Economists all over the world have been puzzled by the current business cycle. They are in a bind to explain why the US real economy shrugged off large monetary tightening by the Federal Reserve, at the same time that the European economy did not fall into a deep recession subsequent to a huge energy-price shock and record tightening by the European Central Bank. Their predicament is all the more real given that labour markets appear to have decoupled from the real economy.
These developments contrast starkly with what one would expect in a normal business cycle and reveal the economic profession’s persistent ignorance of the business cycle. In the aftermath of the 2007-2008 financial crisis, it had seemed that the lessons learned from the 1930s had prevented the collapse of global finance and trade and resulted in a downturn far shorter and less severe than the Great Depression. Economics had triumphed. Yet, here we are again, agonising over whether historical rules of thumb apply to the current situation.
The Great Depression had put non-interventionists on the defensive. John Maynard Keynes blamed recessions on changes in saving and investment behaviour that caused a shortfall in demand. In challenging the traditional understanding of the role of money in the economy, he showed how its mismanagement could cause problems. Governments then used both monetary and fiscal policy to maintain full employment.
By the early sixties, the pendulum had swung back. In 1963 Milton Friedman and Anna Schwartz resurrected the pre-Depression “monetarist” view that monetary stability is a cure for all macroeconomic ills. Other economists added the insight that people learn to anticipate policy changes and adjust their behaviour accordingly, such that sustained stimulus would eventually cause inflation to accelerate – they were vindicated by runaway prices in the 1970s.
But the Keynesians mustered their forces again, stealing some of their critics’ ideas and building a new model based on a synthesis of Keynesian and neoclassical theories. Central Banks were given the job of keeping a lid on inflation. It worked for a time, with downturns becoming less frequent and less severe while inflation was kept low and stable. Lo and behold, expansions lasted longer.
Alas, post-Covid we are back to a violent disagreement on business-cycle behaviour. The New Keynesians running central banks are being attacked again by many neoclassical economists. The latter are emboldened by the fact that central banks, regulatory agencies, and finance ministries have erred repeatedly in their prognostications over the past decade.
It is not inconsequential that new research has raised misgivings about the old orthodoxy on the proper role of fiscal policy and the risks posed by large-scale financial flows. Various economists have renewed the debate about the relationship between unemployment and inflation. They are questioning whether labour markets can heal as quickly as predicted and suggest that the risks of targeting a low rate of inflation are being underestimated.
Meanwhile, along comes Thomasz Wieladek who, in The Economist, recently argued that economists are possibly mistaking one type of recovery for another. Wieladek wrote that there are two types of economic recoveries: one is the so-called Hamilton theory, wherein the economy recovers from a recession but fails to reach the level of output that would have been obtained had it kept growing instead; and the other is the Friedman recovery, wherein the economy grows very quickly following a recession and reverts to the level of output that would have been reached had it not contracted. One can immediately appreciate why resolving this conundrum is crucial.
What’s the difference?
Some readers might find it difficult to understand the economic difference between the two types. Let me try to make it easy. In a Hamilton recovery, the recession severely batters the supply side of the economy – job markets weaken – and, since demand needs to fall below supply, inflation can only be tamed by reducing demand. In contrast, in the Friedman version, the supply side is unaffected.
In a very interesting article, he explains the macroeconomic puzzles of the past couple of years. He claims that Friedman recoveries are very rare, such that in their analysis of recoveries across 192 countries over 40 years, Valerie Cerra and Sweta Chaman Saxena found only three complete and six partial Friedman recoveries. All other recoveries were of the Hamilton type. This explains why standard business-cycle rules of thumb are, therefore, all based on Hamilton recoveries.
“This time is different,” he says, because the recovery from the Covid-19 recession has been Friedmanesque. So out go the business-cycle rules of thumb about the timing of a recession, how labour markets react, and what needs to be done to bring inflation back down.
In his support, Wieladek reminds us of three puzzles:
Puzzle No. 1: Despite significant monetary tightening, economies have been surprisingly resilient – the US economy registered annualised growth of 5.2% in the third quarter of 2023; though European economies were mostly stagnating, they still churned an impressive outcome considering the brutal energy-price shock they endured.
Puzzle No. 2: Labour markets have held up, though growth slowed. While the 20% annualised reduction in vacancies in the American economy should have led to unemployment rising by a couple of percentage points, the increase has been much lower; even in the Euro area, where the unemployment rate has been very sensitive to monetary policy in the past, the rate hasn’t risen yet.
Puzzle No. 3: What Wieladek calls “immaculate disinflation”: high, demand-driven inflation in America has come down substantially, without a weak real economy or labour market, despite significant monetary tightening. Similarly, inflation is falling in the euro area, yet the unemployment rate remains at a record low.
These puzzles can be explained by a Friedman recovery, not by a Hamilton one. If that is, indeed, the case, then policymakers will ruin the economy if they interpret strong growth as a sign of excess demand and therefore future inflation – leading to monetary tightening. Instead, they should look at the strong growth as a sign of the supply side accommodating demand – leading to monetary easing to prevent inflation from running below target.
What about Malta?
How does the controversy affect us in Malta? To a certain extent, we are very much at the mercy of what happens elsewhere, both on the ground (as a small island which imports most of its necessities, we are price-takers) and in terms of policymaking (our monetary policy has been farmed out to the European Central Bank). To a limited extent, we have control over fiscal policy, though this is rather short-lived given the European Commission’s intention to reinstate fiscal rules eased during and post-Covid.
We are also not helped by the fact that official or exhaustive dating for the Maltese business cycle is practically non-existent. As Reuben Ellul, a principal economist at the Central Bank of Malta, has written, “It is not clear whether the overall Maltese economy is synchronised with the cycles of its European neighbours, or whether any synchronisation has been affected by changes in Malta’s political economy, or membership of the Monetary Union.”
In what I might call a pioneering analysis of events between 1972 and 2020, Ellul wrote a paper in 2021 where he applied the so-called Bry-Boschan algorithm and Markov switching model to classify peaks and throughs, as well as the cycle length and cycle turning points, in a series of GDP and employment data.
In spite of limitations in the data, Ellul found evidence (see chart) for recessionary episodes between 1973Q2 and 1973Q3, 1982Q3 and 1982Q4, 2004Q1 and 2004Q2, and 2011Q1 and 2011Q2. Interestingly, he diplomatically asserts that the Great Recession of 2008Q4-2009Q1 has been “erased” from Maltese economic history. As for 2020, he admits that there is an element of uncertainty as to the exact timing of that recession. He also found four sharp peaks consistent with high recession probabilities in early between 1973Q2 and 1973Q4, 2001, 2004Q1-Q2, 2008Q4-2009Q1 and 2011Q1-Q2.
In any case, Ellul concludes that the economic contractions registered in the 2000s and the high economic growth rates registered by the Maltese economy imply that Malta gained considerable momentum in the later part of the 2010s, achieving higher levels of economic convergence to its European peers in recent decades.
It would be remiss for the Central Bank of Malta, the Ministry of Finance, and the University of Malta to undertake a more extensive and deep analysis of business cycles in the Maltese economy. Such an analysis has implications for a range of policy trade-offs, including the optimal aggressiveness of financial regulation and stability, the appropriate mandates for monetary and fiscal policies, the optimal level of foreign exchange reserves as insurance against the impact of shocks, and maintaining a conservative fiscal stance during booms.