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Friday, May 27, 2011

Will the Economy Return To the Old Normal?

There's been some pushback against the statement I made in this post that the economy would *eventually* return to the trend rate of growth it has displayed since at least 1870.

This is a debate, in part, about whether the economy returns to trend after a shock, i.e. whether shocks are permanent or temporary. It is also a debate about the nature of the trend itself, i.e. whether the trend rate of economic growth is a smooth process that can be approximated by a trend line (with demand shocks responsible for most of the variation around the trend), or if the trend is a variable series subject to both permanent and temporary shocks (so that a substantial part of the variation in output over time comes from the trend itself, i.e. from supply-shocks -- an extreme version of this view asserts that all variation in output can be attributed to supply-shocks).

The point I wanted to make in the post was about the slow recovery, not trend reversion. Thus, I probably could have made it better if I had acknowledged the controversy over trend reversion, noted that if shocks are permanent we'll never, ever return to where we were, and then made the point that, "even if you believe, as I do, that the economy trend reverts, that doesn't mean it will happen fast or that policy has no role to play in helping the economy recover." That might have kept the focus on the slow recovery rather than the question about trend reversion (I intended the answer to the question in the title -- "Does This Ease Your Worries?" -- to be no, but not sure that came through as clearly as I intended).

But the question about trend reversion is important, and should not be swept aside. This is not the first time the topic of trend reversion has been debated in the blogosphere. Let me start with Greg Mankiw who thinks shocks are permanent rather than temporary (he uses the term stationarity instead of trend reversion -- stationarity is a broader concept but the difference is of little consequence for this discussion):

Team Obama on the Unit Root Hypothesis, by Greg Mankiw: All academics, to some degree, suffer from the infliction of seeing the world through the lens of their own research. I admit, I do it too. So when I read the CEA's forecast analysis, this sentence jumped out at me:

a key fact is that recessions are followed by rebounds. Indeed, if periods of lower-than-normal growth were not followed by periods of higher-than-normal growth, the unemployment rate would never return to normal.

That is, according to the CEA, because we are now experiencing below-average growth, we should raise our growth forecast in the future to put the economy back on trend in the long run. In the language of time-series econometrics, the CEA is premising its forecast on the economy being trend stationary.

Some years ago, I engaged in a small intellectual skirmish over this topic along with my coauthor John Campbell. Here is the abstract of our paper:

According to the conventional view of the business cycle, fluctuations in output represent temporary deviations from trend. The purpose of this paper is to question this conventional view. If fluctuations in output are dominated by temporary deviations from the natural rate of output, then an unexpected change in output today should not substantially change one's forecast of output in, say, five or ten years. Our examination of quarterly postwar United States data leads us to be skeptical about this implication. The data suggest that an unexpected change in real GNP of 1 percent should change one's forecast by over 1 percent over a long horizon.

The view that Campbell and I advocated is sometimes called the unit-root hypothesis (for technical reasons that I will not bother with here). It contrasts starkly with the trend-stationary hypothesis. ...

Finally, I should note that there is much to forecasting beyond the univariate models in my work with Campbell. And our paper, of course, was only one piece of a large literature. The CEA might well be right that we are in for a robust recovery over the next few years. I don't pretend to have as good a forecasting staff sitting in my Harvard office as the CEA has. (I miss you, Steve Braun.) I certainly hope they are right. We could all use some good economic news right now.

Brad DeLong responds to Mankiw:

Permanent and Transitory Components of Real GDP, by Brad DeLong: Sigh. ... Mankiw is arguing that the Obama administration's forecast is too high... Mankiw is arguing that future economic growth is likely to be just average--that there will be no post-recession catch-up during which growth is faster than average.

Whether an unexpected fall in production is followed by faster than average catch-up growth depends what kind the fall in production is. A fall in production that does not also change the unemployment rate will in all likelihood be permanent. A fall in production that is accompanied by a big rise in the unemployment rate will in all likelihood be reversed. You have to do a bivariate analysis--to look at two variables, output and unemployment. You cannot do a univariate analysis and expect to get anything useful out.

Guess what kind of unexpected fall in production we are experiencing right now? ...

But Greg Mankiw knows this. At the bottom of his column he writes:

I should note that there is much to forecasting beyond the univariate models in my work with Campbell...

In other words, he notes that when constructing a real forecast it makes no sense to ignore the information in the unemployment rate. And:

[O]ur paper, of course, was only one piece of a large literature. The CEA might well be right...

And that is certainly the way to bet.

Paul Krugman follows up with:

Roots of evil (wonkish), by Paul Krugman: As Brad DeLong says, sigh. Greg Mankiw challenges the administration’s prediction of relatively fast growth a few years from now on the basis that real GDP may have a unit root — that is, there’s no tendency for bad years to be offset by good years later.
I always thought the unit root thing involved a bit of deliberate obtuseness — it involved pretending that you didn’t know the difference between, say, low GDP growth due to a productivity slowdown like the one that happened from 1973 to 1995, on one side, and low GDP growth due to a severe recession. For one thing is very clear: variables that measure the use of resources, like unemployment or capacity utilization, do NOT have unit roots: when unemployment is high, it tends to fall. And together with Okun’s law, this says that yes, it is right to expect high growth in future if the economy is depressed now.
But to invoke the unit root thing to disparage growth forecasts now involves more than a bit of deliberate obtuseness. How can you fail to acknowledge that there’s huge slack capacity in the economy right now? And yes, we can expect fast growth if and when that capacity comes back into use.

It's the "if and when" part I was emphasizing. Yes, trend reversion is the best bet, but trend reversion can be fast or slow, and in this case I expect it to be very slow -- much too slow for policymakers to sit idle waiting for the economy to take care of itself.

Continuing, more recently (i.e. today) Noahopinion adds:

Past performance is no guarantee of future results, by Noah Smith: "Past performance is no guarantee of future results." This is the most common caveat in finance. It means that, despite the fact that past and future are often correlated, that correlation is no guarantee; something may happen in the future that never happened in the past. In technical terms, economic and financial processes might not be ergodic.

This is why, unlike Mark Thoma, I am not reassured by a long-term plot of United States gross domestic product. Mark writes:

As you can see from this picture, historically we've always recovered from recessions. Eventually. ... I am confident that we'll return to trend this time as well, the question is how long it will take us to get there.

He illustrates this with the following famous graph:

The idea is that because this graph sort of looks like a straight line (although if you look closely, you'll see that it's not!), that it will continue to look sort of like a straight line into the future.
But off the top of my head, I can think of no good reason to think that this is true. The kinda-sorta stability of the long-term U.S. GDP growth rate is not a law of the Universe, like conservation of momentum, which is (we hope) fixed and immutable. It is a past statistical regularity whose underlying processes we don't fully understand. There may be solid, long-term factors that will keep our growth at this "trend," or there may not. ...
Japan's growth history looks very different from ours. It seems to have suffered some "trend breaks" in growth. And my question is: Why should we believe that this will not happen to us?
One common answer is that long-term growth for a mature economy will continue at roughly the rate of technological progress. But this is a tautology, since economists measure "technological progress" simply as the the long-term rate of GDP growth. This leads some economists to look at slowing growth and conclude that technological progress is slowing. And maybe they're right! The point is that whether long-term growth represents "technology" or some combination of underlying processes, there is no law of the universe that says that these processes grow at a constant exponential rate.
And in addition to "trend breaks," there is no guarantee that U.S. GDP does not also contain unit roots. ... Even if the U.S. returns to its "trend" growth rate of 2 or 3 percent, there seems to me to be no good reason to believe that it will return to its trend level.
So no, this graph does not ease my worries. Past performance is no guarantee of future results. It may well be that a return to our "trend" growth rate, and/or a return to our "trend" level of output, may be contingent on our policy choices. At least, I am not willing to assume that that is not the case...

I am not 100% certain of trend reversion. Further, I think there's reason to question the natural rate model itself. As I wrote many years ago (2006), I've always liked Friedman's Plucking model as an alternative. In this model deviations from trend are temporary, i.e. there is trend reversion and stationarity, but the model of the trend is very different than with natural rate models -- it represents a maximum rather than a central tendency. (I should add that this is not the only alternative to natural rate models, e.g. Roger Farmer has also been working on this in some of his recent research):

New Support for Friedman's Plucking Model, by Mark Thoma: Milton Friedman's "plucking model" is an interesting alternative to the natural rate of output view of the world. The typical view of business cycles is one where the economy varies around a trend value (the trend can vary over time also). Milton Friedman has a different story. In Friedman's model, output moves along a ceiling value, the full employment value, and is occasionally plucked downward through a negative demand shock. Quoting from the article below:

In 1964, Milton Friedman first suggested his “plucking model” (reprinted in 1969; revisited in 1993) as an asymmetric alternative to the self-generating, symmetric cyclical process often used to explain contractions and subsequent revivals. Friedman describes the plucking model of output as a string attached to a tilted, irregular board. When the string follows along the board it is at the ceiling of maximum feasible output, but the string is occasionally plucked down by a cyclical contraction.

Friedman found evidence for the Plucking Model of aggregate fluctuations in a 1993 paper in Economic Inquiry. One reason I've always liked this paper is that Friedman first wrote it in 1964. He then waited for almost twenty years for new data to arrive and retested his model using only the new data. In macroeconomics, we often encounter a problem in testing theoretical models. We know what the data look like and what facts need to be explained by our models. Is it sensible to build a model to fit the data and then use that data to test it to see if it fits? Of course the model will fit the data, it was built to do so. Friedman avoided that problem since he had no way of knowing if the next twenty years of data would fit the model or not. It did. I was at an SF Fed Conference when he gave the 1993 paper and it was a fun and convincing presentation. Here's a recent paper on this topic that supports the plucking framework (thanks Paul):

Asymmetry in the Business Cycle: New Support for Friedman's Plucking Model, Tara M. Sinclair, George Washington University, December 16, 2005, SSRN: Abstract This paper presents an asymmetric correlated unobserved components model of US GDP. The asymmetry is captured using a version of Friedman's plucking model that suggests that output may be occasionally "plucked" away from a ceiling of maximum feasible output by temporary asymmetric shocks. The estimates suggest that US GDP can be usefully decomposed into a permanent component, a symmetric transitory component, and an additional occasional asymmetric transitory shock. The innovations to the permanent component and the symmetric transitory component are found to be significantly negatively correlated, but the occasional asymmetric transitory shock appears to be uncorrelated with the permanent and symmetric transitory innovations. These results are robust to including a structural break to capture the productivity slowdown of 1973 and to changes in the time frame under analysis. The results suggest that both permanent movements and occasional exogenous asymmetric transitory shocks are important for explaining post-war recessions in the US.

Let me try, within my limited artistic ability, to illustrate further. If you haven't seen a plucking model, here's a graph to illustrate (see Piger and Morley and Kim and Nelson for evidence supporting the plucking model and figures illustrating the plucking and natural rate characterizations of the data). The "plucks" are the deviations of the red line from blue line representing the ceiling/trend:

Notice that the size of the downturn from the ceiling from  a→b (due to the "pluck") is predictive of the size of the upturn from b→c that follows taking account of the slope of the trend. I didn't show it, but in this model the size of the boom, the movement from b→c, does not predict the size of the subsequent contraction. This is the evidence that Friedman originally used to support the plucking model. In a natural rate model, there is no reason to expect such a correlation. Here's an example natural rate model:

Here, the size of the downturn a→b does not predict the size of the subsequent boom b→c. Friedman found the size of a→b predicts b→c supporting the plucking model over the natural rate model.

There's a lot more to say about this, much, much more, but let me wrap up for now by saying that while I expect the economy to return to trend, though very slowly, I am by no means 100% certain about this. There are certainly reasons to question trend reversion, there are also reasonable alternatives to the natural rate model, and there are good theoretical and empirical reasons to pursue them.

    Posted by on Friday, May 27, 2011 at 12:33 AM in Economics, Methodology | Permalink  Comments (64)


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