What Mistake Will We Make Next Time?

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Economists succumbed to hubris in the early 21st century. The Nobel Prize winner Robert Lucas even said the basic problem for macroeconomics had been “solved.”

You don’t hear that kind of complacency today, as policy makers fret about a lack of ammunition for fighting the next recession. But we should worry just as much about the long-term impact of that crisis response, not just for the economy but society as a whole.

That’s one grain of wisdom to emerge from the heated, although not always illuminating, debate about Modern Monetary Theory, or MMT. Come the next downturn, policy makers won’t be able to leave the job of stabilizing the economy to central bankers, and economists probably can’t afford to leave the distributive consequences of their policies to politicians.

Extrapolation Bias

What economists term “extrapolation bias” is at the heart of most major downturns. In plain English, that’s the belief that the good times can carry on forever. The extra error that policy makers in most advanced economies made in the early years of this century was to assume that central bankers could safely focus on the single goal of stabilizing consumer prices. Asset prices and the financial markets, to an important degree, could be left to look after themselves.

Now we know different. Financial stability — and macro-prudential tools to tame the credit cycle — are front and center of economic debates. A central banker who pays close attention to changes in asset prices or what’s happening to bank balance sheets is no longer seen as a crank. But central banks still have the same inflation targets and a relatively narrow range of tools for achieving them. They’re also going into the next recession with significantly less room for maneuver.

Limited Room on Rates

Typically, the Federal Reserve cuts the policy rate by 5 percentage points in the course of an easing cycle. They have less than half that space to cut now before they hit zero. In Japan and the eurozone, rates are already at a record low. At the time of writing, investors are not expecting the European Central Bank or the Bank of Japan to even bring official rates out of negative territory before 2022.

The very knowledge that policy tools are in short supply could in itself increase the risk of a downturn by exacerbating the reaction of financial markets to bad news. Every recession scare risks becoming a self-fulfilling prophesy. So it matters what policy makers can say to convince consumers and businesses they are able to keep a floor under the economy.

The Role of Economists

Chastened by the global financial crisis, what advice can economists offer on this crucial question?

First, policy makers must show they’re going to work extra hard to avoid a recession in the first place. We’ve seen signs of that in the Fed’s “pivot” since December 2018, which has encouraged market participants to see the central bank as prepared to err on the side of too much inflation for a significant period. This approach is much harder for the ECB and the BOJ to adopt when their chances of getting close to 2 percent inflation in the near future are considered low.

Second, convince the world that next time you won’t rely on monetary policy alone. This is especially hard for the eurozone, as Clive Crook explains. The Growth and Stability Pact regulating euro-area debts and deficits now has at least some sensitivity to the cycle. But the framework for supporting countries that get into trouble would almost certainly push them to tighten fiscal policy in the teeth of weak demand.


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