It was the worst of times; it was, well, ...
The debate that has raged over monetary and fiscal policy for the last several years has restored the issue of stabilization policy — once a standard element of graduate work, but increasingly pushed to the margins in recent decades — to the consciousness, if not the practice, of macroeconomics. It also has me thinking about the last time there was a similar crisis in macroeconomic policy. That earlier episode was the stagflationary 1970s; it too was a period of considerable uncertainty — Galbraith's Age of Uncertainty from which this blog's title is derived.
The 1970s followed a period of remarkable global growth quite similar to the "Great Moderation" of our own day. But the golden age of growth of the late 1950s and 1960s stalled in the face of domestic and external imbalances and OPEC shocks. In hindsight, it is clear that the supply-side shock of higher oil prices rendered some share of the advanced countries' capital stock uneconomic virtually overnight and that this had a significant negative impact on potential output. Efforts to sustain demand, therefore, resulted in sustained inflationary pressures that were eventually embedded in expectations, making the tradeoff between inflation and unemployment elusive, to say the least. In the end, it took the "Volker disinflation" of the early 1980s, and specifically the recession of 1981–82, to bring inflation expectations down.
The lesson from that experience, apart from its catalytic effects on efforts to derive macro models from so-called "deep" parameters (tastes, technology, endowments), was the need to identify structural changes that impinge on potential output. This lesson can be summed up as: don't assume that high past potential growth will be sustained into the future. It is a lesson that bears on current policy debates.
In this respect, many commentators have warned in the wake of the global financial crisis that pre-crisis output reflected a "bubble economy," particularly with regard to the U.S. real estate market. Attempting to return to those halcyon days, they warn, would risk temporizing with an inflationary episode like that in the 1970s. Perhaps.
I am conscious of that possibility. At the same time, however, I wonder if there is also a risk in over-compensating — in placing too much weight on the untested assumption that potential output must be much lower than the pre-crisis level. If so, and policy is less aggressive than it could be in restoring full employment, there is a danger of self-validating empiricism: slow growth from inadequate demand will be construed as evidence of lower potential.
Getting the call right on this issue is therefore of critical importance. What should we look at in assessing this question? Frankly, I'm not sure. But if it were up to me, I'd look closely at the employment-to-population ratio. And in contrast to the 1970s, when the ratio in most OECD countries was either constant or rising, my sense is that in countries suffering the largest output declines in the wake of the global crisis, employment to population declined steeply and has yet to recover to pre-crisis levels.
Just something to bear in mind in thinking about conditional commitments under forward guidance and the timing of Fed tapering.