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Demand, Supply, and what is new after 2008

An alterative title might be my usual comment reminding Krugman’s readers of the history of “hysterisis”.

Krugman wrote a very clear even better than usual post summarizing how his views on macroeconomics have changed since 2008. It is best to click the link, but the one sentence summary is that he wasn’t surprised by the liquidity trap, but he was surprised that the Phillips curve seems to be flat at very low inflation rates so low inflation followed by a period of high unemployment doesn’t become deflation.


Off topic comment on how Krugman’s talk will be off topic.
I will exploit the flow of Thomists who came here by clicking Mark Thoma’s link here to get people to read the following semi relevant addition.

Krugman mentioned the original impetus for his post: “I’m supposed to do a presentation next week about “shifts in economic models,” “. I fear his presentation will be a bit off topic. That is I don’t think the failure of the accelerationist Phillips curve which surprised him will cause a shift in the models most macroeconomists use. It should — a horizontal Phillips curve implies that the economy isn’t self correcting even when it isn’t at the zero lower bound. But I guess most macroeconomists will continue to use models in which detrended variables converge to a unique steady state. The reason I am confident about this is the main point of this post. Such models failed utterly to fit European data from the 1980s on. But they are still used. The models were patched by making the unexplained exogenous trend very flexible and complicated.

The policy implications remained the same — take care of inflation and unemployment will take care of itself. They are now invulnerable to evidence, because when unemployment fails to converge to what had been considered a normal level, it is concluded that there must be nothing to be done, because it is assumed that it must it just must return to normal, so we have to accept 10% as the new normal if we aren’t Spanish, since they have to accept 20% as their new normal.

The key policy implication that one should focus on inflation became invulnerable to evidence in the 80s. It is an article of faith and methodological a priori. The claim that monetary policy and fiscal austerity can’t affect long run unemployment has become a no true Scotsman fallacy. When the prediction that tight money and disinflation would not be followed by high unemployment failed utterly, the prediction became that no true effect of monetary policy on unemployment could be permanent. The accelerationist Phillips curve can’t fail — it can only be failed.

Here I noted that almost universal macroeconomists’ confident claim about the long run self correction of the real economy is an a priori assumption, and not an implication of theory (that is other standard core assumptions such as rational expectations) or supported by evidence).

The discussion has continued with contributions at Brad DeLong’s blogs here and here. Krugman replied here (including a link to the Thoma post which links to this post)

end update.

I wrote a semi snarky comment in which I suggested that the reason he was surprised is that the examples he always has in mind are the USA (of course) and Japan in the 90s, while he doesn’t constantly think about the European unemployment problem.

The natural unemployment rate hypothesis failed spectacularly in Europe in the 1980s. Extremely high unemployment did not lead to deflation — rather it coexisted with moderate inflation for a long time, then with low inflation.

Krugman posted a graph showing how the US graph of inflation and unemployment has changed (just click the link and look). In the past high unemployment gradually lead to lower inflation and then to lower inflation and unemployment — this is the pattern predicted by Friedman, Phelps, Tobin (and discussed already by Samuelson and Solow in 1960). But in the recent past extremely high unemployment has come with low and stable core inflation.

Things used look very different here in Italy than in the USA. Here is a graph of data from before January 2008. Extremely high unemployment was consistent with moderate and then with low inflation. The only clear shift in inflation occurred in 1996 and 1997 (which may or may not be when Italians began to think they might actually earn the wonderful reward of being allowed to adopt the Euro).


By 2008, The flat Phillips curve (the Fillipo curve?) was already very clear to anyone who read Italian newspapers.

Here are all data which are available on FRED (yes I sit in Rome and surf to St Louis for Italian data). Oddly the harmonized unemployment series is only available (at FRED) from 1983 on.


In this graph there is also very little sign of Friedman-Phelps cycles. The old pattern was a steady decline from extremely high inflation — it looks almost like an expectations unaugmented Phillips curve. But then (really from 1986 on) there was fairly stable moderate to low inflation along with extreme swings in unemployment. I stress that this is CPI inflation including food and energy not core inflation. the peak oil spike in 2007 and the collapse in 2008 are clearly visible. It is possible that the most recent observations show a slide to actual persistent deflation, but it is more likely that the recent decline in inflation is due to the collapse of the price of oil.

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One long term indicator changes to Yellow

by New Deal democrat (Bondadd blog)

One long term indicator changes to Yellow

One long leading indicator has turned from green (positive) to yellow (caution): mortgage rates.

Since middle class wages peaked in the 1970s, the ability to refinance debt at lower interest rates has been an important coping mechanism.  Particularly since the 1980s, whenever

  • real wages have stagnated,
  • the effects of refinancing debt have dwindled, and
  • the ability to cash in an appreciated asset has stalled,

the middle class has retrenched by curtailing its debt load, thereby bringing about a recession.

(You can read a post from me on this, dating from the blogosphere’s primitive era, here.)

As the below graph shows, each of the last 3 recessions has occurred after a period of 3 years (red) where mortgage rates have failed to make a new low:

The failure of mortgage rates to make a new low is not the *signal* for a recession.  Rather, it has been a necessary predicate.

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Dilemmas, Trilemmas and Difficult Choices

by Joseph Joyce


Dilemmas, Trilemmas and Difficult Choices

In 2013 Hélène Rey of the London Business School presented a paper at the Federal Reserve Bank of Kansas City’s annual policy symposium. Her address dealt with the policy choices available to a central bank in an open economy, which she claimed are more limited than most economists believe. The subsequent debate reveals the shifting landscape of national policymaking when global capital markets become more synchronized.

The classic monetary trilemma (or “impossible trinity”) is based on the work of Robert Mundell and Marcus Fleming. The model demonstrates that in an open economy, central bankers can have two and only two of the following: a fixed foreign exchange rate, an independent monetary policy, and unregulated capital flows. A central bank that tries to achieve all three will be frustrated by the capital flows that respond to interest rate differentials, which in turn trigger a response in the foreign exchange markets.  Different countries make different choices. The U.S. allows capital to cross its borders and uses the Federal Funds Rate as its monetary policy target, but refrains from intervening in the currency markets. Hong Kong, on the other hand, permits capital flows while pegging the value of its currency (the Hong Kong dollar) to the U.S. dollar, but forgoes implementing its own monetary policy. Finally, China until recently maintained control of both its exchange rate and monetary conditions by regulating capital flows.

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Disgusting. Is Whole Foods a victim of fraud, or is it in on the fraud? Who knows?

In a report titled “A Deadly Feast: What you are not told about your Thanksgiving turkey,” an advocacy group called Direct Action Everywhere, known as “DxE,” alleged that Diestel Turkey Ranch operated one “picture perfect” farm with about 400 animals in Sonora, Calif. This farm, the group said, was certified “5+” in an animal-welfare system adopted by Whole Foods. (“Step 1″ is the lowest rating for suppliers who want to be certified: “no cages, no crates, no crowding.” “Step 5+” is the highest: “animal centered, entire life on same farm” with extensive outdoor access.)

However, DxE claimed, “no turkeys raised at the 5+ Sonora farm are actually sold at Whole Foods or anywhere else.” …

“Diestel Turkey Ranch, which has received Whole Foods’ highest rating for animal welfare, operates a showcase farm in Sonora, CA that is heavily promoted in the company’s marketing and described as ‘humane,’” DxE’s report read. “However, the showcase farm does not, in fact, raise any animals for sale — it’s nothing more than a prop.”

Whole Foods Thanksgiving turkeys endure ‘horrific conditions’ at Calif. farm, activists say, Justin Wm. Moyer, Washington Post, today

My Thanksgiving dinner this year will be the same as last year’s: A mostly-open-air vegan/vegetarian potluck whose main course (the one I’ll choose; there will be others offered) will be a vegan meatloaf-looking dish with mushroom gravy, one of the most delicious dishes I’ve ever had.

Like the Pilgrims!  Minus the turkey.  (I’m not the cook, and I don’t have the recipe; sorry.)

But while I have been known to try to persuade friends to buy free-range turkeys for the holiday—Trader Joe’s has them and they’re not that expensive—I know that most people, including most people I know, will be having factory-farm turkeys at their dinner.  Knowingly.

But here’s a situation in which people who care about animal cruelty in agriculture, and can afford to and are willing to pay an apparently hefty premium for their holiday poultry, are being defrauded not just of money but also of their sense of ethics.

The title of this post poses a rhetorical question, not one that I expect an AB reader to answer, but Whole Foods’ reaction to the report suggests that the answer to the question is not what I (and, I’m sure, their customers) would hope.  According to the WP article, “Whole Foods as well as Diestel Turkey Ranch took issue with the accusations, saying that the activists’ mission was not farm animal welfare, but the elimination of farm animal meat consumption.”  Non sequiturs work only if your target audience is comprised of political consultants.

I know that most people who will be buying a Thanksgiving turkey already have bought theirs.  But I think it’s important to disseminate this information even at this late date.

Happy Thanksgiving, all!

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No Surprise Productivity Growth is Slow

The following graph shows a pattern of productivity growth through a business cycle. The graph plots my UT index against Year over Year % change in productivity for the past 41 years. (Link to FRED data for graph, 1974 to present)

productivity gut

The UT index is a measurement of effective demand. It measures the difference between effective labor share and the composite utilization of labor and capital. The UT index is mostly a measure of spare capacity. As the UT index falls to zero, the business cycle is maturing and coming to an end. As the UT index average rises from zero, a business cycle is going through and recovering from a recession.

The orange line is data from 1974 to 2001. The high portion of the orange line where the UT index goes over 19% happened during the Volcker recession. That portion shows high spare capacity but low productivity growth. It is an anomaly because the recession was induced.

The blue line is data since 2002. The red dot near the crossing point of the axes shows the current data point for 3Q 2015.

The plot moves within the shaded area. For instance, if you expect to have productive growth of 4%, data shows that you need to have a UT index of spare capacity at least 6%. Also, if you have 0% growth in productivity, you can expect to have less than a UT index of 7%.

On the other hand, if I see a UT index of 1%, I would expect productivity growth to be between 0% and 2%. If I see a UT index of 10%, I would expect productivity growth between 2% and 5%.

The general trend is that productivity will increase when more spare capacity opens up in a business cycle.

Looking at the position of the red dot of current data (1% UT index, 0% productivity growth), there really is no surprise that productivity growth is low.

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Thoughts on Summers on the Productivity Slowdown

I received this *.pdf and an invitation to read it from my colleague and sometimes co-author Alessandra Pelloni. I had a lot of thoughts which I post here as they can’t do any harm.

Two comments before the jump and 5 after the jump.

I think it will be hard to massage the data away from the conclusion that
when there are recessions, subsequent output growth is lower. The
question is, is the relationship best thought of as causal. After all, if
productivity slowed down, you might expect investment to slow down,
you might expect the stock market to go down. And so, if events were
happening that were reducing the underlying rate of growth, and people
came to realize that those events were happening, you might expect the
economy to go into recession.
And so the question where there’s certainly much more room for argument
is whether the relationships I described are causal. And here, there’s no
God’s truth. We don’t get to contrive recessions to do a controlled
experiment on the question. Blanchard and I do what I think is the sensible
way to approach the question, which is we look at recessions with
different causes. We look at recessions that are associated with tight
money to reduce inflation. That seems like a relatively pure case of a
demand side reduction. We look at recessions that follow the bursting of
bubbles. We look at other recessions not associated with those kinds of
events. We look at recessions associated with fiscal contractions. We look
at recessions associated with credit contractions.
Separately, I have looked at declines and output associated with fiscal
contractions and what has happened to potential GDP revisions in
response to those contractions and I would say that a summary of that
research is that economic logic is borne out the apparent hysteresis
estimate from a demand side recession is lower than the apparent
hysteresis estimate if you look

this is very interesting. I haven’t read the paper which he cites . I agree with Summers that more better be done on this topic.

I have some thoughts. One is housing again. Housing investment is just as much a part of aggregate demand as investment in plant and equipment. However, it has less to do with labor augmenting technological progress. I think conceptually it is more like durable goods purchases for an extremely extremely durable good. A housing bubble bursting is different from a high-tech bubble bursting.

Another is what about long term effects of periods of extremely high demand (also known as wars). Wars are not caused by good technological progress. This is government spending and X and works better for military spending than for total spending.

Another is what happens to estimates of the natural rate of unemployment. In theory it shouldn’t depend on productivity growth. The original story by Friedman referred to labor market institutions. The old Blanchard and Summers 1986 hysteresis paper was about employment not output. A productivity slowdown might cause a recession (if as argued firms don’t notice and keep on investing a lot, then suddenly cut investment when they realize). It should not cause elevated unemployment a decade later.

Suddenly loose monetary policy. After the stock market crash of 1987, the non independent Bank of England (aka Thatcher) panicked and loosened monetary policy. It turned out that UK unemployment didn’t have to be high after all.

I’d say the practical proposal here is to look at employment and unemployment not GDP.

Briefly, I have a kind of intermediate position on QE and negative interest
rates and stuff. [skip]

I am of a view that is in a sense intermediate. I believe that if the only
game in town is monetary policy, the risks of excessive unemployment
hardening in to structural non-employment and structural output losses
exceed any risks associated with financial instability. And so, when the
only game in town is monetary policy, I tend to be supportive of finding
ways for monetary policy to be expansure (sic).

But I take very seriously, unlike some of my friends who share that view,
the ideas that sufficiently low rates – A, are of questionable efficacy in
stimulating investment; B, the investment they stimulate is likely to be of
dubious quality. After all, think about the investments you would do with
a 1.5% tenure rate but you would not do with a 1% tenure rate, what is
their likely quality to be?

I agree that low interest rates don’t have that much effect on investment really and that they cause investment with a small effect on labor productivity. But really, the story is much simpler than the one Summers tells. Interest rates mainly affect residential investment. It isn’t easy to get a negative term on a real interest rate (achieved expectable whatever) using business investment or non residential fixed capital investment. This makes sense. One hint is that it is one of the many bees in Krugman’s bonnet. He is often right.

I don’t think that even larger houses would cause higher US labor productivity. I think US houses are plenty large enough already. In any case, the claim about the magnitude of the effect of interest rates on investment is testable. I think there is a lot of sloppy thinking (on the web at least) in which the obvious effects of monetary policy in the early 80s (involving changes of interest rates on the order of 1000 basis points) implies that a change of dozens of basis points is reason to get excited and a possible hypothetical change of say around 100 is the key issue.

So anyway, I sure agree with Summers on this one. Unconventional monetary policy is better than nothing but not a decent substitute for fiscal stimulus.

On the other hand, while I think his point about the low quality of investment which is made only if the required return is tiny is valid, actual required returns are much greater than the risk free interest rate. Market risk premiums are high. The one relevant to society is the sum of two terms. The first, subtraction of the expected value of losses due to default is really a correction to expected returns (it appears as part of the risk premium of a corporate bond but it is part of the expected return not a high expected return compensating risk). The second is the contribution to aggregate risk if, say, a bubble bursts and there is a recession. It is possible to estimate the second term (as in Mehra and Prescott). It is tiny compared to actual average returns on risky assets minus the risk free rate. It is very possible that socially desirable investment will only be made if the risk free real rate is negative. This is consistent with dynamic efficiency and everything. I agree with Summers’s conclusion, but he is using a bit of clever rhetoric discussing the interest rate not the many different interest rates.

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