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Tuesday, December 01, 2015

'The Centrality of Policy to How Long Recessions Last'

Simon Wren-Lewis:

The centrality of policy to how long recessions last: Paul Krugman reminds us that one of the most misguided questions in macroeconomics is ‘are business cycles self-correcting’. ... That answer ... 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... 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? ... 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. ...
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..., 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.

And I as noted in my last column, the evidence is mounting that that poor policy can do more than slow a recovery, it can also permanently reduce our productive capacity.

    Posted by on Tuesday, December 1, 2015 at 07:10 PM in Economics, Macroeconomics | Permalink  Comments (24)


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