Michael Evans
2/2/2006, 12:38 PM
Ben Bernanke segued into the Fed Chairman?s office so effortlessly that many senators were not even aware that the hearings had been held. While it?s certainly true enough that Bernanke is a distinguished economist with no political baggage, the lack of any animosity ? or even interest ? in his nomination signaled something else. Macroeconomics, unless if messes up, doesn?t matter very much any more.
The concept of ?fine-tuning? the economy to optimize performance reached its zenith in the 1960s, but it didn?t last very long. After a decade of stellar performance, the economy reverted to its previous cyclical performance with a vengeance: four recessions in the next 12 years. These years were punctuated by a large variety of temporary tax rate changes on both personal and corporate income: the 10% surcharge, cancellation and reinstatement of the investment tax credit, changes in the timing of withholding patterns, one-time rebates, and so on. By the time the inflation rate had risen to 13% and the prime rate had peaked at 21 ½%, the entire concept had been thoroughly discredited. But like most bad academic ideas, it took a long time to die. After all, Keynes?s seminal tract, The General Theory of Employment, Interest, and Money, was published in 1936 but not put to practical use until 1961. Similarly, it took about two decades for fine-tuning of fiscal policy to die out completely, although after 1981 tax rate changes were generally designed to be permanent rather than temporary.
Since the U.S. economy has suffered through only two minor recessions in the past 23 years, as compared to 9 recessions in the previous 37 years, it would appear that economic stability has been substantially improved by any reasonable measure (although some Eager to Publish academic economists dispute even this finding). To what can we attributed this improved performance?
1. The end of fine-tuning
2. Credible monetary policy, which means both buyers and sellers believe that inflation will remain low and stable.
3. Increase in foreign trade as a proportion of total GDP lessens domestic business cycles.
4. Switch to a service-sector economy, which is less vulnerable to cyclical disturbances; although even industrial production shows milder fluctuations
Monetary variables remain very important in the sense that well over half of the fluctuations in annual changes in GDP from 1959 to the present can be explained by lagged changes in interest rates and the real money supply. However, it does not logically follow from that statement that monetary policy causes business cycle fluctuations. When inflation rises for reasons that are unrelated to monetary policy, the Fed must necessarily raise the cost and restrict the availability of credit, and when real growth stagnates or declines for reasons that are unrelated to monetary policy, the Fed must necessarily reduce the cost and increase the availability of credit. Alan Greenspan was very effective in accomplishing those goals over the past (almost) two decades.
But what causes these disturbances? The few remaining macroeconomists that anyone takes seriously (as opposed to paid political hacks) have attempted to answer this question by introducing the concept of the ?real business cycle? ? that cyclical fluctuations were caused by shocks in the real sector rather than the monetary sector. Indeed, Edward Prescott and Finn Kydland recently were awarded the Nobel Prize for that work. While this is certainly a valid concept, it raises as many questions as it answers. First, what causes these real sector shocks ? and are they perhaps monetary disturbances in disguise? Second, why is it that what could be considered perhaps the premium example of a real sector shock ? an energy crisis ? has had virtually no impact on either the U.S. or world economy over the past year even though oil and natural gas prices have both risen to record levels?
As it turned out, the oil shocks affected the economy adversely primarily because of curtailed supply rather than higher prices. The Fed had little choice not to ease as long as inflation was rising, and then to ease once the economy fell into recession. Supply disruptions are not something the Fed can handle very well even in the best of circumstances. If a Middle East conflict restricts or completely eliminates oil shipments from that part of the world, Bernanke could not reasonably be blamed for the resulting economic chaos.
The only other major shocks of the past two decades have had a hefty monetary component. The first was the stock market crash in 1987. It occurred in part because wise-guy speculators thought Greenspan would not have the guts to impose monetary discipline to the same degree as Volcker did. While they were spectacularly wrong, that didn?t keep them from peddling their opinions the next year. The crash did not cause a recession because the Fed reacted quickly. However, by pumping too much liquidity into the economy, the Fed did boost the inflation rate, and hence had to tighten substantially in 1988 and 1989, which partially contributed to the mild recession that started the following year. Many economists thought he waited too long to start tightening again.
The other major shock was the collapse of Long Term Capital Management in 1998. For those who don?t follow financial markets, it was a mere blip on the horizon. But for those closely associated with the Wall St scene, it was almost a disaster. Here again, Greenspan saved the day by timely easing ? and here again, he overstayed his welcome. This time, the ensuing stock market bubble pushed stocks so far out of line that they eventually crashed of their own weight and the economy turned down in late 2000; while there would have been some slowdown no matter what the Fed did, many economists think the 2001 recession could have been avoided if Greenspan quickly tightened again once it was clear that the LTCM crisis had passed, hence keeping stocks from rising to such unrealistically high levels.
Greenspan?s decision to keep the Fed funds rate at an unbelievably low 1% rate through mid-2004 was largely responsible for the huge increase in housing prices over the past two years. Opinion is sharply divided about whether the reversal of the runup in housing prices will eventually lead to another recession. We don?t think so, and look for another modest increase in housing prices this year. On the other hand, we are expecting for 2% to 2 ½% growth for the year, well below the consensus forecast of 3 ½%. So here again, monetary policy, by overreacting to a shock elsewhere in the system, probably will contribute to some increase in economic instability.
Shocks will happen again: supply disruptions, wars, terrorist attacks, financial collapse caused by excessive speculation, and perhaps other events we can?t even imagine. To the extent that these do occur, the economy will wobble, and the Fed will presumably do the best it can. These will all come as surprises; if we knew about them in advance, they probably wouldn?t happen at all. Monetary policy will be there to act as a buffer. But it is not there to set the agenda of policy ? it properly reacts to shocks and tries to steer the economy back to equilibrium, but does not try and determine that equilibrium.
As far as macroeconomic policy, it is optimized when it encourages free enterprise and free trade, balances the budget over the business cycle ? surpluses in booms, deficits in recessions ? and reduces government expenditures to the minimum consistent with a democratic society and the wishes of the voters. These are important goals, but they don?t involve macroeconomics per se, with its laundry list of suggestions for fine-tuning fiscal policy that will allegedly enhance the growth rate while reducing inflation.
It has been known for quite some time that fine-tuning was an experiment that failed. But only recently have we come to realize that although the wrong person at the helm of the Fed could have very serious repercussions, simply having a competent economist who does not attempt to impose his own views or manipulate the behavior of economic activity can now be classified as a non-event.
The concept of ?fine-tuning? the economy to optimize performance reached its zenith in the 1960s, but it didn?t last very long. After a decade of stellar performance, the economy reverted to its previous cyclical performance with a vengeance: four recessions in the next 12 years. These years were punctuated by a large variety of temporary tax rate changes on both personal and corporate income: the 10% surcharge, cancellation and reinstatement of the investment tax credit, changes in the timing of withholding patterns, one-time rebates, and so on. By the time the inflation rate had risen to 13% and the prime rate had peaked at 21 ½%, the entire concept had been thoroughly discredited. But like most bad academic ideas, it took a long time to die. After all, Keynes?s seminal tract, The General Theory of Employment, Interest, and Money, was published in 1936 but not put to practical use until 1961. Similarly, it took about two decades for fine-tuning of fiscal policy to die out completely, although after 1981 tax rate changes were generally designed to be permanent rather than temporary.
Since the U.S. economy has suffered through only two minor recessions in the past 23 years, as compared to 9 recessions in the previous 37 years, it would appear that economic stability has been substantially improved by any reasonable measure (although some Eager to Publish academic economists dispute even this finding). To what can we attributed this improved performance?
1. The end of fine-tuning
2. Credible monetary policy, which means both buyers and sellers believe that inflation will remain low and stable.
3. Increase in foreign trade as a proportion of total GDP lessens domestic business cycles.
4. Switch to a service-sector economy, which is less vulnerable to cyclical disturbances; although even industrial production shows milder fluctuations
Monetary variables remain very important in the sense that well over half of the fluctuations in annual changes in GDP from 1959 to the present can be explained by lagged changes in interest rates and the real money supply. However, it does not logically follow from that statement that monetary policy causes business cycle fluctuations. When inflation rises for reasons that are unrelated to monetary policy, the Fed must necessarily raise the cost and restrict the availability of credit, and when real growth stagnates or declines for reasons that are unrelated to monetary policy, the Fed must necessarily reduce the cost and increase the availability of credit. Alan Greenspan was very effective in accomplishing those goals over the past (almost) two decades.
But what causes these disturbances? The few remaining macroeconomists that anyone takes seriously (as opposed to paid political hacks) have attempted to answer this question by introducing the concept of the ?real business cycle? ? that cyclical fluctuations were caused by shocks in the real sector rather than the monetary sector. Indeed, Edward Prescott and Finn Kydland recently were awarded the Nobel Prize for that work. While this is certainly a valid concept, it raises as many questions as it answers. First, what causes these real sector shocks ? and are they perhaps monetary disturbances in disguise? Second, why is it that what could be considered perhaps the premium example of a real sector shock ? an energy crisis ? has had virtually no impact on either the U.S. or world economy over the past year even though oil and natural gas prices have both risen to record levels?
As it turned out, the oil shocks affected the economy adversely primarily because of curtailed supply rather than higher prices. The Fed had little choice not to ease as long as inflation was rising, and then to ease once the economy fell into recession. Supply disruptions are not something the Fed can handle very well even in the best of circumstances. If a Middle East conflict restricts or completely eliminates oil shipments from that part of the world, Bernanke could not reasonably be blamed for the resulting economic chaos.
The only other major shocks of the past two decades have had a hefty monetary component. The first was the stock market crash in 1987. It occurred in part because wise-guy speculators thought Greenspan would not have the guts to impose monetary discipline to the same degree as Volcker did. While they were spectacularly wrong, that didn?t keep them from peddling their opinions the next year. The crash did not cause a recession because the Fed reacted quickly. However, by pumping too much liquidity into the economy, the Fed did boost the inflation rate, and hence had to tighten substantially in 1988 and 1989, which partially contributed to the mild recession that started the following year. Many economists thought he waited too long to start tightening again.
The other major shock was the collapse of Long Term Capital Management in 1998. For those who don?t follow financial markets, it was a mere blip on the horizon. But for those closely associated with the Wall St scene, it was almost a disaster. Here again, Greenspan saved the day by timely easing ? and here again, he overstayed his welcome. This time, the ensuing stock market bubble pushed stocks so far out of line that they eventually crashed of their own weight and the economy turned down in late 2000; while there would have been some slowdown no matter what the Fed did, many economists think the 2001 recession could have been avoided if Greenspan quickly tightened again once it was clear that the LTCM crisis had passed, hence keeping stocks from rising to such unrealistically high levels.
Greenspan?s decision to keep the Fed funds rate at an unbelievably low 1% rate through mid-2004 was largely responsible for the huge increase in housing prices over the past two years. Opinion is sharply divided about whether the reversal of the runup in housing prices will eventually lead to another recession. We don?t think so, and look for another modest increase in housing prices this year. On the other hand, we are expecting for 2% to 2 ½% growth for the year, well below the consensus forecast of 3 ½%. So here again, monetary policy, by overreacting to a shock elsewhere in the system, probably will contribute to some increase in economic instability.
Shocks will happen again: supply disruptions, wars, terrorist attacks, financial collapse caused by excessive speculation, and perhaps other events we can?t even imagine. To the extent that these do occur, the economy will wobble, and the Fed will presumably do the best it can. These will all come as surprises; if we knew about them in advance, they probably wouldn?t happen at all. Monetary policy will be there to act as a buffer. But it is not there to set the agenda of policy ? it properly reacts to shocks and tries to steer the economy back to equilibrium, but does not try and determine that equilibrium.
As far as macroeconomic policy, it is optimized when it encourages free enterprise and free trade, balances the budget over the business cycle ? surpluses in booms, deficits in recessions ? and reduces government expenditures to the minimum consistent with a democratic society and the wishes of the voters. These are important goals, but they don?t involve macroeconomics per se, with its laundry list of suggestions for fine-tuning fiscal policy that will allegedly enhance the growth rate while reducing inflation.
It has been known for quite some time that fine-tuning was an experiment that failed. But only recently have we come to realize that although the wrong person at the helm of the Fed could have very serious repercussions, simply having a competent economist who does not attempt to impose his own views or manipulate the behavior of economic activity can now be classified as a non-event.