Chapter 14: The Past and Future of the
Macroeconomy
J. Bradford DeLong
--First Draft-1999-07-25: 4,872 words
As time passes the structure of the macroeconomy changes. Consumers’
opportunities and spending patterns change. The types of industries that
investors focus on change. The role of international trade and the role of the
government change as well.
It would be very surprising if the patterns of macroeconomic fluctuations
remained unchanged as all of these factors that underpin the macroeconomy—the
role of government, the behavior of consumers, the costs and benefits of
investment, the importance of international trade—all changed.
This chapter takes a step back. It looks, first, at the changing pattern of the
business cycle. It stresses that the most important thing appears to be that the
pattern of the business cycle and of macroeconomic fluctuations has changed
remarkably little over the past century, in spite of enormous changes in the
structure of the economy. It also attempts to project forward into the future the
effects on the macroeconomy of continued structural change in the modern
economy.
And, last, it tries to point out what, from a macroeconomic point of view, the
desirable road for structural change would be. What kinds of structural changes
would give us a better-behaving macroeconomy? Are the structural changes that
are ongoing now likely to do so?
The Changing Nature of Cyclical Fluctuations
New Eras and New Economies
The first thing to note is that the fundamental nature of the business cycle—of
macroeconomic fluctuations—is always about to undergo a profound shift.
Every time there is a prolonged economic expansion in the United States, there
are strong intellectual currents that emerge that claim that the entire boom-bust
expansion-recession pattern of the traditional business cycle is over, and that
there truly is a radically different "new economy."
This was the case in the expansion of the 1920s, that led economists to hope that
the newly-constructed Federal Reserve (founded in 1913) had learned how to
stabilize output by eliminating the fluctuations in interest rates that caused
financial crises. Many claimed that the decade of the 1920s truly did see a "New
Era.” Irving Fisher, the most prominent monetarist economist of the firtst half of
this century whom we have seen before in the “Fisher Effect” went as far as to
make the rash claim on the eve of the great 1929 stock market crash that stock
prices had reached a "permanent and high plateau."
[Figure: Economic growth and stability in the 1920s—and after]
The prolonged expansion of the 1960s led the Department of Commerce to
change the name of its Business Cycle Digest to the Business Conditions Digest.
They appeared to think that it was silly to have a publication named after a
phenomenon that no longer existed, and both President Eisenhower’s and
President Johnson’s chief economic advisors agreed that progress in economic
science and led to substantial progress toward economic stability, and opened up
new dimensions of political economy.
[Figure: Economic growth and stability in the 1920s—and after]
Only the long expansion of the 1980s--under the shadow of the just-past Volcker
disinflation and its associated deep recession--failed to generate a large and vocal
intellectual current willing to declare that traditional macroeconomic patterns
were at an end. Nevertheless, there were some who believed that the
macroeconomy during the two terms of President Reagan had undergone a
profound structural change for the better (but a structural change that was then
undone upon the election of President Bush).
And the expansion of the 1990s has generated yet another set of "new economy"
advocates. The expansion has been long, and has attained a remarkably low level
of unemployment without accelerating inflation. It may truly mark the end of the
Phillips Curve as we have known it.
[Figure: the 1990s: the end of the Phillips curve?]
Yet increases in real wages have been disappointingly low throughout the 1990s
expansion. And increases in productivity have been uneven.
[Figure: Real wages and productivity in the 1990s]
It seems reasonable to bet that the long expansion of the 1990s will be followed
by a recession, and that claims that the short decade of the 1990s has seen a
fundamental change in the macroeconomy will turn out to be wrong. For always,
at least up until now, the claims of a "new economy" that have blossomed forth
near the end of a prolonged economic boom have proven wrong. Such
expansions come to an end, and are followed by recessions in which real,
nominal, and financial variables follow the same very standard business cycle
patterns that had just been dismissed as obsolete half a century before.
Certainly a look outside the United States, either at Japan, at the financial-crisis
ridden emerging economies, or at Europe with its stubbornly high
unemployment does not lend strength to the claim that traditional business cycle
patterns have come to an end.
Structural Changes
In one sense it is surprising that predictions of the end of the business cycle have
not yet come true. Structural changes over the past century have been immense,
carrying us from a largely agricultural economy with poor communications,
small firms, and relatively unproductive and rigid technologies to today's largely
service economy with extraordinary access to information and giant firms.
The size of the marginal propensity to consume that largely determines the size
of the multiplier has shrunk. A hundred years ago the government’s social
insurance state was barely in embryo, the tax system was not at all progressive,
and most households found it very difficult to borrow in order to see themselves
through a year of low income and of unemployment. Today, by contrast, the
American financial system loans immense amounts of money to all kinds of
consumers. In standard economic theory, that should allow them to smooth their
consumption spending—to greatly reduce the impact of changes in their incomes
on changes in consumption, to reduce the marginal propensity to consume—and
such reductions in the marginal propensity to consume should carry along with
it a substantial reduction in the size of the multiplier.
The same holds true for automatic stabilizers. They appear to exert a powerful
stabilizing force on the economy. They were not present a century ago.
Thus we would have expected a substantial reduction in the size of the business
cycle—in the economy’s reaction to different types of shocks—from the
reduction in the multiplier itself.
Such a reduction in business cycle size should have been further reinforced by
the rise of financial automatic stabilizers like deposit insurance. One major factor
making depressions larger in the distant past was the fear that you needed to
pull your money out of the bank and hide it underneath your mattress because
your bank might fail. Such sudden increases in the demand for cash during
financial panics caused interest rates to spike, investment to fall, and production
to decline.
Today the existence of a large deposit insurance system has all but eliminated
this fear. And it should have put a further reduction in the size of the business
cycle in place.
The Persistence of the Business Cycle
Yet the qualitative phenomenon of the business cycle has persisted across the
entire past century. And business cycles appear to be quantitatively similar. At
least—the Great Depression aside--differences in the magnitude of business-cycle
declines in employment and output measured as shares of the economy at the
time are relatively hard to find. It seems very likely that business cycles have
shrunk somewhat. And different measures give slightly different answers. But
for none of the measures is the difference between pre-Great-Depression and
post-World War II cycles impressively large.
[Figure: The changing size of the business cycle?]
Yet even though business cycles appear to be about the same size relative to the
size of the economy, they are not quite the same animals as they were back
before the Great Depression. The fall in the multiplier, the arrival of automatic
stabilizers, and the increasing power of central banks have allowed monetary
policy to offset many of the kinds of shocks that generated pre-Depression
business cycles. The absence of significant stabilization springs from the fact that
the increasing power of central banks has created a new class of shocks:
recessions deliberately induced by monetary authorities to curb rising inflation.
As economist Christina Romer wrote in the Journal of Economic Perspectives:
"...increasing government control of aggregate demand... has served to
damp many recessions... [but] demand management... has not been
used single-mindedly to effect [output] stabilization... the rise of the
policy-induced recession... explains why the economy has remained
volatile [in output]."
Thus the post-World War II economy appears to have had fewer small recessions
caused by shocks to the IS and LM curves. Stabilization policy has worked, in
that it allows for the central bank working in combination with automatic
stabilizers to react when the economy threatens to turn down into recession
because of any sudden shock.
But stabilization policy has also not worked. At least four times in the United
States since World War II—at the start of the 1970s, in the mid-1970s, in the
Volcker disinflation at the start of the 1980s, and at the very end of the 1980s—
the Federal Reserve has engineered a recession, or has at least willingly accepted
a substantial risk of a recession, in order to accomplish its policy goal of curbing
inflation that has crept upward to a range in which the Federal Reserve fears
damaging consequences if it is allowed to creep upward any more.
[Figure: Policy-induced recessions since World War II]
If the prewar boom-and-bust business cycle was driven by, in John Maynard
Keynes’s phrase, the “animal spirits” of investors’ shifts from optimism to
pessimism and back again (and by financial panics), the post-World War II
boom-and-bust business cycle has been driven by economic policies that have
allowed rises in inflation, followed by the development of a consensus within the
Federal Reserve that the rise in inflation must be reversed.
It is somewhat depressing, moreover, that the gains from stabilization policy
appear to have been small. The post-World War II economy has not been that
much more stable. Nearly fifty years ago Milton Friedman warned that
stabilization policy, if pursued overly aggressively by policy makers who did not
understand its limits, could easily turn into destabilization policy. It looks as
though his gloomy warning was very close to being correct.
Where did this overly-aggressive commitment to stabilization policy come from?
The macroeconomic instability of the 1970s appears to have had three causes,
depending on how deeply one wishes to look into the underlying situation.
At the first, surface level, the United States had an unstable macro economy in
the 1970s because until the 1980s no influential policy makers—until Paul
Volcker became Chairman of the Federal Reserve—would place a sufficiently
high priority on keeping inflation from rising. As long as inflation remained
relatively low, it was not seen as a crisis, and so other goals took precedence
among every group of economic policy makers. Thus Presidents, Congressmen,
and members of the Federal Open Market Committee were willing to accept the
risk of increasing inflation to achieve other goals. And only after inflation had
risen—only after it had reached the level of a political crisis—did a consensus
develop that priorities needed to be changed, and were steps to reduce inflation
taken.
Thus under this interpretation, the United States after World War II had a boombust stop-go business cycle because the political system could pay attention to
only one phenomenon at a time: when inflation wasn’t a crisis, it wasn’t an issue.
Only with the acceleration of inflation toward the end of the 1970s did political
sentiment begin to shift. For rising inflation did become a severe political
problem in 1979. And Paul Volcker was then nominated and confirmed as Chair
of the Federal Reserve in a political environment in which control of inflation—
rather than reducing the unemployment rate—was the highest priority for
economic policy. The Volcker-led Federal Reserve quickly signalled its intention
to place first priority on controlling inflation by shifting its operating procedures
to place a greater emphasis on money supply targets.
At a second, deeper, level, the United States had a burst of inflation in the 1970s
because economic policy makers during the 1960s dealt their successors a bad
hand: an unfavorable Phillips curve. Thus the policies of the 1960s left economic
policy makers of the 1970s with a painful dilemma: either higher-than-usual
inflation, or higher-than-usual unemployment. Bad cards coupled with bad luck
made inflation in the 1970s worse than anyone expected it might be. And
unsuccessful attempts to find a way out of this dilemma gave the economy the
boom-bust cycle of the 1970s.
[Figure: Share of post-WWII business cycle disturbances that came in the
1970s]
Could U.S. monetary policy makers have responded to rising wage inflation at
the end of the 1960s, and ended the inflation of the 1970s before it started? At a
technical level, of course. Consider West Germany, the first economy to
undertake disinflation. The peak of German inflation in the 1970s came in 1971:
thereafter the Bundesbank pursued a policy of making inflation reduction its first
priority. The mid-1970s cyclical peak in inflation was lower than the 1970 peak;
the early-1980s cyclical peak in West German inflation is invisible.
At a third, deepest level, the truest cause of the inflation of the 1970s was the
memory of the Great Depression. The Great Depression made it impossible for a
while to believe that the business cycle was a fluctuation around rather than a
shortfall below potential output and potential employment.
The memory of the Great Depression made everyone very skeptical of taking the
average level of capacity utilization or the unemployment rate as a measure of
the economy’s sustainable productive potential.
Thus in the early 1960s prominent economists could write of how 4 percent was
an “interim” target for the unemployment rate—and that they saw no reason
that the “final” target for unemployment might not be signficantly lower without
producing unacceptable consequences for the rate of inflation. As long as the
average level of capacity utilization and the unemployment rate was not a guide
to the long-run sustainable level, there would be strong pressure to “close the
gap”—to see if unemployment could not be pushed even lower and capacity
utilization higher.
Only after the experiences of the 1970s were economic policy makers persuaded
that the flaws and frictions in American labor markets made it unwise to try to
use stimulative macroeconomic policies to push the unemployment rate down
below percent, and to hold it there. Only after the experiences of the 1970s were
policy makers persuaded that the minimum sustainable rate of unemployment
attainable by macroeconomic policy was relatively high, and that the costs—at
least the political costs—of even moderate high one-digit inflation were high as
well.
The Future of the Business Cycle?
Yet for almost all of your lives—“you” being the typical reader of this textbook—
the fact is that the business cycle has been relatively quiescent. There does appear
to be a large difference between the size of the pre-1984 business cycle, and what
has gone on for nearly two decades now.
[Figure: Pre-1984 and post-1984 sizes of economic fluctuations]
One possibility is that the past decade and a half have been the result of good
luck—that business-cycle macroeconomic performance has been good because
there have not been many shocks or any truly large shocks to the economy. But
just as the relatively placid 1960s were followed by the disruptive 1970s, perhaps
the 1990s will turn out to be followed by an equally turbulent decade.
A second possibility is that lessons have truly been learned from the experience
of the 1960s and 1970s. Today there appears to be much more consciousness of
the limits of stabilization policy, and much less willingness to pursue aggressive
policy goals.
Perhaps economic policy makers have learned how to have a steady hand on the
tiller. Whether the management of aggregate demand has been steadier because
of new economic theories, the skill of particular policymakers, or a new
consensus about the goals of policy is hard to say. But it is clear is that replace
the steady hand on the tiller with an unsteady one, and the volatile business
cycle could return instantaneously.
Ongoing Changes in the Macroeconomy
Another thing that is clear is that the structural changes in the economy will
continue. The increase in financial flexibility that allows consumers to borrow
will continue. The increase in financial flexibility will also make it more difficult
to read the financial markets—and is thus likely to make monetary policy
somewhat more difficult to conduct. International trade will continue to expand.
The odds are that international investments will become easier to make, and so
the speed with which capital flows across national borders will increase. And
labor markets are likely to continue to change as well.
Financial Flexibility
Already liquidity constraints play a relatively small role in determining
consumption spending in America—certainly a much smaller role than they
played at the beginning of this century, or even early in the post-World War II
period. Economists’ theories tell us that if liquidity constraints are absent, then
the marginal propensity to consume should be very low. The level of
consumption should depend on one’s estimate of one’s lifetime resources, and be
affected by changes current income only to the extent that changes in current
income change one’s estimate of lifetime resources.
[Figure: consumer debt and income]
Now economists’ theories may overstate the case. Tying your current level of
spending to your current level of income is a reasonable rule-of-thumb for
managing one’s affairs. And it just isn’t worth the time spent to do better than
one does by using reasonable rules-of-thumb. So the marginal propensity to
consume may remain at some noticeble fraction, and increasing ease of
borrowing may not lead the multiplier to completely disappear.
Nevertheless, the multiplier will grow smaller. Already there is one major
introductory economics textbook—Mankiw’s Economics—that does not discuss
the multiplier. It will surely play a smaller role in the economy (and in
economics) in the future.
Globalization
The future is likely to see international trade continue to expand. Increased trade
will further lower the multiplier: a greater portion of changes in domestic
spending will show up as changes in demand for foreign-made goods. So the
economy at home will be even less vulnerable to domestic shocks that disturb
employment and output. On the other hand, increased international integration
means that the domestic economy is more vulnerable to foreign shocks: recession
abroad that lowers demand for exports will have repercussions at home.
[Figure: the two eras of globalization]
Nevertheless, there should be a net gain in stability. Since foreign and domestic
shocks will to some degree offset each other, an economy that is somewhat
vulnerable to both foreign and domestic shocks should exhibit smaller business
cycles than an economy that is vulnerable to domestic shocks alone.
[Figure: Diversification of vulnerability, and potential reduction in the size of
macroeconomic fluctuations]
Counteracting to some degree the increase in international trade will be an
increase in the magnitude of international financial flows. The odds are that
international investments will become easier to make. And the odds are—as
means of international communication increase—that investors in one country
will become much more confident in making investments in another. So the
speed with which capital flows across national borders will increase.
As discussed in chapter 13, all indications to date are that increased flow of
capital across national borders is a potential source of financial crisis and
macroeconomic volatility. The process of international investment may still be
worth supporting: it promises benefits—faster industrialization on the
developing periphery, higher rates of return on investments made by investors
from the industrial core, diversification to reduce risk—as well.
[Figure: Increased magnitude of capital flows]
But it is likely that the next generation of business cycles will be judged to have
gone well or ill depending on whether the financial crises generated by crossborder financial flows are handled well or badly.
Monetary Policy
The increase in financial flexibility that reduces the multiplier will also make it
more difficult to read the financial markets—and is likely to make it somewhat
more difficult to conduct monetary policy. Monetary policy works, after all,
because the central bank’s open market operations change interest rates. The
central bank’s open market operations have large effects on interest rates because
the assets traded—Treasury bills on the one hand, and reserve deposits at
regional Federal Reserve banks on the other hand—play key roles in finance.
There are few substitute assets that can serve the functions that they serve.
But as financial flexibility increases—as there become more and more ways of
structuring transactions, and more and more kinds of financial instruments are
traded—any one kind of asset becomes less and less of a bottleneck. Thus in the
future it is likely that changes in the supply of Treasury bills will have less of an
effect on interest rates than they do today, and thus that open market operations
will become somewhat less effective.
Labor Markets and Unemployment
Labor markets are likely to continue to change as well. And changes in labor
markets promise to have significant effects on the business cycle. Unemployment
is, after all, the business cycle’s central feature.
But what effects changes in labor markets will have on the business cycle
depends very much on how labor markets work in the macroeconomic context.
And if there is an area where economists’ knowledge is most shaky, it is this one.
So discussion of changing labor markets and the changing business cycle is
postponed to the chapter 16—the chapter on the future of macroeconomics as a
body of knowledge.
Inventories and Computers
And there is one last change in the economy…
[Computers, inventory control, and the inventory cycle…
[Figure: The inventory cycle and the business cycle]
[To be written]
[Figure: The falling inventory-sales ratio]
Building a Better Macroeconomy?
Which of these structural changes should be regarded as helpful from a
macroeconomic view—as likely to help in the taming of the business cycle?
First, from a macroeconomic view at least, increased domestic financial flexibility
seems to be a good thing. Increased ability to borrow and lend—to find money
for investments and to smooth consumption, so that neither consumption
spending is constrained by current income nor investment spending constrained
by current profits—seems highly likely to reduce the size of the business cycle by
reducing the multiplier, and reducing the sensitivity of investment spending to
the current state of output.
Increased domestic financial flexibility does carry with it worries that monetary
policy will become less effective. But it is hard to see this as a serious concern.
Monetary policy today is plenty effective at controlling production, employment,
and prices—albeit with long and variable lags. Even a considerable reduction in
the power of open market operations would still leave central bankers with
more-than-ample tools to carry out whatever kinds of policies they wished.
Second, increased control over inventories is another structural change that
promises to yield benefits that may be significant: at least, Alan Greenspan thinks
so. [To be written…]
Third, a more informed electorate—one that understands the dance that the
central bank undertakes, as it tries to keep inflation low, keep the Phillips curve
in a favorable position by keeping expectations of future inflation low, and also
keep employment high and growth rapid. This isn’t a change that is necessarily
happening. But it is one that would be very desirable from the perspective of
obtaining better macroeconomic policies. [To be expanded…]
[Box: Fed-bashing: a dangerous vice?]
[To be written]
Fourth and most problematic is the increasing economic integration of the world.
This process is progressing without a doubt: it could be halted with sufficient
political measures, but it is unlikely to be. And such international economic
integration brings substantial financial crises along with it.
Recall the East Asian crisis of 1997: a sudden shift in investors’ expectations that
meant that $100 billion a year in international capital flows that had financed
investment in East Asia was no longer there. That $100 billion a year had
financed the employment of 20 million people working in investment industries,
who dug sewer lines, built roads, erected buildings, and installed machines as
both domestic and foreign investors bet that there was lots of money to be made
in East Asia's industrial revolution. These 20 million East Asian workers had to
find new jobs outside of investment industries.
By now—here in the year 2000—we would hope that the fall in the value of East
Asian currencies will bring the supply of and demand for foreign exchange back
into balance. Falling exchange rates make East Asian goods more attractive to
European and American purchasers. But in the short run of the financial crisis
anyone in East Asia who has borrowed in dollars finds the home-currency value
of their debt interest and principal rising when the exchange rate fell.
Couldn't governments stop exchange rates from falling? Yes--East Asian
governments could stop their exchange rates from falling by raising interest rates
to and perhaps beyond sky-high levels. But high interest rates make it
unprofitable to invest or build, and so cause an East Asian depression as well.
Could anything have been done? Yes--and the IMF did it by lending to East Asia.
Lending dollars to East Asian countries now allowed them to keep their
exchange rates from falling as far and their interest rates from rising as high as if
the countries had been left on their own to deal with the international capital
market. With less of a decline in exchange rates, fewer firms and financial
institutions with dollar liabilities went bankrupt. With less of a rise in interest
rates, fewer investment and construction projects were cancelled. The East Asian
depression was smaller than it would be otherwise. But the IMF's resources are
limited.
So was there any way to avoid getting into this mess?
Op-ed writers opine about "crony capitalism" and "unsustainable investment"
and "weak financial systems" and "overlending." But such factors were no worse
in the East Asia of 1997 that suffered such a crisis than in the East Asia of 1990 or
1985 or 1980 or 1975 that did not. And in every year before 1997 those who
worried about "overlending" in East Asia were wrong: those who invested in
East Asia received enormous profits, as East Asia proved to be the most rapidlygrowing and fastest-industrializing region that the world economy had ever
seen. It is only the sudden shift in capital flows away from East Asia that makes
investment "unsustainable" and financial systems "weak" and lending
"excessive."
So what caused the shift in investment patterns? Unfortunately for economists
and for economics as a social science, we can't find any cause of the shift in
investment patterns that is proportional to the effect. The shift in Wall Street's
desires to invest in East Asia appears to have been impelled much more by the
trend-chasing and herding instincts of Wall Streeters--a community of people
who talk to each other too much, and whose opinions often reflect not judgments
about the world but simply guesses about what average opinion expects average
opinion to be--than by any transformation in the fundamentals of East Asian
economic development.
Here we have reached the limits of economics. Economists are good at analyzing
how asset markets work if they are populated by far-sighted investors with
accurate models of the world and long horizons. Economists are even good at
pointing out that such asset markets can be subject to multiple equilibria-situations in which it is rational to be optimistic and rational investors are
optimistic if they think that everyone else is optimistic, and in which it is rational
to be pessimistic and rational investors are pessimistic if they think that everyone
else is pessimistic.
But what determines which of these "multiple equilibria" actually happens in the
real world? What determines the switch of an economy from one such
configuration to another? The transactions that economists analyze are economic
transactions: purchases and sales of goods and assets made with an eye toward
maximizing wealth or expected utility. But the transactions that determine which
equilibrium will match investor expectations are social and psychological
transactions: flows of gossip through telephone wires, the spread of rumors,
people taking notice of other people's worried frowns or confident expressions-all of this taking place around the globe at the speed of light, as news and
information and gossip and rumor propagate through the social network of
investors.
But by now we are into social psychology, beyond the bounds of economics.
Yet successful answers to these questions seem to be necessary if we are to judge
whether further globalization of the world economy is to be welcomed or
guarded against.
Chapter summary
Main points
[To be written…]
Analytical exercises
[To be written]
Policy exercises
[To be written, and revised for each year within editions]