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Wednesday, March 21, 2012

Fed Watch: On Straw Men

Tim Duy:

On Straw Men, by Tim Duy: Arnold Kling claims I am using a straw man:

Recently, bloggers have been talking about potential output or potential GDP. I find the discussion to be frequently misleading. For example, Mark Thoma quotes Tim Duy:

If we claim the economic potential of the nation has declined - that in aggregate, we can not make as much stuff as we did a few years ago...

But nobody claims that. The pessimists on potential output only claim that it is growing below some previous trend. They never claim that it has declined in absolute terms.

I refer Kling to St. Louis Federal Reserve President James Bullard:

The wealth shock view puts a different expectation in play. The negative wealth shock lowers consumption and output. But after the recession ends, the economy simply grows from that point at an ordinary rate, neither faster nor slower than in ordinary times. It is more like an earthquake which has left one part of the land higher than another part. There is no expectation of a “bounce back” to a higher level of output after the recession ends. This is closer to what has actually happened since mid-2009. Output has grown at a moderate rate, but not a rapid rate, since the recession ended.

Read carefully: "...like an earthquake which has left one part of the land higher than another part." (Side note: I kind of like that simile). He is clearly saying that the 5% drop in output during the recession was a permanent shift. Unless you really believe that potential GDP was overestimated by 5% - in which case we would expect inflation to have been much higher than actually experienced - the only reasonable conclusion is that at least one person believes that in fact potential GDP declined in absolute terms during the recession.

Also refer to Grep Ip:

You don’t need to be a supply sider to believe that potential has fallen; you could equally worry that actual output has been depressed for so long, that hysteresis has set in and dragged potential down with it.

He proceeds with charts of GDP for Sweden and Korea, both of which reveal what are interpreted as downward shocks to the absolute level of potential output. And note, I don't ignore the possibility that Ip is in fact correct - the failure to respond with significant force to the recession may very well have allowed cyclical issues to fester into structural ones. And this is even more likely if Bullard's position is widely adopted by policymakers such that they actively manage the economy along the new trend. In such a case the hysteresis can be the result of a self-fulfilling prophesy. If we deliberately keep people unemployed, they will eventually become structurally unemployed or exit the workforce.

I don't in any way disagree that the rate of potential output growth may be slower than prior to the recession, thus estimates of the output gap might be lower than those currently available. But there is indeed another concern that there has been a negative shock to (long run) potential output in absolute terms.

    Posted by on Wednesday, March 21, 2012 at 12:33 AM in Economics, Fed Watch, Monetary Policy | Permalink  Comments (34)


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