JE STIGLITZ 0% Probability 0 Months of Expansion Figure 1-Probability of an expansion ending, 1945-1997 Note: Probability estimated using logit regressions on NBER Business Cycle dates 100% Probability I 0.2 0 Months of recession Figure 2- Probability of a recession ending, 1945-1997 Note: Probability estimated using logit regressions on NBER Business Cycle dates
Figure 1 – Probability of an expansion ending, 1945–1997 Note: Probability estimated using logit regressions on NBER Business Cycle dates. 100% Probability 0% Probability Figure 2 – Probability of a recession ending, 1945–1997 Note: Probability estimated using logit regressions on NBER Business Cycle dates. 100% Probability 0% Probability 204 J.E. STIGLITZ
CENTRAL BANKING From this perspective, downturns come as a surprise, an unexpected event not anticipated, or imperfectly anticipated, or whose consequences were not fully cal ulated, perhaps because of misunderstandings about the structure of the economy Monetary authorities seek to offset these effects, to restore the economy to its otential. In the short run, there is a tendency of monetary authorities to think of the downturn as a temporary deviation, which will correct itself shortly. Given the lags in the effectiveness of monetary policy, expansionary policies might then complement the natural forces of recovery, leading to inflation. Over time, if the downturn persists, political pressure -even on an independent monetary author ity -to do something mounts, the policy of doing nothing, or doing too little becomes hard to maintain. Moreover. information about the true nature of the downturn becomes more apparent This pattern is clearly evidenced in the series of pronouncements of the Fed Chairman between 1991 and 1993. Even as the National bureau of economic Research was about to declare that the economy was in recession in July 1991 the Fed Chairmans Humphrey-Hawkins testimony (which he is required to give before Congress twice a year) did not indicate that the Fed was worried about recession. 'To be fair, economic forecasters have almost always missed reces- sions.(Also, I should add parenthetically that one of the responsibilities of Fed officials is to maintain confidence in the economy. Private views may be more pessimistic than public pronouncements. Still, in this particular case, policy eemed to conform remarkably closely to the public pronouncements. Moreover, the Fed Chairman is a master of Fedspeak some say a modern version of a Iphic oracle which is designed to carefully calibrate what information is re- vealed and what is obscured rather than to provide complete enlightenment. This rovides plenty of opportunity for him to make announcements that bolster con- fidence in the economy while being sufficiently vague so that in retrospect they seem to provide keen insights into the workings of the economy regardless of As the downturn persisted the Fed continued to see it as an unexpected shock This viewpoint is evident in the Humphrey-Hawkins testimony from Febnt es, leading to a ' cyclical downturn that would respond to standard policies 1991 which reads nOnetheless, the balance of forces does appear to suggest that this downturn could well prove shorter and shallower that most prior post war recessions. An important reason for this assessment is that one of the most negative economic impacts of the Gulf war -the run-up in oil prices- has been reversed. Another is that the substantial decline in interest rates over the past year and a half -especially over the past several months- should ameliorate the contractionary effects of the crisis in the Gulf and of tighter credit availability 7 The prepared statement reads, 'On balance, the economy still appears to be growing, and the likelihood of a near-term recession seems low
From this perspective, downturns come as a surprise, an unexpected event not anticipated, or imperfectly anticipated, or whose consequences were not fully calculated, perhaps because of misunderstandings about the structure of the economy. Monetary authorities seek to offset these effects, to restore the economy to its potential. In the short run, there is a tendency of monetary authorities to think of the downturn as a temporary deviation, which will correct itself shortly. Given the lags in the effectiveness of monetary policy, expansionary policies might then complement the natural forces of recovery, leading to inflation. Over time, if the downturn persists, political pressure – even on an independent monetary authority – to do something mounts; the policy of doing nothing, or doing too little becomes hard to maintain. Moreover, information about the true nature of the downturn becomes more apparent. This pattern is clearly evidenced in the series of pronouncements of the Fed Chairman between 1991 and 1993. Even as the National Bureau of Economic Research was about to declare that the economy was in recession in July 1991, the Fed Chairman’s Humphrey-Hawkins testimony ~which he is required to give before Congress twice a year! did not indicate that the Fed was worried about recession.7 To be fair, economic forecasters have almost always missed recessions. ~Also, I should add parenthetically that one of the responsibilities of Fed officials is to maintain confidence in the economy. Private views may be more pessimistic than public pronouncements. Still, in this particular case, policy seemed to conform remarkably closely to the public pronouncements. Moreover, the Fed Chairman is a master of Fedspeak – some say a modern version of a Delphic oracle – which is designed to carefully calibrate what information is revealed and what is obscured rather than to provide complete enlightenment. This provides plenty of opportunity for him to make announcements that bolster con- fidence in the economy while being sufficiently vague so that in retrospect they seem to provide keen insights into the workings of the economy regardless of what happens.! As the downturn persisted the Fed continued to see it as an unexpected shock leading to a ‘normal’ cyclical downturn that would respond to standard policies. This viewpoint is evident in the Humphrey-Hawkins testimony from February 1991 which reads ‘@n#onetheless, the balance of forces does appear to suggest that this downturn could well prove shorter and shallower that most prior postwar recessions. An important reason for this assessment is that one of the most negative economic impacts of the Gulf war – the run-up in oil prices – has been reversed. Another is that the substantial decline in interest rates over the past year and a half – especially over the past several months – should ameliorate the contractionary effects of the crisis in the Gulf and of tighter credit availability.’ 7 The prepared statement reads, ‘@O#n balance, the economy still appears to be growing, and the likelihood of a near-term recession seems low.’ CENTRAL BANKING 205
JE STIGLITZ was not until the economy was on its way to recovery, in February 1993 that the Fed finally recognized the 'economy has been held back by a variety of structural factors, '[emphasis added] most notably fundamental weaknesses in the financial system As the nature of the problem became clearer, and as the political pressure to do something mounted, monetary policy was eased 24 times, contributing to the recovery. The pattern evidenced in our most recent recession is typical, as con- firmed by the statistical data: Figure 2 shows that there is a strong time depen- dency in recovery TABLE 1- AVERAGE DURATION (IN MONTHS)OF US BUSINESS CYCLE EXPANSIONS AND RECESSIONS T Recession Expansio December 1854-August 1929 October 1945-March 1991 II Source: NBER These patterns are markedly different from those that prevailed before the Great Depression. Since World War Il, expansions are longer and recessions are shorter, as Table 1 shows. Figure 3 shows, using data for the United States for the period 1854 to 1918 that prior to the Great Depression, expansions did end of old age. The probability of an expansion ending increased markedly the longer the expansion continued, with a probability of approximately one-third in the sec ond year, increasing to two-thirds in the fourth. By contrast, recovery from a downturn seems to have been largely a random event, as Figure 4 shows. While some of these changes could have been accounted for by changes in the structure of the economy, I suspect that it is improved macropolicy(including automatic fiscal stabilizers) that accounts for much of the change Incidentally, these results strongly rebut the claim of Christina Romer (1986) that there is no evidence of improved macroeconomic performance in the post war period. Her argument relies on adjustments in output series which are debat able. Our methodology only requires qualitative assessments about whether the economy is expanding or contracting. Because it does not require measures for every subcomponent of GDP and because it can utilize data from other sources, the timing of expansions and downturns provides a far more robust way of as- sessing economic performance 8 In part due to the interaction of the 1986 tax reform which eliminated many of the tax subsidies to real estate that had been enacted in earlier legislation, with the regulatory forbearance that allowed the financial problems to mount, culminating in the savings and loan debacle in 1989
It was not until the economy was on its way to recovery, in February 1993, that the Fed finally recognized the ‘economy has been held back by a variety of structural factors,’ @emphasis added# most notably fundamental weaknesses in the financial system.8 As the nature of the problem became clearer, and as the political pressure to do something mounted, monetary policy was eased 24 times, contributing to the recovery. The pattern evidenced in our most recent recession is typical, as con- firmed by the statistical data: Figure 2 shows that there is a strong time dependency in recovery. These patterns are markedly different from those that prevailed before the Great Depression. Since World War II, expansions are longer and recessions are shorter, as Table 1 shows. Figure 3 shows, using data for the United States for the period 1854 to 1918 that prior to the Great Depression, expansions did end of old age. The probability of an expansion ending increased markedly the longer the expansion continued, with a probability of approximately one-third in the second year, increasing to two-thirds in the fourth. By contrast, recovery from a downturn seems to have been largely a random event, as Figure 4 shows. While some of these changes could have been accounted for by changes in the structure of the economy, I suspect that it is improved macropolicy ~including automatic fiscal stabilizers! that accounts for much of the change. Incidentally, these results strongly rebut the claim of Christina Romer ~1986! that there is no evidence of improved macroeconomic performance in the postwar period. Her argument relies on adjustments in output series which are debatable. Our methodology only requires qualitative assessments about whether the economy is expanding or contracting. Because it does not require measures for every subcomponent of GDP and because it can utilize data from other sources, the timing of expansions and downturns provides a far more robust way of assessing economic performance. 8 In part due to the interaction of the 1986 tax reform which eliminated many of the tax subsidies to real estate that had been enacted in earlier legislation, with the regulatory forbearance that allowed the financial problems to mount, culminating in the savings and loan debacle in 1989. TABLE 1 – AVERAGE DURATION ~IN MONTHS! OF US BUSINESS CYCLE EXPANSIONS AND RECESSIONS Time period Recession Expansion December 1854–March 1991 18 35 December 1854–August 1929 21 25 October 1945–March 1991 11 50 Source: NBER 206 J.E. STIGLITZ
CENTRAL BANKING 100% Probability Months of Expansion Figure 3- Probability of an expansion ending, 1854-1929 Note: Probability estimated using logit regressions on NBER Business Cycle dates These results, while they show convincingly that monetary policy matters and has been used to improve the overall performance of the economy, do not require us to believe that the monetary authority behaves perfectly or even that it is ef- ficient. I already discussed one example of a mistake: the Fed doing too little and acting too late to avert or minimize the depth and duration of the 1990-1991 recession. A second illustration is the current expansion which can be thought of s also partially attributable to mistakes, at least initially. There is a tendency to think of mistakes as one-sided- always working to the detriment of the economy t mistakes, by their nature, should be random, and in at least some cases work to the benefit of the economy. In this case, there were in fact two errors on the part of the Fed, with one more than offsetting the other Throughout the earlier 1990s, the Fed continued to have an overly pessimistic view concerning the nairu (non-accelerating inflation rate of unemployment) and the economys potential for reducing unemployment without inflation increas- ing. But they also continued to underappreciate the role of financial markets and continued to fail to understand key aspects of banking behavior. Had they better understood these factors, given their beliefs about the nairU and given their strong aversion to inflation, they would have prevented the unemployment rate from declining below 6.0 percent to 6.2 percent. It might have been a long time
These results, while they show convincingly that monetary policy matters and has been used to improve the overall performance of the economy, do not require us to believe that the monetary authority behaves perfectly or even that it is ef- ficient. I already discussed one example of a mistake: the Fed doing too little and acting too late to avert or minimize the depth and duration of the 1990–1991 recession. A second illustration is the current expansion which can be thought of as also partially attributable to mistakes, at least initially. There is a tendency to think of mistakes as one-sided – always working to the detriment of the economy. But mistakes, by their nature, should be random, and in at least some cases should work to the benefit of the economy. In this case, there were in fact two errors on the part of the Fed, with one more than offsetting the other. Throughout the earlier 1990s, the Fed continued to have an overly pessimistic view concerning the NAIRU ~non-accelerating inflation rate of unemployment!, and the economy’s potential for reducing unemployment without inflation increasing. But they also continued to underappreciate the role of financial markets and continued to fail to understand key aspects of banking behavior. Had they better understood these factors, given their beliefs about the NAIRU and given their strong aversion to inflation, they would have prevented the unemployment rate from declining below 6.0 percent to 6.2 percent. It might have been a long time Figure 3 – Probability of an expansion ending, 1854–1929 Note: Probability estimated using logit regressions on NBER Business Cycle dates. CENTRAL BANKING 207
JE STIGLITZ 100% Probabili Months of recession Figure 4- Probability of a recession ending, 1854-1929 bability estimated using logit regressions on NBER Business Cycle dates possibly never- before we learned about the economy's real potential. It was our good fortune that they did not see accurately where the economy was going To understand what happened- and why the Fed failed (fortunately) the strength of the recovery we need to return to the early days of the Clinton Administration. When the President took office in February 1993, he moved quickly to introduce a deficit-cutting budget. Eventually the Congress enacted a plan to reduce the deficit by $500 billion over five years(in contrast, the 1997 balanced budget legislation only cut the deficit by $200 billion over five years Old-style Keynesians warned that deficit reduction would undermine the fragile recovery. Those of us who believe that the markets were forward-looking, under- stood that credible, pre-announced deficit reduction would lower interest rates and thus stimulate the economy. What took us all by surprise was just how much it 9 Indeed, I have argued that there is a reverse hysteresis effect: as the unemployment rate is re Iced, previously marginalized workers are drawn into the labor market, develop and maintain worker and job search skills that might otherwise have atrophied, and the economy's NAIRU is thereby ac- tually lowered. If this is the case, then the 'mistake of allowing the unemployment rate to fall below 6 percent was actually crucial in the economy's longer-term improved performance. See Stiglitz
– possibly never – before we learned about the economy’s real potential.9 It was our good fortune that they did not see accurately where the economy was going! To understand what happened – and why the Fed failed ~fortunately! to see the strength of the recovery – we need to return to the early days of the Clinton Administration. When the President took office in February 1993, he moved quickly to introduce a deficit-cutting budget. Eventually the Congress enacted a plan to reduce the deficit by $500 billion over five years ~in contrast, the 1997 balanced budget legislation only cut the deficit by $200 billion over five years!. Old-style Keynesians warned that deficit reduction would undermine the fragile recovery. Those of us who believe that the markets were forward-looking, understood that credible, pre-announced deficit reduction would lower interest rates and thus stimulate the economy. What took us all by surprise was just how much it was stimulated. 9 Indeed, I have argued that there is a ‘reverse hysteresis effect:’ as the unemployment rate is reduced, previously marginalized workers are drawn into the labor market, develop and maintain worker and job search skills that might otherwise have atrophied, and the economy’s NAIRU is thereby actually lowered. If this is the case, then the ‘mistake’ of allowing the unemployment rate to fall below 6 percent was actually crucial in the economy’s longer-term improved performance. See Stiglitz ~1997!. Figure 4 – Probability of a recession ending, 1854–1929 Note: Probability estimated using logit regressions on NBER Business Cycle dates. 208 J.E. STIGLITZ