This is a title that is sure to spur some angry comments. Didn’t the financial crisis prove that mainstream macroeconomics was hopelessly flawed, that the ‘Great Moderation’ (fifteen or so years of relatively stable inflation and output) that preceded the crisis was a sham, or worse still a cause of the crisis, and basing policy on lots of maths and rational expectations has been totally discredited?
One of the architects of that macroeconomic mainstream is Lars Svensson. He wrote a number of key papers on inflation targeting using lots of maths and rational expectations. Probably for that reason, he was a member of Sweden’s equivalent of the Monetary Policy Committee from 2007 to 2013. By the middle of 2009 Swedish short term interest rates were, like most other places, close to their ‘zero lower bound’ - in this case 0.25%. But in mid 2010 they began to rise again, reaching 2% at the end of 2011. The primary motivation for this continuing rise in rates was a concern that Swedish consumers were taking on too much debt.
Svensson fiercely and publicly opposed these increases, and eventually left the central bank in frustration. He argued that there was still plenty of slack in the economy, and raising rates would be deflationary, so that inflation would fall well below the central bank’s target of 2%. By the end of 2012 inflation had indeed fallen to zero, and since then monthly inflation has more often been negative than positive. It was -0.4% in September. This week the Swedish central bank lowered their interest rate to zero.
OK, so one eminent macroeconomist got a forecast right. Plenty of others get their forecasts wrong. Why the big deal? Suppose you took the statement in my first paragraph seriously. The Great Moderation was about central banks having an explicit forward looking target for inflation, and varying interest rates with the aim of trying to achieve it. So if the success of that policy was a sham or worse, and had been exposed by the financial crisis, a central bank should not worry too much if they abandon it. They should certainly not worry if they deviate from it because of concerns about the financial health of the economy. Which is exactly what the Swedish central bank did.
Now Sweden has negative inflation, and interest rates have come right back to zero. Deviating from what mainstream macroeconomists in general advocate (and what one in particular recommended) has proved a costly mistake. (Svensson estimates it has cost 60,000 jobs.) So maybe the story with the financial crisis is a little more nuanced. Perhaps good monetary policy, aided by the analysis of mainstream New-Keynesian theory, did help bring about the pre-crisis moderation in inflation and output variability. The Achilles heel was that monetary policy lost traction when nominal rates hit zero, but a number of mainstream macroeconomists had discussed the implications of that possibility before it happened in 2009. In the UK at least (and also elsewhere), it was politicians and central bank governors that did not take the consequences of this possibility seriously enough. The financial crisis suggests that what was missing was better financial regulation (including macroprudential monetary policy tools), rather than a need to rewrite how we set interest rates.
I am certainly not claiming that mainstream macroeconomics is without fault, as regular readers will know (e.g.) However it is important to recognise the achievements of macroeconomics as well as its faults. If we fail to do that, then central banks can start doing foolish things, with large costs in terms of the welfare of its country’s citizens. And while it might appear unseemly to occasionally blow one’s own profession’s trumpet, I suspect no one else is going to.