This year began with recession fears throwing a spotlight on the elephant in the room. As the cover of The Economist put it a few weeks back – central banks may be out of ammo to fight recession.
How and why did we get here?
As students of the business cycle we have a perspective that is different from that of most mainstream economists. Because of our focus on cycles, we have a good handle on what is cyclical and, by elimination, what is not.
This is why, back in the summer of 2008, pre-Lehman, we were able to first identify the long-term pattern of weaker and weaker growth during successive expansions, stretching back to the 1970s. In fact, Eduardo, your New York Times colleague Floyd Norris wrote about our findings at the time.
In April 2009, in the depths of the Great Recession, the talk at the London G20 conference was all about Depression, but that same month ECRI predicted that the U.S. recession would end by the summer of 2009. And so it did.
By early 2010, the reality of the new expansion had engendered expectations of a V-shaped recovery, given the depth of the downturn. As I recall, there was much talk of the so-called “Zarnowitz Rule” invoked by the IMF’s late Michael Mussa, to the effect that the deeper the recession, the stronger the initial stage of the revival.
Wouldn’t you know it, that quickly got simplified to: “the deeper the recession, the stronger the revival,” dropping the key qualifier “initial stage.”
Perhaps this simplified version gained so much traction because it fit well with Milton Friedman’s plucking model, where he envisioned output as a string attached to an upwardly sloping ceiling, being occasionally plucked down by recessionary shocks; following which the string snaps back to the upwardly sloping ceiling, again in line with the simplified Zarnowitz rule.
The gap between these flawed expectations of revival and the reality of growth slumping in the so-called “recovery summer” of 2010 supported the case for what became a Grand Experiment, starting with QE2 that fall, intended to boost the economy to “escape velocity;” in other words, to boost the economy to a self-sustaining course, back to “business as usual,” with long-term trend growth around 3%.
But instead of questioning those assumptions, after years of zero interest rate policy (ZIRP) and quantitative easing (QE) failing to achieve that objective, the Fed and other central banks kept doubling down.