What almost kills you, makes you weaker

Mikael Juselius, a highly regarded Finnish researcher currently working at the Finnish National Bank, hosted a public lecture at Corvinus University on April 24th, which was organized by the Institute of Finance and the Institute of Economics. With years of experience in the field of economics, he has developed strong expertise in monetary policy, financial stability, and macroeconomic analysis. 

Mikael works as a full-time researcher at the National Bank of Finland. In their system, he functions as an autonomous researcher who gets to work on topics that are most interesting to him. “I have soft constraints, meaning I have to do a certain amount of policy writing each year, but these topics are all connected to the research papers I’m writing.” He sits down with his superiors once a year and agrees on the topics he will be working on in the forthcoming year. 

Learnings from deep contractions 

He presented a talk at Corvinus University about an important topic that he has studied with his co-authors (David Aikman, Mathias Drehmann, and Xiaochuan Xing). In a paper that they published last year, they describe the effects of deep contractions over the long term. Using data from the 1970s until today, they show that the effects were nonlinear and asymmetric: there was no such persistence following less severe contractions or large expansions. While scarring after financial crises is well-known, it also occurred after the deep contractions of the 1970s and 1980s that followed energy price shocks and restrictive monetary policy to combat high inflation. 

According to Mikael, the data shows that booms do not have long lasting positive effects and small recessions do not have long lasting negative effects on the economy. On the other hand, significant recessions always carry long lasting negative consequences, which leave scars on the economy: “I think we can draw the general conclusion from our findings, that policy may need to respond asymmetrically to the business cycle. If decision-makers want to learn from past mistakes, they should be much more reluctant to allow booms to continue. Because there are no permanent benefits from that. Conversely, it may be beneficial to be more accommodative during contractions to avoid deep recessions.” 

At the same time, Mikael Juselius pointed out that it is a very difficult standpoint for a policymaker working in a central bank, who has a fixed mandate: “When you’re making policies, basically you’re trying to prevent things that will happen five years in the future. And this is tough for any policymaker. They need to stand in front of the cameras and say, ‘Okay, guys, we’ve had fun, but we have to take away the punch bowl from the party because some problems could arise from how we are living now in five years.’ It sounds almost impossible, and if they take the punch bowl away, the public is not going to see the exact problem they were protecting society from.” 

Scarring means losing technology 

Scarring has quite tough implications for coming generations. Mikael suggests that there could be a loss of both skills and technology when contractions happen and businesses slow down or go bust, resulting in lost knowledge. 

“I’m not a theorist, but it would be great to do research on the labor market. The factors of production are not even essential for scarring, so labor won’t matter to a large extent, but what will matter is technology. Technology can come in two forms: labor-augmenting technology, which is education skill-based, or capital-augmenting. 

I think these two must be the source of scarring in some sense. If I want to do something unrelated to specific parts of the economy, I would have to think about something related to the duration of the crisis, or simply the fact that there is a distributional effect, where certain parts of firms innovate. When there’s a big crisis, we lose technology and knowledge.” 

We are getting poorer 

And there’s another effect that has been happening in the past few years due to the Covid pandemic: deglobalization. A less globalized world means fewer opportunities for competition. “What we are seeing today, I think, is a little bit of deglobalization, and if you extend it and it becomes very long, the volume of production has to lower as well.” 

One consequence that can already be felt across Europe is the skyrocketing inflation rates. According to Mikael, the trend of our money is losing its value could continue in the forthcoming period: 

“I think we are getting poorer; we have to get poorer. In the macro sense, there are two ways you can get poorer. We can either agree to cut our salaries, or we can have inflation. And the former is harder.” 

Inflation and the central bank 

Mikael has already done some research on inflation from a different angle. He showed that there’s a connection between demography and inflation in joint research conducted with Corvinus University rector, Előd Takáts. “We were both working for the Bank of International Settlements, and we had this idea that if dependency ratios between the young and older generations go up, so does inflation.” 

At first, they were both skeptical, saying there’s no way it would work. But the pattern turned out to be very strong in the data. “And to my surprise, Előd came back a week later and showed that the pattern is actually consistent with life-cycle effects on real interest rates in an overlapping generations model.” 

They had a hard time publishing the paper, but in the end, the Journal of Economic Dynamics and Control published it. While they were writing the article, they were forecasting inflation resulting from the retirement of the baby boomer generation. At that time, they could not have seen the supply shock and the huge rise in inflation happening nowadays. Mikael believes he can’t draw a connection between demographics and inflation right now, but it is worth revisiting the topic 10 years from now to see if aging has generated a long-lasting rise in inflation. 

There’s no easy answer to this question from a Central Bank’s point of view, says Mikael Juselius. Raising interest rates are essential to slow down inflation rates. However, there is a real risk at the current juncture that wage-price spirals could derail economy if members of society try to preserve their purchasing power by demanding higher wages. This would set the economy down a dangerous path. 

The interview was conducted by Dr. Géza Sebestyén and László Tucsni.