What Recovery: Reading Notes

My Roosevelt Institute paper on potential output came out last week. (Summary here.) The paper has gotten some more press since Neil Irwin’s Times piece, including Ryan Cooper in The Week and Felix Salmon in Slate. My favorite headline is from Boing Boing: American Wages Are So Low, the Robots Don’t Want Your Jobs.

In the paper I tried to give a fairly comprehensive overview of the evidence and arguments that the US economy is not in any meaningful sense at potential output or full employment. But of course it was just one small piece of a larger conversation. Here are a few things I’ve found interesting recently on the same set of issues. .

Perhaps the most important new academic contribution to this debate is this paper by Olivier Coibion, Yuriy Gorodnichenko, and Mauricio Ulate, on estimates of potential output, which came out too late for me to mention in the Roosevelt report. Their paper rigorously demonstrates that, despite their production-function veneer, the construction of potential output estimates ensures that any persistent change in growth rates will appear as a change in potential. It follows that there is “little value added in estimates of potential GDP relative to simple measures of statistical trends.” (Matthew Klein puts it more bluntly in an Alphaville post discussing the paper: “‘Potential’ output forecasts are actually worthless.”) The paper proposes an alternative measure of potential output, which they suggest can distinguish between transitory demand shocks and permanent shifts in the economy’s productive capacity. This alternative measure gives a very similar estimate for the output gap as simply looking at the pre-2008 forecasts or extrapolating from the pre-2008 trend.  “Our estimates imply that U.S. output remains almost 10 percentage points below potential output, leaving ample room for policymakers to close the gap through demand-side policies if they so chose to.” Personally, I ‘m a little less convinced by their positive conclusions than by their negative ones. But this paper should definitely put to the rest the idea (as in last year’s notorious CEA-chair letter) that it is obviously wrong — absurd and unserious — that a sufficient stimulus could deliver several years of 4 percent real growth, until GDP returned to its pre-recession trend. It may or may not be true, but it isn’t crazy.

Many of the arguments in my paper were also made in this valuable EPI report by Josh Bivens, reviving the old idea of a “high pressure economy”. Like me, Bivens argues that slow productivity growth is largely  attributable to low investment, which in turn is due to weak demand and slow wage growth, which blunts the incentive for business to invest in labor-saving technology. One important point that Bivens makes that I didn’t, is that much past variation in productivity growth has been transitory; forecasts of future productivity growth based on the past couple of years have consistently performed worse than forecasts based on longer previous periods. So historical evidence gives us no reason see the most recent productivity slowdown as permanent. My one quibble is that he only discusses faster productivity growth and higher inflation as possible outcomes of a demand-driven acceleration in wages. This ignores the third possible effect, redistribution from from profits to wages — in fact a rise in the labor share is impossible without a period of “overfull” employment.

Minneapolis Fed president Neel Kashkari wrote a long post last fall on “diagnosing and treating the slow recovery.” Perhaps the most interesting thing here is that he poses the question at all. There’s a widespread view that once you correct for demographics, the exceptional performance of the late 1990s, etc., there’s nothing particularly slow about this recovery — no problem to diagnose or treat.

Another more recent post by Kashkari focuses on the dangers of forcing the Fed to mechanically follow a Taylor rule for setting interest rates. By his estimate, this would have led to an additional 2.5 million unemployed people this year. It’s a good illustration of the dangers of taking the headline measures of economic performance too literally. I also like its frank acknowledgement that the Fed — like all real world forecasters — rejects rational expectations in the models it uses for policymaking.

Kashkari’s predecessor Narayan Kocherlakota — who seems to agree more with the arguments in my paper — has a couple short but useful posts on his personal blog. The first, from a year ago, is probably the best short summary of the economic debate here that I’ve seen. Perhaps the key analytic point is that following a period of depressed investment, the economy may reach full employment given the existing capital stock while it is still well short of potential. So a period of rapid wage growth would not necessarily mean that the limits of expansionary policy have ben reached, even if those wage gains were fully passed through to higher prices. His emphasis:

Because fiscal policy has been too tight, we have too little public capital. … At the same time, physical investment has been too low… Conditional on these state variables, we might well be close to full employment.  … But, even though we’re close to full employment, there’s a lot of room for super-normal growth. Both capital and TFP are well below their [long run level].  The full-employment growth rate is going to be well above its long-run level for several years.  We can’t conclude the economy is overheating just because it is growing quickly.

His second post focuses on the straightforward but often overlooked point that policy should take into account not just our best estimates but our uncertainty about them, and the relative risks of erring on each side. And if there is even a modest chance that more expansionary policy could permanently raise productivity, then the risks are much greater on the over-contractionary side. [1] In particular, if we are talking about fiscal stimulus, it’s not clear that there are any costs at all. “Crowding out” is normally understood to involve a rise in interest rates and a shift from private investment to public spending. In the current setting, there’s a strong case that higher interest rates  at full employment would be a good thing (at least as long as we still rely on as the main tool of countercyclical policy). And it’s not obvious, to say the least, that the marginal dollar of private investment is more socially useful than many plausible forms of public spending. [2] Kashkari has a post making a similar argument in defense of his minority vote not to raise rates at the most recent FOMC meeting. (Incidentally, FOMC members blogging about their decisions is a trend to be encouraged.)

In a post from March which I missed at the time, Ryan Avent tries to square the circle of job-destroying automation and slow productivity growth. One half of the argument seems clearly right to me: Abundant labor and low wages discourage investment in productivity-raising technologies. As Avent notes, early British and even more American industrialization owe a lot to scarce labor and high wages. The second half of the argument is that labor is abundant today precisely because so much has been displaced by technology. His claim is that “robots taking the jobs” is consistent with low measured productivity growth if the people whose jobs are taken end up in a part of the economy with a much lower output per worker. I’m not sure if this works; this seems like the rare case in economics where an eloquent story would benefit from being re-presented with math.

Along somewhat similar lines, Simon Wren-Lewis points out that unemployment may fall because workers “price themselves into jobs” by accepting lower-wage (and presumably lower-productivity) jobs. But this doesn’t mean that the aggregate demand problem has been solved — instead, we’ve simply replaced open unemployment with what Joan Robinson called “disguised unemployment,” as some of people’s capacity for work continues to go to waste even while they are formally employed. “But there is a danger that central bankers would look at unemployment, … and conclude that we no longer have inadequate aggregate demand…. If demand deficiency is still a problem, this would be a huge and very costly mistake.”

Karl Smith at the Niskanen Center links this debate to the older one over the neutrality of money. Central bank interventions — and aggregate demand in general — are understood to be changes in the flow of money spending in the economy. But a lon-standing tradition in economic theory says that money should be neutral in the long run. As we are look at longer periods, changes in output and employment should depend more and more on real resources and technological capacities, and less and less on spending decisions — in the limit not at all. If you want to know why GDP fell in one quarter but rose in the next (this is something I always tell my undergraduates) you need to ask who chose to reduce their spending in the first period and who chose to increase it in the first. But if you want to know why we are materially richer than our grandparents, it would be silly to say it’s because we choose to spend more money. This is the reason why I’m a bit impatient with people who respond to the fact that, relative to the pre-2008 trend, output today has not recovered from the bottom of the recession, by saying “the trend doesn’t matter, deviations in output are always persistent.” This might be true but it’s a radical claim. It means you either take the real business cycle view that there’s no such thing as aggregate demand, even recessions are due to declines in the economy’s productive potential; or you must accept that in some substantial sense we really are richer than our grandparents because we spend more money. You can’t assert that GDP is not trend-stationary to argue against an output gap today unless you’re ready to accept these larger implications.

The invaluable Tom Walker has a fascinating post going back to even older debates, among 19th century anti-union and pro-union pamphleters, about whether there was a fixed quantity of labor to be performed and whether, in that case, machines were replacing human workers. The back and forth (more forth than back: there seem to be a lot more anti-labor voices in the archives) is fun to read, but what’s the payoff for todays’ debates?

The contemporary relevance of this excursion into the archives is that economic policy and economic thought walks on two legs. Conservative economists hypocritically but strategically embrace both the crowding out arguments for austerity and the projected lump-of-labor fallacy claims against pensions and shorter working time. They are for a “fixed amount” assumption when it suits their objectives and against it when it doesn’t. There is ideological method to their methodological madness. That consistency resolves itself into the “self-evidence” that nothing can be done.

That’s exactly right. When we ask why labor’s share has fallen so much over the past generation, we’re told it’s because of supply and demand — an increased supply of labor from China and elsewhere, and a decreased demand thanks to technology. But if it someone says that it might be a good idea then to limit the supply of labor (by lowering the retirement age, let’s say) and to discourage capital-intensive production, the response is “are you crazy? that will only make everyone poorer, including workers.” Somehow distribution is endogenous when it’s a question of shifts in favor of capital, but becomes exogenously fixed when it’s a question of reversing them.

A number of heterdox writers have identified the claim that productivity growth depends on demand as Verdoorn’s law (or the Kaldor-Verdoorn Law). For example, the Post Keynesian blogger Ramanan mentions it here and here. I admit I’m a bit dissatisfied with this “law”. It’s regularly asserted by heterodox people but you’ll scour our literature in vain looking for either a systematic account of how it is supposed to operate or quantitative evidence of how and how much (or whether) it does.

Adam Ozimek argues that the recent rise in employment should be seen as an argument for continued expansionary policy, not a shift away from it. After all, a few years ago many policymakers believed such a rise was impossible, since the decline in employment was supposed to be almost entirely structural.

Finally, Reihan Salam wants to enlist me for the socialist flank of a genuinely populist Trumpism. This is the flipside of criticism I’ve sometimes gotten for making this argument — doesn’t it just provide intellectual ammunition for the Bannon wing of the administration and its calls for vast infrastructure spending,  which is also supposed to boost demand and generate much faster growth? Personally I think you need to make the arguments for what you think is true regardless of their political valence. But I might worry about this more if I believed there was even a slight chance that Trump might try to deliver for his working-class supporters.


[1] Kocherlakota talks about total factor productivity. I prefer to focus on labor productivity because it is based on directly observable quantities, whereas TFP depends on estimates not only of the capital stock but of various unobservable parameters. The logic of the argument is the same either way.

[2] I made similar arguments here.


EDIT: My comments on the heterodox literature on the Kaldor-Verdoorn Law were too harsh. I do feel this set of ideas is underdeveloped, but there is more there than my original post implied. I will try to do a proper post on this work at some point.

16 thoughts on “What Recovery: Reading Notes”

  1. “A number of heterdox writers have identified the claim that productivity growth depends on demand as Verdoorn’s law (or the Kaldor-Verdoorn Law). For example, the Post Keynesian blogger Ramanan mentions it here and here. I admit I’m a bit dissatisfied with this “law”. It’s regularly asserted by heterodox people but you’ll scour our literature in vain looking for either a systematic account of how it is supposed to operate or quantitative evidence of how and how much (or whether) it does.”

    Josh, are you familiar with the work of John McCombie? If so, what’s your take on his contributions concerning Kaldor-Verdoorn law?

    1. I like both McCombie and Felipe quite a lot. I m going to revise that portion of the post, it is too harsh.

  2. On the topic of long term “real” GDP-index growth there is this interesting work by an ex-Fed analyst that shows that current “real” GDP-index is actually on trend, the 1949-1994 trend, and it is the years 1995-2008 who have been an anomaly, figure 5 here: noisefromamerika.org/articolo/why-the-fed-s-zero-interest-rate-policy-failed

    The same applies BTW to the SP500, there there is a clear regime change in 1995, with an explosion in P/E ratios.
    The two are not unrelated probably: a significant boost to the “real” GDP-index was given by extraordinary financial profits, which in 2008 turned out to have been “imaginary”, because of accounting “mistakes”, mostly the under-depreciation of risk or equivalently its shifting off balance sheet.

    But looking at the “real” GDP-index is largely pointless, even if it is a game that Economists love, because the “methodologies” used by the BEA to compute it have been “improved” so much that it is difficult to understand how it relates to the political economy; for example J Stiglitz wrote that «Likewise, quality improvements – better cars rather than just more cars – account for much of the increase in GDP nowadays.» and J Fox of Bloomberg also wrote «Without adjusting for deflation, value added in computer and electronics manufacturing is up 45 percent since 1997. With the adjustments, it’s up 699 percent!».

    Regardless whether the “real” GDP-īndex is on the 1949-1994 trend, the 1995-2008 one, or the 1949-2008 one, that its growth could be raised to 4% per year, even without the help of “improvements” in the “methodologies” used by the BEA, seems to me quite plausible, by means foul or fair:

    * The greek government managed better than that by constantly expanding debt-financed imports until they reached 25% of the “real” GDP-index (please don’t even think the obviously stupid objection that CIF imports are subtracted from the “real” GDP-index).
    * Spending from or because even bigger capital gains could help, according to ex FOMC member R Fisher one of their major goals has been to “frontload a tremendous market rally to create a wealth effect”.
    * That 4% could be achieved by an expansion of work hours and at the same time of the number of workers, as some political economists argued When B Sanders proposed a goal of “real” GDP-index growth of 4%.

    1. I’ll have to look at that more closely. I agree that measurements of “real” GDP are problematic. That’s why in the report I emphasize more that we’re not seeing any of the normal signs of binding supply constraints — rising wages and prices.

      Also worth noting that the fall in output per hour is shared very widely across the economy, even in sectors where hedonic pricing and other questionable adjustments are not important. So I think there is something real there, though I absolutely agree with you that we cannot take the headline numbers at face value.

    2. Re +700% growth in IT.

      I did a rapid search on google with “advertisement mac 1997” and this is the first thing I got:


      I think that this stuff today would sell for less than 1/8 of an iPhone, and in 1997 an iPhone would have sold for much more than 8 times that stuff. I also think that an iPhone is much less an high end product that that stuff was and therefore there are much more iPhones produced than there were those pads produced.

      So on the whole I think that +700% growth in IT is a very conservative evaluation.

      If you ignore quality improvements though you are treating a green screen thingie with external keyboard as the same thing of an iPhone.

      1. This is a hard question. It’s not obvious to me that a quantitative measure of “quality improvement” is possible at all. if it is – wouldn’t it make more sense to think of it in functional terms? The Macbook I am using now is certainly much prettier than the bulky computer I would have been using 20 years ago, but I can’t type any faster on it.

        1. I agree with this, but I think that we should be clear that the problem is in the concept of “real value”, and hence “real dollars”, not in measured inflation.

          “Real value” is an operational variable that is defined through some statistical procedures, and is not really “real”.
          Inflation is defined as the change of nominal price of one unit of this “real” value, and hence has some problems too.
          We could use different definition for inflation, for example the change of the nominal value of production per hour of labour, but this would be a different value.
          But many people who doubt the inflation numbers don’t follow this line, they either:
          a) believe that the government is somehow cheating with the inflation number (those are often hidden goldbugs); this implies a lower growth than reported;
          b) believe that there is some “consumer surplus” that is not accounted for in statistics; this implies an higher growth than reported.

      2. «So on the whole I think that +700% growth in IT is a very conservative evaluation.»

        +700% of what? Handwaving?

        «If you ignore quality improvements though you are treating a green screen thingie with external keyboard as the same thing of an iPhone.»

        Our blogger has replied more diplomatically, but I’ll try to be clearer:

        GDP is supposed to be a measure of *final* physical gross *output*:

        * The “final” means that intermediate products should not be counted, things like accounting, research, axles, marketing, etc. for cars; only cars. Any and every IT gizmo, hw or sw, used in industry and services is not “final”, because it is used towards building something else. If IT had improved “+700%” or whatever it is, that would be accounted for in an immensely higher final output. The same applies to finance or whatever else.

        * As to actually final, that is either goes into capital or in the hands of consumers, what counts is *output*. Having a car that is twice as nice is not the same as having two cars, because two people can go to two different destinations with two cars. Having for the same price a 60 inch TV set instead of a 30 inch TV does not make the viewer able to view a movies twice as fast or two movies at the same time.

        There can be real improvement in final output, like cars that go fast or break down less often, for the same price, but it is quite pointless to account for them in GDP, because we know it is pretty weird anyhow.

        «believe that the government is somehow cheating with the inflation number (those are often hidden goldbugs); this implies a lower growth than reported;»

        Goldbugs think that the reported “real” GDP-index and the CPI are *massively* cheated. My best guess is that the “improvements” in the “methodologies” account for 1-2 percent points, and that actual GDP growth for the past 40 years has been roughly half of the “improved” one, and GDP-per-capita growth has been quite small, which would account for the flat/falling median wages. I also reckon that the SP500 is rather “improved” by its “methodologies”, and probably the conventional estimate that its long term “risk free” yield is 7% is perhaps double of a more realistic one.

        My guess is that much of the “improved” growth matches massive accounting fraud, a colossal ballooning of the “bezzle”, especially in the finance sector: its weight in GDP has grown from 2% to 8%, how is that possible? It requires an average household with a $50,000/year income to spend at least $4,000/year in finance fees, mostly directly. What does that buy?

        Sometimes I find some components of GDP, that is physical quantities, long term, and the trends are not exciting, consider “Light Weight Vehicle Sales” and “New Privately Owned Housing Starts”, 1974-2017 compared to population, 1976-2016:


        1. I’m basically sympathetic to this altho it’s not clear that there is any true price level measure out there, so I’m not sure I would use the word “cheated”.

          It might be better to do economics purely in terms of money values and physical quantities. But we’d have to throw out most existing theory and empirical work — heterodox as much mainstream — and it’s not obvious how we’d replace it.

          1. «It might be better to do economics purely in terms of money values and physical quantities.»

            As to this, to avoid misunderstandings, this is not at all what I am arguing, and indeed this quote does not suggest that: my argument here is narrowly that GDP is technically a vector of physical quantities, and what is commonly called “real GDP” is actually an estimated monetary index computed using 2-3 layers of “methodologies” :-).
            This said I reckon that there is some value in using that “real” GDP-index, but also that it is necessary to complement it with an understanding of the underlying physical quantities, or else the impact of the “methodologies” dominates.

            Getting a realistic impression of something as complex and multidimensional as the gross domestic production of a large advance economy is a very difficult challenge, and can only be confronted with much discretion and double checking. My main thesis is that just looking at the “real” GDP-index is rather insufficient and unrealistic. Apparently A Greeenspan himself and other policymakers look also at proxies and physical quantities like sales of male underwear (which is not an index).

            «use the word “cheated”»

            That word you attributed to the “goldbugs”. I would not use it either, because as far as I know the BEA do not actually misreport the physical quantities they use to build the “real” GDP-index. My impression is that the “real” GDP-index is the result of sincere (but not necessarily that accurate) physical stats and the application of the publicly published “methodologies”.
            But I also regard it as a significantly biased index, and my guess is that the direction and size of the bias are not mere happenstance.

        2. “+700% of what? Handwaving?
          GDP is supposed to be a measure of *final* physical gross *output*”

          I mean that the current output in final IT goods is more than 8 times the output in final IT goods in 1997, if measured in “real value”.
          I think you misunderstand “real” value, and therefore inflation; I’ll try to explain what I mean with some fictitious examples.

          1) Suppose that in the total output of the year USA in t1 consists in 1000 muffins, and each muffin sells for 1$ (nominal GDP 1000$).
          Then in t2 total GDP is 1100 muffins, each muffin sells 1.1$, for a nominal GDP of 1210$.
          In this case it is simple to calculate that inflation is 10%, and real growth is 10%, but this happens because we are assuming that the whole product of the USA is made of the same product, so we can easily calculate the “real” growth simply counting the muffins.
          If we have more than one product, the problem becomes more complex, because the relative price and quantity of the stuff produced can vary.

          2) suppose for example that the whole product of the USA in t1 consists in 500 muffins, each selling for 1$, and 250 cakes that sell for 2$ each, then the nominal output is 1000$.
          But then in t2 the total output consists in 800 muffins, each selling for 0.9$, and 300 cakes, each selling for 2.5$, for a total output of 1470$.
          So how much of this is real growth, and how much inflation?
          How is this calculated?
          Some government office will calculate an “average” inflation weighting the two product in some way, and then once they estimate inflation, they divide the nominal output for the inflation deflator, and estimate the real growth. Notice that the process is the opposite than in (1): in (1), we knew real growth, we knew nominal growth, and from this we deduced inflation.
          But in (2) (and in the real world) we know nominal growth, we estimate inflation from some weighted basket of commodities, and from this we deduce real growth.
          This literally means that “real dollars” depend on the assumed inflation, and not the other way around.
          Since it is obvious that the choice of the products for the basket, and the way they are weighted, are a subjective choices, “real dollars” are not at all real, but just an operative indicator.

          3) then we add the problem of quality adjustment. Suppose that the basket of commodities in t1 contains some computer, let’s say a commodore64 (that in 1982 sold for 600$: https://en.wikipedia.org/wiki/Commodore_64). But then in t2, ten years later, nobody uses the commodore64 anymore, they use the PC386, that at the time costs double the c64, so the government office switches the PC386 for the c64 in the basket, calculating it at twice the value of the c64 (because that is the selling price ratio in t2). Then in t3 the PC386 is substituted by iPhone1, that again cost twice the PC386. So in practical terms the government office is calculating the iPhone1 as 4 c64, because of the price ratio at the time when they change the basket.
          But in reality, there is no way to say that in t3 a c64 would represent 1/4 of the value of the iPhone1 if it was present on the market, because the price of stuff changes in a non linear way.
          This particular “quality improvement” is what everybody fixates about, but it is just an extension of the problem in (2).

          In fact there is no way to calculate inflation the way it is defined without having 2 and 3.

  3. I read the post in econospeak, what a jerk pgl is. I now know to ignore his posts, which are mainly rehashes of the liberal eco-blogosphere anyway (I may not disagree with such but there is usually little value added).

    1. I’m told that he is a retired guy who was given posting privileges at Econospeak as a favor to Mark Thoma, whose friend he is. He’s easy to ignore but it’s a bit more annoying when he gets signal-boosted by DeLong.

  4. BTW to state the obvious, but still: this graph is particularly relevant to the “What Recovery” theme of this blog post:


    It shows that in 1976-2006 working population growth rose, the “real” GDP-index rose rather faster, yet unit sales of light vehicles and buildings production went sideways or a slightly downward trend, while the USA became ever more suburbanized: that is, an increasing number of better off suburban working age adults bought slightly fewer light vehicles and buildings, except for a bit of an uplift 1996-2006.

    It also shows what in 2006-2016 a sharp and definite downwards trend for both light vehicle sales while the working age adult population and GDP continues to grow. How is that possible? What kind of recovery is one in which suburban americans hang on to old cars and fading buildings, instead of keeping up with the Joneses?

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