Economists these days seem to want to describe two financial regimes. One is a “normal” regime, which can be regulated by conventional monetary policy. The other is a “crisis” regime, which cannot. Here is a metaphor to think about:
Imagine the economy as a car, with Fed monetary policy consisting of pressing on the accelerator pedal. The Fed tries to maintain a constant speed, and sometimes that means pushing hard on the accelerator and other times it means letting up. In the normal regime, the Fed just deals with road friction and hills.
In the crisis regime, the car has a flat tire. The Fed can press really hard on the accelerator pedal, and yet the car is not going to go as fast as people want.
Until recently, macroeconomic theory focused on the normal regime, dealing with road friction and hills. What are the microfoundations? What policy rules work best? etc.
But what about the crisis regime? Scott Sumner’s view would be that there is no such regime. He would say that we are seeing a normal regime in which the Fed has stubbornly failed to press hard enough on the accelerator pedal.
When I hear mainstream economists praise TARP, I think they believe that troubled banks were the macroeconomic equivalent of a flat tire, and you needed TARP to patch the tire. Perhaps this is correct. However, I do not think we can tell this story very well by using the models that were designed to describe the normal regime. As of now, I think that there is a huge gap between mainstream intuition, which thinks in terms of the flat tire, and mainstream modeling, which deals with road friction. In particular, treating financial markets as if they were just another potential source of road friction is probably not going to cut it.
I also do not think that “the zero bound” is the flat tire.
What might be the flat tire is an adverse equilibrium in an economy with multiple equilibria. Think of the economy as having channels of trust. When the channels of trust are open, we have the good equilibrium. When the channels of trust are closed, we have the bad equilibrium. Finance is particularly subject to these multiple equilibria. If people believe that financial instruments are safe, then borrowers can obtain lenient credit at low rates. But in an adverse equilibrium, creditors have doubts, and borrowers are constrained.
In the adverse equilibrium, there is less economic activity. This might explain the intuition that the financial crisis was horrible, and bailing out banks kept things from getting worse. However, it does not necessarily support the intuition that fiscal policy and quantitative easing are helpful.
And I do not necessarily endorse this particular model of the flat tire.
It is always worthwhile to flip the explanation to see if it is still believable and whether the same prescription is offered. If people believe investments will be productive, they will be willing to borrow, but in adverse equilibrium, borrowers have doubts and instead insist on liquidation. This essentially same explanation reverses the prescription. Is there a reason the economy can’t grow as rapidly with the private sector liquidating debt? Is there a reason the private sector is liquidating debt rather than expanding it? Is the problem the credit constrained or unwilling? Is the problem creditor doubts or expectations?
Sounds plausible enough to me. The same 0.25% nominal interest rate that is too low when everyone expects high NDGP growth is too high when everyone expects low NGDP growth.
A bit off-topic, but this one is partly inspired by you: http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/12/i-do-not-understand-recovery-from-recessions.html
AD/PSST hybrid.
Why not take the next logical step though and abandon the notion of there being ‘normal’ regimes in the first place (whether against which to postulate ‘crisis’ regimes, or not). Why would the economic ‘regime’ of a country be binary rather than a continuum of ‘regimes’, some more bad/good than others? (As we all understand it is with, say, countries, or even within a single country over time.)
If the ‘regime’ is *always in flux*, there is no equilibrium and no normal to speak of. Policy derived from an assumption of ‘normal’ and of equilibrium will therefore be mostly wrong, and more to the point, will often misdiagnose as a ‘demand shortfall’ (or whatever) what is really an exogenous *shift to a materially worse regime*. Such misdiagnosis may be good for the people who openly rooted for and prompted the bad-shift but not for the rest of us.