Koppl on From Crisis to Confidence

|Peter Boettke|

One of the most creative and fertile minds within the modern Austrian school of economics -- Roger Koppl (see, e.g., his SDAE Presidental address) -- has a new monograph out with IEA ... From Crisis to Confidence.  As Roger summarizes his argument: 

The recent economic crisis has destroyed some of the supposed ‘certainties’ of economic theory and policy. Both are in question as we try to understand the Great Recession and the long slump that followed. Something has gone terribly wrong and we need to mend our ways. To some it looks like market failure, which suggests the need for more command and control. But if the crisis is a tragic example of government failure, then we had better move away from command and control and toward freer exchange.

In the IEA monograph From Crisis to Confidence I argue that the Great Recession and long slump were both consequences of policy mistakes. But to see how and why we need a more or less ‘Austrian’ theory that has not been part of mainstream macroeconomics in the recent past. Some of this Austrian theory is well established and some new.

The Great Recession was a classic Austrian trade cycle. A mistaken loose-money policy drove interest rates to inappropriately low levels. These ‘artificially’ low interest rates encouraged investment. They told investors that the public had become thriftier, that they had released resources for investment. This stimulus to investment is strongest for the most ‘interest sensitive’ sectors such as housing.

At the same time, however, those low interest rates discouraged the very savings they seemed to reflect. In this way, a loose money policy by the government’s central bank created inconsistencies between the plans of savers and investors. For a while everything seemed to be fine and we got a booming economy with growing output. But because of those plan inconsistencies, the boom could not have lasted. The ‘unsustainable boom’ had to end in a bust. That’s one way recessions can happen, and that’s what happened in the Great Recession.

Mainstream macroeconomics has not had room for the ‘interest rate mechanism’ that tells us the boom was unsustainable. It cannot adequately explain, therefore, the recent recession. Many mainstream economists have seen clearly, however, that the Great Recession was a matter of ‘sectoral shifts’ driven by inappropriately low interest rates. Mainstream macroeconomics may be ready absorb this piece of more or less Austrian macroeconomics. Today’s mainstream theory, however, does not seem to have an explanation for the long slump that followed the bust. Here too, Austrian theory can help.

A healthy economy recovers relatively quickly from a recession. This time, however, the recovery was slow. We have had a series of policy innovations and interventions intended to bolster the economy’s health. But the patient languished under the doctors’ care and we got the long slump, with employment low and growth slow.

The problem has been a series of policy innovations, which created economic policy uncertainty. Careening from one improvised policy to the next created uncertainty and knocked confidence out of the system. Mainstream macroeconomics today has been able to spot the empirical connection between an anaemic economy and economic policy uncertainty. But it has no solid theoretical explanation. In From Crisis to Confidence I outline a theory of confidence that helps to explain why recovery from the Great Recession has been so slow and painful.

The ideas I discuss in the monograph are rooted in an economic theory that rejects the mechanistic models of recent mainstream macroeconomics in favour of a more human vision of the economy and of economic theory. If people and particles are different, we need a theory about people to avoid the tragic policy errors that gave us the Great Recession and the long slump.

Koppl is always an engaging and challenging read, this monograph however given its topical importance seems to be a must read.

Comments

[Matej]

I´ve just read it and it´s truly excellent. It´s a must read, indeed. ;)

[David Skarbek]

Koppl gave an insightful and interesting presentation to a packed audience at the IEA a few weeks ago. I'm sure the book is even better.

[Michael Giberson]

I read the following post on Economist's View immediately after reading this post above. Thoma excerpts remarks from the president of the Minneapolis Fed concerned with the persisting un- and under-employed resources in the economy and how if we could just get aggregate demand up enough to attain a 2 percent inflation target, all those resources would be put to work...

I'd say Koppl's views are much needed.

http://economistsview.typepad.com/economistsview/2014/08/persistently-below-target-inflation-rate-is-a-signal-that-the-us-economy-is-not-taking-advantage-of-.html

[Barkley Rosser]

Roger is always a good read. My only caveat is that I think that the Fed for some time now has been trying to create an environment of stable expectations and policy certainty or continuity. One can argue that their supposedly stable policy is the wrong one, and it may be impossible for them to achieve the outcome they want for a variety of reasons, but I think it is inaccurate to charge the Fed with engaging in a lot of herky-jerky arbitrarily changing policies recently.

[Jerry O'Drsicoll]

I agree with Barkley on the Fed's intentions. But Roger seemed to be talking about macroeconomic policy in general. There is a lot of other policy uncertainty out there, e.g., on taxes and regulation.

And the Fed's early response in 2008 was composed first in denial, then sterilized lending, and only then something like lender of last resort (albeit done incorrectly). Lots of uncertainty created there.

[Barkley Rosser]

Jerry,

Clearly the Fed was completely incoherent and botched up as the crisis erupted in 2008. My comment about policy consistency referred to more recent conduct and efforts.

[Roger Koppl]

What Jerry said.

I don't think I made any specific commentary on the Yellen period. I do note that "transcripts seem to show that monetary policy was self-consciously influenced by the Taylor rule by 1995 if not earlier (Asso et al. 2010). It seems that Janet Yellen was particularly important in bringing about this result (Asson et al. 2010: 2, 15)" (p. 21). Around p. 72 I note her apparent support of the sort of discretionary regulation we got with Dodd-Frank.

I would also note here that Yellen has defended discretion in both monetary policy and macroprudential policy. The “Federal Reserve and other central banks,” she has said of the former, “certainly don’t slavishly follow prescriptions from any rule. They retain discretion to deviate from such prescriptions when responding to severe shocks, unusually strong headwinds, or significant asymmetric risks” (Yellen 2011, p. 9). Thus, there would seem to be a greater scope for discretion under Yellen than John Taylor would advocate. It seems likely, then, that we have more monetary-policy uncertainty than necessary, but not necessarily all that much of it.

My bias is to claim that the scope for discretion Yellen allows is this terrible bad thing creating Big Player effects and causing cancer and earthquakes. Unfortunately for my biases, the evidence from the Bloom-type literature seems ambiguous. Baker et al. (2013) report, “Strikingly, monetary policy uncertainty does not appear to have increased” since 2007. But Baker et al. (2012) find that “Monetary policy accounts for about one-third of policy-related economic uncertainty in the period from 1985 to 2011” and “historically high levels of economic policy uncertainty in 2010 and 2011 predominately reflect concerns about taxes and monetary policy.” Bekaert et al. (2013) find a fairly direct connection between monetary policy and a measure of Knightian uncertainty, the variance premium of the VIX as defined in Carr and Wu (2009). Maybe the evidence is saying that our fragile monetary institutions themselves create so much monetary-policy uncertainty that we can't measure much of an *increase* in moments of crisis. I don't know. I would note that the "loose suit" (what Taylor calls the "Great Deviation") began about 2002, not 2007. Maybe that's part of why we don't see a jump in 2007.

[Jerry O'Drsicoll]

Roger,

I think you put your finger on it.

The problem is institutional uncertainty, i.e., uncertainty inherent in the institutional structure. Within that inherent uncertainty, Barkley is correct that the Fed is trying to minimize uncertainty by better communication, etc. I have applauded Bernanke for doing that, while decrying discretion.

Yellen repeats a canard that a monetary rule precludes responding to shocks. That is what Bagehot wrote about. Under a gold standard, providing liquidity in a crisis was incorporated in the rule. If Bernanke had followed Bagehot in 2008, Fed policy would not have been incoherent.

[Thucydides]

Is it economic policy uncertainty, or is it that the economy is saturated with debt that has caused the stagnation?