Slower Economic Growth in the Future as a Result of the Financial Crisis - Grasping Reality with Both Hands
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Grasping Reality with Both Hands The Semi-Daily Journal of Economist J. Bradford DeLong: Fair, Balanced, RealityBased, and Even-Handed Department of Economics, U.C. Berkeley #3880, Berkeley, CA 94720-3880; 925 708 0467; delong@econ.berkeley.edu.
Economics 210a Weblog Archives DeLong Hot on Google DeLong Hot on Google Blogsearch July 14, 2010
Slower Economic Growth in the Future as a Result of the Financial Crisis How much slower? I don't know. But it will be slower. 0.2% per year? 0.1% per year? We are live at the Economist: Will the financial crisis and its aftermath lower the world economy's potential rate of growth?: Yes, largely because central bankers will behave differently Brad DeLong our guest wrote on Jul 14th 2010, 12:56 GMT I THINK that the answer has to be yes. The net result of the financial crisis will be that the world's average unemployment rate and level of capacity utilisation will be higher, which means that businesses will be able to grasp fewer economies of scale, which means that profits will be lower, which means that investment spending to try to capture those profits will be lower, which means that global economic growth will be lower. The unemployment rate and the level of capacity utilisation will be lower for two reasons. The first is what Larry Summers and Olivier Blanchard liked to call "hysteresis" in unemployment after recessions. Workers who are out of work— http://delong.typepad.com/sdj/2010/07/slower-economic-growth-in-the-future-as-a-result-of-the-financial-crisis.html
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Slower Economic Growth in the Future as a Result of the Financial Crisis - Grasping Reality with Both Hands
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especially workers who are out of work for a long time—lose a good deal of their market-relevant human capital. Their networks of contacts that allow them to easily get and change jobs, their habits of punctuality, their workplace skills, and their selfesteem all erode. The long-term unemployed, especially, drop out of the effective labor force—and it is damnably hard to reattach them all to employment absent a full-scale World War II-style inflationary boom. The second reason is that central banks are going to act differently in the future than in the past. There used to be three broad philosophies of central banking—call them regulationism, punchbowlism, and Greenspanism. Regulationism is that bankers have to be very tightly constrained in what they can do and what investments they can make, because only if bankers are kept under very tight regulatory supervision can the central bank dare risk making credit loose enough to produce full employment. If banks are not tightly regulated, then making credit loose is like giving a bottle of brandy to...—well, you know what the bank will do, you just don't know against which wall it will do it. Punchbowlism, by contrast, is the belief that the benefits from free-wheeling and innovative finance in greasing the flow of capital from savers to businesses make it worth deregulating finance, but then the central bank must maintain relatively tight money; it was, as 1950s and 1960s Federal Reserve Chair William McChesney Martin liked to say, make sure to take the punchbowl away once the party really gets going. The third position was Greenspanism: that modern central banks know a lot more about the economy and the financial sector than their predecessors, and so—as long as we don't see big signs of consumer price inflation—can afford to follow loose-money policies even in the context of deregulated financial markets. As long as unemployed workers are still wallflowers around the edges of the room, Alan Greenspan might say, the Federal Reserve should not only let the punch flow but spike the punchbowl with the grain alcohol of 1% interest rates to, in the words of Jay-Z and Missy Elliot: Let's get this party started right! Let's get drunk and freaky! And the two-decade long Great Moderation gave Greenspanism credibility. It certainly did to me. Well... well, now we have failed to reregulate financial markets sufficiently to make anybody comfortable that the straight jacket is tight enough to constrain banks: Regulationism is out of the question. And all of us ex-Greenspanists have recanted and repented. So, for a generation at least, central banks will follow a very different policy. Think not that they will merely take the punchbowl away when the party gets started. They are, instead, going to forbid even the filling of a punchbowl. They are going to hunt down punchbowls in their pantries and smash them all. We see this right now, as every excuse—nonexistent inflationary pressures, nonexistent lack of confidence in reserve currency debts, et cetera—is trotted out to justify premature tightening when there is still something like 10% of excess demand slack in the world economy. The higher structural unemployment rate from "hysteresis" and the higher unemployment from central banks' inevitable future bias toward tight money have to be weighing on business decision-making as they plan investment for the future. How much? How big? I don't know. I don't have a good quantitative estimate.
http://delong.typepad.com/sdj/2010/07/slower-economic-growth-in-the-future-as-a-result-of-the-financial-crisis.html
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Brad DeLong on July 14, 2010 at 08:12 AM in Economics, Economics: Federal Reserve, Economics: Labor, Economics: Macro, Obama Administration | Permalink Favorite
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Comments Andy Harless said... I sense a certain cognitive dissonance here. On the one hand, you acknowledge having recanted your Greenspanism. On the other hand, you ridicule the punchbowlists. Which are you? For my part, I am an unrepentant Greenspanist. Ideally, I'm a modified Greenspanist with a higher inflation target and preferably with that target embodied in a price-level rule or (even better, I'm beginning to think) a nominal-GDP-level rule that would produce more confidence in the central bank's response to a financial crisis. But I'll take traditional Greenspanism as a second best. There will be financial crises from time to time. But the underlying cause of the current depression was not the financial crisis but the pre-existing global savings glut. To toss aside Greenspanism is essentially to surrender to the global savings glut, to say that we will accept a more-or-less permanent mild depression (or even a serious depression) in order to avoid the risk of occasional severe recessions. I recommend against making deals with the devil unless you have a very good lawyer. And here's something I don't understand. The Greenspanist consensus was that we should have 2% inflation and not worry about the collateral effects of easy money. Clearly there were problems with that view as a whole. But how is it that central bankers have taken the lesson to be that we should have 2% inflation and do worry about the collateral effects of easy money? The collateral effects of easy money would be much less of a problem if the inflation rate were higher, since that would give central banks the option of easing further in response to a financial crisis, after already having been easy to begin with. In principle one could adjust both premises of the old consensus, and each adjustment would reduce the need for the other. But there isn't the slightest suggestion that central bankers are considering discarding the low inflation part of the old consensus. Why are they convinced that the solution to this optimization problem is a corner solution and not an interior one? Reply July 14, 2010 at 01:57 PM Jonathan said in reply to Andy Harless... "Greenspanism: ... can afford to follow loose-money policies even in the context of http://delong.typepad.com/sdj/2010/07/slower-economic-growth-in-the-future-as-a-result-of-the-financial-crisis.html
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deregulated financial markets" I think it's the "context of deregulated financial markets" part that is DeLong's problem here (and, FWIW, mine). Reply July 14, 2010 at 03:44 PM Andy Harless said... It seems to me that punchbolwism -- as a permanent policy -- is easily reduced to absurdity. You're saying that central bankers will never quite allow goods and labor markets to get to equilibrium, for fear of the dangerous consequences in asset markets. But rational agents will then anticipate that goods and labor markets will always be below equilibrium, which is equivalent to saying that there will never be a positive price (or wage) level low enough to satisfy them. If agents are all perfectly rational and anticipate one another's actions, then as soon as a punchbowlist regime is credibly announced, all commerce will cease. On a more practical level -- where the regime is imperfectly credible and agents are imperfectly rational -- punchbowlism is likely to result in ever-accelerating deflation. In other words, in order to avoid acute financial crises, we choose instead to have a chronic one. Reply July 15, 2010 at 10:35 AM Andy Harless said... Basically I'm making Milton Friedman's Natural Rate of Unemployment argument, only in reverse. Central banks can affect the unemployment rate in the short run, but not in the long run. But keeping financial markets "safe" essentially requires keeping the unemployment rate above its long-run value. We know this because we observed the financial instability that resulted when central banks were doing a good job of keeping the unemployment rate at its long-run value. But central banks can't control the unemployment rate in the long run, so trying to keep it below its long-run value will lead to even worse instability. Ergo, punchbowlism is self-defeating. The sensible thing to do (assuming there is not adequate regulation) is to go to my modified Greenspanism with its higher inflation target. Barring that, we should just go back to standard Greenspanism and live with the occasional financial crises. Reply July 15, 2010 at 10:51 AM Comments on this post are closed.
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Slower Economic Growth in the Future as a Result of the Financial Crisis - Grasping Reality with Both Hands
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