Preliminary Notes: Robert Hall at Jackson Hole Wisely Embraces the Cutting-Edge Macroeconomics of 1898
Robert Hall http://www.kansascityfed.org/publicat/sympos/2013/2013Hall.pdf http://www.kansascityfed.org/publicat/sympos/2013/2013.Hall.handout.pdf says that the cutting-edge macroeconomics we need today is that of Knut Wicksell's Knut Wicksell's Geldzins und Guterpreis, originally published in 1898:
The United States and most other advanced countries are closing on five years of flat-out expansionary monetary policy that has failed in all cases to restore normal conditions of employment and output. These countries have been in liquidity traps, where monetary policies that normally expand the economy by enlarging the monetary base are ineffectual…. The U.S. economy entered this state… [as] real-estate claims came close to collapse…. Rising risk premiums discouraged investments in plant, equipment, and new hiring… declining collateral values… forced… deleveraging. The combination of low investment and low consumption resulted in an extraordinary decline in output demand, which called for a markedly negative real interest rate, one unattainable because the zero lower bound on the nominal interest rate coupled with low inflation…. As output demand recovers, the lower bound will cease to be an impediment and normal conditions will prevail again.
Quite negative real rates in the recoveries from the 1973-75 and 1981-82 deep recessions made possible their V shapes. The nominal interest rate cannot be more than a bit negative, because investors always have the option of holding currency, with a guaranteed save nominal return of zero. With stable low inflation, as the U.S. and all other advanced countries have experienced for a lengthy period, the zero lower bound on the nominal rate places a bound on the real rate that is a huge constraint on the economy…
Compare to DeLong and Summers (1992):
A large easing of monetary policy, as measured by interest rates, moderated but did not fully counteract the forces generating the recession that began in 1990. The relaxation of monetary policy seen over the past three years in the United States would have been arithmetically impossible had inflation and nominal interest rates both been three percentage points lower in 1989. Thus a more vigorous policy of reducing inflation to zero in the mid 1980s might have led to a recent recession much more severe than we have in fact seen…
I think that in this context 2007-2013 counts as a huge empirical win for the A-Team…
And then Bob thwacks the linear accelerationist Phillips Curve:
A burst of inflation would permit an adequately low real rate even with the ZLB. The Fed responded aggressively to the events of 2008…. Other central banks followed suit, though not with the same determination. But far from relieving the interest bound, the policy failed to prevent a decline in inflation, a decline that has worsened recently…. Recent experience has shown the defects in economists’ earlier thinking about inflation. Since the birth of the Phillips curve in the 1950s, the idea has dazzled macroeconomists that inflation depends on tightness or slack. Yet extreme slack has done little to reduce inflation over the past 5 years (fortunately!) and extreme tightness in the late 1990s did not result in much inflation.
Because the rate of inflation is completely central to understanding the ZLB and the current and future states of the U.S. and other major economies, I spend some effort in this paper reviewing ideas about equilibria with variable tightness. All of these ideas rest on a central contribution in macro theory, the Diamond-Mortensen-Pissarides model, honored by the Nobel Prize in economics in 2010…
But, alas! I do not think he makes much progress. It is a very hard problem.
And then Hall turns overly optimistic:
I discuss the forces that are likely to continue the expansion and ultimately release the U.S. economy from the ZLB, meaning that the economy is back to normal. One is the ebbing of the high risk premiums that investors assigned to business income, which held back investment and job creation. Another is the growing shortfall of the capital stock, which has declined since 2008 despite population growth, and is now far below normal, generating a pent-up demand for investment.
The capital stock is far below normal, but so is demand. We can see this in housing, where we are now 5 million houses below trend but where we have an extra 6 million households living in their sisters' basements, and hence we still have a remarkably weak pace of housing construction. The argument that Wicksellian forces working to raise the risk-free natural rate of interest--falling risk premiums as memory of the 2008 collapse ebbs, and rising marginal products of capital as the capital stock depreciates--will quickly return us to normal seems to me to be unwarrantedly optimistic.
He concludes by aggressively joining the opposition to the Stein-George point of view that hopes for a quick exit from the ZLB via monetary tightening:
The central danger in the next two years is that the Fed will yield to the intensifying pressure to raise interest rates and contract its portfolio well before the economy is back to normal. The worst step the Fed could take would be to raise the interest rate it pays on reserves. The analysis of this paper focusing on the zero lower bound applies equally to a reserve rate above zero. Every percentage point increase in the reserve rate drives the real interest rate up and contracts the economy by the principles discussed here.
And saying that we do not need a higher inflation target than 2%/year because we can achieve a better result via smart financial regulation that limits banker ability to indulge in overleverage:
With respect to policies that might lower the probability of a repetition of the multi-trillion dollar disaster of the past five years, it is true that a policy of higher chronic inflation would have given monetary policy more headroom for expansion to counteract the decline in output demand and to prevent it from causing a decline in output. But I see that response as distinctly second-best. Much preferable are policies to maintain a robust financial system that responds smoothly to declines in real-estate prices…. Derivatives create exposures that are not recorded as leverage, but are fully apparent in stress tests. With a stable, bullet-proof financial system, policies of low inflation are quite safe.
I am going have to think hard a lot more about Hall's attempts to use DMP to math up Keynes's (1936) attempts to build a model in which high unemployment is an actual equilibrium, rather than merely a sticky-wage disequilibrium…