A poor response to short-run problems can create long-run headaches
By G.I. | WASHINGTON
TWO spectacular failures stain 20th century macroeconomic policy in America: the Great Depression and the Great Inflation. They share an important ingredient: in both, policy makers could not properly gauge the economy's potential output, i.e. its productive capacity.
As my colleague notes here, many in the 1930s blamed the Depression on supply-side causes: Austrians considered it payback for years of overinvestment, while others cited the inevitable pain of reallocating resources between dying and growing industries. John Maynard Keynes wrote in 1930, “We are being afflicted with a new disease...namely, technological unemployment. This means unemployment due to our discovery of means of economising the use of labour outrunning the pace at which we can find new uses for labour.”
In the 1960s and 1970s policymakers made the opposite error. As Athanasios Orphanides, now governor of Cyprus' central bank, has exhaustively documented, they persistently overestimated the economy's potential output and thought the natural rate of unemployment was lower than it really was. As a result they ran persistently overstimulative policy, producing high and entrenched inflation. Mr Orphanides' chart, below, shows policymakers thought the output gap (the extent to which actual GDP fell short of its potential) in 1976 was a whopping 14% of GDP. But they later concluded that slower productivity growth, demographic factors and the oil shock had been degrading potential for years, and by the 1990s reckoned the gap that year was only around 5%.
These two episodes are important for addressing the dilemma that confronts macro policymakers today. Last week I pointed to three puzzles in the economic data—sluggish GDP growth, relatively rapid declines in unemployment, and stubborn core inflation—that all made sense if the level and growth of potential output are lower than we thought.
This argument has been made before, in particular by hawks at the Fed. Tyler Cowen has eloquently argued that productivity growth is in secular stagnation. As I said last week, I don't yet share this view. I'm playing devil's advocate here, and even the devil deserves a fair trial. The failures of the 1930s and 1970s demonstrate that the stakes are high. If potential really is lower, it has disturbing implications for policymakers and investors: it means the structural component of today's budget deficits are larger than believed and the Fed has less room to keep interest rates at zero. A less friendly Fed will be bad for bonds, and lower potential means lower equilibrium profits and profit growth and thus less equity upside. But if we wrongly assume potential is lower than it really is, we risk accepting years of enormous and unnecessary welfare losses.
Several commentators have pushed back against the notion that these puzzles are a sign that potential has fallen. My colleague says sluggish growth is no surprise, but the obvious result of too-tight monetary policy. But if monetary policy were systematically too tight, inflation should have fallen much further than it has; instead, both actual and (survey-based) expected inflation have been surprisingly stable, and higher than forecast by outfits like the IMF and the Fed who assign a relatively large weight to the output gap in the determination of inflation. The stability of inflation may be down to well-anchored inflation expectations, but this is ex-post reasoning; it's not an unambiguously superior explanation than reduced potential.
Felix Salmon laid out a deleveraging-based argument for reduced potential, arguing that previous growth was sustainable only with ever bigger dollops of debt:
It makes sense that if we needed ever-increasing amounts of debt to keep up that long-term GDP growth rate, then when the growth of the debt market stops, our potential growth rate might fall significantly.
Tim Duy disagrees, since this would in effect blame a shortfall in demand for a reduction in the supply-side capacity of the economy. I do have some quibbles with Mr Salmon's case, but he's right that deficient demand can reduce potential. I recommend readers check out Mark Thoma's explanation of how demand shocks can temporarily depress the supply side of the economy. Potential has long been known to have a strong cyclical component: a recession will normally discourage businesses and workers from investing in physical and human capital. A model of the business cycle by Charles Fleischman and John Roberts of the Federal Reserve Board finds potential growth fell to 1.7% in 2010 from 2.3% in 2005. But when growth picks up, investment recovers and along with it the capital stock. Mr Thoma says policy makers should not hold back on stimulative policies for fear of hitting a short-run supply ceiling, since that ceiling will rise as demand and investment pick up.
Where the supply and demand side explanations for the economy's depressed state converge is when demand remains deficient for so long that its cyclical impact on potential becomes structural. Mr Fleischman and Mr Roberts reckon the single biggest contributor to the recent decline in potential growth is the fall in the labour force participation rate since 2007. Perhaps this has been largely demographic, in which case the loss of potential was inevitable and permanent. But it may reflect hysteresis: the tendency of someone who has been unemployed a long time to become unemployable and eventually quit the labour force altogether. Demand can have a powerful effect on labour supply. In a 1984 paper Larry Summers and Kim Clark found that the Second World War dramatically boosted women's participation rates, and the boost persisted long after the war ended and the baby boom was working to push participation down. The opposite could now be occurring: with the long-term unemployed now such a large share of the jobless, we could be doing permanent damage to the economy's productive potential.
I hope not. I recently looked back at the Congressional Budget Office's estimates of potential around the 1991 and 2001 recessions. Both were followed by jobless recoveries. Three years after 1991 recession the CBO had revised down its estimates of potential by around 3%; but by 2000, it had more than revised back the difference. After the 2001 recession, the CBO actually revised potential up by 2% as productivity surged. This shows that, at least for those episodes, recession need not leave a permanent scar on the economy's productive capacity.
