Again With Potential Output, by Tim Duy: St. Louis Federal Reserve President James Bullard graciously responded to my most last post regarding his much considered speech. I actually do not enjoy drawing Bullard's attention, in that it makes me fear that one day I will find that my access to FRED has been disabled.
On what Bullard and I agree on is this: There are different estimates of potential GDP. I discussed this point last year:
Now, before you roll your eyes, as I am inclined to do, note the CBO estimate of potential output is not the only estimate. Menzie Chinn reminds us of the variety of estimates of potential output, some of which suggest that, at the moment, the output gap is actually positive.
In that post I discussed some possible reasons we might consider a downward shock to potential GDP. Near the end, I concluded with this:
While not discounting the probability that some structural factors are at play, the primary challenge facing the US economy is insufficient demand. Optimally, I think the best solution to this challenge is that demand emerges from the external sector – and here I mean NET exports, export and import competing industries. This source of demand would support needed structural change, ultimately for the good of the US and global economies. This adjustment requires a relatively complicated expenditure-switching story on a global basis. I don’t know how to avoid such a story. Barring this outcome, one falls back on fiscal policy, which can surely do the job, but risks maintaining the current pattern of global imbalances. And perhaps such concerns are overblown; after all, so far the fears of a Dollar/current account crisis have not emerged.
Bullard takes a different approach. First, he rejects the CBO estimate offhand because it is not the outcome of "full DSGE model" and "there is nothing about the CBO potential calculation that allows "bubble" levels of output." Before we reject the CBO model outright, it is worth considering it basic effectiveness as a guide:
I see two recent episodes of output in excess of CBO potential, both of which were associated with what I believe were asset-price bubbles and also induced monetary tightening to stem inflationary pressures (which seems to contradict Bullard's assertion that the CBO estimate leaves no room for bubbles). If this was a significant overestimate of potential output in during the housing bubble, I would have expected more severe inflationary pressures.
Of course, even if the CBO estimates were roughly correct during the bubble, perhaps there has been a significant downward shift in potential. And here again I think Bullard and I can find common ground - potential output is not a measured variable, it is estimated. We really shouldn't blindly follow such estimates, but instead look for corroboration in other data. I tend to fall back on unit labor costs for a signal that wages pressures are outstripping productivity growth and threatening to sustain an inflationary dynamic:
I don't see a reason for concern at this point. But put aside the CBO estimate for a moment, and move onto the crux of Bullard's argument:
If households and businesses had ignored the house price developments as a sort of amusing side show, it would not have been so important. But our rhetoric about the decade suggests otherwise. Households consumed more through cash-out refinancing, developers built more, borrowing increased, Wall Street produced new financially-engineered products to feed the boom, and ancillary industries like transportation thrived. Output went up, and labor supply was higher than it otherwise would have been.
There are two parts to this theory. One is a demand side story - the debt-fueled housing bubble supported consumption and investment, supporting actual GDP growth. I don't think anyone disagrees with that view. The second part of the story is supply side, that the extra activity induced additional labor supply. With the housing bubble now popped, all of the related output and labor supply now melts away:
So, what Irwin's picture is doing is taking all of the upside of the bubble and saying, in effect, "this is where the economy should be." But that peak was based on the widespread belief that "house prices never fall." We will not return to that situation unless the widespread belief returns. I am saying that the belief is not likely to return--house prices have fallen dramatically and people have been badly burned by the crash. So I am interpreting your admonitions on policy as saying, in effect, please reinflate the bubble. First, I am not sure it is possible, and second, that sounds like an awfully volatile future for the U.S., as future bubbles will burst once again.
Now, I agree that the bubble cannot be reflated, nor should it. But this leads into what I don't like about Bullard's story housing bubble story. From my post last July:
Also arguing for a largely demand side explanation to the current weak employment numbers is what looks like a pretty obvious link between asset bubbles and full employment over the last decade. As long as households had a mechanism to support demand, achieving full employment was not a problem. If not households, then why can’t another form of demand fill the gap?
In Bullard's model, the housing bubble popped, and millions of people who were employed are no longer employed, nor should we expect them to be employed (or to reenter the labor force) as there is no way to do so absent another bubble. This seems to me an obvious place for fiscal policy and monetary policy to step into the breach and compensate for the lost demand. That millions of people's labor and output be lost simply because they no longer believe that housing prices don't always rise is a gross waste of resources.
You can tell a story in which that bubble-driven demand was necessary to compensate for negative equilibrium interest rates for risk free assets (driven by excessive saving by Asian central banks and aging demographics in the developed world). Rather than wait for another asset bubble to come along and lift demand, or twiddle your thumbs hoping another recession doesn't hit while you are at the zero bound, you could pull out the old-Bernanke playbook and implement an even more aggressive mix of fiscal and monetary policy to compensate for the lost demand and flood the world with risk free assets.
Now, as to Bullard's appeal instead to a New Keynesian framework, I am more sympathetic. Basu and Fernald opine:
..the major effects of the adverse shocks on potential output seem likely to be ahead of us. For example, the widespread seize-up of financial markets has been especially pronounced only in the second half of 2008. We expect that as the effects of the collapse in financial intermediation, the surge in uncertainty, and the resulting declines in factor reallocation play out over the next several years, short-run potential output growth will be constrained relative to where it otherwise would have been.
This is similar to my thoughts that somewhere in the background there is need for some structural change, toward export and import competing industries. That said, I still find it hard to believe that this is the primary story given that the downturn negatively affected employment across almost all industries. If structural adjustment was the primary issue, I would have anticipated a narrower range of affected industries.
Bottom Line: Bullard and I agree that there are different estimates of potential output. I think that if he wants to throw out the CBO estimate, he needs to provide another estimate to serve as a policy guide. And I would agree that any estimate, CBO included, needs to be continuously monitored in the light of actual incoming data. I still disagree with his asset-bubble model of potential GDP shifts. At its core it is a demand story with maybe a second-order labor supply aspect, and does not explain why no other source of demand can compensate for the lost housing bubble and induce higher labor supply. In the past I have considered reallocation stories similar to what can be derived from a time-varying NK measure of potential output, but again question that this is the primary concern at the moment.
And if you just can't get enough of this debate, Barkley Rosser argues there are arguments in favor of Bullard's position.
Let me add one note of my own. Bullard argues that the difference between the flexible and sluggish price outcomes in a New Keynesian model, measured by the difference between the "sticky price and flexible price level of output," is superior to the standard output gap measure. I have no argument with that in the context of a standard NK model. However this measure is based upon the assumption that Calvo type price rigidity (or something similar) is driving economic fluctuations. If this is not the way in which shocks are being transmitted to the real economy in this crisis, then this measure may not be the right index for setting monetary policy. I think stickiness in housing prices is part of the story, and perhaps wage rigidity as well -- so price stickiness is part of the slow recovery (though it's not clear that housing really fits the Calvo framework) -- but I'm not convinced this fully captures the breakdown in financial intermediation, balance sheet losses, and solvency/liquidity issues (for banks, businesses, and individuals) that characterized the recession, and that are still holding back the recovery. If we haven't captured the important ways in which shocks are affecting the real economy in our models, then the models won't serve as effective guides to policy.