – Be careful what we wish for …. I think the days of cheap petrol and private transport are over for the advanced nations.
I consider that a separate problem to controlling a demand-driven inflation. Central banks cannot really put a lid on imported inflation (via petrol prices) without severely damaging domestic activity.
Inflationary expectations are probably more driven by the ability of the price setters to pass on perceived current or future cost pressures. With massive excess capacity in labour markets around the globe it is very difficult to mount a case that workers will be in a position to really prosecute wage demands sufficient to drive an inflationary spiral.
So I am skeptical of the oil hikes being transitory – but if they are not major structural change will be required (moving away from oil-based production and transport). In the meantime I consider the lack of economic growth to be sufficient to quell the development of spiralling inflationary expectations.
3. How long will the bond market trust the United States?
Posing this question really gives the game away.
When hasn’t the “bond market” trusted the US?
Mankiw says that it is a:
… remarkable feature of current financial markets is their willingness to lend to the federal government on favorable terms, despite a huge budget deficit, a fiscal trajectory that everyone knows is unsustainable and the failure of our political leaders to reach a consensus on how to change course. This can’t go on forever — that much is clear.
It can go on forever because not everyone “knows” the budget deficit is “unsustainable”. The bond markets clearly do not have the same model as the mainstream economists consider them to use.
The fact is that the bond markets need government debt not the other way around. The requirement that the US federal government issue debt to match its net spending is voluntary only.
In financial terms, there is no such requirement. The US government knows that and the bond markets know that. If at any point, the bond markets considered they had more “power” than they actually have and started to make life difficult for the US government (under the current arrangements) those voluntarily-imposed requirements would change very quickly.
Japan has had larger deficits to match against public debt issuance for two decades now and they have never had any trouble finding purchasers despite near zero yields over that time.
Please read my blog – Who is in charge? – for more discussion on this point.
Mankiw then really becomes tragic:
Less obvious, however, is how far we are from the day of reckoning … [the bond market] … trusts our leaders to get the government’s fiscal house in order, eventually, and is waiting patiently while they exhaust the alternatives.
But such confidence in American rectitude will not last forever. The more we delay, the bigger the risk that we follow the path of Greece, Ireland and Portugal. I don’t know how long we have before the bond market turns on the United States, but I would prefer not to run the experiment to find out.
He will die wondering.
But in conflating the US with the EMU nations really provides an insight into why Mankiw is puzzled and asking these questions. The US has zero risk of following in the path of Greece, Ireland and Portugal.
The reason is obvious – they operate different monetary systems. The US is a sovereign issuer of its own currency, the other three nations surrendered that luxury when they joined the EMU and operate using a foreign currency (the Euro).
There is no legitimate comparison between nations that operate within a fiat currency system where the sovereign state has the monopoly on currency issuance and nations that operate within the Eurozone.
The questions that Mankiw is asking reflect that fact that the economic framework he is operating in considers that there is a US risk of insolvency.
That should be his fundamental question: Why use a framework that is in denial of the basic reality of the monetary system?
If there is no risk of default arising from financial considerations and the federal government can always fund itself without recourse to the bond market – then other questions not asked by Mankiw become more compelling.
Such as: how to design an adequate employment-rich fiscal intervention to ensure there is full employment at all times.
Most of the denial that is around at present among economists arises from the fact that their tool box is insufficient to understand what has actually happened. I sense that there is a lot of ad hoc work going on at present – tinkering around the edges of New Keynesian models to try to incorporate the financial sector more realistically etc.
This work will remain fundamentally flawed because the intrinsic nature of these models is inapplicable to the world that we live in. It would be better – in this spirit of admitting there are things that are not known – to abandon those frameworks and adopt frameworks that not only predicted the crisis but can more consistently explain what is going on.
It is clear that the economy is riddled with uncertainty and there are lots of guesses and judgements that we make as economists in forming views of the future.
But the questions we ask about the uncertainties should be conditioned by a sound understanding of how the monetary system operates and differences between monetary systems.
It is a waste of time to ponder whether a nation like the US faces insolvency risk just because Greece does.
It is a waste of time designing responses to ward of a bond market strike when those responses damage economic growth and are based on the false assumption that the bond market matters much.
The questions Mankiw says are puzzling him just arise from an inadequate framework of analysis. That is where I would be putting my effort.
I have run out of time today. I am travelling this afternoon. Tomorrow, my blog will be late and will probably be a short commentary on the Australian federal budget which is presented tomorrow night (19:30). But I won’t get back from my current travels until late tomorrow so the blog will be delayed.
That is enough for today!