We must not forget that, in the Great Recession, prominent central bankers rejected modern macro theory as useless. That was, of course, when useful theory was most needed. Stabilization authorities complained that consensus modeling failed to provide practical guidelines for their efforts to combat the extreme instability that threatened depression. While most of the criticism was made in private, Jean-Claude Trichet went public. The head of the European Central Bank opened his annual Central Banking Conference in 2010 with an in-your-face challenge to the macroeconomics academy: “When the crisis came, the serious limitations of existing economic and financial models immediately became apparent. Macro models failed to predict the crisis and seemed incapable of explaining what was happening to the economy in a convincing manner. As a policymaker during the crisis, I found the available models of limited help. In fact, I would go further: in the face of the crisis, we felt abandoned by conventional tools.”
At the time, I was confident that the humiliating trip to the woodshed would push the academy to assign top-priority status to reconstructing macro theory to be stabilization-relevant. In particular, I thought modern stabilization theory would be reworked to restore the centrality of the management aggregate nominal demand, especially in circumstances of gathering nonstationary contractions in total spending. I was wrong. Most mainstream New Keynesians have, after a relatively brief spell of lying low, brushed off the bitter criticism and resumed asserting that their disgraced market-centric general-equilibrium model is settled theory.
This week’s post continues the GEM Blog’s documentation of the unhappy results from perpetuating the fraud that mainstream stabilization theory is thoroughly adequate for effectively explaining the range of actual instability. We are told that research that goes beyond refinements of consensus thinking is a waste of time. What follows illustrates the harmful effect on macro research by looking at the most recent Papers and Proceedings of the Annual Meeting of the American Economic Association (January 4-6, 2019), published last month. Not that long ago, papers on macro stabilization, largely because its problems involve huge welfare costs, dominated AEA meetings. Today, in the age of settled macro theory, stabilization theory is hardly mentioned, even while the memory of Great-Recession losses estimated in the trillions of dollars is still fresh.
Of the thirty-three multi-paper subject areas included in the published Proceedings, only two appear to be relevant to stabilization theory: (1) Monetary Policy Frameworks and the Zero Lower Bound and (2) The Next Crisis: From Where and Are We Ready? And those promising titles mislead, as the authors avoid a close look at the 2008-09 class of macrodynamics, largely because its extreme instability cannot be rationally accommodated in “settled” market-centric general-equilibrium theory.
Zero Lower Bound
This subject area is not uninteresting and better understanding of monetary intervention in the context of a zero-bound target interest rate would be at least somewhat useful to policymakers. But, as readers of the GEM Blog know, such analysis has little relevance to the sort effective monetary management required in crises featuring nonstationary contractions of nominal demand. The zero-bound literature is instead relevant to stationary demand contractions that yield familiar, relatively mild recessions. In the familiar Keynesian narrative, such shifts in total spending are corrected, after relatively short lags, by automatic stabilizers augmented by central-bank “lean-against-the-wind” intervention. Stabilizers include lower interest rates and higher public deficits, income-support programs triggered by involuntary job- and income-loss, and other counter-cyclical transfer payments. Meanwhile, the central bank seeks to speed recovery via open-market purchases of short-term Treasury debt, increasing system liquidity and further reducing interest rates. The lower interest rates encourage investment and household spending.
Trichet’s complaint is rooted in a different problem, i.e., nonstationary demand contractions and their consequent outsized recessions that threaten to morph into depressions. NDD overwhelms automatic stabilizers and orthodox central-bank intervention. If not contravened, extreme instability induces rapidly cumulating forced job and income loss, collapsing output and profits, gathering price deflation, debt default, wealth destruction, and cataclysmic depression. NDD circumstances, which also impair lending by and funding for financial institutions, require very aggressive, very prompt nominal-demand management to prevent massive welfare loss.
The GEM model of NDD instability provides the sort of effective guidelines for which the central banks were looking. (For elaboration, see the 3/22/2019 post.) It centrally features the loss of investor/lender confidence in stabilization authorities’ trend employment/output objective. Nancy Stokey (2009) taught us that, as investors/lenders become less certain about macro prospects, simple inaction becomes increasingly rational. In particular, buyers of financial assets reasonably respond to uncertainty inherent in a nontrivial possibility of unchecked NDD by moving to the sidelines, waiting for the emergence of a credible floor under asset prices. Stokey’s analysis is considerably enriched by the GEM Project’s rooting of rational inaction in the breakdown in stabilization authorities’ real-side credibility.
In NDD circumstances, the Fed target interest rate promptly falls to zero, but encountering the zero bound doesn’t much matter. Given such crisis conditions, interest rates exert little influence on investment or any other kind of spending. What matters instead is expectations of trend profits and employment and, therefore, the capacity of stabilization authorities to reverse collapsing nominal demand. (The demand collapse combines with meaningful wage rigidity, microfounded in the Project, to rationally induce rapidly contracting employment and output.) That “settled” mainstream macro theory accommodates neither NDD or MWR explains why modern Ptolemaic research emphasizes SDD-class recessions and fusses over zero-bound problems.
The Next Crisis
The second subject area, “The Next Crisis: From Where and Are We Ready”, requires only a brief look. Mainstream analysts are misled by their own “settled” theory into believing that the most reliable way to prevent Great Recessions/Depression is to eliminate originating macro shocks. They get stuck trying to figure out how to prevent the sort of financial shock, centered around the securitization of subprime residential mortgages, that disrupted asset markets in 2008.
There are at least two problems that make the prevention approach tragically inadequate. First, financial markets evolve rapidly, in part to avoid the sort of regulation put in place after the Great Recession. The content of the three papers professing to identify from where the next NDD episode will come almost certainly will be way off-target; the range of reasonable suspects is way too big. Second, there is no reason to assume the originating crisis must be financial. Now the suspect population is really huge. The GEM Project takes the only sensible approach here. It reasons that it is foolish to rely on preventing shocks that may lead to future NDD crises. It recognizes that effective stabilization strategy must instead emphasize assembling the most powerful demand-management tools possible for use by authorities in their efforts to quickly halt and reverse NDD whenever and wherever it is organizing itself. The goal should be prevent the demand collapse that inherently links macro shocks to Great Recessions and Depressions.
Blog Type: New Keynesians Saint Joseph, Michigan