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Tuesday, 1 December 2015

The centrality of policy to how long recessions last

For economists

Paul Krugman reminds us that one of the most misguided questions in macroeconomics is ‘are business cycles self-correcting’. This is a particular case of another mistake, which is to say that the duration of the business cycle depends on the speed of price adjustment. That answer is seriously incomplete, because it only holds for a particular set of monetary policy rules (plus assumptions about fiscal policy).

It is very easy to see this. Suppose monetary policy is so astute that it knows perfectly all the shocks that hit the economy, and how interest rates influence that economy. In that case absent the Zero Lower Bound the business cycle would disappear, whatever the speed of price adjustment. Or suppose monetary policy followed a credible rule that related real interest rates to the output gap rather than excess inflation. Once again the speed of price adjustment is not central to how long business cycles last. As Nick Rowe points out, if you had a really bad monetary policy recessions could last forever.

A better answer to both questions (self-correction and how long business cycles last) is it all depends on monetary policy. Actually even that answer makes an implicit assumption, which is that there is no fiscal (de)stabilisation. The correct answer to both questions is that it depends first and foremost on policy. The speed of price adjustment only becomes central for particular policy rules.

So why do many economists (including occasionally some macroeconomists) get this wrong? Why are textbooks often quite unclear on this point? It could be just an unfortunate accident. We are so used to teaching about fixed money supply rules (or in my case Taylor rules), that we can take those rules for granted. But there is also a more interesting answer. To some economists with a particular point of view, the idea that getting policy right might be essential to whether the economy self-corrects from shocks is troubling. They prefer to think of a market economy as being ‘naturally’ self-correcting, and to think that government intervention only has a role to play if there is some serious ‘market imperfection’. The market imperfection in the case of business cycles is price rigidity.

Focusing on this logic alone can lead to big mistakes. I have heard a number of times good economists say that in 2015 we can no longer be in a demand deficient recession, because price adjustment cannot be that slow. This mistake happens because they take good policy for granted. It is almost certainly true that no recession should last this long, because fiscal policy can substitute for monetary policy at the Zero Lower Bound. But with sub-optimal policy the length of recessions has much more to do with that bad policy than it has to do with the speed of price adjustment.

Just how misleading a focus on the speed of price adjustment can be becomes evident at the Zero Lower Bound. With nominal interest rates stuck at zero, rapid price adjustment will make the recession worse, not better. Price rigidity may be a condition for the existence of business cycles, but it can have very little to do with their duration.        

15 comments:

  1. Simon,

    tangentially related to the above, have you looked at Matt Rognlie's paper What Lower Bound?

    http://economics.mit.edu/grad/mrognlie/research

    his other papers look great too.

    [two asides: people like him make me feel good about the future of the economics professions; people like him make me feel very bad about my own productivity / abilities]

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    1. Rognlie theories of negative interest rates really are for the NK birds and the Swedish Central Bank. The Riksbanken, punishes commercial banks for holding too many "reserves", using negative overnight rates. This to force the banks to lend more retail. Unfortunately, nobody at the Riksbanken had been told that banks don't lend "reserves", except to other banks with central bank accounts, as part of the settlement process.

      There is no magic "money multiplier" of reserves into "money supply". Loans create deposits that create the need for "reserves"; not the other way around. This year, Riksbanken was starting QE, swapping bonds back into "reserves" to increase the reserves (liquidity) it was trying to reduce with negative overnight interest rates. You may be aware that Riksbanken is the sponsor for the (not really a) Nobel Prize in economics!!!???

      I would like someone to show me irrefutable evidence of where "monetary policy" has increased aggregate demand in an economy suffering fiscal austerity.

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    2. acorn,

      right, but any individual bank that finds itself with more reserves than it wants, what does it do? One option is to expand lending. Yes loans create deposits and CB will supply reserves as needed, but then there is such a thing as net settlements when reserves are moved between banks (by analogy, this is like when you make a loan to somebody and crate a deposit account for them with £100 in it, then they turn up a the cashier and ask for the £100 in cash - this is the bit some internet MMT warriors seem to forget). And yes if all banks try to do shed reserves by expanding lending, they cannot all do that because reserves just get passed around between them, however as their balance sheet expands in the process, if no new reserves are put into the system, reserve ratios will fall to a level when bank no longer regard them as excess. Which is fine by the CB.

      I am not going to say this is certainly what happens - there's many a slip between cup and lip - but it's not an incoherent story nor does it rest on a misguided literal interpretation of the money multiplier parable taught to students to explain how fractional reserve banking creates broad money via credit creation.

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    3. "I would like someone to show me irrefutable evidence of where "monetary policy" has increased aggregate demand in an economy suffering fiscal austerity."

      Canada, mid to late 1990's.

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    4. "The subsequent austerity drive was one of the most severe in the global north, and remains the foundation for the right's strategy of death by a thousand cuts carried on by Harper Conservatives." http://thetyee.ca/Opinion/2015/08/25/Canadas-Harsh-Austerity/

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    5. Luis, the Treasury creates "reserves" when it spends them into existence, every day. When it pays my pension, my bank keeps the reserve in its account at the BoE and puts an exact duplicate amount in my current account. (Balance sheet continues to balance).

      I can withdraw my pension as cash from an ATM and my banks current account at the BoE will drop by the cash amount during settlement. I take my cash to another bank and open a deposit account, for instance, and put my cash in. This new bank will have its reserve account at the BoE, topped up with that cash amount. The monetary base (MB), that is cash and reserves, has not changed through out the process.

      I could have done the same with a cheque drawn on my bank and deposited in another bank. In that case when the cheque clears the exact equivalent "reserve" at the BoE will move from my bank to the new bank.

      If my bank is short (long) of reserves it will borrow (lend) them. The BoE likes that to happen around its target interest rate; which can be any rate it wants, positive or negative. It will drain or supply the reserves level with government Bonds to keep that rate. Or, as it does now, pay interest on reserves because QE has created a lot of reserves, which would normally force the overnight rate to zero. (Which is where MMT says it should be permanently, with a real time fiscal policy used for inflation control. That means a budget review every day, not a theatrical event once, or now, twice a year.)

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  2. " Actually even that answer makes an implicit assumption, which is that there is no fiscal (de)stabilisation."

    Fair point.

    For your main question though: Keynes' General Theory has been a very influential book, and it is puzzling that Keynes holds the money supply fixed when he asks whether the economy is self-correcting. Why didn't he hold the price of gold fixed instead, given what the UK had been doing? I wonder if that is the unfortunate historical accident?

    Historians of Thought needed.

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  3. "Suppose monetary policy is so astute that it knows perfectly all the shocks that hit the economy, and how interest rates influence that economy. In that case absent the Zero Lower Bound the business cycle would disappear, whatever the speed of price adjustment."

    Is this right in the case of cost-push (markup) shocks? In a NK model, I thought that a (positive) markup shock moves inflation up and output down. So the only way that the central bank could perfectly stabilise output (the business cycle) would be to lower interest rates and push inflation even further away from target.

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  4. Blenheim, try reducing the tyre pressures, this may reduce cost-push (markup) shocks. The central bank could perfectly stabilise output (the business cycle), by using a 98 RON petrol grade instead of the normal unleaded 95 grade.

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  5. "Are business cycles self-correcting?"

    Business cycles are homeostatic, or they wouldn't be cycles. :) Whether you want to say that they are self-correcting is another question.

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    1. I have since learned that so-called business cycles in modern economic theory are not actually cycles. So they are not homeostatic, are they?

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  6. Mr. Wren Lewis, you state “one of the most misguided questions in macroeconomics is ‘are business cycles self-correcting’”. Then you explain that you cannot answer this question without knowing the monetary policy and/or fiscal policy responses to these cycles.

    My question: assuming no monetary policy response and no fiscal policy response, and assuming that we are not near the zlb (or that significantly negative interest rates are possible), do you think that business cycles are in principle self-correcting? As you state “it all depends on monetary policy”, it seems to me as if your answer to that question is “no”.

    Anton

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  7. http://bilbo.economicoutlook.net/blog/?p=32453
    Recessions are always a problem and can always be avoided - using very strong auto-stabilisers and proactive fiscal policy.

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  8. you state:
    'To some economists with a particular point of view, the idea that getting policy right might be essential to whether the economy self-corrects from shocks is troubling. They prefer to think of a market economy as being ‘naturally’ self-correcting, and to think that government intervention only has a role to play if there is some serious ‘market imperfection’.

    Hubbard in his intro Macro text, questions the legitimacy of Keynes's paradox of thrift:

    'An increase in saving, by increasing the supply of loanable funds, should lower the real interest rate and increase the level of investment spending. ...this increase in investment spending might offset some or all of the decline in consumption.'

    Had this been written in 2006, one might cut the author a break. Instead, the sentences in the textbook follow the observation that in the USA, 2008-2009, the savings rate jumped, and some invoked the paradox of thrift as a contributor to the depth of the 2009 decline. The sentences quoted above are offered as a possible reason to doubt the Paradox of thrift concept.

    You remember the sharp rebound in business investment in the USA, 2008-2009, reflecting the plunging cost of finance? Oh, wait, treasury yield plunged, but risky rates soared as investment collapsed.

    Faith in the self correcting nature of cycles, outside of the policy backdrop, endures. Alongside strong beliefs one now also needs to practice a special kind of cognitive dissonance.

    Bob Barbera

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  9. I do agree that policy determines the speed and shape of the recovery, but take issue with the notion that price rigidities cause the business cycle. There was little price rigidity to speak of under the gold standard when 20-30% declines in prices were not uncommon.

    Rather, in my opinion, the true cause of the business cycle is monetary policy and the bootstrapping problem affecting the economy. In other words, incomes have to be anticipated ex-ante in order to be generated ex-post. This means that there is no endogenous process toward full employment, nor that there is some level of interest rates that can lead to both price stability and full employment. More on this here http://tinyurl.com/jhbfj3h

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