Saturday, May 28, 2011

Trends, Doom, and Gloom

A few negative pieces of information seem to have put the usual people in a funk. DeLong is panicing, Krugman invokes the D-word, and David Leonhardt wants something done NOW. Mark Thoma is more restrained, but wants us to "fix" the deficient demand problem he perceives.

Thoma shows us some pictures from one of Lucas's talks, one of which shows the US real per-capita GDP time series going back to 1870. The key feature of the time series, as most people know, and as I point out to my undergraduate students, is that it hews very closely to a 2% growth trend, excluding the Great Depression and World War II. What we find compelling about this is that it conforms roughly to the behavior of a standard neoclassical growth model subject to a constant rate of growth in total factor productivity (TFP). Of course, while the neoclassical growth model tells us a nice simple story about trend growth, it does not have much to say about the Great Depression, what was going on in World War II, or what causes fluctuations about trend. As we know, those issues get us into various kinds of stochastic shocks, frictions, heterogeneity among economic agents, etc., that we add to the basic framework.

Fundamentally, though, most macroeconomists seem to agree on what the basic driving forces are behind economic growth and the models that are useful for understanding trend growth. This I think is the source of Mark Thoma's faith that we will ultimately return to the 2% per-capita real GDP trend growth path that we embarked on in 1870 (or earlier). Most of us cannot see any good reason why historically-observed TFP growth should not continue indefinitely in the US at a rate that produces historically-observed per-capita trend GDP growth.

But how have we been doing recently relative to trend? The first chart shows the natural log of post-1947 aggregate real GDP (not per-capita) with a fitted linear trend, which implies average growth of 3.3%. The next chart shows the percentage deviations of real GDP from the trend. The interesting thing about this chart is the recent history. Note that the largest recent positive devation from trend was 3.43% in 2000, and that the growth rate in real GDP has (roughly) been below the post-1947 average of 3.26% since. The current deviation from trend is an enormous -13.4%, which is unprecedented in the 64-year sample.

Thus, in this sense things definitely look bad. Given the slow recovery from the recent recession, we are continuing to lose ground relative to the post-1947 trend. Can we say that the post-1947 trend is "potential GDP," and that we currently have a 13.4% output gap? Of course not. Without understanding the mechanism driving the recession, we cannot say what economic inefficiencies might be at work here or what fiscal and monetary policy should be doing about this, if anything. David Leonhardt has the answers though. In fact, he read about it in a textbook:
Any temporary measures will eventually need to lapse, of course. But the current moment remains a textbook time to use them — when the economy is struggling to emerge from the aftermath of a terrible recession.
I'm not sure what textbook David has in mind. Presumably this book has a description of a quantitative model of the macreconomy that includes some financial frictions and allows us to think about how the incentive problems in the mortgate market and, more broadly, in the financial intermediation sector, acted to bring on the recent downturn. Such a model must also tell us how quantitative easing works to boost output, as Leonhardt seems convinced that Ben Bernanke is reading the same book:
The Fed could stop worrying so much about inflation, which remains historically low, and look at how else it might encourage spending. As Mr. Bernanke has said before, the Fed “retains considerable power” to lift growth.

Now, I'm not sure whether this is encouraging or not, but the next chart shows the path of real GDP from the most recent NBER-dated business cycle peak, relative to the previous two recessions. What is interesting here is that, given the depth of the recent recession, the negative deviation from a 3.26% growth trend (from the NBER-dated business cycle peak) appears no more persistent than in the recent two recessions. Thus, whatever phenomenon is driving the slow recovery may not be new, and may have nothing to do with the particulars of the financial crisis.

In any event, what I do not like in any of the blog/mainstream news posts I have linked to above is the notion that we know exactly what is going on, and exactly what we should be doing about it. There are good reasons to question Keynesian orthodoxy in the current context. Even if we thought that sticky wages and prices were important factors in the recent recession (which I do not), it is hard to believe that the effects of this stickiness would matter 14 quarters after the onset of the recession. Those pushing the Keynesian narrative need to provide us with some more explicit evidence about wage and price stickiness as it relates to recent events.

Further, though Keynesians may wish for more stimulus, they are not going to get it. It cannot come from the Fed, for reasons I have discussed before, and the federal government seems incapable of deciding how big it wants to be, let alone whether it wants to engage in Keynesian fine-tuning.


  1. Most of us cannot see any good reason why historically-observed TFP growth should not continue indefinitely in the US at a rate that produces historically-observed per-capita trend GDP growth.

    So, if I understand correctly, one could expect the historical 3.26% yearly growth in input to continue. But:

    The current deviation from trend is an enormous -13.4%

    So, one could almost say there is a gap in output between the current situation and the historically-observed TFP growth rate. But no; and not just no, but "of course not":

    Can we say that ... we currently have a 13.4% output gap? Of course not.

    I honestly don't understand the distinction you're making here, much less how you can consider it, as you apparently do, self evident.

  2. In the post you link to to say “It cannot come from the Fed”, you write:

    “If the government is no better or worse than the private sector in some activity, then if the government engages in more of that activity this is irrelevant. The government's activity simply displaces the same private activity one-for-one. If the government and the private sector have exactly the same technology for producing coffee cups, the government cannot increase the supply of coffee cups by producing more, unless it drives the private sector producers out of business. This is essentially the basis for all the government neutrality theorems we know about.”

    Allright, let me try this, which is related to Andy Hareless’s comment’s point 2:

    1) Suppose the coffee cup industry has a typical supply curve. It slopes upward. The industry has large sunk fixed costs, and it’s producing at a point where utilization of those fixed costs is such that marginal costs are rising. A typical situation.

    2) Suppose that the government is able to produce coffee cups at about zero marginal cost (like it can produce loanable currency at about zero marginal cost, putting aside inflation risk for now), or suppose that the government is willing to sell below marginal cost because there are large positive externalities to coffee cups; they make unemployed workers more productive and attractive to employers.

    Thus, the government decides to lower the market price and increase the quantity consumed of coffee cups. The current price of a coffee cup is $5, and the government says we will sell as many as people want to buy at a price of $3.

    Will the government be able to hold that price at $3 and increase consumption of coffee cups greatly, without every private coffee cup producer ceasing production?

    Yes. Due to the upward sloping supply curve for the industry, there’s still a substantial, although smaller, number of coffee cups that the industry can produce where marginal cost is still less than the $3 price.

    In the short run, private coffee cup producers will keep right on producing and selling that number of coffee cups at the $3 price because it’s still at or above marginal cost for those units. Now, in the long run, it may no longer be enough above the marginal cost to cover the fixed costs. But in the short run, and medium run too, those fixed costs are sunk, the factory’s already been built. Until it wears out, they’ll keep producing any units with fixed costs at or below the $3 price.

    Thus, in the short or medium run, at least, the government can supply coffee cups, and lower the price, without just displacing private supply 1 for 1.

    Now, with loanable funds, you have the same thing, an upward sloping supply curve, not a flat one. If the current market interest rate is 3%, and the government says it will supply as much loanable funds as people want at 2%, the new price WILL drop to 2%. At that new price private suppliers will consume more, and save less, supplying less loanable funds, but a certain amount of loanable funds will still have for them a lower marginal cost than the 2% (as current consumption has diminishing returns).

    So, the government will be able to lower the interest rate without displacing all private suppliers of loanable funds. The private suppliers will still want to supply a non-zero amount when the market price drops to 2%. And at the lower price of 2%, demand and utilization will, of course, rise.

  3. First anonymous,

    "one could expect the historical 3.26% yearly growth in input to continue"

    I'm saying that's not crazy. It's a least based on a coherent model, but requires some blind faith that long-run TFP growth continues at its historical pace.

    "I honestly don't understand the distinction you're making here..."

    I think that's because you don't understand what an "output gap" is. As commonly used in Keynesian economics, the term applies to the gap between "efficient" output and actual output. To tell me what the output gap is, you have to have a theory for what is causing the gap, and then go about measuring it. In principle the gap could be zero, it could be the whole 13.4%, or it could be something else.

  4. So what you're saying is, we're way off trend, nobody knows why, and we shouldn't try anything until we do know why?

  5. I think we can reasonably expect a return to trend somewhere around the neighborhood of 2-3%, assuming we don't make any bad policy choices (and this includes not changing policy to adapt to new situations). So far I think we have avoided serious policy errors that will impact long-run growth. That's not to say I'm not concerned about the large deviation from trend growth. My suspicion is a lot of that is cyclical and will correct itself in due time. I think government policy may want to turn to increasing the efficiency of the economy, this would help in both the short and the long run.

    On your note about Keynesians - there is really no piece of evidence that could make any of the Keynesians you mentioned reconsider their model. All they need is a chart of real GDP and a trend line and they are able to tell you if we are experiencing inadequate "demand." They don't care about the details of specific recessions or even try to figure out underlying fundamentals. For example, when all of the Keynesians starting whaling about Japan's "Lost Decade" and how we are on the road to that, I looked at Japan and thought the situation there looked nothing like what the New Keynesian model would suggest. The more I read about the situation there, the more it looked like the problems were supply-side and bad government policy. I'm not sure how anybody could read Caballero's "zombie lending" paper or Hayashi-Prescott's lost decade paper or NBER's 2003 book "Structural Impediments to Growth in Japan" and still come away and seriously argue that Japan's problem is all about "aggregate demand." Now, of course, I'm not arguing that every economist should be familiar with this literature - that would be unfair. What I am arguing is that if you are going to keep parroting that the U.S. is on it's way to a "Lost Decade" you damn well better have read the academic literature on the topic. This especially goes for people that are public intellectuals. I get the feeling people like Krugman, DeLong, etc. have never read any of these papers. Similarly, I get the feeling these people don't care about the details of this recession. It's just a drop in demand and nothing is going to change their mind.

    Although, speaking of New Keynesian economics, I think I know why these guys are pessimistic. There were a lot positive signs that are now turning negative. Gas prices were high and rising, but now it looks like they are falling - this will do major damage to the U.S. economy. It originally looked like there might be a resurgence of labor union power this year, but those hopes seem to have been premature. And now even Obama is even calling for corporate taxes to be cut, which we know is contractionary. That damn "Paradox of Toil" of the standard New Keynesian model will get you every time ! (see this paper: ).

    (To be fair to Gauti Eggertsson though, he at least considers in the introduction these implications could be considered a weakness of NK theory, I doubt most Keynesians would be willing to admit their theory could be wrong - no matter how odd or foolish some of the outcomes of the model may be).

  6. ScottB,

    No, you haven't got it yet. I have some ideas about what is going on, which I have discussed at length in other posts, but I'm not willing to offer a serious policy conclusion in a blog piece without the serious research to back it up. David Leonhardt's ideas seem to come straight out of Krugman's blog and his op ed pieces. Krugman is of course very sure of himself and, as is well known, not shy about offering policy advice with very little to back it up.


    Thanks. You're very thoughtful, as usual. Yes, humility is typically not a characteristic of the purveyors of the paradigm.

  7. “the government cannot increase the supply of coffee cups by producing more, unless it drives the private sector producers out of business.”

    I’ll make it more succinct.

    Suppose the private market supply curve is sloping upward, as is normal.

    Suppose the current price is $3. Draw your dash-dash-dash’s to the supply curve from $3 to a current quantity, q0. Also, draw a standard downward sloping demand curve that intersects at $3.

    Now, the government decides, for whatever reason, to supply as many coffee cups as consumers want for only $2. Draw your dash-dash-dash’s from $2 to the new quantity that the private producers will supply – It’s less, but it is not zero.

    Now keep on drawing your dash-dash-dash line to the amount that consumers will buy at $2 from the demand curve – It’s greater than before the government intervention.

    Thus, the government DID increase the supply of coffee cups, and private production DID NOT go to zero.

    There was not a 1 for 1 trade-off. On the graph you can see that the amount the government produced was equal to the whole private shortage at a price of $2 (D$2 – S$2), but the amount the private sector lowered production fit WITHIN that area; it was just (S$3 – S$2). On the graph your dash-dash-dash’s will make two rectangles. The government’s added supply is equal to the length of both rectangles together. The private sectors decrease in supply is equal to just the length of the first rectangle.

    Your theorem may be assuming long run, where suppliers won’t make enough above marginal cost to cover fixed costs and normal profit, but in the short run, fixed costs are sunk, and they’ll keep producing any units whose marginal cost is less than the price.

  8. "Without understanding the mechanism driving the recession, we cannot say what economic inefficiencies might be at work here or what fiscal and monetary policy should be doing about this, if anything."

    What alternative drivers are there and, approximately, how serious would you take the top 3 or 4?

    Unemployment, household balance sheet issues, incredible inequality built-up over the last 4 decades, and the tightening of credit (meaning less people have less discretionary or any $ as well as access to other people's $) would seem pretty dominate drivers for a notable consumer economy, no?

    What could be more dominate drivers in the context of our economy?

    I imagine businesses not hiring and banks, for instance, parking their money at the Fed to take advantage of higher interest rates there are strong and closed spigots, but the first is likely largely based on low demand and the second is likely kind of related to the first - no business expansion for the banks to invest in.

  9. Richard,

    You have to do it in general equilibrium, and take account of how the government finances this. I got my students to do some of these exercises. Take the model in Chapter 5 of my intermediate macro book, but be a little more explicit. The utility function is u(c+g,l); c is consumption of privately-produced goods, g is goods provided by the governnment, and l is leisure. Assume a standard constant returns production technology y=f(K,L), where y is output, K is capital (though you can drop the capital if you want), and L is labor. The aggregate resource constraint is c+g=F(K,h-l), where h is the consumer's time endowment. Assume that the government has access to lump-sum taxes. Now, suppose a competitive equilibrium where g=0, and let (c*,l*) be the quantities of consumption and leisure in equilibrium. Then, suppose that the government levies lump-sum taxes to provide g. Since it is a perfect substitute for private consumption, this is irrelevant, as long as g<=c*. The key, relative to your example, is that taxes reduce the consumer's disposable income by the same amount as the reduction in spending on private goods, and then the government makes that up by providing the consumer with the goods directly. You can have the government actually produce the goods, and it won't make any difference. However, if the government sold the goods at a loss, then that could make a difference, but that could only be detreimental. You can think about cases where the government matters of course. For example, suppose c and g are not perfect substitutes, and that g is something only the government can produce. You can even get serious multipliers with complementarity between c and g.

  10. “However, if the government sold the goods at a loss, then that could make a difference, but that could only be detrimental.”

    Ok, so it seems like maybe we agree that the government could increase the production of coffee cups, and drive down the price, and increase the consumption of coffee cups, without driving all of the coffee cup producers out of business, at least in the short run, and maybe not for many years.

    And if it’s true for coffee cups, then perhaps we agree that it’s true for loanable funds; the government can increase the supply of loanable funds, and drive down the price, the interest rate, without driving out of the market all of the private providers of loanable funds, either short-term lending or long-term.

    There’s still, then, the question of could it be detrimental or inefficient.

    1) If there are positive externalities, then it could certainly still be efficient for the government to produce and sell the product at a loss.

    2) You note the exception, “g is something only the government can produce.”; fiat currency applies.

    3) There is the possibility where the government can produce something cheaper than the private section, like if there are giant economies of scale leading to natural monopoly, giant transactions costs, asymmetric information, etc. You can also argue that perhaps government can produce loanable funds cheaper, at least in the short run – the Fed just prints them, or credits them electronically; it doesn’t have to incur the cost of giving up current consumption like a private party.

    So, with regard to QE, it looks like perhaps we agree that it can lower long-term rates, at least in the short run, and thus increase borrowing, and thus stimulate the economy and increase hiring. There’s still the question of whether it’s efficient or worthwhile. It looks like it may be to me given the three reasons above, with a positive externality being the decrease in unemployment and loss of skills, of employability. And Krugman’s babysitting story also looks persuasive, at:

  11. Richard,

    "So, with regard to QE, it looks like perhaps we agree that it can lower long-term rates, at least in the short run, and thus increase borrowing, and thus stimulate the economy and increase hiring."


  12. "incredible inequality built-up over the last 4 decades"

    There is no evidence that inequality is inefficient. Stop confusing inefficiency with "what I don't like."

  13. The idea that increased demand will lead to more jobs may be wrong. The information economy does not need so many workers, what with computerizing, robots, off shoring (including managerial jobs), simple demand leading to jobs is probably wrong.

  14. I can think of one scenario where quantitative easing could matter in the current situation, though I'm not sure how realistic this is (or if my intuition is serving me badly). Let's assume the central bank and the private sector are just as capable of investing and intermediating all classes of assets initially. Observation suggests that asset markets are segmented across different types of investors. I'm sure it takes a certain kind of human capital and experience to adequately invest in different classes of financial assets and so only certain people can plausibly invest in some classes of financial assets (of course, if this is true, it's not clear why the central bank would be as skilled as the private sector but let's just go with it). Now, let's assume that there is some exogenous destruction of those agents ability to exchange certain classes of assets. Maybe there is a virus that only targets puttable bond traders and they are all dead now or maybe, more realistically, the people who intermediate certain kinds of commercial paper have lost the ability to raise funds to invest and intermediate. This has consequences since other agents in the private sector can't "pick up the slack" because they don't have the necessary expertise. So, in this scenario, when the central bank comes in and purchases these classes of assets, I think it must be having some effect in equilibrium. Obviously I'd need some kind of model and I'd need to explicitly model the frictions associated here to figure out the implications for output, welfare, and whether my intuitive reasoning even holds in general equilibrium (though I doubt I could pull this off, I'm in that in between stage where I understand what goes on in these more sophisticated models, but I'm not quite at the point where I can write my own from scratch) - but I think in the scenario I described central bank asset purchases should have the ability to move yields around, which should matter.

    I think this story I'm telling could have maybe mattered in late 2008, but I doubt it holds in 2010-2011. Also, long-term Treasuries aren't particularly difficult assets to invest in and intermediate. I think almost any financier can trade these things adequately enough. But perhaps the central bank purchase of assets that require a certain degree of sophistication to trade could matter, in certain conditions. Of course, then we have to wonder whether the central bank does have the skill to invest in sophisticated assets as skillfully as private sector agents. Since I'm assuming not everyone in the private sector has the same skill set, it may be a stretch to assume the central bank does. On top of that, we have to wonder whether it would be wise for the central bank to hold risky assets. But, I'm mostly just bouncing ideas around in my head for fun, I'm not sure if this is a plausible story or not or, if true, the effects would be quantitatively large.

  15. Pretty funny, some anonymous poster quoted my mentioning inequality and stated there's no proof inequality is inefficient.

    Well, I raised inequality as one factor in the context of a consumer economy where the consumers have little $ to spend due to family balance sheet issues, unemployment, and tighter credit.

    In fact, I added the following parenthetical phrase to make sure that was clear - "(meaning less people have less discretionary or any $ as well as access to other people's $)".

    Hey, "anonymous", if you're going to snipe, at least hit the target.

  16. What result or aspect of New Monetarism disallows the NAIRU?

    NAIRU anon

  17. Vincent sure doesn't understand economics.

  18. There is an even more pessimistic slant on all of this of coarse. Malthus will be right, eventually. Maybe we are reaching that eventuality. What are the economic consequences of bumping into planetary limits? Consider John Greer's theory of catabolic collapse in which an over extended society can no longer grow because of the overhang of deferred maintenance on its existing infrastructure. Total income can no longer pay the maintenance bills. (think decaying bridges & highways, schools and rust belt cities.) Recently Greer suggested that catabolic collapse began in this country in 1974 (about the peak on the post-war deviation from GDP graph). I commented on Greer's assertion at the time - and have link to the original post here:

  19. Ted,

    Yes, exactly. The stories (and these are just stories; there is no rigorous theory for this) about how QE works are market segmentation (or "preferred habitat") stories. As you say, you might be able to construct a rationale for the some of the Fed's temporary interventions at the height of the crisis in fall 2008 that would follow your stories. But intermediating long-term Treasury securities seems like quite an unsophisticated activity at the moment, and it's hard to believe the Fed has some special advantage. Having the Fed intermediate private assets is another matter altogether, as you point out, and there are any number of dangers lurking there.


    You are apparently a member of the Academy of Dismal Scientists. Sometimes I'm astonished at our ability to adapt and work through adversity. That long history of per-capita income growth is driven by the sustained power of knowledge and invention. A groundbreaking innovation, such as a new carbon-free energy source, would certainly go a long way.

  20. Stephen, The implications of the laws of thermodynamics is quite dismal, but I'm basically an upbeat guy. I, too, am continually amazed at how human ingenuity continues to surpass previous limits. However, having a constant positive exponent is not the same thing as being stable. When the irresistible force meets the immovable object, something's got to give.

  21. Stephen,

    It's partly my story that leads me to think the the Fed's purchase of mortgage-backed securities may have mattered initially. Of course, whether these purchases are a good thing for welfare is a completely different question and, once again, you need an explicit model for that.

    Frankly, I think it's pretty amazing our policy makers have no model for QE, but yet were so easily willing to try it. Like you said, all they have are stories. I just told a story in my previous comment that I came up with after thinking about it for 15 minutes and, as far as I can tell, isn't that much less sophisticated than anything I've heard from our policy makers. If my very coarse speculation is boneheaded and crazy, the only harm I've done is taken up some space on the comments section of a blog. If our policy makers are wrong, they have just taken a multi-hundred billion dollar gamble that can have enormous consequences. They don't even know if QE does anything. For a moment though, let's be generous to the Federal Reserve and assume QE can have real effects in the current environment (something I'm not convinced of at all - especially in the case of long-term Treasury purchases for the reason I mentioned earlier). How do they know moving yields around makes us better off? Without an explicit model of behavior you can't conclude anything about the welfare consequences of this action - especially since if asset market are segmented, then buying certain assets has distributional consequences.

    Personally, I think it's really scary that policy makers at an institution as important as the Federal Reserve haven't given these considerations the seriousness they deserve.

    (Random side note, but your blog has definitely made me consider Washington for college, I never much thought about it until I started reading your blog).

  22. Steve,

    Why do you think your views are marginal and quite far from the mainstream consensus in the profession? Curious.

  23. Neil Young once said that he tried driving in the middle of the road, but found he much preferred the ditch, or something like that. That's about how I feel.