Tuesday, March 26, 2013

Snowbank Macroeconomics

Macroeconomic policy discussions keep reminding me, as a Minnesotan just making it through the winter, of a car stuck in the snow. For the uninitiated, when your car is truly stuck in a snowbank, gunning the engine doesn’t help. Your wheels spin. Maybe a little snow flies. Maybe the car shivers in place. But you don't have traction. Pumping the gas pedal up and down doesn't help. Twisting the steering wheel doesn't help. Putting on your emergency blinkers is recommended--but it doesn't get you out of the snowbank, either. Time to find a shovel, or dig that bag of sand or cat litter out of your trunk to spread under the wheels, or look for friendly passers-by to give you a push.

During the recession of 2007-2009 and since, U.S. policymakers have stomped hard on macroeconomic gas pedals. But although the unemployment rate has come down from its peak of 10% in October 2009, it remains near 8% --and the Congressional Budget Office is predicting sustained but still-slow growth through 2013. As a result, those who recommended stomping on the fiscal and monetary macroeconomic pedals are on the defensive. Some of them are doubling-down with the argument that if only we had stepped even harder on the macroeconomic pedals, recovery would have happened faster, and/or that we should stomp down even harder now.

My own belief is that we stepped about on fiscal and monetary gas pedals about as hard as we conceivably could back 2008 and 2009. Although I had some disagreements with the details of how some of these policies were carried out, I think these policies were generally correct at the time. But the recession ended in June 2009, according to the National Bureau of Economic Research, which is now almost four years ago.  In the last few years, we have all become inured to fiscal and monetary policies that would have been viewed as extreme—even unthinkably extreme—by onlookers of all political persuasions back in 2005 or 1995 or 1985.

Consider fiscal policy first. Here's a figure generated with the ever-useful FRED website maintained by the St. Louis Fed, showing federal budget deficits and surpluses since 1960 as a share of GDP. Even with smaller budget deficits in the last couple of years, the deficits remain outsized by historical measures--in fact, larger as a share of GDP than any annual deficits since World War II.

FRED Graph

Federal debt held by the public has grown from 40.5% of GDP in 2008 to a projected (by the Obama administration in its 2013 budget) 74.2% of GDP in 2012. This rise of 34 percentage points in the ratio of debt/GDP over four years is very large by historical standards.

For comparison, the sizable Reagan budget deficits of the 1980s increased the debt/GDP ratio from 25.8%  in 1981 to 41% by 1988—a rise of about 15 percentage points over seven years. During the George W. Bush years, the debt-GDP ratio went from 32.5% in 2001 to 40.5% in 2008—a rise of 8 percentage points in eight years.  Going back to the Great Depression, the debt/GDP ratio rose from 18% of GDP in 1930 to about 44% in 1940 – a rise of 26 percentage points over 10 years.

The only comparable U.S. episodes of running up this kind of debt happened during major wars. For example, the federal debt/GDP ratio went from 42.3% in 1941 to 106.2% in 1945—a rise of 54 percentage points in four years. From this perspective, the fiscal stimulus from 2008 to 2012, as measured by the rise in the debt/GDP ratio, has been about about two-thirds of the size of World War II spending. Of course, World War II, the debt/GDP ratio then fell to 80% in 1950 and 45% in 1960.  Conversely, the current debt/GDP ratio is on track to keep rising.

My guess is that most people of would have believed, circa 2005, that a fiscal stimulus that was double or more the size of the Reagan deficits or the Great Depression stimulus was plenty “large enough” to deal with a recession that led to a peak unemployment rate of 10%.  I have no memory of anyone back in 2008 or 2009 (myself included) who argued along these lines: "Of course, this extraordinary fiscal stimulus may only be modestly successful. It may help drag the economy back from the brink of catastrophe, but leave unemployment rates high for years to come. And if or when that happens, the appropriate policy will be to continue with extraordinary and even larger deficits for five years or more after the recession is over."

Monetary policy got the gas pedal, too. Here's a figure of the federal funds interest rate, which up until a few years ago was the Fed's main tool for conducting monetary policy. The Federal Reserve took its target federal funds interest rate down to near-zero in late 2008, and has been promising to keep it near-zero into 2014. With this tool of monetary stimulus essentially used to the maximum (there are practical difficulties in creating a negative interest rate), the Fed has taken to policies of “quantitative easing,” which refers to direct purchases of over $2 trillion of federal debt and mortgage-backed securities, as well as policies that seek to “twist” long-term and short-term interest rates to keep the long-term rates low.

FRED Graph 
These monetary policies are clearly extreme steps. Looking back at the history of the federal funds interest rate since the Federal Reserve gained its independence from the U.S. Treasury back in 1951—and announced that it would pursue low inflation and sustained economic growth, rather than just keeping interest rates low so that federal borrowing costs could also remain low--it has never tried to hold interest rates at levels this low, much less to do so for years on end.  

If you had asked me (or almost anyone) back in 2005 about the likelihood of a Federal Reserve of holding the federal funds interest rate at near-zero levels for six or seven years or more, while at the same time printing money to purchase Treasury bonds and mortgage-backed securities, I would have said that the probability of such a policy was so low as to not be worth considering.  I have no memory of anyone back in 2008 or 2009 (myself included) who argued along these lines: "Of course, this extraordinary monetary policy may only be modestly successful, and may well leave unemployment rates high for years to come. And if or when that happens, the appropriate policy will be to continue with near-zero interest rates for five years or more after the recession ends, along with and printing additional trillions of dollars to buy debt."
When it comes to the very aggressive fiscal and monetary policies that the U.S. has pursued in the last few years, my own views occupy an uncomfortable middle ground. I supported those policies when they were enacted in 2008 and 2009, and continue to believe that they were mostly the right thing to do at the time. This view puts me at odds with those who opposed the policies at the time. On the other hand, I have become increasingly uncomfortable, nearly four years after the official end of the recession, with the idea that the main focus of macroeconomic policy should be to continue stomping on the macroeconomic gas pedals. This view puts me at odds with those who favor continuation or expansion of these policies. I'm reminded of an old line from Milton Friedman, "The problem with standing in the middle of the road is that you get hit by traffic going in both directions."

Snowbank macroeconomics suggests that after a financial crisis and a recession is over, and when you have tried gunning the engine for a few years, you need to think about alternatives. It's easy enough to generate a list of potential policies, many of which I've posted about over time.

It would be easy to extend this list to steps that might help to bring health care costs under control, or to take steps to address the long-run financial problems of Social Security, or implementing financial reforms to make a recurrence of the 2007-2009 disaster less likely. My point is not to limit the possibilities, but just to note that is that when macroeconomic policy is stuck in the snowbank, not working as well as anyone would like to boost growth and jobs, it's time to focus on some alternatives.

Of course, when anyone suggests that it's time to start easing back on our long-extended stomp on the macroeconomic gas pedal, and start focusing policy attention elsewhere, that person is soon accused of not believing in "standard macroeconomics," or not believing in the idea that government can help with countercylical policy in recessions. But in spring of 2013, such remonstrations are a bit like telling the driver stuck in the snowbank that if you don't favor a policy of just jamming on the gas as hard as possible for as long as possible, then you must not believe in the scientific properties of the internal combustion engine.

Sometimes aggressive expansionary macroeconomic policy can be the boost that the economy needs, and I believe that stomping on the macroeconomic gas pedal made sense in 2008 and 2009. But clearly, not all the problems faced by a sluggish economy in the aftermath of a financial crisis and deep recession have solutions as simple as mountainous budget deficits and subterranean interest rates. Indeed, the U.S. economy will eventually face some risks and tradeoffs from a continued rise in its  debt/GDP ratio and in a continued policy of rock-bottom interest rates.
At a minimum, it seems fair to note that that the macroeconomic situation of 2013 is quite a bit different from the crisis and recession of 2008 and  2009, and so proposing exactly the same policies for these two different times is a little odd on its face. Moreover, the extraordinarily aggressive macroeconomic policies of the last five years have not worked in quite the ways, for better or for worse, that most people would have predicted back in 2008 or 2005 or 1995 or 1985. It seems clear that the U.S. economy needs much more than just an longer dose of the macroeconomic policies we have already been following for years.