The following has numbers for the UK, but the logic if not the numbers also apply to the US: see Mark Thoma here.
Imagine the following lottery. If you win, you receive a total of £5000 over the next few years. The cost of a ticket? The risk that inflation will be 0.5% higher than it would otherwise have been for a couple of years, where inflation includes the rate that wages increase.
To enter the lottery in the UK you need to cut interest rates. This lottery is just another way of describing the key argument I made in Monday’s Independent article(now complete with chart).
Of course you want to know the odds of getting the prize. The odds come in the form of a puzzle. What are the chances that the economy has, over the last ten years, permanently lost 15% of its normal ability to produce goods and services. Something that has probably never happened to the UK before. [1] Those are the chances of you NOT winning.
We can of course discuss those numbers. But in the UK that discussion appears largely absent. Instead all the talk is about interest rate increases. We seem to have collectively written off 15% of national GDP with just a shrug. ‘Oh that must be supply and there is nothing conventional macro policy can do’ is the general view. That view may be right, but it is important enough that this should be the centre of the national debate. Instead we talk about the need to normalise interest rates, as if the real economy was doing just fine.
Time for a DeLong type lament. If you had told me ten years ago that a decade hence UK output per head would be 15% below the 1955-2008 trend, inflation was zero and yet people would be talking about raising interest rates I would have said you were mad. If you had said that at a time when interest rates and real wages are at record lows the government was proposing to not invest for the future because that was the best way to prepare for the next crisis I would have said you knew nothing about business and economics. If you had said that just years after a huge financial crisis, followed by a host of financial scandals, the City regulator would be sackedbecause the Chancellor wanted less tough regulation I would have said you were thinking about some corrupt state and not the UK. If this is all a bad dream, what will it take to wake people up?
[1] Economies do appear to suffer some permanent loss to potential output after financial crises: there is a handy summary of studies here(table 4.1) - HT Andrew Goodwin
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