David R. Henderson  

Greenspan Embraces "Regime Uncertainty" Explanation

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In a recent e-mail alerting me to an important 2011 piece by Alan Greenspan that I somehow had missed ("Activism," International Finance 14:1, 2011: pp. 165-182), Jeff Hummel writes the following:

One of the unusual features of the current recession is the long persistence of high unemployment. Despite the claims of Carmen Reinhart and Kenneth Rogoff, deep recessions accompanied by financial panics are usually followed by steep and rapid recoveries, at least in U.S. history, with the exception of the Great Depression. (This was demonstrated in a paper by Michael Bordo and Joseph Haubrich.) Most explanations for the current persistence of high unemployment fall into one of three broad categories:

1. Insufficient aggregate demand. This is the position of the Sumnerites who advocate more monetary stimulus and the Keynesians who advocate more fiscal stimulus. While I agree with Scott Sumner that Bernanke's monetary policy was too tight when the crisis hit during 2007-2009, I think that is irrelevant now. Why hasn't there been sufficient time for inflexible wages or prices to adjust?

2. Structural unemployment. This is the explanation offered in different forms by Arnold Kling, Tyler Cown, and others. Although I agree with Bryan Caplan's critique that inflexible wages are still necessary for this explanation to work, it does provide some basis for the persistence of the inflexibility. But that only pushes the question one step back; why is the amount of structural unemployment so much greater in this recession than in past recessions?

3. Regime uncertainty caused by government activism. This is the thesis developed by Robert Higgs to explain the length of the Great Depression, and he has invoked it for the recent recession.


Now to the Greenspan piece. Although he does not use the words "regime uncertainty," a term introduced by Robert Higgs to describe what he believes led to the slow recovery from the Great Depression, Alan Greenspan endorses regime uncertainty as an explanation of the U.S. economy's slow recovery from the recent recession. Some choice excerpts follow.

From his abstract:

I infer that a minimum of half and possibly as much as three-fourths of the effect can be explained by the shock of vastly greater uncertainties embedded in the competitive, regulatory and financial environments faced by businesses since the collapse of Lehman Brothers, deriving from the surge in government activism. This explanation is buttressed by comparison with similar conundrums experienced during the 1930s. I conclude that the current government activism is hampering what should be a broad-based robust economic recovery, driven in significant part by the positive wealth effect of a buoyant U.S. and global stock market.

His data:
For non-financial corporate businesses (half of gross domestic product), the disengagement from illiquid risk is directly measured as the share of liquid cash flow they choose to allocate to illiquid long-term fixed asset investment (henceforth, the capital-expenditure, or 'capex', ratio). In the first half of 2010, this share fell to 79%, its lowest peacetime percentage since1940.

His bottom line:
That non-financial business had become markedly averse to investment in fixed, especially long-term, assets appears indisputable. But the critical question is, why? While most in the business community attribute the massive rise in their fear and uncertainty to the collapse of economic activity, they judge its continuance since the recovery took hold in early 2009 to the widespread activism of government, in its all-embracing attempt to accelerate the path of economic recovery.

Greenspan's version of Harold Demsetz's "Nirvana Fallacy:"
Regrettably, the evidence is such that policy makers and economists can harbour different, seemingly credible paradigms of the forces that govern modern economies. Those of us who see competitive markets, with rare exceptions, as largely self-correcting are most leery of government intervening on an ongoing basis. The churning of markets, a key characteristic of 'creative destruction', is evidence not of chaos, but of the allocation of a nation's savings to investment in the most productively efficient assets - a necessary condition of rising productivity and standards of living. But human nature being what it is, markets often also reflect these fears and exuberances that are not anchored to reality. A large number, perhaps a majority, of economists and policy makers see the shortfalls of faulty, human-nature-driven markets as requiring significant direction and correction by government.

The problem for policy makers is that there are flaws in both paradigms. For example, a basic premise of competitive markets, especially in finance, is that company management can effectively manage almost any set of complex risks. The recent crisis has cast doubt on this premise. But the presumption that intervention can substitute for market flaws, engendered by the foibles of human nature, is itself highly doubtful. Much intervention turns out to hobble markets rather than enhancing them

.
His incredibly strange, incorrect statement:
For the second half of the 20th century, Americans, belatedly dismayed with the restraints of regulation, dismantled most controls on economic activity.

Where is the uncertainty?
It is impossible to judge the full consequences of the many hundreds of mandated rulemakings required of financial regulators in the years ahead by the Dodd-Frank Act. The degree of complexity and interconnectedness of the global 21st century financial system, even in its current partially disabled form, is doubtless far greater than the implied model of financial cause and effect suggested by the current wave of re-regulation. There will, as a consequence, be many unforeseen market disruptions engendered by the new rules.

Greenspan's Little Bit of Hope:
However, the political kick-back on federal 'bailouts' (and activism generally) may dissuade policy makers from a repetition of the large-sized interventions of the recent past. And if indeed the current crisis is a once-in-a-century event, the current 'anything goes' regulatory ethos in a crisis could eventually fade and deficits may undergo contraction. Importantly, any withdrawal of action to allow the economy to heal could restore some, or much, of the dynamic of the pre-crisis decade, without its imbalances.

Note: I am on vacation at my cottage in Minaki, Canada, which explains my less-frequent posts and my less-than-usual replies to commenters.

Update: Before posting this, I decided to check quickly, given my limited connectivity, what other bloggers were saying about Greenspan's piece. Here's Brad DeLong.


Comments and Sharing


CATEGORIES: Macroeconomics , Regulation



COMMENTS (10 to date)
John Thacker writes:
While I agree with Scott Sumner that Bernanke's monetary policy was too tight when the crisis hit during 2007-2009, I think that is irrelevant now. Why hasn't there been sufficient time for inflexible wages or prices to adjust?

I believe that the general argument here is that inflation has been very low since 2009, and people suffer from money illusion and thus wages are sticky at the zero bound. People dislike 1% wage cuts during 2% inflation a lot more than they dislike 0% wage changes during 3% inflation, or 1% raises during 4% inflation. Therefore it has taken longer for people to adjust.

This explanation is also useful, as Bryan and others note, for 2.

John Thacker writes:

From what I recall, unemployment insurance (which has been repeatedly extended) is based on previous wage, unlike welfare, so the extensions make wages more sticky.

Normally they're supposed to be paid out of insurance premiums, but it seems to me that the repeated long extensions are a form of welfare to people who used to have good jobs. Why should they get more than people who never had good jobs?

Ken B writes:

Minaki! That's near Quetico Park isn't it? I canoed there when I was young. Lovely area.

I am gobsmacked by the statement about dismantling regulations. There was some good deregulation -- long distance, trucking, airlines -- but the federal register weighs more than I do.

Tony N writes:
The problem for policy makers is that there are flaws in both paradigms. For example, a basic premise of competitive markets, especially in finance, is that company management can effectively manage almost any set of complex risks. The recent crisis has cast doubt on this premise. But the presumption that intervention can substitute for market flaws, engendered by the foibles of human nature, is itself highly doubtful. Much intervention turns out to hobble markets rather than enhancing them

But acting in accordance with the second premise can lead to the illusion that the first is wrong as well.

A pair of grandmasters can effectively manage the most complex positions on a chessboard, but if you suddenly change the rules on them on move ten—tell them their bishops no longer move diagonally—then they’re liable to look pretty foolish.

Two Colorado economists say it isn't just tangible business investment;

We develop a novel approach towards measuring cash flow risk, and we consider investment in both tangible and intangible assets. We find that our measures of cash flow uncertainty have a significantly negative impact on corporate employment and corporate investment in both tangible and intangible assets. Economically, if cash flow uncertainty were to revert to levels observed back in 2005, corporate employment would increase by more than 1.89 million jobs, investment in tangible assets would increase by more than 10%, and investment in intangible assets would increase by more than 19%. Furthermore, we document that our risk measures have had a more negative impact on corporate employment and corporate investment in tangible and intangible assets during economic recessions than during economic expansions. These findings have significant policy implications. To wit, if policy makers would like corporations to increase their employment and investment, they should focus on policies that decrease corporate cash flow uncertainty.

MikeP writes:

Those of us who see competitive markets, with rare exceptions, as largely self-correcting are most leery of government intervening on an ongoing basis.

This can't be correct. I have been assured by the mainstream media that Alan Greenspan no longer thinks markets work.

Shayne Cook writes:

First, I applaud Jeff Hummel for stating quite concisely the 1 dominant train of economics thought (Aggregate Demand) applying to the current U.S. economy, and 2 alternative trains of thought - Structural (Kling, Cowen, et.al.) and Regime Uncertainty (Higgs, Greenspan, et.al.). Well done.

Jeff then poses the following very relevant question to the "Aggregate Demand" types (Sumner, et.al. and Krugman, et.al.):

Why hasn't there been sufficient time for inflexible wages or prices to adjust?

The answer to that question is that: Effectively all of the fiscal and monetary stimulus that has thus far been applied to the U.S. economy, has been applied specifically to preclude price adjustment - for both labor and goods/services!

Coincidentally, that same answer serves also to answer much of Jeff's question to the "Structural Unemployment" types (Kling, Cowen, et.al):

But ... why is the amount of structural unemployment so much greater in this recession than in past recessions?

Labor, and particularly unskilled/semi-skilled labor, is competing with a global, not just local (U.S.), labor force. And without a functioning, global market-based "price discovery" mechanism, that sector of the labor force has precisely no incentive to even seek to re-align - find "comparative advantage" - with global labor competition.

Nodnarb the Nasty writes:

I wish this Hummel guy would start blogging. He's obviously got a lot of good stuff bouncing around in his head. T'would be great if he'd be willing to share more often with the rest of us...

Jim Rose writes:

New Keynesian macroeconomics gave up on sticky wages sometime ago.

Next, the issue was sticky prices, but that did not hold up well. Prices changed a little too quickly (every 4 months rather than once a year). Menu costs were too thin a reed.

Next, of late, Mankiw has trumpeted sticky information in response to a growing awareness that the new Keynesian model is hard to square with the facts including not generating persistent movements in output following monetary shocks

It all vindicates Robert Barro’s ‘New Classical and Keynesians, or the Good Guys and the Bad Guys’:
• Instead of providing new theoretical results and hypotheses for empirical testing, the objective often seems to be to provide respectability for the basic viewpoint and policy prescriptions that characterised the old Keynesian models.
• It may well be more rewarding to look instead for new theoretical insights, empirical hypotheses, and policy implications.
Bellante (1992) likewise noted that the search in Keynesian macroeconomics for microeconomic foundations is to blunt criticism, rather than because it is otherwise useful. The analytical apparatus may change, but the policy conclusions are the same.

Shayne Cook writes:

Follow up ... (partly in response to Jim Rose and others):

The fiscal stimulus (deficit spending) that has been applied to the U.S. economy over the past 4+ years is decidedly NOT Keynesian. Keynes advocated deficit financed increases of (G)overnment spending on new goods and services as remedy for anemic AD. Ostensibly, if AD is supported/increased - via increased (G)overnment spending for new goods and services - (I)nvestment spending will increase to service the increased AD. Once that happens, increased (C)onsumption spending is enabled.
THAT, is the Keynes general theory - cause and effect - in a nutshell.

A check of BEA nominal GDP data (see: www.bea.gov, Table 1.1.5) shows that (G)overnment consumption expenditures for new goods and services - as a percentage of GDP - over the past 4 years is only about 1 percentage point above that of the preceding 30 years. And it is actually less than the (G) component of the Reagan years. Remarkable, given Government deficits have been about 10% of GDP over the same 4 year period. If you run the percentages of GDP components (G + I + C + NE) back far enough, you'll see Ronald Reagan was more of a Keynesian than is Barack Obama. (Probably much to David R. Henderson's chagrin, a substantial portion of Reagan's Keynesianism was applied to the purchase of new defense-related goods and services.)

Point being, the exorbitant Government deficit spending of the past 4 years has NOT been applied to direct purchases of new goods and services, as Keynes advocated. It has NOT therefore directly increased AD or GDP. Furthermore, it has dissuaded/precluded new (I)nvestment spending. (See Greenspan paper, linked).

The exorbitant Government deficit spending of that past 4 years - and into the foreseeable future - has been solely and exclusively transfer payments increase.

That deficit-financed transfer payment expansion has had two major net effects - only 1 of which has any immediate impact on AD/GDP:
1.) Prop up (C)onsumption spending - at previously high price levels*, and
2.) Transference of a great deal of private debt into public debt.

* Note on (C)onsumption spending: The oft-cited Consumption spending component of GDP at 70% is misleading. Consumption, as a percentage of GDP over the previous 30 years or so, has averaged about 67% of GDP - although consistently rising. (C)onsumption spending, as a percentage of GDP in 2011 (the last full year in the BEA table), stands at 71.07% of GDP. (C)onsumption spending was about 66% of nominal GDP when I first started teaching college level economics back in the mid-1990s.

It's little wonder then that the exorbitant levels of fiscal stimulus have thus far failed to budge either AD or GDP. It isn't Keynesian spending. Fiscal spending has, in effect, and monetary policy, with intent, merely propped up prices and thereby precluded deflation.

While precluding (or attenuating) deflation is a laudable goal in and of itself, sustained price supports of this magnitude certainly dissuade and virtually preclude price adjustments.

To Greenspan's paper/assertions (and Higgs, I presume), (I)nvestment spending component of GDP is anemic and will stay that way as long as price levels are not market-based, but instead "propped up" only by known unsustainable levels of fiscal and monetary stimulus.

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