In his 2003 presidential address to the American Economics Association, Robert Lucas, a distinguished practitioner of the field and a Nobel laureate, proclaimed that “macroeconomics was born as a distinct field in the 1940s, as part of the intellectual response to the Great Depression” and that he was able to say confidently “that macroeconomics in this original sense has succeeded: Its central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades.”
This was, of course, untrue.
Just four years later, in 2007, the United States began to tip into recession. About a year after that, the recession triggered a financial crisis that led to a much more rapid collapse of demand — setting off a period that we don’t formally refer to as a “depression” but that certainly had most of the relevant characteristics of one. And that Great Recession became, though not strictly universal, certainly a global phenomenon, striking Britain, Japan, and the European Union with spillover effects to South Africa, most of Latin America, and beyond.
And though 10 years later the American labor market has largely recovered, the same cannot be said for Europe. What’s more, the output lost during the crisis is in a sense never coming back — trillions in human wealth are simply gone forever. The United States alone lost somewhere on the order of $5-10 trillion worth of economic output, with much more damage accruing abroad.
Even worse, the world continues to struggle with the political consequences of the crisis. Around the world, progress toward freer trade and more economic integration has halted, anti-immigration parties are on the rise, and the prestige of liberal democracy has eroded around the world.
The field of policy that Lucas derided as a solved problem is known technically as “macroeconomic stabilization.” It’s mainly done by central banks like the US Federal Reserve, the European Central Bank, and the Bank of Japan, which routinely manipulate short-term interest rates. When pressed by the severity of the 2008 crisis, they tried more exotic methods like quantitative easing — basically bulk purchases of long-term government bonds — as well. But it goes beyond the central banks. National legislatures also play a role in fighting downturns by enacting (or not) fiscal stimulus programs.
There’s nothing inevitable about how things played out in 2008. Australia hasn’t had a recession in 30 years, and in theory equally skillful governments of bigger countries could produce the same result. The goal of macroeconomic stabilization is to make sure that recessions are rare, shallow, and short. And 15 years ago, policymakers were convinced that they had it all figured out.
The Great Recession made it clear that they had not. The uncontroversial tool of short-term interest rates wasn’t powerful enough, and the other options are the subject of both academic and political disagreement. Meanwhile, with the crisis in the rear-view mirror politicians have moved on to discussing other things. But though policymakers in Japan appear to have finally hit on a formula that works to stimulate a deeply depressed economy — a mixture of large budget deficits, direct central bank setting of long-term as well as short-term interest rates, and even printing money to buy shares of stock — these ideas remain controversial, untested, and in some cases illegal in the west.
Depressions, however, are extraordinarily damaging. And though the most recent global downturn largely spared the world’s poorest people, that was much more a matter of good luck than policy design. Crafting a science and technology of macroeconomic stabilization that can reliably prevent depressions could alleviate the suffering of millions, while simultaneously minimizing the odds of political catastrophes unleashed by economic mismanagement.
The cost of recessions is enormous
The Congressional Budget Office routinely publishes estimates of the “potential output” of the United States — how much goods and services could be produced if the available stock of human labor and capital goods were fully utilized, as they would be in a system of perfect macroeconomic stabilization. If actual output exceeds potential output by too much, inflation will result. When it falls short, we have elevated unemployment and sluggish wage growth.
A chart that simply subtracts actual GDP from potential GDP reveals the striking fact that since the dot-com crash of 2000, America has had below-potential output every single year of the 21st century.
This has given us, in the aggregate, $5.5 trillion less of total goods and services than we would have had in a properly stabilized economy.
But even that is a significant underestimate of the aggregate cost of poor macroeconomic management to the country. That’s because potential output is in part a function of past actual output. When the stock of capital goods — that’s buildings, machines, and business equipment — is fully employed, then there are strong incentives to invest in making new capital goods that raise potential output in the future. Similarly, when people are working rather than unemployed, they are building on-the-job skills that make them more valuable workers in the future.
In 2017 and 2018, we are only falling slightly below our economy’s ability to produce things. But that closing of the gap largely reflects a steady shrinking of our expected capacity — in other words, we’re likely underestimating just how much economic damage we’ve suffered because our forecasts for expected output have fallen steadily over time.
This means the real cost of poor macroeconomic management in the 21st century could easily be twice as high as my numbers. But worse, if you take the implications of falling potential output fully seriously, the implication is that we will forever be at least somewhat poorer than we otherwise could have been. And of course those are only the costs to the United States of America. The impact in the Eurozone — whose total output is somewhat larger than America’s — has been, if anything, more severe.
And in some respects the next recession could be even worse.
The world’s poorest (mostly) got lucky
Though the Great Recession ravaged hundreds of millions of people around the world, it didn’t impede global progress toward reductions in steep absolute poverty. This was good news, but it led, in some ways, to an unfortunate tendency in humanitarian circles to characterize the economic calamity as a kind of distraction from the real good news about the global economy. The truth is that the global poor got lucky and, unless the world’s understanding of macroeconomic stabilization improves, they may not be so lucky next time.
The two most important pieces of good luck are that China and India entered the recession with the ability to fight the downturn via massive fiscal stimulus (in China’s case) and conventional interest rate cuts (for India), which not only had a large direct impact on poverty but also managed to sustain growth in most of sub-Saharan Africa, which was exporting a lot to China.
But not all developing countries were so lucky. Places like South Africa and much of Latin America and the Caribbean were more economically linked to the US and Europe than to China and suffered massively. And Africa’s strong performance despite a global recession was exceptional by historical standards. Prior to the 2008-2009 business cycle, relatively mild recessions in the rich world (the recessions so mild that they prompted Lucas to proclaim the whole problem irrelevant) had more severe impacts on Africa’s commodity-oriented economies than they did on the countries that originally set them off.
Of course, if China and India somehow never have a recession again, then perhaps global poverty can continue falling indefinitely no matter how poorly the US and European economies are managed. But the risk is that as China and India continue to converge economically with the developed world, they will increasingly face the exact same policy challenges as the developed world — meaning the question of effective macroeconomic stabilization should be seen as a fundamentally global problem.
Recessions make for crazy politics
Deep recessions, meanwhile, also have the unfortunate consequence of pushing rich countries’ economic policy in directions that are harmful to the world’s most vulnerable people.
The core problem of the knock-on political consequences of bad macroeconomic policy is that during a recession, the objective facts of economic policy change. When the labor market is healthy, then policies that boost productivity and growth make the vast majority of people better off even if they do displace some workers. People who lose jobs just find new ones.
When the labor market is unhealthy, people tend to feel differently about politics and policy. But those feeling are rooted in objective reality. It’s genuinely true that technological advancement, openness to trade, immigration, and other growth-promoting policies can be damaging to many people.
Consider trade. Paul Krugman spent much of the downturn years arguing that restricting trade with China would help boost the American economy, given the high unemployment rate. Gauti Eggertsson of Brown University and the New York Fed has a fairly convincing paper arguing that during the New Deal, policies to form cartels and reduce agricultural output actually improved economic growth because higher prices broke the cycle of deflation. Similarly, but going in the other direction, low unemployment and labor scarcity creates a strong constituency for openness to immigrant workers who become objectively necessary for growth when there’s no reserve army of domestic unemployed.
Japan, for example, is becoming increasingly welcoming toward immigrants even as the rest of the world is moving in the opposite direction precisely because Japan has gotten ahead of other rich countries in its macroeconomic management. Japan’s labor force participation rate is at an all-time high, which is great news for Japanese people, but also makes more immigration objectively desirable, which is in turn creating enormous new opportunities for residents of poorer countries. If every rich country could get as good at recession-fighting as Japan, the entire global political climate would be much more benign.
We can do better — but will we?
The core problem of the Great Recession, looking back, is precisely that Lucas’s complacent forecast really did seem sensible at the time. It appeared for a span of decades that central banks had learned how to successfully manipulate short-term interest rates in a predictable and reliable way that, while not avoiding recessions altogether, made them relatively short and painless.
That era came to a crashing halt in 2007-08. Interest rates were already low by the time the downturn struck, so further cuts in short-term rates — the Fed’s traditional main tool — was not much help. The Federal Reserve cut them all the way down to zero, but that wasn’t low enough. And neither the Fed nor other major central banks had a clear game plan for what to do once you get to zero.
When we needed a robust response to the Great Recession, we were ill-equipped both as a matter of politics and policy. Congress tried fiscal stimulus and the Fed tried several rounds of quantitative easing, and the best evidence suggests that they both helped. But neither was enacted on a scale sufficient to actually cure the problem, and both were the subject of massive political backlash. At the moment, Fed policymakers and professional staff have a somewhat clearer view of the technical issues than they did pre-recession, but they still have no specific game plan for what to do next time, and there’s zero political consensus about what they should do.
Over the past decades, a range of countries have experimented with some different approaches that seem to work — massive quantitative easing in Japan, exchange rate manipulation in Switzerland, credit policy in China — but none of them are clearly understood or universally accepted. Most importantly, the biggest and most influential central banks in the world — the Fed and the European Central Bank — haven’t clearly embraced any of these solutions as its game plan for the next time around. Nor have the American or European political systems reached any kind of consensus on the use of discretionary fiscal policy as an alternative to relying on central banks.
An underrated option that probably deserves more consideration is to dispense with a lot of the complexity and simply have the central bank print money and give directly to citizens as a kind of combined fiscal/monetary stimulus. There is, however, a wide variety of possible solutions and it’s not particularly important which one is picked as long as something is picked.
But instead, everyone is left standing around essentially hoping that the problems that afflicted us a decade ago won’t arise again, even though almost nothing has been done to try to prevent their recurrence. Whether or not that changes in time is one of the biggest issues facing the future of humanity and deserves to be taken more seriously.