Menzie Chinn says he doesn’t understand it but I sure do. James Bullard, governor of the St. Louis Federal Reserve, suggests (PDF) that in the aftermath of a bubble “output gap” may not be particularly useful in figuring out what happened or the way forward:
The recent recession has given rise to the idea that there is a very large “output gap†in the U.S. The story is that this large output gap is “keeping inflation at bay†and is fodder for keeping nominal interest rates near zero into an indefinite future. If we continue using this interpretation of events, it may be very difficult for the U.S. to ever move off of the zero lower bound on nominal interest rates. This could be a looming disaster for the United States. I want to now turn to argue that the large output gap view may be conceptually inappropriate in the current situation. We may do better to replace it with the notion of a permanent, one-time shock to wealth.
Or, said more simply, we just aren’t as rich as we thought we were. The basic idea is that extrapolating from the 4th quarter of 2007 to the present assuming some fixed rate of growth is wrong. When the value of the bubble commodity collapses that value doesn’t go anywhere. It’s just gone. And not just the value of the bubble commodity but the values of other commodities that depend on the value of the bubble commodity or the expectation that the value of the bubble commodity will continue to increase forever. Those are gone, too.
Rather than implementing policies aimed at exploiting nonexistent productive capacity we should be identifying what will help the economy to grow and do that. I think it’s eliminating waste in the form of deadweight loss. Other people might have other views but I think that’s the shortest distance between two points. As my micro prof put it, we don’t know how to create prosperity but we do know how to create shortages.
From thr link:
“The key to the large output gap story is the use of the fourth quarter of 2007 as a benchmark for where we expect the economy to be today. The idea is to take that level of real output, assume the real GDP growth rate that prevailed in the years prior to 2007, and project out where the “potential†output of the U.S. should be.”
Bullard is without question one of the most clueless Fed governors in the country. Potential output is not determined by drawing a line from the peak of the previous business cycle, it’s an estimate based on employment of all available resources. In the 1950’s and 1960’s the country averaged 90% utilization, it averaged 80% in the 1980’s, 90’s and 2000’s, and it’s at 75% now. We are nowhere near our maximum output, which means we aren’t near maximum employment, wages salaries or productivity.
Actually it’s even worse: Bullard is claiming a drop in asset values has somehow permanently destroyed some of our productive capacity. Productivity and wealth, potential GDP and spending, are not the same things.
I think what he’s referring to is this.
Paul Krugman, among many others, has been pushing it for years. Here’s another, similar graph Dr. Krugman posted for the EU.
Here’s a handy reference for how the CBO calculates potential output. They’ve updated a bit since that document was published but I suspect it’s pretty close. I think it’s problematic for any number of reasons not the least is crosstalk among sectors.
Once you’ve sifted through all of the verbiage and mathematical notation, it all boils down to a chart pretty much like the one linked to above, cf. p. 32.
Here’s my question for you: do you think that a bubble produces false measurements of production or not? I do. I think it’s obvious that it does. My view is that it is the nature of bubbles that they render potential output impossible to calculate. Potential output could be represented by the extension of trend the charts suggest. Or it could be represented by present output. Or any point in between.
@Dave Schuler
Each bubble we’ve had has related to asset values. The dot com bubble, the housing bubble, the credit bubble. When these burst wealth is destroyed, there’s no question about that. But productive capacity is based on machines, people and natural resources. None of these are altered by lowered property or equity values. It’s perfectly reasonable to have low wealth and high-incomes and spending. Adam Smith discussed this in the Wealth of Nations: how the colonies were far less wealthy than Great Britain but had far higher incomes and prosperity because of their high productivity and commercial activity.
The financial crisis was a failure of the financial system, not the real economy which I maintain is as robust as ever. The problem is we’ve gotten our understanding of the relationship between to two reversed: financial wealth derives from claims against production, not production from financial wealth.
It may be based on them but it’s measured in dollars. When the dollar values for the machines, people, or resources go down, so does the productive capacity.
Additionally, what’s useful for building houses may not be particularly useful in building electronics. Try building an iPad with a Bobcat.
James Bullard link pp 3-4:
To me, this seems obvious. Furthermore, some of this wealth was used to leverage additional debt. Many Lines of Credit have been frozen or called, and new debt based upon home value is not being issued as before. There are also many people who are trying to pay down their debt.
First comment (lilnev) from Menzie Chinn link:
The US government has borrowed $5 trillion since 2008. How much more is needed?
“For the Snark was a Boojum, you see.”
The circular answer is “as much as would be needed”. The more practical answer is roughly $1 trillion per year until the economy became self-starting, assuming some sort of fiscal multiplier (which is itself a subject of some debate).
However, if potential production has actually declined, it’s an entirely different ballgame.
@Dave Schuler
I took @lilnev to mean that the US should increase deficit spending, and if I understand correctly, this can be accomplished by increased spending or decreased revenue (taxes). Is your $1 trillion an increase in the budget or deficit (or both)? More importantly, what are the indicators the goal has been reached?
The stimulus was $800 billion. This was deemed to be enough by some, but others wanted it to be bigger. I never heard a number from the bigger crowd, but at this point, $3-4 trillion seems like a bargain.
I appreciate your putting out a number. I am not being argumentative, and my questions are somewhat rhetorical. It seems that the debate is missing agreed upon concepts and definitions. This should not be trivial, but when the argument enters the political realm, more confusion is beneficial for politicians.
At the projected growth, I think that eventually the debt will become crushing, but this assumes the interest rate for the debt will increase. With Europe about to collapse economically and China slowing down, the US may be the least crappy place to invest, and this may provide the stimulus needed.
“For the Snark was a Boojum, you see.”
I thought financial wealth was dependent on the government printing money and taxing it. :p
If a trillion in deficit spending is the magic number, well, aren’t we there? Three years of trillion-plus deficits? Or are we supposed to add an additional trillion on top?
According to memos that have leaked out Cristina Romer thought that something like $1 trillion on top of what was actually spent was necessary. Larry Summers apparently nixed that.