Fog Lights and the Reinhart-Rogoff Hypothesis

August 8th, 2012 at 10:20 am

Matt Yglesias packs a lot of insight into this post about a new paper by economists associated with the Romney campaign about how the former governor’s plan would help the economy, and how badly the President’s actions have hurt it.  But plan should really be “plan” here, as Ezra stressed the other day.  There’s simply not enough specificity in what Gov Romney has proposed to draw anything like the conclusions in the paper by his surrogates.

Nevertheless, Brad DeLong just dismembers the thing here–it’s a devastating takedown.

But what I wanted to talk about was something Matt references in his post.  He notes the famous findings by Reinhart and Rogoff that recessions rooted in financial crises take much longer to grow out of, as key sectors are deleveraging and credit markets take a long time to recover.  However, he notes:

…not everyone is persuaded by their causal argument. The alternative view—which I hold to—is simply that the policy response to financial crisis tends to be bungled since the simple mechanism of interest-rate targeting doesn’t work. So one view is that we’ve done about as well as we could have, and another view is that we didn’t have appropriately stimulative monetary and fiscal policies.

Matt’s noted this before, using an analogy that I’ve often kept in mind (it’s something like this…I couldn’t find it):  if you’re driving in inclement conditions, you’re more careful.  In a storm, you slow down, you put the wipers on high.  In the fog, if you’ve got them, you put on your fog lights.

By which he means that R/R should not be taken as a fait acommpli, a condemnation to a long slog like the one in which we’re currently stuck.  Their insights should tell us to turn on the fog lights, i.e., that special, aggressive interventions are needed, including those that hasten deleveraging (e.g., loan modifications including principal reductions), aggressive monetary policy, and fiscal stimulus that will likely have to be larger and last longer than the usual dose.

(Silly season warning: this is the part where some R operative writes a press release saying some former Obama official just criticized the administration.  Nope…we took action in all of those areas, as did the Federal Reserve…obviously, there are good arguments as to whether the admin’s responses went far enough, but that quickly gets entangled with the political gridlock that’s blocked so much of their agenda…see DeLong on some of this.)

I generally agree with Matt, though I think it’s wrong to assume policy can fully offset contractions of the magnitude of the great recession.  In some cases, even fog lights don’t protect you and you have to pull over and wait for at least some of the fog to lift.  In other words, there are constraints to how large a stimulus can be effectively implemented (along with political constraints as to its size and composition, e.g., politics pushes you toward tax cuts which are uniquely ineffective in a deleveraging cycle).  They are political constraints to how much moral hazard the system will accept in terms of writing down debt.  There are potential feedback effects that you’ve got to worry about, e.g., if you write down debt, will that spook potential investors and slow the credit market recovery?

Some corrections just take longer than others.

But the point is well taken.  And while we should be doing more, we’re actually doing less, and even threatening to do worse than less (the fiscal cliff), while the Fed keeps warning that they’ll pull the trigger on further monetary stimulus without actually doing it.

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3 comments in reply to "Fog Lights and the Reinhart-Rogoff Hypothesis"

  1. Phil Perspective says:

    They are political constraints to how much moral hazard the system will accept in terms of writing down debt. There are potential feedback effects that you’ve got to worry about, e.g., if you write down debt, will that spook potential investors and slow the credit market recovery?

    Why? There didn’t seem to be a problem with throwing unlimited money at the banksters. Are you admitting that we do in fact make policy to benefit the banksters(and the elite) and everyone else is secondary?

  2. Peter K. says:

    Unlike many of my fellow Monday morning quarterbacks I’d agree that the political constraints were large. With the benefit of 20/20 hindsight, I would have pushed for more aid to the states and for more aid to the housing market. I would have nationalized one of the banks like Citi as was done effectively with the auto industry. And to be really picky I would have pushed more on the Fed.

    But most of what was done worked (imagine a McCain Presidency or if the Republicans hadn’t taken the House) and I am Obama went forward with health care reform (see the relief and positive reaction to the recent Supreme Court decision.)

  3. Some Guy says:

    I think if stimulus is fog lights, the analogy would be not that you have to pull over, just that some fog is bad enough that you have to drive slower.

    And I agree. The idea that fiscal and monetary policy could offset the entirety of all shortfalls in our driving speed is unrealistic. There are real constraints to policy responses besides just political ones. Even in the great moderation, we still couldn’t completely offset comparatively small recessions. Some of that was issues with composition of stimulus, but I think it also reveals limitations on the effect of policy.

    As an aside, I think one thing about the fiscal cliff that’s a bit overlooked is that we are not yet in a position to offset fiscal contraction via monetary policy. If we could ease up on the accelerator of fiscal policy at the same time interest rate cuts provide a tailwind, we probably would probably get quite a bit done on the deficit without undermining our momentum. That’s why I’m not averse to can kicking. Ideally, an incremental approach, perhaps tied to the unemployment rate?