10/24/10 2:18 PMSlower Economic Growth in the Future as a Result of the Financial Crisis - Grasping Reality with Both Hands

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Grasping Reality with Both HandsThe Semi-Daily Journal of Economist J. Bradford DeLong: Fair, Balanced, Reality-Based, and Even-HandedDepartment of Economics, U.C. Berkeley #3880, Berkeley, CA 94720-3880; 925 7080467; delong@econ.berkeley.edu.

Economics 210aWeblog ArchivesDeLong Hot on GoogleDeLong Hot on Google BlogsearchJuly 14, 2010

Slower Economic Growth in the Future as a Result of the

Financial Crisis

How much slower? I don't know.But it will be slower. 0.2% per year?0.1% per year?

We are live at the Economist:

Will the financial crisis and itsaftermath lower the worldeconomy's potential rate ofgrowth?:

Yes, largely because central

bankers will behave differently

Brad DeLong our guest wrote on Jul14th 2010, 12:56 GMT I THINK thatthe answer has to be yes.

The net result of the financial crisiswill be that the world's averageunemployment rate and level of capacity utilisation will be higher, which means thatbusinesses will be able to grasp fewer economies of scale, which means that profits willbe lower, which means that investment spending to try to capture those profits will belower, which means that global economic growth will be lower.

The unemployment rate and the level of capacity utilisation will be lower for tworeasons. The first is what Larry Summers and Olivier Blanchard liked to call"hysteresis" in unemployment after recessions. Workers who are out of work—

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especially workers who are out of work for a long time—lose a good deal of theirmarket-relevant human capital. Their networks of contacts that allow them to easilyget and change jobs, their habits of punctuality, their workplace skills, and their self-esteem all erode. The long-term unemployed, especially, drop out of the effective laborforce—and it is damnably hard to reattach them all to employment absent a full-scaleWorld War II-style inflationary boom.

The second reason is that central banks are going to act differently in the future than inthe past.

There used to be three broad philosophies of central banking—call them regulationism,punchbowlism, and Greenspanism. Regulationism is that bankers have to be verytightly constrained in what they can do and what investments they can make, becauseonly if bankers are kept under very tight regulatory supervision can the central bankdare risk making credit loose enough to produce full employment. If banks are nottightly regulated, then making credit loose is like giving a bottle of brandy to...—well,you know what the bank will do, you just don't know against which wall it will do it.Punchbowlism, by contrast, is the belief that the benefits from free-wheeling andinnovative finance in greasing the flow of capital from savers to businesses make itworth deregulating finance, but then the central bank must maintain relatively tightmoney; it was, as 1950s and 1960s Federal Reserve Chair William McChesney Martinliked to say, make sure to take the punchbowl away once the party really gets going.

The third position was Greenspanism: that modern central banks know a lot moreabout the economy and the financial sector than their predecessors, and so—as long aswe don't see big signs of consumer price inflation—can afford to follow loose-moneypolicies even in the context of deregulated financial markets. As long as unemployedworkers are still wallflowers around the edges of the room, Alan Greenspan might say,the Federal Reserve should not only let the punch flow but spike the punchbowl withthe grain alcohol of 1% interest rates to, in the words of Jay-Z and Missy Elliot:

Let's get this party started right! Let's get drunk and freaky!

And the two-decade long Great Moderation gave Greenspanism credibility. It certainlydid to me.

Well... well, now we have failed to reregulate financial markets sufficiently to makeanybody comfortable that the straight jacket is tight enough to constrain banks:Regulationism is out of the question. And all of us ex-Greenspanists have recanted andrepented.

So, for a generation at least, central banks will follow a very different policy. Think notthat they will merely take the punchbowl away when the party gets started. They are,instead, going to forbid even the filling of a punchbowl. They are going to hunt downpunchbowls in their pantries and smash them all.

We see this right now, as every excuse—nonexistent inflationary pressures, nonexistentlack of confidence in reserve currency debts, et cetera—is trotted out to justifypremature tightening when there is still something like 10% of excess demand slack inthe world economy.

The higher structural unemployment rate from "hysteresis" and the higherunemployment from central banks' inevitable future bias toward tight money have tobe weighing on business decision-making as they plan investment for the future.

How much? How big? I don't know. I don't have a good quantitative estimate.

10/24/10 2:18 PMSlower Economic Growth in the Future as a Result of the Financial Crisis - Grasping Reality with Both Hands

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Brad DeLong on July 14, 2010 at 08:12 AM in Economics, Economics: FederalReserve, Economics: Labor, Economics: Macro, Obama Administration | Permalink

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Comments

Andy Harless said...I sense a certain cognitive dissonance here. On the one hand, you acknowledge havingrecanted your Greenspanism. On the other hand, you ridicule the punchbowlists.Which are you?

For my part, I am an unrepentant Greenspanist. Ideally, I'm a modified Greenspanistwith a higher inflation target and preferably with that target embodied in a price-levelrule or (even better, I'm beginning to think) a nominal-GDP-level rule that wouldproduce more confidence in the central bank's response to a financial crisis. But I'lltake traditional Greenspanism as a second best. There will be financial crises from timeto time. But the underlying cause of the current depression was not the financial crisisbut the pre-existing global savings glut. To toss aside Greenspanism is essentially tosurrender to the global savings glut, to say that we will accept a more-or-lesspermanent mild depression (or even a serious depression) in order to avoid the risk ofoccasional severe recessions. I recommend against making deals with the devil unlessyou have a very good lawyer.

And here's something I don't understand. The Greenspanist consensus was that weshould have 2% inflation and not worry about the collateral effects of easy money.Clearly there were problems with that view as a whole. But how is it that centralbankers have taken the lesson to be that we should have 2% inflation and do worryabout the collateral effects of easy money? The collateral effects of easy money wouldbe much less of a problem if the inflation rate were higher, since that would givecentral banks the option of easing further in response to a financial crisis, after alreadyhaving been easy to begin with. In principle one could adjust both premises of the oldconsensus, and each adjustment would reduce the need for the other. But there isn'tthe slightest suggestion that central bankers are considering discarding the lowinflation part of the old consensus. Why are they convinced that the solution to thisoptimization problem is a corner solution and not an interior one?

Reply July 14, 2010 at 01:57 PMJonathan said in reply to Andy Harless..."Greenspanism: ... can afford to follow loose-money policies even in the context of

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deregulated financial markets"

I think it's the "context of deregulated financial markets" part that is DeLong's problemhere (and, FWIW, mine).

Reply July 14, 2010 at 03:44 PMAndy Harless said...It seems to me that punchbolwism -- as a permanent policy -- is easily reduced toabsurdity. You're saying that central bankers will never quite allow goods and labormarkets to get to equilibrium, for fear of the dangerous consequences in asset markets.But rational agents will then anticipate that goods and labor markets will always bebelow equilibrium, which is equivalent to saying that there will never be a positiveprice (or wage) level low enough to satisfy them. If agents are all perfectly rational andanticipate one another's actions, then as soon as a punchbowlist regime is crediblyannounced, all commerce will cease. On a more practical level -- where the regime isimperfectly credible and agents are imperfectly rational -- punchbowlism is likely toresult in ever-accelerating deflation. In other words, in order to avoid acute financialcrises, we choose instead to have a chronic one.

Reply July 15, 2010 at 10:35 AMAndy Harless said...Basically I'm making Milton Friedman's Natural Rate of Unemployment argument,only in reverse. Central banks can affect the unemployment rate in the short run, butnot in the long run. But keeping financial markets "safe" essentially requires keepingthe unemployment rate above its long-run value. We know this because we observedthe financial instability that resulted when central banks were doing a good job ofkeeping the unemployment rate at its long-run value. But central banks can't controlthe unemployment rate in the long run, so trying to keep it below its long-run valuewill lead to even worse instability. Ergo, punchbowlism is self-defeating. The sensiblething to do (assuming there is not adequate regulation) is to go to my modifiedGreenspanism with its higher inflation target. Barring that, we should just go back tostandard Greenspanism and live with the occasional financial crises.

Reply July 15, 2010 at 10:51 AMComments on this post are closed.

Why Macro MattersSeeking Alpha - Oct 17, 2010No wonder Brad DeLong is always saying Krugman's right about everything. I agree,the Fed (like the Supreme Court) clearly does respond at least somewhat to ...Related Articles » « Previous Next »

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