Radical macro lessons from the Great Recession

The relationship between NGDP targets, a higher inflation target and helicopter money

Just suppose that lower oil prices help generate a period of significantly above average growth in the OECD economies over the next five years. We avoid deflation, but despite more rapid growth modest increases in interest rates keep inflation at or below target. Even if this happens, the story of the Great Recession will not have been a happy one. If you compare where we are now to where we might have been without a financial crisis, there remains a huge gap. Even if we go a good way to closing that gap over the next five years, this very gradual recovery will have cost us dear. In some countries (most of the Eurozone) that cost is currently reflected in high levels of unemployment, while in others (the US) it manifests itself in real wage stagnation or decline. (The UK is now in the latter group: if you are bored with hearing this from me, see this from John Van Reenen.)

Are there lessons to learn from this? You can probably divide economists into two camps at this point. One group, the ‘supply group’ - which would include most of those setting monetary policy - tend to think that we have largely done the best we could under the circumstances. By circumstances, I mean two related things: a rather surprising increase in inflation during 2011, and an apparent decline in the ability of the ‘supply side’ of the economy to grow at the kind of rates we might have expected before the crisis. While the former is undeniable, the second is conjecture, because we cannot observe the key driver of long term growth, which is technical progress.

The second group of economists attribute more of the slow recovery since the financial crisis to deficiency in aggregate demand. I am in that second ‘demand’ group, and have argued that fiscal austerity is responsible for a great deal of the slow recovery. Implicit in such arguments is the idea that had demand been strong, any further increase in inflation around 2011 would have been modest and temporary, which with wise monetary policy need not have led to any increase in interest rates.

I think most of the demand group also share a view that it would be a large mistake to shrug off this bad experience as a one-off, or as something that only occurs every century or so. The ‘one-off’ story could focus on an unfortunate misreading of the Eurozone crisis: however, while this might explain the change in attitudes is some important institutions like the IMF, it is less plausible in explaining why policy makers around the world switched to austerity. The ‘every century’ idea is wrong because it fails to note the changes that have been brought about by the widespread adoption of 2% inflation targets, coupled with a view that the ‘natural’ real interest rate is also likely to remain low for some time.

Different members of the demand group have proposed three different and radical innovations in macroeconomic policy to help avoid this kind of mistake happening again. These are targeting the level of nominal GDP (NGDP), raising the inflation target, and some form of helicopter money. Are these innovations alternatives or complementary to each other?

There are some (notably market monetarists) who seem to argue that changing monetary policy to NGDP targets is sufficient. My own view is less optimistic. A clear advantage of NGDP targets (and not its only advantage) is that they would create expectations of a more expansionary policy during and after the recovery phase from a recession, but in my view this would not be enough to prevent liquidity traps happening. This is because I see the problem of the liquidity trap (nominal interest rates being unable to fall below some lower bound around zero) as central to why the Great Recession was so prolonged, and episodes where we experience a liquidity trap as becoming more frequent because the inflation target (explicit, or implicit within the NGDP target) is low.

Raising the inflation target is an obvious way of reducing the frequency of liquidity traps. If the natural real interest rate is 2%, for example, then with a 4% inflation target, the nominal interest rate has much further to fall before the lower bound is reached than if the inflation target was 2%. It is important to note that this argument does not preclude adopting a NGDP target, because any target path for NGDP includes an implicit inflation target. For that reason, you can view NGDP targets and a higher inflation target as either complementary or alternatives, where the latter is true only if you think one device does the required job by itself.

Helicopter money is essentially giving the central bank an additional instrument - a form of fiscal stimulus. In that sense it is rather different from NGDP targets or a higher inflation target, because it involves instruments rather than the objectives of monetary policy. For that reason, in principle it could be a complement to both the other radical suggestions. In a way helicopter money is best seen as an alternative to Quantitative Easing, and there is no reason in principle why QE is not compatible with NGDP targets or a higher inflation target. It is possible of course that if helicopter money was shown to be effective in dealing with liquidity traps, then it would make the case for other radical changes less compelling.

If I’m being realistic, I think that if the first sentence of this post turns out to be true, the chances of any of these radical changes being adopted before the next liquidity trap episode are very small. A period of strong growth will be sufficient for policy makers to pretend that the slow recovery from the financial crisis was either a one-off or the best that could be done in the circumstances. Instead I suspect that as the economy moves ever closer to its pre-crisis trend, the demand group of economists will convince more of the supply group that they were wrong. This will give greater credibility to the idea that radical changes to policy are required, and each alternative will receive greater analysis and probably greater support amongst economists by the time the next liquidity trap episode occurs. 

Deflation, inflation, oil prices and asymmetries

When both headline and core inflation rose above target after the financial crisis, helped by rising oil prices, the Fed and Bank of England kept their nerve and did not raise interest rates. They saw through what was a temporary episode. The ECB’s judgement was not as good. Even in the UK it was close, with three out of nine MPC members voting for a rate increase for a few months. But it was the outcome that mattered - excess inflation was ignored because it was temporary. To what extent is what we are seeing right now just the mirror image of this period?

In terms of where inflation is and the monetary policy response, the situation today does indeed look like a mirror image. Headline inflation is or is about to be negative, and core inflation has fallen below target. As Tim Duy points out for the US, core inflation seems to be heading lower rather than returning to target. However I think that is where the symmetry ends. While the dangers of letting inflation rise above target because of temporary shocks are small, the dangers in the opposite direction are more serious. 

One of the arguments used by the inflation hawks when oil prices were high is that even if the impact of higher oil prices on inflation was itself temporary, there was a danger that inflation expectations would increase, and the central bank would lose its anti-inflation credibility. My response at the time was three-fold: first, the private sector can see the reason that rates are not being raised (the continuing recession), so credibility should not be in danger; second, the best indication that the expectations that matter have shifted is when nominal wage inflation starts to pick up (which it did not), and third when that happens it will be easy to restore credibility and reduce expectations by raising rates. [1]

None of these arguments apply with deflation today. Then unemployment was clearly too high. Today unemployment is not clearly too low. How far we are from the natural rate is unclear, but no one would argue that we are in a boom that is the mirror image of the recession a few years ago. The second argument is that we could use changes in nominal wages as a clear indicator that the inflation expectations that mattered had shifted. That argument is not symmetrical because of the well known resistance to nominal wage cuts. Finally if credibility does seem about to be lost, the central bank will find it very difficult to take action to restore it because of the Zero Lower Bound (ZLB).

Please allow me to get technical for just one paragraph, which can be safely skipped. As has often been pointed out, the ZLB means that there are two steady states in the economy associated with a given real interest rate: the ‘intended’ equilibrium with target inflation, and the ‘ZLB equilibrium’ when inflation is negative. I recently discussed a paper that treated agents views about which equilibrium was appropriate as a ‘belief’ and that perhaps the liquidity trap could be a manifestation that agents believed we were heading for the ZLB steady state. The controversial aspect of this analysis is the suggestion that this belief could be shifted by the monetary authorities raising rates. I find that very unconvincing, but it would be a mistake to dismiss the exercise completely on that account. In that post I did suggest an alternative rationalisation for why we might be heading for the ZLB equilibrium: agents no longer believed that the monetary authority had the means to stop it happening.

This last asymmetry is the one that troubles me the most, and why I am not as relaxed as monetary policy makers appear to be about deflation. There are three interpretations of this relaxed attitude to negative headline inflation. The first is the one I suspect monetary policy makers actually hold, which is that the beneficial impact of lower prices on demand will with a year or so push inflation back to target, so there is no reason for concern. [2] I think the probability is that they are correct, but good policy does not just think about the most likely outcome, but should also be robust to risks, particularly risks with large consequences.

The second interpretation that the private sector could give for the relaxed attitude by central banks in the US and UK is that deviations above and below 2% are not treated symmetrically. In theory this should be more of a concern in the US than the UK, because in the UK asymmetry is against the central bank’s mandate. However I’m not sure the private sector thinks that is as important as MPC members do. There is one obvious additional asymmetry between now and a few years ago: many of those calling for higher rates back then are still pushing for higher rates today.

The third interpretation about why central banks are doing nothing is there is nothing they can do. Quantitative Easing seems to have come to a permanent halt either because it has stopped having a useful effect, or because policy makers fear it is having undesirable consequences. Under this interpretation the inflation target loses credibility not because the private sector no longer believes policy makers’ stated objectives, but because they no longer believe they have the means to achieve them. 

This possibility is the one that should really be worrying central banks right now. It is a scenario that is quite consistent with what is currently happening, and it puts at risk central bank credibility in a most fundamental way. Quite simply, central bank credibility is destroyed because people believe they have lost the ability (rather than the will) to do their job, and there is very little central banks can do to get it back because of the ZLB. This is what should be giving central banks nightmares. Strangely, however, they seem to be sleeping just fine.

[1] A footnote for macroeconomists: this is why I have never been convinced by Cochrane’s worries about using the inflation target as a transversality condition.

[2] Resistance to nominal wage cuts may also dampen any the deflationary path, giving time for these positive effects to come through. However resistance to nominal wage cuts does not mean the ZLB equilibrium will never occur – in the paper I discuss in this post, it is the reason why that equilibrium is associated with high unemployment.