The USA is not in a liquidity trap any more
This post is related to the debate about fiscal policy and medium run growth which has become entangled with the Sanders or Clinton debate (which I will attempt to avoid). Some extremely Keynesian economists (DeLong, Pro Growth Liberal,, Menzie Chin, Paul Krugman, and (warning pdf) C and D Romer have expressed skepticism about the possibility that fiscal stimulus could cause US GDP to return to the pre-2008 trend.
They have focused on estimates of potential output and the output gap. Basically there are two arguments one is that simple extrapolation of the pre-2008 trend would give an over optimistic guess of potential output, because the rate of true technological progress has exogenously decreased. The other is that low demand has had permanent negative effects. The evidence for either (or both) is that measured total factor productivity growth has been very slow.
The conclusion is that it is unwise to try to calculate the output gap by trying to guess the trend in potential output. Alternatively, the output gap can be calculated by attempting to measure slack directly. The standard measure of slack is the unemployment rate which is now normal. Another is the ratio of employment to prime age (25-54) population which is very low. I’d add that the ratio of vacant jobs to employment is very high, the quit rate is normal and real wages have begun to grow. The pattern is very confusing and it is possible for the same person to reach very different conclusions on different days.
The point (if any) of this post is that I don’t think this matters much. The argument that fiscal stimulus will not cause higher output in the medium term is that, if output surpasses potential output inflation will accelerate and the Fed will raise interest rates cancelling the fiscal stimulus. The argument is based on a prediction about monetary policy.
I don’t think we need to estimate the output gap to predict the Fed’s response to fiscal stimulus or the Fed’s response to rapid GDP growth and declining unemployment. The Fed Open Market Committee (FOMC) has already raised the target federal funds rate up to the still very low 0.25%-0.5%. They have made it very clear that they are considering further rate increases. It could not be more clear that markedly reduced unemployment will convince them to raise interest rates.
The US economy is not at the zero lower bound anymore. This just means that the FOMC no longer wishes it could achieve a negative federal funds rate, that is, the interest rate is above zero so the zero lower bound isn’t binding. This is a statement about what the FOMC will do not what it should do.
Unless there is a political revolution including repeal of the Federal Reserve Act, the possible effects of further fiscal stimulus are limited.
Some people on twitter have the impression that Krugman and C Romer have suddenly ceased to be Keynesian, but they haven’t changed at all. Their views on fiscal policy depend entirely on whether the ZLB is binding (and always have). Krugman has never been what he calls (with the diplomatic tact for which he is famous) a vulgar Keynesian.
So really they aren’t making an argument based on economics but rather one based on politics i.e. what will a politically appointed body do in response to certain conditions. The fed isn’t required by US law or nature or god to raise rates in response to a certain level of unemployment.
But what makes these economists experts on politics? I suppose their real expertise here is being able to get in to the minds of the fed reserve decision makers because they all have similar educational, professional, and social backgrounds.
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Interesting stuff but I’m probably out of my depth trying to comment. I know that Dean Baker and the folks at CEPR have had some interesting things to say about LFPR and the output gap.
Just a quick search on their site turned up this one: http://cepr.net/blogs/cepr-blog/declining-civilian-labor-force-participation-an-aging-population-or-a-weak-economy?highlight=WyJvdXRwdXQiLCJnYXAiLCJnYXAnIiwib3V0cHV0IGdhcCJd
Hope you’ll follow with some more posts on this as you think it through.
That’s a good insight. The Federal Reserve’s focus on inflation has always been anti-growth. In a market economy it is almost impossible to have economic growth without inflation as rising prices are a market economy’s means of signalling rising demand.
Someone once explained India as being a middle class nation of over 100,000,000 in a poor nation of over a billion. Most people in India were only marginally part of the economy and even less part of that middle class economic core. There is a similar situation in almost every economy, what we might think of as the core and a population outside it.
Our failure to provide adequate fiscal stimulus has reduced the size of the core. More Americans are now outside the mainstream economy, and our growth prospects, without increased stimulus, are limited. Our economy is at a new normal, and that’s all the Federal Reserve cares about.
I still think a large stimulus could grow our economy to include more Americans again. Despite protestations, our economy has much more slack than it appears. If anything, our low rising productivity is a sign of under-utilization. A thousand car a day facility is going to look pretty unproductive if it is only producing a hundred cars a day. My guess is that inflation will be a lot weaker than predicted.
More seriously, the Federal Reserve is going to raise rates anyway in response to the demands of the wealthy who feel that the government owes them not just immense wealth and huge unearned incomes, but increasing immense wealth and even huger unearned incomes. Rising rates will have less negative effect on our economy if it is actually growing in both GDP and participation.
I think this is the crux of your discussion:
“The argument that fiscal stimulus will not cause higher output in the medium term is such that; if the higher output surpasses potential output, inflation will accelerate and the Fed will raise interest rates cancelling out the fiscal stimulus. The argument is based on a prediction about monetary policy.”
I apologize as I added some words and punctuation. Hasn’t the issue with The Fed not having employment as one of its goals anymore been in existence since Paul Volcker and Reagan? The Fed abandoned employment years ago. This is no surprise to me and it should be talked about more. We are sacrificing Main Street again for Financial growth.
I do not see Main Street doing much to protest this outcome. We do not pick leaders of our nation who will bring about change. We are too afraid of them and are willing to settle for less. Our political environment today is witness to such.
efcdcons the economists I cited are talking about economics — the output gap and the Phillips curve and such. I (mildly) criticize them saying economic limits are irrelevant since the political limit is binding.
So what makes me an expert on politics ? I can write as if I were an expert on politics because I have an angrybear username and password and a cookie (I don’t remember the password but this computer does).
More seriously, it is not too hard to understand the thought of FOMC members, because they publish minutes of their meetings. I think they have made it very clear that they would respond to a huge stimulus by increasing the target federal funds rate. Tim Duy is a good source for fedwatching http://economistsview.typepad.com/timduy/
But in any case, I and only I am bringing the Fed into this particular debate.
Run thanks for adding punctuation and words. I don’t think the current Fed cares only about inflation. Yellen in particular is a dove. The Bernanke Fed made huge, gigantic, unprecedented efforts to stimulate the economy. Even the Randian Greenspan allowed unemployment to decline below the level that many Keynesian economists (incorrectly) thought was necessary for price stability.
Too concerned about possible inflation to allow GDP growth to average 5.4% over 10 years does not imply concerned only about inflation.
Now it is true that the current FOMC insisted, for no comprehensible reason, on a tiny increase in the target fedfunds rate last December. I think the only argument for doing so was that they thought that they had promised an increase in 2015. More generally there seems to be something in the water which causes people to become more inflation phobic when they are on the Fed board of governors.
google krugman bernane borg
krugman summers fischer insider
Thanks for the return, I will
So why is growth still so anemic in the US, and even more so in Europe. I guess Waldman has a good gig as a professor. Did he even read this?
I think growth is anemic mostly because of cuts to government spending. For one thing, across the USA and Europe GDP growth is very strongly correlated with the change in G (government consumption plus investment). There is also some dismal stuff related to housing and residential investment, but austerity is most of it.
The point of this post is that increased G won’t help if the monetary authority responds by raising interest rates — and they will.
I think the economies need new heads of government, new parliamentary majorities and new central bankers so that all will support expansionary and mildly inflationary policies.
I stress that not gonna happen is not the same thing as shouldn’t happen. If I could, I would make Sanders the President, Senate, House of Representatives and Fed open market committee (for a 4 year temporary dictatorship). But I can’t.
My gig is OK. Workload very nice, pay very low compared to US universities.
on a Pox. If you have vaccinia and no theory about how it works, then you can eliminate small pox in the developed world. Vaccination was practiced back before they new jack about the immune system. In fact, innoculation with small pox itself was used before they discovered that cow pox works too and doesn’t risk killing you.
History says people do things without theory. They do things that work without theory too sometimes. See also breeding plants and animals before anyone had thought of the idea of a gene let alone DNA.
Some theories have been extremely useful. The idea that bacteria cause disease has saved many lives. But atheoretic empirical observations have also been useful, and that only because they were used.
The example of vaccination and small pox proves my point. It was widely used with no more theory than hey this works. Now some people didn’t accept evidence without theory. One was Bernard Shaw. I think that good insight into the value of devotion to theory can be obtained by reading his Doctors’ Delusions. He was notoriously smart and perfectly capable of debating the economists of his time (or ours) but his contempt for the “rude empricism” of Jenner and Jesty lead him astray.
You mostly said in your comments what I inplied in my last few lines:
“I think the economies need new heads of government, new parliamentary majorities and new central bankers so that all will support expansionary and mildly inflationary policies.
I stress that not gonna happen is not the same thing as shouldn’t happen. If I could, I would make Sanders the President, Senate, House of Representatives and Fed open market committee (for a 4 year temporary dictatorship). But I can’t.”
The overall economy is still very weak, and the Fed is still far too close to the ZLB. Get that fiscal stimulus going right through those inevitable Fed rate hikes. Keep that fiscal foot on the throttle until the Fed is at least up to 5% or better; this restores at least some measure of rate leeway to the Fed. Maybe the growth wouldn’t be as much as vulgar Keynesians hope for, but it’s likely to be at least a little better than just leaving it as is. We need out of the liquidity trap, and away from being even near the liquidity trap.
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Thank you for the response. I have to push back on “But in any case, I and only I am bringing the Fed into this particular debate.”
Romer and Romer specifically say in their analysis
“As a result, capacity constraints would likely lead to inflation and the Federal Reserve raising interest rates long before such high growth rates were realized.”
The argument seems to be “There are ‘economic’ reasons (phillips curve, estimated output gap etc.) why this type of stimulus wouldn’t produce the results that some people think are possible. But even if we are wrong on the estimated output gap etc. the plan still wouldn’t work because the Fed would introduce growth retarding measures due to fear of inflation.”
It just seems like another way to TINA, but instead of telling people they don’t understand the esoteric minutia of macroeconomics and why “economics” says TINA it’s like “fine, economics might not be limiting, but capital’s class allies won’t allow it to happen so too bad.”
I’m a bit late to the show…
So the Fed will take away the punch bowl before anyone has arrived at the party much less before the party gets out of hand. Fair enough.
But let’s get back to the initial question about potential output. Let’s suppose a different Fed, a Fed that does want to get us near potential. And several questions arise. First, how far are we away from potential? Second, how fast can we grow? And third, can policy affect the rate of growth? I argue that theory matters a lot.
It seems that the austerians would argue that we are at potential and in the 2006/7 period we were above potential. The hysteresis boys would argue we are near potential and the economy’s potential was squandered by not acting from 2009 until now. The heterodox are arguing that we are well below potential.
With respect to the second question, the austerians have us pegged to a permanently lower potential growth rate, the mainstream tends to lean that way but with significantly more chin scratching, and the heterodox see it as more policy related.
On the question of policy affecting growth rates, one part of the austerian world says there is not much we can do (productivity growth is exogenous) while the second branch is still preaching tax cuts and deregulation. It seems the mainstream might fall into the exogenous camp as well. The heterodox do seem to provide prescriptions. First, they see an enormous waste of resources in rent seeking — finance, IP, and antitrust — just to name three. It moves the smartest workers into non-productive endeavors, blocks innovation, and concentrates income and wealth. That in turn, creates a negative feedback loop creating more inequality and more rent seeking.
I think it’s pretty important that we sort this out. The Tyler Cowen’s of the world are arguing that we are at potential GDP and productivity is low, will remain low, and is exogenous. That’s a pretty convenient argument in explaining why the Kooch’s are rich, you’re getting poorer, and there is nothing anyone including the gov’t can do about it. It absolves the policy makers and supports no gov’t action and justifies inequality as the natural outcome of forces beyond our control.
So what about the mainstream of the profession? The hysteresis boys have little room for active policy measures since we’re near potential and not much in the way of policy other than redistribution, i.e. neo-liberalism with transfers. There is often the blah blah blah about more education funding.
The heterodox do seem to believe there is room for growth toward trend in the medium run and higher productivity growth in the longer run. The recent presidential order that regulatory agencies increase competition in markets. while anemic, is an acknowledgement that the heterodox are on to something. (The importance of the competition arguementt has drifted into the mainstream but the fact that mainstream appointees at the DOC and FTC have failed so miserably at antitrust enforcement and consumer protection is a implicit acknowledgement that the mainstream was very late to the party.)
So yeah, theory matters. The whole neo-liberal agenda was theory based. And it wasn’t just the crazy supply-siders. the mainstream told us it was all education and technology — not trade that was affecting wages (Lawrence and Hoxby); that having only four airlines wasn’t a competition problem (and that having only three firms in an industry is often fine thank you); that most deregulation including banking deregulation was just fine; and that inequality doesn’t affect growth (just read Krugman’s earlier ruminations); that trade deals will benefit labor, not just capital, and on and on. Following this advice since 1980 got us where we’re at. Unless, of course, Tyler is right and there was nothing we could have done about it….
efcdcons Yes Romer and Romer did discuss the Fed — what I wrote in reply to your earlier comment was incorrect. What I should have written was that the Romers (and others) discuss the Fed responding to inflation, so one has to predict economic outcomes to predict the Fed’s actions. In particular, they assume that the Fed will restrain output growth once and only once output has reached potential output, so it is important to figure out what potential output is. I disagree. The Fed has made it clear what they will do and it doesn’t involve waiting for acceleration of inflation.
T: Two things.
Hysteresis is a fancy tricky Greek word. I don’t think it is easy to make sense of sentences which contain “hysteresis” and “potential output” or “hysteresis” and “too late”. The idea of potential output was that is an output level which macro policy makers just have to accept — whatever it is, they can’t get output higher for long. The concept, basically the defnition of the word “potential”, requires that it is exogenous — potential does not depend on effort because outcomes are the result of two different things: potential and effort.
If a non accelerating inflation level of output depends on past macroeconomic policy – then it is not potential output. This isn’t pure semantics. The question is what should macro policy makers accept as given.
Hypothetically it might be possible to argue that the consequences of insuffiicient stimulus from 2009 through now are irreversible and just have to be accepted. But no one has made that argument. There are those who argue that the stimulus was eccessive because Keynes is totally wrong. There are those who argue that furhter stimulus will have long lasting benefits (the hysteresis boys). There are even those who argued that current policy is about right and that output just happens to be disappointingly low for reasons not related to demand during 2008-2015. But there really isn’t anyone who argues that hysteresis works on the way down but not on the way up.
In fact the hysteresis boys (DeLong and Summers) argued that conventional paleo Keynesian analysis underestimates the benefits of stimulus — their argument was basically the argument that Friedman made when it was noted that his analysis wasn’t conventional paleo Keynesian analysis. Now one might almost imagine that I am questioning Brad’s logical consistency, but I owe Brad too much to criticize him.
Second your comment doesn’t include numbers (except for 2006/7 , 2009 and 1980). The debate between G Friedman vs Krugman, Delong, Romer, Romer and 3 other CEA chiefs is about numbers. Friedman assumes a multiplier of around 1 and around 10. The others note the inconsistency — nothing about the economy but rather something about the internal logic of Friedman’s paper (that is the lack of any). This doesn’t mean they are rejecting Keynes, or that they think the multiplier is zero or that they oppose further fiscal stimulus. In fact they follow Keynes and all support further fiscal stimulus. DeLong asserts that the multiplier is about 3, the others that it is about 1.5. DeLong certainly doesn’t think we are close to potential output.
thanks for your patient response.
are you saying that policy cannot affect potential output and that the response of output to policy when hysteresis exists is symmetrical? (Seems that potential output has been significantly revised by various gov’t entities.)
Wasn’t the Friedman issue one of conflating a one time vs permanent change in stimulus. Or to get his increase in output, the one time stimulus has to be 10 times more effective than postulated.?
On G Friedman — yes that is the issue. Friedman made an embarrassing mistake. He was unlucky and it got a huge amount of attention. It’s past time to move on.
On policy and “potential output”: what I was trying to say is that I object to the phrase “potential output”. The original belief (from back in the 60s through 2008) was that macroeconomic policy, that is aggregate demand management, that is the Federal funds rate, government purchases of goods and services and the budget deficit, can’t affect potential output. That is implied by the ordinary english meaning of “potential”. It is a level of output that macro policy makers must accept, because they can’t improve on it.
Potential output is also identified as the level of output consistent with non-accelerating inflation. That is how it is estimated in practice (with a Phillips curve).
If there is hysteresis then the two definitions of “potential output” are different. A period of high demand (with increasing inflation) can cause permanently higher output. So that highest level of output which macro policy makers must accept and that which macro policy makers must accept if they consider inflation over 2% to be intollerable become different.
If there is hysterisis, then central bankers obsession with inflation can have huge costs. An open minded atheoretic look at the data sure supports the view that the disinflation of the 80s had huge immense gigantic costs in Europe.
Thanks again for your reply.
I raise the Friedman point only to note that both he and JW seem to imply there is another mechanism absent from a paleo-Keynsian analysis that would increase output greater than the traditional multiplier. (It wasn’t in the paper.) Hence my reference to some nascent productivity effect. I don’t mean to pile on.
I think I was inarticulately trying to draw the distinction between exogenous potential output and potential output that can be affected by policy. However, I’m a little confused about what you mean when you say “cause permanently higher output.” Do you get PHO by raising the inflation target above 2% permanently or due you just need a temporary “period of high demand (with increasing inflation)” before returning to some rate of constant inflation, maybe 2%?
So, for example, how would demand policies that lead to PHO affect the CBO projection of potential output seen in the graph below relative to historical trend?
You’re one patient guy…
Excellent post. I’m surprised that several of the commenters don’t see it that way. They’re right that the Fed should be more eager to let things run and not tighten until we really see the inflation. Employment should be the higher of the two goals in the dual mandate. But this Fed has already tightened once pre-emptively and it looks to want to tighten again.
Historical reminder: Greenspan cut the Fed funds rate after Clinton got his first budget passed that included the tax hikes.