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Long Run Growth and the end of The End of (Monetary Policy) History

Summary:
Suppose everyone believes that we have reached The End of History, as far as monetary policy is concerned. The new inflation-targeting regime adopted by central banks has finally solved the age-old problem of the business cycle. There will be no more booms and busts. Maybe not yet solved perfectly, but the broad outlines of the solution are already in place, and all that remains is the boring technical work of bringing central banks' implementation of that policy closer and closer to perfection. And then suddenly Something Happens. And it does not matter for this blog post what exactly that Something is. All that matters is that, whatever it is, it causes everyone to stop believing they have reached the End of Monetary Policy History. They stop believing that central banks have the correct framework to tame the business cycle. Future booms and recessions will be bigger and last longer than they had previously expected they would be. How will the end of The End of Monetary Policy History affect investment? I think it would cause investment to fall. And that fall in investment (as a percentage of GDP) would cause the labour productivity growth rate to fall, which would cause the long run GDP growth rate to fall. And this fall in the growth rate would happen even if the growth rate of employment were unaffected by the end of The End of Monetary Policy History.

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Suppose everyone believes that we have reached The End of History, as far as monetary policy is concerned. The new inflation-targeting regime adopted by central banks has finally solved the age-old problem of the business cycle. There will be no more booms and busts. Maybe not yet solved perfectly, but the broad outlines of the solution are already in place, and all that remains is the boring technical work of bringing central banks' implementation of that policy closer and closer to perfection.

And then suddenly Something Happens. And it does not matter for this blog post what exactly that Something is. All that matters is that, whatever it is, it causes everyone to stop believing they have reached the End of Monetary Policy History. They stop believing that central banks have the correct framework to tame the business cycle. Future booms and recessions will be bigger and last longer than they had previously expected they would be.

How will the end of The End of Monetary Policy History affect investment? I think it would cause investment to fall. And that fall in investment (as a percentage of GDP) would cause the labour productivity growth rate to fall, which would cause the long run GDP growth rate to fall. And this fall in the growth rate would happen even if the growth rate of employment were unaffected by the end of The End of Monetary Policy History.

If you want to see a formal model which shows why investment and long run growth would fall if the (subjective) variance of Aggregate Demand increased you can read my old paper with Vivek Dehejia. The key point in that model is that even if booms and recessions are symmetric, their effects on the profitability of investment are not symmetric. A recession means that capital services are wasted at the margin, because the extra output cannot be sold. But booms are not good, because a bigger queue of customers does nothing for profitability if you cannot produce more to meet the extra demand. So an increase in the expected variance of booms and busts reduces the expected marginal profitability of investment, which reduces investment. And Vivek and me did all the math (with the help of an anonymous referee who deserves a medal) to show that we get this result even if firms set prices and output to maximise expected profits in the face of uncertain Aggregate Demand.

It is important to distinguish between the (expected) level of Aggregate Demand and the (expected) variance of Aggregate Demand. A low (expected) level of Aggregate Demand will reduce investment demand. That investment accelerator mechanism makes sense both theoretically and empirically. (It explains why the IS curve can slope up). And that level-effect is what Simon Wren-Lewis is talking about in his good post that inspired me to get my act together and write this one. But I think that Simon could only create a model in which this level-effect creates multiple equilibria and self-fulfilling prophecies with an implausibly elastic labour supply function, or very strongly increasing returns to scale, or something like that. (Or by deleting the real wage equation in a search model like Roger Farmer does.) In this post I am talking about a variance-effect. So I don't need any of that weird stuff to make it all work. The labour supply curve can be perfectly inelastic, and it still works fine.

What was the Something that Happened? The 2008/9 Great Recession, of course. What I'm arguing here is that maybe it wasn't just a recession like most recessions. Or, more importantly, it wasn't perceived as a recession like most recessions. It changed how people viewed their world, and changed their confidence about the future and the ability of central banks to manage that future. It was perceived as the end of The End of Monetary Policy History.

And it is indeed too big a coincidence to suppose that an exogenous slowdown in long-run growth just happened to coincide with the Great Recession. And if we reject that coincidence, we must either say the exogenous slowdown in long-run growth was what caused the recession (some sort of RBC story) or else explain why the fall in Aggregate Demand caused the fall in long-run growth. And it might be a level-effect story, like Simon's, or a variance-effect story, like mine. But Something Happened.

If Simon is right, then getting back to "full employment" will be enough to solve the problem. If I'm right, it won't be enough, and we will need to convince people we have fixed the problem and it won't happen again.

We need a regime change. But instead all I see is that the demand for a monetary policy regime change is slowly sliding down the agenda as the world's economies slowly "recover". This is not what "recovery" is supposed to look like.

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