It really does now look like President Donald J. Trump, and markets are plunging. When might we expect them to recover? . . . . If the question is when markets will recover, a first-pass answer is never.
. . . . . .
It’s true that we’ve been adding jobs at a pretty good pace and are quite close to full employment. But we’ve been doing O.K. only thanks to extremely low interest rates. There’s nothing wrong with that per se. But what if something bad happens and the economy needs a boost? The Fed and its counterparts abroad basically have very little room for further rate cuts, and therefore very little ability to respond to adverse events.
Now comes the mother of all adverse effects — and what it brings with it is a regime that will be ignorant of economic policy and hostile to any effort to make it work. Effective fiscal support for the Fed? Not a chance. In fact, you can bet that the Fed will lose its independence, and be bullied by cranks.
So we are very probably looking at a global recession, with no end in sight. I suppose we could get lucky somehow. But on economics, as on everything else, a terrible thing has just happened.This is just silly, as Krugman himself later acknowledged. Employing analysis I learned from my hero, Paul Krugman, I was able to foresee that the Brexit would not, in fact, precipitate a recession in Britain, as did Krugman himself. Don't do anything ridiculous like confuse what Republicans say when out of power (Deficits are evil! Hard money is a moral imperative!) with what they will actually do in power. Of course the Republicans will give effective fiscal support to the Fed; they are doing it already. And I have no doubt their fondness for tight money will end the minute it threatens their electoral fortunes. The Republicans taking power will give a boost to the economy. Markets are celebrating.
The current state of the economy is so-so. It could be better and it could be worse. Unemployment is falling below 5% and wages are starting to rise for the first time since the crash in 2008. Employers are starting to complain that rising wages are cutting into their profits. All this may be a sign that we are reaching the peak of the business cycle. At the same time, inflation and interest rates are extremely, even pathologically low, a sign that there is still slack in the economy. What are the chances of a recession some time during the next four years?
Here I will defer to my hero, Paul Krugman. Krugman identifies two kinds of recessions. One occurs when the central bank tightens to stop an overheating economy and accelerating inflation. Recovery is rapid once it eases off. In the 1950's and '60's, the Fed made frequent use of these, but the last such example was the 1981-1982 recession, used the break the inflationary spiral from the 1970's. That recession was unusually severe because it had particularly high inflation to fight, but as soon as the Fed eased up, the economy rebounded just in time for the 1984 election. Since then, inflation has managed to stay low without such interventions, but a new kind of recession has arisen -- the kind that follows bursting bubbles. We have seen mild ones in 1991-92 and 2000-2001 and a severe one in 2008-2009. These are less frequent than the earlier recessions, but recovery is slower.
And now, he fears, we may be heading into an age of secular stagnation, i.e., one in which total savings exceed investment opportunities and large amounts of capital will lie unemployed. The result is permanent slack in the economy, slow growth, low inflation, and pathologically low interest rates. Monetary expansion cannot cure the slack because even if it lowers short-term rates to zero, savings will still exceed investment opportunities. So, is the plus side of secular stagnation an end to the business cycle? Clearly there will be no opportunity for economies to overheat and thus no need for central banks to step on the brakes. Will there be speculative bubbles? Possibly, although those are usually the product of "irrational exuberance" during good times, which seem notably lacking right now.
And yet . . . And yet Krugman is calling for higher inflation, in the 4-5% range, so that in case of recession, central banks, by lowering real interest rates to zero, will effectively make it negative 4-5%. And yet when I look at graphs of the business cycle, we do look as though we are drawing near the peak, extremely low inflation and interest rates notwithstanding. And yet the last business cycle peaked in 2007, which will make next year ten years later. It seems a stretch to imagine the peak-to-peak business cycle would be over 13 years.
So, right now we have an improved economy, but one with some slack and no apparent prospects of ever ending the slack. What do do? Krugman and others like him recommend a fiscal stimulus, with monetary accommodation, both to end the slack in the economy and to encourage somewhat higher inflation to make it easier for the Fed to lower interest rates in future recessions. The main obstacle to such a course so far has been that all parties have been faint-hearted. Prudence has led all responsible parties to balk at the sort of deficits such a policy would entail, and the whole finance industry wants higher interest rates to increase profits.
Enter Republicans to the rescue. Every Republican knows that deficits only matter when a Democrat is in the White House. They also know that deficits that result from tax cuts don't count; only deficits from spending increases count. Also, military spending doesn't count either, only social spending. So, Republicans are doing what they always do, proposing massive tax cuts and a military buildup. Trump is now adding a new measure to the mix -- a trillion dollar infrastructure plan. I have no idea whether they will reject the infrastructure as an extravagance and stick to the tax cuts and military buildup or whether partisanship will prove stronger than principle and they will reject it. But one thing I am confident about is that Republicans will never be faint-hearted about deficits brought about by tax cuts, especially at the top. Remember, it is Republican dogma that no tax increase can ever be justified. And while they theoretically favor spending cuts to match the tax cuts, in practice they are not prepared to do anything that unpopular, so deficits will surge. Granted Krugman and company don't think tax cuts at the top deliver much of a multiplier, but I am inclined to think that the form of fiscal stimulus matters less than the central bank's willingness to accommodate it with monetary policy.
So, what are the chances there? Hard to say. It is true that central banks have also proven faint-hearted and not been willing to give a really aggressive monetary stimulus to get the economy going, but less to favor inflation over 2%. And it is also true that so long as Obama has been in power, Republicans have maintained an almost theological commitment to tight money as a universal and timeless moral imperative, some even going so far as to endorse a gold standard.
Well, make no mistake. Once Trump is inaugurated, Republicans will regard tight money as a universal and timeless imperative that must be continued in good times and bad, in all economic circumstances. To propose any deviation from this moral imperative would show a lack of principle. No amount of human suffering can ever justify deviation from this universal and timeless imperative and, indeed, the more pain the Fed inflicts with tight money the better, since it will mean a richer reward down the road. So money must always be kept tight, without exceptions -- unless a Republican is in the White House and tightening might hurt his political fortunes, in which case we must be reasonable.
But Republican politicians will not determine monetary policy; the Fed will determine monetary policy. Will the Fed accommodate? That one is harder to answer. Certainly, with a Republican in the White House, the pressure for politicians to tighten will vanish. What about the pressure from banks, theorists and (to the extent that it exists), the general public?
Ironically, I think that if the Fed manages to accommodate Republican fiscal expansion enough to get the slack out of the economy, the pressure to tighten might lessen. Fiscal stimulus is deeply counterintuitive and has proven impossible for political reasons (in Europe and the US, now and in the 1930's). Less apparent but nonetheless there are some similar pressures on central banks. Since most people think of inflation solely in terms of prices and not of wages, people tend to become extremely inflation averse when their wages are stagnant, even though stagnant wages are in themselves part of very low inflation. Likewise, the finance industry gets upset about low interest rates and puts pressure on central banks to tighten when rates get low. But there, too, there is a bit of zen at play. As Milton Friedman says, high nominal interest rates are a sign that money has been too loose; low nominal rates are a sign that it has been too tight.
How can this be so? The first half is simple. Too-easy money leads to inflation. Inflation leads to high interest rates. The second half is merely a reflection of the first. Too-tight money depresses the economy, a depressed economy leads to low interest rates because of the lack of investment opportunities. Still, automatically linking them to monetary policy makes yet another assumption. If high interest rates are the result of easy money, it means that inflation is necessarily the result of too-easy monetary policy and can always be cured by monetary tightening. This is an uncontroversial statement that basically everyone agrees with.
But the second side makes another assumption -- that a depressed economy is always the result of too-tight monetary policy and that, regardless of what shocks it receives, an economy can always be revived by monetary expansion. That latter is very controversial indeed. Can central banks always boost the economy by printing more money? And keep in mind that central banks "print" money by buying up government debt. That means that they can continue a monetary expansion only if the government obliges by running massive deficits. Well, all evidence is that the Republicans are going to oblige in that regard! Once they get the slack out of the economy, interest rates will rise and the finance industry will stop clamoring for tightening. Once nominal wages start to rise more, people will stop being as upset about rising prices. Krugman thinks we need 4-5% inflation to ensure that central banks will have maneuvering room to cut rates in case of recession. We have often had inflation at that rate during good times and no one has minded in the least.
So the question should be, will the Fed have the nerve to keep expanding when inflation rises above its official target? Or to raise its inflationary target, which was sheer madness in the past, but might be okay now that there is a Republican in the White House? I am guessing that the current leadership will not be willing to raise its inflation target. I have no sense at all whether they will allow inflation to overshoot its target once the pressure to tighten recedes.
But then again, it will take time for inflation to start rising above the 2 percent target. Current chairman Janet Yellen's term expires in February, 2018. Maybe by the time it expires, the Republicans can find a hack who cares more about Republican political fortunes that responsible monetary policy and will continue to expand until inflation reaches 4-5%. It doesn't seem so far-fetched.
Krugman loves saying that what we need is for central banks to credibly promise to be "irresponsible," but they are such staid institutions that he is not sure it is possible. That is one reason why he thinks they need some fiscal support. Well, if there is one person whose promises to be irresponsible will be absolutely credible, it is Donald Trump. But other Republicans aren't far behind. Maybe they can find an equally irresponsible person to manage the Fed and actually revive the economy.
Next: How it can go wrong.