Do longer expansions store up trouble for the future?
By Scott Sumner
A recent FT article criticizes the view that we should try to eliminate the business cycle:
All this begs the question of whether longer really is better when it comes to business cycles. Recessions are a natural and normal part of capitalism, not something to be avoided at all costs. Indeed, the Deutsche Bank economists argue that productivity would be higher and American entrepreneurial zeal stronger if the US business cycle had not been artificially prolonged by monetary policy. . . .
Long periods of expansion invariably result in too much leverage, followed by a correction, and usually a recession. . . .
Maybe a tech productivity surge will eventually come along and turn this market-driven recovery cycle into something that spreads prosperity more widely. More likely there will be hell to pay for leaving the lights on too long.
I’m skeptical of this view. It’s not at all obvious why a period of too much borrowing needs to be followed by a period of high unemployment. If I borrowed too much I’d be inclined to work harder, not take a long vacation. A period of sharply rising unemployment is usually caused by sharp declines in NGDP growth, i.e. tight money, although bad supply-side policies may also cause unemployment.
The empirical studies I’ve seen suggest that long expansions do not store up trouble for the future, and indeed are no more likely to be followed by deep recessions than are short expansions.
Australia in now 28 years into their current expansion. Their central bank (the RBA) has a done a good job of maintaining adequate growth in NGDP. However, I do have some doubts about Philip Lowe, who has headed the RBA since 2016. Some of his remarks suggest that the RBA may be willing to tolerate a period of below target inflation as a way of preventing financial excesses. I view that as a mistake.
Australia has a 2% to 3% inflation target range, as part of a US-style dual mandate that also looks at employment. I certainly don’t favor slavishly targeting a given inflation figure, but I see no good reason for the recent undershoot of inflation in Australia.
Due to Lowe’s tight money policy, short-term interest rates have now fallen to 1.25% in Australia. As a result, the RBA may need to use unconventional monetary policy in the future. They were able to avoid using these policies during the Great Recession, and could have continued avoiding unconventional policies if they had kept inflation closer to 2.5%. The recent below target inflation is an unforced error in policy.
Stephen Kirchner has a paper that discusses how QE might be used in Australia if needed to prevent a recession. It is also one of the clearest explanations of market monetarist ideas that I have ever read. Here’s one example:
Confusion arises from the fact that long-term interest rates in the United States typically rose during QE episodes and declined during the intervening periods. Yields also rose in response to QE-related announcements.18 While QE is generally conceived to work through lowering long-term interest rates, that is only the static or liquidity effect. The dynamic effect is to raise expectations for long-term economic growth and inflation and this is also reflected in longer-term interest rates, which consistently rose during QE episodes and fell during the intervening periods (Figure 1).
Exactly. The purpose of QE is NOT to lower long-term interest rates. Rather the goal is to reduce interest rates relative to the equilibrium, or “natural” rate of interest. The main effect of QE is to raise the equilibrium rate of interest, not lower market rates.
Read the whole thing.