What Does an Unmanaged Macroeconomy Look Like?

by: Brad DeLong

In some very nice musings about Lawrence Summers's farewell address, Greg Ip commits one misstep when he writes that (American economic policy: The legacy of Larry Summers):

What will scholars’ verdict of Mr Summers’ contribution be?... The pessimistic view... macroeconomic activism failed because its success in the decades before the crisis sowed the seeds of ever more risk-taking and complacency...

It is certainly possible that the relative macroeconomic calm of what we used to call the "Great Moderation" from 1985-2005 played a material role in setting the stage for our current volatility and distress. But in the larger sweep of history, even our current volatility and distress has been quite effectively handled and managed--at least compared to what went on back before the U.S. government and the Federal Reserve took on the mission to attempt and handle and manage the macroeconomy.

We can see this if we take a look back and ask the question: what does an economy without effective macroeconomic regulation look like?

We do not have all that many examples. Britain's Bank of England started regulating the macroeconomy in response to the industrial business cycle back in 1825. The Bank of France was not far behind. Almost as soon as a country had a capital-intensive industrial sector capable of generating a modern business cycle, it had a central bank to stabilize its macroeconomy.

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The U.S. was an exception. It lost its proto-central bank to Andrew Jackson in the 1830s. It did not acquire a central bank until 1913--and the central bank had no clue what to do in a recession after the death of Benjamin Strong in 1928. The pre-World War II U.S. was as close to an economy without effective macroeconomic regulation as we have--and even there we have occasional monetary and banking policy conducted by the pickup central banks that were the House of Morgan in 1907 and the Belmont-Morgan syndicate in 1895. It was the passage of the Employment Act of 1946 that marked the start of systematic stabilization policy in the United States.

And, at least from the perspective of the metric that is the non-farm unemployment rate--the agricultural sector does not have an industrial business cycle, after all--there is no evidence that macroeconomic management has not been vastly better than the alternative.

Greg Ip:

FOR two years the Obama Administration’s economic policy has been caricatured from the right as an invasive expansion of government and from the left as a cowardly capitulation to Wall Street free market fundamentalism. How can it be both things at once? It helps to understand the philosophy of the man who most embodies that policy, Larry Summers, who today delivered perhaps his final public speech as Barack Obama’s National Economic Council director. The "Summers Doctrine" fuses microeconomic laissez faire with macroeconomic activism. Markets should allocate capital, labour and ideas without interference, but sometimes markets go haywire, and must be counteracted forcefully by government.

The most liberal economists concede the intrinsic superiority of markets in allocating real economic resources but many make an exception for financial markets. Mr Summers doesn’t, and that’s what critics from the left most hold against him. In his tenure in the Clinton Administration he championed the repeal of Glass-Steagall and blocked Brooksley Born’s efforts to regulate over-the-counter derivatives. Mr Summers holds regulators in low esteem.... He brought this view with him to the White House, battling efforts on the Hill and inside the Administration to nationalise banks, corral bankers’ pay, or curb derivatives and trading activity.

Yet Mr Summers’ mistrust of government is not the same as a trust in markets.... Mr Summers supplemented his academic appreciation of markets’ limitations with real-world experience in the Clinton Administration. The Mexican and east Asian financial crises demonstrated to horrific effect how markets could rapidly go from complacency to panic. Mr Summers sums up the lesson with a line he attributes to former Mexican president Ernesto Zedillo: “Markets overreact—and that means policy has to overreact.” Crises call for the financial equivalent of the “Powell Doctrine”: the application of overwhelming monetary force so that market participants have no doubt about the ability and will of policymakers. Austrian economists fret that this simply sows moral hazard; to Mr Summers, this was precisely the point: with the government providing insurance against catastrophe, investors could take more risks, generating more innovation, more growth, and more welfare....

When Mr Summers reflected on his two years in the White House in today’s speech....

Scholars … will continue to debate just how close the American financial system and economy came to all-out collapse in the six months between September of 2008 and April of 2009… Had it not been for President Obama’s willingness to support a sufficiently aggressive response … I have little doubt that we would be looking at a vastly different world today.

He framed the recent tax deal Mr Obama negotiated with Republicans the same way. Excluding the extension of expiring tax provisions, it contains about $280 billion of new stimulus. Only by the standards of the last few years is that less than overwhelming. Mr Summers went on:

It is right and necessary for government to counteract private sector deleveraging. … Even with our deficits, the amount of extra debt is less than the amount of reduced borrowing in the private sector… the recent tax agreement … averts what could have been a serious collapse in purchasing power and adds far more fiscal support than most observers thought politically possible.

What will scholars’ verdict of Mr Summers’ contribution be?... The optimistic view is that the economy is now in a sustained, though restrained, recovery that will prove Mr Summers right. The pessimistic view takes two paths. One follows Ireland, a country that applied more Powell doctrine than it could afford; by guaranteeing all its banks’ liabilities it has undermined the solvency of the sovereign. This seems unlikely. The other follows Japan into a trap of stagflation and deflation, one that Mr Summers is unwilling to dismiss: “The risks of deflation or stagnation in the United States exceed the risks of uncontrolled growth or high inflation.” If that is indeed America's fate, we may conclude that macroeconomic activism failed because its success in the decades before the crisis sowed the seeds of ever more risk-taking and complacency...