Luca Fornaro on Hysteresis, Endogenous Growth, and Aggregate Demand Policies

Luca Fornaro is a senior researcher at CREI and professor at both UPF and the Barcelona School of Economics. In Luca’s first appearance on the show, he discusses his expansive work on, hysteresis, stagnation traps, endogenous growth, aggregate demand policies, the medium run, population growth and much more.  

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Read the full episode transcript:

This episode was recorded on April 23rd, 2025

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Welcome to Macro Musings, where each week, we pull back the curtain and take a closer look at the most important macroeconomic issues of the past, present, and future. I am your host, David Beckworth, a senior research fellow at the Mercatus Center at George Mason University. I'm glad you decided to join us.

Our guest today is Luca Fornaro. Luca is a researcher at CREI in Barcelona, Spain, where he works on international macroeconomics. Luca has done extensive work on hysteresis, endogenous growth, and aggregate demand policies, and he joins us today to discuss these topics and their implications for macroeconomic policy today. Luca, welcome to the program.

Luca Fornaro: Thank you very much for the invitation, David. It's a pleasure.

Luca’s Background

Beckworth: Well, it's great to have you on. We have chatted a lot on Twitter, now X, over the years, and you've been very careful to remind me and to tell me about the importance of endogenous growth models, aggregate demand policy. Of course, I'm a big fan of aggregate demand policy, a certain version of it, nominal GDP targeting, Luca. Our paths definitely overlap there, and maybe we'll talk about that later. But I want to talk to you about hysteresis and its relevance for today. Before I do that, Luca, tell us a little bit about yourself and about CREI, the institution where you work.

Fornaro: Let me tell you a little bit, how I got into macroeconomics, perhaps to start with. I grew up in Italy, which is a very interesting country from a macroeconomic perspective. For instance, when I was a teenager, it was the late '90s, early 2000s. That was the time when Italy was making a big fiscal adjustment in order to enter the Euro. It was natural to get interested in this kind of question.

I went to university and then I did a masters at the Paris School of Economics. Then I met Philippe Aghion, who taught a very nice course on endogenous growth. He hinted at this idea that there could be interaction between endogenous growth, endogenous productivity growth, and business cycle. That's how I got interested in that type of research questions.

Beckworth: This is an important point we'll come back to, but just to lay it on the table, one of the key insights of the endogenous growth models is that the business cycle—you really can't divorce that from trend growth, right? The business cycle itself can affect productivity and where the underlying trend of the economy goes. That's an important insight from those models, something you've worked on extensively. Tell us also about your institution, though, before we move on. Tell us about CREI.

Fornaro: After doing my PhD at the London School of Economics, I joined CREI. CREI is a research center in Barcelona, and it is affiliated with the Universitat Pompeu Fabra. And our mandate is to produce academic research. We are about 15 macroeconomists. We have people like Jordi Galí, Jaume Ventura, Alberto Martin, or Fernando Broner. I must say it's a great place because we have a lot of freedom to do whatever research we want, and it's a very good environment to grow as a researcher. I was very lucky to start my career here, and I'm very happy to be here.

Hysteresis

Beckworth: It looks like a fantastic place. Lots of great research coming out of there. Let's talk about hysteresis and, again, endogenous growth models more generally. Luca, my first introduction to endogenous growth models was Paul Romer and his discussions about the importance of population growth, idea generation. It took me a long time to make the connection between endogenous growth models and the type of work that you're doing. I want to begin the discussion, Luca, with a story about a person, just to paint a picture of what I think hysteresis is.

I'm going to paint this picture, Luca, you tell me if it's a good analogy for hysteresis and endogenous growth models. To do this, Luca, I'm going to invoke a friend of the program, and that's Peter Conti-Brown. You might be familiar with Peter Conti-Brown. He's a legal scholar of the Federal Reserve, a good friend of the show again, but Peter also happens to be a powerlifter. Powerlifting is you go bench press, squat, and deadlift. Right now, Luca, he can max out a total of 1,100 pounds. He's aiming for 1,500.

Now, I share all this because he's disclosed it on a Substack, so Peter, if you're listening, I don't think you will mind me sharing this information because you've disclosed it to the world already. Here's the thing. If he gets to 1,500, let's just say 550 squats, 400 on the bench press, 550 on deadlift—let's say he gets there—and then one day he gets incredibly sick. He gets a bad case of pneumonia, he's bedridden for months, he can't do much, his breathing is worse, he loses his strength, muscular atrophy. When he goes back to the gym, he can only get 800 total. He goes from 1,500 to 800.

Now, let's say he's going to the gym every day. He feels good, his health is restored, but he's lost all that strength. Unless he really pushes hard—he runs the body “hot,” so to speak—he's not going to get back to that peak he had, right? He can just go along and maintain and do what he's doing, but he would have to work extra hard, extra rigorous training sessions to get back to 1,500.

In my mind, that's a view of what hysteresis is. The economy gets hit with a deep recession, and people—they lose their skills, their capital, their productivity. They're out of their workforce, they're permanently scarred. Even capital is affected because you don't have people coming into work, less demand for factories, and such.

The economy itself can be permanently on a lower trajectory or lower capacity, a potential GDP growth path. To get it back to where it should be, you have to run the economy hot, just like Peter would have to work extra hard. You'd have to run the economy hot. Is that a good analogy to paint the picture of hysteresis?

Fornaro: I think there is something to it because, definitely, the concept of hysteresis, at least in the literature that I work on, is associated with the idea that if you have a spell of weak demand, weak economic activity, that might discourage, as you said, skill accumulation by workers, but also investment by firms including investment in innovation activities. That's going to have an impact on the future and long-run productive capacity of the economy. Yes, it's definitely the idea that a spell of weak demand, weak economic activity, can cast a long shadow into the future and create damage [to] potential output into the future.

Beckworth: It's a decent analogy, but we want to make it a better one. We want to flesh this idea out and discuss your research. But let me ask this question, because I know some of our listeners might be thinking it right now. Why talk about hysteresis and endogenous growth models now? Didn't we just go through a massive overheating period? At least in the US, one might argue, we ran the economy hot, we got high inflation. Why worry about it now? I'll give my explanation for the US, and maybe you can give your explanation for Europe. 

Why Talk About Hysteresis Now?

But here's why I think this is still relevant: because right now, many forecasters are suggesting we might be headed toward a recession. The trade war, the tariffs—these shocks that may hit the economy—might bring us to a recession. As we'll discuss later, even negative supply shocks can ultimately turn into something worse—that can turn into weak aggregate demand under the right circumstances, and you could get some of the hysteresis. Again, a key point I think from the literature from your work is that even a supply shock or a mild recession can leave permanent scars on the economy if allowed to persist.

In my mind, this is something very relevant because we could have a recession this year. I would also add, it looks like the Fed and their framework review is going to get rid of makeup policy in FAIT. That, to me, is an important way you deal with hysteresis challenges. That would be my argument for why this is an important conversation. But let me throw it over to you, Luca. Why do you think this is an important conversation, say, for Europe?

Fornaro: Let me quote Mario Draghi on this, because I think he said something very interesting. Mario Draghi delivered a speech back in December. Of course, he was building up on his report on the state of the European Union, where he argues that low productivity growth is a big issue for the European Union. In this December speech, he argued that one of the drivers, one of the causes, behind this low productivity growth is weakness of internal demand.

His point is very interesting because it says, look, in Europe, we've been having tight fiscal policy since the great financial crisis for several reasons. That has translated into a period in which internal demand has been weak. If you're in an environment in which internal demand is weak, firms do not have an incentive to invest to build up their future productive capacity. That's the way through which a spell of weak internal demand translates into low productivity growth and a low future productive capacity.

I think that from the perspective of Europe, the problem with hysteresis is that the connection between demand and growth is particularly salient. We can see that also, in the recovery since COVID, compared to the US, in Europe, we've been having a much smaller fiscal stimulus. Also, Europe was hit by a very severe negative supply shock with the rising gas prices following Russia's invasion of Ukraine, which is something that the US experienced to a smaller extent. We are seeing that that translated into a slowdown in investment and a slowdown in trend productivity growth.

Beckworth: If you look at Europe's real GDP series—and it's always dangerous to draw trend lines, but just as a first approximation—if you look at real GDP in Europe after, say, 2008, after the great financial crisis, you got the Eurozone crisis. Real GDP never returns back to that trend path. It's always been below, and then the same thing is true since the pandemic.

Fornaro: Pretty much, yes. What happened during the pandemic is that initially it looked like Europe would recover its previous trend, but then Russia's invasion of Ukraine created a very negative supply shock. Since then, we've been going way below the prepandemic trend.

Beckworth: That's a case of hysteresis where the economy's gotten smaller, and, in theory, it could have been larger. It could have been back where it would've been otherwise. We want policies that can address that.

Stagnation Trap

Let's use that as a motivation to this first paper of yours I wanted to discuss. And this is a 2018 paper with Gianluca Benigno, who also is a past guest of the podcast, by the way. I was excited to see his name. He's been on the show, and I follow him closely on X, and he has a newsletter I follow as well. But you have a paper with him called “Stagnation Traps.” Give us the executive summary. What does this paper argue, and what do you show in it?

Fornaro: Let me start by telling you the context, the background, that gave rise to that paper, because we wrote it in the aftermath of the Great Recession. That was precisely a time in which most advanced economies—the US, the Euro area, the UK—were experiencing a spell of weak aggregate demand. What was interesting from our perspective is that that coincided with this slowdown in productivity growth.

In our mind, the connection was evident because, as Draghi has pointed out, when you have weak demand, firms do not have incentives to invest and to increase their productivity. But it turned out that this connection between aggregate demand and productivity growth was not really there in the mainstream literature. The mainstream macroeconomic literature tends to separate the study of business cycle and the management of aggregate demand from the determinants of long-run productivity growth.

With that paper, what we wanted to do is to build up a framework that would allow us to think about the relationship between aggregate demand, monetary policy, and productivity growth in a unified setting. We came up with this model, which we think of as an “occasion growth framework.” The “occasion” part comes from the fact that, as in typical occasion analysis in our model, a period of weak aggregate demand might translate into a period of low economic activity. At the same time, in that framework, we borrow from the endogenous growth literature the idea that productivity growth is the result of firms' investment in innovation.

It's interesting to think jointly about these two factors because there is a feedback loop. One side of the loop is what Draghi highlighted: A period of weak demand translates into low investment and low productivity growth. But it turns out that low productivity growth also affects demand. Why? It's very simple. Because if you're in an economy in which people forecast that productivity growth is weak, and that their future income is going to be lower than what they expected, that is going to accept downward pressure in aggregate demand.

On one hand, low demand translates into low growth. But also, low growth translates into low demand, and that creates a feedback loop. Essentially, what we show in that paper is that if this feedback loop is strong enough, the economy can get stuck in a stagnation trap. That's a persistent state in which low growth loop and weak demand reinforce each other.

Perhaps one of the key aspects of that paper is that if the fundamentals are sufficiently weak, you can get stuck in a stagnation trap, even just due to animal spirits. Even just due to pessimism on the side of households and firms. Because if expectation of low growth kicks in, that is going to translate into weak demand, giving little incentive for firms to invest and to increase their productivity, which validates the initial expectations.

Beckworth: Even just weak expectations themselves can become self-fulfilling, create this stagnation trap. Do you think the period after the great financial crisis, the Great Recession, as you alluded to—you alluded to Europe, the US, Japan—they all had weak growth, productivity was low. You think this is a period that is well captured by the idea in your paper?

Fornaro: I think that all these economies that experienced the liquidity traps in the aftermath of the Great Recession had symptoms of a stagnation trap. Because, in all these cases, demand was weak, and productivity growth slowed down. With hindsight, if I have to think about the cases in which the symptoms were stronger, I will come up with the Euro area and the UK. There, the productivity growth slowdown has been really impressive. Perhaps it's not by chance, because these are the two cases in which fiscal policy has been more restrictive, in which fiscal policy has played less of a role of pushing out the economy out of the Great Recession. Perhaps the Draghi is right after all. A period of weak demand compounded by a weak fiscal policy response can generate a stagnation trap.

Beckworth: The stagnation trap does rely heavily on this endogenous growth model. Is that correct? It's a key component here.

Fornaro: The key component here is that weak aggregate demand translates into low future productive capacity and low future income, which I think is a pretty sensible idea. Because, again, it goes back to the notion that firms invest in order to increase their future profits. If they forecast that future aggregate demand is going to be weak, there are no profits to capture. They have less incentive to invest to increase their future productive capacity. That's an idea which is well captured by the endogenous growth model. That's why we build on that literature in our work.

The Medium Run

Beckworth: I just want to really focus on this point because I think it's fair to say—we call it the classical dichotomy in standard macro—is there's short run, there's long run. In the long run, nominal measures don't affect the real economy. Oftentimes, it's easy to say, "Hey, there's the business cycle activity, and then there's trend real growth." What endogenous growth models really highlight is that you can't make that clean distinction, that business cycles do affect the trend growth. We can't just say there's this part to growth and there's the second part. They're intertwined. Isn't that the key takeaway from endogenous growth models?

Fornaro: Yes. Another way to see it, which is the way that I like, is that between the short run and the long run, there is a medium run. What is the medium run? It's a span of time long enough so that firms have had a chance to adapt their productive capacity and the technology that they use. We are thinking about 5 to 10 years horizon. And that horizon is a bit of a gap in conventional macroeconomics because of this dichotomy that you mentioned.

I like to see my work speaking to the medium run, where the interaction between business cycle, macroeconomic policy, and productivity growth are likely to be important. Also, because in my view, it's hard to say something empirically about the long run, not because we don't have long enough data series. I see my work really as describing what is going to happen over the next 5 or 10 years. If a recession or a shared monetary contraction has an impact on productivity over the next 5, 10 years, I think that the insight from my work applies.

Beckworth: When you look at the United States, we did run the economy hot. At least it's arguable that we ran the economy hot—we had large fiscal stimulus, the Fed was very accommodative—and it looks like we popped back, we had a V recovery. It happened, it was great. It was very different than 2008. 2008, more of like an L-recession. The economy collapses, and then it grows, it continues to grow, but it's at a much lower trend path or growth path. Whereas in 2020, 2021, it's the V-shape. It falls, and it comes back up quickly.

Now, some people might say, "Well, yes, David, we had a V recovery because it was a supply-side recession,” that “We shut the economy down, we opened it up, so it had to happen quickly." Maybe I'm getting ahead of myself for your next paper, but your point, and I think the question I want to ask you is, empirically, do you see the 2020, 2021 response in the US as data points supporting the arguments you're making that had we not had—again, maybe it was overdone, maybe it was too much—but had we not had these really supportive macroeconomic policies, we may have had another L-shaped recession?

Fornaro: I think that's definitely a possibility. It's always the case in macro. It's hard to be counterfactual. It's hard to know what would have happened without this big fiscal stimulus. But if I look back at the Great Recession—in which the macroeconomic stimulus was smaller, and we did see, as you said, an L-shaped recovery—and I compare it to the COVID one—in which there was a way bigger fiscal stimulus, a way quicker recovery, productivity growth going back to pre-COVID forecast—I would say that that's consistent with the idea that simulating aggregate demand during a recession can help you to heal the scars from the recession to productivity.

Also, again, we can draw a comparison to the case of the Euro area. In the Euro area, we had a larger shock but also smaller fiscal stimulus, and we are seeing a period of stagnation right now. If you compare the trajectory of the US and the Euro area, one strong hypothesis that you can put forward is that the big fiscal stimulus had a big part on coming back to trend of the US economy.

Beckworth: I'm in this kind of awkward place where I think macroeconomic policy—and by that, I mean fiscal policy, monetary policy in the United States—probably was too much. In fact, I'm pretty certain it was too much in my view. However, there's also a place where it was needed. I feel like we did something right. There's a lesson to be learned in providing adequate support when you have a recession.

What I want to do is I want to thread this needle. I want to say, “Let's replicate the good part of that experience and not overdo it.” There is a way to get the best of both worlds here. Many critics, however, will only say that we overdid it, we did too much. I think there's a way to kind of stay in the middle of the lane and say, "Look, let's have really supportive policies when we have a really, really deep recession like that, and let's go back.” And I'm reminded, Luca, of the 1930s in the US. We had the Great Depression, the price level fell about 30 percent, and then we're in the mid-1930s, and it's the inflation rate starting to pick up. I think I looked at the data recently, it's 4 percent or 5 percent inflation. The Fed is starting to get nervous about inflation. But the price level is 30 percent below where it was before. Aggregate demand is still very anemic. There's not been full employment recovery, unemployment is still large. It's easy to miss the forest from the trees. You look at the inflation rate versus where the dollar size of the economy is.

For me, that's my concern, is when we have deep recessions. I think you can say the pandemic was a really deep one. It just was a really quick recovery, too. When you have really deep recessions, you need macroeconomic policies in place that can bring us back out so we don't get to the place where we have hysteresis. We have a decade of below, arguably below, trend growth. I know there's listeners who will disagree with that. That's why I think this framework review is so important.

I know listeners probably get tired of me talking about the Fed's framework review, but I really do believe FAIT—again, it's not perfect, again, macroeconomic policy was too stimulative—but FAIT, I believe, allowed some of that excess fiscal stimulus, the excess monetary policy, to help get us out of that deep recession. Again, I would hope we could do it better next time.

Managing Expectations with Automatic Stabilizers

Before we move on to your next paper, I want to just park here a little bit more on the expectations part and the endogenous growth model. Your work is very interesting, Luca, and it reminded me of another guest that I've had on the program, and that's Roger Farmer. He does something similar. He looks at a model. In fact, he doesn't like New Keynesian models. He doesn't like real business cycle models either. He disparages those, and he completely does away with the Phillips curve.

He has this belief function he brings into his model, because he says expectations are so important and there's multiple equilibria. The economy can end up at a bad spot and be stuck there for a while. You've got to manage expectations. His solution is to target the stock market. He thinks there's a connection between the stock market, consuming out of wealth, and expectations. What would be your policy prescriptions, though? I've talked a lot about mine. I've mentioned Rogers. What would you recommend, we go into a deep recession? The ECB, the European Union, looks to you, Luca, what should we do? What would you recommend?

Fornaro: If I can take a step back, if you take seriously this kind of theories in which a recession and the stagnation trap might happen due to a wave of pessimism, the policy—the class of policy—that you want to have in place are automatic stabilizers. You want to have some policies in the background that prevent expectations from going pessimistic. For instance, the fact that monetary policy acts in a countercyclical manner can be thought as an automatic stabilizer.

On the fiscal side, we have automatic stabilizers such as unemployment benefit. Now that's some stimulus that goes up as the economy gets weaker. I think that what these theories of hysteresis tell you is that we should also look at business investment. Perhaps we should think about automatic stabilizer for business investment. If weak business investment is a problem, because it reduces our future productive capacity and might translate into weaker demand in the present, that's a margin on which you want to act.

I think that there is a lot to be researched on the benefit of having some automatic stabilizers that target investment by firm and try to make sure that recession does not have scarring effects on future productivity. Now, what if you've fallen into a deep recession, perhaps with scarring effects? You are in a very bad situation because of several reasons, the first of which is that if a recession triggers a slowdown in productivity growth, inflation might not fall by a lot because weak productivity growth tends to sustain, first, marginal cost and inflation. You may get in a situation in which economic activity is weak, but inflation is not too low, which is an uncomfortable place to be if you are a central bank.

Second, if you take theories of stagnation seriously, they suggest that marginal changes in policy will not have a large impact. Marginal change in monetary policy or in fiscal policy might have a very weak impact. What can work are large policy changes that help younger people's expectation on the high growth equilibrium. You want to go big, and of course, you have the risk of going too big, which is perhaps what happened during the COVID recovery. Once again, what this class of model tells you is that not only aggregate stimulus matters, but its composition is crucial.

You want to try to engineer a stimulus that jumpstarts investment so that you try to jumpstart the productivity growth rate of the economy, which is easy in theory, in the simple model that we work on. It's much harder to do in practice. I think there are big gains trying to go into that direction—trying to understand how to design macroeconomic policy that fosters investment and give us productivity growth—and perhaps embed them in our automatic fiscal stabilizers.

Beckworth: Those are great points, Luca, and thank you for bringing me back down to earth, that it's not just about when you're in a deep recession—you want preventative measures. You want to have policies in place that manage expectations, as you said, so that you don't actually get to the cliff and go over it. You want automatic stabilizers.

Once you're in that deep recession, another great point you just brought out was, it's not just about getting money out the door to be spent, it's about targeting it to investment spending, because that really does seem to play an important role in the business cycle and expectation formation. That also suggests it's important for us to be looking at supply-side policies as well. Making it easier for businesses to operate, to form. Those may be longer structural challenges.

Fornaro: I definitely think so. Again, supply-side policy, insofar as the full-scale investment and productivity growth, can be a tool to manage aggregate demand. There is a catch, because you need to ensure that higher investment and higher productivity growth translate into widespread gains for the whole society. Why bring this up? Because another point that Draghi made in his speech in December is that one problem of the European Union is that it relied too much on policies that reduce real wages by making it very easy to fire workers, the labor market is very flexible.

If you are achieving higher investment, higher growth by keeping real wages down, then the benefits of this high growth are not going to be shared widespread among the society, and that's going to have a small impact on aggregate demand. I would say that supply-side policies can help insofar as they restart growth, but you want the kind of supply-side policy that brings income gain for a large segment of the society so that that has a sizable impact on aggregate demand.

Beckworth: You want to foster innovation, ideas, R&D research, genuine long-term sustainable real growth. And hopefully, that will be spread widely as opposed to taking shortcuts on the supply side.

Fornaro: Yes, that's the idea. You want to try to jumpstart the economy by making firms more productive, not by making them more competitive by reducing labor costs. That's a policy that might work in the very short run, but it's not going to give you sustainable growth in the long run, which, again, I think is a brilliant point made by Draghi.

What About Population Growth? 

Beckworth: Let me go back to the original endogenous growth models, Paul Romer, and again, the way that I originally saw them, because I think it's pertinent, it's relevant here to our discussion. One of the implications of those models is that you need population growth because people bring ideas, and you can think of that as supply side. You have more people, there's going to be more idea generation. I believe though that there's that demand side story as well. The bigger, the healthier the market, the more labor specialization can occur, more productivity growth that way.

A key insight of his model is that we need population growth to get idea generation. Yes, there's diminishing returns to idea generation. Chad Jones had that subsequent, the semi-endogenous growth model, there's diminishing returns to generating ideas. It strikes me then a challenge for the world is we have decline in population growth rates, and so we're not going to get all the idea generation. Maybe AI is our solution, I don't know. Do you worry about that, that one of the key supply side drivers, population growth, is not something we can't necessarily rely on going forward?

Fornaro: I definitely do worry about it. Being a European, we have definitely a problem of low productivity growth. And being an Italian, which low population growth is a very serious problem. However, you touch on the debate between fully endogenous and semi-endogenous growth model. There is this dichotomy in the endogenous growth literature. Some model in the strand of Romer or Aghion and Howitt predict that we are going to have steady growth out of firms' investments. Some other, like Chad Jones predicted, in the long run, productivity growth is the result of population growth.

However, when you think about the implication of these two classes of models for the medium run, what's going to happen over the next 5 or 10 years, they are surprisingly similar. Even if you work with the type of model that Chad Jones has proposed, you do see that the kinds of policy that sustains demand and creates an environment where firms can invest are going to have an impact on productivity growth. I would say that if you focus on the medium run on a 10 years’ horizon, the difference is not that important.

Beckworth: Oh, very interesting. I was focusing more on the long run where population growth is more consequential. You're saying, "Look, there's the medium run." Like Keynes said, “In the long run, we're all dead.” In the medium run, we might still be alive, and we need some good macroeconomic policies, both preventative, the automatic stablers, but also if you hit that, that big depression. What do you do to get out of it? Keep us alive in the medium run, right, Luca?

Fornaro: That's exactly how I see it. I mean, the literature on the long run is very interesting, but it's very hard to empirically assess who is right or wrong. Also, people, firms, when they form their decision, I don't think they have the very long run in mind, but perhaps the horizon of what is going to happen over the next decade. I think that if you want to understand how firms behave, how households behave during a recession, focusing in the medium run is the right horizon.

The Empirical Side

Beckworth: Let me ask you about the empirics of this research agenda. How do we measure, how do we know, when we have hysteresis? I mean, I gave a simple explanation, look at some simple trend lines on real GDP, but you as a researcher probably want something a little more robust, a little more rigorous. How do you think about the empirical side of hysteresis and stagnation traps and all that stuff?

Fornaro: That's a great question. Here, we're facing a problem, around data limitation, because if you want to focus on aggregate macro data, I think that the time series that we have are not long enough to tell us about what is going to happen definitely in the long run, but also perhaps over a decade or so. Luckily, now, we are adding a new wave of research, which is looking at the connection between, most of all, macroeconomic policy, firms' investment, and productivity, which suggest that there might be something to it.

For instance, there is work on the monetary policy front done by Jorda, Taylor, and Singh and by Yueran Ma and Kaspar Zimmerman, who suggest that monetary policy interventions, for instance, a monetary policy contraction, might depress productivity growth by discouraging firms' investment. There is also some very interesting recent work on the fiscal policy side. There is a very nice paper by Paulo Surico and by Antolin-Diaz, which suggests that public R&D spending tends to foster investment and investment in R&D by private firms and result into higher productivity growth.

There is a very interesting paper by Ethan Ilzetzki from the LSC which studies an historical example in which government purchases improved firms, led firms to invest more and improve their productivity. Looks at the impact of government purchases of airplanes during World War II, and he finds that this demand stimulus led firms to upgrade their productive technique and become more productive. I think that there is this new wave of research. I hope and I think that there will be more in the future that they will tell us more about, most of all, the empirical strength of these effects. Again, we have to be clever because we are facing data limitation in that the time span of the data that we have is not very long.

Beckworth: That is the curse of the macro economist, right? Identification, having data. We can't do randomized controlled experiments on humanity. We can't run the world through recessions, then through booms. We do what we can with the data that we have. Now, you mentioned, I believe, the Sanjay Singh, Oscar Jorda, and Alan Taylor paper. That was interesting to me because they have this great data set that spans, I don't know, 1870 to the present, 40-some countries.

What was interesting is they clearly show there is hysteresis, right? They showed that—Was it monetary policy tightening? Is that what it was that leads to the hysteresis?—you actually see a decline in the capacity of the economy, productivity of the economy, which was really fascinating. It's clear evidence that there is hysteresis. This is a great example, and that was a great answer. It also leads to a question I want to ask you that they also look at. They look at monetary easing and they don't see kind of a reverse of hysteresis.

I don't want to use the word reverse hysteresis because I think reverse hysteresis is when you're at the bottom of a deep recession and you come back. I'm thinking more, let's say, you're at full employment. Let's say you're on the right trend path. Can you run the economy hot and get some added benefits? Can you get added productivity, added potential world GDP growth if you're already at full employment and then you run the economy hot? I think their papers suggest the answer is no. I wanted to see what you thought about that.

Fornaro: I think that that's very much an open question, because it's true that they find that monetary contraction tends to depress productivity growth, while they don't find a positive impact on productivity for monetary expansion. Other papers, the one for instance by Zimmermann and Ma, do suggest that even monetary expansion can have a positive impact on productivity. Ethan Ilzetzki's paper looks at the case in which fiscal stimulus done in an economy which is running hot—because the US economy during World War II had a very low unemployment rate—managed to increase firms’ productivity. I think that the jury is still out.

Let me also say that I think there are good theoretical reasons to think that it might be hard to find an impact from running the economy hot on productivity, because personally, I see having a robust aggregate demand is a necessary condition to have healthy productivity growth. You want to have robust aggregate demand to give firms incentives to invest and to become more productive in the future, but it's not a sufficient condition because they can come up with historical episodes in which a hot economy coincided with a slowdown in productivity growth.

Perhaps the best episode is Spain, the country where I live in. Spain, between the early 2000s and the great financial crisis, was a very hot economy. That strong demand. And employment rate was declining massively. This hot economy was due to the inflows of foreign capital. At the same time, over this period, productivity growth was stagnant. It didn't pick up. I think the reason is that we had strong aggregate demand, but this aggregate demand went to sectors such as services or construction, where the scope for productivity gains is limited. When you want to increase productivity by running the economy hot, you need to be careful both about the level of aggregate demand but also about its composition. Where is this aggregated demand going? Is it going to sectors which have scope for productivity growth, or is it going to construction, which is the typical example in which the scope for productivity gains are  very limited?

I think that this is a very interesting question. Finding a definite answer is going to be hard because whether high aggregate demand leads to higher productivity is a complex issue that depends on the composition of demand, not just on its level.

Beckworth: Once again, we don't have a lot of data to test it, so we have to stick to theory here.

Fornaro: Here, I can tell you that we have some historical patterns that keeps on repeating itself. If you look at historical episodes of countries that experienced a large capital influence, which has a source of demand boom, of running the economy hot, perhaps surprisingly you find that they tend to be associated with the slowdown in productivity growth.

It's interesting because, if you look at the impact of capital influence on productivity through the lenses of a simple neoclassical growth model, you would expect that influence of foreign capital should boost firms' investment and future productivity. It looks like in the data, that's the opposite. The case of Spain is the best example.

I have another paper with Gianluca Benigno and Martin Wolf called “The Global Financial Resource Curse,” which suggests that something like that might have operated in the US during the period of the global saving glut, the massive capital flows from China. We think of this kind of episode as the episode of financial resource curse, because they're similar to the natural resource curse literature, which the discovery of natural resources push demand toward construction and services that creates a productivity growth slowdown. Here, the countries are not discovering natural resources, they're in access to cheap finance from abroad. On that, we do have quite a bit of evidence.

Directing Capital Flows

Beckworth: What are the policy implications? What you found and what you show in that paper is that when the capital flows in and it stimulates aggregate demand, you want it directed into the right sectors. What often happens is it goes to construction, to housing, the non-tradable sector, not as productive. How would one do that? How would one direct that added aggregate demand stimulus?

Fornaro: That's, again, a great question. The first response that you might have is if capital flows are going to repress productivity, perhaps we should stop capital from flowing in. We should take policies that reduce capital interests and the trade deficits.

In that paper, we argue that a better possibility is to use this cheap money coming from abroad to finance investment in sectors which have more scope for productivity growth, which is hard to do in practice. We do have some guidance from some recent empirical evidence. There is a very nice paper just published by Karsten Müller and Emil Verner, where they look at credit booms and their impact on productivity. They separate credit booms that go to nontradable sectors, so construction services, and credit booms that go to tradable sectors, so manufacturing and tradable services.

What they find is that credit boom going to the nontradable sector tend to be associated with slowdown of productivity growth, while credit boom going toward the tradable sector tend to predict high productivity growth in the future. We have a little bit of guidance of where you want this money to go. Then how to get there in an efficient way is a difficult and open question.

Beckworth: This is very interesting, Luca, because the current Trump administration, some of the thought leaders in it, raise this very question. They may not use the term “financial curse,” but they do look at the dollar's exorbitant privilege as a burden of sorts because all this capital is flowing in, and they believe it's gone to the wrong sectors. What you're suggesting is we don't want to necessarily end the capital flows, we just want to direct them in a more productive way, put them into something in the tradable sector, maybe some industries that we think they're important. Is that a fair interpretation of what you're saying?

Fornaro: Exactly. The idea is that our work suggests that, yes, there might be a negative effect from running a large trade deficit and importing a lot of capital, but these negative effects come a bit from a domestic policy failure. Failure to direct this capital where there is scope for productivity growth. If I think about the US now, for instance, green investment, even though they're not very popular right now, but green investment would be an obvious sector that I would subsidize.

Beckworth: Speaking of President Trump, right now, as you know, he's running a trade war. From the US perspective, I think you can say we're getting negative supply shocks. These tariffs are effectively negative supply shocks on the economy and likely to create a recession if they persist. That's what many forecasters are now saying.

The Scars of Supply Shocks

You have a great paper that speaks to this very question about supply shocks. Can they scar permanently? You have coauthored this paper with Martin Wolf. This is not Martin Wolf of the Financial Times; this is Martin Wolf, the economist. The paper's title is “The Scars of Supply Shocks: Implications for Monetary Policy.” Walk us through this paper and tell us how this ties into this bigger narrative that you're telling about hysteresis.

Fornaro: We wrote that paper in response to the COVID recession, where supply shock became salient on the global supply chain disruption, high energy prices. We wanted to think about the implication that the shock had in this Keynesian growth model.

I think that there are mainly two lessons to be drawn. The first, which is what you already said, is that in these frameworks, even a temporary negative supply shock can have a persistent negative effect on the future productive capacity, because, for instance, if you have a period in which tariffs are high, firms may have a hard time accessing intermediate input, they might have a hard time to invest to increase the future productivity. Or perhaps during a period of negative supply shock, the central bank might want to react by increasing the policy rate, increasing the cost of credit, which is also going to be a drag on investment by firms. This endogenous mechanism makes the impact of negative supply shock more persistent.

The second result is about inflation. We know that negative supply shocks tend to be inflationary, tend to increase production costs. If you add to that, this endogenous response of investment and productivity, you see that this inflationary effect can spread out into the future, because if firms cut back their investment, they're going to be less productive in the future. Their production costs are going to be higher in the future, and that's going to create high inflationary pressures.

We think that that's a pretty cool result because, during the COVID pandemic, inflation was more persistent than many people had anticipated. Perhaps that has something to do with the endogenous response of investment in productivity. That tells you also something about the appropriate macroeconomic policy to disinflate the economy, because the usual one is to run a monetary policy tightening, because that's going to reduce aggregate demand and inflation in the present. But the monetary tightening is likely to have a negative impact on investment, as well as the empirical paper that we cited before suggests.

If so, monetary tightening may reduce inflation in the present, but by reducing social productivity, it might push inflationary pressures into the future. There might be an intertemporal inflation trade-off for the central bank. Again, if you put that together, you see that if you want to disinflate successfully the economy, you need to complement a monetary tightening with fiscal policy that preserves the productive capacity of the economy, for instance, subsidies to investment, to make sure that a monetary tightening does not translate into lower productivity growth in the future.

I would say that the Biden administration went into that direction, because a monetary tightening was coupled with subsidies to a certain type of investment, for instance, in green technologies.

Beckworth: A key channel through which even a temporary supply shock can have permanent effects is the response to monetary policy. I also think, though, back to the pandemic, again, that the economy, it fell so dramatically, such a sharp drop. Even if it was a supply shock, even if it was temporary, it was really, really deep. Had we done nothing, just the expectations, the uncertainty could have created some self-fulfilling issues.

In my mind, it's often harder than—at least when we talk about it, or we write it down—to separate cleanly a supply shock from a demand shock. A supply shock can quickly turn into something like a demand shock. Again, the pandemic: If we close the economy down, unemployment explodes, people suddenly get pessimistic. They're worried about their mortgages on their homes. They worry about making payments, having food on the table. This could quickly turn into something where it becomes a demand problem, even though it starts out as a supply problem. There are ways to go from supply to demand, even without the monetary policy authority acting, correct?

Fornaro: That hits on another insight from that paper, if you want, because if a shock generates through the mechanism that we talk about, scaling affects permanent damage to the product capacity of the economy and to people's future income. That's going to translate into low demand today, because people anticipated that they would be poorer in the future; they would be less willing to spend in the present. So you're totally right.

Once you think about supply shocks through the lenses of this Keynesian growth framework, you see that they can quickly morph into a negative demand shock. You can get this bad combination of high inflation and low aggregate demand.

Another insight that this type of model gives you is that animal spirits may play a role. When the fundamentals of the economy are weak, that's when animal spirits can trigger the amplification mechanism that we talked about before and push the economy into a stagnation trap. I think that putting all this together, a strong policy response was the right kind of response to prevent a low-growth mindset from kicking in.

Beckworth: I think this is relevant even now because, at least in the US, as we head into this year of uncertainty with what seems like supply shocks hitting the economy, we're going to see inflation go up, and we're going to see real GDP go down. In fact, last week Fed Chair Jerome Powell made a speech. He goes, "This is a challenging scenario when our dual mandate is in tension, when we have the two goals going in different directions."

I think the important point is, initially, they might want to look through this, and that is a central bank operating procedure. When you have supply shock inflation, just look through it initially, but then they get concerned: "If we look through it too much, if inflation expectations become unanchored, what do we do?" Then they want to tighten. How much looking through can they do? How much tightening can they do? You suggested they tighten, but then they have an offsetting fiscal policy to support the tightening.

The Nominal GDP Targeting Solution

Let me throw out my solution to this problem. You won't be surprised, Luca, but I think nominal GDP targeting is the answer because nominal GDP targeting allows a central bank to look through inflation. In fact, a nominal GDP target, central banks don't even look at inflation in the short term. Their eyes are focused on total aggregate demand, and they try to stabilize that. They don't worry about inflation in the short run. They try to keep aggregate demands stable. You got a nominal anchor. Inflation expectations shouldn't be exploding. What do you think about that solution?

Fornaro: I tend to agree with you. I think that it would be an improvement compared to the current framework because it embodies the idea that you might want to look through temporary inflationary pressures that you want to stimulate the economy when aggregate demand becomes weaker. Personally, I think that monetary policy is one tool that we have to stabilize the economy. But even the experience of the post-financial crisis, and the zero lower bound and liquidity trap kind of issues, fiscal policy should also play a role.

Nominal GDP targeting could be an improvement on the current monetary policy frameworks, but I think that framing stabilization policy purely in terms of monetary policy is not going to be enough. We need to bring fiscal policy into the picture.

Beckworth: No, absolutely. I just think having, though, the framing of a nominal GDP target will empower and guide fiscal policy as well as monetary policy. If the understanding is we can't have high inflation, it's going to affect policymakers who want to do fiscal policy, if they're worried also about inflation.

I think creating the environment that a framework gives you permission to keep aggregate demand stable, whether it's through monetary policy or fiscal policy, I think it's a powerful tool. So, I agree. I don't think in deep, deep recessions monetary policy by itself can do it, but you got to empower macro policy to do something. Anyways, I think nominal GDP level targeting completely changes the mindset.

Again, go back to the 1930 example I gave you. Policymakers were focused on inflation in 1934, hitting 4, 5 percent, even though the price level was 30 percent lower. Had they looked at the dollar size of the economy, they'd be like, "Oh my goodness, we still haven't reflated. We're still way below where people thought their nominal incomes would be." I'm thinking of just more of a general framework, but fair point on that.

Fiscal Stagnation

Beckworth: Luca, we've been talking about how to get out of stagnation traps, how to be concerned even about supply shocks, because it can lead to hysteresis as well. A lot of the solutions involve fiscal support. What happens if we have so much fiscal support? We got a large debt of GDP, and there's fiscal worries.

I bring that up because you have a nice paper titled “Fiscal Stagnation.” What is fiscal stagnation? Then how do we close this circle? How do we tie this all together and come up with a clean policy solution?

Fornaro: Thanks for bringing that up. A lot of my work and a lot of what we talk about suggests that you want to have fiscal stimulus. But of course, the problem is how do you finance it? Up to now, we finance it largely through running up government debt. We are in a situation in which public debt related to GDP is very high in most advanced economies. That triggered Martin Wolf and me to think about it and about the implication for productivity growth.

We have this new paper called “Fiscal Stagnation” in which we provide a framework that allow us to think about public dynamics and productivity growth jointly. We think there is value added to it because of a two-way interaction between fiscal policy and growth. If you think about it, if you have a government with a high stock of public debt, you need to come up with high primary surpluses in order to sustain it. In doing so, you're likely to take measures such as imposing high taxes on labor or capital, or cutting down public investment that are going to hurt firms' investment and productivity growth. High primary surpluses might damage productivity growth.

At the same time, a slowdown in growth tends to push up the debt-to-GDP ratio. It's going to call for even higher fiscal adjustment in order to make the debt sustainable. There is an amplification effect going from fiscal distortion to growth. What we show in the paper is that this amplification effect can lead the economy to a state that we call fiscal stagnation. That's a persistent and self-sustaining state of high fiscal distortion, so high taxes, low public investment, and weak growth.

Then in the paper, we ask, what can you do to get out of it? What can you do to get out of fiscal stagnation? We consider two approaches. One is to do fiscal austerity. The classic solution. You have a high stock of public debt, you want to run it down, so why not increase taxes even more to get more fiscal revenue and repay the debt? The problem with this solution is that high taxes are going to make the low investment problem even worse. They're going to generate low growth. They're going to make the adjustment through that margin particularly painful.

Another option is to think about progrowth policies. What if you put in place fiscal policy that helps to jumpstart investment and growth? You reduce the public debt-to-GDP ratio by increasing GDP. That's definitely a more appealing solution, but it is a problem, which is the following. Many of the fiscal interventions that stimulate investment are subject to what, in macroeconomics, we call a time consistency issue. The government, before firms have invested, has an incentive to promise low future taxes, high future public investment, to attract investment by firms.

Once firms have invested, the government might have an incentive to break these promises made in the past in tax, the return from investment at a high rate. Progrowth policies are a potentially good solution, but they require credibility and commitment on the side of the government, so they might be hard to attain.

Actually, we think that this is a relevant paper, especially if I look at the experience of my country, Italy, over the last 30 years. In Italy, we've been having very high public debt since the early '90s. To sustain it, the Italian government had to come up with very high primary surpluses, which were a dangerous combination of high taxes on labor and capital and low public investment. Over the same period, productivity growth has slowed down remarkably.

Now, there are many drivers behind the productivity growth slowdown in Italy, but I think that fiscal distortion is one of them. I think that it's really a case in which there are elements of fiscal stagnation. Given that in many countries, public debt is reaching Italian levels, one wonders whether this kind of dynamics can happen soon as well.

Beckworth: The best solution is to simply grow your way out of the high debt burden, get the GDP and the denominator to grow more rapidly. That's the least painful way.

Fornaro: That's the least painful way. That's also extremely hard to attain, both because, in practice, it's hard to design a fiscal policy that boosts growth. Second, because even if we can do that, they are going to be subject to this time consistency issue. For instance, again, promising low future taxes might be an appealing example before firms have invested. But of course, investment has been done, and the government has an incentive to say, "I need fiscal revenue. I will tax these profits at a higher rate than what I promised." That might be hard.

There are other possible solutions, thinking about debt write-down, or about taxing wealth, imposing a wealth tax to reduce public debt. They come with their own problem. I think that's a discussion that we need to have, for sure, in Italy, where public debt, I think, is a big drag on growth, but potentially in other advanced economies too.

Beckworth: This ties into your previous articles that we discussed, and that you also invoke the endogenous growth model here, too. You're arguing that this fiscal austerity becomes a drag because of that endogenous growth story. You're tying fiscal policy to investment demand, to productivity, with expectations, and you get this fiscal stagnation trap. Is that a fair assessment?

Fornaro: Yes, exactly. One key mechanism behind fiscal stagnation is the idea that tight fiscal policy, by depressing aggregate demand, or by imposing distortionary taxes, or by taxing low public investment, are going to discourage private investment and so, growth. Yes, endogenous growth is really key.

Beckworth: Luca, we are running low on time. Any final thoughts on this paper, your “Fiscal Stagnation”? Listeners, we'll provide links to all of his papers in the podcast webpage. But tell us, Luca, any final thoughts on your fiscal stagnation paper?

Fornaro: Yes. What I can say is that in that paper, we provide a very simple model to think about the relationship between growth, public debt, and fiscal policy. I think a very, very important area of research that could be followed in the next year would be to try to quantify the strength of these effects to come up with empirical evidence on the impact of fiscal policy and growth. We cited some before, but I think that that's a priority for macroeconomic research: to bring endogenous productivity growth into debt sustainability analysis.

Beckworth: Very interesting. Circling back to the very beginning, we want to avoid these very situations where we have high debt to GDP by making sure that we don't get into hysteresis in the first place. We don't have collapses in aggregate demand. We want to have good policy in place. You suggested we want to have good automatic stabilizers, and if we get past that, have good aggregate demand policies in a deep recession, so that we don't get to the place where we have the situation to deal with. If we do, turn to Luca's paper, and he'll provide some answers. With that, our time is up. Our guest today has been Luca Fornaro. Luca, thank you so much for coming on the program.

Fornaro: Thank you very much.

Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. Dive deeper into our research at Mercatus.org/monetarypolicy. You can subscribe to the show on Apple Podcasts, Spotify, or your favorite podcast app. If you like this podcast, please consider giving us a rating and leaving a review. This helps other thoughtful people like you find the show. Find me on Twitter @DavidBeckworth and follow the show @Macro_Musings.