From Mainly Macro, March 2:
The
only two lectures on Oxford’s core undergraduate macro course that I
still teach, and which I have just taught, are the last two on fiscal
policy. I use the privilege of the last
lecture to end on a reflective note. I acknowledge that macro rightly
got a lot of stick by largely ignoring the role of finance, but I
also point out that the poor recovery has involved a vindication of
the core macro model: austerity is a bad idea at the ZLB, QE was not
inflationary and interest rates on government debt did not rise but
fell.
So far so familiar.
But I end by showing them my this chart.
And I say that we
really have no idea why there has been no recovery from the Great
Recession, so there are plenty of mysteries left in macro. The puzzle
is sharpest in the UK because the pre-crisis trend is so stable, but
something similar has happened in most places. I think it is a
suitable note of humility (and perhaps inspiration) on which to end the
course.
A mechanical way to
explain what has happened is to bend the trend: to suggest that
technical progress has been slowing down for some time. This
inevitably means that the pre-crisis period is transformed into a
boom. I have been highly skeptical about that story, but I have to
admit part of my skepticism comes in part from traditional ideas about what
inflation would do in a boom.
However another
explanation that I have always wondered about and which others
are beginning to explore is that perhaps we remain in an extended
period of demand deficiency. Keynesian theory is very suggestive that
such a possibility could occur. Suppose that firms and consumers came
to believe that the output gap was currently zero when it is not, and
that they erroneously believed that the recession caused a step
change both in potential GDP but also possibly its growth rate.
Suppose also that unemployed workers priced themselves into jobs by
cutting their (real) wage or disappearing by no longer looking for
work. The former could happen because firms could choose more labour
intensive production techniques: scrapping
the car wash machine for workers with hoses.
In that situation,
how do we know that we are suffering from demand deficiency? The
traditional answer in macroeconomics is nominal deflation: falling
wages and prices. But because workers have already priced themselves
into jobs, nothing more will come from the wages route. So why would
firms cut prices?
If the pre-crisis
trend still applies, it means that there are a large number of
innovations waiting to be embodied in new investment. With this new
more efficient capital in place, firms would either increase their
profits on selling to their existing market or try to expand their
market by undercutting competitors. We would get an investment led
recovery, accompanied by rising productivity and perhaps falling
prices.
But suppose the
innovations are just not profitable enough to generate an
increase in profits that would justify undertaking the investment, even
though borrowing costs are low....MORE
