No, Greenspan Was Not Right

Nick Rowe asks an interesting question:

In 2003, Alan Greenspan argued that the Fed needed to set low interest rates to prevent falling into a liquidity trap and deflationary spiral... In 2008, Greenspan's critics argue that those same low interest rates caused an asset bubble, which burst, causing the economy to fall into a liquidity trap and deflationary spiral. Is it possible that Greenspan and his critics were both right? Was the US economy doomed either way?

My answer is no. A deflationary spiral of the kind Nick describes is the result of a collapse in aggregate demand that creates expectations of further declines in nominal spending and ultimately the price level. Along the way the policy interest rate hits its lower bound of zero, real debt burdens increase, and financial intermediation gets disrupted. These conditions better describes today than 2003. The deflation scare of that time was simply a panicked misreading of deflationary pressures arising from robust productivity gains. To make my case I have re-posted with some editing portions of a previous post:

These next three figures make my case. The first figure shows productivity--as measured by non-farm business labor productivity--did see an acceleration in its year-on-year (Y/Y) growth rate around 2003:


The figure also shows the ex-post real federal funds rate (ffr) relative to the Y/Y productivity growth rate. Assuming there were no significant changes in intertemporal preferences and population growth rates, this first figure suggests the Fed was pushing its policy rate down as the natural rate--which is a function of intertemporal preferences, population growth rate, and productivity growth rate--was increasing.

The next figure shows the Y/Y growth rate of nominal spending--measured by final nominal sales to domestic purchasers--against the nominal ffr. The year in question, 2003, is highlighted by the two dashed lines. This figure indicates nominal spending or aggregate demand was not collapsing but rather growing throughout 2003. The ffr, on the other hand was being pushed to down to 1%.


So productivity was increasing and aggregate demand was not collapsing. What about the weak labor market? One story is that the "jobless recovery" was simply the consequence of the above productivity gains. Another story is that the existing low ffr was pushing the cost of capital down and encouraging an inordinate substitution of capital for labor by 2003. In either case, there is no justification for further lowering of the ffr in 2003. The figure below sheds some light on this view. It graphs real non-residential fixed investment against total nonfarm employment with the year 2003 again delineated.

This figure shows that non-residential fixed investment was recovering in 2003 while employment remained flat. Firms, therefore, were investing in their capital stock while avoiding new additions to labor. I suspect monetary policy played some role in this development.

So Greenspan may have thought a deflationary spiral was around the corner in 2003, but the data indicates there was none in sight.