The Need for Regime Change

Traders watch the announcement that the Fed will leave interest rates “exceptionally low”

Photo by STAN HONDA/AFP/Getty Images

If you look at the last two bits of big-time macro stabilization failure in the west—the Great Depression and the inflation of the 1970s—you got what I’d call a change of regime as a result. The Depression discredited the gold standard and a whole set of related notions. The Great Inflation discredited ideas about the Phillips Curve (note interestingly that Keynes himself warned about this). So now we’re here again mired in failure and we’re getting … what?

We had, until recently, the Great Moderation Consensus that automatic fiscal stabilizers are a good thing and then beyond that the Federal Reserve has the ability to stabilize the macroeconomy by fiddling with interest rates. Well now here we are and the Federal Reserve can’t stabilize the macroeconomy by fiddling with interest rates. That calls for the creation of a new regime. But it’s clear that despite a few stabs in the direction of Quantitative Easing and communications management that Ben Bernanke isn’t going to give it to us. It’s not simply that the current recession isn’t being brought to a rapid end, it’s that nothing whatsoever is being done about the underlying weaknesses in the American economic system that it revealed. We’re not moving toward persistent 5 percent inflation targeting in order to ensure that we never hit the zero bound again. We’re not adopting NGDP level targeting. We’re not adopting exotic fiscal/monetary hybrid operations of the Zhang/Parameswaran/Waldman sort. Nor are we moving toward entrenching fiscal stimulus at the zero bound in some politically and institutionally tractable way. There is a growing bloc of people—including Paul Ryan, Rick Perry, and Newt Gingrich—who seem to be saying that we should implement a regime change that abandons hope for demand-side macroeconomic management and returns us to commodity-backed currency. But in the world of people who do believe in macroeconomic management, what I’m hearing from the Powers That Be is a lot of what seem like narrowly focused tactical holding actions. Current and former members of the administration largely express the view that there’s not much more they could realistically have done to stimulate the economy, and the Federal Reserve hints vaguely at the idea that further unorthodox measures would carry unspecified risks. But nobody currently or formerly near the centers of power is saying what they conclude from this.

The old plan was this: Use interest rates to stabilize demand and ensure full employment.

And the old question was: What if 0 percent nominal interest rates are inadequate to produce full employment?

And we had two answers: Use quantitative easing and discretionary fiscal policy to stabilize demand and ensure full employment.

But we don’t have full employment, and the word from the Treasury and the Eccles Building seems to be: Quantitative easing and discretionary fiscal policy on the scale needed to stabilize demand and ensure full employment are politically or institutionally impossible.

This is a really big deal. It means that either we need to discover a new paradigm for stabilizing aggregate demand, or else we need a whole new way of thinking about economic policy choices that doesn’t assume the economy will operate at nearly full employment over the long-term. New paradigms for demand management seem to strike a lot of America’s policy elite as uncomfortably radical, but if you think about it the implications of the other option are much more radical. All kinds of ideas economists and businessmen would normally dismiss as fallacies could, in fact, be true if the government is simply abandoning the idea of full employment. And if the government isn’t abandoning the idea of full employment then they have a mighty strange way of showing it. Either there are tools they can use to bring us back to full employment rapidly, in which case they should be used, or else the tools don’t exist in which case creating them should be a matter of some urgency. After all, not only has this current labor market slack gone on for a long time, but it’s not as if this is going to be the last recession in American history.