Narayana Kocherlakota has a follow up to something of his I posted yesterday:
How Cheap Labor and Capital Suggest that Faster Growth is a Great Deal: In my last post, I stated that the current low level of real wages and real interest rates suggested that there may be large net social benefits associated with markedly faster growth. In this post, I provide a more detailed justification for this claim. I consider the possibility that the government expands its level of activity sufficiently that capital, labor, and output all grow 2.5% faster per year (something like 4-5% per year) than is currently projected over the next four years. Under this alternative profile, all three variables would be (a little more than) 10% higher than is currently projected at the end of 2020.
Because of constraints on the supply of labor and capital, the alternative profile that I propose would push upward on real wages and real interest rates. The key to my analysis is that both real wages and real interest rates are unusually low by historical standards. I use conventional elasticity estimates to argue that the supply pressures induced by the alternative growth profile would only be sufficient to push these prices back into more normal ranges.
Let me begin with employment. This picture is key in understanding the opportunities that may be available. It depicts the evolution of labor share - the ratio of real wages to average labor productivity - in the nonfarm business sector.
This ratio remains low by historical standards. The low level suggests that, for whatever reason, labor is unusually cheap. (Note the Congressional Budget Office projects that real wages and productivity will grow at roughly the same rate over the next five years.)
I am proposing an alternative profile that scales up both labor and capital by 10% in four years’ time. If production is constant-returns-to-scale, this profile will leave average labor productivity unaffected. However, in order to induce workers and non-workers to increase aggregate labor input by 10%, the real wage will have to rise. The recent meta-analysis of labor supply estimates elasticities in Chetty, et. al. suggest that it would require an increase of about 12% in the real wage to increase aggregate hours to that extent. That would push labor share back up to be a little higher than its 2000 peak (admittedly near the top of its historical range).
The above analysis ignores income effects on labor supply (that are usually estimated to be small). Incorporating those effects would push up on my estimate of the needed increase in the real wage. But the analysis also assumes that we are currently at full employment (which I don’t believe). The current underemployment of labor means that, for many workers, the shadow real wage is even lower than the observed real wage. Hence, allowing for involuntary underemployment at the current time would push down on my estimate of the needed increase in the real wage.
Let me turn from labor to capital. As argued here, the average productivity of capital is near its usual historical level. My proposed alternative growth path would not change this average productivity. But, as measured by Treasury Inflation Protected Securities (TIPS), the five-year real interest rate is very low (about zero). Again, capital looks cheap by historical standards.
My proposed faster growth profile would put upward pressure on the real interest rate. If households anticipated that their consumptions were to grow 2.5% faster per year, their demand for TIPS and other forms of saving would decline. Assuming an intertemporal elasticity of substitution of 1, the fall in demand would push the real interest rate back to 2.5 percent, which is consistent with more usual historical ranges. (Caution: There is a large range of available estimates of the relevant elasticity.)
Again, this discussion of capital assumes full employment. I have argued for some time that the current real interest rate is actually above r* (the real interest rate that would be consistent with full resource utilization). Given that consideration, my proposed alternative growth profile would lead to a lower real interest rate than 2.5 percent.
To sum up: I consider a growth profile in which capital, labor, and output all grow 2.5% faster per year than is currently anticipated for the next four years. Such a growth profile would put upward pressure on the real wage and the real interest rate. However, the real wage and the real interest rate both seem unusually low relative to historical norms. The above analysis suggests that the price pressures from my proposed alternative growth path would only be sufficient to push those prices back into alignment with their historical ranges.
Let me close with three brief comments.
- The above is obviously simplistic on many dimensions. I'd love to see more sophisticated analyses that use market prices as a source of information.
- The above is an analysis of the benefits of increasing the growth rate of potential output. The alternative growth profile should not put any extra pressure on the Fed to dampen inflationary pressures.
- I ignore an effect that I believe could be important. The prospect of higher demand could lead to more innovation and faster total factor productivity growth over this period. I argue here that we saw exactly that kind of effect from anticipated higher demand in the Great Depression. Such an effect would make faster growth an even better deal.