An ebook containing the papers and presentations from the European Central Bank’s central banking forum conference in Sintra Portugal is now available. Mario Draghi and his colleagues are to be greatly commended for running a forum that is so open to profound challenges to central banking orthodoxy.
The volume contains a paper by Olivier Blanchard, Eugenio Cerutti and me on hysteresis and separately some of my reflections asserting the need for a new Keynesian economics that is more Keynesian and less new. Here I summarize these two papers.
Blanchard Cerutti and I look at a sample of over 100 recessions from industrial countries over the last 50 years and examine their impact on long run output levels in an effort to understand what Blanchard and I had earlier called hysteresis effects. We find that in the vast majority of cases output never returns to previous trends. Indeed there appear to be more cases where recessions reduce the subsequent growth of output than where output returns to trend. In other words “super hysteresis” to use Larry Ball’s term is more frequent than “no hysteresis.”
This finding does not in and of itself establish the importance of hysteresis effects. It might be that when underlying growth rates fall recessions follow but that recessions have no causal impact going forward. In order to address this issue we look at the impact of recessions with different precursors. We find that even recessions that are associated with disinflationary monetary policies or the drying up of credit have substantial long run output effects suggesting the presence of hysteresis effects.
In subsequent work Antonio Fatas and I have looked at the impact of fiscal policy surprises on long run output and long run output forecasts using a methodology pioneered by Blanchard and Leigh. Since fiscal policy effects operate primarily through aggregate demand, this provides a way to avoid the causation question. We find that fiscal policy changes have large continuing effects on levels of output suggesting the importance of hysteresis.
I was struck that in a vote taken at the conference close to 90 percent of the participants indicated that they believe there are significant hysteresis effects. While there is much more work to be done, I believe that as of right now the right presumption is in favor of hysteresis effects despite their exclusion from the standard models used in almost all central banks.
Towards a New Macroeconomics
My separate comments in the volume develop an idea I have pushed with little success for a long time. Standard new Keynesian macroeconomics essentially abstracts away from most of what is important in macroeconomics. To an even greater extent this is true of the DSGE (dynamic stochastic general equilibrium) models that are the workhorse of central bank staffs and much practically oriented academic work.
Why? New Keynesian models imply that stabilization policies cannot affect the average level of output over time and that the only effect policy can have is on the amplitude of economic fluctuations not on the level of output. This assumption is problematic at a number of levels.
First, if stabilization policies cannot effect average levels of employment and output over time they are not nearly as important as if they can. Beginning the study of stabilization with this assumption takes away much of the motivation for doing macroeconomics.
Second, the assumption is close to absurd. It is surely reasonable to assume that better policy could have avoided the Depression or the huge output losses associated with the financial crisis without having shaved off some previous or subsequent peak.
Third, contrary to the now common view that macroeconomics is best understood by studying the stochastic properties of stationary time series, the most important macroeconomic events are in some sense one off. Think of the Depression or the Great Recession or the high inflation of the 1970s.
The problem has always been that it is difficult to beat something with nothing. This may be changing as topics like hysteresis, secular stagnation, and multiple equilibrium are getting more and more attention. As well they should. US output is now about 10 percent below a trend estimated through 2007. If one attributes even half of this figure to the effects of recession and assumes no catch up on this component until 2030 the cost of the financial crisis in the USA is about 1 year’s GDP. And matters are worse in the rest of the industrial world.
As macroeconomics was transformed in response to the Depression of the 1930s and the inflation of the 1970s, another 40 years later it should again be transformed in response to stagnation in the industrial world. Maybe we can call it the Keynesian New Economics.