…when the Great Recession is compared not to other U.S. cycles but to the Big 5 financial crises and the U.S. Great Depression (thanks to U.S. Treasury for adding that to the graph), the current cycle actually compares pretty favorably. This is likely due to the coordinated global response to the immediate crises in late 2008 and early 2009. While the initial path of both the global and U.S. economies in 2008 and 2009 effectively matched the early years of the Great Depression – or worse – the strong policy response employed by nearly all major economies – both monetary and fiscal – helped stop the economic free fall.
This is worth highlighting because of the eagerness of policymakers to embrace Reinhart and Rogoff as an excuse to avoid fiscal and monetary policy. For instance, see St. Louis Federal Reserve President James Bullard in the Financial Times:
Some may argue that real output and employment in the US have not returned to the pre-crisis, bubble-induced path that seemed to prevail in the mid-2000s. Indeed, US employment is about 4.7m lower than at its peak in January 2008. But this is to be expected. Recoveries in the aftermath of financial crises tend to be especially protracted, as the work of Carmen Reinhart and Kenneth Rogoff has documented.
Bullard sees Reinhart and Rogoff as an excuse to do nothing. After all, why even try when history has proved the long-lasting impact of financial crises? Bullard completely misses the alternative argument – that if financial crises are long-lasting, then the policy response needs to be more aggressive. As Lehner points out, aggressive policy response can mitigate the impact of the crisis. Bullard should read Reinhart and Rogoff as a demand to do more, not an excuse to do less.
Indeed, Reinhart and Rogoff have said as much. Via Ezra Klein:
…if you look at the leaked memo that the Obama administration was using when they constructed their stimulus, you’ll find, on page 10 and 11, a list of prominent economists the administration consulted as to the proper size for the stimulus package. And there, on page 11, is Rogoff, with a recommendation of “$1 trillion over two years” — which is actually larger than the American Recovery and Reinvestment Act. So if they’d been following Rogoff’s advice, the initial stimulus would have been even bigger — not nonexistent.
As for Reinhart, I asked her about this for a retrospective I did on the Obama administration’s economic policy. “The initial policy of monetary and fiscal stimulus really made a huge difference,” she told me. “I would tattoo that on my forehead. The output decline we had was peanuts compared to the output decline we would otherwise have had in a crisis like this. That isn’t fully appreciated.”
Bullard also argues against a higher inflation target:
To argue against monotonic convergence now would imply that when unemployment is above the natural rate, monetary policy should aim for inflation above the Fed’s 2 per cent target. On the face of it, this does not make sense: the US has experienced periods when both inflation and unemployment have been above desirable levels. In the 1970s this phenomenon was labelled stagflation. Monetary policy has been regarded as poor during that period.
Scott Sumner already identified the sad mistake Bullard makes here. Essentially, Bullard has a limited sense of history – he knows of only two possible monetary equilibriums, one with 2% inflation and low unemployment, the other with infinite inflation and high unemployment. What about the Great Recession? Couldn’t current monetary policy, with below target inflation and above target unemployment, also be regarded as poor? And isn’t that the situation we are in now, as Bullard himself admits?
What does Rogoff have to say about the 2% inflation target? From the FT last year:
If direct approaches to debt reduction are ruled out by political obstacles, there is still the option of trying to achieve some modest deleveraging through moderate inflation of, say, 4 to 6 per cent for several years. Any inflation above 2 per cent may seem anathema to those who still remember the anti-inflation wars of the 1970s and 1980s, but a once-in-75-year crisis calls for outside-the-box measures.
And more recently:
…many (if not necessarily all) central banks will eventually figure out how to generate higher inflation expectations. They will be driven to tolerate higher inflation as a means of forcing investors into real assets, to accelerate deleveraging, and as a mechanism for facilitating downward adjustment in real wages and home prices.
Rogoff apparently does not take his research to imply that policymakers should give up. And he explicitly identifies higher inflation targets as a potential tool. Yet Bullard (like most of the Fed) is married to the 2% target without any consideration that the appropriate inflation target may vary across time and economies, and he essentially cites Rogoff as a reason to justify this position. You can’t do more, so why try?
Bottom Line: Policy is effective even in the aftermath of a financial crisis. Don’t let policymakers fool you into believing otherwise.
Update: I notice some Twitter chatter of surprise that Rogoff was not completely opposed to fiscal stimulus (I thought everyone read Ezra Klein). Some additional quotes from the FT would be helpful:
At the root of today’s credibility deficit is a failure to come to grips with the long, slow growth period that is typical of post-financial crisis recovery…By far the main problem is a huge overhang of debt that creates headwinds to faster normalisation of post-crisis growth – that is why post-financial crisis growth is typically very slow…It is far from clear that any huge temporary fiscal stimulus will rev up the engine enough to achieve self-sustaining growth…The most direct remedy, of course, would be to find expeditious approaches to cleaning up balance sheets whilst maintaining the integrity of the financial system…If direct approaches to debt reduction are ruled out by political obstacles, there is still the option of trying to achieve some modest deleveraging through moderate inflation of, say, 4 to 6 per cent for several years.
I think the story here is that fiscal stimulus is only a temporary measure, not a long-run solution. The long-run solution is dealing with the debt overhang, which can be addressed with more aggressive monetary policy.
This post was originally published at Tim Duy’s Fed Watch and is reproduced here with permission.
2 Responses to “Excuses Not To Do More”
The value of policy response to financial crises can only be partially measured by recovery of employment in the medium term. The balance of the measure is how well economies perform in the long run, raising the possibility that a policy mix may provide superior results over the medium term but fail over the longer term for any number of reasons including the accumulation of too much debt. For example, Spain recovered comparatively faster than either Sweden or Finland but today is far worse off than either country. I understand the euro crisis weighs upon Spain perhaps making Norway a better example which handled its finacial crisis in 1987 in a manner totally different than how we (the US) did in 2008. Among other things, Norway wrote down share capital very before providing assistance, did not provide blanket guarantess and did extend liquidity to insolvent financial institutions. And this leads to my final point which is that what comprises a policy response is more complicated than either fiscal or monetary policy. Many structural issues should be included in the discussion.
Typo. Extended liquidity to only solvent institutions.