The Logic of Recovery Winter

What are the basic forces driving economic recovery? Here’s how I see it:

Start with the premise that mass unemployment is a strange phenomenon. It shouldn’t happen. And most of the time it doesn’t happen. Say that it doesn’t happen because there’s such a thing as a “natural rate of interest” at which savings and investment line up properly, spending flows through the economy and resources are all employed. The country might be rich or it might be poor depending on how many resources it has available, but you won’t just have people sitting around doing nothing. A recession happens for one of several reasons. One is that the central bank might deliberately set interest rates above the natural rate in order to break the back of inflation. A second is that the central bank might accidentally set interest rates above the natural rate because it’s inept. A third is that something freaky might happen that depresses the natural rate to below where the central bank put it. In all three of those cases, you normally expect the central bank to adjust and end the recession. But suppose you have a Type 3 recession in an economy that, like ours, features physical currency where nominal interest rates can’t go below zero. In this case the appropriate thing for the central bank to do would be to try to elevate inflation expectations in order to reduce the real interest rate (which is not afflicted by the zero bound) and spark recovery. But suppose the central bank says “sorry unemployed workers, we will in fact crucify manking upon a cross of two percent Personal Consumption Expenditure Deflator targeting” what happens then? Well then you get the United States of America for the past 18 months.

We haven’t been in a recession—the economy has been growing. We haven’t been in a deflationary spiral—inflation expectations are low but stable. What that means is that with every passing month the natural rate goes up a bit. That means the gap between what the central bank is willing to do and what the central bank ought to do narrows. And that, in turn, means that growth accelerates.