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.
