If there is a recession, how bad could it be?

I’ve put a chart here showing real economic growth in the US since 1901.  An alternative title for this graph would be “The vindication of macroeconomic management”.  Many people tend to be quite dismissive of macroeconomists, thinking them little better than astrologers and little use for much beyond stimulating discussion.  This graph tells you one very important reason why that’s wrong.

I want you to see in this graph three distinct phases.  In the first, before the use of macroeconomic management (which really began after the Second World War), we see a certain degree of volatility in economic growth.  A few of the extreme movements visible here can be related directly to the First and Second World Wars; most cannot.  After macroeconomic demand management was introduced (built upon the ideas of Keynes), volatility in US growth fell dramatically (i.e. contrary to much ill-informed discussion on the right, Keynesianism and the so-called “Neo-Classical Synthesis” was a great success).  Following various 1960s critiques of Keynesian methods there was a switch away from Keynesian methods to monetary rules in the 1970s (as can be seen, these worked no better for the US in growth volatility terms) and then to modern monetary techniques during the 1980s (particularly under Volcker and Greenspan).  The introduction of these modern monetary techniques was associated with a reduction in volatility almost as dramatic as the reduction in the Keynesian period (so, though Keynesian techniques were successful, we eventually worked out how to do even better).

Now, it is quite plausible that the next year or two will see quite low growth — even recession — in the US.  That would mean a point or two on this line that went below the x-axis.  Problems could just conceivably be even worse than this.  But don’t rely on it for political purposes — don’t just assume that the economy is going to be so bad that current governments will be automatically ejected, and especially don’t assume that the US is going to be mired in recession for a long time.  Perhaps the extraordinary nature of current events (especially if UK house prices continue to fall significantly, adding securitized UK housing debt to the sub-prime debt problem — perhaps taking down a number of European institutions) — perhaps the one-in-a-generation nature of these events will defeat even the skill of modern central bankers.  But I doubt it.

I have appeared in all kinds of media over the past couple of years criticizing the Bank of England, mainly for not raising interest rates.  But my disagreements with the MPC have lain at the level of a quarter point here, a half point there.  The debate between those that agreed with me and those that agreed with the MPC was an important one — there might have been 0.2 per cent of GDP at stake, perhaps £20bn or more.  But though certainly worth debating, these discussions are dwarfed by the changes visible in my figure, in which tens of percentage points of GDP over a few years might be at stake.  I may not think that the MPC has been doing things perfectly, and the cost of errors might be more than I have suggested, but I don’t think the MPC or the Fed or the ECB have got things all that wrong, and I have every confidence that policy will be used aggressively and (near enough) appropriately.  With felicitous use of monetary policy we may yet walk the tightrope between rising inflation and recession, and the slowdown in growth may not seem so very out of keeping with the fluctuations in my chart above.

I certainly think there will be a slowdown, and that it will probably be materially more significant than that predicted in the Budget.  I also think that recent events should make us look again at the use of inflation targeting in its current form and that the fiscal rules need radical surgery.  However, for the reasons I have set out above (and elsewhere), I think we are much more likely to have a slowdown that will seem painful by the standards of the past fifteen years, but be much less dramatic than much overwrought press commentary.  I would urge David Cameron and his team to be careful about making apocalyptic predictions.  Quite apart from the risk of looking like a Jeremiah or appearing to revel in the grief of others, there is the risk of looking like a fool and for Brown and Darling to appear vindicated in two years’ time.  We certainly don’t want that!

Comments

[Mike]

With due repect we are in unchartered territory now. The global economy has been fired by credit and now the entire banking system is seizing up due to 'creative instruments' that have suddenly gone horribly wrong.

I am in no position to make predictions but I doubt very much that this is just an ordinary blip in a lengthy business cycle.

You are right to disuade Cameron from being too apocalyptic but I would advise Osborne to have some kind of plan under wraps just in case.

[Steevo]

Well I think the comparison with usage of graphs is overly simplistic but that's not to dismiss the significance of macroeconomics. My point tho is probably just as overly simplistic but I think just as significant. I'll speak for the US market. It seems to me the main problem is a state of mind, pervasive irrational and desperate mistrust, and I think the Fed and media have complicated and exasperated this. Lets face it, it was inevitable the bubble would burst and housing prices and construction would have to come down. Over 90% of our mortgages are solvent, I'm not sure "crisis" properly defines significant difficulty with home ownership. And bailing out financial institutions regardless of the Fed's intent IS rewarding bad/iresponsible behavior. I'm not saying regulation, tight regulation for accounting practices isn't needed but let the market determine where the chips fall. A Fed, pumping in tax dollars, is further hurting our debt and I believe only delaying the inevitable. We need a cleansing and that means we're going to have to suffer. Its time to realize the only force capable to determine the outcome of this volatility and lack of faith is the investment community. When people reduce transportation because fuel is too expensive, oil will go down. When they realize Wal Mart is as crowded as ever, gold won't look so good.

[Renny]

'If' there's a recession?

I did not think there was any doubt about it.

[Jonathan Powell]

Well, I agree with the final paragraph but I'm not convinced by the pro-Keynesian stuff. Firstly, I would question the data used to construct the graph, since an analogous graph in Barro's textbook on macroeconomics shows much less volatility before the Great Depression. I believe the difference is that Barro uses data taken from Christina Romer, which corrects for the deficiencies in the pre-1929 data.

Now, it's still true that business cycles have moderated over time, but it's far from clear that this was as a result of Keynesian demand management. Many economists (Milton Friedman, say) would argue that such policies were counterproductive, perhaps increasing volatility (relative to what it would have been, rather than what it was in previous cycles) or at best was ineffective (for example, due to Ricardian equivalence) merely leading to much higher inflation. So I hardly think it's "ill-informed" to claim that the neoclassical synthesis was unsuccessful. The correlation between the adoption of Keynesian policies and the decline in volatility does not imply one caused the other.

It's more likely that the decline in volatility has resulted from new technologies and the shift from agriculture and manufacturing towards services. The improvement in monetary policy since Greenspan does seem to have reduced volatility somewhat, but I would argue this shows the Keynesian approach was unsuccessful, and that modern monetary policy owes more to the success of monetarism (although they don't target money directly, the effect of changes in interest rates in response to changes in the economy has been to stabilize the rate of money growth as recommend by Friedman).

So although I think your conclusion may well be correct (there's no reason to expect a particularly severe recession) I think it would be unwise if unreconstructed Keynesianism took a foothold in the party that was the first to reject it. Keynesianism was wrong in theory and wrong in practice. I find it depressing to read otherwise, particularly on a centre-right website.

[Tony Makara]

Andrew, do you think the MPC could be under political pressure to part shadow the ECB, and is afraid to cut rates too quickly for fear of a widening differential between Sterling and the Euro, given that this will translate into higher prices for EU foodstuffs on the high street?

[Andrew Lilico]

Jonathan Powell@16:12

Keynesian analysis was flawed in many ways. Friedman's critiques were very important, I imbibed them with my mother's milk, and I have faith in Friedman still. But we need not believe that the Keynesian/neoclassical synthesis was completely worthless in order to believe that inflation targeting is better. Macroeconomic techniques have moved on considerably these seventy years, and one would have to be an anachronistic fool to propose "unreconstructed Keynesianism" now (though, alas!, there do seem to be a few unreconstructed fools among today's press corps). But we do not need to disrespect the giants of the past in order to stand on their shoulders.

Tony@16:24,

No. I don't believe the MPC makes any attempt to shadow the ECB. It is, however, true that (as you suggest) sterling depreciation and its implications in terms of higher import prices are a factor in MPC decision-making.

[Jonathan Powell]

Andrew,

It's not so much that I disrespect Keynes (indeed, I think without Keynes there could be no monetarism--as Friedman said, "we're all Keynesians now") I just think that he was wrong (I also think Friedman may have been wrong about some things, to a far lesser extent) and thus statements like,

Keynesianism and the so-called “Neo-Classical Synthesis” was a great success

are pretty misleading and potentially damaging. It was only by rejecting such this approach (against the advice of the 364 economists) that Britain was able to move forward, and it's to the credit of New Labour that they adopted a broadly monetarist macro policy.

Although there may be a case for a discretionary monetary policy (in the sense of inflation targeting or whatever) to stabilize the economy, I don't see any evidence that the old fashioned demand-management did anything but make matters worse. Moreover, one would expect conservatives to be instinctive believers in free market capitalism, and thus skeptical of claims that government can or should stabilize the economy, and more sympathetic to alternative points of view.

[Tony Makara]

Labour can't claim any plaudits for an economy that used credit to increase purchasing power rather than sustained buying power coming out of wages and increased productivity. The overvaluation of Sterling and the availability of cheap imports from the east have masked what is in effect an inflationary economy. The strong pound has bought Labour time but an economy cannot be fuelled by credit indefinitely just as Sterling is sure to weaken, and as many predict, may even go the way of the Dollar. Basically Labour have run out of cards to play and now we are in an economic dead-end. The MPC cannot cut rates too assertively for fear of a widening differential between Sterling and the Euro. It is also certain that the Chinese will look to strengthen their currency to cool their overheating economy, and this, combined with a weaker Pound, will be a further factor in importing inflation. The main danger though is EU food produce which will hit the government hard manifesting as voter-visible high street inflation. There really is no way out for Labour and stagflation looks more likely every day.

[Yet Another Anon]

A lot of the problems of the 1920s especially social problems, but also economic problems stemmed from the aftermath of WWI.

No doubt the Boer War had an effect too on the the broader world economy, the US had little involvement in WWI only joining at a very late stage in 1917.

as Friedman said, "we're all Keynesians now"
Didn't he say that after he was commissioned by the Nixon administration to come up with a solution to welfare, and decided that it would be better to scrap the whole system and replace it with a Negative Income Tax.

John Biffen later adapted the saying in the early 1980s after the Standard Rate of VAT was doubled and spending and taxes for a time rose, saying "We're all Social Democrats now".

Strictly speaking, monetarism is the doctrine that inflation can be controlled through the use of the money supply, the first term under Margaret Thatcher saw an experiment in this with cuts in the coin and note issue to restrict inflation as taxes rose, and inflation jumped to 22% after which the government switched to using Interest Rates. Problems with restricting the money supply being that government could only restrict supply of cash, bonds etc.... that they issued, cheques and electronic transactions rather frustrate such attempts.

[Andrew Lilico]

Jonathan,

Much of what you are saying is right (and important), but I think you're quite getting correct what the Friedmanite monetarist critique was. Friedman had a number of critiques of Keynesian theory and practice. Probably the two best known are Friedman's "permanent income hypothesis" and his critique of the Phillips curve.

- The permanent income hypothesis had the consequence that the Keynesian "multiplier"
effect did not exist (the multiplier was (virtually) one). Hence (to put matters crudely) increasing the budget deficit would not increase GDP.

- The critique of the use of the Phillips curve meant that there was no long-run trade-off between output and unemployment.
Unemployment could not be taken below the "natural rate" in the long-term, and attempts to do so would cause ever-increasing inflation.

I suspect that it is the latter critique you are referring to when you talk of Friedmanites suggesting that Keynesian demand management created instability.

Another set of critiques concern the relative potency of fiscal and monetary policy. According to the advocates of "Ricardian equivalence" running a budget deficit will not tend to raise expenditure, even in the short-run (as, for example, Friedman suggested it might in his Phillips
curve critique) because people will anticipate their need to pay higher taxes in the long term to pay off the debt, and so reduce their consumption today by an
amount that precisely offsets the effect of the greater budget deficit. The consequence of this is that deficit financing will have no effect on output.

Perhaps you'll correct me, but I'm not aware of any Friedmanite critique of the goal of output stabilization. It is
output stabilization I am writing about above. Clearly you are correct to highlight the output stabilising effects of other developments than macroeconomic demand management - I was well aware of those, but didn't want to complicate the discussion unnecessarily. You might also want to argue that the output stabilisation effects from the 1940s to 1970s were more the result of automatic stabilizers than of active demand management.

We could debate the 1981 Budget, and I suspect that you and I would agree with each other though disagree with a number of other contributors. However, I should go to bed now...

[Acorn]

For those that did not get a first in Macroeconomics, the following is one of the more understandable explanations. Notice the date it was published - Feb 2007.

http://www.merkfund.com/merk-perspective/insights/2007-02-06.html

[Jonathan Powell]

Yet Another Anon:

Not sure when Friedman first quipped that, "we're all Keynesians now", though I do know Nixon adopted the phrase and is sometimes credited with it.

You're right to say that, in a narrow sense, monetarism prescribes directly targeting the money supply to control inflation, and that attempts to do so in practice were largely unsuccessful (although in fairness the methods used were not quite what Friedman had in mind).

However, in a broader sense the monetarist arguments have been largely accepted by economists and policy makers, e.g. inflation is a monetary phenomenon; fiscal policy should not be used to smooth the business cycle; deficit financing is ineffective and inflationary; the free market system is basically stable, with crises such as the Great Depression being caused by government policy etc.

The reason we don't hear about monetarists any more is that their teachings have now become conventional wisdom. Although money supply targeting was unsuccessful, one can think of present day monetary policy as being a roundabout way of controlling the money supply (over the long run) as the monetarists recommended. The important thing is that central banks are now held responsible for controlling inflation, rather than wage/price controls etc.

Andrew,

Although there are critiques of output stabilization which should not be dismissed (e.g. from economists such as Robert Lucas, or Real Business Cycle theory) this is separate from Friedman's critique. He was indeed concerned with output stabilization, BUT crucially he saw government as the source of instability, in particular via monetary policy.

So whereas having a monetary policy which maintains relatively stable money supply (as opposed to the Fed's policies pre-Volcker, particularly in the Great Depression) increases stability (at least in Friedman's view) that's quite different from saying that the government needs to intervene to stabilize an inherently unstable economy, which is the implication of your article. Similarly, automatic stabilizers merely imply the absence of government policies to continuously balance the budget which are likely to increase instability. That's different from saying the government should actively use fiscal policy to stabilize the economy, which is what the Keynesians advocated.

[Acorn]

You are not getting it yet! Another message from those at the front.

http://www.merkfund.com/merk-perspective/insights/2008-01-30.html

[Andrew Lilico]

Jonathan Powell,

You misrepresent me considerably. I did not suggest for a moment that the economy is inherently unstable. And I have not recommended that the government pursue active fiscal policy to stabilize the economy.

I *do* believe that well-directed macroeconomic policy can tend to stabilize output growth, making economic fluctuations smoother than they would be without policy interventions. I believe that it is quite clear (notwithstanding your well-made points about the other factors that also promote output stabilization) that macroeconomic policy since the war has had considerable success in doing this. We now believe that we know how to do this better with monetary policy (and hence with flexible exchange rates) than with fiscal policy.

On this point, I am very interested in the Lucas Critique, on which I have written papers. Lucas' argument is roughly as follows. In a well-functioning economy agents will make optimal decisions for themselves, and government action cannot make them better off if government does not know something that private agents do not know (this is provable via other theorems). But if the government *does* know something that private agents do not know, what would be best would be for the government to tell them (to give up its informational advantage) rather than to attempt to exploit that informational advantage in policy.

The question on which I have written is how, despite the power of Lucas' argument, it can remain the case that macroeconomic management can have an effect stabilizing output. My answer is that monetary policy (and, indeed, fiscal policy, though it is harder to do with fiscal policy for reasons I shall come to in a moment) is a means by which the Central Bank (or the Treasury, or whatever other arms of government are involved) communicates to the public. An interest rate change should be conceived of as an attempt by the MPC to give up its informational/interpretational advantage by changing a price. The monetary policy regime (inflation targeting, say) is the grammar for understanding the meaning of interest rate signals.

Signals could be sent via fiscal policy, also. But fiscal policy is much blunter (once-per-year comments, rather than once-per month) and it has proven much more difficult to develop a clear set of fiscal rules (much harder to make up a grammar of fiscal policy signals). For this reason, demand management through monetary policy is superior. This is probably also the key reason that interest rate policy is better than money supply control.

Far too technical, all this, for a politics website, but there you go anyway...

[Jonathan Powell]

Andrew,

Apologies if I misrepresented your views. So, when you say that Keynesian demand management was a success, you are suggesting this was because the government was using fiscal policy to convey information to the private sector which it would otherwise not know, and which helps it to make more efficient decisions.

This isn't the conventional story of how Keynesian policy is supposed to work, to say the least. It's clear that even if one accepts this view, such an approach is likely to be less efficient than interest rate changes, on that at least we're in agreement. However, I'm instinctively skeptical about the idea that the government has better information than the private sector, although I concede that such a situation is a possibility.

[Andrew Lilico]

In case there are any real nerds out there, what I have written about isn't *actually* the Lucas Critique itself (that concerns the drawing of policy inferences from empirical forecasting models based on data from previous periods before the policy under consideration was enacted). But it can be seen as an implication...

Just an anorak's clarification.