So is [GDP below its potential] today, and can monetary policy do anything about it? Sawicky says yes, Prescott says no. What say I? Two-handed economist that I am, I may not go all the way to Prescott’s view—but I lean in that direction.
Prescott is arguing that the late 1990’s boom was a real business shock. I’ll grant him that. When Prescott writes the following, I have to disagree:
What about busts? Let’s begin with the assumption that tight monetary policy caused the recession of 1978-1982. This myth is so firmly entrenched that I could have called this downturn the “Volcker recession” and readers would have understood my reference… But looking closer at the data we see that output began its downward trend in late 1979 while monetary policy was still easy through most of 1980. Also, output continued its decline through 1982, when it began to climb at a time when monetary policy remained tight. These facts do not square with conventional wisdom. Our obsession with monetary policy in the conduct of the real economy is misplaced.
Oh good grief. There were four distinct periods of Volcker monetary policy: (1) his initial tight money, (2) his subsequent easing in 1980 which Prescott mentions, (3) round two of tight money when he got a load of Reagan’s fiscal stimulus, and (4) the easing of tight money after the damage known as the Reagan recession was done and could be reasonably assumed to bring inflation down. Has Prescott ever heard of lags? His case that money does not matter is specious at best (at worst, it seems suitable for the pages of the National Review).
David talks about economists with two hands. Well, a two-handed economist understands that productivity shocks exists AND knows that Keynes had a point in his 1936 General Theory.