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Structural confusion

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Assessing US tax cuts, Italian public spending, and Fed or ECB policy all require a distinction between the 'cyclical' and 'structural'. But even when you who know the difference, it is easy to make a policy mistake.

Many macro-economic variables fluctuate, often in cycles, around a more stable equilibrium. Economists use different terms for these equilibrium variables, like 'natural' for unemployment and interest rates, or 'underlying' or 'potential' or 'trend' for output growth. These concepts are important for assessing the impact of fiscal stimulus, like recently in the US and Italy, or the dilemmas of the Fed and ECB. Stimulus can’t solve structural problems, but it can create them. Furthermore, it is difficult to measure structural variables, so even well-intentioned cyclical policies can turn out to be mistakes.

Fiscal policy is made in the heat of public debate, while the distinction between cyclical and structural variables is not suited to one liners. That’s why the straight-talking President Truman once demanded a “one-handed economist”; because when asked if fiscal spending is good for growth the typical economist will answer something like, “on the one hand, fiscal stimulus will boost growth temporarily, but on the other, its effect in the long-run depends on the exact nature of the policies and how they might impact productivity.” It is easier to sell recent policies like Italian fiscal spending or US tax cuts as simply “good for growth”. But that doesn’t make them good policies. Both countries have gross debt-to-GDP ratios above 100%, so ineffective stimulus can do lasting damage to creditworthiness. Italy’s growth problems are more structural than cyclical and it is unclear that the US had a growth problem at all. The US might have been better off keeping its powder dry until the next recession (possibly in 2020).

When it comes to monetary policy things are even more complicated. You need a three-handed economist to explain it. On the first hand, monetary policy can temporarily boost growth above trend. But, on the second hand, it can only do so as long as unemployment is above its natural rate, otherwise you risk permanently higher inflation. However, on the third hand, monetary policy can only boost growth if the policy rate is set below the natural interest rate. So, if the natural rate is ‘low’ then the policy rate needs to be kept low too, even just to keep growth and unemployment at their structural levels and meet the inflation target.

All these structural variables move around and you can’t observe them directly, so it typically takes a while to figure out they’ve changed. An important reason why inflation rose sharply in the US during the 1970s is because the Fed kept trying to boost growth before it realised trend growth had slowed.

Right now a structural variable that central bankers are struggling with is the natural rate of interest. There is a consensus that it has declined, but by how much? One way to find out is to hike rates and see what happens, but that risks choking growth. The Fed has already paused hiking sooner than it had signalled, due in part to stress in financial markets. The shape of the yield curve is another indicator that markets think the Fed funds rate is close to the natural rate. In the euro-zone the ECB hasn’t even started hiking yet and growth is slowing while inflation is only just near the target. That could be a sign that the natural interest rate is low and hiking rates would make the slowdown worse. Even if the ECB avoided this mistake it would be stuck, like the Bank of Japan, with no room to hike rates and no room to cut them. That would be bad news for savers and could bring other negative side-effects including financial stability risks. It would also not be a good starting point for the next recession.

To avoid this, structural polices that push up productivity growth are needed. These relate to areas like infrastructure, human capital, innovation and management practices. But those are outside of the control of central banks and also not always easy for politicians to sell with one-liners.

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Author(s)
Menno Middeldorp
Chief Economist, Director Knowledge Development Rabobank Rabobank KEO
+31 6 8389 9872

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