Bookblogging:The Failure of the Great Moderation

Another section of the Great Moderation chapter from my book. I’m getting a lot of value from the comments, both favorable and critical, so please keep them coming.

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Failure

Whether it was a real economic phenomenon or a statistical illusion, the Great Moderation, considered as a pattern of long expansions punctuated by brief and mild recessions, is clearly over. In retrospect, it was over by the time its discovery was announced in the early 2000s. The recovery from the 2001 recession was not, as advocates of the Great Moderation supposed, the beginning of a third long expansion in the United States. Rather, it was weak, short-lived and overwhelmingly driven by the unsustainable bubble in housing prices and the expansionary monetary policies of Greenspan and Bernanke. The expansion lasted only six years, and it was four years old before total employment regained the pre-recession peak. All of the employment gains of the expansion, and more, were wiped out in the first few months of the global financial crisis.

The US experience was fairly typical of the developed countries. While some, such as Australia and Canada did rather better, others such as Ireland and Iceland suffered economic meltdowns with output losses in excess of 10 per cent. 

But it is not sufficient to point out the obvious fact that the Great Moderation is finished. The thinking that made so many economists willing to endorse claims that the business cycle had been tamed by financial liberalisation remains influential and is implicit in many arguments about policy responses to the Crisis. So it is important to understand why the Great Moderation hypothesis was so badly wrong. 

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The dissenters

While the boom persisted, the view that the Great Moderation was the product of unsustainable policies received little attention. It was espoused only by old-style Keynesians, a relatively marginal group on the left of the economics profession, and members of the Austrian School, a fringe group on the right. While the two groups agreed in offering a negative prognosis, they differed radically regarding both diagnosis and proposed cure.

 Keynesians argued that, without adequate regulation, financial instability was inevitable. This view was part of the assumed background for Keynesians of all kinds, but it was particularly stressed by the post-Keynesian school associated with the late Hyman Minsky.  

Minsky focused on the instability of credit and investment processes in a market economy and argued that capitalist financial systems are inherently unstable because large swings in investor expectations tend to occur over the course of the economic cycle. He argued that in a recession, expectations are subdued. As the recovery gathers pace, profits rise and balance sheets are restored. Caution remains for a period, reflecting memories of the previous downturn. As the economy continues to grow, perhaps spurred further by technological breakthroughs or unexpectedly high rates of growth, profits are rebuilt and expectations of future growth begin to rise. Caution begins to recede. Increasingly, animal spirits are stirred and banks begin lending more freely and credit expands. Even cautious investors are encouraged to join the upward surge for fear of forfeiting profit opportunities. Momentum builds behind what Minsky referred to as the “euphoric economy.” This attracts highly leveraged asset speculators–Minsky called them “Ponzi financiers”–who rely on rising asset prices to service debt and who drive the market further upward. Increasingly, the market is dominated by speculation about sentiments and movements in the market rather than about fundamental asset values.

Minsky’s work became a standard namecheck for Keynesians writing about financial crises past, present and future. For example, Charles Kindleberger used Minsky’s model as the basis for his study Manias, Panics, and Crashes, declaring that “the model lends itself effectively to the interpretation of economic and financial history. In my own work with political scientist Stephen Bell, I noted that the main obstacle to broader acceptance of Minsky’s work was the lack of a formal derivation from microeconomic foundations (see Ch …) and concluded that ‘Another significant cycle of asset price movements, especially in one of the major economies, could see a fundamental revision of thinking about the costs and benefits of liberalized financial systems.’

While Keynesians argued that instability is inherent in weakly regulated financial systems, economists of the Austrian school generally claimed that the business cycle was the product of government intervention, and particularly of central banking. This view was derived from the work of Friedrich von Hayek and Ludwig von Mises, economists who were literally Austrians by birth. But if the Austrians agree on the evils of central banking, they disagree on almost everything else. Some, endorsing the judgement of the mainstream economists who awarded Hayek the Nobel prize in economics, see him as having far surpassed the initial contributions of his teacher von Mises.  Others see von Mises as the true source, and his American student Murray Rothbard as his intellectual heir. 

The disagreements don’t stop there. Some Austrians, despite generally rejecting government, favor a government-enforced gold standard and the prohibition of fractional reserve banking (the system by which banks lend out most of the money deposited with them, retaining only a fraction to meet the needs of depositors who wish to withdraw their funds). Others advocate ‘free banking’ with no government role of any kind, a position which is perhaps more intellectually consistent, but somewhat undermined by the observation that free banking systems have been tried and failed (the 1890s boom and bust in Australia is a particularly clear-cut example.

Whatever their disagreements and theoretical limitations, Keynesians and Austrians mostly got it right as regards the bubble economy of the decade leading up to the crisis. This is not to say that they predicted the timing and course of the crisis in detail. It is in the nature of bubbles that their bursting is unpredictable and has unpredictable consequences. Even the most accurate prophets, such as Nouriel Roubini of the Stern School of Business focused more on international imbalances and unsustainable housing prices rather than on the largely opaque superstructure of financial transactions that financed and magnified these imbalances.

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Was there really a Great Moderation?

The abrupt end to the Great Moderation raises anew the question of whether it was a real phenomenon or an over-optimistic interpretation of the data. Even when the Great Moderation was generally accepted, it was not the only interpretation put forward. In a paper published by the Brookings Institute in 2001 Olivier Blanchard of MIT and John Simon of the Reserve Bank of Australia argued that the data implied a long-term decline in volatility since the 1950s, interrupted temporarily in the 1970s and early 1980s.

 Although this interpretation fitted the data as well as the standard view, it was not widely accepted.The reason is obvious enough. A statistical test suggesting that the economy was much more volatile in the 1950s and 1960s than in the 1990s is hard to accept in view of the actual experience of the postwar boom as a period of strong growth and low unemployment. If measures of volatility contradict this experience, the obvious response is to suggest that they must not be measuring the right thing. 

But if data on quarterly volatilty can so easily be used to derive results that are so obviously problematic, this must cast doubt on their use to support the standard Great Moderation story. It is therefore worth looking more closely at the measures and their interpretation.

The first difficulty with a focus on the volatility of output growth is that it takes no account of changes in the average rate of economic growth. Looking at US growth rates, for example, the standard deviation of the rate of economic growth was 2.0 per cent in the 1960s, as compared to 1.5 percentage points in the 1990s. This seems to support the usual story suggesting a decline in volatility

But the average rate of output growth was 4.3 per cent in the 1960s, and only 3.0 per cent in the 1990s. So, expressed relative to the average growth rate, volatility was actually lower in the 1960s. 

A second problem is that  quarterly volatility measures are sensitive to relatively short-term fluctuations (in the statistical jargon, this is called high-frequency volatility). The same is true of the NBER measure which defines a recession as a downturn lasting a few quarters. These measures have their advantages, but they miss some critical features of the cycle.

Although the post war boom was characterised by relatively frequent recessions these recessions were not felt as being particularly severe because they were typically followed by rapid and strong recoveries – they had to be, given the high average rate of economic growth.

The recoveries following the recessions of 1990-91 and 2001 were different, so different that the term ‘jobless recovery’ was coined to describe them. Well after output had begun to recover, employment kept falling and unemployment kept rising. In each case the recovery in output was sufficient to constitute a recovery according to the popular ‘negative growth’ definition, and also according to the somewhat broader criteria used by the NBER.  But to the average person, the early years of these expansions felt much like recessions.

President George HW Bush was among the first casualties of the new-style business cycle. By the time of the 1992 US election, the economy was about 18 months into an expansion, according to the standard measures. But Bill Clinton, campaigning on the slogan ‘It’s the economy, stupid’ was able to capitalise on the actual experience which was that of continuing depressed conditions.

The same experience was repeated after the 2000 recession.

The jobless recovery phenomenon was not confined to the US. In Australia, for example, the economy went into recession in 1989 and, on the standard measures, began a renewed expansion in 1990. But unemployment peaked at … in … and did not regain its 1989 levels until … , … years into one of the longest expansions on record. 

As in the US, … The Labor government that had presided over the recession managed to scrape back into office in 1993. By 1996, with an expansion more than five years old, and unemployment rates finally declining, Labor hoped to be rewarded for the recovery. But the opposition parties judged the public mood more accurately, arguing that ‘five minutes of economic sunshine’ was no reward for what was popularly perceived as a multi-year recession.

But if the standard measures of quarterly volatility did not match the experience of workers in general, they fitted very neatly with that of participants in financial markets. For these groups the recessions were periods of severe les

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Individual and aggregate volatility

Economic analysis of the Great Moderation showed a striking paradox. Even though economic aggregates appeared to be more stable than at any time in the past, individuals and families experienced ever-increasing risk, volatility and instability. Risk has, it seems, increased in every dimension. Income inequality has grown substantially, in part because income mobility has increased, but also because lifetime income has become more risky. Short term variability in income has also increased.

This is a surprise. Since aggregate income Is just the sum of all individual incomes, it would seem that an increase in individual risk should translate into an increase in the riskiness of aggregate income, even allowing for the fact that some gains and losses will cancel out.

Economic analysis of the paradox came to the conclusion that the development of financial markets had weakened links between economic variables such as income and consumption. Faced with a decline in income, households could borrow to maintain their consumption levels. As a result, the flow-on impact of a shock in one sector of the economy to consumer demand for the economy as a whole was reduced. This meant that high levels of volatility in individual incomes could co-exist with aggregate stability.

But, was such a pattern sustainable? If variations in income are transitory, then borrowing to maintain living standards through a rough patch makes sense. But responding to a permanent decline in income by going into debt is a recipe for disaster. And it’s obviously difficult to tell in advance whether an income decline is going to be temporary or permanent.

Not surprisingly, as income volatility increased, so did the number of people who got into trouble by relying on borrowing. The most direct measure is the number of people filing for bankruptcy. This has increased in most English-speaking countries, but nowhere more than in the United States. In the early years of the 21st century, more than 2 million people declared bankruptcy every year. In fact, in these years, Americans were more likely to go bankrupt than to get divorced. The commonest immediate causes of bankruptcy were job losses and unexpected health care costs. But the underlying cause was a culture of indebtedness which meant that most people who experienced financial stress rapidly ran into trouble meeting existing commitments.

In 2005, the credit card industry hit back at the rising bankruptcy rates with the Bankruptcy Abuse Prevention and Consumer Protection Act, which put a number of obstacles in the path of people seeking to resolve their debt problems through bankruptcy. In the year before the law came into effect, over two million households rushed to file. In the months immediately following ‘reform’, bankruptcies dropped almost to zero, and remained well below those of the pre-reform period for several years. But the pressures of increasing debt meant that many people had no choice but to negotiate the newly established obstacles to declaring bankruptcy, and the numbers doing so gradually increased. 

The onset of the financial crisis was initially reflected more in foreclosures than in bankruptcies. Most mortgages in the US are (legally in some states and de facto in others) non-recourse, which means that, after foreclosing on the house offered as security creditors cannot go after the other assets of the borrower. This means that, even if a foreclosure yields far less than the amount owed, the borrower’s obligations are discharged. For this reason, as long as the crisis was primarily confined to housing markets, bankruptcy rates rose only gradually. But, with the onset of high unemployment, and the end of easy access to credit of all kinds, bankruptcy rates soared in early 2009. It now seems likely that the number of bankruptcies in 2009 will be more than 1.5 million, exceeding all previous years, except for 2005 when people were rushing to beat the deadline of bankruptcy reform.

Despite the volatility of individual income, and the risks of relying on credit markets, economists focused on macroeconomic aggregates continued to celebrate the Great Moderation right through 2007.  2008 came as a rude shock.

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The GFC

The Great Moderation has vanished with surprising rapidity, though in retrospect its unsustainability has been evident since the late 1990s.

Bernanke’s Great Moderation hypothesis was not the first claim that the business cycle had been tamed, and it is unlikely to be the last. Every sustained period of growth in the history of capitalism has led to the proclamation of a New Era, in which full employment and steady economic growth would continue indefinitely. None of these proclamations has been fulfilled. 

But, even by the unexacting standards of past economic projections, the Great Moderation has been one of the more spectacular failures. The Golden Age of Keynesianism lasted three decades, and delivered big increases in living standards throughout the developed world. 

By contrast, the Great Moderation in the US didn’t really begin until the end of the first Bush recession in the early 1990s, and almost collapsed in the dotcom crash of 2000. It was only the reckless monetary expansionism of Bernanke’s predecessor, Alan Greenspan, that reinflated the bubble economy of the 1990s, and paved the way for an even more disastrous crash a few years later.

It is clear that the global economy is undergoing a severe recession, which will generate a substantial increase in the volatility of output. But even the economy recovers in 2010, as is suggested by some optimistic forecasters, crucial elements of the Great Moderation hypothesis have already been refuted. Over the period of the Great Moderation, all the major components of aggregate output (consumption, investment and public spending) became more stable. By contrast, any recovery will be the result of a massive fiscal stimulus, with a huge increase in public expenditure (net of taxes) offsetting large reductions in private sector demand.

The crisis has also invalidated most of the popular explanations for the Great Moderation. As will be discussed in more detail in Chapter …, the idea that improvements in monetary policy have been a force for economic stabilization looks rather silly, now that a crisis generated within the financial system has brought about a crisis against which the standard tools of monetary policy, based on adjustments to interest rates, have proved ineffective.

 It is to the credit of central banks that, when their standard tools failed, they were willing to adopt more radical measures such as quantitative easing (that is, printing money and using it to purchase securities such as government bonds and corporate paper). Such radical steps, which contrast sharply with the passive response to the financial shocks of the Great Depression, have helped to prevent a complete meltdown of the financial system. But willingness to abandon failed policies does not change the fact of failure.

But if the pretensions of central banks have been shaken, those of financial markets have been utterly discredited. There is now no reason to give any credibility to the view that financial markets provide individuals and households with effective tools for risk management. Rather, in aggregate, the unrestrained growth of financial markets has proved, as on many past occasions, to be a source of instability and not a stabilising factor. 

Just as the failure of the efficient markets hypothesis has destroyed much of the theoretical basis of the policy framework dominant in recent decades, the collapse of the Great Moderation has destroyed the pragmatic justification that, whatever the inequities and inefficiencies involved in the process, the shift to economic liberalism since the 1970s delivered sustained prosperity. If anything can be salvaged from the current mess, it will be in spite of the policies of recent decades and not because of them.

 

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China and India

In the wake of the GFC, some advocates of economic liberalism have sought to shift the ground of debate, arguing that, whatever the impact of financial globalisation on developed countries, it has been hugely beneficial for India and China which, between them, account for a third of the world’s population. 

There are all sorts of problems with this argument.

The relatively disappointing economic performance of China and India in the postwar decades certainly provides strong grounds for criticising the economic policies of Mao Zedong and Nehru. But even in the days when some observers saw these policies as providing an appropriate development path for the countries that adopted them, no one seriously proposed their adoption by developed countries. And as more attention has been focused on the irrational aspects of these policies (such as the Great Leap Forward, in which people were made to melt down their cooking pots to provide scrap for backyard smelters, which presumably produced new cooking pots, or the dozens of licenses required to undertake the simplest economic activity in India) it has become easier to understand why their removal or relaxation 

At the same time, neither of these rapidly-growing economies come anywhere near meeting the standard description of a free-market economy. China still has a huge state-owned enterprise sector, a tightly restricted financial system and a closely managed exchange rate. India began its growth spurt before the main period of market liberalisation and also retains a large state sector. In both countries, as earlier in Japan and South-East Asia, the state has played a major role in promoting particular directions of development.

In summary, while the development success stories of China and India, and, before them of Japan and the East Asian tigers, may have some useful lessons for countries struggling to escape the poverty trap, they can tell us nothing about the relative merits of economic liberalism and social democracy.

140 thoughts on “Bookblogging:The Failure of the Great Moderation

  1. Also Tim – there is nothing whatsoever to suggest recurrent or non recurrent government spending is “not politically feasible” to stimulate demand… Says who?

  2. There seem to be four things under discussion here: a) volatility of aggregate output; b) volatility of individual income; c) lost output due to underemployment of resources; d) the rate of economic growth. No doubt there are individuals who push further, but at a first cut the Great Moderation claim has to do with a) and perhaps c) — except that we never talk about excessive output due to overemployment of resources, though we do tend to think that booms are in some sense excessive — and b) — bearing in mind that there are many other sources of individual volatility. In the really long run growth is a matter of advances in technology, and doesn’t have much connection with volatility. In the sort of long run growth may result from rapid capital accumulation, which was probably the case in the post war period, and again the relationship with volatility is tangential, though it is an important point that tight regulation of banking and Keynesian policies didn’t impair accumulation. This is all at least a bit controversial, so your views might be a bit different, or more than a bit, but I think the chapter needs to step back and take a more explicit stance on the causal connections here.

  3. Alice,

    Milton Friedman and the Gruen-Shuetrim model of the Australia both found 1 year peak lags from monetary impulses to nominal GDP.

  4. @Tim Peterson
    That doesnt surprise me Tim but a peak lag is only a peak lag…and of the rest of the lag? According to this link which I will post below – the peak effect on inflation unfolds at two years, the effect on output takes a year and a half to peak but three years to fully unwind. Peak effect is not the full effect Tim. In addition, I doubt whether Professor Friedman took into account Prof Keynes’s animal spirits (in particular low spirits), much preferring to focus of rigidities in wages and prices for a reason why Monetary Policy not be quite so quick to take effect as first imagined or modelled..
    http://economistsview.typepad.com/economistsview/2006/05/lags_in_monetar.html

    as they say…you can lead a horse to water but..

  5. @Tim Peterson
    Then Tim – from this, your link…might suggest fiscal policy has a longer more sustained effect, than Monetary policy, which might only be a short term fix.?

  6. Tim Peterson, whilst Japan experimented with quantitative easing between 2001-06 it was the surge in oil prices and exports to China’s which were more or less ended deflation and improveed Japan’s economy.

  7. Alice,

    If you want longer term effects from monetary policy you can just move interest rates from neutral for longer (not too long or you will get cumulative inflation/deflation). A VAR impulse respose involves using the estimated policy reaction function after the initial impulse; you don’t need to do that in practice.

    Michael: I can’t track down Japanese GDP figuires but I seem to remember that recovery started in the early 2000s before the oil price hike. Leading experts like Ben Bernanke, Ben McCallum and Anna Schwartz all agree that quantitative easing works.

    In particular, monetary growth analogous to quantitative easing was what used to end deflationary recessions in the gold standard era.

  8. @Tim Peterson
    Tim – I question your devotion to monetary policy. It has been the major focus of policy makers since the mid 1970s along with the one eyed focus on inflation and the complete turning away from any real concern over unemployment. Interestingly the abandonment of the focus on full employment from the 1970s on in Australia and other nations, and the moving away from the role of the government in this country (and probably others) as an active employer saw unemployment jump sharply to a new higher normal level from the mid 1970s on and it has continued an fairly strong upward drift. I would go so far as to suggest that someone needs to specifically investigate the tax changes that occurred in the tax year ended 1976 and other overly generous concessions granted in the form of income tax cuts.

    I suggest that the emphasis on the only “acceptable form of fiscal policy is lower taxes” as this paper, you cited, proposes (and even the paper itself acknowledges that the deficit burden of lower taxes in the longer term cannot be taken into account in the study or estimated (and we do now have large deficits in many industrialised nations). The paper also cites other works that found contrary to your paper than government spending does provide a significant stimulus.

    I also note the UK has recently raised the top income earners income tax rate and some hedge fund managers are leaving for Switzerland. That might not actually be a bad thing.

  9. Alice,

    You seem to be suggesting long run non-neutrality for monetary policy in your comentary on the 1970s; if so, you are on your own in the modern era! I can dig up evidence for money neutrality if you so desire: there is a hell of a lot of it and it would take me a while to wade through it.

    Layard, Jackman and Nichol’s book on unemployment is one such study. They find money is neutral (ie the Philip’s curve is in the vertical long run) and attribute the higher NAIRU in Europe in the 1980s to demographics, and micro-level phenomena.

    Estimated policy reaction functions of modern central banks (eg the Taylor rule) typically find that there is a weight of .3 to .5 on estimated output gap; a 1% decrease in output relative to potential causes central banks to lower interest rates by .3 or .5 percentage points. This does not indicate lack of concern over unemployment.

  10. Tim Peterson, my reading suggests Japan adopted quantitative easing was too late and that growth in the 2003-07 period was export driven due to strong external demand for Japanese goods especially from China which grew from 10% in 2002 to 15% in 2007.

  11. @Tim Peterson

    I dont think I am on my own Tim. Not at all in the modern era!. In all honesty your so called “modern era” has a lot of questions to answer when it comes to the effectiveness of policy.

    I dont think the “monetary policy focus” has been neutral at all. It is not the only tool in the tool shed but you would think so after the past three decades….and one wonders why???…could it just be that a low inflation environment helps the rich more than the poor and a low unemployment environment helps the poor more than the rich….no that couldnt possibly be the reason for the love affair with all things monetary… could it Tim? And it couldnt be because if governments are not spending on public goods and services (which help the poor and created jobs for them), the rich can save more on income tax…no that couldnt possibly be the reason could it Tim?

    Start digging up your evidence Tim when unemployment has been climbing since the mid 1970s and has been twisted to exclude nearly every demographic looking for more than one hours work a week and most of the new school leavers as of recently (its a disgrace how this number has been toyed with and legislation changed to give workers a pittance in weekly hours – some politicians clearly must think the ordinary person is a fool – well not fool enough).

    And Tim, no I wont accept that we need to get “used to a higher Nairu” as Prof Friedman and friends thought necessary to tell us all at some point…but this is getting a tad tiring and I am losing my patience now. I dont think many people want more of the same and although you are doing a sterling job trying to convince me with a Bernanke text, its time for a change.

  12. @Tim Peterson
    On the Taylor Rule….has anyone in the central bank noticed its not working that well in regard to unemployment (or has unemployment been amputated completely from any idea of output gaps)? Not working here and not in the US obviously.

  13. And anyone who claims to have tamed the business cycle has taken his hands right off the wheel and is admiring his own reflection in the mirror IMHO.

  14. Alice,

    I do not appreciate the tone of your last post; please keep things civil!

    Money neutrality means that monetary policy has no lasting impact on real variables. If you aren’t alone in disputing this, could you provide a citation of empirical research post 1970 that agrees with you?

    Until this year, unemployment has been lower in Australia, the UK and the US than it was in most of the 1970s.

    Inflation hurts the savings of lower income people who hold their money in bank deposits. Higher income folk own equities and real estate that keeps pace with inflation.

    The NAIRU can be lowered by micro policy/active labour market programs.

  15. Surely Greenspan has refuted money neutrality? Can anyone believe in money neutrality after his mismanagement? Bubbles and crashes cause misallocation and other wastes of resources and as a consequence affect real variables. You never regain all that was lost, therefore the consequences are permanent. The studies that get published often are more a reflection of the econometrician’s priors, than anything, and it hasn’t been fashionable to believe or publish other than what became the new dogma anyway.

  16. @Tim Peterson
    Tim…how do we pay for “an active labour market micro reform policy?” Ill hazard a guess on what you might suggest…. More tax cuts for business? Only today if you notice, Bernanke is suggesting “we have to tolerate higher levels of unemployment”

    ….what? Yet again? Higher still? I would have thought, and so would most sensible ordinary people, unemployment is too high already. Its way past time we gave up the over reliance on monetary policy and the power of the mythical tax cut. Its an outright nonsense and its bearing heavily in growing tides of unemployed.

    I hear you say that in the US “the Okun relationship between the output gap and unemployment has broken down.” Thats just a convenient excuse to ignore unemployment to deliver spurious monetary and tax policies that continue to keep the wealthy classes in comfort and make the rich even richer, fuel growing inequalities, at the expense of a rising tide of poor.

    My solution is far better. Increase the taxes on upper income earners and corporate entities like the UK is doing to fund the welfare programs, pay for the deficit and the bail outs, to keep people feeding their families and travelling on the bus looking for jobs which these trickle down theories failed to deliver increasingly over the past twenty years. Use the money from higher income taxes to fund government infrastructure projects that keep people gainfully employed so that they too have a chance to innovate and develop.

    Not just to be greedy and claim some theory disconnect (or to engage “hired hand” economists a la Booth to do so), to keep pushing and inventing more of the same arrant economic policy nonsense.

    There are genuine economists and there are zombie career economists Tim. There always have been.

  17. Prof – just wondering if up there in your post it should read “unwillingness to abandon failed policies does not change the fact of failure.”..rather than “willingness?”

  18. I don’t agree with your proposal Alice but I share your lament that people seem all too willing to accept unemployment as natural and unavoidable. Personally I’d cut wage regulation and taxes. In particular payroll tax should be abolished pronto (even JQ agrees with that one).

    Income tax rate cuts don’t need to be focused at the top end of town. For instance I’d love to lock in an annual percentage increase in the tax free threshold. And we could in fact halve all income tax rates over a roughly ten year period if a mere 1% of total federal revenue (from all sources) was allocated to income tax rate cuts each year for ten years. Real revenue growth per capita is in excess of 1% so government spending could still increase.

  19. @TerjeP (say tay-a)
    Terje – the point I was trying to make is that we have already pursued many of your suggestions for the past thirty odd years (the supply side focus). The top end as you call them and business has had substantial concessions granted but the result has been a monstrous bubble in asset prices, the entrepreneurial weaving of excess incomes into some pretty dangerous toxic financial assets along with this graph for US unemployment (link below) Terje. This measure of unemployment in the US (called U-6) is double what is quoted in the newspapers (U-3) which is under 10% and thats what we commonly hear. But its well worth noting that unemployment in the US were it counted the way it was in the great depression and for many decades after, would be higher still than U-6 (16.2%) at 17.5%. Yet the worst of it is, we know unemployment is a lagging indicator and didnt peak until three years after the 29 meltdown.

    Now if that doesnt spell trouble and the need for a focus using obviously something more substantial than the great experiment of a supply side, business tax cuts, lower income taxes, smaller government, large tax cuts for the wealthy classes, monetarist output gap with unemployment apparently amputated from consideration) then I dont know what further I can say.

    The zombies models have taken over and real intelligence has died along the way somewhere.

    http://data.bls.gov/PDQ/servlet/SurveyOutputServlet

    If that link doesnt work

    go to this screen – select U-6 and then select show graphs

    http://www.bls.gov/webapps/legacy/cpsatab12.htm

  20. @TerjeP (say tay-a)
    Terje – if you further into that site and examine unemployment rates by industry in the US from 1999 to 2009 (assuming U-3, not even U-6 ie being very conservative with the unemployment measure) you can note that unemployment is much higher in almost all sectors that actually produce a tangible good (manufacturing etc, construction eg where current rates of unemployment are 20%).

    The only safer industries (in terms of unemployment) are govt, education and defence (5%) and interestingly enough – the financial services sector unemployment is only 6%. The govt sector unemployment rate here is one argument for government spending on services and projects that create direct employment Terje – as a cushion against the extremes of the business cycle.

    So despite what we hear in the media of unemployed US finance sector workers begging on the streets in the US – this is obviously not the real picture. Most other industries apart from these two and self employment (which somehow includes caring??) have rates of unemployment in excess of 10%, some well in excess…and that is by the very conservative “headline rate.” Using U-6 would approx double the headline U3 rate.

  21. Freelander,

    Money is not neutral in the short run.

    Alice: the Okun gap breaking down being an excuse to ignore unemployment is a non-sequitur. Given the lower bound on the federal funds rate, it is difficult to tell if the Fed is reacting to unemployment or to the output gap.

    Getting back to my previous points: inflation control matters because inflation is a saddle path without monetary policy that controls it (ie by increasing or reducing interest rates by more than 1:1 when inflation deviates from a target). This means that inflation will explode upwards or downwards in response to a shock to demand or costs.

    Milton Friedman was right in stating that monetary policy (defined as monetary base growth) is the only game in town for inflation control. This could be acomplished through accomodated fiscal policy, but that would only be cosmetically fiscal policy; monetary policy would be doing the heavy lifting.

  22. @Tim Peterson
    I completely disagree with you Tim. Monetary Polcy is not “”the only game in town”” and that is becoming rapidly obvious even though some want to keep playing with the same old toys and push the same failed policies as Prof Q suggests above (and it shouldnt have been sold by as the only game in town for the past thirty years btw).

    Thats why we have a toolshed of economic indicators (not just an inflation target), not so that economists can ignore other indicators like unemployment and wave the magic interest rate wand, and tell everyone else to get used to a new NAIRU!! which keeps going up, but so that they actually address growing problems like unemployment and inequality before the unemployed themselves address it with crime or political instability or health system burdens or family structure breakdowns (dont forget all those nasty social costs of unemployment…That can tear down policy myopia faster than you or I can argue about it).

  23. Monetary Policy cant do heavy lifting. It is the obvious policy weakling. That is the entire problem with it and when it tries to do heavy lifting it either throws everyone’s property to the banks, or it throws everyone’s retirement savings to the banks. Either way, the banks win.

  24. Interest rate hikes – banks win homes, interest rate reductions – banks gamble the retirement savings of millions away in speculative bubbles. Thats all Monetary Policy does when it imagines it can do the heavy lifting against inflation or recessions. It either plunges people into debt on their home and business loan repayments or it inflates the value of their financial assets into a bubble of monumental proportions with interest rate cuts.
    Monetarists just dont get it. Its always heads the bank wins, tails the bank wins and meanwhile unemployment and private debt grows insidiously larger with every little market foray and every business cycle. For so called non interventionists, Monetary Policy has increasingly, thanks to its neatly pressed myopic followers, become the most interventionist of all policies of all time, I would suggest.

  25. Terje, the argument that abolishing payroll tax will have a significant impact on creating jobs is flawed and has been thoroughly debunked by many economists.

    Payroll tax has marginal impact on employment levels for a number of reasons:
    – as a proportion of the overall costs of employing people (wages, superannuation, regulations) payroll tax in Australia is not that high
    – payroll tax effectively works as an income tax and a consumption tax. Employers pay for it by reducing other worker benefits and passing some costs onto consumers
    – if governments abolished payroll tax, the revenue would need to be replaced by some other tax that would have some negative impact on economic activity and employment. So the net impact on employment would be neutral or negligible

    Given all these factors, there is little reason to believe that doing away with payroll tax would have much impact in creating more jobs. The only reason abolishing payroll tax gets trotted out in these debates is that it is a more palatable option for people on both sides of politics than other more contentious measures.

  26. Alice,

    The NAIRU is lower in the US now than in the 1970s at 4.5%.

    Monetary policy definitely works on inflation. Monetary policy caused the inflation of the 1970s (not OPEC; stagflation had set in in the USA and UK in 1970). Monetary policy ended the inflation in most places in the 1980s and here in 1990. Hardly a weakling.

    Consider the quantity exchange equation: MV=PY.

    M is the money supply, V is velocity (the number of times the money is used to buy goods and services), P is the price level and Y is real GDP.

    Fiscal policy acting on its own can only cause a one off level shift in the trend for V (velocity); it can only have a one off effect on nominal income and hence inflation. M in the above can keep growing at any rate; it is the only thing that can make a permenant difference to inflation.

    It matters not that short term interest rates are typically the instrument for monetary policy; the above policy applies.

    Switching attention to interest rates, it is worth looking at the Taylor principle.

    If we start with the Fisher equation:

    r(t)=R(t)-Pi(t)

    where r(t) is the real interest rate, R(t) the nominal interest rate and Pi(t) the inflation rate,

    we can see that, ceteris paribus, higher inflation lowers the real interest rate. This in turn will stoke up demand, lead to more inflation and, in another turn of the screw, lower real interest rates even more. The converse happens with lower inflation.

    Taylor pointed out that to avoid these bad outcomes, you need to (1) set a target for inflation and (2) increase/decrease the nominal interest rate by more than 1-for-1 for any overshooting/undershooting of the target.

    You can put anything else you like in your reaction function (Greenspan is said to have looked printouts of over 100 variables in the bathtub) provided that you target the equilibrium values of those variables, and follow Taylor’s advice on reacting to inflation.

  27. Alice:

    Geting back to me previous point about counter-cyclical recurrent spending; what bits of Federal government spending do you propose altering? Defence: do we hire soldiers for 1-2 year and then sack them? Medicare: put drugs on the PBS and then remove them? Hire and fire federal police?

  28. On monetary policy: I think that one aspect of monetary policy – keeping inflation under control throughout the 2007-8 oil shock – was spectacularly successful.

    If you think fiscal policy trumps monetary policy look at the US experience in the early 80s. In the tug of war between highly expansionary fiscal policy and very tight monetary policy, monetary policy won hands down, with nominal income growth slowing from 14% per anum to 3-4% per anum. If that isn’t heavy lifting, I would like to know what is!

  29. Come on Tim Peterson, why don’t you tell the world as to why the USA is in a real poo?

  30. Bad risk management practices and overly loose monetary policy, combined with the tail effects of the oil shock (particularly on the auto industry).

    Asset pricing models used for risk management did not take into account feedback effects from macro variables to asset prices (particulaly the case for the Gaussian copula models used to price mortgage backed securities, which were priced based on 14 years of housing boom data from the credit default swap market).

    At the macro level, conversely, effects of asset prices on demand were not modelled properly; in particular, macro models did not model financial intermediation, using a ‘black box’ model of the transmission mechanism.

    Also, I suspect that exvessive risk taking was encouraged by the LTCM bailout – when loans and derivative contracts were implicitly guarenteed people had incentives to take riskier positions. This was definitely the case with Fanny Mae/Freddy Mac, although these were not responsible for the majority of bad lending practices.

    Ridiculously bad practices by the credit rating agencies also deserve a big slice of the blame.

    Sub-Taylor rule interest rates which fanned the housing boom certainly didn’t help.

    Finally, the deficiencies of the Basel accord regulatory regime, which allowed banks to count non-deposit liabilities as capital, and gave them massive scope to shift liabilities off their balance sheets and out of the sight of regulators, were a major factor behing the bust.

  31. Tim Peterson, now you have me intrigued, has monetarism been effectual or ineffectual for the USA given the poo they are in?

  32. If by monetarism you mean quantitative easing, then I think it is starting to work right about now.

  33. The doubling of monetary base by the Fed though the TAF and long bond open market operations.

  34. @Michael of Summer Hill
    Nothing is working in the US Michael – including the monetarists prescriptions on how best to run economies. Another thing that isnt working is the mass de-regulation of financial sectors – allowing them to “go global” and take their tax contributions and capital with them.. (translate as “we fought the law… and we won..!!).

  35. Tim Peterson, I’m a bit slow these days and thick but if monetarism is working then why is America swimming in the poo?

  36. @Tim Peterson

    Tim you state “The NAIRU is lower in the US now than in the 1970s at 4.5%.”
    Ive never heard a more blatant piece of delusionism. Here Tim – Ill post the link again for you. You obviously didnt read it the first time. Unemployment in the US is tracking around 17.5% if we measured it as they did during the great depression AND for many decades after until they (who was they?? Politicians? Monetarists? or delusionists???…)

    go to this screen – select U-6 and then select show graphs

    http://www.bls.gov/webapps/legacy/cpsatab12.htm – then data retreive Tim and hit U-6

    You may want to check by industry so here is the link for that

    http://www.bls.gov/webapps/legacy/cpsatab11.htm

    check the boxes by industry in the US, then once data retreived, click “show graphs”

    Dont tell me NAIRU is lower than the 1970s when we have….9.9 for non agriculture, mining 12.6, construction 18.2, manufacturing 12.4, durable goods 13.7, wholesale and reatil trade 9.7, transportation 8.8, financial activities 6.1, education and health 6.1, leisure and hospitality 12.1, other serices 7.1, agriculture 12.1, govt 5.1,

    Dont you understand Tim – your Nairu (and everyone elses definition of Nairu – just doesnt matter one bit when cyclical unemployment is added…where in this list of unemployment rates by industry in the US do you see anything approaching your quoted Nairu figure – which makes Nairu a dream and a concoction for any time except full employment and NAIRU is entirely a manipulated theoretical construct.

    This is real unemployment with real consequences and further it is likely conservative and counted as U-3 – the supposed “official measure” of recent decades – this is not the way it was counted during the Great Depression which is closer to but still above the U-6 measure.

    So Tim, what that means is that you take all these numbers I just wrote here for each industry in the US and double each one and add a percent.

    Then you tell me you still think NAIRU is what matters. I dont think so.

  37. Tim Peterson, I’m baffled for if everthing is hunky dory as you say then why are interest rates so low?

  38. @Tim Peterson

    Tim you state “The NAIRU is lower in the US now than in the 1970s at 4.5%.”
    Ive never heard a more blatant piece of delusionism. Here Tim – Ill post the link again for you. You obviously didnt read it the first time. Unemployment in the US is tracking around 17.5% if we measured it as they did during the great depression AND for many decades after until they (who was they?? Politicians? Monetarists? or delusionists???…) fiddled it.

    go to this screen – select U-6 and then select show graphs

    http://www.bls.gov/webapps/legacy/cpsatab12.htm – then data retreive Tim and hit U-6

    You may want to check by industry so here is the link for that

    http://www.bls.gov/webapps/legacy/cpsatab11.htm

    check the boxes by industry in the US, then once data retreived, click “show graphs”

    Dont tell me NAIRU is lower than the 1970s when we have….9.9 for non agriculture, mining 12.6, construction 18.2, manufacturing 12.4, durable goods 13.7, wholesale and reatil trade 9.7, transportation 8.8, financial activities 6.1, education and health 6.1, leisure and hospitality 12.1, other serices 7.1, agriculture 12.1, govt 5.1,

    Dont you understand Tim – your Nairu (and everyone elses definition of Nairu – just doesnt matter one bit when cyclical unemployment is added…where in this list of unemployment rates by industry in the US do you see anything approaching your quoted Nairu figure – which makes Nairu a dream and a concoction for any time except full employment and NAIRU is entirely a manipulated theoretical construct.

    This is real unemployment with real consequences and further it is likely conservative and counted as U-3 – the supposed “official measure” of recent decades – this is not the way it was counted during the Great Depression which is closer to but still above the U-6 measure.

    So Tim, what that means is that you take all these numbers I just wrote here for each industry in the US and double each one and add a percent.

    Then you tell me you still think NAIRU is what matters. I dont think so.

  39. @Tim Peterson
    and further Tim – for someone who so deeply and obviously subscribes to Monetary Policy, in response to Michael of SH who asked you why the US is in such deep poo, you responded

    “Bad risk management practices and overly loose monetary policy”

    So it would appear your Monetary policy is not the heavy lifter it seemed to be after all, more like subject to human fallibility.

    And what areas would I suggest Government expanded its role in?? Public construction, education, health, roads, ports and infrastructure. They did a better job than these PPS we have paid dearly for without any grand plan for the future. You need to realise what governments are capable of and yes sure it will cost more in taxes but thats fine if those who benefit more, pay more, which has not been happening (as the wealthy and coorporate entities have been permitted under lax regulation to basically just absolve themselves of a sense of participation and responsibility for income tax.”

    And no I dont suggest Govts should hire policeman and put them off again. I suggest hiring policemen, training them properly and keeping them.

    I really do get impatient with the “flexible labour market response” brigades….we let them get loose in the public sector and they made a complete and utter mess. No young people coming in, old people who should be retired coming back..people and departments literally dont know the job anymore.

    Tim – your efficient markets flexiblly adjusting models are all wrong – I hate to tell you but someone should. Prof Friedman only had half the picture, not all of it. He really was bit of a newbie on the block but he didnt move mountains and he has caused a lot of damage. His policies were fine and beneficial for a country emerging from the staid long term dysfunctional grip of a communist regime but apart from that he falls short managing economies who were already partly market based and partly government based (social democracies, centrist, mixed economies – call it what you want – in those economies, the policies of Prof Friedman have done nothing but make a mess).

  40. Tim Peterson, maybe the USA shrank only 1% in the second quarter of 2009 ontop of the 6.4% contraction in the first three months of this year, but to say everything is hunky-dory is a bit premature for there is approximately 1.89 million homes which may still foreclose this year and no sign of bottoming out.

  41. Alice,

    Don’t you understand what the NAIRU is? It is the equilibrium level of unemployment and ceteris paribus causes a stable inflation rate. Unemployment can be above it or below it, _without invalidating the concept_; suggesting that it does is another non sequiter. Of course there is a large cyclical unemployment rate at the moment, but inflation is falling, consistent with the NAIRU.

    The point is that in the US the early to mid 2000s a stable inflation rate was compatible with unemployment as low as 4.5%. In the 1970s, the inflation rate accelerated when unemployment went below 6%. And inflation was higher in the 1970s in every year except when price controls were employed in 1971-73.

    Lower unemployment and lower inflation in the 2000s; this is a product of the NAIRU (a) not involving any tradeoff between unemployment and inflation in the long run (contrary to your suggestion) and (b) being lower in the 2000s than the 70s.

    Of course the NAIRU matters. It sets a lower bound on how low unemployment can go before accelerating inflation sets in. A long run of accelerating inflation benefits the wheelbarrow makers and no-one else, so the NAIRU sets a practical bound on unemployment. Which is not to say that it can’t be altered, just that it can’t be altered by demand management.

    At the moment cyclical unemployment is the issue of the day. But as the economy recovers America will enjoy the benefit of a NAIRU lower than it was in the 70s.

    I don’t see what historical unemployment series have to do with neurality unless they changed definition since the 1970s.

    Look at:

    http://research.stlouisfed.org/fred2/series/UNRATE?cid=12

    for a comparison of unemployment rates under the same definition between the 1990s and 2000s.

  42. Alice,

    Monetary policy definitely is a heavy lifter in terms on controlling nominal income growth. If the Fed had stuck to the Taylor rule human fallibility would not be an issue.

    >And what areas would I suggest Government expanded its role in?? Public >construction, education, health, roads, ports and infrastructure.

    This was _not_ the question I posed. I would like to know which recurrent (ie consumption not investment) expenditures you would use for _counter cyclical_ purposes.

    > And no I dont suggest Govts should hire policeman and put them off again. I
    > suggest hiring policemen, training them properly and keeping them.

    Ie you are not talking about counter cyclical expenditure manipulation.

    If you use capital expenditures for counter cyclical purposes you have a considerable design lag. That was why I raised the issue of counter cyclical recurrent expenditures.

    So, I pose the same question to you again: what federal recurrent expenditures would you use for counter cyclical policy?

  43. Alice,

    Monetary policy definitely is a heavy lifter in terms on controlling nominal income growth. If the Fed had stuck to the Taylor rule human fallibility would not be an issue.

    >And what areas would I suggest Government expanded its role in?? Public >construction, education, health, roads, ports and infrastructure.

    This was _not_ the question I posed. I would like to know which recurrent (ie consumption not investment) expenditures you would use for _counter cyclical_ purposes.

    > And no I dont suggest Govts should hire policeman and put them off again. I
    > suggest hiring policemen, training them properly and keeping them.

    Ie you are not talking about counter cyclical expenditure manipulation.

    If you use capital expenditures for counter cyclical purposes you have a considerable design lag. That was why I raised the issue of counter cyclical recurrent expenditures.

    So, I pose the same question to you again: what federal recurrent expenditures would you use for counter cyclical policy?

  44. You didnt qualify your question and I gave my answer Tim. I would like to see greater Government investment. Thats not countercyclical. Thats permanent but it also helps contracyclical policies.

    Its also called a bigger government and bigger government service provision (I wont cushion words – Im sure you understand this clearly enough) eg government transport initiatives and government public goods provision in the economy. I like my economy mixed thanks because the private sector is unreliable and more volatile.

    I still like the private sector to have a solid role but I see no reason whatsoever this country should follow market fundamentalism (and only market and only tolerate government investment when there is a hiccup???? Thats not my idea). Its called a mixed economy. Its what we always were and what we were best at until US marketr rhetoric and the delusionists and their models took over policy, for the worse.

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