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Wednesday, July 30, 2008

Kenneth Rogoff: The Global Economy is Still Growing Too Fast

Kenneth Rogoff says we need to raise interest rates to prevent inflation, to quit trying to stimulate the economy with fiscal policy, and allow financial institutions to fail:

The world cannot grow its way out of this slowdown, by Kenneth Rogoff, Financial Times: As the global economic crisis hits its one year anniversary, it is time to re-examine not just the strategies for dealing with it, but also the diagnosis underlying those strategies. Is it not now clear that the main macroeconomic challenges facing the world today are an excess demand for commodities and an excess supply of financial services? If so, then it is time to stop pump-priming aggregate demand while blocking consolidation and restructuring of the financial system.

The huge spike in global commodity price inflation is prima facie evidence that the global economy is still growing too fast. ...

Absent a significant global recession..., it will probably take a couple years of sub-trend growth to rebalance commodity supply and demand at trend price levels (perhaps $75 per barrel in the case of oil...) In the meantime, if all regions attempt to maintain high growth through macro­economic stimulus, the main result is going to be higher commodity prices and ultimately a bigger crash in the not-too-distant future.

In the light of the experience of the 1970s, it is surprising how many leading policymakers and economic pundits believe that policy should aim to keep pushing demand up. In the US, the growth imperative has rationalised aggressive tax rebates, steep interest rate cuts and an ever-widening bail-out net for financial institutions. The Chinese leadership, after having briefly flirted with prioritising inflation..., has resumed putting growth as the clear number one priority. Most other emerging markets have followed a broadly similar approach. ... Of the major regions, only ... the European Central Bank has resisted joining the stimulus party... But even the ECB is coming under increasing ... pressure as Europe’s growth decelerates.

Individual countries may see some short-term growth benefit to US-style macroeconomic stimulus... But if all regions try expanding demand, even the short-term benefit will be minimal. Commodity constraints will limit the real output response globally, and most of the excess demand will spill over into higher inflation.

Some central bankers argue that there is nothing to worry about as long as wage growth remains tame. ... But as goods prices rise, wage pressures will eventually follow. ...

What of the ever deepening financial crisis as a rationale for expansionary global macroeconomic policy? ... Inflation stabilisation cannot be indefinitely compromised to support bail-out activities. However convenient it may be to ... bail out homeowners and financial institutions, the gain has to be weighed against the long-run cost of re-anchoring inflation expectations later on. Nor is it obvious that the taxpayer should absorb continually rising contingent liabilities...

For a myriad reasons, both technical and political, financial market regulation is never going to be stringent enough in booms. That is why it is important to be tougher in busts, so that investors and company executives have cause to pay serious attention to risks. If poorly run financial institutions are not allowed to close their doors during recessions, when exactly are they going to be allowed to fail? ...

[T]he need to introduce more banking discipline is yet another reason why the policymakers must refrain from excessively expansionary macroeconomic policy ... and accept the slowdown... For most central banks, this means significantly raising interest rates to combat inflation. For Treasuries, this means maintaining fiscal discipline rather than giving in to the temptation of tax rebates and fuel subsidies. In policymaker’s zealous attempts to avoid a plain vanilla supply shock recession, they are taking excessive risks with inflation and budget discipline that may ultimately lead to a much greater and more protracted downturn.

Where I differ is on the risk of inflation over the longer run - I am more inclined toward Mark Gertler's view -  and on the fragility of the financial system. Inflation is a concern, but raising interest rates too fast risks throwing the financial sector into a tailspin, and that would bring the economy down with it, and that's a risk I'd rather not take. We need to keep an eye out for signs that inflation is becoming embedded and self-reinforcing, but we need to be even more concerned about a domino effect taking hold in the financial sector. That danger is not yet over.

As for fiscal policy, first, I am not worried about one shot increases in spending creating the continuous increases in demand needed to fuel a long-run inflation (see here for a summary of the estimated effects of the stimulus on GDP). However, beyond that, it's important to remember that our problems are not just from high world demand causing high commodity prices. If that was the only problem we face - it this was just a "plain vanilla supply shock recession" - I'd be inclined to agree. But we are also having a financial crisis and that requires a different response (and makes our policy needs different from countries that are not having a mortgage meltdown - our problem isn't plain vanilla). The evaporation of credit represents a shock to demand, and unless that demand is replaced during the period when financial markets are recovering, we will have lower output and employment growth than we are able to sustain.

Update: Paul Krugman:

The Rogoff doctrine, by Paul Krugman: Ken Rogoff is one of the world’s best macroeconomists, so I take whatever he says seriously. But — you know that’s the kind of statement that is followed by a “but” — I’m having a hard time understanding his demands for a world slowdown.

Ken tells us that

The huge spike in global commodity price inflation is prima facie evidence that the global economy is still growing too fast.

And then he calls for

a couple of years of sub-trend growth to rebalance commodity supply and demand at trend price levels

Um, why? Basically, the world is employing rapidly growing amounts of labor and capital, but faces limited supplies of oil and other resources. Naturally enough, the relative prices of those resources have risen — which is the way markets are supposed to work. Since when does economic analysis say that the way to deal with limited supplies of one resource is to reduce employment of other resources, so that the relative price of the limited resource returns to “trend”?

Presumably there’s some implicit argument in the background about why a sharp rise in the relative price of oil is more damaging than leaving labor and capital underemployed. But that argument isn’t there in Ken’s recent pieces. Model, please?

I agree that

Dollar bloc countries have slavishly mimicked expansionary US monetary policy

and that’s a real issue: the Fed is pursuing very loose policy to deal with a US financial crisis, and that’s inflationary in countries that are pegged to the dollar without facing our problems. But that’s an argument for breaking up Bretton Woods II; it’s not an argument for tighter Fed policy.

Since this is coming from Ken Rogoff, I assume that there’s some deeper analysis here. But I can’t infer it from the articles I’ve read. Please, sir, can I have some more?

    Posted by on Wednesday, July 30, 2008 at 12:33 AM in Economics, Financial System, Fiscal Policy, Monetary Policy | Permalink  TrackBack (0)  Comments (51)

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