The era of prolonged stagnation may be coming to an end
The author is a senior researcher at Brown University and a former chief economic adviser to the Indian government. Josh Felman also contributed to this article
The Biden administration’s fiscal stimulus plans have been criticized by macroeconomists who fear they will trigger inflation. Unprecedented package size, 1.9 tons, Of course it is worth worrying about. However, some of the fiercest attacks have come from supporters of the long-term stagnation hypothesis. This is strange because the assumption implies that higher inflation is a feature of any revitalization strategy, not a mistake.
The long-term stagnation hypothesis holds that low investment suppresses aggregate demand and drags down growth and inflation. According to this diagnosis, the economically developed countries have been trying to increase aggregate demand for decades, but so far they have achieved little success.
As Japan moved towards deflation in the mid-1990s, the Bank of Japan listened to Paul Krugman’s suggestion that it should “Credibly promised to be irresponsible“And embarked on the implementation of a series of fiscal packages and quantitative easing policies in order to break low inflation expectations. But this huge effort has neither changed the inflation dynamics, nor has it sustained growth.
After the 2008 financial crisis, the Federal Reserve and the European Central Bank also tried risky monetary policies. They are also short, even if they raise asset prices to bubble levels, they have been below the inflation target, encouraging companies to assume dangerous leverage and distorting global capital allocation.
Just when everything seemed to fail, President Joe Biden raised the stakes and announced a large-scale fiscal stimulus plan designed to free the U.S. economy from malaise. For those who do not believe in prolonged stagnation, this is a mistake. In their view, the economy is close to its potential and shortages abound. Therefore, a large injection of demand will lead to high inflation.
What is even more difficult to understand is the sharp criticism of supporters who have been stagnating for a long time. After all, the Biden strategy is nothing more than a credible commitment to irresponsibility, applicable to fiscal policy. In addition, advocates of prolonged stagnation have long believed that higher inflation is desirable.
Proponents believe that the essence of the macro dilemma is that the equilibrium real interest rate—the real rate of return required to keep economic output equal to potential output—has been significantly negative, and the nominal policy interest rate cannot be far below zero. Therefore, the central bank We have fallen into a trap: As long as the inflation rate is low, the real policy interest rate will remain at an excessively high level. But precisely because interest rates are too high, aggregate demand will remain weak and inflation will remain too low. The only way out of this trap is to reduce the real policy interest rate to an equilibrium level if the exogenous event triggers moderate inflation. This is exactly what Biden’s package plan might do.
but if Stimulus proved to be excessive? In this case, it can solve another policy dilemma. For some time, despite the accumulation of financial distortions, interest rates have been kept at the lowest level because the central bank is unwilling to tighten policy when inflation is low. The cost of taking action (slowing growth) is directly visible, while the benefits are nominal and future (preventing financial crises). Therefore, raising interest rates is incompatible with incentives.
However, if fiscal policy is sufficient to stimulate demand and make inflation an obvious and real danger, then the central bank may eventually tighten monetary policy.Higher inflation may be God from the machine This gives the central bank a reason to take action, and the wider public will accept it.
In the long run, stagnationists believe that moderate inflation has other benefits. Nominal interest rates can be raised, so the central bank will have more room to cut interest rates before they approach the zero lower limit. For this reason, Olivier Blanchard, the former chief economist of the IMF, long ago called for a 4% inflation target. At the time, the proposal received little support. But today, as the actual inflation rate in the United States reaches 5%, even if only temporarily, a higher inflation target becomes more reasonable.
So, if a higher inflation rate is both necessary and desirable to get rid of the long-term stagnation, why are its main advocates suddenly worried? Maybe they think that the stagnation era is ending on its own, which is triggered by the shift in productivity. Or they worry that moderate inflation may trigger a spiral of wage prices that the Fed cannot control, as happened in the 1960s and 1970s, leading to painful recessions. Whether their concerns are justified remains to be seen, but at least for now, prolonged stagnation is an orphan.