Can Anybody Tell Me Why the Frack Eugene Fama Thinks the U.S. Economy Was in Recession in 2006?
Twitterstorm delong: February 11, 2012

Asset Prices and Potential Output

Paul Krugman maintains that potential output is independent of asset prices:

Bubbles and Economic Potential: The ongoing discussions of economic policy and principles since the Great Recession struck have, I have to say, been a source of continuing revelation. Again and again one sees people with seemingly sterling credentials — Federal Reserve presidents, economists with Ph.D.s from good schools — propounding views that I thought were obvious fallacies, at least to anyone who had studied the subject a bit. And the hits just keep coming. The latest, via Scott Sumner, is St. Louis Fed president James Bullard’s suggestion (pdf) that the bursting of the housing bubble has permanently reduced U.S. potential output:

A better interpretation of the behavior of U.S. real GDP over the last five years may be that the economy was disrupted by a permanent, one-time shock to wealth. In particular, the perceived value of U.S. real estate fell substantially with the 30 percent decline in housing prices after 2006. This shaved trillions of dollars off of the wealth of the nation. Since housing prices are not expected to rebound to the previous peak anytime soon, that wealth is simply gone for now. This has lowered consumption and output, and lower levels of production have caused a significant disruption in U.S. labor markets…

Bullard… [is] seeming to say that a drop in asset prices is itself a destruction of output capacity. What?

And yet we have David Andolfatto apparently endorsing this view, and Tyler Cowen at least expressing sympathy. What is going on?

OK, first things first. Capital gains are not counted in GDP. The direct effect of a bursting bubble on measured output is zero. Nor, by the way, is a fall in asset prices counted as a decline in the capital stock, which is in principle measured in physical terms. So what are these guys talking about? Maybe the idea is that the burst bubble reduces demand, and hence leads to lower production. But at that point you’re into a Keynesian world of deficient demand, and you should be talking about ways to close the gap, not accepting it as a fact of life….

Imagine… farmland prices go through the roof. Then those prices slump. Why should this impair the ability of the farmers to keep growing corn?… And guess what — this isn’t a hypothetical example…. US farmland prices…. US farm output…. Do you see a permanent reduction in farm production when the bubble burst? I don’t….

Well, you might say, but farmers don’t buy a large fraction of farm output, whereas homeowners buy a large fraction of overall US output. Bzzzt! You’re talking demand-side economics again, and making, whether you know it or not, the case for monetary and fiscal stimulus. At a basic level, this is all kind of terrifying. If top financial officials and credentialed economists can’t even avoid getting confused about the difference between asset prices and productive capacity, what hope is there for rational policy discussion?

I think that there is a possible second-order effect of asset prices on potential output.

Think of it this way: Workers swap leisure for money. Businesses use labor to build stuff. Households--including rich investing households--pay money to businesses to buy stuff. If there is a bubble then investors think some forms of new property are much more valuable than they really are, are willing to pay through the nose for them, and businesses are willing to pay higher wages to pull more workers into employment.

Suppose that there are a bunch of workers who are willing to work only if they are paid more than $40K a year, and due to the housing bubble investors think their time pounding nails in Nevada produces $60K a year of value, while in actual fact the houses they build in Nevada will only be worth $30K per year of labor input once the bubble crashes. Such workers will be employed during the bubble, and out of the labor force after the bubble collapses.

Is this an explanation for why unemployment should fall during a bubble and permanently rise after the collapse of a bubble? No, it is an argument that labor force participation should rise during the bubble and fall back to its pre-bubble level afterwards. It is, at most, a second-order part of what is going on. It might be out there--and it might well not.

But this possible second-order effect does not seem to be what Bullard, Andolfatto, and Cowen are talking about…