Tuesday, June 1, 2010

Growth, stabilization and recovery policies

Mark Thoma has two interesting posts that differentiate between macroeconomic policies that are pursued to promote economic growth (policy that attempts to maximize the long-run growth rate) and stabilize growth (keeping the economy as close as possible to the long-run growth path).

Since the early 1980s, coinciding with the period of "The Great Moderation", pursuing the stabilization policy using the prevailing New Keynesian model involved "targeting an interest rate with a Taylor rule that responds to output and inflation, where the response to inflation was more than one to one". The remarkable, two-decade long stability (in growth and inflation) gave the impression that the business cycle had been conquered (and optimal stabilization policy achieved) using monetary policy. It was now felt that all other macroeconomic policy levers, including fiscal policy, could now be deployed to pursue the maximum growth objective.

This conventional wisdom meant that even when the world economy entered the Great Recession, policy-makers were interested in pursuing policies like tax cuts and infrastructure spending that were skewed more towards long-run economic growth instead of stabilization. He writes,

"Other types of spending, the types that get money into people’s hands and puts people to work right away, might have worked faster and had a greater benefit in terms of moving the economy closer to trend, but since these policies were harder to justify in terms of their contribution to long-run growth, they could not find the support they needed...

The policies that maximize growth are different from the polices that stabilize the economy, and insistence that all policies can be justified by their contribution to long-run growth causes us to sacrifice economic stability. The policies we put into place should pay attention to both goals, but I believe we have paid far too much attention to growth in formulating recent policy, and not nearly enough to stability... we have to realize that stabilization is an important policy goal, and that it does not always lead to the same policies that are needed to maximize growth."

In another article, Mark Thoma examines the policies required to stabilize the economy by effectively managing an economic recovery. Primarily, given the uncertainty surrounding the nature of the recovery (V, U, L, W-shaped) and the persistance of high unemployment rate, he argues that any exit from the expansionary fiscal and monetary stimuluses may be premature. Given the clear lag between economic recovery, the magnitude of the job losses, and the extent and duration of growth required to reach normalcy in the labor markets, specific policies aimed at adding jobs would be essential to make any meaningful dent on the unemployment situation even on the medium-term.

The emergence of structural unemployment due to the shake-ups in the housing and financial sectors and general business re-organization in response to the recession, means that millions of workers may have to re-equip themselves with newer skills. Passively relying on economic growth and the dynamics of the markets is only likely to create the conditions for a painful and slow recovery path. Aggressive government intervention in the form of specifically tailored job-creation policies is a necessity. Mark Thoma also advocates support for state and local governments, whose forced contractionary policies, have the potential to off-set the beneficial effects of any centrally managed stimulus programs.

See earlier posts here, here, and here which talk specifically about job-creation policies.

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