Reversion to Trend

John Cochran’s Wall Street Journal op-ed complaining about the “Johnny One-Note” prescription of some Keynesians (particularly folk Keynesians) opens with this paragraph:

Output per capita fell almost 10 percentage points below trend in the 2008 recession. It has since grown at less than 1.5%, and lost more ground relative to trend. Cumulative losses are many trillions of dollars, and growing. And the latest GDP report disappoints again, declining in the first quarter.

Now let’s stop right there. I’m broadly sympathetic to what comes next—that when your model fails you need to adjust your model, that the assumptions in the model which lead to the inadequate stimulus package of 2009 were absurdly wrong, and more measures based on the same assumptions will be just as inadequate—but I’d go farther. What makes him think that trend prior to 2008 was anything but an illusion? I think that our persistent (and IMO endemic) slow growth has been the case since 1992-1993 when China pegged the yuan to the dollar, we received an enormous flood of low-priced Chinese goods, the American economy was hollowed out, and every sector but those that were in bubbles (technology, housing) or directly subsidized by the government, e.g. education and healthcare, languished.

IMO the last six years haven’t been bucking the trend. They’ve been a reversion to trend.

Onwards:

If you look hard at New-Keynesian models, however, this diagnosis and these policy predictions are fragile. There are many ways to generate the models’ predictions for GDP, employment and inflation from their underlying assumptions about how people behave. Some predict outsize multipliers and revive the broken-window fallacy. Others generate normal policy predictions—small multipliers and costly broken windows. None produces our steady low-inflation slump as a “demand” failure.

These problems are recognized, and now academics such as Brown University’s Gauti Eggertsson and Neil Mehrotra are busy tweaking the models to address them. Good. But models that someone might get to work in the future are not ready to drive trillions of dollars of public expenditure.

I think that’s obviously right but, sadly, while correctly characterizing the past it doesn’t show a way forward. He goes on to critique Brad DeLong, Lawrence Summers, etc. for wanting to return to Keynes’s actual policy prescriptions. In my view their basic mistake is in not wanting to return to them enough since they continue to long for a federal government that’s a consumer of last resort rather than Keynes’s view of the central government as the employer of last resort.

His prescription:

In the alternative view, a lack of “demand” is no longer the problem. Financial observers now worry about “reach for yield” and “asset bubbles.” House prices are up. Inflation is steady. The Federal Reserve evidently agrees, since it is talking about taper and exit, not more stimulus. Even super-Keynesians note that five years of slump have let physical and human capital decay, which “demand” will not quickly reverse. But we are stuck in low gear. Though unemployment rates are returning to normal, many people are not even looking for work.

Where, instead, are the problems? John Taylor, Stanford’s Nick Bloom and Chicago Booth’s Steve Davis see the uncertainty induced by seat-of-the-pants policy at fault. Who wants to hire, lend or invest when the next stroke of the presidential pen or Justice Department witch hunt can undo all the hard work? Ed Prescott emphasizes large distorting taxes and intrusive regulations. The University of Chicago’s Casey Mulligan deconstructs the unintended disincentives of social programs. And so forth. These problems did not cause the recession. But they are worse now, and they can impede recovery and retard growth.

I agree with that as far as it goes but, again sadly, it doesn’t go far enough. Even if by some miracle all of the issues complained about above were remedied, we’d still be left with the fundamental problems that we import too much, export too little, and don’t produce enough of what we consume.

But even getting to that point will be insurmountably difficult. Those who have become accustomed to subsidies including bankers, teachers, doctors, consumers of healthcare, and consumers of cheap imported goods will not relinquish their subsidies cheerfully.