Introduction to Macroeconomics -Chapter 16-Book Summary-Sociology, Summaries of Macroeconomics

Download Introduction to Macroeconomics -Chapter 16-Book Summary-Sociology and more Summaries Macroeconomics in PDF only on Docsity! Chapter 16 1 Final Chapter 16: Changes in the Macroeconomy and Changes in Macroeconomic Policy J. Bradford DeLong Questions How has the structure of the economy changed over the course of the past century? How has the business cycle changed over the past century? How has economic policy changed over the past century? What are future prospects for successful management of the business cycle? Why does unemployment in Europe remain so high? Why does growth in Japan remain so low? 16.1 Changes in the Macroeconomy Chapter 16 2 Final The Past The structure of the macroeconomy is not set in stone. As time passes the economy changes. And the patterns of aggregate economic activity that macroeconomics studies change too. Consumers’ opportunities and spending patterns change. Industries grow and shrink. The role of international trade steadily expand. The role of the government changes too, rising sharply during the New Deal era of the 1930s and the Great Society era of the late 1960s and early 1970s. It would be surprising indeed if the patterns of macroeconomic fluctuations remained unchanged as all of these factors that underpin the macroeconomy change. Chapter 16 5 Final the marginal propensity to consume. Such reductions in the marginal propensity to consume should carry along with them a substantial reduction in the size of the multiplier. The same holds true for automatic stabilizers. They appear to exert a powerful stabilizing force on the economy. They were not present a century ago. Moreover, the past century has also seen the rise of financial automatic stabilizers like deposit insurance. One major factor making depressions (most notably the Great Depression) larger in the distant past was the fear that you needed to pull your money out of the bank and hide it underneath your mattress because your bank might fail. Such sudden increases in the demand for cash during financial panics caused interest rates to spike, investment to fall, and production to decline. Today the existence of a large deposit insurance system has all but eliminated this fear. Moreover, the pace and direction of material progress changed. Back in the late nineteenth century the bulk of improvements in labor productivity came from capital deepening: the building-up of the infrastructure and the factories of the country. In the twentieth century the bulk of improvements in labor productivity came from improvements in the efficiency of labor, themselves produced by improvements in science and technology: inventions and innovations in materials production, materials handling, and organization. The share of economic activity oriented toward the future increased as well. Research and development became not a casual by-product of the rest of economic activity, but an organized branch of industry and a key component of investment. At least partly as a result, labor efficiency growth in the twentieth century proceeded at twice the pace of Chapter 16 6 Final labor efficiency growth of the nineteenth century. And there are few if any signs that the pace of growth in the early twenty-first century will be slower. Yet in spite of all of these changes in the structure of the economy, the U.S. economy's business cycle has continued. The patterns of the business cycle we see today would seem very familiar to those who watched business cycles late in the nineteenth century. Everything else in the economy changes, yet the business cycle seems to remain largely the same. There are some signs that fluctuations in unemployment have become smaller in recent years (and many signs that the 1930s saw the extraordinarily violent business cycle of the Great Depression). But the major lesson is that—in spite of a number of structural changes that one would have thought likely to diminish the size of the business cycle—it remains and has remained largely the same. Table 16.1—Business Cycle Indicators Period Typical Swing in Unemployment Typical Swing in Nonfarm Unemployment Proportion of Time Spent in Recession 1870-1910 2.3% 4.4% NA 1886-1915 2.9% 4.8% 22% 1901-1930 1.4% 1.9% 30% 1916-1945 7.2% 8.7% 28% 1931-1945 8.1% 10.1% 18% 1946-1975 1.2% 1.3% 19% 1976-1998 1.3% 1.3% 11% 1946-1998 1.5% 1.5% 15% Chapter 16 7 Final Source: Author’s calculations from estimated provided by Christina Romer, and from Historical Statistics of the United States. Future Changes We should not imagine that change is over: it will continue. We can already see some of the future changes that will transform the macroeconomy in the future. The increase in financial flexibility that allows consumers to borrow will continue. The increase in financial flexibility will also make it more difficult to read the financial markets--and is thus likely to make monetary policy somewhat more difficult to conduct. International trade will continue to expand. The odds are that international investments will become easier to make, and so the speed with which capital flows across national borders will increase. And labor markets are likely to continue to change as well. Consumption Already liquidity constraints--the inability to borrow and the consequent fact that consumption spending is limited by income--play a relatively small role in determining consumption spending in America. They certainly a much smaller role than they played at the beginning of this century, or even early in the post-World War II period. Economists’ theories tell us that if liquidity constraints are absent, then the marginal propensity to consume should be very low. The level of consumption should depend on one’s estimate of one’s lifetime resources, and be affected by changes current income Chapter 16 10 Final 98 a sudden shift in investors’ expectations that meant that $100 billion a year in international capital flows that had financed investment in East Asia was no longer there. That $100 billion a year had financed the employment of 20 million people working in investment industries, who dug sewer lines, built roads, erected buildings, and installed machines as both domestic and foreign investors bet that there was lots of money to be made in East Asia's industrial revolution. These 20 million East Asian workers had to find new jobs outside of investment industries. The fall in the value of East Asian currencies has gone a long way to bringing the supply of and demand for foreign exchange back into balance. Falling exchange rates make East Asian goods more attractive to European and American purchasers. East Asia's economies are growing rapidly again But what caused the sudden sharp shift in investment patterns? Unfortunately for economists, and unfortunately for economics as a social science, we cannot find any disturbing cause proportional to the large effect. The shift in Wall Street's desires to invest in East Asia appears to have been impelled much more by the trend-chasing and herding instincts of Wall Streeters--a community of people who talk to each other too much, and whose opinions often reflect not judgments about the world but simply guesses about what average opinion expects average opinion to be--than by any transformation in the fundamentals of East Asian economic development. And here we have reached the limits of economics. Economists are good at analyzing how asset markets work if they are populated by far-sighted investors with accurate models of the world and long horizons. Economists are even good at pointing out that Chapter 16 11 Final such asset markets can be subject to multiple equilibria--situations in which it is rational to be optimistic and rational investors are optimistic if they think that everyone else is optimistic, and in which it is rational to be pessimistic and rational investors are pessimistic if they think that everyone else is pessimistic. But that is all they can say. Note that the process of international investment may still be worth supporting. It does promise powerful benefits: faster industrialization on the developing periphery, and higher rates of return on investments made by investors from the industrial core, diversification to reduce risk. And these benefits may well outweigh the costs of international financial crises. Nevertheless, it is likely that the next generation of business cycles will be judged to have gone well or ill depending on whether the financial crises generated by cross-border financial flows are handled well or badly. Monetary Policy The increase in financial flexibility that reduces the multiplier will also make it more difficult to read the financial markets. It is also likely to make it somewhat more difficult to conduct monetary policy. Monetary policy works, after all, because the central bank’s open market operations change interest rates. The central bank’s open market operations have large effects on interest rates because the assets traded—Treasury bills on the one hand, and reserve deposits at regional Federal Reserve banks on the other hand—play key roles in finance. There are few substitute assets that can serve the functions that they serve. Chapter 16 12 Final But as financial flexibility increases any one kind of asset will become less and less of a bottleneck. There will be more and more ways of structuring transactions. More and more kinds of financial instruments will be traded. Thus in the future it is likely that changes in the supply of Treasury bills will have less of an effect on interest rates than they do today. Open market operations are likely to become somewhat less effective, and monetary policy somewhat more difficult to conduct, in the future. Will this make much of a difference? Nobody knows. But monetary policy today is plenty effective at controlling production, employment, and prices--albeit with long and variable lags. Even a considerable reduction in the power of open market operations would still leave central bankers with more-than-ample tools to carry out whatever kinds of policies they wished. The fear that increases in financial instability will rob central banks of their power to control economies is a fear for a time at least a generation in the future. Will these ongoing and future changes in the structure of the macroeconomy have as little effect on the relative size of the business cycle as past changes appear to have had? To answer that question we need to look at the history of macroeconomic fluctuations. Inventories Fourth and last of the changes that we can foresee is that improvements in information technology will improve businesses’ ability to control their inventories. Mismatches between production and demand—unanticipated large-scale inventory accumulation or drawdowns—have been a principal source of fluctuations in unemployment and output Chapter 16 15 Final Figure 16.3: Consistent Series of Booms and Recessions Legend: Pre-World War I recessions are almost exactly the same length as post- World War II recessions. Post-World War II expansions, however, are half again as long as pre-World War I expansions. Source: Christina Romer. We can reach a few solid conclusions about the changing cyclical variability of the American economy. The first and most obvious fact is the extraordinarily large size of Chapter 16 16 Final the business cycle during the interwar period--the 1920-1940 period that came after World War I and before World War II. The Great Depression that began in 1929 was only the largest of three interwar business cycles. Other major contractions in economic activity took place in 1920-22 and 1937-38. Figure 16.4: The Great Depression Relative to Other Business Cycles U.S. Unemployment 0% 5% 10% 15% 20% 25% 1870 1890 1910 1930 1950 1970 1990 Year Legend: Calculating fluctuations in unemployment according to a methodology Chapter 16 17 Final consistent with the post-WWII data reveals that past unemployment estimates contained in Historical Statistics of the United States overstated the size of the depression of the 1890s. Source: Christina Romer and Historical Statistics of the United States. A second clear conclusion is that in the post-World War II era the business cycle, measured relative to the size of the economy, has been a little bit but not much smaller than back before World War I. The shrinkage in the business cycle appears to be between 25 and 30 percent. The postwar business cycle is a somewhat smaller animal, but it is surely of the same species. Thus many of the changes in the economy since 1900 must have roughly cancelled each other out. The decline of agriculture as a share of employment and production (as a rule not very susceptible to the industrial business cycle) has been offset by the rise in importance of relatively acyclical services (also not very susceptible to the business cycle). An increase in the lifespan of capital equipment due to more durable materials might be thought likely to increase cyclical volatility because more of economic activity takes the form of long-term bets on the future. But this has apparently been offset by faster technological obsolescence, which reduces the effective economic life of investments in fixed capital. A smaller multiplier due to reduced liquidity constraints on households has presumably had some effect. But perhaps keeping spending proportional to income remains a useful rule of thumb even as credit becomes widely available, and so Chapter 16 20 Final recessions. Both overall survey studies and detailed studies of cases like the interest rate cuts that followed the stock market crash of 1987 teach the lesson that the Federal Reserve had considerable success in cutting short recessions and in accelerating growth in the early stages of the subsequent economic expansion. There is no doubt that automatic stabilizers as well have played a role in moderating the business cycle. Yet a third innovation in economic policy--deposit insurance--has had effects that are harder to quantify. However, as Christina Romer observes, "the obvious starting point is the observation that financial panics were ubiquitous before World War I and almost nonexistent since World War II… there were major panics in 1890, 1893, 1899, 1901, 1903, and 1907--all of them the source of substantial contractionary pressure on real GDP. Perhaps the effects of deposit insurance have been large as well: we are not really sure. How Economic Policy Has Not Worked But if economic policy since World War II has prevented or moderated many recessions, it has caused recessions as well. The existence of policy-induced recessions like that of 1981-82 and 1990-1992 is what explains why there has not been a more dramatic reduction in the size of the business cycle over time. At least four times in the United States since World War II the Federal Reserve has engineered a recession, or has willingly accepted a substantial risk of a recession, in order to accomplish its policy goal of curbing inflation. It has had to curb an inflation rate that has crept upward into an uncomfortably high range. Chapter 16 21 Final If the prewar boom-and-bust business cycle was driven by, in John Maynard Keynes’s phrase, the “animal spirits” of investors’ shifts from optimism to pessimism and back again (and by financial panics), the post-World War II boom-and-bust business cycle has been driven by economic policies that have allowed rises in inflation, followed by the development of a consensus within the Federal Reserve that the rise in inflation must be reversed. The minutes of the FOMC meetings identify seven moments since World War II at which the Federal Reserve took steps to reduce the growth rate of aggregate demand because inflation was thought to be too high. At each of these seven moments, therefore, the Federal Reserve risked a recession in order to try to reduce inflation. It sought to combat an inflationary cost-price spiral in spite of the fact that if it did so it would run the risk of incurring temporary unemployment. Why have economic policymakers in the post-World War II era found themselves repeatedly driven to risk recession in order to fight inflation? In the late 1940s inflation was allowed to accelerate because the Federal Reserve had adopted the mission of keeping interest rates low to reduce the cost of financing the huge national debt incurred during World War II. The Federal Reserve was not satisfied with this mission, and in fact negotiated the Treasury-Federal Reserve Accord of 1951 to remove it from its list of policy objectives. In the 1960s and 1970s inflation was allowed to accelerate for reasons that economists still debate. I have stressed historical accidents and the lingering memory of the Great Chapter 16 22 Final Depression. Stanford economist John Taylor stresses mistaken economic theories held in the early 1960s--in particular, the Phillips curve model of Samuelson and Solow constructed under the assumption that inflation expectations were and would remain static. -- deserve considerable blame. Political scientists like Edward Tufte stress political business cycle considerations. At the first, surface level, the United States had an unstable macro economy in the 1970s because until the 1980s no influential policy makers--until Paul Volcker became Chairman of the Federal Reserve--would place a sufficiently high priority on keeping inflation from rising. As long as inflation remained relatively low, it was not seen as a crisis, and so other goals took precedence among every group of economic policy makers. Thus Presidents, Congressmen, and members of the Federal Open Market Committee were willing to accept the risk of increasing inflation to achieve other goals. And only after inflation had risen--only after it had reached the level of a political crisis-- did a consensus develop that priorities needed to be changed, and were steps to reduce inflation taken. Thus under this interpretation, the United States after World War II had a boom-bust stop-go business cycle because the political system could pay attention to only one phenomenon at a time: when inflation wasn’t a crisis, it wasn’t an issue. Only with the acceleration of inflation toward the end of the 1970s did political sentiment begin to shift. For rising inflation did become a severe political problem in 1979. And Paul Volcker was then nominated and confirmed as Chair of the Federal Reserve in a political environment in which control of inflation—rather than reducing the Chapter 16 25 Final But if the business cycle has remained in spite of—and in part because of—active macroeconomic policy, it is important to remember that active macroeconomic policy has made a disaster on the order of magnitude of the Great Depression inconceivable. To see how bad things could get in an extreme situation when economic policy does not do its job, we need only to look back seventy years at the Great Depression. The Magnitude of the Great Depression The speed and magnitude of the economy's collapse during the first stages of the Great Depression was unprecedented: nothing like it had been seen before, and nothing like it has been seen since. From full employment in 1929, real GDP fell until it was nearly 40 percent below potential output by 1933. Investment collapsed: by 1932 real investment spending was less than one-ninth of what it had been three years before. And by 1933 unemployment had reached a quarter of the labor force. Chapter 16 26 Final Figure 16.5: Real GDP Relative to Potential Output During the Great Depression Real GDP Relative to Potential Output 50% 60% 70% 80% 90% 100% 110% 1929 1931 1933 1935 1937 1939 Year Legend: The Great Depression saw the steepest fall in real GDP relative to potential output ever. Source: Author’s calculations from Historical Statistics of the United States In our analytical framework it is straightforward to understand why investment and real GDP fell so far so fast between 1929 and 1933. They did so because of an extraordinary Chapter 16 27 Final rise in real interest rates. Real interest rates that had been four percent in 1929 spiked to nearly thirteen percent by 1931, and stayed high throughout 1932. With such high real interest rates, naturally investment spending fell off. Figure 16.6: The IS Curve and the Great Contraction, 1929-1933 Moving Along the IS Curve, 1929- 1932 0% 2% 4% 6% 8% 10% 12% 14% 40% 50% 60% 70% 80% 90% 100% 110% Real GDP Relative to Potential Output 1929 1932 Legend: Sharp rises in expected real interest rates due to deflation and rising risk premiums pushed the economy far up the IS curve between 1929 and 1932. Chapter 16 30 Final rising sharply: deflation played a big role too. The Initial Shock Economists have proposed many candidates for the shock that triggered the Great Depression. Perhaps the stock market crash of 1929 reduced wealth and increased uncertainty, and caused a downward shift in the baseline level of consumption. Perhaps the availability of consumer credit in the 1920s caused a consumption spending boom that then came to a natural end. Perhaps there was excessive residential investment in the 1920s because builders failed to realize the consequences of the restrictions on immigration put into place in the mid-1920s on long run housing demand. Perhaps the recognition that the housing stock was too large triggered a downward shift in the baseline level of investment. Perhaps the Federal Reserve's increases in interest rates in 1928 in an attempt to reduce stock market speculation triggered the initial slump. Practically any analyst soon reaches the conclusion that the response was disproportionate to the initial shock. Somehow the American economy at the end of the 1920s was very vulnerable in the sense that a small shock could cause a big depression. It is this disproportion between the hard-to-find initial shock and the subsequent depression that makes many economists fear that the economy will be unstable if not managed by appropriate government policies. Chapter 16 31 Final Consequences of the Price Level Decline Economists have reached a consensus that a sufficiently aggressive and activist monetary policy could have stemmed the price decline, and so ended the Great Depression much earlier if undertaken rapidly and aggressively enough. Policies of massive federal deficits funded by money-printing, coupled with aggressive open market operations to increase the monetary base could have, if carried far enough, produced inflation. And without the high real interest rates produced by deflation in the early 1930s, it is hard to see how there could have been a Great Depression. Falling price levels reduce real GDP through two separate channels. The first is the real interest rate channel that we have seen above: the real interest rate is the nominal interest rate minus the inflation rate, so deflation leads to high real interest rates, to a move up and to the left along the IS curve, and to falling real GDP and employment. But there is a second channel as well. Unexpected falls in the price level redistribute wealth from debtors to creditors. Those businesses that are heavily in debt find that they cannot pay, and so they go bankrupt. Those financial institutions which have loaned to heavily indebted businesses find that their loans are worthless, and so they go bankrupt as well. Deflation destroys the web of credit that channels funds from savers through banks and other financial institutions to businesses wanting to invest. More than one-third of U.S. banks failed in the first years of the Great Depression. And without the web of financial intermediaries to channel investment through the financial markets, maintaining or restoring the flow of investment becomes very difficult. Chapter 16 32 Final These effects of deflation are long-lasting. Even after real interest rates have returned to normal, the deflation-driven destruction of the web of financial intermediation will continue to depress investment. So it was in the Great Depression. 16.3 Macroeconomic Policy: Lessons Learned Stabilization For almost all of your lives--"you" being the typical reader of this textbook--the business cycle has been relatively quiescent. A substantial difference in business cycle behavior comes from dividing the post-World War II era into two periods with the breakpoint chosen at the end of the Volcker disinflation in the early 1980s. The pre-1984 years show much more business cycle volatility than do the post-1983 years. Chapter 16 35 Final makers have recognized the limits of what they can achieve, because of the skill of Paul Volcker and Alan Greenspan, because of better economic theories to guide policy, or simply because of good luck. It is clear that every time in the past a "new era" or a "new economy" has been proclaimed, the same old business cycle has soon returned. The expansion of the 1920s led economists to hope that the newly-constructed Federal Reserve had learned how to stabilize output by eliminating the fluctuations in interest rates that caused financial crises. Irving Fisher, the most prominent monetarist of his day. went as far as to claim on the eve of the 1929 crash that stock prices had reached a "permanent and high plateau." The prolonged expansion of the 1960s led the Department of Commerce to change the name of its Business Cycle Digest to the Business Conditions Digest, for it seemed silly to them to have a publication named after a phenomenon that no longer existed. Both President Eisenhower’s and President Johnson’s CEA Chairs, Arthur Burns and Walter Heller, agreed that there had been substantial progress in economic science and policymaking toward economic stability that opened up new dimensions of political economy. One can be optimistic about the future of macroeconomic policy. One can count up all of the lessons that economists and policymakers have successful learned over the course of the twentieth century. One can be especially optimistic from the perspective of the United States today. For from that perspective macroeconomic policy appears remarkably successful. Unemployment is very low, at levels that have not been seen in a generation. Inflation is also low, at levels that have not been seen in a generation either. The stock market is at Chapter 16 36 Final record highs, both absolutely and relative to corporate earnings and dividends-- suggesting that the market at least expects a very bright future. The increase in income inequality that was an extremely worrisome social trend in the United States appears to have stopped (even though it has not reversed itself). And in recent years measured productivity growth has been rapid, suggesting that the political claims by Clinton administration officials in the early 1990s that deficit reduction would lead to a high- investment, high-productivity-growth, high-income-growth recovery were largely correct. Nevertheless, it is likely that the long expansion of the 1990s will be followed by a recession. And what will follow in the way of management of the business cycle is ours to decide. 16.4 Macroeconomic Policy: Lessons Un- or Half- Learned One can also be pessimistic about the future of macroeconomic policy. One can count up all of the lessons that economists and policymakers have not learned, or have half- learned, or have learned and then forgotten over the course of the twentieth century. Certainly a look outside the United States, either at Japan, at the financial-crisis ridden emerging economies, or at Europe with its stubbornly high unemployment does not lend strength to the claim that traditional business cycle patterns have come to an end. Chapter 16 37 Final Lessons Unlearned: High European Unemployment Europe at the end of the 1990s is not in a Great Depression. Nevertheless, unemployment rates in western Europe at the end of the 1990s are within hailing distance of the rates achieved during the Great Depression. Unemployment averages ten percent in the zone of countries that now share the common currency of the euro. Figure 16.9: European Unemployment Legend: The growth of unemployment in fifteen western European countries, 1960- 1995. (ESP = Spain; FIN = Finland; BEL = Belgium, IRE = Ireland; ITA = Italy; FRA = France; DEU = Germany; NLD = Netherlands; NOR = Norway; AUT = Chapter 16 40 Final economists who have examined European unemployment dissent from the conventional wisdom of the editorial writers and the politicians. They tend to see western Europe not as locked into high unemployment, but as in a reversible situation. Just as increases in unemployment in the 1970s and 1980s raised the natural rate of unemployment in Europe, so decreases in the rate of unemployment in the 2000s would in all likelihood lower the natural rate of unemployment in Europe. A Grand Bargain? Economists’ views of western European unemployment thus suggest there is potential for much improvement. Have central bankers and governments shift to a more expansionary monetary policy. As demand expands, people will find that the natural rate of unemployment is falling. The falling natural rate of unemployment will create still further room for demand expansion, and for further unemployment rate reduction. Central bankers may fear that the economists’ view is wrong and that the conventional wisdom is right--that attempts to expand demand and reduce unemployment a little bit will lead to accelerating inflation as unemployment falls below its (high) current natural rate. So begin the process with some steps to eliminate labor-market rigidities: reduce employers’ contributions to social security, reduce severance costs, transfer unemployment insurance money from the payment of benefits to assistance with job search, and allow the minimum wage to fall. These steps should leave central bankers confident that there is room to expand demand in the context of a falling natural rate of unemployment. Chapter 16 41 Final But governments find that such steps to initiate the process of demand expansion can be portrayed as an attack on the standard of living of the unemployed--as an anti-worker anti-human policy. Only if governments are confident that reform of the social insurance system will be accompanied by stronger demand and higher employment will they be willing to undertake their part of the grand bargain. Otherwise they will fear that--with high interest rates and slow demand growth--social insurance system reform will merely change high Classical unemployment to high Keynesian unemployment, and in the process create mass poverty. And only if central banks are confident that their expansionary monetary policies will be accompanied by social insurance system reform would it make sense for them to risk lower interest rates and a change in monetary policy. Even if the conventional wisdom is right, such a grand bargain promises to make everyone--the currently-unemployed, the currently employed who pay taxes to support the social insurance system, politicians dealing with high unemployment, central bankers accused of being out of touch with human experience--better off. And if the economists’ view is right--if the principal determinant of a high natural rate of unemployment in Europe is the fact that unemployment has been high in Europe for a long time--then the benefits to such a grand bargain are overwhelmingly large. Yet European politicians and central bankers have been unable to learn how to deal with their high, stubborn rates of unemployment. Chapter 16 42 Final Lessons Half-Learned: Japanese Stagnation The End of the Bubble Economy The standard analysis of how the Japanese economy entered its present period of stagnation is straightforward. The Japanese stock market and real estate market rose far and fast in the 1980s--to unsustainable “bubble” levels. And eventually the market turned, and both the real estate and stock markets collapsed. When stock and real estate prices collapsed, it was discovered that lots of enterprises and individuals had borrowed heavily against their real estate and security holdings, putting up their real estate and their stocks as collateral. After the collapse, not only were those who had borrowed heavily bankrupt, but the banks and other institutions that had loaned them money were bankrupt as well: the value of the collateral they had accepted would no longer suffice to allow them to repay their creditors. One problem was that no one was exactly sure which institutions were bankrupt--which institutions had liabilities in excess of their assets. Thus no one was anxious to lend money to anyone: you might well never see your money again if the organization you loaned it too was one of the ones that had extended itself during the bubble economy of the late 1980s. A second problem was regulatory forbearance: the belief that the best way to solve the problem was to pretend that it did not exist, try to let business go on as usual, and hope that a few good years would allow all of the institutions that were “underwater” to make enough in profits that they could repay their debts even given the low value of the collateral that they had accepted. Chapter 16 45 Final bank push the interest rate it charges close to zero (to make it very easy and cheap to borrow money). If that isn't enough you should try to deliberately engineer moderate inflation. If demand is depressed because people think investing in corporations is too risky, change their minds by making the alternative to investment spending even more risky. And if the alternative is hoarding your money in cash, then eat away a share of its real purchasing power eaten away every year by inflation. So far Japan has changed its fiscal policy to run big deficits (but, as any student of the Great Depression would suspect, they haven't been big enough). Japan has lowered its short-term safe nominal interest rates to within kissing distance of zero. But these haven't done enough good. The lessons of the Great Depression have been only half-learned. Lessons Half-Learned: Moral Hazard Even in the United States, it seems as though some of the lessons on economic policy taught by the past century of experience have been only half-learned. Consider the problem of dealing with financial crises: those moments when large and highly-leveraged financial institutions have or are about to fail, and when there is a genuine fear that a chain of bankruptcies is about to be triggered. In such a situation the fear that the organization to which one might lend will fail will greatly retard lending. The flow of funds through financial markets will slow to a trickle, Chapter 16 46 Final as savers conclude that keeping their wealth close at hand in safe forms is a much better opportunity than lending it to organizations wishing to lend that are probably bankrupt. Thus such a financial crisis is likely to see the IS curve shift far and fast to the left as the level of investment spending collapses. If this leftward shift in the IS curve is not stemmed, then there will be a recession and the financial crisis will rapidly become worse as businesses that were solvent at normal levels of production and sales find that the fall- off in demand has bankrupted them. What to do in such a situation was first outlined by Bagehot a century and a quarter ago. The government needs to--rapidly--close down and liquidate those organizations that are fundamentally bankrupt. If they would be bankrupt even if production and demand were at normal levels relative to potential, then they should be closed. The government needs to lend money--albeit at a high, unpleasant, penalty rate--to organizations that would be solvent if production and demand were at normal levels, but that nevertheless suffer a cash crunch now. The key is twofold: Government support is necessary in order to prevent a deep melt- down of the entire financial system. Government assistance must be offered on terms unpleasant enough and expensive enough that no one in advance wishes to get into a situation in which they need to draw on it. Moreover, the government must accept that its ability to distinguish between these two classes of institutions is imperfect, and that it will inevitably make mistakes. Yet more and more in the political discussion over economic policy one hears the claim that government provision of liquidity and support in a financial crisis is dangerous--that Chapter 16 47 Final it causes “moral hazard” because organizations place riskier and riskier bets counting on government support to bail them out if things go wrong. The right policy in a financial crisis is a completely hands-off one. A century and a quarter of experience suggests that this is only a half-truth. Moral hazard is a problem, but so is a Great Depression. The balancing point is hard to determine: bank and financial regulators must impose rules that restrict the growth of moral hazard, assistance in times of financial crisis must be expensive and painful to the organization drawing on the government, and yet the worst outcome—a freezing-up of the financial system and a severe recession—must be guarded against. To focus on only one of these three rather than balancing between them is to recommend bad economic policy. The Ultimate Lesson It is strange that neither European nor Japanese governments appear to have learned the lessons that macroeconomists have to teach. It is also strange that fundamentals of crisis policy that seemed settled more than a century ago are still up for grabs in America’s political debate. The principal lesson is that it seems to be very hard to learn the lessons of history. Thus the future of economic policy seems likely to be similar to the past: gross mistakes will be made, historical analogies will be misapplied, and economists and other observers after-the-fact (and sometimes during-the-fact) will find major policy mistakes made by governments and central banks to be inexplicable: we will genuinely be unable to figure out just what the people who made the decisions were thinking. Chapter 16 50 Final Important Concepts Stabilization policy Financial automatic stabilizers Financial flexibility Liquidity constraints Globalization Cyclical volatility Policy-induced recessions Animal spirits Classical unemployment Bubble economy Moral hazard Bagehot rule Analytical Exercises 1. What changing factors since the start of the twentieth century would make one expect business cycles to become larger? 2. What changing factors since the start of the twentieth century would make one expect business cycles to become smaller? 3. As the macroeconomy continues to change in the twenty-first century, do you expect business cycles to become larger or smaller? Chapter 16 51 Final 4. Why has production become more stable in the United States since the early 1980s? 5. Why does unemployment remain high in Europe today? 6. Why does Japan remain depressed today?