Former Governor of the Bank of England, Mervyn King is suggesting that “Economics Needs a Post-Crash Revolution” in a seeming admission that current frameworks don’t work in a world of radical uncertainty and necessary reallocation.
Is the former BOE governor and academic icon correct, or is this an unfair critique of the mainstream? As a summary, I have two issues with his argument:
- Reallocation does not have anything to do with “average demand”, which is predominantly a monetary policy issue,
- If excessive reallocation is necessary and requires government assistance, where are the “high return” industries that need reallocation to them?
Let me explain.
In Professor King’s view:
“Escaping from a low-growth trap sprung by radical uncertainty isn’t like climbing out of a Keynesian downturn, with temporary monetary or fiscal stimulus restoring demand to its trend path. It requires instead a reallocation of resources from one component of demand to another, from one economic sector to another, and from one company to another.”https://www.bloomberg.com/opinion/articles/2019-10-27/economics-revolution-needed-to-fix-great-stagnation
This is quite a confusing opinion, as King is either saying nothing is of consequence (eg that a reallocation will occur in the future), or that “people won’t reallocate unless we make them” which is a pretty awkward statement.
I agree with Prof. King that some economic questions and stylised facts need to be changed post-GFC. But before moving into the further argument, I would like to discuss the possible causes of the Great Depression first – as King’s argument is based on a comparison to that time period.
Why did the Great Depression happen?
There were lots of things happening at once during that economic downturn between 1929 and 1939 – some of them demand shocks, some of them supply shocks, some of them were technology, some were policy, some were solely about coordination.
During the Great Depression the prevailing view was that there was a “secular stagnation” – growth was lower because the easy gains had been used up.
Keynes stated that there could be a coordination issue with a lack of demand – and although active fiscal policy appeared to help, it didn’t get the economy back to trend – and so it was seen as a bit of both. Then World War II happened, and the output surged.
Seeing that, economists got really confused and started investigating – although the idea there was a demand/investment shortfall compared with secular stagnation remained. Friedman then came out and said it was all about monetary policy. Although, I don’t think this is as major a departure as some people act. Instead, it is the changing tone from “supply” to “demand” in how people think about the relative shocks.
Let’s look at all the supply shocks: 1) The dustbowl droughts in the US destroying their food producing capacity. 2) A breakdown in lending due to bank runs. 3) The breakdown of the gold standard and lift in uncertainty. 4) International trade retaliation and the rise of tariffs.
All these things reduced the capacity to produce of the US and global economies. But falling prices, and the fact that output could be ramped up A LOT due to the war tells that there was a demand based coordination failure.
The “coordination failure” idea captures a number of the same issues that were raised in debate then as essentially structural (debt deflation, weak expectations) – but Friedman’s innovation was to cut through and note that anchoring macro-variables could help to solve these very issues, and that was the role of monetary policy (eg NGDP targeting).
We can see how an understanding of the Great Depression – and the debates they had at the time – gives quite a perspective on all the things people talk about now.
Slowing population growth, a slowdown in “technological innovation” from finding the “easy gains”, slowing convergence between countries. All these things explain why the “trend” in output growth may have slowed, and if demand didn’t immediately slow this would have been represented in above trend output and a slump after – however, that should have been represented by rising factor prices as well.
In the Great Depression, unemployment was still very high when economists were saying it was “solved”. Where now, the unemployment rate has been pushed down finally – as a result, if activity is still below trend the supply hypothesis appears more reasonable than it was then.
But, we have to also then ask if we are measuring capacity in the labour market properly (eg do a bunch of countries have low labour force participation rates). It doesn’t appear that is the issue (unlike 3 years ago).
Back to the disagreement with Mervyn Kings’s reallocation statement
The Great Depression didn’t require a “forced reallocation”, it just required that people expected sufficient growth in order to be willing to invest – at a level where these expectations were self-reinforcing at the aggregate level.
Imagine the government says- “I know that you should invest in perfume bottles, and if you don’t start doing it I am going to make you”.
Doesn’t it sound economically wrong?
It does! Because the economy ALWAYS needs reallocations – that is what markets and relative prices do.
Saying that there needs to be a reallocation is an empty statement, and then if we make it non-empty (eg saying there should be more investment in perfume bottles) we need to ask why private agents are not doing it.
The government has neither the information or even the right to force turn around and state that people should change what they are doing because of technology (as it is not an externality), and instead it SHOULD be a question about the way policy can help shape expectations of “average demand” to ensure that private agents don’t face undue uncertainty.
Prof. King is saying “it isn’t a monetary policy issue, as it needs a reallocation”, but it IS a monetary policy issue.
The private sector will reallocate if they are facing the incentive to. And if their expectations were based on a consistent rate of growth in nominal GDP, then any deviation from that average provides a signal to reallocate towards or away from that activity.
Instead, because they expect average nominal growth to be low, they fall into a self-reinforcing cycle of not undertaking the high return “reallocation” investments.
Also there is another issue. If there is a required “reallocation” there HAS to be possible high return activities – this is a bit different from the “secular stagnation” and “low natural interest rates” that he is pointing to as evidence of his own point.
If there is necessary reallocation, where is the reallocation to? If private agents can’t observe the answer then it is unclear how government would be able to.
So surely the solution must be appropriate monetary conditions – not active reallocation of “something”.