Sunday, February 19, 2017

The Great Recession: This Time Really is Different



David has a piece up at the Daily Caller highlighting an article by economist Robert Barro, who claims that the U.S. economy should have recovered much faster from the recession than it actually did. David expands on this point, arguing that too much focus on fiscal stimulus is to blame for the anemic recovery. I don’t find either of these arguments very convincing.

David begins by referencing what I consider to be macroeconomists’ go-to resource for understanding what to expect after a systemic financial crisis: “The Aftermath of Financial Crises”, by economists Carmen Reinhart and Kenneth Rogoff. But David suggests that the work of economists Robert Barro and Tao Jin should displace this resource from the all-star list.

Two thoughts: First, are Barro & Jin and Reinhart & Rogoff even addressing the same question? It certainly doesn’t seem so.

The details are a bit technical, but the goal of Barro & Jin’s paper is to improve our understanding of asset-pricing patterns, including the so-called “equity premium puzzle”—a conundrum that has left economists unable to reconcile the existence of large equity premiums with the way we think households make economic decisions. To do that, part of Barro & Jin’s approach is to model “rare macroeconomic events”—such as the world wars and the Great Depression—then use consumption data going back to 1851 to estimate them. Interestingly, the financial crisis of 2007-08 does not show up as a rare macroeconomic event in Barro & Jin’s paper.

By contrast, Reinhart & Rogoff ask how we should expect an economy to behave in the aftermath of systemic financial crises, such as the one we just experienced. In their own words,

“We have presented evidence that recessions associated with systemic banking crises tend to be deep and protracted and that this pattern is evident across both history and countries…Today, there can be little doubt that the U.S. has experienced a systemic crisis.” 

Translation: Barro & Jin tell us how we should generally expect an economy to recover after a very deep recession, but Reinhart & Rogoff tell us how we should expect an economy to recover specifically after a systemic financial crisis. Now, I don’t claim to be an expert on the rare events or financial crisis literature, but David’s conclusion that Reinhart & Rogoff’s work “doesn’t withstand scrutiny” is strange when the two papers seem to ask fundamentally different questions.

Second, despite the evidence on systemic financial crises, should we have nevertheless expected the economy to recover quickly and robustly? I’m not so sure. In fact, several economists have argued from the very beginning that we would have a slow recovery. In part, that’s because the Federal Reserve (a.k.a., “the Fed”) normally fights recessions by cutting short-term interests, but this time, even pushing interest rates to zero wasn’t enough. So David’s insinuation that we should have had a stronger recovery, even without the tools of conventional monetary policy is, to me, baffling.

Now, I don’t mean to suggest that the economy shouldn’t have done better—we could have, and should have, had a much larger fiscal stimulus than what we ultimately got. But David doesn’t like that answer either. In fact, he blames fiscal stimulus for the slow recovery.

This is a debate that David and I have had several times. Yet David still asserts comically obvious fallacies, such as fiscal stimulus fails because “government must first remove a dollar from the economy to spend it in the economy.”

There are multiple problems with statements like this, but the most obvious is that it ignores the fact that the U.S. federal government, working through the Fed and the Treasury, is the monopoly issuer of the dollar: there is no operational constraint on our government to “first remove a dollar from the economy” before it can purchase things like roads and bridges.

The truth is that there are plenty of reasons to believe that fiscal stimulus works. In fact, most economists believe that it works. One need only look at the giant natural experiment Europe has so kindly provided to see that large changes in government spending during recessions matter. If David and his ilk were right about fiscal stimulus, then the cuts to government spending in Europe wouldn’t have had such negative economic effects.

Despite all this, David insists that fiscal stimulus merely amounts to a misallocation of economic resources, ultimately making the recession worse. Fortunately, it’s pretty tough to misallocate resources during a recession when there’s so many of them sitting idle—e.g., unemployed workers, empty factories—and literally not being used.

So don’t be fooled by David. Slow economic recovery is seemingly normal after systemic financial crises, so there’s no mystery here. It’s true that we could have done better, but not for the reasons David claims.

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