How will history judge the Almost-Depression of 07-09?


In 20 years time, the concensus amongst economic historians will be that the prime reason behind the Almost-Depression was central bankers' reluctance to pursue aggressive enough monetary policy, either by generating some inflation so that real interest rates can come down, or by other means.

They will argue that a few percentage points additional inflation would have worked wonders in softening the recession, and they will dismiss arguments that long-term central bank credibility would have suffered as a result. They will marvel at how anyone could have let below target inflation (let alone deflation) take hold, and they will label as disingenuous claims that the tools available to central bankers and policy makers at the time were insufficient to generate the required degree of inflation at will.

They will comment extensively on the shocking lack of international co-ordination, both amongst central banks and governments. Finally, they will have some rude things to say about using fiscal policy, with all its adverse effects on public finances, when a small tax on monetary assets (i.e. inflation) could have done a better job, and much more neatly.

In other words, the consensus in 20 years' time will be what Scott Sumner is already saying today.

6 comments:

  1. Mahony Says:

    Another article that is bad for my nervous system.

  2. Shane Says:

    You're still assuming that standard measures are still effective. Credit supply is no longer a simple function of a base rate+margin (if it ever was). It's much more complicated than that now, and we still don't fully understand. But, that's beside my point, which follows:

    A nice little bout of (unanticipated) inflation right now would of course prevent a painful bout of de-leveraging, right around the western world. But the effect on the reputation of central banks' ability to maintain price stability could be catastrophic - and there's enough moral hazard growth on the balance sheet about after the bailout mania of the last 18 months.

    Central banks have painstakingly built up credibility over the last 30-odd years. The increases in long-term rates that would inevitably accompany a chunk of medium-term inflation could do worse damage to growth prospects (and restoring the public finances) than the sickness you're trying to cure.

    Quantifying this is anyone's guess, but we have to realise that inflation is not as simple a solution as it sounds.

    O, and welcome back!

  3. Robert Johnson Says:

    Gosh dang! It's like you've been reading economic history or something! It IS much easier to 'explain' things after the fact than it is to make useful predictions or policy recommendations, isn't it?

  4. Shane Says:

    Of course. But try imagine how worse we'd be if we never studied what happened before.

    PS: there are plenty cynical places on the web. This isn't one yet thankfully.

  5. datacharmer Says:

    Shane - thanks for the welcome, nice to see you here too.

    I think the only thing needed to increase inflation is a stated desire to do so. The tools are there.

    Now, on credibility, I don't think that it would take as big a blow as you suggest, but I don't have any strong evidence to back this assertion. In any case, ideally you should have the transition to a new framework altogether: either Sumner's proposal of targetting nominal GDP (an excellent suggestion), or a permanently higher rate of target inflation - say 4% instead of 2%. I think there's strong enough evidence that the current target is too low, precisely because of recessionary episodes like the current one.

    By the way: note that there's no need for unanticipated inflation: all you need is to escape the zero bound. The 'unanticipated' bit just adds a nice little bonus.

  6. Robert Johnson Says:

    Shane,

    First I'd like to concede your point about cynical places on the web. My tone was unnecessarily sarcastic. Not conducive to discussion. My apologies.

    And of course we should study the past, and try to explain it. The problem is that this can degenerate very rapidly into post hoc story telling - which can actually obstruct understanding. Much more useful would be this: study the past and develop a comprehensive and detailed descriptive philosophy of the most relevant dynamics, and then make a narrow prediction of the type: "when these factors are present, this result will occur." If your prediction doesn't pan out, then you need to work on that descriptive philosophy some more.

    Merely telling a story to explain a limited set of past events produces a non-falsifiable claim - and that ain't science.