How Strong Are þe Economy's Equilibrium-Restoring Forces?

Answer: not strong at all in þe absence of þe right fiscal & monetary policies, & þe right fiscal & monetary policies are, broadly, þe Keynesian & þe Minskian ones—at least for þose economies þt...

Answer: not strong at all in þe absence of þe right fiscal & monetary policies, & þe right fiscal & monetary policies are, broadly, þe Keynesian & þe Minskian ones—at least for þose economies þt have enough fiscal & monetary space at þeir disposal to pursue þem…

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These days—that is, for at least the past generation and a half—the self-stabilizing equilibrium-restoring “natural” forces at work in the American economy have, in general, not quite been “AWOL”. But they have been, at least until our rocket-like post-plague recovery, certainly weak.

I mean, look at the unemployment rate over the forty years before the recent plague:

After a downturn, the unemployment rate returned to its full-employment range of 3.5-5% after the four recessions from 1981 to 2019 at, respectively:

• 0.75%-points/year,

• 0.25%-points/year,

• 0.6%-points/year, and

• 1%/-pointsyear

for a simple arithmetic average of 0.65%-points/year.

And the top performer, the 1%/year falling unemployment rate of the mid-190s, came as a result of Reagan's extraordinary-if-half-accidental boosting of the economy through fiscal policy. And even that effort got us only to a 7% unemployment rate. There recovery stalled for 3 years. (And economists began wringing their hands about how 7% unemployment was actually now "full employment"; they were wrong.)

And the 0.75%/year after 2010? That came with huge numbers of people extremely angry at Ben Bernanke's “unnatural” interest-rate and quantitative-easing policies, and at Obama’s even daring to propose a grossly under-ambitious fiscal federal stimulus.

So what does this pre-plague history tell us about the strength of the self-stabilizing forces in a modern monetary economy?

It tells us that they are not very strong at all.

It tells us that without active and effective monetary and fiscal policies aimed at subordinating other policy goals to the goal of a rapid return to full employment, the economy can remain stuck in a low-growth, high-unemployment trap for a long time. It tells us that relying on the invisible hand of the market to restore equilibrium is not enough. It tells us that we need the visible hand of the government to steer the economy towards its potential.

Of course, as Nick Rowe has pointed out many times, one cannot speak of the “strength” of equilibrium-restoring forces “independent of monetary and fiscal policy”. There is always some of both monetary and fiscal policy around. All you can reason about is:

• The strength of equilibrium-restoring forces when monetary and fiscal policy are at some baseline.

• How those forces would grow or shrink as the monetary and fiscal policy rules varied from that baseline.

• You can speak of “natural” forces only if there is an obvious “natural” monetary and fiscal policy baseline, and there isn’t.

• But there are certainly some monetary and fiscal policies that can greatly retard the speed with which an economy can recover from a high-unemployment depression.

“Balance the budget immediately”, “create a liquidity crisis by allowing the stock of trusted liquid assets to fall”, and “create a solvency crisis by allowing the price level to fall while a heavy stock of nominal debts remains unresolved” are three of them.

Now these are not new lessons. We should have learned them back in the 1800s. I, at least, thought we had learned them as a result of the Great Depression of the 1930s, when Keynesian economics emerged as a response to the failure of classical economics to explain and solve the crisis.

And yet we had forgotten those lessons by the time of the global financial crisis of 2008-9 that turned into the Great Recession of 2008-2010.

Part of the reason was Milton Friedman’s monetarist bastardization of the lessons of the 1930s. Friedman claimed that the real lessons of the 1930s were that (a) fiscal policy—governement purchases—did not matter, (b) debt and financial stability mattered only to the extent that they impacted the total supply of trusted liquid assets, and (c) keep the stock of trusted liquid assets from falling (or raise it by enough) and all would be well. Lots of people believed him. Unfortunately, those people in 2009 included Fed Chair Ben Bernanke, Treasury Secretary Tim Geithner, at least 15 Democratic senators, and the 20 Republican senators who were not absolute monetary loons—plus the dominant bureaucrats and politicians of Europe.

Perhaps we learned the lessons of the 1930s again from the Great Recession of 2008-20010? Neo-Keynesian economics revived as a response to the failure of neoclassical economics to prevent and cure the crisis. After 2010, one could write about “balance-sheet recessions” and “deficit-reducting expansionary fiscal policy”, and at least gain a hearing.

Certainly in 2020-2021 Keynesian economics was riding high as the proper reaction to the plague, and the proper policy to rapidly restore the economy to full employment.

One can be optimistic about the future. One can think we have learned the lessons better than before. One can thinl we have seen more clearly and convincingly how monetary and fiscal policies do make a difference in stabilizing and stimulating the economy in times of shock and uncertainty. But maybe all this is simply demonstrating that one can be a fool.

Still, in the plague and in its aftermath, we have seen monetary policy more creative and effective than before. The Federal Reserve responded to the plague with unprecedented speed and scale, cutting interest rates to zero, expanding its balance sheet by trillions of dollars, launching new lending facilities and asset purchase programs, providing forward guidance and outcome-based commitments, and signaling a more flexible and inclusive approach to its inflation and employment targets. These actions have helped to lower borrowing costs, support credit markets, boost asset prices, stimulate aggregate demand, and anchor inflation expectations.

And, more importantly, for the long run perhaps these actions have also helped to foster innovation and adaptation in the private sector. By providing ample liquidity and low interest rates, the Fed encouraged businesses and consumers to invest in new technologies, products, processes, and business models that can improve productivity, efficiency, quality, and sustainability in the long run. By providing stability and confidence, the Fed enabled businesses and consumers to adjust to new realities and needs that can increase diversity, flexibility, and openness in the long run.

Moreover, fiscal policy has also shown itself as more coordinated and effective than before. The federal government responded to the plague with spending—purchases and transfers—unprecedented in size and scope. It provided direct relief to households, businesses, states, and localities, as well as funding for public health, education, infrastructure, research, and development. These measures have helped to cushion the income and consumption losses, protect the jobs and livelihoods, and enhance the health and education outcomes of millions of Americans.

The growth-accounting and industry-level data we have seen about the effects of the economic reaction to the plague revealed a sharp fall in productivity in rival physical-commodity and a rise in productivity in nonrival information-commodity production—and as time passes the plusses from the second seem to me likely to overwhelm the first. The plague was a deadly and devastating shock to humanity and to humanity’s economy, bringing, primarily, megadeaths, while also causing unprecedented disruptions, losses, and uncertainties. But my strong suspicion is that the long-run economic consequences of dealing with economic transformation and of countervailing policies during the plague years have done more good than the plague itself did harm. I see stimulated innovation, improved governance, and enhanced resilience. And in the long run, it is these factors that will shape the furture and far-future prospects of human economic growth and welfare once we look beyond the next business cycle.

I see the plague and what has come after as spurring entrepreneurship and experimention, I belong to those who think that the market economy massively underinvests in R&D. After all, how could it possibly be otherwise? Small firms do not see a benefit from researching development that quickly diffuses elsewhere. Large firms see some benefit, but they see bigger benefits from creating moats to maintain their current market power.

Thus something like the plague years, which focused a lot of attention on how to produce in the future, and which generated a lot of experimentation and learning from that experimentation, has to be good. It created a strong incentive and opportunity for innovation across sectors and domains, as businesses and consumers have adapted to new realities and needs. As far as digitization and automation are concerned, it crammed two decades of experimention and build-out into two years. Thus there is the potential to increase productivity, efficiency, and quality.

The future for humanity is thus brighter than it was four years ago, I think.