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.