Gregory Mankiw's Pop Quiz on the Economy

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Saturday, 07 May 2011 13:08

In his weekly column in the NYT, Gregory Mankiw gave a three question quiz for economists. His questions are:

1) How long will it take for the economy’s wounds to heal?

2) How long will inflation expectations remain anchored?

3) How long will the bond market trust the United States?

Let's start with questions 2 and 3, because these are easier. 

The answer to question number 2 seems obvious -- as long as there is no inflation. Why should people expect inflation when they are not seeing any? There is no evidence of generalized cost pressure in the economy as all indexes of wages are showing the rate of wage growth remaining pretty much constant. Commodity prices did rise, but this was mostly just a return to pre-recession levels, and it is not clear that these prices are even sticking at their higher level. This question is sort of like asking in the middle of a drought in the desert, when will people expect rain? Presumably when they see clouds on the horizon and not until then.

The answer to question 3 largely follows the answer to question 2. After all, the real threat to those holding U.S. government bonds is inflation, not insolvency, unlike the euro zone countries that Mankiw refers to in his piece. The United States can always print more dollars to meet its obligations. Greece cannot do the same with euros.

The idea being pushed by many in policy circles that at some point the bond markets will lose faith in the ability of the U.S. government to pay its debts is absurd on its face. This would be like saying that if I issued iou's, that were payable in my iou's, that the markets would be worried about my ability to meet my commitments.

Ultimately there can be an issue of inflation, where the markets would worry that the United States might print so much money as to seriously reduce the value of its currency, but this just brings us back to question #2. With inflation nowhere on the horizon, it is difficult to see why the bond markets would have this concern any time in the near future.

Okay, on to question #1. This is obviously a trick question, since it depends on what policies the country pursues. If the deficit hawks get full control over the levers of government and we start cutting spending rapidly, then it will take many many years before the economy recovers.

Similarly, if inflation hawks at the Fed can force increases in interest rates, like their counterparts at the European Central Bank, then recovery can take a very long time.

On the other hand, if we could get another big jolt of stimulus, a more aggressive monetary policy, or a big fall in the dollar to boost net exports, then we could see the economy recover fairly quickly. However, this is a political question, not an economic one, so Mankiw is being tricky by slipping it into his econ quiz.

Mankiw's gets in a cheap shot against the Obama administration in framing this question. He tells readers:

"When President Obama took office in 2009, his economic team projected a quick recovery from the recession the nation was experiencing. The administration’s first official forecast said economic growth, computed from fourth quarter to fourth quarter, would average 3.5 percent in 2010 and 4.4 percent in 2011. Unemployment was supposed to fall to 7.7 percent by the end of 2010 and to 6.8 percent by the end of 2011.

"The reality has turned out not nearly as rosy. Growth was only 2.8 percent last year, and the first quarter of this year came in at a meager rate of 1.8 percent. Unemployment, meanwhile, lingers well above 8 percent, and according to Ben S. Bernanke, the Federal Reserve chairman, is expected to keep doing so throughout this year.

"Economists will long debate whether President Obama’s policies are to blame or the patient was just sicker than his economists realized."

Actually, the forecasts were not so much wrong about the pace of the recovery as they were about the severity of the downturn. The first forecast from the Obama team assumed that in the absence of any stimulus the unemployment rate would peak at around 9.0 percent in the first quarter of 2010. Instead, with the economy losing more than 600,000 jobs a month at the time President Obama took office, the unemployment rate soared to 9.3 percent by the second quarter of 2009, just as the stimulus package was first having an impact.

One needs only to compare the projections to the actual data at the time when the Obama program first went into effect to know that there is no doubt that the "patient was just sicker than the economists realized." It is difficult to understand how honest economists could debate this proposition.

Nor is it easy to understand the purpose of the comparison to the growth following the 1981-82 recession:

"But there is no doubt that the pace of this recovery will come nowhere close to matching the one achieved after the last deep recession, when President Ronald Reagan presided over a fall in the unemployment rate from 10.8 percent in December 1982 to 7.3 percent two years later."

The recession of the early 1980s was a classic Fed-induced recession. The recession came about because the Fed pushed interest rates through the roof. The answer was easy: lower interest rates. When the Fed did lower rates, there was enormous pent-up demand for houses and cars, which sent the economy soaring. The last recession was not started by high interest rates and there is no pent-up demand for housing (maybe to some extent cars) to tap. Is it really surprising that we can't follow the same path to recovery this time?