Month: February 2023

New Paper: Rethinking Supply Constraints

I have a new paper on how we conceptualize the supply side of the economy, coauthored with Arjun Jayadev. I presented a version of this at the Political Economy research Institute in December 2022. You can watch video of my presentation here — I come on, after some technical difficulties, around 47:00. (The other presentations from the conference are also very worth watching.) The paper will be published in the upcoming issue of the Review of Keynesian Economics. (The linked version is our draft; when the published version comes out I’ll post that.)

Our fundamental argument is that while macroeconomic supply constraints are normally conceptualized in terms of a level (or level-path) of potential output, in many contexts it would be better to think in terms of a constraint on the rate of change — a speed limit rather than a ceiling.

While this is a general argument, it’s motivate by the experiences of the pandemic and the post-financial crisis recovery of the preceding decade. We think the speed-limit conception of supply constraints makes sense of a number of macroeconomic developments that are hard to make sense of in the conventional view.

First, deviations in output are persistent. We saw this clearly in the wake of the Great Recession, but it seems to be a more general phenomenon. There’s a long-standing empirical finding that there’s no general tendency of output to return to its previous trend. One way we could explain this is the real business cycle way — short-term as well as long-term variation in output growth are driven by changes in the economy’s productive capacity. But of course, there is lots of evidence that business cycles are driven by demand. Alternatively, we could argue that potential grows steadily but actual output may remain far below it indefinitely. I was making arguments like this a few years ago. The problem is that direct evidence on the output gap (unemployment, growth in wages and prices, businesses’ reported capacity utilization rates, etc.) suggest that the output gap did close over the course of the 2010s. So we’re left with the idea that potential output adjusts to actual output — hysteresis. But if we take this idea seriously, it rules out the conventional idea of a level of potential output. In a world where hysteresis is important, a zero output gap is consistent with lots of different level-paths of output; supply constraints only bind the speed of the transitions between them.

Second, there’s no well-defined level of full employment. (Here we have to ding Keynes a bit.) Employment grows steadily over business cycles — there’s no sign of convergence to some long-term trend. Estimates of the NAIRU or natural unemployment rate follow actual unemployment more or less one for one. And if we try to make a bottom-up estimate of full employment — what fraction of the population could plausibly be engaged in paid work — we end up with a value much higher than actual employment even at cyclical peaks.

Third, we observe inflation and other signs of supply constraints in response to changes in the composition of output and employment, and not just in the level. This has been very clear during the pandemic, but there’s good reason to think it’s true in general.

Fourth, increasing returns are pervasive in real economies. This is a bit of a different argument than the first three, since it’s not pointing to a directly observable macro phenomenon. But it’s important here, because it means that we can’t assume that businesses are already using the lowest-cost technique and increasing output will cause unit costs to rise. One way of thinking about this is to imagine a cost landscape that is rugged, not smooth. Moving from one locally low-cost position to another may require traversing a higher cost region, which will appear as supply constraints during the transition. A clear example of this is the transition from carbon to renewable energy sources.

We also argue that this perspective is more consistent with a sociologically realistic view of what “the economy” is. Real economies are not homogeneous “factors” being added to a “production function” which then spits out some quantity of output. They are complex systems of cooperation between human beings, which are embedded in all kinds of other social relationships and the reproduction of households and other social organisms. These relationships cannot be torn up and recreated at any moment — changing them is costly. They evolve only gradually over time. From this point of view, it is wrong to divide the facts about the economic world into a set of long-run, fundamental, exogenous factors and short-run endogenous factors. Who is actually working, and at what, is as much a part of the economic data, no less easily shifted, than the number of people who are potentially available for work.

This way of thinking about the supply side has several implications for policy. First, rising prices and other signs of supply constraints cannot be taken as evidence for the long-run limits on the economy’s productive potential. In general, we should be skeptical of suggestions that recent rises in the prices of energy, food and other essential commodities reflect the “end of abundance”.

On the positive side, our view suggests that the response to positive output gaps should include not only conventional “supply side” measures, but measures to overcome the coordination and information problems and other frictions that limit rapid changes in productive activity. This implies planning of some sort, though not necessarily central planning in the traditional sense. Another implication is that because prices can adjust more quickly than productive activity can (the emphasis on price stickiness is backward in our view), rapid shifts in activity can generate large price spikes that are not informative about long-run production possibilities and produce undesirable shifts in income. This suggests that price regulation has an important role in smoothing the transition fro one pattern of activity to another.

Specific examples and evidence on all these points are in the paper. You should read it! A final point I want to emphasize here is that we are not saying that supply constraints are limits on adjustment speed in an absolute, universal sense. We are saying that insofar as we need a simple, first-cut description of the supply side, we will usually do better to imagine a constraint on adjustment speed rather than on the level of output and employment.

 

At Barron’s: The Fed’s View of the Economy Matters for More than Monetary Policy

(I write a monthly opinion piece for Barron’s. This is the most recent one; you can find earlier ones here.) 

Has the inflationary fever broken at last? The headline Consumer Price Index, which was rising at a 17 percent annual rate last June, actually fell in December. Other measures show a similar, if less dramatic, slowing of price growth. But before we all start congratulating the Federal Reserve, we should think carefully about what else we’re signing up for.

For Fed Chair Jerome Powell, it’s clear that slower price growth is not enough. Inflation may be coming down, but labor markets are still much too tight. “Nominal wages have been growing at a pace well above what would be consistent with 2 percent inflation over time,” he said recently, so “another condition we are looking for is the restoration of balance between supply and demand in the labor market.” 

The model of the economy that the Fed is working with looks something like this: most prices are, at the end of the day, set as a markup over wages. Wage increases depend on the relative bargaining power of workers and employers, and that in turn depends on labor market tightness. Labor market tightness depends on aggregate demand, which the Fed can influence through interest rates. Yes, there are other influences on inflation; but it’s clear that for the Fed this story is central. Indeed, we might call it the Federal Reserve View.

Is this story a fair description of the real world? Yes and no.

A useful rule to remember is that the rise in average wages must equal the rise in the price of domestically-produced goods, plus productivity growth, plus the share of income going to workers. All else equal, higher wages mean higher prices. But all else is not always equal. It’s possible to have faster wage growth and stable inflation if profit margins are falling, or if productivity is rising, or if import prices are falling.

In the short run, these other factors can easily outweigh wage growth. Just look at the 10 years prior to the pandemic. Hourly wages grew almost twice as fast in the second half of the decade as in the first half — nearly 4 percent annually, versus 2 percent. Yet inflation as measured by the CPI was no higher over 2015-2019 than over 2010-2014. That was thanks to productivity growth, which accelerated significantly, and import prices, which declined. (Workers’ share of national income did not change significantly.)

On the other hand, there is a limit to how fast productivity can rise, or profit margins or import prices can fall. No one doubts that if wages were to rise by, say, 10 percent year after year, inflation would eventually rise.

Critics of the Fed have questioned whether these long-run relationships tell us much about the inflation we are seeing now. There are plenty of things that cannot go on forever but can, and should, go on for a while. Rapid wage gains might be one of them. While Powell clearly still sees wage growth as excessive, others might look at the latest Employment Cost Index—less than 1% growth, compared with 1.4% at the start of 2022—and see a problem taking care of itself.

The Fed’s current plan is to increase unemployment by 1 percent over the next year, throwing 1.6 million people out of work. If the link between labor market conditions and prices is not as tight as they think, that’s a lot of suffering being inflicted for no reason. 

But there’s an even bigger problem with the Federal Reserve View: what else follows once you accept it. If price stability requires a weaker labor market – one in which employers have an easier time finding workers, and workers have a harder time finding jobs – that has implications that go far beyond monetary policy.

Take the Fair Trade Commission’s recent ban on non-compete clauses in employment contracts. When President Biden issued the executive order that led to this action, he explicitly framed it as a way of shifting bargaining power to workers and allowing them to demand higher pay. “If your employer wants to keep you,” he said, “he or she should have to make it worth your while to stay.” 

This sounds like good news for workers. But here’s the problem: from the Fed’s point of view, businesses are already paying too much to hold onto their employees. As Powell has said repeatedly over the past year, there is currently a “real imbalance in wage negotiating” in favor of workers. He wants to make it harder for people to switch jobs, not easier. So if the non-compete ban delivers what the President promised, that will just mean that rates have to go up by more.

Or think about minimum wage laws. Thanks to widespread indexing, nearly half the states saw significant increases in their minimum wages at the start of this year. Others, like New York, are moving in this direction. For many people the case for indexing is obvious: It makes sure that the incomes of low-wage workers in retail, fast food and other services keep pace with rising prices. But for the Fed, these are exactly the wages that are already rising too fast. Higher minimum wages, from the Fed’s point of view, call for higher interest rates and unemployment.

There’s nothing new or secret about this. In a typical macroeconomics textbook, the first example of something that raises the “natural rate” of unemployment (the one the central bank targets) is more generous unemployment benefits, which encourage workers to hold out for higher wages.

Publicly, the Fed disavows any responsibility for labor market policy. But obviously, if your goal is to maintain a certain balance of power between workers and employers, anything that shifts that balance is going to concern you.

This problem had dropped from view in recent years, when the Fed was struggling to get inflation up to its target. But historically, there’s been a clear conflict between protecting workers and keeping unemployment low. Under Alan Greenspan, Fed officials often worried that any revival of organized labor could make the job of inflation control harder. Treasury Secretary Yellen made a version of this argument early on in her career at the Fed, observing that “lower unemployment benefits or decreased unionization could … result in a decline in workers’ bargaining power.” This, she explained, could be a positive development, since it would imply “a permanent reduction in the natural rate of unemployment.”

Unfortunately, the same logic works the other way too. Stronger unions, higher minimum wages, and other protections for workers must, if you accept the Federal Reserve View, result in a higher natural rate of unemployment — which means more restrictive monetary policy to bring it about.

It’s easy to understand why administration officials would say they trust the Fed to manage inflation, while they focus on being the most-pro-labor administration in history. Unfortunately, dividing things up this way may not be as simple as it sounds. If that’s what they think their job is, they may have to challenge how the Fed thinks about its own.