Jeffrey Sachs's new SciAm column titled “The Economic Need for Stable Policies, Not a Stimulus” forcefully reinforces the lesson I drew from my interviews with Prescott and Phelps. Sachs highlights:
The U.S. political-economic system gives evidence of a phenomenon known as “instrument instability.” Policy makers at the Federal Reserve and the White House are attempting to use highly imperfect monetary and fiscal policies to stabilize the national economy. The result, however, has been ever-more desperate swings in economic policies in the attempt to prevent recessions that cannot be fully eliminated.
President Barack Obama’s economic team is now calling for an unprecedented stimulus of large budget deficits and zero interest rates to counteract the recession. These policies may work in the short term but they threaten to produce still greater crises within a few years. Our recovery will be faster if short-term policies are put within a medium-term framework in which the budget credibly comes back to balance and interest rates come back to moderate sustainable levels.
Looking back to the late 1990s, there is little doubt that unduly large swings in macroeconomic policies have been a major contributor to our current crisis. …
We need to avoid reckless short-term swings in policy. Massive deficits and zero interest rates might temporarily perk up spending but at the risk of a collapsing currency, loss of confidence in the government and growing anxieties about the government’s ability to pay its debts. That outcome could frustrate rather than speed the recovery of private consumption and investment.
Most important, we should stop panicking. One of the reasons we got into this mess was the Fed’s exaggerated fear in 2002 and 2003 that the U.S. was following Japan into a decade of stagnation caused by deflation (falling prices). To avoid a deflation the Fed created a bubble. Now the bubble has burst, and we’ve ended up with the deflation we feared!
By the way, here's my earlier post on “Managing Expectations Better.”
Prescott told me that he considers economic theory that treats the economy like a machine attached to policy levers that can be pulled to achieve the intended outcomes to be pseudoscience. He actually compared stimulus-mongering Keynesians to chemists before Dalton. (I gathered that Dalton is Robert Lucas.) Commenter Odograph gave me a bit of grief for quoting Prescott saying “Stimulus is not part of the language of economics,” when of course, as Mankiw's poll shows, 90% of economists believe you can get a growth boost by fiscally goosing the economy when resources are underutilized. I don't know whether Prescott agrees or not (maybe not if he really thinks you can't surprise an economy twice). But Prescott's general point is pretty much the same as Sachs's here: discretionary macroeconomic policy is very likely to be self-defeating and we'd do better to concentrate on setting in place a sound structure of stable rules. When I asked what he would have advised, Prescott said he wished Obama had used his considerable political capital to form some kind of task force to very deliberatively restructure the tax system, the entitlement system, the financial system, etc., instead of pushing for a stimulus. But when the President instead uses his political capital telling people to panic, you just get more of the kind of mess Sachs describes. The government under both Bush and Obama has been giving us ridiculous fool-in-the-shower macro policy, and it really needs to stop.