Why don't we see big NGDP crashes any longer?
By Scott Sumner
Before WWII, the government did not measure nominal GDP. But economists Robert Gordon and Nathan Balke put together estimates of nominal GNP, for the period after 1875. (For the US, changes in NGDP and NGNP are highly correlated.)
We used to occasionally see big drops in NGNP; here are some examples:
1893:1 to 1894:2 down 20%
1907:3 to 1908:1 down 14%
1920:2 to 1921:1 down 29%
1929:3 to 1933:1 down 53%
1937:3 to 1938:1 down 14%
During the “Great Recession”, NGDP fell by 3% from mid-2008 to mid-2009. Europe had a similar decline, and then almost no decline at all in the “double dip” recession that began in 2011, which was quite serious. Conversely, small declines in NGDP seem to cause more harm than in the old days, perhaps because wages are stickier.
Here I’d like to discuss the puzzling fact that we no longer see big drops in NGDP. One explanation is that Fed policy now prevents this from occurring. And I think that’s the right answer. But it’s also a bid strange, because modern central banks are so widely seen as being “out of ammo”. Admittedly this is less true of the Fed in 2016, as rates have started rising. But in Europe and Japan, rates are lower than at any times during the Great Depression (although T-bill yields did become a tiny bit negative during the late 1930s.)
If you truly believed that central banks were out of ammo, then you’d presumably be puzzled that NGDP did not occasionally plunge by double digits. All it would take is an increase in the real demand for base money, an occurrence that is not at all unlikely when base money is a close substitute with Treasury debt. So why don’t we see that anymore?
In my view we don’t see deep NGDP declines because investors correctly understand that central banks won’t allow them. This creates an expectation that next year’s NGDP won’t be very different from this year’s NGDP. And these expectations help stabilize current AD. In contrast, under the gold standard, the price level was close to a random walk.
Why don’t others see things this way? Perhaps because central banks have an asymmetric reaction function. They will work hard to prevent catastrophic drops in NGDP, doing “whatever it takes” but won’t push aggressively to achieve more rapid growth, once the economy has moved to a “satisfactory” growth path. So they seem impotent.
I was reminded of this a few days ago, when Mario Draghi caused the euro to soar and European stock prices to plunge, with suggestion that further rate cuts were unlikely. Previously he had a “whatever it takes” can-do attitude, and I think his complacency at the press conference shocked the markets. Draghi will work hard to prevent a eurozone depression, but won’t take controversial steps to promote a faster recovery, if the current recovery is seen as adequate.