The Economist: Improvements in Productivity Need to Be Accommodated by Monetary Policy

I was delighted see that the Economist noticed my paper with Susanto Basu and John Fernald: "Are Technology Improvements Contractionary?" This is the paper for which the first sentence in the abstract is simply "Yes." Even better, the Economist interpreted it correctly: the historical pattern of technology improvements being contractionary is an indictment of the historical monetary policy response to technology shocks. 

Standard optimal monetary policy theory suggests that monetary policy should come close to stabilizing the price level around a steady trend. The failure of monetary policy to do this in response to technology shocks can be seen in these estimated impulse responses:


The failure to have sufficiently stimulative monetary policy after technology improvements results in the dysfunctional impulse responses shown below, in which employment and investment fall in response to an improvement in technology!


One of the underappreciated aspects of these results is what strong evidence they provide against real business cycle models. Nothing that comes anywhere close to a social planner's problem would result in a reduction in investment in response to an immediate permanent technology improvement that we estimate. And if the technology improvement was predicted in advance, a negative response of investment to the actual arrival of the technology improvement would be even harder to generate.  

It isn't that the real business cycle model couldn't be approximately true in the future: better monetary policy would make the economy behave a lot like a real business cycle model would say it should. The "Divine Coincidence" of monetary policy is that keeping prices on a steady track is exactly what is needed to keep output, employment, investment, the real interest rate and so on at the natural level that a real business model would deliver. There may be modest departures from the Divine Coincidence, but if a central bank were doing monetary policy as it should, it would be quite difficult to statistically distinguish the behavior of the economy from what a real business cycle model would lead to. 

Monetary policy does not act instantaneously. Even with excellent monetary policy, the economy may be away from the natural level for 9 to 15 months after an unexpected shock, simply do to the lags in the effects of monetary policy. But there is forewarning for many shocks, and shocks that act through the financial system are likely to have the same lags in their effects as monetary policy, so vigorous enough monetary countermeasures should be able to limit damage to a few month's time after a financial shock that does not diminish the long-run capacity of the economy. A key point though, is that "vigorous enough" may mean using negative interest rates for a brief period of time until the economy is put to rights and positive interest rates can be restored. On this, see my post "On the Great Recession."  

Here is the paragraph in which the Economist refers to our paper, after positing a new high-skilled-labor-saving medical technology:

Indeed, in a paper published in 2006, Susantu Basu, John Fernald and Miles Kimball concluded that advances in technology are usually contractionary, tending to nudge economies towards slump conditions. They estimated that technological improvements tend to depress the use of capital and labour (think, in this example, stethoscopes and doctors) and business investment (new clinics) for up to two years. To those living through such periods, this depressing effect would show up in lower inflation and wage rises. That, in turn, suggests that an alert central bank with an inflation target ought to swing into action to provide more monetary stimulus and keep price and wage growth on track. That stimulus should spur more investment in growing parts of the economy, helping them to absorb quickly the resources freed up by the new, doctor-displacing technology and thus averting a slump.

The Economist then proceeds to diagnose why central banks might do this:

Two obstacles usually get in the way of such a benign outcome. First, these steps unfold with a lag. The slowdown in price and wage growth will be gradual, as displaced workers tighten their belts and compete with other jobseekers for new employment. Central banks might then wait to see whether low inflation reflects a genuine economic trend or is merely a statistical blip. Even after they act, their tools take time to have an effect.

To the extent the Economist is right in its diagnosis, I have these several things to say to central bankers caught in this kind of thinking. First, a track of prices that is too low is something that should be corrected just as quickly as a track of prices that is too high. If you don't think so, you probably have too high a long-run inflation target, as I discuss in "The Costs and Benefits of Repealing the Zero Lower Bound...and Then Lowering the Long-Run Inflation Target." With a zero inflation target, the idea that prices going off track in the downward direction is just as serious as prices going off track in the upward direction is easier to feel at a gut level. Second, central banks should act quickly on whatever information they have, knowing that they can reverse course quickly if further information points in the opposite direction. Third, as I have emphasized at many central banks in my visits to central banks around the world, central banks should begin a major international cooperative effort to monitor early signs of technological change. 

I discuss these monetary policy issues and more in my paper "Next Generation Monetary Policy."


Thanks to Ori Heffetz for alerting me to this article in the Economist