NOT since the Great Depression has America seen an extended period with near double-digit unemployment. It’s true that unemployment reached an even higher peak in late 1982, but the rate plunged rapidly in the 1983-84 recovery. We haven’t seen similar declines in this recovery, and there is no indication that things will change in the foreseeable future.

It is discouraging to see so many economists grasping for anecdotal evidence to explain the sluggish nature of the recovery. Any analysis needs to begin by isolating the relative contribution of supply and demand-side factors. Over the past three years nominal GDP has increased by a total of about 4%, which is more than 11% below trend. Thus a lack of aggregate demand is clearly the proximate cause of the Great Recession.

The more difficult question is whether the slow recovery is due to a demand shortfall, or structural factors. NGDP fell by 4% between the spring of 2008 and the spring of 2009, the sharpest decline since 1937-38. Since that time, spending has increased at about 4% per year. By contrast, NGDP rose at an 11% rate during the first 6 quarters of the 1983-84 recovery. In addition, the inflation/real growth splits are fairly similar in each case: 7.7% real growth and 3.3% inflation during 1983-84, and 2.5% real growth and 1.6% inflation during the current recovery. Once again, the data is broadly consistent with the recovery being inhibited by a lack of nominal spending.

However there are some indications that aggregate supply may also be slowing the recovery. After falling sharply in 2009, both core inflation and nominal wage growth have leveled off in the 1% to 2% range. Most natural rate models predict that inflation and wage growth should continue to slow in in the face of high unemployment created by a lack of aggregate demand.

THE Bank for International Settlements argues that due to high levels of structural unemployment there is less slack in the global economy than is commonly believed. They see higher inflation as a threat, and recommend that central banks tighten monetary policy.

There are all sorts of problems with the BIS recommendation. First, central banks should target market inflation forecasts, and various market indicators suggest that US inflation will remain below 2% for the next 5 years. More importantly, it’s a mistake for central banks to base policy on estimates of “slack”, and/or structural unemployment.

Although most economists are aware of the Lucas Critique, many remain unaware of its implications. We see frequent studies trying to estimate “the” multiplier or “the” level of structural unemployment, despite the fact that these concepts are not stable parameters, but rather highly sensitive to the policy regime. For example, the fiscal multiplier depends on how monetary policymakers respond to fiscal decisions; indeed the multiplier would be precisely zero if the central bank was successfully targeting inflation.

MOST natural disasters do not have a major impact on the business cycle. However it is too soon to know the full extent of the damage to Japan, and thus I will focus my comments on the likely impact in other parts of the world.

News of the war in Libya and the tsunami in Japan has depressed yields on US Treasury bonds, as well as the prices of assets such as stocks and (non-oil) commodities. In my view this calls for a reconsideration of the lessons from the 1970s. The traditional view is that the various supply shocks played a major role in driving the inflation rate up to double digit levels, although other factors such as monetary policy also played a role. But a close look at the data suggests that the problem was mostly caused by extremely rapid nominal GDP growth, which actually tended to slow during energy shock periods like 1974 and 1980. From this perspective, monetary policy was the key driver of rapid NGDP growth, high trend inflation, and high nominal interest rates.

Today everything seems different. Instead of 20% interest rates, we have yields on 5-year Treasury bonds falling below 2% on news of the disaster in Japan. In my view this is more than just a flight to safety, it also reflects a dysfunctional monetary policy regime that still hasn’t adapted to the zero-rate environment, and is excessively focused on inflation, not total nominal spending.

THE US does not face an imminent fiscal crisis. The US government will not default on its debts, and it’s even unlikely that the Fed will be forced to monetise federal debts. However our fiscal regime is becoming increasingly dysfunctional, thus radical reform would be quite helpful. I’ll sketch out what I view as ideal, with the understanding that political constraints will make actual reforms much more modest.

Despite 9% unemployment, a rapid move toward fiscal austerity in the US would be highly desirable. Before doing so, however, Congress and the Fed need to get on the same page regarding stabilisation policy. The government should give the Fed a desired trajectory for nominal GDP growth over the next 10 years, and instruct them to engage in level targeting, which involves making up for any near-term overshoots or shortfalls. This would anchor NGDP growth expectations, allowing Congress to sharply reduce the deficit without endangering the recovery.

The next step is to reduce expenditures.