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Yes, largely because central bankers will behave differently
Brad DeLong our guest wrote on Jul 15th 2010, 13:23 GMT

I THINK that the answer has to be yes.

The net result of the financial crisis will be that the world's average unemployment rate and level of capacity utilisation will be lower, which means that businesses will be able to grasp fewer economies of scale, which means that profits will be lower, which means that investment spending to try to capture those profits will be lower, which means that global economic growth will be lower.

The unemployment rate and the level of capacity utilisation will be lower for two reasons. The first is what Larry Summers and Olivier Blanchard liked to call "hysteresis" in unemployment after recessions. Workers who are out of work—especially workers who are out of work for a long time—lose a good deal of their market-relevant human capital. Their networks of contacts that allow them to easily get and change jobs, their habits of punctuality, their workplace skills, and their self-esteem all erode. The long-term unemployed, especially, drop out of the effective labor force—and it is damnably hard to reattach them all to employment absent a full-scale World War II-style inflationary boom.

The second reason is that central banks are going to act differently in the future than in the past.

There used to be three broad philosophies of central banking—call them regulationism, punchbowlism, and Greenspanism. Regulationism is that bankers have to be very tightly constrained in what they can do and what investments they can make, because only if bankers are kept under very tight regulatory supervision can the central bank dare risk making credit loose enough to produce full employment. If banks are not tightly regulated, then making credit loose is like giving a bottle of brandy to...—well, you know what the bank will do, you just don't know against which wall it will do it. Punchbowlism, by contrast, is the belief that the benefits from free-wheeling and innovative finance in greasing the flow of capital from savers to businesses make it worth deregulating finance, but then the central bank must maintain relatively tight money; it was, as 1950s and 1960s Federal Reserve Chair William McChesney Martin liked to say, make sure to take the punchbowl away once the party really gets going.

The third position was Greenspanism: that modern central banks know a lot more about the economy and the financial sector than their predecessors, and so—as long as we don't see big signs of consumer price inflation—can afford to follow loose-money policies even in the context of deregulated financial markets. As long as unemployed workers are still wallflowers around the edges of the room, Alan Greenspan might say, the Federal Reserve should not only let the punch flow but spike the punchbowl with the grain alcohol of 1% interest rates to, in the words of Jay-Z and Missy Elliot: "let's get this party started right! Let's get drunk and freaky!"

And the two-decade long Great Moderation gave Greenspanism credibility. It certainly did to me.

Well...well, now we have failed to reregulate financial markets sufficiently to make anybody comfortable that the straight jacket is tight enough to constrain banks: Regulationism is out of the question. And all of us ex-Greenspanists have recanted and repented.

So, for a generation at least, central banks will follow a very different policy. Think not that they will merely take the punchbowl away when the party gets started. They are, instead, going to forbid even the filling of a punchbowl. They are going to hunt down punchbowls in their pantries and smash them all.

We see this right now, as every excuse—nonexistent inflationary pressures, nonexistent lack of confidence in reserve currency debts, et cetera—is trotted out to justify premature tightening when there is still something like 10% of excess demand slack in the world economy.

The higher structural unemployment rate from "hysteresis" and the higher unemployment from central banks' inevitable future bias toward tight money have to be weighing on business decision-making as they plan investment for the future.

How much? How big? I don't know. I don't have a good quantitative estimate.

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About our guest

Professor of Economics at U.C. Berkeley
United States
Contributions: 13

Brad DeLong is a professor of economics at U.C. Berkeley, chair of the Political Economy of Industrial Societies major, and a research associate of the National Bureau of Economic Research. He was educated at Harvard University, where he received his PhD in 1987. He joined UC Berkeley as an   associate professor in 1993. He became a full professor in 1997.Professor DeLong also served in the U.S. government as Deputy Assistant Secretary of the Treasury for Economic Policy from 1993 to 1995. He worked on the Clinton Administration's 1993 budget, on the Uruguay Round of the General Agreement on Tariffs and Trade, on the North American Free Trade Agreement, on macroeconomic policy, and on the unsuccessful health care reform effort.



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