Thoughts on Potential Output, Monetary Policy, and Economic Weblogging: A Comment on Scott Sumner's Comment on Bullard and Duy
TheMoneyIllusion » Where Bullard is right and where he is wrong: Now we can see the damage to monetary policy by the widespread (but false) view that this recession was caused by the bursting of the housing bubble, and the resulting financial crisis [rather than by a failure to properly inflate the money supply]. Interestingly, this is exactly that same argument that the Fed used in the 1930s; “Do you mean you want us to go back to the false prosperity of 1929?” Most economists would now say; “Yes. The 1927-29 expansion saw no inflation at all. There is no evidence the economy was overheated in 1929.”…
Both [2007 and 2009] might have seen output slightly above the mythical “natural rate.”… But it’s important to recognize the nature of Bullard’s argument… a return to 1930s macro after a 70 year hiatus…. NGDP growth followed a fairly stable path along a 5% trend line after 1990. It might have been slightly too high in 2007, but nothing of the sort that would cause a major crisis….
This is admittedly a qualitative story, but much of the rhetoric about the U.S. economy during this period fits this description. So it is not that the bubble destroyed potential, instead it is that actual output was higher than properly-defined potential during the mid-2000s, and then it crashed back as the bubble burst.
But where is the evidence for this? I think everyone agrees that housing construction was too high in 2004-06. But that doesn’t mean RGDP was too high… the resources that went into housing could have come at the expense of other sectors. Housing is only about 5% of GDP. Is there evidence that AD was too high? Maybe a tad too high, but nothing out of the ordinary compared to other business cycle expansions. How about SRAS? Bullard mentions a rise in labor supply caused by the housing bubble, but I don’t see the logic. What would be evidence for a rise in labor supply? Presumably you’d see unusual patterns in the employment to population ratio during the 2000s, but I just don’t see it. His best argument would be that… increased preference for leisure was temporarily covered up by a housing bubble that mysterious caused people to want to work more. Then when they found they could no longer build houses, they decided they didn’t want to work at all…. I just don’t see the argument, or the data to support such an argument….
Here’s the Bullard argument I find most troublesome:
As I noted earlier, the Irwin description is the dominant view of the U.S. economy. But, as you and many others have stressed, we have not seen the bounce back toward potential that would be suggested by that picture. That is giving me pause, and frankly I think it is giving everyone who follows the U.S. economy pause….
I think… Bullard is confusing two completely unrelated issues, the link between monetary policy and NGDP, and the link between NGDP and RGDP…. During this period of recovery NGDP has been growing at about 4%, which I consider tight money. So the explanation for the slow recovery is quite easy, money has been too tight…. But even if money has been easy, it doesn’t help Bullard’s case. Now the mystery would be why the “easy money” hasn’t boosted NGDP, not why slow NGDP growth hasn’t triggered fast RGDP growth. There’s no direct effect of easy money on RGDP. It works, if it works at all, by boosting NGDP growth. Then if we assume wages and prices are sticky in the short run, the higher NGDP growth will (partly) translate into higher RGDP. But only if you get the desired NGDP growth. And that hasn’t happened…. Ben Bernanke has called for fiscal stimulus at various times, tacit admission that the Fed sees an AD shortfall.
The Fed’s current position is very similar to the Fed’s stance in 1932—they’ve done their job, provided low rates and a greatly enlarged monetary base, now why isn’t the economy recovering? I think we now know why the economy wasn’t recovering in 1932, money was way too tight. As soon as FDR adopted a (Woodfordian) price level target, the economy turned around on a dime…. If we get adequate NGDP growth, growth high enough where Bernanke doesn’t have to worry about Congress suddenly getting religion on the deficit, and if the economy still doesn’t recover, then we can entertain real[-side] theories of the recession….
I do like Bullard’s new argument better than the old one….
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…. This has lowered consumption and output, and lower levels of production have caused a significant disruption in U.S. labor markets….
[But t]here is no reason to assume that building too much investment goods (housing) would cause people to want to build fewer consumer goods. Indeed in a well functioning economy overbuilding in one sector should cause resources to re-allocate into other sectors. Output of consumer goods would probably rise…. And even if I’m wrong about the effect of less housing wealth on consumer goods production… [y]ou can’t simply assume that lower consumption translates into lower output; it could lead to higher investment or exports. Indeed that’s the sort of adjustment predicted by most equilibrium models. Now you might make a Keynesian argument that less wealth depressed AD, but Bullard is claiming the problem is not a lack of AD.
I notice that Bullard did not repeat this argument… criticism by economics bloggers may have nudged him in the right direction. This represents a sort of victory for the economics blogosphere, and especially Tim Duy.
Those of us who have wasted our time in this business over the past decade got into it because we were horrified by episodes that showed the conventional press corps engaged in extraordinary efforts to lower the level of the economic policy debate and felt that somebody, somewhere needed to try to do something constructive. The Bullard-Duy exchange is a powerful piece of evidence that we--and those of us whom the fish that are the conventional news media have hired in their attempt to turn into birds, and those of our fellow travelers in the conventional press corps who kept the faith and tried to keep the cold altars lit--have to a surprising degree succeeded: our time was not, after all, wasted.
At least not completely.