Skip to main content

The anti-demand coalition

In yesterday's blog post Paul Krugman summarizes very well the position of some academic economists who deny the potential role that aggregate demand might have in explaining business cycles and, as a result, they reject any policies that might have an effect via the demand channel. Their models are only driven by changes in the productive capacity of an economy which means that the Great Recession (or the Great Depression) must have been the result of some destruction in our capital stock or our inability to remember how to work or produce or somehow our technology got worst than in previous years.

It might be that these economists are just describing an ideal world using assumptions that are very far from the real world but how is it possible that these ideas seem to have such a strong influence in economic policy and even support among the general public? Why is it that countercyclical policy (fiscal or monetary) has been challenged so much during the current crisis? Most policy makers and certainly the public at large do not share the assumptions used by those economic models. In fact, when most people are asked to describe the dynamics of economic crisis, they immediately refer to some notion that shortages of demand cause recessions. When I teach about recessions and I ask my students about the cause of business cycles they immediately tell a story that sounds like the very basic keynesian multiplier (spending reduces income which further reduces spending...). But when the same students are asked to give their views about appropriate economic policies during a crisis, they immediately show their distrust in governments and central banks in their ability to help smooth business cycles. Somehow, expansionary fiscal policy or monetary policy cannot work because it is driven by the government.

So we end up with an odd coalition of views against countercyclical economic policy: those who rely on models where by definition countercyclical policy is ruled out and those who do not believe in these models (they laugh at them if you explain all the assumptions) but because they have no trust in governments they end up reaching the same conclusion.

Comments

Post a Comment

Popular posts from this blog

You can lower interest rates but can you raise inflation?

Last week the Bank of England lowered their interest rates. This combined with previous moves by the ECB and the Bank of Japan and the reduced probability that the US Federal Reserve will increase rates soon is a reminder that any normalization of interest rates towards positive territory among advanced economies will have to wait a few more months, or years (or decades?). The message from the Bank of England, which is not far from recent messages by the Bank of Japan or the ECB is that they could cut interest rates again if needed (or be more aggressive with QE purchases). Long-term interest rates across the world decreased even further. The current levels of long-term interest rates have made the yield curve extremely flat. And in several countries (e.g. Switzerland) interest rates at all horizons are falling into negative territory. The fact that long term interest rates is typically seen as the outcome of large purchases of assets by central banks around the world. In fact, many se...
Post a Comment
Read more

The missing lowflation revolution

It will soon be eight years since the US Federal Reserve decided to bring its interest rate down to 0%. Other central banks have spent similar number of years (or much longer in the case of Japan) stuck at the zero lower bound. In these eight years central banks have used all their available tools to increase inflation closer to their target and boost growth with limited success. GDP growth has been weak or anemic, and there is very little hope that economies will ever go back to their pre-crisis trends. Some of these trends have challenged the traditional view of academic economists and policy makers about how an economy works. Some of the facts that very few would have anticipated: - The idea that central banks cannot lift inflation rates closer to their targets over such a long horizon. - The fact that a crisis can be so persistent and that cyclical conditions can have such large permanent effects on potential output. - The slow (or inexistent) natural tendency of the economy to adj...
Post a Comment
Read more

The permanent scars of economic pessimism

Gavyn Davies at the Financial Times reflects on the growing pessimism of Central Banks regarding the growth potential of advanced economies. In the US, the Euro area or the UK, central banks are reducing their estimates of the output gap. They now think about some of the recent output losses as permanent as opposed to cyclical. It output is not far from what we consider to be potential, there is less need for central banks to act and it is more likely that we will see an earlier normalization of monetary policy towards a neutral stance. Why did they change their mind? Is this evidence consistent with the standard economic models that we use to think about cyclical developments? Measuring potential output or the slack in the economy has always been challenging. One can rely on models that capture the factors that drive potential output (such as the capital stock or productivity or demographics) or one can look at more specific indicators of idle capacity, such as capacity utilization or...
Post a Comment
Read more