Dean Baker goes on a vicious—even for him!—tear in response to Robert Samuelson’s column this morning on the state of economics knowledge about the business cycle. Dean’s take down is definitely worth a read, as I too have been struck by the increasingly complex explanations offered for a sequence of economic events that seems fairly straightforward, though as Dean stresses, was broadly missed (though not by him).
Dean takes you through the details, but they’re well known to my readers as well: housing bubble inflates, enriching credit providers/intermediaries and ignored by financial regulators, bubble bursts, huge negative wealth effect and negative shock to credit system, deleveraging cycle exacerbated by lack of debt forgiveness (policy mistake #1), fiscal response was and is insufficient (policy mistake #2).
Am I shaving too close with Occam’s Razor? Not that I can see, but feel free to add complexity if it is warranted. Dean argues that those who missed all of the above are compelled to weave a complex web of events to protect their reps. Perhaps so. At any rate, like they say, “make your explanations as simple as possible but no simpler.”
There are two closely related pieces of all this that I’d like to pull out, because unlike the accountability question of who missed the bubble and why (not that this is unimportant), they’re forward looking. Both relate to not learning the wrong lessons from the Great Recession and weak recovery.
First, there’s an idea in the Samuelson piece that I hear a lot, and its sequencing goes like this: each cycle in recent decades involves a destructive bubble. Said bubbles are in no small part the fault of the Federal Reserve, i.e., the bubbles are the unintended consequence of their macro-management policy: by holding down interest rates to stimulate more demand, they’re inflating asset bubbles.
This line of thinking, of course, embeds an implicit up-weighting of the Fed’s anti-inflation mandate and down-weighting of their full employment mandate. As you can imagine, that makes me unhappy, and we don’t want that.
One reason it is wrong is it ignores the critical role of financial oversight, both by the Fed and other banking regulators. If you’re worried about your weight, you could stop eating, or you could regulate your intake to healthy foods in moderate portions. The former will kill you, the latter will make you healthy. The Fed of course must be able to practice macro-management through interest rate policy. Ample, adequate financial market oversight is an essential complement to those activities.
Second, expansionary fiscal policy is a highly effective response to temporary demand contractions but you’ve got to apply it until it’s no longer needed. Again, this is simple arithmetic. GDP is nothing more than (C)onsumption, (I)nvestment, (G)overnment spending, and net exports. In expansions, the private sector taps demand leading to more C, which signals investors to engage in more I and a virtuous cycle is underway (our persistent trade deficits are a big problem in this story but put them aside for now). In recessions, C&I are temporarily missing in action, and G must step in.
And, in fact, G did so with the Recovery Act and subsequent stimulus measures as well, but the pivot to deficit reduction came too soon. Just last year fiscal drag took a huge 1.5 percentage point bite out of GDP—by Okun’s Law, that’s 75 basis points added to the unemployment rate. (Baker: “It’s sort of like the fire department that rushes to the burning school building and watches in horror as it goes up in flames because they had forgotten to turn on the fire hydrant.”)
So let’s be careful not to learn the wrong lesson here either.
I see no obvious reason to “call in rewrite” when it comes to our basic understanding of recent economic history. Large, persistent bubbles do tremendous damage when they burst so financial oversight must be vigilant in spotting and deflating them. Both fiscal and monetary policies are effective, but the former must stay “on” until it’s no longer needed (and then, to avoid longer-term deficits, it must come “off”) and the latter must be complemented by financial oversight to avoid excessive asset inflation.
If you want to wind yourself up in knots of complexity, be my guest. But in the interest of the greater good, unless you’re sure it’s needed, please keep it to yourself.