This is the five year anniversary of the collapse of Lehman Brothers, and the steady stream of retrospectives has given me cause to think back on my own journey.
There is little doubt that my views have changed substantially over the subsequent five years — mostly with regard to the potency of policy, and therefore the appropriate place of policy markers.
I started the period with fairly dry views: I was on the dry side of the mainstream for academic economists (the academic I most admired was Tom Sargent), and well outside the (Keynesian) mainstream for a financial market economist.
For example, I doubted that either fiscal or monetary policy had important impacts on real variables over meaningful periods (say longer than five years), and was fairly sure that the impact of fiscal and monetary policy was small even over shorter periods … I no longer hold these views.
The financial crisis delivered a fairly serious stress-test of economic dogma. It threw up not only extreme cases, but also contrasting ones (the contrasting approach to fiscal policy taken by the US and UK governments, for example). Folks will be writing PhD’s on this period for a generation, but allow me some premature conclusions of my own.
Fiscal Policy: fiscal policy certainly works in the short run. It may work for bad reasons, but it does work. I now have no qualms with the assertion that the Government can temporarily increase the demand for goods and services by buying more stuff.
As wasteful as it might well have been in Australia (and in many other places), there simply wasn’t much evidence for the proposition that the private sector, anticipating higher future taxes, would pull back in equal measure. At least in the case where the private sector is already retrenching (as it was in the wake of the financial shocks that started the crisis of 2008) there is fairly compelling evidence that fiscal policy works.
Given this, there’s a reasonable case for a trade-off between wasting human capital (by allowing a demand shortfall to persist) and wasting taxpayer money via hasty spending (a.k.a. ‘fiscal stimulus’).
In the presence of large shocks, I now support increased government spending. Of course, in the long run, it’s only likely to increase welfare if the marginal product of Government spending is not only positive, but also sufficiently high — but i am now comfortable that there is trade-off to be made here, and that some wasteful spending might be okay so long as it keeps folks in work.
A part of the problem with this as a policy strategy is corruption, and another part of the problem is waste. A way to manage both is to plan ahead. I think it’s important that governments do so, by maintaining infrastructure priority lists and detailed up-to-date schema for executing (if necessary).
Monetary Policy: the old dogma is that the central bank sets the price level, and that is all. Over the years, all the arguments were about the period in which money might have a temporary impact on real variables.
Is there such a period? How long is the short run? Even if there is a short run trade-off, is it worth exploiting?
I still hold the view that the only thing a central bank can do in the long run is set the price level, but I am no longer sure that this is the only thing they ought to focus on over shorter periods. Central banks seem to be able to move both real and nominal variables over meaningful periods – and it seems likely that they are able to increase welfare by nudging the economy in beneficial directions. And yes, it even seems that they have the wisdom to use these powers at the ‘right’ time (so the trade off is worth exploiting).
The evidence has been around for some time, particularly in equities (see the above chart which splits equity returns into the three days around the FOMC meetings, and the rest — all the returns come around Fed days) — but being a rates guy, i had not noticed.
It seems that some central banks (well, at least one of them) can have a very large impact on real variables for a meaningful period of time.
The evidence that challenged me most on this was late in the crisis – it was the sharp increase in long-term US real yields as the fed started talking about tapering their bond purchases. This is very weird if you have even a mild ‘neutrality’ view of money.
Up until that time, the main thing that had happened was that real yields fell as the FOMC eased monetary policy. That didn’t tell theorists anything much, as the FOMC and market may have been both responding to the evidence that the economy was weak.
The move away from QE3, and the consequent increase in real yields (but less so the collapse in break-even rates of inflation) challenged me, as it occurred despite fairly lack-lustre data. Thus, i do not buy the story that real yields have risen and that the Fed has got less dovish because the data has picked up.
In this case, i think the data has remained weak and that very long dated real yields have risen due to the Fed’s change of stance. Particularly at the long end, this should not occur. Central banks ought not be able to change 30yr real rates (even if you think the short run is a long time!).