Stanley Fischer: Reflections on macroeconomics then and now
Speech by Mr Stanley Fischer, Vice Chair of the Board of Governors of the Federal Reserve
System, at the "Policy Challenges in an Interconnected World" 32nd Annual National
Association for Business Economics Economic Policy Conference, Washington DC, 7 March
2016.
* * *
The chart can be found at the Board of Governors of Federal Reserve System's website
I am grateful to David Lopez-Salido, Andrea Ajello, Elmar Mertens, Stacey Tevlin, and Bill English of the Federal
Reserve Board for their assistance. Views expressed are mine, and are not necessarily those of the Federal
Reserve Board or the Federal Open Market Committee.
I am grateful to the National Association for Business Economics (NABE) for conferring the
fourth annual NABE Paul A. Volcker Lifetime Achievement Award for Economic Policy on me,
thereby allowing me the honor of following in the footsteps of Paul Volcker, Jean-Claude
Trichet, and Alice Rivlin. The honor of receiving the award is enhanced by its bearing the name
of Paul Volcker, a model citizen and public servant, and a giant in every sense among central
bankers.
One thinks of many things on an occasion such as this one. My mind goes back first to growing
up in a very small town in Zambia, then Northern Rhodesia, and to the surprise and delight my
parents would have felt at seeing me standing where I am now. They would have been even
more delighted that my girlfriend, Rhoda, whom I met when my parents moved to a bigger
town in Zimbabwe, and I have been happily married for 50 years. But that is not the story I will
tell today. Rather, I want to talk about our field, macroeconomics, and some of the lessons we
have learned in the course of the last 55 years - and I say 55 years, because in 1961, at the
end of my school years, on the advice of a friend, I read Keynes's General Theory for the first
time.
Did I understand it? Certainly not. Was I captivated by it? Certainly, though "captured" is a
more appropriate word than "captivated." Does it remain relevant? Certainly. Just a week ago
I took it off the bookshelf to read parts of chapter 23, "Notes on Mercantilism, the Usury Laws,
Stamped Money and Theories of Under-Consumption." Today that chapter would be headed
"Protectionism, the Zero Lower Bound, and Secular Stagnation," with the importance of usury
laws having diminished since 1936.
There is an old joke about our field - not the one about the one-handed economist, nor the
one about "assume you have a can opener," nor the one that ends, "If I were you, I wouldn't
start from here." Rather it's the one about the Ph.D. economist who returns to his university for
his class's 50th reunion. He asks if he can see the most recent Ph.D. generals exam. After a
while it is brought to him. He reads it carefully, looking perplexed, and then says, "But this is
exactly the same as the exam I wrote over 50 years ago." "Ah yes," says the professor. "It is
the same, but all the answers are different."
Is that really the case? Not really, though it is true to some extent in the realm of policy. To
discuss the question of whether the answers to the questions of how to deal with
macroeconomic policy problems have changed markedly over the past half-century or so, I will
start by briefly sketching the structure of a basic macro model. The building blocks of this model
are similar to those used in many macro models, including FRB/US, the Fed staff's large-scale
model, and a variety of DSGE (dynamic stochastic general equilibrium) models used at the
Fed and other central banks and by academic researchers.
The structure of the model starts with the standard textbook equation for aggregate demand
for domestically produced goods, namely:1
1. ;
2. Next is the wage-price block, which is based on a wage or price Phillips curve. Okun's
law is included to make the transition between output and employment;
3. Monetary policy is described by a money supply or interest rate rule;
4. The credit markets and financial intermediation are built off links between the policy
interest rate and the rates of return on, and/or demand and supply functions for, other
assets;
5. The balance of payments and the exchange rate enter through the balance of
payments identity, namely that the current account surplus must be equal to the
capital account deficit, corrected for official intervention;
6. Dynamics of stocks: There are dynamic equations for the capital stock, the stock of
government debt, and the external debt.
When I was an undergraduate at the London School of Economics (LSE) between 1962 and
1965, we learned the IS-LM model, which combined the aggregate demand equation (1) with
the money market equilibrium condition set out in (3). That was the basic understanding of the
Keynesian model as crystallized by John Hicks, Franco Modigliani, and others, in which it was
easy to add detail to the demand functions for private-sector consumption, C; for investment,
I; for government spending, G; and for net exports. The Keynesian emphasis on aggregate
demand and its determinants is one of the basic innovations of the Keynesian revolution, and
one that makes it far easier to understand and explain what factors are determining output and
employment.
Continuing down the list, on price and wage dynamics, the Phillips curve has flattened
somewhat since the 1950s and 1960s.2 Further, the role of expectations of inflation in the
Phillips curve has been developed far beyond what was understood when A.W. Phillips - who
was a New Zealander, an LSE faculty member, and a statistician and former engineer -
discovered what later became the Phillips curve. The difference between the short- and
longrun Phillips curves, which is now a staple of textbooks, was developed by Milton Friedman and
Edmund Phelps, and the effect of making expectations rational or model consistent was
emphasized by Robert Lucas, whose islands model provided an imperfect information reason
for a nonvertical short-run Phillips curve. In Okun's law, the Okun coefficient - the coefficient
specifying how much a change in the unemployment rate affects output - appears to have
declined over time. So has the trend rate of productivity growth, which is a critical determinant
of future levels of per capita income.
In (3), the monetary equilibrium condition, the monetary policy decision was typically
represented by the money stock at the LSE and perhaps also at the Massachusetts Institute
of Technology (MIT) after the Keynesian revolution (after all, "L" represents the liquidity
preference function and "M" the supply of money); now the money supply rule is replaced by
an interest-rate setting rule, for instance a reaction function of some form, or by a calculated
"optimal" policy based on a loss function.
The development of the flexible inflation-targeting approach to monetary policy is one of the
major achievements of modern macroeconomics. Flexible inflation targeting allows for
flexibility in the speed with which the monetary authority plans on returning to the target inflation
rate, and is thereby close to the dual mandate that the law assigns to the Fed.
A great deal of progress has been made in developing the credit and financial intermediation
block. As early as the 1960s, each of James Tobin, Milton Friedman, and Karl Brunner and
Alan Meltzer wrote out models with more fully explicated financial sectors, based on demand
functions for assets other than money. Later the demand functions were often replaced by
pricing equations derived from the capital asset pricing model. Researchers at the Fed have
been bold enough to add estimated term and risk premiums to the determination of the returns
on some assets.3 They have concluded, inter alia, that the arguments we used to make about
how easy it would be to measure expected inflation if the government would introduce
inflationindexed bonds failed to take into account that returns on bonds are affected by liquidity and
risk premiums. This means that one of the major benefits that were expected from the
introduction of inflation-indexed bonds (Treasury Inflation-Protected Securities, generally
called TIPS), namely that they would provide a quick and reliable measure of inflation
expectations, has not been borne out, and that we still have to struggle to get reasonable
estimates of expected inflation.
As students, we included NX, net exports, in the aggregate demand equation, but we did not
generally solve for the exchange rate, possibly because the exchange rate was typically fixed.
Later, in 1976, Rudi Dornbusch inaugurated modern international macroeconomics - and here
I'm quoting from a speech by Ken Rogoff - in his famous overshooting model.4 As globalization
of both goods and asset markets intensified over the next 40 years, the international aspects
of trade in goods and assets occupied an increasingly important role in the economies of
virtually all countries, not least the United States, and in macroeconomics.
At the LSE, we took a course on the British economy from Frank Paish, whose lectures
consisted of a series of charts, accompanied by narrative from the professor. He made a strong
impression on me in a lecture in 1963, in which he said, "You see, it (the balance of payments
deficit) goes up and it goes down, and it is clear that we are moving toward a balance of
payments crisis in 1964." I waited and I watched, and the crisis appeared on schedule, as
predicted. But Paish also warned us that forecasting was difficult, and gave us the advice
"Never look back at your forecasts - you may lose your nerve." I pass that wisdom on to those
of you who need it.
I remember also my excitement at being told by a friend in a more senior class about the
existence of econometric models of the entire economy. It was a wonderful moment. I
understood that economic policy would from then on be easy: All that was necessary was to
feed the data into the model and work out at what level to set the policy parameters.
Unfortunately, it hasn't worked out that way. On the use of econometric models, I think often
of something Paul Samuelson once said: "I'd rather have Bob Solow's views than the
predictions of a model. But I'd rather have Solow with a model than without one."
We learned a lot at the LSE. But wonderful as it was to be in London, and to meet people from
all over the world for the first time, and to be able to travel to Europe and even to the Soviet
Union with a student group, and to ski for the first time in my life in Austria, it gradually became
clear to me that the center of the academic economics profession was not in London or Oxford
or Cambridge, but in the United States.
There was then the delicate business of applying to graduate school. There was a strong
Chicago tendency among many of the lecturers at the LSE, but I wanted to go to MIT. When
asked why, I gave a simple answer: "Samuelson and Solow." Fortunately, I got into MIT and
had the opportunity of getting to know Samuelson and Solow and other great professors. And
I also met the many outstanding students who were there at the time, among them Robert
Merton. I took courses from Samuelson and Solow and other MIT stars, and I wrote my thesis
under the guidance of Paul Samuelson and Frank Fisher. From there, my first job was at the
University of Chicago - and I understood that I was very lucky to have been able to learn from
the great economists at both MIT and Chicago. Among the many things I learned at Chicago
was a Milton Friedman saying: "Man may not be rational, but he's a great rationalizer," which
is a quote that often comes to mind when listening to stock market analysts.
After four years at Chicago, I returned to the MIT Department of Economics, and thought that
I would never leave - even more so when MIT succeeded in persuading Rudi Dornbusch,
whom I had met when he was a student at Chicago, to move to MIT - thus giving him too the
benefit of having learned his economics at both Chicago and MIT, and giving MIT the pleasure
and benefit of having added a superb economist and human being to the collection of such
people already present.
MIT was still heavily involved in developing growth theory at the time I was a Ph.D. student
there, from 1966 to 1969. We students were made aware of Kaldor's stylized facts about the
process of growth, presented in his 1957 article "A Model of Economic Growth." They were:
1. The shares of national income received by labor and capital are roughly constant over
long periods of time.
2. The rate of growth of the capital stock per worker is roughly constant over long periods
of time.
3. The rate of growth of output per worker is roughly constant over long periods of time.
4. The capital/output ratio is roughly constant over long periods of time.
5. The rate of return on investment is roughly constant over long periods of time.
6. The real wage grows over time.
Well, that was then, and many of the problems we face in our economy now relate to the
changes in the stylized facts about the behavior of the economy: Every one of Kaldor's stylized
facts is no longer true, and unfortunately the changes are mostly in a direction that complicates
the formulation of economic policy.5
While the basic approach outlined so far remains valid, and can be used to address many
macroeconomic policy issues, I would like briefly to take up several topics in more detail. Some
of them are issues that have remained central to the macroeconomic agenda over the past 50
years, some have to my regret fallen off the agenda, and others are new to the agenda.
1.
Inflation and unemployment: Estimated Phillips curves appear to be flatter than they
were estimated to be many years ago - in terms of the textbooks, Phillips curves
appear to be closer to what used to be called the Keynesian case (flat Phillips curve)
than to the classical case (vertical Phillips curve). Since the U.S. economy is now
below our 2 percent inflation target, and since unemployment is in the vicinity of full
employment, it is sometimes argued that the link between unemployment and inflation
must have been broken. I don't believe that. Rather the link has never been very
strong, but it exists, and we may well at present be seeing the first stirrings of an
increase in the inflation rate - something that we would like to happen.
2. Productivity and growth: The rate of productivity growth in the United States and in
much of the world has fallen dramatically in the past 20 years. The table shows
calculated rates of annual productivity growth for the United States over three periods:
1952 to 1973; 1974 to 2007; and the most recent period, 2008 to 2015. After having
been 3 percent and 2.1 percent in the first two periods, the annual rate of productivity
growth has fallen to 1.2 percent in the period since the start of the global financial
crisis.
The right guide to thinking in this case is given by a famous Herbert Stein line: "The
difference between a growth rate of 1 percent and 2 percent is 100 percent." Why?
Productivity growth is a major determinant of long-term growth. At a 1 percent growth
rate, it takes income 70 years to double. At a 2 percent growth rate, it takes 35 years
to double. That is to say, that with a growth rate of 1 percent per capita, it takes two
generations for per capita income to double; at a 2 percent per capita growth rate, it
takes one generation for per capita income to double. That is a massive difference,
one that would very likely have severe consequences for the national mood, and
possibly for economic policy. That is to say, there are few issues more important for
the future of our economy, and those of every other country, than the rate of
productivity growth.
At this stage, we simply do not know what will happen to productivity growth. Robert
Gordon of Northwestern University has just published an extremely interesting and
pessimistic book that argues we will have to accept the fact that productivity will not
grow in future at anything like the rates of the period before 1973. Others look around
and see impressive changes in technology and cannot believe that productivity growth
will not move back closer to the higher levels of yesteryear.6 A great deal of work is
taking place to evaluate the data, but so far there is little evidence that data difficulties
account for a significant part of the decline in productivity growth as calculated by the
Bureau of Labor Statistics.7
3. The ZLB and the effectiveness of monetary policy: From December 2008 to
December 2015, the federal funds rate target set by the Fed was a range of 0 to
1⁄4 percent, a range of rates that was described as the ZLB (zero lower bound).8
Between December 2008 and December 2014, the Fed engaged in QE - quantitative
easing - through a variety of programs. Empirical work done at the Fed and elsewhere
suggests that QE worked in the sense that it reduced interest rates other than the
federal funds rate, and particularly seems to have succeeded in driving down
longerterm rates, which are the rates most relevant to spending decisions.
Critics have argued that QE has gradually become less effective over the years,
and should no longer be used. It is extremely difficult to appraise the effectiveness
of a program all of whose parameters have been announced at the beginning of the
program. But I regard it as significant with respect to the effectiveness of QE that the
taper tantrum in 2013, apparently caused by a belief that the Fed was going to wind
down its purchases sooner than expected, had a major effect on interest rates.
More recently, critics have argued that QE, together with negative interest rates,
is no longer effective in either Japan or in the euro zone. That case has not yet
been empirically established, and I believe that central banks still have the
capacity through QE and other measures to run expansionary monetary policies,
even at the zero lower bound.
4. The monetary-fiscal policy mix: There was once a great deal of work on the optimal
monetary-fiscal policy mix. The topic was interesting and the analysis persuasive.
Nonetheless the subject seems to be disappearing from the public dialogue; perhaps
in ascendance is the notion that - except in extremis, as in 2009 - activist fiscal policy
should not be used at all. Certainly, it is easier for a central bank to change its policies
than for a Treasury or Finance Ministry to do so, but it remains a pity that the fiscal
lever seems to have been disabled.
5. The financial sector: Carmen Reinhart and Ken Rogoff's book, This Time Is
Different, must have been written largely before the start of the great financial crisis.
I find their evidence that a recession accompanied by a financial crisis is likely to be
much more serious than an ordinary recession persuasive, but the point remains
contentious. Even in the case of the Great Recession, it is possible that the U.S.
recession got a second wind when the euro-zone crisis worsened in 2011. But no one
should forget the immensity of the financial crisis that the U.S. economy and the world
went through following the bankruptcy of Lehman Brothers - and no one should forget
that such things could happen again.
The subsequent tightening of the financial regulatory system under the Dodd-Frank
Act was essential, and the complaints about excessive regulation and excessive
demands for banks to hold capital betray at best a very short memory. We, the official
sector and particularly the regulatory authorities, do have an obligation to try to
minimize the regulatory and other burdens placed on the private sector by the official
sector - but we have a no less important obligation to try to prevent another financial
crisis. And we should also remember that the shadow banking system played an
important role in the propagation of the financial crisis, and endeavor to reduce the
riskiness of that system.
6. The economy and the price of oil: For some time, at least since the United States
became an oil importer, it has been believed that a low price of oil is good for the
economy. So when the price of oil began its descent below $100 a barrel, we kept
looking for an oil-price-cut dividend. But that dividend has been hard to discern in the
macroeconomic data. Part of the reason is that as a result of the rapid expansion of
the production of oil from shale, total U.S. oil production had risen rapidly, and so a
larger part of the economy was adversely affected by the decline in the price of oil.
Another part is that investment in the equipment and structures needed for shale oil
production had become an important component of aggregate U.S. investment, and
that component began a rapid decline. For these reasons, although the United States
has remained an oil importer, the decrease in the world price of oil had a mixed effect
on U.S. gross domestic product. There is reason to believe that when the price of oil
stabilizes, and U.S. shale oil production reaches its new equilibrium, the overall effect
of the decline in the price of oil will be seen to have had a positive effect on aggregate
demand in the United States, since lower energy prices are providing a noticeable
boost to the real incomes of households.
7. Secular stagnation: During World War II in the United States, many economists
feared that at the end of the war, the economy would return to high pre-war levels of
unemployment - because with the end of the war, demobilization, and the massive
reduction that would take place in the defense budget, there would not be enough
demand to maintain full employment.
Thus was born or renewed the concept of secular stagnation - the view that the
economy could find itself permanently in a situation of low demand, less than full
employment, and low growth.9 That is not what happened after World War II, and the
thought of secular stagnation was correspondingly laid aside, in part because of the
growing confidence that intelligent economic policies - fiscal and monetary - could
be relied on to help keep the economy at full employment with a reasonable growth
rate.
Recently, Larry Summers has forcefully restated the secular stagnation hypothesis,
and argued that it accounts for the current slowness of economic growth in the United
States and the rest of the industrialized world. The theoretical case for secular
stagnation in the sense of a shortage of demand is tied to the question of the level of
the interest rate that would be needed to generate a situation of full employment. If
the equilibrium interest rate is negative, or very small, the economy is likely to find
itself growing slowly, and frequently encountering the zero lower bound on the interest
rate.
Research has shown a declining trend in estimates of the equilibrium interest rate.
That finding has become more firmly established since the start of the Great
Recession and the global financial crisis.10 Moreover, the level of the equilibrium
interest rate seems likely to rise only gradually to a longer-run level that would still be
quite low by historical standards.
What factors determine the equilibrium interest rate? Fundamentally, the balance of
saving and investment demands. Several trends have been cited as possible factors
contributing to a decline in the long-run equilibrium real rate. One likely factor is
persistent weakness in aggregate demand. Among the many reasons for that, as
Larry Summers has noted, is that the amount of physical capital that the revolutionary
information technology firms with high stock market valuations have needed is
remarkably small. The slowdown of productivity growth, which as already mentioned
has been a prominent and deeply concerning feature of the past six years, is another
important factor.11 Others have pointed to demographic trends resulting in there being
a larger share of the population in age cohorts with high saving rates.12 Some have
also pointed to high saving rates in many emerging market countries, coupled with a
lack of suitable domestic investment opportunities in those countries, as putting
downward pressure on rates in advanced economies - the global savings glut
hypothesis advanced by Ben Bernanke and others at the Fed about a decade ago.13
Whatever the cause, other things being equal, a lower level of the long-run equilibrium
real rate suggests that the frequency and duration of future episodes in which
monetary policy is constrained by the ZLB will be higher than in the past. Prior to the
crisis, some research suggested that such episodes were likely to be relatively
infrequent and generally short lived.14 The past several years certainly require us to
on this issue among economists, but the views to some extent appear to depend on whether the economist
making the prediction is an optimist or a pessimist.
10
This research includes recent work by Johannsen and Mertens (2015) and Kiley (2015) that uses extensions of
the original Laubach and Williams (2003) framework. An international perspective on medium-to-long-run real
interest rates is provided by U.S. Executive Office of the President (2015). Reinhart and Rogoff (2009) and Hall
(2014) discuss the long-lived effects of financial crises on economic performance. See also Hamilton and others
(2015). I have, in addition, drawn on Fischer (forthcoming).
11
It is also a major factor explaining the phenomenon of the economy's impressive performance on the jobs front
during a period of historically slow growth.
12
See, for instance, Gordon (2014, 2016).
13
See Bernanke (2005). See also the recent work by Caballero, Farhi, and Gourinchas (2008); and Mendoza,
Quadrini, and Rios-Rull (2009).
14
See, for instance, Reifschneider and Williams (2000), Blanchard and Simon (2001), and Stock and Watson
(2003).
reconsider that basic assumption. Moreover, recent experience in the United States
and other countries has taught us that conducting monetary policy at the effective
lower bound is challenging.15 And while unconventional policy tools such as forward
guidance and asset purchases have been extremely helpful and effective, all central
banks would prefer a situation with positive interest rates, restoring their ability to use
the more traditional interest rate tool of monetary policy.16
The answer to the question "Will the equilibrium interest rate remain at today's low
levels permanently?" is also that we do not know. Many of the factors that determine
the equilibrium interest rate, particularly productivity growth, are extremely difficult to
forecast. At present, it looks likely that the equilibrium interest rate will remain low for
the policy-relevant future, but there have in the past been both long swings and
shortterm changes in what can be thought of as equilibrium real rates.
Eventually, history will give us the answer. But it is critical to emphasize that history's
answer will depend also on future policies, monetary and other, notably including
fiscal policy.
Concluding remarks
Well, are the answers all different than they were 50 years ago? No. The basic framework we
learned a half-century ago remains extremely useful. But also yes: Some of the answers are
different because they were not on previous exams because the problems they deal with were
not evident fifty years ago. So the advice to potential policymakers is simple: Learn as much
as you can, for most of it will come in useful at some stage of your career; but never forget that
identifying what is happening in the economy is essential to your ability to do your job, and for
that you need to keep your eyes, your ears, and your mind open, and with regard to your mouth
- to use it with caution.
Many thanks again for this award and this opportunity to speak with you.
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