Economic Policy:

Yet if we look a slight deeper we see that business cycles today aren’t the same animals as they were back before the Great Depression. The drop in the multiplier the arrival of automatic stabilizers and the increasing power of central banks have allowed monetary policy to offset several of the kinds of shocks that generated pre-Depression business cycles. The absence of important stabilization springs from the fact that the increasing power of central banks has created a new class of shocks to the economy- recessions deliberately induced by financial authorities to curb rising inflation. The post-World War II economy emerges to have had fewer small recessions caused by shocks to the IS and LM curves. Stabilization policy has exertion in that it allows for the central bank working in combination with automatic stabilizers to react when the economy threatens to turn down into recession because of any sudden shock.

Prior to 1916 it was impossible for the U.S. government to have any consequence on aggregate demand. Government purchases as well as net taxes were so small relative to economic activity that no fiscal policy variation short of fighting a major war could materially shift the IS curve as well as change equilibrium real GDP. The pre-World War I government lacked in anticipation of the founding of the Federal Reserve in 1914 the ability to affect the level of interest rates. Neither financial stabilization policy nor monetary stabilization policy as we know them today was possible back before World War I.

By the beginning of the post-World War II era the power of stabilization policy as well as the government’s commitment to manage aggregate demand was both firmly established. World War II left the United States among a federal government that annually spent about one-fifth of GDP as well as a government committed to countercyclical fiscal policy. Back prior to World War II it had been a commonplace of political and policymaking discourse that taxes must be raised and economies in spending achieved to try to balance the budget in a recession. By means of the 1950s this doctrine was dead- the automatic stabilizers of the federal budget were in place.

The emergence of a important progressive income tax made government revenues substantially procyclical and the emergence of unemployment food stamps, compensation and welfare led government spending to have a substantial automatic countercyclical component as well. During the 1960s the federal government supposed that it ought to be undertaking countercyclical discretionary fiscal policy as well (even though it has never been able to succeed in doing so). In monetary policy a alike shift had been accomplished near the beginning of the post-World War II period. By the early 1950s the U.S. Treasury as well as the Federal Reserve had agreed--in their Accord of 1951--that the principal task of the Federal Reserve was to use monetary policy to stabilize the economy.

There is no uncertainty that the Federal Reserve has attempted to use monetary policy, within the limits placed on it by long as well as variable lags to stabilize the economy and to moderate recessions. Both largely survey studies and detailed studies of cases like the interest rate cuts that followed the stock market crash of 1987 teach the lesson that the Federal Reserve had considerable achievement in cutting short recessions and in accelerating growth in the early stages of the subsequent economic expansion.

There is no uncertainty that automatic stabilizers also have played a role in moderating the business cycle. Thus far a third innovation in economic policy deposit insurance has had effects that are harder to quantify. But as Christina Romer observes the obvious starting point is the observation that financial panics were ubiquitous prior to World War I and almost nonexistent since World War II… there were main panics in 1890, 1893, 1899, 1901, 1903, and 1907 all of them the source of substantial contractionary pressure on real GDP. Possibly the effects of deposit insurance have been large as well: we aren’t really sure.

Prospects:

Possibly the more recent era shows how much more stable our economic system can be with successful institutions that understand the limits of their power. However it is not clear whether the growth of aggregate demand has been smoother for the reason that economic policy makers have recognized the limits of what they can achieve due to the skill of Paul Volcker and Alan Greenspan for the reason that of better economic theories to guide policy or simply because of good luck. It is clear that each time in the past a "new era" or a "new economy" has been decree, the similar old business cycle has soon returned.

The development of the 1920s led economists to hope that the newly-constructed Federal Reserve had learned how to stabilize output by eliminating the fluctuations in interest rates that caused financial crises. Irving Fisher the most famous monetarist of his day. Went to the extent that to claim on the eve of the 1929 crash that stock prices had reached a "permanent and high plateau." The protracted expansion of the 1960s led the Department of Commerce to change the name of its Business Cycle Digest to the Business Conditions Digest for it seemed stupid to them to have a publication named after a phenomenon that no longer existed. Both President Eisenhower’s as well as President Johnson’s CEA Chairs Arthur Burns and Walter Heller, agreed that there had been substantial progress in economic science as well as policymaking toward economic stability that opened up new dimensions of political economy.

One can be positive about the future of macroeconomic policy. One is able to count up all of the lessons that economists as well as policymakers have successful learned over the course of the twentieth century.

One can be particularly optimistic from the perspective of the United States today. For from that perspective macro-economic policy emerge remarkably successful. Unemployment is extremely low at levels that haven’t been seen in a generation. Inflation is as well low at levels that have not been seen in a generation either. The stock market is at record highs both absolutely as well as relative to corporate earnings and dividends--suggesting that the market at least expects an extremely bright future. The raise in income inequality that was an extremely worrisome social trend in the United States appears to have stopped (even though it hasn’t reversed itself). And in recent years calculated productivity growth has been rapid suggesting that the political claims by Clinton administration officials in the early 1990s that deficit reduction would lead to a high-productivity-growth, high-investment, high-income-growth recovery were largely correct.

However it is likely that the long expansion of the 1990s will be followed by a recession. And what will follow in the manner of management of the business cycle is ours to decide.

Lessons Unlearned: High European Unemployment

Europe at the end of the 1990s isn’t in a Great Depression. However unemployment rates in Western Europe at the end of the 1990s are within hailing distance of the rates achieved during the Great Depression. Un-employment averages ten percent in the zone of countries that currently share the common currency of the euro.

Up in anticipation of the end of the 1970s unemployment in Western Europe had been lower sometimes substantially lower than unemployment in the United States. However starting in the 1970s European unemployment began to ratchet upwards. European unemployment increased during recessions, yet it didn’t fall during economic expansions. Throughout the recession of the Volcker disinflation at the start of the 1980s western European and U.S. unemployment rates were about equivalent. However during the later 1980s and 1990s the trend of U.S. unemployment was downward- the trend of European unemployment was stable or upward.

In the U.S. it is probable to understand the co movements of unemployment and inflation over 1960-2000 using the standard Phillips curve. The Phillips curve shifts out in the 1970s as everyone start to expect higher inflation and demographic factors causes the natural rate of unemployment to increase. The Phillips curve shifts reverse in the 1980s as well as 1990s as people regain confidence in the Federal Reserve’s commitment to low inflation and as changing demographic factors cause the natural rate of unemployment to fall. The story doesn’t fit badly. Appointments in the expected rate of inflation reflect changes in the economic policy environment. Movements in the usual rate of unemployment are relatively small and can be linked to plausible factors.

In Western Europe by contrast the accelerationsnist Phillips curve never fit the historical experience very well. Every policy episode from 1970 on--supply shocks the Volcker disinflation the recession of the early 1990s--seemed to shift the Phillips curve further out as well as to further raise the natural rate of unemployment. It appeared as if this year’s natural rate of unemployment was equal to whatever unemployment had happened to be last year.

The dominant vision expressed in Europe in the early 1990s was that high European unemployment was the result of labor market rigidities. Europe possessed restrictions, laws and regulations that made it too difficult for firms to hire new workers cheaply at a relatively low wage and too difficult for firms to fire workers (and Therefore forward-looking firms are reluctant to hire workers. Therefore it was too expensive to conduct a labor-intensive business in Europe or to adjust to changes in the economic environment.

As-per to this dominant view high unemployment in Europe is an equilibrium. Unemployment was what economists describe classical- It arises not from any shortage of aggregate demand however simply from the fact that the state's regulations keep the labor market from clearing. The state's regulations increase the cost of employing the marginal worker far above the extra revenue the typical firm would gain from employing an extra worker.

However the "rigidities" in the European labor market were stronger in the 1960s--when European unemployment was extremely low than they are today. It isn’t that the natural rate of unemployment in Europe has always been high it is that every additional adverse shock that increases unemployment seems to increase the natural rate as well. Therefore many economists who have examined European unemployment dissent from the conventional wisdom of the editorial writers and the politicians. They tend to observe Western Europe not as locked into high unemployment however as in a reversible situation. Just as raise in unemployment in the 1970s and 1980s raise the natural rate of unemployment in Europe therefore decreases in the rate of unemployment in the 2000s would in all likelihood lower the natural rate of unemployment in Europe.

Lessons Half-Learned: Japan

The standard investigation of how the Japanese economy entered its present period of stagnation is straightforward. The Japanese stock market as well as real estate market rose far and fast in the 1980s to unsustainable “bubble” levels. And finally the market turned and both the real estate and stock markets collapsed.

When stock as well as real estate prices collapsed it was discovered that lots of enterprises and individuals had borrowed a lot against their real estate and security holdings putting up their real estate and their stocks as collateral. Subsequent to the collapse not only were those who had borrowed heavily bankrupt however the banks and other institutions that had loaned them money were bankrupt as well- the value of the collateral they had accepted would no longer suffice to allow them to repay their creditors.

One problem was that no one was precisely sure which institutions were bankrupt which institutions had liabilities in excess of their assets. Therefore no one was anxious to lend money to anyone- you might well never see your money once more if the organization you loaned it too was one of the ones that had extended itself during the bubble economy of the late 1980s. A second problem was authoritarian forbearance- the belief that the best way to solve the problem was to pretend that it didn’t exist try to let business go on as usual and hope that a few good years would permit all of the institutions that were “underwater” to make sufficient in profits that they could repay their debts even given the low value of the collateral that they had accepted.

These two problems together denoted that investment spending was depressed. Financial institutions live to channel money from savers with purchasing power to businesses that can use that purchasing power to expand their capital. However in the aftermath of the collapse of the bubble no one really wanted to lend for you couldn’t know whether the organization wanted your money to invest or to try to paper over some of its preceding losses.

The circumstance was analogous to the collapse of investment spending in the Great Depression where the chain of deflation as well as bankruptcies had had similar effects.

The collapse of the Japanese monetary bubble of the 1980s depressed consumption and investment spending. Banks' as well as other institutions' large bets on the real estate market meant that the collapse of the bubble put them underwater with assets and lines of business that were worth less than the debt they already owed that they had borrowed to wonder in real estate. Who will spend in a business or a bank if you fear that your money will be utilized not to boost profitability but instead to pay back creditors who had loaned to the business before you?

Therefore Japan has fallen into a decade of economic stagnation. Growth has been about zero. Unemployment has increases to levels previously unheard-of in Japan. The IS curve has shifted back far to the left. As well as nothing seems to correct it even extremely low nominal interest rates aren’t sufficient to boost investment and aggregate demand. And for nearly a whole decade Japanese economic growth has been extremely slow and stagnant.

What must economic policy makers do in such a situation? The answer to what you must do in order to recover from such a state of depressed aggregate demand is "everything." You must have the government run a substantial deficit (although, as E. Cary Brown of MIT pointed out in the 1950s it needs truly awesome deficit spending--on the order of deficit spending in World War II--to reverse a Great Depression like the U.S. in the 1930s or a Great Stagnation similar to Japan today). You must have the central bank push the interest rate it charges close to zero (to make it extremely easy and cheap to borrow money).

If that is not sufficient you should try to deliberately engineer moderate inflation. If demand is depressed for the reason that people think investing in corporations is too risky change their minds by creation the alternative to investment spending even more risky. As well as if the alternative is hoarding your money in cash then eat away a share of its real purchasing power eaten away every year by inflation.

Therefore far Japan has changed its fiscal policy to run big deficits (however as any student of the Great Depression would suspect they have not been big enough). Japan has lesser its short-term safe nominal interest rates to within kissing distance of zero. However these haven't done enough good. The lessons of the Great Depression have been only half-learned.

Lessons Half-Learned: Moral Hazard

Even in the United States it appears as though some of the lessons on economic policy taught by the past century of experience have been only half-learned. Consider the trouble of dealing with financial crises- those moments when large and highly-leveraged financial institutions have or are about to fail as well as when there is a genuine fear that a chain of bankruptcies is about to be triggered.

In such circumstances the fear that the organization to which one might lend will fail will greatly retard lending. The flow of money through financial markets will slow to a trickle as savers conclude that keeping their wealth close at hand in safe forms is a much better opportunity than lending it to organizations wishing to lend that are probably bankrupt. Therefore such a financial crisis is likely to see the IS curve shift far and fast to the left as the level of investment spending collapses. If this leftward shift in the IS curve isn’t stemmed then there will be a recession and the financial crisis will rapidly become worse as businesses that were solvent at normal levels of production and sales find that the fall-off in demand has bankrupted them.

What to do in such circumstances was first outlined by Bagehot a century and a quarter ago. The government needs to rapidly close down as well as liquidate those organizations that are fundamentally bankrupt. If they would be bankrupt still if production as well as demand were at normal levels relative to potential then they must be closed. The government requires lending money--albeit at an unpleasant, high, penalty rate--to organizations that would be solvent if production and demand were at normal levels, but that nevertheless suffer a cash crunch now.

The key is twofold- Government support is essential in order to prevent a deep melt-down of the entire financial system. Government assistance should be offered on terms unpleasant enough as well as expensive enough that no one in advance wishes to get into a situation in which they need to draw on it. Furthermore the government must accept that its ability to distinguish between these two classes of institutions is imperfect as well as that it will inevitably make mistakes.

Yet more as well as more in the political discussion over economic policy one hears the claim that government provision of liquidity and support in a financial crisis is dangerous--that it causes “moral hazard” for the reason that organizations place riskier and riskier bets counting on government support to bail them out if things go wrong. The right policy in a monetary crisis is a completely hands-off one. A century as well as a quarter of knowledge suggests that this is only a half-truth. Moral hazard is a trouble but so is a Great Depression. The balancing point is tough to determine- bank and financial regulators should impose rules that restrict the growth of moral hazard assistance in times of financial crisis should be expensive and painful to the organization drawing on the government as well as yet the worst outcome a freezing-up of the financial system and a severe recession must be guarded against. To focus on simply one of these three rather than balancing between them is to recommend bad economic policy.

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