Cross-posted from the Roosevelt Institute’s Next New Deal blog. This is a summary of my new paper What Recovery? The Case for Continued Expansionary Policy, also discussed in Neil Irwin’s July 26 article in the Times.
“Right now,” wrote Senator Chuck Schumer in a New York Times op-ed on Monday, “millions of unemployed or underemployed people, particularly those without a college degree, could be brought back into the labor force” with appropriate government policies. With this seemingly anodyne point, Schumer took sides in a debate that has sharply divided economists and policymakers: Is the US economy today operating at potential, with enough spending to make full use of its productive capacity? Or is there still substantial slack, unused capacity that could be put to work if someone — households, businesses or governments — decided to spend more? Is there an aggregate-demand problem that government should be trying to solve?
It’s difficult to answer this question because the economic signals seem to point in conflicting directions. Despite the recession officially ending in June 2009 and the economy enjoying steady growth for the past eight years, GDP is still far below the pre-2008 trend. If we compare GDP to forecasts made before the recession, the gap that opened up during the recession has not closed at all — in fact, it continues to get wider. Meanwhile, the official unemployment rate — probably the most watched indicator for the state of aggregate demand — is down to 4.4%, well below the level that was considered full employment even a few years ago. But this positive performance only partially reflects an increase in the number of Americans with jobs; mostly it comes from a decline in the size of the labor force — people who have or are seeking jobs. The fraction of the adult population employed is down to 60 percent from 63 percent a decade ago (and nearly 65 percent at the end of the 1990s).
Is this decline in the fraction of people employed the inevitable result of an aging population and similar demographic changes, or is it a sign that, despite the low measured unemployment rate, the economy is still far short of full employment? The Federal Reserve — one of the main sites of macroeconomic policy — has already indicated its belief that full employment has been reached by raising interest rates 3 times since December 2016. Fed Chair and Janet Yellen are evidently convinced that the economy has reached its potential — that, given the real resources available, output and employment are as high as can reasonably be expected.
Other policymakers have been divided on the question, in ways that often cut across partisan lines. Senator Schumer’s statement — that the decline in employment is not an inevitable trend but rather a problem that government can and should solve — is a sign of new clarity coming to this murky debate. Along with his call for $1 trillion in new infrastructure spending, it’s an important acknowledgement that, despite the progress made since 2008, the country remains far from full employment.
In a new paper out this week, we at the Roosevelt Institute offer support for the emerging consensus that the economy needs policies to boost demand. The paper reviews the available data on where the economy is relative to its potential. We find that the balance of evidence suggests there is still a great deal of space for more expansionary policy.
We offer several lines of argument in support of this conclusion.
GDP has not recovered from the recession. GDP remains about 10 percent below both the long-term trend and the level that was predicted by the CBO and other forecasts prior to the 2008–2009 recession. There is no precedent in the postwar period for such a persistent decline in output. During the sixty years between 1947 and 2007, growth lost in recessions was always regained in the subsequent recovery.
The aging population does not explain low labor force participation. It is true that an aging population should contribute to lower employment, since older people are less likely to work than younger people. But this simple demographic story cannot explain the full fall in employment. Starting from the employment peak in 2000, aging trends only explain about half the decrease in employment that has actually occurred. And there are good reasons to think that even this overstates the role of demographics. First, during the same period, education levels have increased. Historically, higher education has been associated with higher employment rates, just as a share of elderly people has been associated with less employment; statistically, these two effects should just about cancel out. Second, the post-recession fall in employment rates is not concentrated in older age groups, but among people in their 20s — something that a demographic story cannot explain.
The weak economy has held back productivity. About half the shortfall in GDP relative to the pre-2008 trend is explained by exceptionally slow productivity growth — that is, slow growth in output per worker. While many people assume that productivity is the result of technological progress outside the reach of macroeconomic policy, there are good reasons to think that the productivity slowdown is at least in part due to weak demand. Among the many possible links: Business investment, which is essential to raising productivity, has been extraordinarily weak over the past decade, and economists have long believed that demand is a central factor driving investment. And slow wage growth — a sign of labor-market weakness — reduces the incentive to adopt productivity-boosting technology.
Only a demand story makes sense. The overall economic picture is hard to understand except in terms of a continued demand shortfall. If employment is falling due to demographics, that should be associated with rising productivity and wages, as firms compete for scarce labor. If productivity growth is slow because there aren’t any more big innovations to make, that should be associated with faster employment growth and low profits, as firms can no longer find new ways to replace labor with capital. But neither of these scenarios match the actual economy. And both stories predict higher inflation, rather than the persistent low inflation we have actually encouraged. So even if supply-side stories explain individual pieces of macroeconomic data, it is almost impossible to make sense of the big picture without a large fall in aggregate demand.
Austerity is riskier than stimulus. Finally, we argue that, if policymakers are uncertain about how much space the economy has for increased demand, they should consider the balance of risks on each side. Too much stimulus would lead to higher inflation — easy to reverse, and perhaps even desirable, given the continued shortfall of inflation relative to the official 2 percent target. An overheated economy would also see real wages rise faster than productivity. While policymakers often see this as something to avoid, the decline in the wage share over the past decade cannot be reversed without a period of such “excess” wage growth. On the other hand, if there is still an output gap, failure to take aggressive steps to close it means foregoing literally trillions of dollars of useful goods and services and condemning millions of people to joblessness.
Fortunately, the solution to a demand shortfall is no mystery. Since Keynes, economists have known that when an economy is operating below its potential, all that is needed is for someone to spend more money. Of course, it’s best if that spending also serves some useful social purpose; exactly what that should look like will surely be the subject of much debate to come. But the first step is to agree on the problem. Today’s economy is still far short of its potential. We can do better.