Review 2011: Stop Focusing On The Downside, Because We Lived It Anyway

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As a practical policy matter, monetary neutrality almost forces all official considerations to the downside. If you believe that money cannot alter the baseline for the economy, then the only time to consider the upside is where it is clearly "overheating." In addition to placing inordinate importance on determining trend, in the aftermath of the Great "Recession" it has meant an almost singular focus on preventing another recession rather than perhaps analyzing the full scope of the major (and global) economic problems and inconsistencies.

Even in public pronouncements, Federal Reserve officials have been more likely to applaud their own efforts in this context. It always amounts to some version of "jobs saved" or "at least it wasn't worse," and in many ways, that was how policy discussions progressed. The Fed, it seemed, was far more fearful about the prospects of another recession than the state of the recovery. It may seem, on the surface, a tautology, as a second recession would of its own change the recovery, but what we are talking about is actual recovery prospects apart from what actually happened.

Instead of worrying so much about a double dip, more should have been done to figure out why it wasn't better overall in the first place. Therefore, in the possible occurrence of a double dip, we would have been far better off despite a second recession rather than no double dip and no recovery. Concern more so about another recession meant doing more of the same, whereas focusing instead on the stunted recovery might have - perhaps should have - forced a more determined investigation into actual solutions by seeing the actual problem.

In August 2011, these tensions started to boil as the FOMC deliberations turned more toward recession worry than recovery worry. Given the GDP report just released at that time, Fed models had upgraded their probabilities for imminent recession to as much as one in four. That was far too high, especially so close to the completion of a second QE.

YELLEN. I've marked down my economic growth outlook substantially in light of the information received over recent weeks, and I've become increasingly concerned about the downside risks. The latest data indicate that the U.S. economy has been running alarmingly close to stall speed over recent months, and I anticipate only a modest pickup in growth over coming quarters.

The concern was widely shared:

ROSENGREN. The memo from Vice Chairman Dudley highlights how much the deterioration in incoming data since the spring has increased the New York Fed's estimate of the probability of recession. Many private-sector economists, using similar models, come to similar conclusions. With real GDP for the first two quarters of the year averaging less than 1 percent, it is not surprising that these models are predicting an elevated recession probability, even ignoring intangibles such as congressional dysfunction, European political dysfunction, and the first downgrade of the United States in recent history.

Of course, it was not universally so:

PLOSSER. And we must be careful not to leave the impression that we are reacting to stock market movements. While we may not intend that to be the case, it could very easily be the result of any actions that we take when we act in the midst of such great volatility. I would remind everyone of the story that they all know-the famous quote by Paul Samuelson that the stock market has predicted nine of the past five recessions-and we should not overreact to the admittedly very tumultuous times in the stock market.

But it was becoming established that the Fed's task at that point was to avoid the next recession rather than concern itself with establishing, or even understanding, the full range of recovery. This is an enormously important point that I don't believe can be overstated, especially given what transpired in the years that followed. Even laboring under monetary neutrality, the lack of recovery could have been seen as more than "Congress needs to act" and come closer to rethinking stock price obsession in light of share repurchases versus actually productive capex. It was this reduction of standard for performance that allowed it to continue year after year.

The economy did come close to recession in 2012, to which the Fed responded predictably with more of the same - a third, and then a fourth QE. It then judged its performance almost exclusively by that measure, that the economy had by late 2013 dodged what they saw as the worst case, and therefore was set to go forward, especially by late 2014. In reality, because it was oriented to this view, it failed to appreciate the actual worse case, where there was no recovery at all. The Fed has since arrived at this realization, though it still calls it a recovery (meaning there should have been a parallel effort in semantics).

Perhaps the best way to demonstrate the differences is to turn to the counterfactual. In doing so, I am not claiming an alternate reality, rather just illustrating the potential of a different focus or frame of understanding. As of the latest quarterly figures published last week, Real GDP was 12% above the Q4 2007 prior cyclical peak. That is an astonishingly bad result - a fact which we know very well in how it has broken out as more than just widespread economic discontent.

Let's assume that the 2011 crisis was as severe as the 2008 panic, and therefore, starting in the middle of 2011, the Great "Recession" repeated, at least in terms of length and depth. It was a double dip recession that was as severe as the one that preceded it.

A second massive economic dislocation could have provoked a much greater response than that of the first one. In 2008, despite the fact that Bernanke and the FOMC got almost everything wrong and consistently, disastrously so, they were given the benefit of the doubt to plot a recovery strategy. Had that occurred a second time, they may not have been given any leeway at all, as the public by then might have actually demanded real answers rather than academic conjecture. In so doing, we can assume that actual answers were found and so was actual recovery.

In this counterfactual, we simply splice the 1982-86 track of GDP to the trough of our second GR and find, unsurprisingly, that it is recovery that mattered all along, not avoiding recession, no matter how severe.

By Q4 2016, Real GDP would have been 17% above the prior "cycle" peak, greater than the 12% actually realized, even though there is another GR right in the middle. Economists will no doubt object - not without good reason - that this counterfactual makes too many assumptions, mainly that we can't simply assume robust recovery, especially after another massive event that would have surely created further negative feedbacks. Policymakers in 2008 were, after all, worried it would turn into another Great Depression, so imagine their concern if the 2008 economy repeated in 2012.

But that is also a counterfactual where no matter what had occurred throughout the past thirty years, policymakers always claimed all of it would have been worse without their effort. As I wrote last year:

It is no coincidence that the Federal Reserve, in particular, saw emergency in every single financial event from that point forward. From the 1987 crash to the S&L crisis to LTCM and the dot-coms, Greenspan's Fed reacted as if each were a threat on par with 1929 without ever bothering to figure out if that were actually true (and why it might not be).

Here we are in 2017, and the worst case has become real anyway, even though officials tell us they successfully avoided a worse fate each time. Larry Summers presented a chart in his secular stagnation presentation, also from last year, that should put to rest any notions about "it could have been worse."

Monetary policy has been focused on avoiding a further downside rather than figuring out where the upside disappeared to. Again, the former meant doing QE over and over and over again, whereas the latter may have pointed in different and actually useful directions that didn't waste so much time accomplishing so very little. We may find it will actually take another crisis to get there, which is why, having wasted these last five years, I almost wish a second GR had happened in 2012 - and so, avoiding it has been counterproductive as well as very costly.

Again, counterfactuals aren't evidence, let alone proof. What we do know is that the current state of the economy is dangerous, so what did happen is the worst possible result. From that, it makes perfect sense to seriously consider why that was and how things might have been done differently. All that my alternate scenario shows is that recovery is the far more important piece of the puzzle, and everything we do should be related to figuring out how to solve it. Repeating the same things, including fiscal "stimulus," that have already been thoroughly, globally disproven is to keep the same worst case where the economy seems to grow, if only because it avoids recession.

I completely understand why reducing regulations, repealing Obamacare, and cutting taxes have struck a nerve, where many see Reagan and, thus, the Reagan economy in what Trump will or might do. I simply don't think it is nearly enough, because what ails the world in 2017 is not what ailed it in 1982. In many ways, it is the opposite condition - the Great Inflation featured too many eurodollars, the Great "Recession" not nearly enough. Though eurodollars are at the center of both, at least on the way up growth was still a possibility; on the way down, all the evidence shows that it just isn't. That said, I still remain very optimistic that if we ever do solve the global monetary problem, even by further crisis, the economy unleashed might make the 1982-86 recovery look small.