Economic Reflections at Year End

Op-ed in El Pais

December 20, 2015

Books and movies show that economics has become fashionable. A 500-page French book on global inequality has become an international bestseller. A film about complex credit derivatives has gathered a long list of Hollywood heartthrobs. The science of economics studies the management of scarce resources. During good times it is largely irrelevant; there are plenty of resources for everyone. During crises everybody becomes an amateur economist; it is a survival strategy. As the economy recovers, it is a good time to reflect on what we have learned.

The magnitude of the crisis has generated situations never seen before, and the solutions that have been deployed have generated much criticism, most of it unfair and based on ideological prejudices, or simply that "we have never seen this before and therefore it must be wrong" (for example, the criticisms about zero or negative interest rates). Above all, we have seen that the recipes for managing mild recessions do not work well in cases of deep recessions. It now seems clear that economists have spent too much time studying the economic dynamics of calm periods, and not enough wondering about the dynamics and consequences of deep crises. Many truths that were considered almost absolute are now being questioned openly.

We used to accept that the economy evolved as a business cycle around a potential growth trend that remained more or less unchanged over time. Monetary policy was responsible for modulating the cycle, while fiscal policy should worry only about maintaining long-term sustainability. We were convinced that monetary policy did not affect the growth potential of the economy, and that using a restrictive monetary policy that lengthened a recession in order to force structural reforms was the right strategy. We accepted that central banks could always create inflation and that the key was to avoid inflationary risks, even at the cost of falling into a temporary deflation.

As the kids would say, nope. It is increasingly clear that recessions, especially long ones, have a persistent negative effect on potential growth. As shown in a recent paper by Olivier Blanchard, Eugenio Cerutti, and Larry Summers, economies often recover neither the level nor the rate of pre-recession growth potential.

If the economic policy reaction to the recession is not aggressive enough, it runs the risk of causing permanent damage. For example, in the United States, after several years of expansion, the level of GDP is still 10 percent below where it would have been had the economy continued to grow uninterrupted since 2007. In the eurozone, which is just out of the recession, it is 20 percent below. In these cases, monetary policy, if not eased aggressively, contributes to the reduction of long-term growth potential.

The crisis has also questioned whether central banks can always generate inflation. The Bank of Japan is the best example, but both the Federal Reserve and the European Central Bank are also struggling to convince both markets and the general public that they will be able to revive inflation. The problem is serious. Not only low inflation worsens the debt dynamics but also central banks must increase inflation rapidly to regain the necessary space to be able to lower real interest rates enough to cushion the next recession. It now seems clear that an inflation target of 2 percent is too low, as it was calibrated to accommodate mild recessions and does not give enough room to manage deep recessions. We must aim for an inflation target of 3 to 4 percent.

It is becoming clear that interest rates will stay at zero in the euro area for several years, and fiscal policy will have to be the main instrument to stimulate demand in the next decade. But, unfortunately, the Stability and Growth Pact (SGP) was designed for precisely the opposite situation, as it does not provide a legal mechanism to engineer a fiscal expansion, only to force fiscal adjustment. If some countries decide to adopt an overly restrictive fiscal policy, as Germany is doing now, there is no legal mechanism to correct them. The euro area fiscal policy framework was created for a different world, one of positive interest rates, and it must be urgently reformed to adapt it to the new reality.

There are two reform options, not mutually exclusive. On the one hand are changes in the SGP deficit rules; for example, exempting public investment from the calculations of the deficit because, if well designed, public investment is self-financed by the higher potential growth it generates. On the other hand is the creation of a common fiscal policy, adopting, for example, my recent proposal for a system of Stability Bonds (European bonds to finance up to 25 percent of the debt of euro area member states) to improve the financing of euro area debt and allow for a more effective and expansionary countercyclical fiscal policy during recessionary periods.

We believed that increasing the minimum wage was harmful to job creation, but more recent studies in the United States show that this is not true—and also that better-paid workers are more productive. Or that inequality did not affect growth, but the IMF has concluded that more equal countries grow more. Or that unconditional transfers to the poor reduced their incentive to seek employment, which MIT researchers have shown, with experiments in India, not to be true. Or that the public sector should not engage in investment and innovation, until we realized, as Mariana Mazzucato relates in her book The Entrepreneurial State, that without the technological innovation carried out by the US government the iPhone would not exist.

We must review and update the economics textbooks. The much maligned Keynesianism is more relevant than ever. The conservative doctrine of "trickle-down economics" based on liberalizing economic sectors, cutting taxes, and letting the market do the rest, is not enough for the currently depressed and uneven economy. Monetary and fiscal policies need to be coordinated to accelerate growth. The United States is already raising rates while Europe is still cutting them, a symbol of the relative success of their decisions in recent years. It is a different world.

Merry Christmas and Happy 2016.