It is possible, contrary to the predictions of most economists, that the US will get through this disinflationary period and make the proverbial “soft landing.” This should prompt a more general reconsideration of macroeconomic forecasts.
The lesson is that they have a disturbing tendency to go wrong. It is striking that Larry Summers was right two years ago to warn about pending inflationary pressures in the US economy, when most of his colleagues were wrong. Yet Summers may yet prove to be wrong about his current warning about the looming threat of a recession. The point is that both his inflation and recession predictions stem from the same underlying aggregate demand model.
It is understandable when a model is wrong because of some big and unexpected shock, such as the war in Ukraine. But that is not the case here. The US might sidestep a recession for mysterious reasons specific to the aggregate demand model. The Federal Reserve’s monetary policy has indeed been tighter, and disinflations usually bring high economic costs.
It gets more curious yet. Maybe Summers will turn out to be right about a recession. When recessions arrive, it is often quite suddenly. Consulting every possible macroeconomic theory may be of no help.
Or consider the 1990s. President Bill Clinton believed that federal deficits were too high and were crowding out private investment. The Treasury Department worked with a Republican Congress on a package of fiscal consolidation. Real interest rates fell, and the economy boomed — but that is only the observed correlation. The true causal story remains murky.
Two of the economists behind the Clinton package, Summers and Bradford DeLong, later argued against fiscal consolidation, even during the years of full employment under President Donald Trump. The new worry instead was secular stagnation based on insufficient demand, even though the latter years of the Trump presidency saw debt and deficits well beyond Clinton-era levels.
The point here is not to criticize Summers and DeLong as inconsistent. Rather, it is to note they might have been right both times.
And what about that idea of secular stagnation — the notion that the world is headed for a period of little to no economic growth? The theory was based in part on the premise that global savings were high relative to investment opportunities. Have all those savings gone away? In most places, measured savings rose during the pandemic. Yet the problem of insufficient demand has vanished, and so secular stagnation theories no longer seem to apply.
To be clear, the theory of secular stagnation might have been true pre-pandemic. And it may yet return as a valid concern if inflation and interest rates return to pre-pandemic levels. The simple answer is that no one knows.
Again, it is not just a matter of intervening surprises, which inevitably confound all attempts to apply science and social science. It is that we economists are not sure which model to consult in the first place. How, for example, did Japan move so rapidly from a fast-growth economy to a bubble economy to a slow-growth economy? I haven’t seen good answers to this question.
How much can the Fed control real interest rates? In the 1990s, economists worked very hard to establish the existence of a modest “liquidity effect” on real interest rates through monetary policy. More recently, the Fed pushed ZIRP — Zero Interest Rate Policy — and real borrowing rates were negative for the US Treasury for many years in a row. It is hard to be sure how much Fed policy mattered, but suddenly it felt it was a different world, at least until the pandemic emergency relief measures came along.
One practical upshot is that perhaps people shouldn’t be paying so much for expensive private-sector macroeconomic forecasts. Each economist has his or her models, but there isn’t any way to know when one model stops working and another starts to matter.
As for policy, beware of any statement that there is “no need to worry” about a pending crisis — be it monetary, fiscal, financial or whatever. “It’s been fine so far” is a relevant observation, but it is hardly reassuring. Macroeconomics does not quite justify the confidence the world seeks to place in it.
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