Kevin Warsh, an exiting Fed governor, has a recent interview in The International Economy in which I want to highlight his views on the anemic recovery:

TIE: The current recovery has produced less than half the growth rates achieved during the recovery after the 1981–82 recession. For example, for most of 1983, growth stayed consistently above 8 percent and for a time exceeded 9 percent. Why do you think the current recovery has been so modest? Some would argue it’s a Ricardo equivalence effect—the size of the public and private debt is inhibiting consumption. Others say the stimulus wasn’t large enough. Others argue there’s never been a major recovery without housing leading the way, yet housing is still in the basement. If you bought a house within two or three years of the peak, for example, negative equity makes it difficult to refinance even if interest rates are low. Banks still have a lot of inventory on their balance sheets, particularly with the level of foreclosures. Maybe banks don’t want to write off bad assets until there are profits. Would removing inventory from balance sheets and putting it back in the market help clear this process and make housing more affordable—and thereby improve the prospects for a healthier recovery? Why has this recovery been so modest? Is the answer simply that recovery after financial crises is always difficult?

Warsh: Only by the standard of the deepest, darkest day of the crisis is this economic recovery even plausibly satisfactory. On a historical basis, the economic recovery is modest, and unacceptably so. Some describe this recovery as the “new normal” and suggest we should just get used to it. Others suggest that recoveries from global financial crises are inevitably weak, and so we should lower our standards. I call this the new malaise. Instead of lowering our standards, we should improve our policies and raise our expectations.

So why is the recovery weak? First, the symptoms have been confused with the disease. Some policymakers have tried to steer a housing recovery without an economic recovery. So there have been a dozen or so programs to “fix” the housing crisis on the theory that once that’s repaired, the broader economy will come roaring back. These housing programs, however wellintended, have done little, in my view, to help the housing markets or the real economy. A housing recovery will begin when real household incomes improve, not before.

Second, intentions aside, the broad suite of macroeconomic policies has tended to favor the big over the small—big banks have been advantaged over small banks; big businesses have been favored versus small businesses; and those big multinationals with access to the global economy and global financial markets have benefitted more than those on the front lines of job creation.

Third, macroeconomic policies, in my view, have been preoccupied with the here and now, not the long term. So going back several years, Washington has compensated for a faltering economy with temporary programs that plug quarterly GDP arithmetic, but do far less to support longrun growth. Massive stimulus has proven not to be as efficacious as many academic models would suggest.

I, personally, have never bought into the notion that financial crises produce slow recoveries. The problem is confusing near-zero interest rates with “easy money”. It isn’t the financial crisis that causes anemic recovery, it is inadequate monetary accommodation. This holds unless you happen to believe in infinitely elastic money demand over a significant period of time; which I doubt even Keynes actually believed, and in any case, has never existed in the real world. The Great Contraction of the 1929-32 caused an extreme financial crisis, however monetary devaluation of 1932-33 caused the highest rate of growth in industrial production in the history of the US, even with a severely damaged banking system. Warsh is correct that we shouldn’t be complacent, we should improve our policies, and raise our expectations…more importantly, doing so should be mechanical. Elsewhere in the article Warsh says that we need to focus on the trajectory of inflation, and not where inflation has been. I think he should be even more creative, and call for a NGDP level target. Not only would this be a policy improvement, but given a credible central bank promise to a target path for NGDP (with a commitment to compensate for slack or overshoots) expectations of future Fed policy would become more or less automatic. This is what we should strive for.

To me, there is no mystery as to why we are experiencing an anemic recovery.1 In the deepest, darkest days of the crisis, there was literally no focus on monetary policy. Indeed, people were idly claiming that the Fed was being accommodative, even as it held the Fed Funds Rate well above zero while the TIPS spread collapsed, real rates soared, and various markets were in free-fall. There may, indeed, be a new normal, in which instead of raising nominal wages and prices (the easy way out), we grind through dis-inflation/deflation in order to bring real wages and prices into line with the new output trajectory (the hard way out)…but everyone needs to realize that is not a cruel fate, it is a choice.


1H/T Macus Nunes

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