Long Run Growth and the end of The End of (Monetary Policy) History

Suppose everyone believes that we have reached The End of History, as far as monetary policy is concerned. The new inflation-targeting regime adopted by central banks has finally solved the age-old problem of the business cycle. There will be no more booms and busts. Maybe not yet solved perfectly, but the broad outlines of the solution are already in place, and all that remains is the boring technical work of bringing central banks' implementation of that policy closer and closer to perfection.

And then suddenly Something Happens. And it does not matter for this blog post what exactly that Something is. All that matters is that, whatever it is, it causes everyone to stop believing they have reached the End of Monetary Policy History. They stop believing that central banks have the correct framework to tame the business cycle. Future booms and recessions will be bigger and last longer than they had previously expected they would be.

How will the end of The End of Monetary Policy History affect investment? I think it would cause investment to fall. And that fall in investment (as a percentage of GDP) would cause the labour productivity growth rate to fall, which would cause the long run GDP growth rate to fall. And this fall in the growth rate would happen even if the growth rate of employment were unaffected by the end of The End of Monetary Policy History.

If you want to see a formal model which shows why investment and long run growth would fall if the (subjective) variance of Aggregate Demand increased you can read my old paper with Vivek Dehejia. The key point in that model is that even if booms and recessions are symmetric, their effects on the profitability of investment are not symmetric. A recession means that capital services are wasted at the margin, because the extra output cannot be sold. But booms are not good, because a bigger queue of customers does nothing for profitability if you cannot produce more to meet the extra demand. So an increase in the expected variance of booms and busts reduces the expected marginal profitability of investment, which reduces investment. And Vivek and me did all the math (with the help of an anonymous referee who deserves a medal) to show that we get this result even if firms set prices and output to maximise expected profits in the face of uncertain Aggregate Demand.

It is important to distinguish between the (expected) level of Aggregate Demand and the (expected) variance of Aggregate Demand. A low (expected) level of Aggregate Demand will reduce investment demand. That investment accelerator mechanism makes sense both theoretically and empirically. (It explains why the IS curve can slope up). And that level-effect is what Simon Wren-Lewis is talking about in his good post that inspired me to get my act together and write this one. But I think that Simon could only create a model in which this level-effect creates multiple equilibria and self-fulfilling prophecies with an implausibly elastic labour supply function, or very strongly increasing returns to scale, or something like that. (Or by deleting the real wage equation in a search model like Roger Farmer does.) In this post I am talking about a variance-effect. So I don't need any of that weird stuff to make it all work. The labour supply curve can be perfectly inelastic, and it still works fine.

What was the Something that Happened? The 2008/9 Great Recession, of course. What I'm arguing here is that maybe it wasn't just a recession like most recessions. Or, more importantly, it wasn't perceived as a recession like most recessions. It changed how people viewed their world, and changed their confidence about the future and the ability of central banks to manage that future. It was perceived as the end of The End of Monetary Policy History.

And it is indeed too big a coincidence to suppose that an exogenous slowdown in long-run growth just happened to coincide with the Great Recession. And if we reject that coincidence, we must either say the exogenous slowdown in long-run growth was what caused the recession (some sort of RBC story) or else explain why the fall in Aggregate Demand caused the fall in long-run growth. And it might be a level-effect story, like Simon's, or a variance-effect story, like mine. But Something Happened.

If Simon is right, then getting back to "full employment" will be enough to solve the problem. If I'm right, it won't be enough, and we will need to convince people we have fixed the problem and it won't happen again.

We need a regime change. But instead all I see is that the demand for a monetary policy regime change is slowly sliding down the agenda as the world's economies slowly "recover". This is not what "recovery" is supposed to look like.

Comments

[Nikola]

Maybe the Great Recession revealed information about the stability of financial markets when interest rates are low. Could it be that low expected growth yields low interest rates, which breeds expectations of bigger booms and busts, further decreasing the expected level of GDP? Sort of a self-perpetuating cycle.

And if low interest rates increase expected variability, does fiscal policy become a more appropriate solution than monetary policy?

[Majromax]

> If you want to see a formal model which shows why investment and long run growth would fall if the (subjective) variance of Aggregate Demand increased you can read my old paper with Vivek Dehejia. The key point in that model is that even if booms and recessions are symmetric, their effects on the profitability of investment are not symmetric.

Would this analysis by itself say that even absent recessions, an NGDP level target is superior to inflation targeting?

Even if an inflation target is perfectly executed with small stochastic error, the actual level of NGDP in the medium to long term (15-30 years out) has considerable uncertainty: about sqrt(Nyears)*std(inflation) if year-to-year inflation errors are uncorrelated, with a fixed and unchanging real rate. Risk aversion then implies that interest rates on long-term investments would be suboptimal.

[Frank Restly]

Nikola,

"And if low interest rates increase expected variability, does fiscal policy become a more appropriate solution than monetary policy?"

Fiscal policy may become more appropriate as long as the fiscal policy prescription itself does not depend on those low interest rates.

Conventional government spending / cutting taxes that are financed through debt issuance can increase economic volatility if they are dependent on low interest rates to keep government from owing more in interest than available tax revenue can pay.

It becomes a vicious cycle - central bank / market cuts interest rates, government borrows at those low interest rates to finance tax cuts and / or spending, economy starts to recover, central bank / market raises interest rates, government cuts spending / raises taxes, economy falters.

[Scott Sumner]

Nick, You said:

"And it is indeed too big a coincidence to suppose that an exogenous slowdown in long-run growth just happened to coincide with the Great Recession."

I think that this may be exactly what happened. The growth slowdown would have occurred even if we had not had the Great Recession. (It's partly demographics). I'd go further and argue that the slowdown in trend growth helped to cause the Great Recession. The slowdown reduced the Wicksellian natural rate, and the world's central banks were slow to spot this change. Taylor Rule type thinking led to unintentional monetary tightening in 2008. A given interest rate setting (2% after Lehman failed) was much tighter than the Fed assumed.)

Note that this slowdown began before the Great Recession, as the equilibrium real interest rate has been gradually declining for several decades.

[Nick Rowe]

Scott: The slowdown in labour force growth was clearly partly due to demographics, and that part would have happened anyway. Though that would not have explained slowing productivity growth. And maybe there was a steady slowing of investment that would have happened anyway. But the apparent break in the trends just looks too big and sharp. Like in Simon Wren-Lewis' chart of UK GDP per capita. The same trendline works pretty well, from 1955 to 2008. Then it doesn't.

Nikola: real interest rates were falling steadily, until the recession. And a good monetary policy regime ought to work even if real interest rates are low. Though it might well have been that the *existing* monetary policy regime could not work well with low real interest rates.

Majro: "Would this analysis by itself say that even absent recessions, an NGDP level target is superior to inflation targeting?"

Well, I think our model is too simple to really distinguish between inflation targeting and NGDP level-path targeting. But maybe.

[marcus nunes]

Nick: Related
http://ngdp-advisers.com/2017/02/24/growth-mnuchin-wishes/
Also, the surge in variance has again been contained, so what´s left is the level effect.

[Nick Rowe]

marcus: your third graph seems to show a break in trend.

I think what matters for investment is the *expected future* variance. How confident are people that we won't see a repeat?

[Lord]

I am sure you are right since compound returns are reduced by variance.

What do you think changed the previous time (Great Depression)? Recovery was actually quite strong with abandoning gold but from a low level until the fall of 37 followed by the war boom. That fiscal policy could cure where monetary could not?

[James Alexander]

Excellent post.

Slightly OT. Why is it that only "investment" increases productivity? Why not "organisation", "property rights", "competition/anti-trust", "trade", etc, etc? What is the evidence that only "investment" causes increases in productivity?

[Nick Rowe]

Lord: the mechanism here is more of a non-linearity, rather than compounding. It works with one-period investment too.

Good question about the 1930's. My reading of the economic historians is that it was going off gold, rather than fiscal policy, that led to the end of the Depression. (But the US raised reserve requirements, which didn't help.). But regardless of monetary vs fiscal, I think the idea that "something can and will be done" could have restored confidence.

But one would need to look at investment data.

James: thanks!

I would think that all those other things can and do increase productivity too. But it's investment that matters for my argument here, because it is chosen by people and firms, is costly in the present, and has uncertain future returns that depend on AD.

[James Alexander]

I was more thinking that when labour is cheap, the labour market sticky (i.e. low levels of job switching), nominal wage growth low, there is less incentive to economise on it. To reorganise. Higher growth in AD livens up the labour market, and is equivalent to higher nominal wages (at a given population growth). So reorganisation also depends on AD.

Typically, the biggest, most inefficient organisations on average are governments or government "enterprises", local and national. xamples exist in the private sector too, If labour was scarcer they'd have to do better. Am here defining "scarce" as evidenced only by rising nominal wages. NAIRU, unemployment, underemployment etc seem only able to be tested as measures by actual experience, not theory.

I agree those other things like property rights, trade, anti-trust are less dependent on AD growth. A separate question whether they remain constant. I was more thinking that the traditional idea of productivity-enhancing investment like plant and equipment are pretty old fashioned in our internet-enabled world.

[Andrew_FL]

"But one would need to look at investment data."

If you read Higgs' "Regime Uncertainty" he points out that annual net private investment in the US went negative through 1935 and didn't exceed its 1929 level until 1941 (during WWII, private investment was almost completely displaced by war spending by the government, and the deflator becomes unreliable).

Higgs actually describes the data behaving similar to your theory here, but he attributes it to institutional uncertainty, especially of the property rights regime, rather than your mechanism.

IMO in the US at least, depressed investment is related to regulatory policy changes. But this is an interesting possible other reason.

[James Alexander]

Not sure if you can read this, but the article here explores some of the current issues to which I was referring:
https://www.ft.com/content/74769eae-fff8-11e6-8d8e-a5e3738f9ae4

Plentiful labour supply, easy to (cheaply) hire and fire, as in U.K. Vs France, leads to lower productivity even if much higher employment.

[rsj]

Nick,

Do you really believe this argument -- meaning, do you believe that this is the root of our problem -- or is the goal to think of all the ways you can get a long term slowdown?

[Henry]

Nick said:

"And it is indeed too big a coincidence to suppose that an exogenous slowdown in long-run growth just happened to coincide with the Great Recession."

David Andolfatto ran a piece on this a few months ago:

http://andolfatto.blogspot.com.au/2016/11/us-postwar-growth-and-pop-in-epop.html#comment-form

In the comments, I suggest that the reason for the slowdown in long run growth is due to a longstanding technological cycle which seems to be running.

In essence, these periods of quiescent growth are due to technological saturation and present an hiatus between the previous burst of growth and the next burst of growth. The next burst of growth will come with a new generation of technology and technological developments which are in the offing.

The focus of many commentators is on monetary policy, its successes and failings, however, explanations might be found somewhere else.

[Nick Rowe]

Andrew: interesting comparison. I think that maybe business cycle uncertainty is more important (at least in successful developed economies) than e.g. tax/regulation regime uncertainty. As I tweeted, a T% probability of recession is like a T% marginal tax rate on the *gross* returns to investment. (At least the taxman lets you write off the dirct costs of your investment before taxing you on the net returns.)

rsj: I believe it is *part* of the Truth. How *big a percentage* of the Truth? That's what I'm much less sure about.

[Patrick]

Maybe the best we can hope for is that people just forget about the Something that Changed?

I seem to remember some posts about forgetting... But I forget (ha!) the specifics.

[Thaomas]

Well part of what would happen is how the monetary authority itself reacts to the change of opinion? Just suppose that Something Happens that makes people doubt that the monetary authority will keep NGDP growing at a fairly constant pace. Surely it makes a difference whether the monetary validates these new doubts by in fact allowing NGDP growth to depart from trend without taking action to bring it back. For this purpose, it may not matter if the reason people loose faith in the monetary authority is that they believe the monetary authority does not have the instruments to keep NGDP on track or it they think that it is politically constrained not to use its instruments vigorously enough.

Part but not all. Outcomes will also depend on how sensitive (if not perverse) fiscal policy is the emergence of a recession with low real interest rates.