Should Policymakers Try to Stabilize the Economy?

Peter Bernstein:

When Should the Fed Crash the Party?, by Peter L. Bernstein, Commentary, NY Times: In  the darkest days of the Depression, Treasury Secretary Andrew W. Mellon, one of the richest men in the United States, opposed any government action to stem the tide of plunging business activity and soaring unemployment. Instead, he urged a policy of supreme indifference.

“Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate,” he said. “It will purge the rottenness out of the system,” he added, and values “will be adjusted, and enterprising people will pick up the wrecks from less competent people.”

John Maynard Keynes, for one, thought that prescriptions like Mellon’s were preposterous. The economist called those who held such views “austere and puritanical souls”...

Keynes won the argument, and government intervention to overcome rising unemployment and falling profits has been standard operating procedure forever after. Nevertheless, the debate over intervention ... replays in today’s headlines.

As the world economy wrestles with the credit crisis and a shattered housing sector, there are those who grumble that too much prosperity caused the excesses that became the root cause of all our troubles. Now, they fear, aggressive countercyclical policies will lead to inflation and threaten a run on the dollar. In some ways, this view derives from Mellon’s dark advice.

Just recently, William Fleckenstein, a successful investment manager in Seattle, said: “Part of me keeps hoping we’ll just let financial gravity take over and have this brutal crack-up. We’d have a decent foundation instead of the balsa wood structure we had coming out of the last bubble.”

This school holds Alan Greenspan responsible for current problems. Critics ... contend that he pressed the panic button as the year-over-year inflation rate plunged from 3.6 percent year over year in May 2001 to only 1 percent just 13 months later. ...

Now, Mr. Greenspan’s critics contend, his determined creation of excess liquidity has left his successor, Ben S. Bernanke, with a mess. In this view, Mr. Bernanke is making matters only worse by carrying out extreme interventions. ...

Did Mr. Greenspan’s Fed make the right decisions? ... It is important to remember that deflation is devilishly hard to deal with. When people expect prices to decline, they tend to hold back from spending, which only makes prices fall further. ...

A profound issue is at stake here. ... Prosperity does not manage itself. William McChesney Martin Jr., the Fed chairman in the 1950s and ’60s, famously declared that the Fed’s role was “to take away the punch bowl just when the party gets going.” If we could refrain from squeezing out the last drop of punch on the upside — a temptation that Mr. Greenspan could not resist during the high-tech boom of the 1990s — fewer maladjustments would develop, and the downside would be less ominous and easier to control.

In the real world, however, managing prosperity is just as complex as managing recessions. How does anyone know precisely when the party gets too good? Mr. Martin’s timing with the punch bowl was less neat than he would have liked. Real G.D.P. declined by an average of 2.5 percent during the three recessions that followed his removal of the punch bowl. During Mr. Greenspan’s tenure, ... G.D.P. declined by an average of only 0.7 percent over two recessions.

In any case, those who echo Mellon’s view about letting downturns run their course are inconsistent in their arguments. This school favors government intervention on the upside, but wants no part of government action when trouble develops. Like Mr. Martin, it believes that government should deal with prosperity by cutting it short, before the party really gets good. But when the economy slips into recession, let ’er rip! ...

The onset of the credit crisis last summer could have led to a replay of many features of the Depression. Was it worth the risk of taking no action, and the resulting social and political consequences, in order to clean house and start fresh?

I have no doubt that today’s authorities are taking risks and are going to make mistakes in managing the complex fallout from the speculative fevers of recent years. Nevertheless, I would still reject Mellon’s advice and those who echo it, because the consequences would be unthinkable.

There are two issues here concerning whether policymakers ought to intervene to stabilize the economy. One is the idea that as the economy goes into a recession the government shouldn't interfere with the process of cleaning out the inefficient, poorly managed firms. Those who hold this "creative destruction" view believe that if it does, it not only interferes with this necessary liquidation process, it also has the potential to create moral hazard problems in the future further undermining the economy's ability to be dynamic, flexible, and innovative.

The other issue concerns the practical problems with intervention. Since the "creative destruction" idea gets plenty of ink, and since I don't agree with it, let me offer a few thoughts on some of the difficulties policymakers face in trying to stabilize output and employment.

Suppose we have an output gap:

That is, output is less than the natural rate of output (the level of output consistent with full employment). Suppose also that either monetary or fiscal policy is an effective policy tool, i.e. one or the other (or both) can move output up or down as desired (not everyone agrees this is a good assumption). Should we intervene to move output to its full employment level?

It depends. The first problem is that the value of the natural rate of output, Y*, is unknown and has to be estimated. We can think of this in terms of output or employment, so this is the same as asking what the unemployment rate target should be. Is it 4%? Is it 6%? Is it 5%? If the current unemployment rate is 5%, the answer matters. If we think full employment is 4% when it's really 6%, then we will implement the wrong policy and try to stimulate the economy to lower the 5% unemployment rate rather than taking the punch bowl away. That is likely to be inflationary.

But it's worse than this for policymakers because policy impacts output fully only after a considerable lag - it can be as long as one to three years - so they have to forecast what the full employment level of output or employment will be in the future, and the target varies over time:

So, policymakers are shooting at a moving target with very slow bullets, and the movements in the target aren't always easy to predict. So you can see why policymakers might have a difficult time.

But it's even worse than this. Not only does the target move, output moves on its own as well. Even if there is no policy intervention at all, eventually output would recover (equal the natural rate again):

The fact that output recovers on its own brings up a couple of considerations. First, suppose that the automatic adjustment of the economy is very fast, e.g. the economy can fix itself independent of policy in three months. In addition, suppose that policy takes six months to have any discernible effect on output. Then by the time the policy intervention hits output, it will already have recovered. In such a case, when policy impacts output after the six month lag, it will knock output away from, not closer to the natural rate and this is precisely the opposite of what we want policy to do. So if policy is relatively slow as compared to the self-healing process, then policy is likely to do more harm than good. This is why we devote so much energy to trying to find out how much time it takes for policy to impact the economy, and to determining how fast the economy can overcome frictions that prevent it from staying at full employment continuously.

Second, suppose that the automatic recovery process is very slow, slower than the effects of a policy intervention. In this case, policy can help, but because output is moving on its own (as is the target), the exact size of the policy intervention is difficult to determine. We don't know for sure how fast the economy will recover when hit by a particular shock, nor do we know for sure how fast policy impacts the economy, the exact size of the impact when it does hit, and the target is not known for sure either. But all of these pieces of information are needed to determine how large the policy shock should be. Give the economy too much of a policy shock and you overshoot causing inflation, too little and output will be too low leaving people unemployed. Further, it's hard to readjust and fine tune as you move forward due to the lags and moving targets, and this often results in a fairly conservative intervention, one that attempts to avoid making big mistakes.

For these and other reasons, policymakers should be humble about their ability to stabilize the economy, and some people believe it is so difficult that they ought not try at all since when they do they are just as likely - or more likely - to make things worse as they are to make things better. This, minimally, increases the variance of output over time. But I don't share that view. Yes, it's hard, but it's not impossible and I think that policymakers do much more to help than they do to hurt. They don't always get it right, part of the problem in the 1970s was that the Fed believed the natural rate of unemployment was much lower than it actually was, but for the most part the interventions have been helpful. We would be much worse off right now had we pursued a hands off approach in response to our current troubles either because we believe in the creative destruction approach, or because we believe the practical problems of policy intervention are too difficult to allow an effective response.

Comments

[Bruce Wilder]

Do you think the economy is oscillating, in a business cycle sine wave? Or bumping up against a ceiling?

If you think, ceiling, and shocks are causing the economy to drop below its potential full employment of resources (and full output), then it makes sense to intervene to hurry the economy back to its full-employment ceiling, because the losses in the meantime, from unemployment are unrecoverable dead-weight losses.

If you think oscillation, then you worry about possibly increasing the frequency or depth of oscillation.

If you are thinking about the employment of resources, and full employment of resources is the obviously Pareto-efficient desirable outcome, I think the ceiling model is appropriate. It is difficult to imagine how an oscillation could be sustained through periodic overemployment of resources. What would overemployment look like?

So, if we are to think about oscillations, what is oscillating, if not employment and output, which are bumping up against a ceiling?

I would humbly submit that one consideration for Policymakers is that there is not a single, "natural" full-employment equilibrium, and that policy, in addition, to striving to reduce the oscillation of whatever it is that is osciallating (money? business activity?), is also striving to keep the oscillations in the neighborhood of full-employment equilibrium.

In other words, as long as the economy is within bounds, we can be confident that "output recovers on its own". Overlooking the syntactical difficulty of making Output an Actor-who-recovers, we might surmise that Output recovers to whichever equilibrium is both nearest and attractive.

In choosing whether and how to respond to oscillations or shocks, Policymakers have to consider whether the economy (or Output) might oscillate near enough to some other attractive equilibrium and then follow an undesired path, aka "recover" toward that alternative, and possibly unfortunate, not-a-full-employment equilibrium.

I think asset bubbles and bubble-collapse do represent an unfortunte oscillation in something. I say, "something" because I am afraid that saying "extended money supply" carries too much unfortunate freight.

And, the danger is that, uncompensated for by deliberate Policy response, the oscillation will carry the economy to an unfortunate equilibrium.

I think it is the possibility that the oscillatin will carry the economy to some unfortunate equilibrium, which accounts to the frenzied Policy response to potential deflation.

The policy consideration is not a matter of gently trying to speed a natural return to full-employment ceiling. Rather, the Policy concern is preventing the economy from falling through a hole in the floor into a high-unemployment basement, climbing out of which would be very time-consuming and difficult.

[Mark Thoma]

See here:
New Support for Friedman's Plucking Model

[gordon]

Prof. Thoma: “That is, output is less than the natural rate of output (the level of output consistent with full employment)”.

And here I was under the impression that one of Keynes’ great contributions was to show that an economy could come to rest at a level of output considerably below full employment! If the “natural rate of output” is always “the level of output consistent with full employment”, then isn’t it true that Say’s Law holds and Keynes wasted a lot of his life solving a non-existent problem?

I think there is also an issue about what unemployment is. Many of the people who are “fully employed” flipping burgers and cleaning houses feel instinctively that they could do more complex and higher-value-added jobs. Some of them – maybe many of them – are right. For such people, what does it mean to call them “fully employed”?

[Mark Thoma]

Interpretations differ, but Keynes' "In the long-run we're all dead" means waiting for the automatic adjustment mechanism takes too long - not that it never occurs - just that it may be a long time in happening, so policy has room to step in and hurry the process along. That's one of the examples above.

On the second point, we call those underemployed. We are careful to say, when talking about this formally, fully and efficiently employed to emphasize that very point. In principles, I use similar examples to explain what is meant be full (as opposed to everybody working) employment.

[s]

We would be much worse off right now had we pursued a hands off approach in response to our current troubles either because we believe in the creative destruction approach, or because we believe the practical problems of policy intervention are too difficult to allow an effective response.

As you state at the outset if you don't know the targets and one uses suspect input numbers to begin with it is impossible to draw a conclusion that is within 5 standard deviations of relevance.

How do we know we would be much worse off? Lots of people say this as if it is revealed fact but never have I seen empirical evidence of it. There is none. Just the experts - the same ones trotted ut to defend the fundeamental story behind housing predicated supply demand, the savings glut, the fall of communism. Lots of patting on the back going around for saving the system, but saving the system from what. Doubling the dosage doesn't cure the cancer. As for the comment that the no intervention crowd wants it both ways, actually by leaeaving the market to its own devices, i.e letting the market set rates, a period of controlled growth - the health kind - would ensue.

I know we got the all clear from JPM and Lehman - both sitting on the board of the ny fed - that the systemic crisis was averted. Then they got the autions nd the rate cuts and recaps at the expense of savers. We do know that it proved byeynd a reasonable doubt that the entire banking system is bankrupt. And the investment banks too. Further all the innovation that was so cheered over the past decade (by the same crowd now patting themselves on the back for having the forsight to save the system) has turned out to be hollow. What of all those great productivity numbers.

As for unemplyment rates the past few years had it close to full employment by your definition and yet the quality of jobs created leaves little to be desired (think enron before it collapsed). If the majjority of the employement gains are uneremploeyed workers how can we have a rate that reflects full employment? Should we have been stimulating the past two years?

When all else fails create more debt and close your eyes and pray the sovereigns show up with the lute. When they don't is when Mellon's roadmap kicks in by default. Thereafter perhaps the application of basic prinicples can be applied but it will take a controlled burn and massive expectations adjustments(including revising down all the potential growth expectations that are wildly overstated) - why don;t we just get on with it. Those underemployed would probably like a restart, the underclass is numb and the middle class broadly would probably vote yeah, which leaves but one subset that must have something worth protect

[s]

As for employment the only jobs being created are low levelservice jobs and the ever efficient government - that is outside the B/D adjustment.

[Winslow R.]

"Suppose also that either monetary or fiscal policy is an effective policy tool, i.e. one or the other (or both) can move output up or down as desired (not everyone agrees this is a good assumption)."

Isn't the disagreement more on how well the current tool works?

I think it's pretty obvious the current monetary tool doesn't work very well, just ask Ben why he's been redesigning it. Not sure why economists seem so reluctant to agree.

Monetary and fiscal forces are always plucking away. Output doesn't just 'move on its own'. Anyone that is taxed/receives goverment payments or pays/earns interest is directly affected by these forces. That means EVERYONE all the time.

Given the plucks of fiscal and monetary policy exist, and there a multiple equilibriums that the private sector ends up, how about designing the plucks to be optimal?

Examples -
A steady state fiscal expenditure of $10 billion/month on military aircraft, provides support to the economy but is it optimal to fund the consolidation of large corporations into a single entity? Why not distribute a majority of government expenditures to those that need full employment (a living wage)?

A monetary policy tool that allows investment bankers to access funds at an interest rate of 2% less than the general public will tend to concentrate economic resources into investment banks. Is it optimal to have debt creation and therefore wealth concentrated amongst the banking class? Why not allow students decide if they deserve student loans?

[Too Many Decimal Point]

"That is, output is less than the natural rate of output (the level of output consistent with full employment)."

No one knows how to calculate this with any degree of accuracy. Trying to stimulate the economy to drive the unemployment rate down another 1/10 of 1% is silly, when the margin of error in calculating the natural rate of unemployment is much larger.

Unemployment during the Depression was 25%, today it is 5%. Apples and oranges. It makes no sense to say we need to inflate away unemployment today because it was 5 times as high 80 years ago. Today's rate is all that matters, and it is not very high.

[Winslow R.]

I failed to mention that monetary policy also is tilted towards those that can more highly leverage. If you have 2% spread and can leverage 33x you can make 66% returns.

Is it fair commercial banks can leverage some 10x and investment banks some 33x, obviously not. Why is 'leverage inequality' getting attention as a fundamental problem with current monetary policy control structure when 'access inequality' is not?

Perhaps the 'creative destructionist' agenda derives its power from the seeming inability of the system to morph.

Destruction becomes the only alternative. It'd be nice to see a mainstream economist theoretically propose the TAF before Bernanke makes it happen in practice.

[3D ART]

Destruction becomes the only alternative. It'd be nice to see a mainstream economist theoretically propose the TAF before Bernanke makes it happen in practice.

[a]

"The first problem is that the value of the natural rate of output, Y*, is unknown and has to be estimated. "

I'd say exactly to this brother! How can you estimate the natural rate of output when there are secular trends (e.g. a long-term movement in the U.S. to more debt) which add bias to the numbers?

" This school favors government intervention on the upside, but wants no part of government action when trouble develops."

I certainly support government intervention; it's a certain kind of government intervention that I'm against. It seems (to an unschooled bumpkin) that many explanations of the Great Depression blame the government, the Austrian school saying it was monetary policy in the 1920s and Milton F. saying it was monetary policy in the 1930s. And that sort of makes people (and economists) feel warm all over, because it makes the Depression out to be caused by the financial system, which is thought to be an overlay on the real economy. On the contrary it seems to me that the problems which caused the Great Depression were ones with the *real* economy, and that the problems with the financial system were just reflections of that.

Fast forward to now. If you assume that the present problem is with the real economy - too many people have promised too much of their future income to other people, too much output (and output of a certain type) is being directed to people who are not in a position to produce an equivalent amount of output to pay for it - then trying to "save" the economy by financial legerdemain should only work if it attacks, directly or indirectly, the underlying problem. But *if* the problem is that Americans are borrowing and consuming too much, then how is the problem solved by going into more debt and mailing out income-tax refunds? *If* the problem is too much debt for too many individuals, and the markets are seizing up because they are "seeing" this problem, then how is the underlying problem solved by offering guarantees to an IB which is having a liquidity crisis and using the Fed balance sheet to shore up IB balance sheets? If the problem is that America is not producing enough of the right mix of products in order to be able to sell them to the world in order to pay for its oil and other imported goods to keep its citizens in comfort, then how is lowering the Fed funds interest rate going to help?

[Gabriel]

I would rather reserve the term "creative destruction" for Aghion's work and call "liquidationists" the people you reference. It's an useful term that might play a respectable point in the future. Better not lose it to the Dark Side (tm). ;-)

[a]

And one last question... If a problem with the American economy is that the financial sector, mostly non-productive or even in some cases wealth-destroying, is claiming too much of national production (huge bonuses...), then should the government be devoting such enormous resources (more than half the Fed's balance sheet) to keep it in business-as-usual mode?

[Farrar]

Winslow R.

"A monetary policy tool that allows investment bankers to access funds at an interest rate of 2% less than the general public will tend to concentrate economic resources into investment banks. Is it optimal to have debt creation and therefore wealth concentrated amongst the banking class?"

I think you are the one that keeps asking why not allow individuals direct access to the Fed and do away with the unfair and unnecessary privilege given to bank intermediaries.

Essentially, what you are suggesting is that the banking system be nationalized, and I think that there is a lot of merit in this idea. Especially since we seem to be running up against limits imposed by exhaustion of easily accessible resources. This would suggest that priority must be given to certain areas of lending and investment, which the so-called financial markets are unable to evaluate efficiently, due to their short term outlook. (The economy started going to hell when corporate treasurers learned how to do discounted cash flow analyses.)

As Bruce Wilder often reminds us (if I understand him correctly), the international economy is already governed as much by command and control as by the mythological market. Perhaps it is now advisable for governments to take over more of the command and control which they have hitherto left to Paine's infamous trans nat corporations.

Otherwise we are eternally running into the kinds of contradictions, which "a" so aptly describes, and I quote:

"*if* the problem is that Americans are borrowing and consuming too much, then how is the problem solved by going into more debt and mailing out income-tax refunds? *If* the problem is too much debt for too many individuals, and the markets are seizing up because they are "seeing" this problem, then how is the underlying problem solved by offering guarantees to an IB which is having a liquidity crisis and using the Fed balance sheet to shore up IB balance sheets? If the problem is that America is not producing enough of the right mix of products in order to be able to sell them to the world in order to pay for its oil and other imported goods to keep its citizens in comfort, then how is lowering the Fed funds interest rate going to help?"

As W.R. points out, privately owned banks have the exorbitant privilege of creating money, which is and should be (according to the US Constitution) a sovereign function . Thus banks are essentially subcontractors of the US government and should be very strictly controlled. It is not and never has been reasonable to consider them as part of the so-called free market economy. They are not just businesses like any other.

But it seems that we are still far from such reforms, and we'll just have to work with the banking system we've got for a while.

[zinc]

Excerpted from Alan Greenspan, "The Age of Turbulence", pp 192-193.

"It is just not crediablt that the Inited States can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress......

Behingd the scenes, Bob Rubin and I began contacting the finance ministers and central beankers of the G-7 nations to coordinate a policy response. We argued quietly but urgently, for the need to increase liquidity and ease interest rates throughout the developed world.

Some of our counterparts were difficult to convince. But at last, as the markets in Europe closed on September 14 (1997), the G-7 issued a carefully written statement. " The balance of risks in the world economy has shifted", it declared. It went on to detail how G-7 policy would shift too, from single mindedly battling inflation toward also fostering growth. "

[superduperdave]

I think Bernstein's piece overlooks a critical point: That is, Greenspan has more than interest rate policy to answer for.

Equally important is the Fed's failure under Greenspan to rein in the banks and the mortgage lenders when it would have made a difference -- using the bully pulpit and regulatory power.

Everyone saw it happening, but everyone was getting rich. Greenspan, a politician dressed up like an economist, couldn't bring himself to do anything about the housing bubble.

I have great respect for Bernstein, but I felt that by leaving this point out, he made a rather one-sided and shoddy defense of the former Fed chief.

[Winslow R.]

superduperdave: "Equally important is the Fed's failure under Greenspan to rein in the banks and the mortgage lenders when it would have made a difference -- using the bully pulpit and regulatory power."

Sorry, but your framework is faulty.

Consider the alternative.
Bush is in office.
China etc. desire to build reserves.
Where are these reserves to come from?

Two choices. Monetary or Fiscal policy?

If you can think of a third way to expand the savings vehicles desired by foreign entities, let me know.

Fiscal Policy
We saw what fiscal choices Bush was making. Greenspan recommended tax cuts rather than have the guy spend. Though Krugman won't probably admit it, that was a very smart thing to do. Imagine Bush spending more money than he already did.....

Monetary Policy
Greenspan threw everything, including the kitchen sink to avoid the need for fiscal policy. The demand for reserves was great and needed to be met until China etc. could be convinced to not save quite so much. We will see a rebalance. Efficiency will increase. Nice not to see Hummers on the road anymore. If China slowed its accumulation of its massiver reserves, Hummers would have never gotten out of hand.

Sorry a, the control policy tools keep the economy humming, sometimes with hummers and sometimes without.

[Lafayette]

What is meant by "full employment"?

Nowadays, it is not anywhere near 0% unemployment.

There is the notion of an Incompressible Unemployment level, meaning the level at which -- with all other parameters doing very well, particularly GDP growth around 3% -- unemployment does not and cannot descend below. It remains incompressible. Why?

The skills called for simply are not to be found amongst the unemployed. And, as the skills mix required advances up the competence latter, fewer and fewer menial or un-skilled jobs are left to provide employment; especially entry-level employment like flipping hamburgers at McDo.

I figure that level is between 2.5 and 3%. Any takers?

Also, if the economy heats up too much it demonstrates not only inflation but a high level of unemployment.

So, what does this mean? It means that Keynesian economics must kick in and -- to my mind, at least -- the government "hires" these people, trains them to new skills, haves them apprentice where possible internally and where not possible in industry/commerce at zero wages (but with benefits) for a trial period of six months.

If the economy is doing well, these people will be hired.

Will that work for everyone unemployed? Surely not. Some are incapable of any skills enhancement. They must then be offered other treatment, such as supervised custodial duties perhaps part-time.

The point is this: We must do something, rather than treat like the society's detritus, which would be inhumane. It is wrong to think that existing social assistance or even philanthropy should handle such cases. This responsibility belongs squarely with the collective, that is, the state.

NB: humane = characterized by compassion and sympathy for the suffering or distressed. Of course, if one feels that "suffering" or "distress" is a matter of bad luck, then we inhabit different planets. That notion is a cop-out, a shirking of duty.

[Winslow R.]

Laf wrote: "There is the notion of an Incompressible Unemployment level, meaning the level at which -- with all other parameters doing very well, particularly GDP growth around 3% -- unemployment does not and cannot descend below. It remains incompressible. Why?"

Because you and most mainstream economists focus on monetary policy which is a very blunt instrument. You can not employ everybody by throwing money at everybody. Someone will always be unable to fit in the shower.

Fiscal policy can target that 3% very efficiently with a minimum job with no necessary impact on inflation. Those that are stuck outside the shower get a wet another way. Mark etc. prefer the EITC but you have to have a job first to collect so kind of acts like a Catch-22. Economists can't imagine there are people employers just don't want to go through the trouble training to employ.

[Lafayette]

WR: You can not employ everybody by throwing money at everybody.

Same ole, same ole, Winslow.

Try harder.

[Winslow R.]

Farrar wrote"Essentially, what you are suggesting is that the banking system be nationalized, and I think that there is a lot of merit in this idea. "

I'm not calling for the nationalization of the banking system.

I'm calling for equal access to the lender of last resort.

The legal ability to open access exists. The current scheme of regulations to implement access are misguided, wrong, and destructive creating unnecessary market failure. Ben has fixed some of it and should change more. So far he appears much smarter than people give him credit for.