Tuesday, August 31, 2010

New from Reinhardt and Reinhardt

When I read Reinhardt and Rogoff's recent book, it was at the time when it was summarized as "financial crises have been more common historically than people think, and financial crises are always harder to recover from than normal recessions". With the initiation of a debate between austerity and stimulus this Spring, Reinhardt and Rogoff have recently been summarized as saying "if your government borrows more than 90% of GDP you will have a sovereign default". The message that irresponsible borrowing can lead to sovereign default obviously comes out in the book, but this was never really the primary thrust of it. Indeed, they highlighted cases of surprisingly high debt tolerance.

The "Carmen Reinhardt is in favor of austerity" approach took another blow with a recent paper by Carmen (U-Maryland) and Vincent (AEI) Reinhardt (HT - Matt Yglesias). I'll quote at length from the conclusion (emphasis, mine):

"The outcome could materialize as a consequence of the failure of policy makers to provide sufficient stimulus after a wrenching event in an economy where rigidities give ample scope to demand management. An important role for credit in supporting spending might imply that an associated collapse in financial intermediation lengthens and deepens the downturn (with the unavailability of credit serving as the propagating mechanism discussed in Bernanke, 1983). In such circumstances, slow growth might be a self-fulfilling prophecy produced by timid authorities who neither supported spending nor dealt with the capital-adequacy problems of key financial institutions. [in other words, "we are way, way, way below full employment and Bernanke wrote this cool paper about how gummed up financial institutions can create a situations that acts like liquidity preference"]

Economic contraction and slow recovery might also feed back on the prospects for aggregate supply. A sustained stretch of below-trend investment and depreciation of human capital prompted by elevated and lengthy spells of unemployment could hit the level and growth rate of potential output. The unemployment rate stays high because it has been high, exhibiting hysteresis as described by Blanchard and Summers (1986). [this is similar to the cyclical unemployment turning into structural unemployment point]

The forcing mechanism for a reduction in aggregate supply might be policy itself. In adverse economic circumstances, political leaders sometimes grasp for quick fixes that impair, not improve, the situation. Included in the list of unfortunate interventions are restrictions on trade (both domestically and internationally), work rules and pay practices, and the flow of credit. The output effects of crises might be persistent because we make them so, in the manner posited for the Great Depression by Cole and Ohanian (2002). [can anyone say "repealing the Bush tax cuts"?]

Or, changed prospects after a crisis might reflect the correction of outsized expectations that fed the prior boom. If, for instance, investors grossly overestimated the possibilities for productivity improvement from a new technology, they might bid up asset prices, borrow against future anticipated income, and invest in myriad capital projects in an unsustainable manner. Chancellor (2000) casts many episodes of financial euphoria and ensuing crash over the centuries in exactly this sequence, from the diving bell, through the steam engine, to the radio, and thereafter. Spending advances rapidly on hope, and, on reality, contracts, and then recovers only slowly. Recent discussions about the “new normal” in reference to the post-crisis landscape leave the impression that the pre-crisis environment was “normal.” In fact, there are reasons to believe that the precrisis decade set a high-water mark distorted by a variety of forces. We have presented evidence here that many of those patterns are reversed not only in the immediate vicinity of the crisis, (as Reinhart and Rogoff, 2009 show), but also over longer horizons that span several years. [You say "liquidation of malinvestment build up by inappropriate subjective valuation", I say "the collapse of animal spirits" - we all say "subjective valuation in investment decisions can be very, systemically, wrong]

For whatever the initiating change, the real interest rate consistent with full employment of resources presumably falls as a consequence of slower economic growth. The logic is that households need less inducement to defer consumption when future consumption prospects are bleaker [in other words, "liquidity preference"]. In addition to the fall-out of a lower real interest rate on asset prices, monetary policy makers need to reconsider the benefits of an inflation buffer to protect from the zero lower bound to nominal interest rates [and that liquidity trap thingy is no joke]. If real GDP growth has permanently tilted down as a consequence of a severe economic dislocation, or at least has done so in a time frame measured by decades, fiscal authorities face lower prospects for revenue and higher pressure on outlays. Similarly, the apportioning of the current budget stance into its cyclical and structural components will shift with changes in the level and rate of growth of potential output."

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