Tag: aggregate demand

At Dissent: Industrial Policy without Nationalism

(This piece was published in the Fall 2024 issue of Dissent.)

In the first two years after Biden’s election, there was considerable enthusiasm on the left for the administration’s embrace of a larger, more active economic role for the federal government. I was among those who saw both the ambitions of the Build Back Better bill and the self-conscious embrace of industrial policy as an unexpectedly sharp break with the economic policy consensus of the past thirty years.

Biden squandered that early promise with his embrace of Israel’s campaign of mass murder in Gaza. His legacy will be the piles of shattered buildings and children’s corpses that he, with aides like Antony Blinken, did so much to create.

The administration has also struck a Trumpian note on immigration, promising to shut down the border to desperate asylum seekers. And internationally, it is committed to a Manichean view of the world where the United States is locked into a perpetual struggle for dominance with rivals like Russia and China.

Can industrial policy be salvaged from this wreckage? I am not sure.

There are really two questions here. First, is there an inherent connection between industrial policy and economic nationalism, because support for one country’s industries must comes at the cost of its trade partners? And second, is it possible in practice to pursue industrial policy without militarism? Or does it require the support of the national security establishment as the only sufficiently powerful constituency in favor of a bigger and more active government?

Much of the conversation around industrial policy assumes that one country’s gain must be another’s loss. U.S. officials insist on the need to outcompete China in key markets and constantly complain about how “unfair” Chinese support for its manufacturers disadvantages U.S. producers. European officials make similar complaints about the United States.

This zero-sum view of trade policy is shared by an influential strand of thought on the left, most notably Robert Brenner and his followers. In their view, the world economy faces a permanent condition of overcapacity, in which industrial investment in one country simply depresses production and profits elsewhere. In the uncompromising words of Dylan Riley, “the present period does not hold out even the hope of growth,” allowing only for “a politics of zero-sum redistribution.” Development, in this context, simply means the displacement of manufacturing in the rich countries by lower-cost competitors.

I don’t know if anyone in the Biden administration has read Brenner or been influenced by him. But there is certainly a similarity in language. The same complaints that Chinese investment is exacerbating global overcapacity in manufacturing could come almost verbatim from the State Department or from the pages of New Left Review. More broadly, there is a shared sense that China’s desire to industrialize is fundamentally illegitimate. The problem, Brenner complains, is that China and other developing countries have sought to “export goods that were already being produced” instead of respecting the current “world division of labor along Smithian lines” and focusing on exports complementary to existing industries in the North.

Fortunately, we can be fairly confident that this understanding of world trade is wrong.

The zero-sum vision sees trade flows as driven by relative prices, with lower-cost producers beating out higher-cost ones for a fixed pool of demand. But as Keynesian economists have long understood, the most important factor in trade flows is changes in incomes, not prices. Far from being fixed, demand is the most dynamic element in the system.

A country experiencing an economic boom – perhaps from a upsurge in investment – will see a rapid rise in both production and demand. Some of the additional spending will falls on imports; countries that grow faster therefore tend to develop trade deficits while countries that grow slowly tend to develop trade surpluses. (It is true that some countries manage to combine rapid growth with trade surpluses, while others must throttle back demand to avoid deficits. But as the great Keynesian economist A.P. Thirlwall argued, this is mainly a function of what kinds of goods they produce, rather than lower prices.)

We can see this dynamic clearly in the United States, where the trade deficit consistently falls in recessions and widens when growth resumes. It was even more important, though less immediately obvious, in Europe in the 2000s. During the first decade of the euro, Germany developed large surpluses with other European countries, which were widely attributed to superior competitiveness thanks to wage restraint and faster productivity growth. But this was wrong. While German surpluses with the rest of the European Union rose from 2 percent to 3 percent of German GDP during the 2000s, there was no change in the fraction of income being spent in the rest of the bloc on German exports. Meanwhile, the share of German income spent on EU imports actually rose.

If Germans were buying more from the rest of the European Union, and non-German Europeans were buying the same amount from Germany, how could it be that the German trade surplus with Europe increased? The answer is that total expenditure was rising much faster in the rest of Europe. Rising German surpluses were the result of austerity and stagnation within the country, not greater competitiveness. If Germany had adopted a program to boost green investment during the 2000s, its trade surpluses would have been smaller, not larger. The same thing happened in reverse after the crisis: the countries of Southern Europe rapidly closed their large trade deficits without any improvement in export performance, as deep falls in income and expenditure squeezed their imports. 

Europe’s trade imbalances of a decade ago might seem far afield from current debates over industrial policy. But they illustrate a critical point. When a country adopts policies to boost investment spending, that creates new demand in its economy. And the additional imports drawn in by this demand are likely to outweigh whatever advantages it gains in the particular sector where investment is subsidized. Measures like the Inflation Reduction Act (IRA) or CHIPS and Science Act may eventually boost U.S. net exports in the specific sectors they target. But they also raise demand for everything else. This is why a zero-sum view of industrial policy is wrong. If the US successfully boosts investment in wind turbine production, say, it will probably boost net exports of turbines. But it will also raise imports of other things – not just inputs for turbines, but all the goods purchased by everyone whose income is raised by the new spending. For most US trade partners, the rise in overall demand will matter much more than greater US competitiveness in a few targeted sectors.

China might look like an exception to this pattern. It has combined an investment boom with persistent trade surpluses, thanks to the very rapid qualitative upgrading of its manufacturing base. For most lower- and middle-income countries, rapid income growth leads to a disproportionate rise in demand for more advanced manufactures they can’t make themselves. This has been much less true of China. As economists like Dani Rodrik have shown, what is exceptional about China is the range and sophistication of the goods it produces relative to its income level. This is why it’s been able to maintain trade surpluses while growing rapidly.

While Biden administration officials and their allies like to attribute China’s success to wage repression, the reality is close to the opposite. As scholars of inequality like Branko Milanovic and Thomas Piketty have documented, what stands out about China’s growth is how widely the gains have been shared. Twenty-first-century China, unlike the United States or Western Europe, has seen substantial income growth even for those at the bottom of the income distribution.

More important for the present argument, China has not just added an enormous amount of manufacturing capacity; it has also been an enormous source of demand. This is the critical point missed by those who see a zero-sum competition for markets. Consider automobiles. Already by 2010 China was the world’s largest manufacturer, producing nearly twice as many vehicles as the United States, a position it has held ever since. Yet this surge in auto production was accompanied by an even larger surge in auto consumption, so that China remained a net importer of automobiles until 2022. The tremendous growth of China’s auto industry did not come at the expense of production elsewhere; there were simply more cars being made and sold.

All this applies even more for the green industries that are the focus of today’s industrial policy debate. There has been a huge rise in production—especially but not only in China—but there has been an equally huge growth in expenditure. Globally, solar power generation increased by a factor of 100 over the past fifteen years, wind power by a factor of ten. And there is no sign of this growth slowing. To speak of excess capacity in this sector is bizarre. In a recent speech, Treasury Under Secretary Jay Shambaugh complained that China plans to produce more lithium-ion batteries and solar modules than are required to hit net-zero emissions targets. But if the necessary technologies come online fast enough, there’s no reason we can’t beat those targets. Is Shambaugh worried that the world will decarbonize too fast?

Even in narrow economic terms, there are positive spillovers from China’s big push into green technology. China may gain a larger share of the market for batteries or solar panels — though again, it’s important to stress that this market is anything but fixed in size — but the investment spending in that sector will create demand elsewhere, to the benefit of countries that export to China. Technological improvements are also likely to spread rapidly. One recent study of industrial policy in semiconductors found that when governments adopt policies to support their own industry, they are able to significantly raise productivity – but thanks to international character of chip production, productivity gains are almost as large for the countries they trade with. Ironically, as Tim Sahay and Kate Mackenzie observe, the United States stands to lose out on exactly these benefits thanks to the Biden administration’s hostility to investment by Chinese firms.

None of this is to say that other countries face no disruptions or challenges from China’s growth, or from policies to support particular industries in the United States or elsewhere. The point is that these disruptions can be managed. Lost demand in one sector can be offset by increased demand somewhere else. Subsidies in one country can be matched by subsidies in another. Indeed, in the absence of any global authority to coordinate green investment, a subsidy race may be the best way to hasten decarbonization.

As a matter of economics, then, there is no reason that industrial policy has to involve us-against-them economic nationalism or heightened conflict between the United States and China. As a matter of politics, unfortunately, the link may be tighter.

They are certainly linked in the rhetoric of the Biden administration. Virtually every initiative, it now seems, is justified by the need to meet the threat of foreign rivals. A central goal of the CHIPS Act is to not only reduce U.S. reliance on Chinese imports but to cut China off from technologies where the United States still has the lead. Meanwhile arms deliveries to Ukraine are sold as a form of stimulus. This bellicose posture is deeply written in the DNA of Bidenomics: before becoming Biden’s national security advisor, Jake Sullivan ran a think tank whose vision of “foreign policy for the middle class” was “Russia, Russia, Russia and China, China, China.”

Thea Riofrancos calls this mindset the “security-sustainability nexus.” Is its current dominance in U.S. politics a contingent outcome—the result, perhaps, of the particular people who ended up in top positions in the Biden administration? And if so, can we imagine a U.S. industrial policy where the China hawks are not in the driver’s seat? Or is the political economy of the United States one in which only a Cold War enemy can motivate a public project to reorient the economy?

In a recent paper, Benjamin Braun and Daniela Gabor argue for the second alternative. It is only “the salience of geopolitical competition” with China that has allowed the United States to go as far with industrial policy as it has. In the absence of much more popular pressure and a broader political realignment, they suggest, the only way that “green planners” can overcome the deep-seated resistance to bigger government is through an alliance with the “geopolitical hawks.”

Many of us have pointed to the economic mobilization of the Second World War as a model for a quick decarbonization of the U.S. economy through public investment. Wartime mobilization — the “greatest thing that man has ever done,” in the words of a contemporary Woody Guthrie song — offers an appealing model for decarbonization. It combines both the most rapid expansion and redirection of economic activity in U.S. history, and the closest the country has ever come to a planned economy. But given the already dangerous entanglement of industrial policy with war and empire, it’s a model we may not want to invoke.

On the other hand, the climate crisis is urgent. And the arguments that it calls for a more direct public role in steering investment are as strong as ever. It’s safe to say that neither the historic boom in new factory construction nor the rapid growth in solar energy (which accounts for the majority of new electrical generating capacity added in 2024) would have happened without the IRA. It’s easy to see how climate advocates could be tempted to strike a Faustian bargain with the national security state, if that’s the only way to get these measures passed.

Personally, I would prefer to avoid this particular deal with the devil. I believe we should oppose any policy aimed at strengthening the United States vis-à-vis China and flatly reject the idea that U.S. military supremacy is in the interest of humanity. An all-out war between the United States and China (or Russia) would be perhaps the one outcome worse for humanity than uncontrolled climate change. Even if the new Cold War can be kept to a simmer—and that’s not something to take for granted—the green side of industrial policy is likely to lose ground whenever it conflicts with national security goals, as we’ve recently seen with Biden’s tariffs on Chinese solar cells, batteries, and electric vehicles. The Democratic pollster David Shor recently tweeted that he “would much rather live in a world where we see a 4 degree rise in temperature than live in a world where China is a global hegemon.” Administration officials would not, presumably, spell it out so baldly, but it’s a safe bet that many of them feel the same way.

Adam Tooze observes somewhere that historically socialists often favored strictly balanced budgets — because they expected, not without reason, that the main beneficiary of lax fiscal rules would be the military. The big question about industrial policy today is whether that logic still applies, or whether an expansion of the state’s role in the economic realm can be combined with a diminution of its capacity for war.

At Barron’s: Thank Full Employment, Not AI, for Rising Productivity

(I write a monthly opinion piece for Barron’s. This one was published there in September. My previous pieces are here.)

New data about productivity are some of the best on record in recent years. That’s good news for economic growth. But just as important, it offers support for the unorthodox idea that demand shapes the economy’s productive potential. Taking this idea seriously would require us to rethink much conventional wisdom on macroeconomic policy. 

Real output per hour grew 2.6% in 2023, according to the Bureau of Labor Statistics, exceeding the highest rates seen between 2010 and the eve of the pandemic. That said, productivity is one of the most challenging macroeconomic outcomes to measure. It is constructed from three distinct series—nominal output, prices, and employment. Short-term movements often turn out to be noise. It’s an open question whether that high rate will be sustained. But if it is, that will tell us something important about economic growth. 

Discussions of productivity growth tend to treat it as the result of unpredictable scientific breakthroughs and new technologies, whose appearance has nothing to do with current economic conditions. This view of technological change as “exogenous,” in the jargon, is entrenched in economics textbooks. And it’s reinforced by the self-mythologizing barons of Silicon Valley, who are only too happy to take credit for economic good news. 

The economic conditions that lead companies to actually adopt new technologies get much less attention, as does the fact that much productivity growth comes from people shifting from lower-value to higher-value activities without the need for any new technology at all.

A recent New York Times article is typical. It discusses faster productivity growth almost entirely in terms of the new technologies — AI, Zoom, internet shopping — that might, or might not, be contributing. Not until 40 paragraphs in is there a brief mention of the strong labor market, and the incentives that rising wages create to squeeze more out of each hour of labor.

What if we didn’t treat this as an afterthought? There’s a case to be made that demand is, in fact, a central factor in productivity growth. 

The economic historian Gavin Wright has made this case for both the 1990s — our modern benchmarks for productivity success stories — and the 1920s, an earlier period of rapid productivity growth and technological change. Wright considers the adoption of general-purpose technologies: electricity in the ‘20s and computers in the ‘90s. Both had existed for some time but weren’t widely adopted until rising labor costs provided the right incentives. He observes that in both periods strong wage growth started before productivity accelerated. 

In the retail sector, for instance, it was in the 1990s that IT applications like electronic monitoring of shelf levels, barcode scanning and electronic payments came into general use. None of these technologies were new at the time; what had changed was the tight market for retail employment that made automation worthwhile.

The idea that demand can have lasting effects on the economy’s productive potential – what economists call hysteresis — has gotten attention in recent years. Discussions of hysteresis tend to focus on labor supply — people dropping out of the labor market when jobs are scarce, and re-entering when conditions improve. The effect of demand on productivity is less often discussed. But it may be even more important.

After the 2007-2009 recession, gross domestic product in the U.S. (and most other rich countries) failed to return to its pre-recession trend. By 2017, a decade after the recession began, real GDP was a full 10% below what prerecession forecasters had expected. There is wide agreement that much, if not all, of this shortfall was the result of the collapse of demand in the recession. Former Treasury Secretary Larry Summers at the time called the decisive role of demand in the slow growth of the 2010s a matter of “elementary signal identification.” 

Why did growth fall short? If you look at the CBO’s last economic forecasts before the recession, the agency was predicting 6% growth in employment between 2007 and 2017. And as it turned out, over those ten years, employment grew by exactly 6%. The entire gap between actual GDP and the CBO’s pre-recession forecasts was from slower growth in output per worker. In other words, this shortfall was entirely due to lower productivity. 

If you believe that slow growth in the 2010s was largely due to the lingering effects of the recession — and I agree with Summers that the evidence is overwhelming on this point — then what we saw in that decade was weak demand holding back productivity. And if depressed demand can slow down productivity growth, then, logically, we would expect strong demand to speed it up.

A few economists have consistently made the case for this link. Followers of John Maynard Keynes often emphasize this link under the name “Verdoorn’s law.” The law, as Keynesian economist Matias Vernengo puts it in a new article, holds that “technical change is the result, and not the fundamental cause of economic growth.” Steve Fazzari, another Keynesian economist, has explored this idea in several recent papers. But for the most part, mainstream economists have yet to embrace it. 

This perspective does occasionally make it into the world of policy debates. In a 2017 report, Josh Bivens of the Economic Policy Institute argued that “low rates of unemployment and rapid wage growth would likely induce faster productivity growth.” Skanda Amarnath and his colleagues at Employ America have made similar arguments. In a 2017 report for the Roosevelt Institute, I discussed a long list of mechanisms linking demand to productivity growth, as well as evidence that this was what explained slower growth since the recession.

If you take these sorts of arguments seriously, the recent acceleration in productivity should not be a surprise. And we don’t need to go looking for some tech startup to thank for it. It’s the natural result of a sustained period of tight labor markets and rising wages.

There are many good reasons for productivity growth to be faster in a tight labor market, as I discussed in the Roosevelt report. Businesses have a stronger incentive to adopt less labor-intensive techniques, and they are more likely to invest when they are running at full capacity. Higher-productivity firms can outbid lower-productivity ones for scarce workers. New firms are easier to start in a boom than in a slump.

When you think about it, it’s strange that concepts like Verdoorn’s law are not part of the economics mainstream. Shouldn’t they be common sense?

Nonetheless, the opposite view underlies much of policymaking, particularly at the Federal Reserve. At his most recent press conference, Fed Chair Jay Powell was asked whether he still thought that wage growth was too high for price stability. Powell confirmed that, indeed, he thought that wage gains were still excessively strong. But, he said, they were gradually moving back to levels “associated — given assumptions about productivity growth — with 2% inflation.”

The Fed’s view that price stability requires limiting workers’ bargaining power is a long-standing problem. But focus now on those assumptions. Taking productivity growth as given, unaffected by policy, risks making the Fed’s pessimism self-confirming. (This is something that Fed economists have worried about in the past.) If the Fed succeeds in getting wages down to the level consistent with the relatively slow productivity growth it expects, that itself may be what stops us from getting the faster productivity growth that the economy is capable of.

The good news is that, as I’ve written here before, the Fed is not all-powerful. The current round of rate hikes has not, so far, done much to cool off the labor market. If that continues to be the case, then we may be in for a period of sustained productivity growth and rising income.

At Barron’s: Inflation Is Falling. Don’t Thank the Fed

(I write a monthly opinion piece for Barron’s. This one was published there in September. My previous pieces are here.)

You wouldn’t necessarily guess it from the headlines, but we may soon be talking about inflation in the past tense. After peaking at close to 10% in the summer of 2022, inflation has fallen even faster than it rose. Over the past three months inflation, as measured by the CPI, has been slightly below the Federal Reserve’s 2% target. Nearly every other measure tells a similar story.

Predicting the future is always risky. But right now, it seems like the conversation about how to fix the inflation problem is nearing its end. Soon, we’ll be having a new debate: Who, or what, should get credit for solving it?

The Fed is the most obvious candidate. Plenty of commentators are already giving it at least tentative credit for delivering that elusive soft landing. And why not? Inflation goes up. The central bank raises interest rates. Inflation goes back down. Isn’t that how it’s supposed to work? 

The problem is, monetary policy does not work through magic. The Fed doesn’t simply tell private businesses how much to charge. Higher interest rates lead to lower prices only by reducing demand. And so far, that doesn’t seem to have happened – certainly not on a scale that could explain how much inflation has come down.  

In the textbook story, interest rates affect prices via labor costs. The idea is that businesses normally set prices as a markup over production costs, which consist primarily of wages. When the Fed raises rates, it discourages investment spending — home construction and business spending on plant and equipment — which is normally financed with credit. Less investment means less demand for labor, which means higher unemployment and more labor market slack generally. As unemployment rises, workers, with less bargaining power vis-a-vis employers, must accept lower wages. And those lower wages get passed on to prices.

Of course this is not the only possible story. Another point of view is that tighter credit affects prices through the demand side. In this story, rather than businesses producing as much as they can sell at given costs, there is a maximum amount they can produce, often described as potential output. When demand rises above this ceiling, that’s when prices rise. 

Either way, the key point — which should be obvious, but somehow gets lost in macro debates — is that prices are determined by real conditions in individual markets. The only way for higher rates to slow down rising prices, is if they curtail someone’s spending, and thereby production and employment. No business — whether it’s selling semiconductors or hamburgers — says “interest rates are going up, so I guess I’ll charge less.” If interest rates change their pricing decisions, it has to be through some combination of fall in demand for their product, or in the wages they pay.

Over the past 18 months, the Fed has overseen one of the fast increases in short-term interest rates on record. We might expect that to lead to much weaker demand and labor markets, which would explain the fall in inflation. But has it?

The Fed’s rate increases have likely had some effect. In a world where the Federal Funds rate was still at zero, employment and output might well be somewhat higher than they are in reality. Believers in monetary-policy orthodoxy can certainly find signs of a gently slowing economy to credit the Fed with. The moderately weaker employment and wage growth of recent months is, from this point of view, evidence that the Fed is succeeding.

One problem with pointing to weaker labor markets as a success story, is that workers’ bargaining power matters for more than wages and prices. As I’ve noted before, when workers have relatively more freedom to pick and choose between jobs, that affects everything from employment discrimination to productivity growth. The same tight labor markets that have delivered rapid wage growth, have also, for example, encouraged employers to offer flexible hours and other accommodations to working parents — which has in turn contributed to women’s rapid post-pandemic return to the workplace. 

A more basic problem is that, whether or not you think a weaker labor market would be a good thing on balance, the labor market has not, in fact, gotten much weaker.

At 3.8%, the unemployment rate is essentially unchanged from where it was when at the peak of the inflation in June 2022. It’s well below where it was when inflation started to rise in late 2020. It’s true that quits and job vacancy rates, which many people look to as alternative measures of labor-market conditions, have come down a bit over the past year. But they still are extremely high by historical standards. The prime-age employment-population ratio, another popular measure of labor-market conditions, has continued to rise over the past year, and is now at its highest level in more than 20 years. 

Overall, if the labor market looks a bit softer compared with a year ago, it remains extremely tight by any other comparison. Certainly there is nothing in these indicators to explain why prices were rising at an annual rate of over 10% in mid-2022, compared with just 2% today.

On the demand side, the case is, if anything, even weaker. As Employ America notes in its excellent overview, real gross domestic product growth has accelerated during the same period that inflation has come down. The Bureau of Economic Analysis’s measure of the output gap similarly shows that spending has risen relative to potential output over the past year. For the demand story to work, it should have fallen. It’s hard to see how rate hikes could be responsible for lower inflation during a period in which people’s spending has actually picked up. 

It is true that higher rates do seem to have discouraged new housing construction. But even here, the pace of new housing starts today remains higher than at any time between 2007 and the pandemic. 

Business investment, meanwhile, is surging. Growth in nonresidential investment has accelerated steadily over the past year and a half, even as inflation has fallen. The U.S. is currently seeing a historic factory boom — spending on new manufacturing construction has nearly doubled over the past year, with electric vehicles, solar panels and semiconductors leading the way. That this is happening while interest rates are rising sharply should raise doubts, again, about how important rates really are for business investment. In any case, no story about interest rates that depends on their effects on investment spending can explain the recent fall in inflation. 

A more disaggregated look at inflation confirms this impression. If we look at price increases over the past three months compared with the period of high inflation in 2021-2022, we see that inflation has slowed across most of the economy, but much more so in some areas than others.

Of the seven-point fall in inflation, nearly half is accounted for by energy, which makes up less than a tenth of the consumption basket. Most of the rest of the fall is from manufactured goods. Non-energy services, meanwhile, saw only a very modest slowing of prices; while they account for about 60% of the consumption basket, they contributed only about a tenth of the fall in inflation. Housing costs are notoriously tricky; but as measured by the shelter component of the Bureau of Labor Statistics, they are rising as fast now as when inflation was at its peak.

Most services are not traded, and are relatively labor-intensive; those should be the prices most sensitive to conditions in U.S. product and labor markets. Manufactured goods and especially energy, on the other hand, trade in very internationalized markets and have been subject to well-publicized supply disruptions. These are exactly the prices we might expect to fall for reasons having nothing to do with the Fed. The distribution of price changes, in other words, suggests that slowing inflation has little to do with macroeconomic conditions within the US, whether due to Fed action or otherwise.

If the Fed didn’t bring down inflation, what did? The biggest factor may be the fall in energy prices. It’s presumably not a coincidence that global oil prices peaked simultaneously with U.S. inflation. Durable-goods prices have also fallen, probably reflecting the gradual healing of pandemic-disrupted supply chains. A harder question is whether the supply-side measures of the past few years played a role. The IRA and CHIPS Act have certainly contributed to the boom in manufacturing investment, which will raise productive capacity in the future. It’s less clear, at least to me, how much policy contributed to the recovery in supply that has brought inflation down.

But that’s a topic for another time. For now it’s enough to say: Don’t thank the Fed.


(Note: Barron’s, like most publications I’ve worked with, prefers to use graphics produced by their own team. For this post, I’ve swapped out theirs for my original versions.)

At Barron’s: Do Interest Rates Really Drive the Economy?

(I write a more-or-less monthly opinion piece for Barron’s. This is my contribution for March 2023; you can find the earlier ones here.)

When interest rates go up, businesses spend less on new buildings and equipment. Right?

That’s how it’s supposed to work, anyway. To be worth doing, after all, a project has to return more than the cost of financing it. Since capital expenditure is often funded with debt, the hurdle rate, or minimum return, for capital spending ought to go up and down with the interest rate. In textbook accounts of monetary policy, this is a critical step in turning rate increases into slower activity.

Real economies don’t always match the textbook, though. One problem: market interest rates don’t always follow the Federal Reserve. Another, perhaps even more serious problem, is that changes in interest rates may not matter much for capital spending.

A fascinating new study raises new doubts about how much of a role interest rates play in business investment.

To clarify the interest-investment link, Niels Gormsen and Kilian Huber — both professors at the University of Chicago Booth School of Business — did something unusual for economists. Instead of relying on economic theory, they listened to what businesses themselves say. Specifically, they (or their research assistants) went through the transcripts of thousands of earnings calls with analysts, and flagged any mention of the hurdle rate or required return on new capital projects. 

What they found was that quoted hurdle rates were consistently quite high — typically in the 15-20% range, and often higher. They also bore no relationship to current interest rates. The federal funds rate fell from 5.25% in mid-2007 to zero by the end of 2008, and remained there through 2015. But you’d never guess it from the hurdle rates reported to analysts. Required returns on new projects were sharply elevated over 2008-2011 (while the Fed’s rate was already at zero) and remained above their mid-2000s level as late as 2015. The same lack of relationship between interest rates and investment spending is found at the level of individual firms, suggesting, in Gormsen and Huber’s words, that “fluctuations in the financial cost of capital are largely irrelevant for [business] investment.”

While this picture offers a striking rejection of the conventional view of interest rates and investment spending, it’s consistent with other research on how managers make investment decisions. These typically find that changes in the interest rate play little or no role in capital spending. 

If businesses don’t look at interest rates when making investment decisions, what do they look at? The obvious answer is demand. After all, low interest rates are not much of an incentive to increase capacity if existing capacity is not being used. In practice, business investment seems to depend much more on demand growth than on the cost of capital. 

(The big exception is housing. Demand matters here too, of course, but interest rates also have a clear and direct effect, both because the ultimate buyers of the house will need a mortgage, and because builders themselves are more dependent on debt financing than most businesses are. If the Fed set the total number of housing permits to be issued across the country instead of a benchmark interest rate, the effects of routine monetary policy might not look that different.)

If business investment spending is insensitive to interest rates, but does respond to demand, that has implications for more than the transmission of monetary policy. It helps explain both why growth is so steady most of the time, and why it can abruptly stall out. 

As long as demand is growing, business investment spending won’t be very sensitive to interest rates or other prices. And that spending in turn sustains demand. When one business carries out a capital project, that creates demand for other businesses, encouraging them to expand as well. This creates further demand growth in turn, and more capital spending. This virtuous cycle helps explain why economic booms can continue in the face of all kinds of adverse shocks — including, sometimes, efforts by the Fed to cut them off.

On the other hand, once demand falls, investment spending will fall even more steeply. Then the virtuous cycle turns into a vicious one. It’s hard to convince businesses to resume capital spending when existing capacity is sitting idle. Each choice to hold back on investment, while individually rational, contributes to an environment where investment looks like a bad idea. 

This interplay between business investment and demand was an important part of Joseph Schumpeter’s theory of business cycles. It played a critical role in John Maynard Keynes’ analysis of the Great Depression. Under the label multiplier-accelerator models, it was developed by economists in the decades after World War II. (The multiplier is the link from investment to demand, while the accelerator is the link from demand growth to investment.) These theories have since fallen out of fashion among economists. But as the Gormsen and Huber study suggests, they may fit the facts better than today’s models that give decisive importance to the interest rate controlled by the Fed.

Indeed, we may have exaggerated the role played in business cycles not just of monetary policy, but of money and finance in general. The instability that matters most may be in the real economy. The Fed worries a great deal about the danger that expectations of higher inflation may become self-confirming. But expectations about real activity can also become unanchored, with even greater consequences. Just look at the “jobless recoveries” that followed each of the three pre-pandemic recessions. Weak demand remained stubbornly locked in place, even as the Fed did everything it could to reignite growth.

In the exceptionally strong post-pandemic recovery, the Fed has so far been unable to disrupt the positive feedback between rising incomes and capital spending. Despite the rate hikes, labor markets remain tighter than any time in the past 20 years, if not the past 50. Growth in nonresidential investment remains fairly strong. Housing starts have fallen sharply since rates began rising, but construction employment has not – at least not yet. The National Federation of Independent Business’s survey of small business owners gives a sharply contradictory picture. Most of the respondents describe this as a very poor moment for expansion, yet a large proportion say that they themselves plan to expand and increase hiring. Presumably at some point this gap between what business owners are saying and what they are doing is going to close – one way or the other. 

If investment responded strongly to interest rates, it might be possible for the Fed to precisely steer the economy, boosting demand a little when it’s weak, cooling it off when it gets too hot. But in a world where investment and demand respond mainly to each other, there’s less room for fine-tuning. Rather than a thermostat that can be turned up or down a degree or two, it might be closer to the truth to say that the economy has just two settings: boom and bust.

At its most recent meeting, the Fed’s forecast was for the unemployment rate to rise one point over the next year, and then stabilize. Anything is possible, of course. But in the seven decades since World War Two, there is no precedent for this. Every increase in the unemployment rate of a half a point has been followed by a substantial further rise, usually of two points or more, and a recession. (A version of this pattern is known as the Sahm rule.) Maybe we will have a soft landing this time. But it would be the first one.

 

What Does It Mean to Say that Inflation Is Caused by Demand?

There has been a lot of debate about whether the high inflation of 2021-2022 has been due mainly to supply or demand factors. Joe Stiglitz and Ira Regmi have a new paper from Roosevelt making the case for supply disruptions as the decisive factor. It’s the most thorough version of that case that I’ve seen, and I agree with almost all of it. I highly recommend reading it. 

What I want to do in this post is something different. I want to clarify what it would mean, if inflation were in fact driven by demand. Because there are two quite distinct stories here that I think tend to get mixed up.

In the textbook story, production takes place with constant returns to scale and labor as the only input. (We could introduce other inputs like land or imports without affecting the logic.) Firms have market power, so price are set as a positive markup over unit costs. The markup depends on various things (regulations, market structure, etc.) but not on the current level of output. With constant output per worker, this means that the real wage and wage share are also constant. 

The nominal wage, however, depends on the state of the labor market. The lower the unemployment rate, and the more bargaining power workers have, the higher the wage they will be in a position to demand. (We can think of this as an expected real wage, or as a rate of change from current wages.) When unemployment falls, workers command higher wages; but given markup pricing, these higher wages are simply passed on to higher prices. If we think of wages as a decreasing function of unemployment, there will be a unique level of unemployment where wage growth is equal to productivity growth plus the target inflation rate.

The conventional story of demand and inflation, from Blanchard. With constant returns to scale and a fixed markup, the real wage is unaffected by short-run changes in output and employment.

You can change this in various ways without losing the fundamental logic. If there are non-labor costs, then rising nominal wages can be passed less than one for one, and tight labor markets may result in faster real wage growth along with higher inflation. But there will still be a unique level of wage growth, and underlying labor-market conditions, that is consistent with the central bank’s target.  This is the so-called NAIRU or natural rate of unemployment. You don’t hear that term as much as you used to, but the logic is very present in modern textbooks and the Fed’s communications.

There’s a different way of thinking about demand and inflation, though, that you hear a lot in popular discussions — variations on “too much money chasing too few goods.” In this story, rather than production being perfectly elastic at a given cost, production is perfectly inelastic — the amount of output is treated as fixed. (That’s what it means to talk about “too few goods”.) In this case, there is no relationship between costs of production and prices. Instead, the price ends up at  the level where demand is just equal to the fixed quantity of goods.

In this story, there is no relationship between wages and prices — or at least, the former has no influence on the latter. Profit maximizing businesses will set their price as high as they can and still sell their available stocks, regardless of what it cost to produce them. 

In the first story, the fundamental scarcity is inputs, meaning basically labor. In the second, what is scarce is final goods. Both of these are stories about how an increase in the flow of spending can cause prices to rise. But the mechanism is different. In the first case, transmission happens through the labor market. In the second, labor market conditions are at best an indicator of broader scarcities. In the first story, the inflation barrier is mediated by all sorts of institutional factors that can change the market power of businesses and the bargaining power of workers. In the second story it comes straightforwardly from the quantity of stuff available for purchase. 

Once concrete difference between the stories is that only in the first one is there a tight quantitive relationship between wages and prices. When you say “wage growth consistent with price stability,” as Powell has in almost all of his recent press conferences, you are evidently thinking of wages as a cost. If we are thinking of wages as a source of demand, or an indicator of broader supply constraints, we might expect a positive relationship between wages and inflation but not the sort of exact quantitive relationship that this kind of language implies.

in any case, what we don’t want to do at this point is to say that one of these stories is right and the other is wrong. Our goal is simply to clarify what people are saying. Substantively, both could be wrong.

Or, both could be right, but in different contexts. 

If we imagine cost curves as highly convex, it’s very natural to think of these two cases as describing two different situations or regimes or time scales in the same economy.1 Imagine something like the figure below. At a point like c, marginal costs are basically constant, and shifts in demand simply result in changes in output. At a point like b, on the other hand, output is very inelastic, and shifts in demand result almost entirely in changes in price.

convex cost (or supply) curve

Note that we can still have price equal to marginal cost, or a fixed markup to it, in both cases. It’s just that in the steeply upward-sloping section, price determines cost rather than vice versa.

Another point here is that once we are facing quantity constraints, the markup over average cost (which is all that we can normally observe) is going to rise. But this doesn’t necessarily reflect an increase in the  markup over (unobservable) marginal cost, or any change in producers’ market power or pricing decisions.

We might think of this at the level of a firm, an industry or the economy as a whole. Normally, production is at a point like a — capitalists will invest to the point where capacity is a bit greater than normal levels of output. As long as production is taking place within the normal level of utilization, marginal costs are constant. But once normal capacity is exceeded by more than some reasonable margin, costs rise rapidly. 

This framework does a couple of things. First, it clarifies that demand can lead to higher prices in two different ways. First, it shifts the demand curve (not shown here, but you can imagine a downward-sloping diagonal line) up and to the right. Second, insofar as it raises wages, it shifts the cost curve upward. The first effect does not matter for prices as long production is within normal capacity limits. The second effect does not matter once production has exceeded those limits. 

Second, it helps explain why shifts in the composition of output led to a rise in the overall price level. Imagine a situation where most industries were at a position like a, operating at normal capacity levels. A big change in the mix of demand would shift some to b and others to c. The first would see lower output at their old prices, while the latter would see little increase in output but a big rise in prices. This has nothing to do with price stickiness or anything like that. It simply reflects the fact that it’s easy to produce at less than full capacity and very hard to produce much above it.

ETA: One of the striking features of the current disinflation is that it is happening without any noticeable weakening of the labor market. We could see that as just one more piece of evidence for the Stiglitz-Regmi position that it was transitory supply problems all along. But if you really want to credit the Fed, you could use the framework here to do it. Something like this:

In a sustained situation of strong demand, businesses will expect to be able to sell more in the future, and will invest enough to raise capacity in line with output. So the cost curve will shift outward as demand rises, and production will remain In the normal capacity, constant marginal cost range. In this situation, the way that demand is raising prices is via wages. (Unlike business capacity, the labor force does not, in this story, respond to demand.) Rising wages raise costs even at normal utilization levels, so the only way that policy can slow process growth is via weaker labor markets that reduce wage growth. But, when demand rises rapidly and unexpectedly, capacity will not be able to keep up in the short run, and we’ll end up on the righthand, steeply upward sloping part of the cost curve. At this point, price increases are not coming from wages or the cost side in general. Businesses cannot meaningful increase output in the short run, so prices are determined from the demand side rather than as a markup. In this context, price stability calls for policy to reduce desired purchases to what business can currently produce (presumably by reducing aggregate income). In principle this can happen without higher unemployment or slower wage growth.

I personally am not inclined to credit the Fed with a soft landing, even if all the inflation news is good from here on out. But if you do want to tell that story, convex supply curves are something you might like to have in your toolkit.

At Barron’s: What We Don’t Talk About When We Talk About Inflation

(I am now writing a monthly opinion piece for Barron’s. This one was published there in July.)

To listen to economic policy debates today, you would think the U.S. economy has just one problem: inflation. When Federal Reserve Chairman Jerome Powell was asked at his last press conference if there was a danger in going too far in the fight against inflation, his answer was unequivocal: “The worst mistake we could make is to fail—it’s not an option. We have to restore price stability…because [it’s] everything, it’s the bedrock of the economy. If you don’t have price stability, the economy’s really not going to work.”

Few would dispute that rising prices are a serious problem. But are they everything?

The exclusive focus on inflation acts like a lens on our view of the economy—sharpening our attention on some parts of the picture, but blurring, distorting, and hiding from view many others.

In the wake of the Great Recession, there was a broadening of macroeconomic debates. Economists and policy makers shifted away from textbook truisms toward a more nuanced and realistic view of the economy. Today, this wide-ranging conversation has given way to panic over rising prices. But the realities that prompted those debates have not gone away.

In the clamor over inflation, we’re losing sight of at least four big macroeconomic questions.

First, does the familiar distinction between supply and demand really make sense at the level of the economy as a whole? In the textbooks, supply means the maximum level of production in the economy, labeled “full employment” or “potential output,” while demand means total spending. The two are supposed to be independent—changes in spending don’t affect how much the economy can produce, and vice versa. This is why we are used to thinking of business cycles and growth as two separate problems.

But in the real world, supply often responds to demand—more spending calls forth more investment and draws people into the labor force. This phenomenon, known by the unlovely name “hysteresis,” was clearly visible in the slowdown of labor force and productivity growth after the Great Recession, and their recovery when demand picked up in the years before the pandemic. The key lesson of this experience—in danger of being forgotten in today’s inflation panic—was that downturns are even more costly than we thought, since they not only imply lost output today but reduced capacity in the future.

Hysteresis is usually discussed at the level of the economy as a whole, but it also exists in individual markets and industries. For example, one reason airfares are high today is that airlines, anticipating a more sustained fall in demand for air travel, offered early retirement to thousands of senior pilots in the early stages of the pandemic. Recruiting and training new pilots is a slow process, one airlines will avoid unless it’s clear that strong demand is here to stay. So while conventional wisdom says that rising prices mean that we have too much spending and have to reduce it, in a world with hysteresis a better solution may be to maintain strong demand, so that supply can rise to meet it. In the textbook, we can restore price stability via lower demand with no long-run costs to growth. But are we sure things work so nicely in the real world?

The second big question is about the labor market. Here the textbook view is that there is a unique level of unemployment that allows wages to grow in line with productivity. When unemployment is lower than this “natural rate,” faster wage growth will be passed on to rising prices, until policy makers take action to force unemployment back up. But in the years before the pandemic, it was becoming clear that this picture is too simplistic. Rising wages don’t have to be passed on to higher prices—they may also come at the expense of profits, or spur faster productivity growth. And not all wages are equally responsive to unemployment. Younger, less-educated, and lower-wage workers are more dependent on tight labor markets to find work and get raises, while the incomes of workers with experience and credentials rise more steadily regardless of macroeconomic conditions. This means that—as Powell has acknowledged—macroeconomic policy has unavoidable distributional consequences.

In his classic essay “Political Aspects of Full Employment,” the great Polish economist Michal Kalecki argued that even if it were economically feasible to eliminate unemployment, this would be unsustainable, since employers’ authority in the workplace depends on “the threat of the sack.” Similar arguments have been made by central bank chiefs such as Alan Greenspan, who suggested that low unemployment was sustainable in the 1990s only because workers had been traumatized by the deep recession of the decade before.

Some would argue that it’s unnecessarily wasteful and cruel to maintain labor discipline and price stability by denying millions of people the chance to do useful work—especially given that, prior to the pandemic, unemployment had fallen well below earlier estimates of the “natural rate” with no sign of accelerating inflation. But if we wish to have a permanent full-employment economy, we need to answer a difficult question: How should we manage distributional conflicts between workers and owners (and among workers), and motivate people to work when they have little to fear from losing their job?

A third set of questions concerns globalization. There are widespread fears that renewed Covid lockdowns in China may limit exports to the U.S. and elsewhere. Seen through the inflation lens, this looks like a source of rising prices and a further argument for monetary tightening. But if we take a step back, we might ask whether it is wise to organize the global economy in such a way that lockdowns in China, a war in Ukraine, or even a factory fire in Japan leave people all over the world unable to meet their basic needs. The deepening of trade and financial links across borders is sometimes presented as a fact of nature. But in reality it reflects policy choices that allowed global production of all kinds of goods—from semiconductors to Christmas decorations and latex gloves—to be concentrated in a handful of locations. In some cases, this concentration is motivated by genuine technical advantages of larger-scale production, in others by the pursuit of low wages. But either way, it reflects a prioritization of cost minimization over flexibility and resiliency. Whatever happens with inflation, this is a trade-off that will have to be revisited in coming years, as climate change makes further disruptions in global supply chains all but inevitable.

Then there is climate change. Here, the inflation lens doesn’t just recolor the picture but practically reverses it. Until recently, the conventional wisdom was that a carbon tax was the key policy tool for addressing climate. An Obama-era economist once quipped that the big question on climate was whether a carbon tax was 80% of the solution, or 100%. A carbon tax would increase the prices of energy, which still mainly comes from fossil fuels, and of travel by private car. As it happens, this is exactly what we have seen: Autos and energy have increased much faster than other prices, to the point that these two categories account for a majority of the excess inflation over the past year. In effect, we’ve seen something like a global carbon tax. But far from welcoming the disproportionate rise in the prices of carbon-intensive goods as a silver lining of inflation, both policy makers and the public see it as an urgent problem to be solved.

To be clear, people are not wrong to be unhappy at the rising cost of cars and energy. In the absence of practical alternatives, these high prices inflict real hardship without necessarily doing much to speed the transition from carbon. One reasonable lesson, then, is that a carbon tax high enough to substantially reduce emissions will be politically intolerable. And indeed, before the pandemic, many economists were already shifting away from a carbon-price-focused approach to climate policy toward an investment-centered approach.

Whether via carbon prices or investment, the only way to reduce carbon emissions is to leave fossil fuels in the ground. Yet an increasing swath of the policy conversation is focused on how to encourage more drilling by oil-and-gas companies, not just today but into the indefinite future. As a response to today’s rising energy prices, this is understandable, given the genuine limitations of renewable energy. But how can measures to boost the supply of fossil fuels be consistent with a longer-term program of decarbonization?

None of these questions have easy answers. But the danger of focusing too single-mindedly on inflation is that we may not even try to answer them.

Demand, Supply, Both, or Neither?

One way current debates over inflation sometimes get framed is whether it’s driven by supply or demand. Critics of the ARPA and other stimulus measures point to various lines of evidence to suggest that rising prices are coming from the demand side, not the supply side; and of course you can find the opposite arguments among its defenders. This sometimes gets conflated with the question of how persistent inflation is likely to be, with a preference for supply-side explanations putting you on “team transitory.”

In my opinion, the question in this form is not well specified. It makes no sense to ask if price rises are driven by supply or by demand. A mismatch between aggregate demand and aggregate supply is one explanation for inflation. To say “inflation would be lower if aggregate demand were lower” is exactly the same statement as “inflation would be lower  if aggregate supply were higher.” This story is about the difference between the two.

The first step, then, is to think about how we can reframe the question in a meaningful way. The issue of specific indicators is downstream from this, as is the question of how long one might expect higher inflation to last. 

Here are some quick thoughts on how we might clarify this debate. 

1. Insofar as we are explaining price changes in terms of aggregate demand and aggregate supply (or potential output) this is a story about an imbalance between the two of them. If we are using this framework, any change in inflation is fully explained by supply *and* fully explained by demand. To turn this into an either-or question, we have to pose an explicit counterfactual. For example, we might say that current spending levels would have led to no (or less) rise in inflation if it weren’t for pandemic. Or we might say that the disruptions of the pandemic would have led to no (or less) rise in inflation if it weren’t for the stimulus bills. The problem is, these aren’t alternatives — both  might very well be true!

2. If the question is specifically whether current aggregate demand in the US would be inflationary even without the pandemic and Ukraine war, it seems to me that the answer is unequivocally No. The fact that real GDP is no higher than trend is, to me, absolutely decisive here. Suppose we thought that two years from now, the economy operating at normal capacity will be capable of producing a certain quantity of cars, houses, tv shows, haircuts, etc. Now suppose two years pass, and we find that people are in fact buying exactly the quantity of cars, houses, tv shows, haircuts, etc. that we had predicted,. If inflation has nonetheless risen, the only possible explanation, within the supply-vs-demand framework, is that the productive capacity of the economy is less than we expected. If buying a certain quantity of stuff is not inflationary in one year, but is inflationary in a later year, then (within this framework) by definition that means that potential output is lower.

Of course it may be true in this scenario that the nominal value of spending will be higher. But this precisely because prices have risen. Suggesting that higher nominal expenditure explains higher inflation is arguing in a circle — it is using the rise in prices to explain that same rise in prices.

To put it another way, aggregate supply or potential output are describing the quantity of stuff we can produce. It makes no sense to say that the potential output of the US economy is $22 trillion dollars. People who look at nominal expenditure in this context are just confused.

(It’s also worth noting that nominal GDP was below pre-pandemic trend until the last quarter of 2021, at which point inflation had been above target and accelerating for a year already. So this story fails on the basis of timing as well as logic.)

So in this specific sense, I think the supply story is simply right, and the demand story is simply wrong. There is no reason to think that the aggregate quantity of goods and services people are trying to purchase today would be beyond normal capacity limits in the absence of the pandemic.

3. Again, though, it all depends on the counterfactual. It does not contradict the preceding point to say that if the ARPA had been smaller, inflation would be lower. Given a fall in the economy’s productive capacity, you are going to see some combination of lower output and income, and higher inflation, with the mix depending on the extent to which demand also falls. Again, demand and supply are two sides of the same story. It’s perfectly consistent to say that in the absence of the pandemic, today’s level of spending would not have caused any rise in inflation, and that if we had allowed spending to fall in line with the fall in potential, the supply disruptions would not have caused any rise in inflation. 

This means the question of whether ARPA was too big is not really a question about inflation as such. It is not going to resolved by any data on whether inflation is limited to a few sectors or is broader, or whether inflation peaked at the end of 2021 or at some later date. The answer to this question depends on how we weigh the relative costs of rising prices versus lost income and output. The more socially costly you think inflation is, the more you are going to think that ARPA was too big. The more socially costly you think unemployment and the associated loss of income is, the more you are going to think the ARPA was the right size, or too small. It seems to me that this is what a lot of the debate over “supply” versus “demand” stories of inflation are really about.

4. So far, I’ve been using an aggregate supply and aggregate demand framework, which is how people usually talk about inflation. But as readers of this blog will know, I am generally skeptical that rising prices are best thought of at the aggregate level. If we don’t like the aggregate framework, we might tell micro stories. There are several flavors of these, any or all of which which could be true. 

First, there is there’s a story about changes in the composition of demand. It’s easy for a business or industry produce less than it usually does, but hard to produce more — especially in a hurry. So sectors of the economy that face reduced demand are likely to respond with lower output, while sectors that face increased demand are likely to respond in some large part with higher prices, especially if the increase is large and rapid. That means we should expect rapid shifts in demand to be associated with higher inflation, even if the total volume of demand is unchanged. 

That’s one micro story. Another is that when certain sectors of the economy face supply constraints, it may be hard to substitute elsewhere. If demand for the sectors facing bottlenecks is very inelastic, and/or they are important inputs for other sectors, then the fall in capacity in those sectors may have a larger effect on prices than a similar across-the-board fall in productive capacity would.  

Another, simpler micro story is that there is no useful information in the aggregate price level at all. If prices are rising for particular goods and services, that is best understood in terms of production conditions and demand for those particular things.

What these stories suggest is that the aggregate supply/demand framework is less useful when there are large, rapid shifts in the composition of spending or production. That framework may be reasonable when we are talking about an economy undergoing steady growth and want to know if somewhat faster growth (spurred perhaps by across the board easier credit) would lead to higher inflation. But it’s not very useful when the economy is undergoing major qualitative changes. It’s not even clear how the concept of aggregate supply is defined when we are seeing big shifts in the composition of output. 

To be clear, none of these micro stories are necessarily arguments for a “supply side” explanation of inflation. Rather, they are reasons why the supply versus demand framework might not be helpful. 

5. Another story about inflation that often gets conflated with aggregate demand but should not be is the extent to which higher wages are driving inflation. In the standard textbook story, the mechanism by which higher demand raises prices is through higher wages. In the textbook story — this is totally mainstream — there are no constraints on the supply side except the supply of labor. The reason higher demand leads to higher inflation is that lower unemployment leads workers to obtain higher wages, which then get passed on to prices. We know this is the theory the Fed is working with. And people like Krugman are saying that there’s no way to have lower inflation without “getting wage growth down considerably.” 

But even though these two things are linked in the textbook story, they are logically distinct. When we talk about a demand-side story of inflation, we need to be clear whether and to what extent this is a story about wages specifically. And as Krugman emphasizes in the linked piece, the question of whether reducing inflation will require slower wage growth is logically independent of the question of whether higher wages are what has driven rising inflation so far.

6. So what is actually at stake here? Before we start talking about who is on what team, we should be sure we know what game they are playing, and where the goals are.

It seems to me that, operationally, the big question people are arguing about is: if real activity — and in particular the labor market — remains on its current trend, will inflation eventually come down on its own? Or if not, can interventions in specific sectors reduce it? Or is a significant slowing of activity across the board required? This forward-looking question is what the fighting is really about. 

There is some relationship between these questions and the causes of inflation, but they are not the same. For example, it is certainly more plausible that resolving a small number of bottlenecks would bring prices down when the price increases are concentrated in a few sectors. But one might also believe — as I and others have long argued — that we underestimate the flexibility of the supply side of the economy in general. If you believe in hysteresis, then even a general overheating might over time lead to faster growth of potential output, as more people are drawn into the labor force and businesses invest and raise productivity. So unless you start from the premise that potential output is normally fixed, “inflation is widespread, therefore we need less demand” is a non sequitur.

(In this light, it would be worth systematically revisiting the arguments about hysteresis made by Lawrence Summers and others during the 2010s.)

7. The question of whether reducing inflation requires lower demand and weaker labor markets is inextricable from your political program and broader worldview. At this moment, we are on the verge of seeing a major new public investment bill that is being presented as a way of bringing down inflation and creating good jobs. This is a huge vindication for arguments that progressives have been putting forward for years. It would be odd if we now turned around and said, “no no, investing in clean energy won’t help with inflation. And we don’t want more jobs, there’s too much demand in the economy already.” If you think that the clean energy investments in the IRA will in fact bring down prices over time, you need an understanding of inflation that’s consistent with that. And if your view of inflation implies that we would be better off not making those investments at this time, then you need to own that position.

(Some people will say the bill is anti-inflationary because it lowers the deficit. First of all, it seems unlikely that the specific tax increases in the IRA will have much if any dampening effect on demand, while the spending components certainly will boost it. Second, even if you thought the bill as a whole will reduce inflation, you still need to have a view on whether the energy provisions specifically will do so.)

I’m not saying you should just make the economic arguments that support your political program. It’s very important to only say things that are supported by logic and evidence! But presumably, you have the worldview you do because it captures important things you think are true about the world. If your analysis of inflation is not consistent with other things that you strongly believe, that suggests that there might be something wrong with your analysis. 

For example, you might believe that potential employment in the US is much higher than conventional estimates of unemployment or the labor force suggest. You could arrive at this belief on the basis of statistical evidence and also from other beliefs that you are strongly committed to — for example, that women and non-white people are just as capable of useful work as white men are. This argument runs directly against claims that the US is currently facing hard supply constraints, so that the only way the growth in wages and prices will moderate is via lower demand. If the conventional unemployment rate vastly understated the number of people available for work in 2015, presumably it still does today. You can’t just ignore those earlier arguments when talking about current inflation.

Similarly, you might believe that business investment and productivity growth depend on demand. Or you might think they depend on decisions made at the firm level — that corporations face a choice between long-term growth and short-term returns to shareholders, which they will make differently in different institutional and legal environments. These long-standing arguments are relevant to the question of whether it’s plausible that corporate profiteering is contributing to current price rises, and whether changes to taxes and regulation could bring down inflation without any need to reduce demand. They are also relevant to the question of whether given sustained strong demand, supply will eventually catch up, via higher investment and faster productivity growth. This Gavin Wright paper argues that scarce labor and rising wages drove the acceleration of productivity growth in the late 1990s. How convincing you find that argument should be relevant to your assessment of inflation today.

Or again, the question of whether conventional monetary policy should be the go-to response to inflation is not (only) a question about inflation. You could have a fully “demand side” account of rising rents — that they are entirely driven by rising incomes, and not by any change in the housing supply — and yet also believe that higher interest rates, by discouraging housing construction, will only make the problem worse. 

It’s a big mistake, in my opinion, to debate inflation in isolation, or to think that debates over inflation are going to be resolved with statistical tests. We first need to step back and think carefully about what question we are trying to answer, and about what account of inflation is consistent with our broader intellectual commitments. The reason I disagree with someone like Jason Furman about inflation isn’t because I have a different read on this or that data series. (I like his empirical work!) We see inflation differently because we have different ideas about how the world works. 

“Inflation is bad. But mass unemployment would have been worse.”

(Lauren Melodia and I had an op-ed in the Nov. 21 Washington Post, challenging the idea that today’s inflation means that the stimulus measures of the past year and half were too large. I’m posting it here as well.)

As we think about rising prices today, it’s important not to lose sight of where we were not so long ago. In the spring of 2020, much of the economy abruptly shut down. Schools and child-care centers closed. Air travel fell below 100,000 people a day, compared with 2.5 million daily passengers in a normal year. No one was staying in hotels or going to the gym. About 1.4 million small businesses shut their doors in the second quarter of the year.

More than 20 million Americans lost their jobs in the early days of the pandemic, and there was a very real possibility that many would face hunger, eviction and poverty. Many economists predicted a deep downturn comparable to the Great Recession that followed the financial crisis of 2007-08, if not the Great Depression of the 1930s.

Even at the start of this year, as Congress was debating the American Rescue Plan, it was far from clear that we were out of danger. In January, there were 10 million fewer jobs than a year earlier. Covid-related deaths were running at 30,000 per week — the highest rate at any point in the pandemic. No one knew how fast vaccines could be rolled out. There was still a real risk that the economy could tip into depression.

Thanks to stimulus measures, including the $2.2 trillion Cares Act, signed by President Donald Trump in March 2020, and the $1.9 trillion American Rescue Plan, signed by President Biden in March 2021, that didn’t happen. People who lost their jobs in restaurants, airports, hotels and elsewhere continued to pay their rent and put food on the table.

For much of 2020 and 2021, all the uncertainty — and the risks associated with vacationing, dining out and so on — meant households held back on spending, and savings piled up. Now, with the economy reopening and the worst of the pandemic (let’s hope) behind us, people are rushing to make use of those savings. Unfortunately, businesses can’t adjust production as fast as people can spend money, resulting in the inflation we’re seeing now: Prices rose 0.9 percent from September to October 2021 and are up 6.2 percent since October 2020.

It would be nice if there were a way to avoid economic catastrophe during the year-plus of pandemic restrictions while also avoiding rising prices today. But in the real world, there probably wasn’t. The pandemic imposed costs on the economy that had to be paid one way or another.

Think of it this way. When a restaurant shuts down for public health reasons, two things happen: Its services are not available for purchase, and the people who work there lose their incomes. If the government does nothing, aggregate demand and supply will remain in rough balance, but the displaced workers will be unable to pay their bills. Alternatively, the government can step in to maintain the incomes of the displaced workers. In this case, the spending that consumers might have done in restaurants will spill over into the rest of the economy — if not right away, then eventually. In a sense, the rising costs we’re seeing today are a result of economic production that didn’t happen last year.

In economics textbooks, the level of demand that brings the economy to full employment will also cause stable inflation — an assumption labeled “the divine coincidence.” But here on Earth, things don’t always work out so neatly. The level of spending required to replace incomes lost in the pandemic, combined with the disruptions to production and trade, meant there was no way to get an adequate recovery without some increase in inflation, especially given the bumps on the road to controlling the coronavirus. As the spread of the delta variant and some Americans’ resistance to getting a vaccine have held back spending on services, demand has spilled over into goods. And as it turns out, our global supply chains are unable to handle a rapid rise in demand for goods — especially because many manufacturers had expected a deep downturn and planned accordingly.

Today’s inflation has surprised many people, including us. We had been more worried about sustained high unemployment. One of us even gave a talk a year ago called “The Coronavirus Recession Is Just Beginning.” We were wrong about that. But then, so was almost everyone. In the summer of 2020, the Congressional Budget Office was predicting that the unemployment rate in late 2021 would be 8 percent; in fact, it has fallen to 4.6 percent. Many private forecasters were similarly gloomy. Under the circumstances, policymakers were absolutely right to prioritize payments to families.

The economist Larry Summers has been making the case since February that the government’s stimulus programs were larger than required and ran the risk of “inflationary pressures of a kind we have not seen in a generation.” Fiscal conservatives are claiming that Summers has been vindicated because inflation is higher than most supporters of the most recent relief package expected. But the economic data doesn’t match the scenario he described.

Summers predicted that the cumulative stimulus impact would be larger than the country’s output gap — the difference between actual and potential gross domestic product. Today, despite the stimulus, both real and nominal GDP remain significantly below the pre-pandemic trend. So unless you think the economy was operating above potential before the pandemic, there’s no reason to think it is above potential now. To the extent that domestic conditions are contributing to inflation, it’s not because spending has surpassed the economy’s capacity but because there has been a rapid shift in demand from services to goods.

In any case, most of the inflation we’re seeing is due not to domestic conditions but to the worldwide spike in food, energy and shipping costs. Perhaps we could have had inflation of 5 percent instead of 6 percent if the stimulus had been smaller. The cost of that trade-off would have been material hardship for millions of families and the risk of tipping the economy into a downturn. And that, fundamentally, is why today’s inflation is not a sign that the stimulus was too large: It has to be weighed against the risks on the other side.

After 2007, the United States experienced many years of high unemployment and depressed growth, thanks in large part to a stimulus that most now agree was too small. Policymakers belatedly learned that lesson, and as a result, the United States is making a rapid recovery from the most severe economic disruption in modern history. Yes, inflation is a real problem that needs to be addressed. In a recent Roosevelt Institute brief, we suggested that rather than raise interest rates, the best way to control inflation is to address supply constraints in the sectors where prices are climbing. But as bad as inflation is, mass unemployment is much worse. Given the alternatives, policymakers made the right choice.

At Roosevelt: Reimagining Full Employment

Mike Konczal, Lauren Melodia and I have a new report out from the Roosevelt Institute, on what true full employment might look like in the United States.

This is part of a larger project of imagining what an economic boom would look like. As Mike and I argued in our recent New York Times op-ed, there’s a real possibility that the coming years could see a historic boom, thanks to the exceptionally strong stimulus measures of the past year and, hopefully, the further expansions of public spending on the way. (Interestingly, the term “boom” is now making it into Biden’s speeches on the economy.) If the administration, Congress and the Fed don’t lose their nerve and stay on the path they’re currently on, we could soon be seeing economic growth and rising wages in a way that we haven’t since at least the late 1990s.

This is going to call for a new way of thinking about economic policy. Over the past decade or more, the macroeconomic policy debate has been dominated by a consensus that is more concerned with the supposed dangers of public debt than stagnation, and sees any uptick in growth or wages as worryingly inflationary. Meanwhile, the left knows how to criticize austerity and bailouts for business, and to make the case for specific forms of public spending, but has a harder time articulating the benefits of sustained growth and tight labor markets.

What we’re trying to do is move away from the old, defensive fights about public debt and austerity and make the positive case for a bigger more active public sector. There’s no reason the Right should have a monopoly on promises faster growth and improvements in peoples material living standards. Post-covid, we’re looking at a new “morning in America” moment, and progressives should be prepared to take credit.

One of the great appeals of the Green New Deal framing on climate change is that it turns decarbonization from a question of austerity and sacrifice into a promise to improve people’s material well being, not decades from now but right now, and in ways that go well beyond climate itself. I think this promise is not just politically useful but factually well-founded, and could just as well be made for other expansions of the public sector.

This is an argument that I and others have been making for years. Of course, any promise of faster growth and higher living standards has to confront the argument, enshrined in macroeconomics textbooks, that the economy is already operating close to potential, at least most of the time — that the Federal Reserve has taken care of the demand problem. In that case, the Keynesian promise that more spending can call forth more production would no longer apply.

We’ve tended to respond to this argument negatively — that there is no evidence that the US now was facing any kind of absolute supply constraint or labor shortage before the pandemic, let alone now. This is fine as far as it goes, and I think our side of the debate has won some major victories — Jay Powell and Janet Yellen both now seem to agree that as of 2019 the US was still well short of full employement. Still, I think it’s legitimate for people to ask, “If this isn’t full employment, then what would be?” We need a positive answer of our own, and not just a negative criticism of the textbook view.

This new paper is an attempt to do just that — to construct an estimate of full employment that doesn’t build in the assumption that recent labor market performance was close to it. One way to do this is to compare the US to other advanced countries, many of which have higher employment-population ratios than the US, even after adjusting for age differences. We chose to take a different approach, one that instead looks at differences in employment rates within the US population.

From the executive summary:

This issue brief argues that potential employment in the US is much higher than we have seen in recent years. In addition to those officially counted in the labor force, there is a large latent labor force, consisting of people who are not currently seeking work but who could reasonably be expected to do so given sustained strong labor demand. This implies much more labor market slack than conventional measures of unemployment suggest.

An important but less familiar sign of labor market slack is the difference in employment rates between groups with more- and less-privileged positions in the labor market. Because less-favored groups—Black workers, women, those with less formal education, those just entering the labor market—are generally last hired and first fired, the gaps between more- and less-favored groups vary systematically over the business cycle. When labor markets are weak and employers can pick and choose among potential employees, the gap between employment rates for more- and less-favored groups widens. When labor markets are tight, and workers have more bargaining power, the gap shrinks.

We use this systematic relationship between overall labor market conditions and employment rates across race, gender, education, and age to construct a new measure of potential employment. In effect, since more-favored workers will be hired before less-favored ones, the difference in outcomes between these groups is a measure of how close hiring has gotten to the true back of the line.

We construct our measure in stages. We start with the fact that changes in employment rates within a given age group cannot reflect the effect of population aging. Simply basing potential employment by age groups on employment rates that have been observed historically implies potential employment 1.7 points higher than the CBO estimates.

Next, we close the employment gaps by race and gender, on the assumption that women and Black Americans are no less able or willing to work than white men of a similar age. (When adjusting for gender, we make an allowance for lower employment rates among parents of young children). This raises potential employment by another 6.2 points.

Finally, reducing the employment gap between more- and less-educated workers in line with the lower gaps that have been observed historically adds another 1.8 points to the potential employment rate.

In total, these adjustments yield a potential employment-population ratio 10 points higher than the CBO estimates, equivalent to the addition of about 28 million more jobs over the next decade.

Adding these 28 million additional jobs over the next decade would require an average annual growth in employment of 2.1 percent. The employment growth that would fully mobilize the latent labor force, as estimated here, is in line with the rate of GDP growth required to repair the damage from the Great Recession of 2007–2009 and return GDP to its pre–2007 trend.

You can read the rest here.

The Persistence of Demand

Here’s the very short version of this very long post:

Hysteresis means that a change in GDP today has effects on GDP many years in the future. In principle, this could be because it affects either future aggregate demand or potential output. These two cases aren’t distinguished clearly in the literature, but they have very different implications. The fact that the Great Recession was followed by a period of low inflation, slow wage growth and low interest rates, rather than the opposite, suggests that the persistent-demand form of hysteresis is more important than potential-output hysteresis. The experience of the Great Recession is consistent with perhaps 20 percent of a shock to demand in this period carrying over to demand in future periods. This value in turn lets us estimate how much additional spending would be needed to permanently return GDP to the pre-2007 trend: 50-60 percent of GDP, or $10-12 trillion, spread out over a number of years.

 

Supply Hysteresis and Demand Hysteresis

The last few years have seen renewed interest in hysteresis – the idea that shifts in demand can have persistent effects on GDP, well beyond the period of the “shock” itself. But it seems to me that the discussion of hysteresis doesn’t distinguish clearly between two quite different forms it could take.

On the one hand, demand could have persistent effects on output because demand influences supply – this seems to be what people usually have in mind. But on the other hand, demand itself might be persistent. In time-series terms, in this second story aggregate spending behaves like a random walk with drift. If we just look at the behavior of GDP, the two stories are equivalent. But in other ways they are quite different.

Let’s say we have a period in which total spending in the economy is sharply reduced for whatever reason. Following this, output is lower than we think it otherwise would have been. Is this because (a) the economy’s productive potential was permanently reduced by the period of reduced spending? Or is it (b) because the level of spending in the economy was permanently reduced? I will call the first case supply hysteresis and the second demand hysteresis.

On the left, supply hysteresis. On the right, demand hysteresis.

It might seem like a semantic distinction, but it’s not. The critical thing to remember is that what matters for much of macroeconomic policy is not the absolute level of output but the output gap — the difference between actual and potential output. If current output is above potential, then we expect to see rising inflation. (Depending on how “potential” is understood, this is more or less definitional.) We also expect to see rising wages and asset prices, shrinking inventories, longer delivery times, and other signs of an economy pushing against supply constraints. If current output is below potential, we expect the opposite — lower inflation or deflation, slower wage growth, markets in general that favor buyers over sellers. So while lower aggregate supply and lower aggregate demand may both translate into lower GDP, in other respects their effects are quite different. As you can see in my scribbles above, the two forms of hysteresis imply opposite output gaps in the period following a deep recession. 

Imagine a hypothetical case where there is large fall in public spending for a few years, after which spending returns to its old level. For purposes of this thought experiment, assume there is no change in monetary policy – we’re at the ZLB the whole time, if you like. In the period after the depressed spending ends, will we have (1) lower unemployment and higher inflation than before, as the new income created during the period of high public spending leads to permanently higher demand. Or will we have (2) higher unemployment and lower inflation than if the spending had not occurred, because the period of high spending permanently raised labor force participation and productivity, while demand returns to its old level?

Supply hysteresis implies (1), that a temporary negative demand shock will lead to persistently higher inflation and lower unemployment (because the labor force will be smaller). Demand hysteresis implies (2), that a temporary negative demand shock will lead to permanently lower inflation and higher unemployment. Since the two forms of hysteresis make diametrically opposite predictions in this case, seems important to be clear which one we are imagining. Of course in the real world, could see a combination of both, but they are still logically distinct. 

Most people reading this have probably seen a versions of the picture below. On the eve of the pandemic, real per-capita GDP was about 15 percent below where you’d expect it to be based on the pre-2007 trend. (Or based on pre-2007 forecasts, which largely followed the trend.) Let’s say we agree that the deviation is in some large part due to the financial crisis: Are we imagining that output has persistently fallen short of potential, or that potential has fallen below trend? Or again, it might be a combination of both.

In the first case, we would expect monetary policy to be generally looser in the period after a negative demand shock, in the second case tighter. In the first case we’d expect lower inflation in period after shock, in the second case higher.

It seems to me that most of the literature on hysteresis does not really distinguish these cases. This recent IMF paper by Antonio Fatas and coauthors, for example, defines hysteresis as a persistent effect of demand shocks on GDP. This could be either of the two cases. In the text of the paper,  they generally assume hysteresis means an effect of demand on supply, and not a persistence of demand itself, but they don’t explicitly spell this out or make an argument for why the latter is not important.

It is clear that the original use of the term hysteresis was understood strictly as what I am calling supply hysteresis. (So perhaps it would be better to reserve the word for that, and make ups new name for the other thing.) If you read the early literature on hysteresis, like these widely-cited Laurence Ball papers, the focus was on the European experience of the 1980s and 1990s; hysteresis is described as a change in the NAIRU, not as an effect on employment itself. The mechanism is supposed to be a specific labor-market phenomenon: the long term unemployed are no longer really available for work, even if they are counted in the statistics. In other words, sustained unemployment effectively shrinks the labor force, which means that in the absence of policy actions to reduce demand, the period following a deep recession will see faster wage growth and higher inflation than we would have expected.

(This specific form of supply hysteresis implies a persistent rise in unemployment following a downturn, just as demand hysteresis does. The other distinctions above still apply, and other forms of supply hysteresis would not have this implication.) 

Set aside for now whether supply-hysteresis was a reasonable description of Europe in the 1980s and 1990s. Certainly it was a welcome alternative to the then-dominant view that Europe needed high unemployment because of over-protective labor market institutions. But whether or not thinking of hysteresis in terms of the NAIRU made sense in that context, it does not make sense for either Europe or the US (or Japan) in the past decade. Everything we’ve seen has been consistent with a negative output gap — with actual output below potential — with a depressed level of demand, not of supply. Wage growth has been unexpectedly weak, not strong; inflation has been below target; and central banks have been making extra efforts to boost spending rather than to rein it in.

Assuming we think that all this is at least partly the result of the 2007-2009 financial crisis — and thinking that is pretty much the price of entry to this conversation — that suggests we should be thinking primarily about demand-hysteresis rather than supply-hysteresis. We should be asking not, or not only, how much and how durably the Great Recession reduced the country’s productive potential, but how how durably it reduced the flow of money through the economy. 

It’s weird, once you think about it, how unexplored this possibility is in the literature. It seems to be taken for granted that if demand shocks have a lasting effect on GDP, that must be because they affect aggregate supply. I suspect one reason for this is the assumption — which profoundly shapes modern macroeconomics — that the level of spending in the economy is directly under the control of the central bank. As Peter Dorman observes, it’s a very odd feature of modern macroeconomic modeling that the central bank is inside the model — the reaction of the monetary authorities to, say, rising inflation is treated as a basic fact about the economy, like the degree to which investment responds to changes in the interest rate, rather than as a policy choice. In an intermediate macroeconomics textbook like Carlin and Soskice (a good one as far as they go), students are taught to think about the path of unemployment and inflation as coming out of a “central bank preference function,” which is taken as a fundamental parameter of the economy. Obviously there is no place for demand hysteresis in this framework. To the extent that we think of the actual path of spending in the economy as being chosen by the central bank as part of some kind of optimizing process, past spending in itself will have no effect on current spending. 

Be that as it may, it seems hard to deny that in real economies, the level of spending today is strongly influenced by the level of spending in the recent past. This is the whole reason we see booms and depressions as discrete events rather than just random fluctuations, and why they’re described with metaphors of positive-feedback process like “stall speed” or “pump-priming.”1

How Persistent Is Demand?

Let’s say demand is at least somewhat persistent. That brings us to the next question: How persistent? If we were to get extra spending of 1 percent of GDP in one year, how much higher would we now expect demand to be several years later?

We can formalize this question if we write a simple model like:

Zt = Z*t + Xt

Z*t = (1+g) Z*t-1 + a(Zt-1 – Z*t-1)

Here Z is total spending or demand, Z* is the trend, what we might think of as normal or expected demand, g is the normal growth rate, and X is the influence of transitory influences outside of normal growth.

With a = 0, then, we have the familiar story where demand is a trend plus random fluctuations. If we see periods of above- and below-trend demand, that’s because the X influences are themselves extended over time. If a boom year is followed by another boom year, in this story, that’s because whatever forces generated it in the first year are still operating, not because the initial boom itself was persistent. 

Alternatively, with a = 1, demand shocks are permanent. Anything that increases spending this year, should be expected to lead to just as much additional spending next year, the year after that, and so on.

Or, of course, a can have any intermediate value. 

Think back to 2015, in the debate over the first Sanders’ campaign’s spending plans that was an important starting point for current discussions of hysteresis. The basic mistake Jerry Friedman was accused of making was assuming that changes in demand were persistent — that is, if the multiplier was, say 1.5, that an increase in spending of $500 billion would raise output by $750 billion not only in that year and but in all subsequent years. As his critics correctly pointed out, that is not how conventional multipliers work. In terms of my equations above, he was setting a=1, while the conventional models have a=0. 

He didn’t spell this out, and I didn’t think of it that way at the time. I don’t think anyone did. But once you do, it seems to me that while Friedman was wrong in terms of the standard multiplier, he was not wrong about the economy — or at least, no more wrong than the critics. It seems to me that both sides were using unrealistically extreme values. Demand shocks aren’t entirely permanent, but they also aren’t entirely transitory.  A realistic model should have 0 < a < 1.

Demand Persistence and Fiscal Policy

There’s no point in refighting those old battles now. But the same question is very relevant for the future. Most obviously, if demand shocks are persistent to some significant degree, it becomes much more plausible that the economy has been well below potential for the past decade-plus. Which means there is correspondingly greater space for faster growth before we encounter supply constraints in the form of rising inflation. 

Both forms of hysteresis should make us less worried about inflation. If we are mainly dealing with supply hysteresis, then rapid growth might well lead to inflation, but it would be a transitory phenomenon as supply catches up to the new higher level of demand.  On the other hand, to the extent we are dealing with demand hysteresis, it will take much more growth before we even have to worry about inflation.

Of course, both forms of hysteresis may exist. In which case, both reason for worrying less about inflation would be valid. But we still need to be clear which we are talking about at any given moment.

A slightly trickier point is that the degree of demand persistence is critical for assessing how much spending it will take to get back to the pre-2007 trend. 

If the failure to return to the pre-2007 is the lasting effect of the negative demand shock of the Great Recession, it follows that  sufficient spending should be able to reverse the damage and return GDP to its earlier trend. The obvious next question is, how much? The answer really depends on your preferred value for a. In the extreme (but traditional) case of a=0, each year we need enough spending to fill the entire gap, every year, forever. Given a gap of around 12 percent, if we assume a multiplier of 1.5 or so, that implies additional public spending of $1.6 trillion. In the opposite extreme case, where a=1, we just need enough total spending to fill the gap, spread out over however many years. In general, if we want to get close a permanent (as opposed to transitory) output gap of W, we need W/(a μ) total spending, where μ is the conventional multiplier.2

If you project forward the pre-2007 trend in real per-capita GDP to the end of 2019, you are going to get a number that is about 15% higher than the actual figure, implying an output gap on the order of $3.5 trillion. In the absence of demand persistence, that’s the gap that would need to be filled each year. But with persistent demand, a period of elevated public spending would gradually pull private spending up to the old trend, after which it would remain there without further stimulus.

What Does the Great Recession Tell Us about Demand Persistence?

At this point, it might seem that we need to turn to time-series econometrics and try to estimate a value for a, using whatever methods we prefer for such things. And I think that would be a great exercise! 

But it seems to me we can actually put some fairly tight limits on a without any econometrics, simple by looking back to the Great Recession. Keep in mind, once we pick an output gap for a starting year, then given the actual path of GDP, each possible value of a implies a corresponding sequence of shocks Xt. (“Shock” here just means anything that causes a deviation of demand from its trend, that is not influenced by demand in the previous period.) In other words, whatever belief we may hold about the persistence of demand, that implies a corresponding belief about the size and duration of the initial fall in demand during the recession. And since we know a fair amount about the causes of the recession, some of these sequences are going to be more plausible than others.

The following figures are an attempt to do this. I start by assuming that the output gap was zero in the fourth quarter of 2004. We can debate this, of course,, but there’s nothing heterodox about this assumption — the CBO says the same thing. Then I assume that in the absence of exogenous disturbances, real GDP per capita would have subsequently grown at 1.4 percent per year. This is the growth rate during the expansion between the Great Recession and the pandemic; it’s a bit slower than the pre-recession trend.3 I then take the gap between this trend and actual GDP in each subsequent quarter and divide it into the part predictable from the previous quarter’s gap, given an assumed value for a, and the part that represents a new disturbance in that period. So each possible value of a, implies a corresponding series of disturbances. Those are what are shown in the figures.

If you’re not used to this kind of reasoning, this is probably a bit confusing. So let me put it a different way. The points in the graphs above show where real GDP would have been relative to the long-term trend if there had been no Great Recession. For example, if you think a = 0, then GDP in 2015 would have been just the same in the absence of the recession, so the values there are just the actual deviation from trend. So you can think of the different figures here as showing the exogenous shocks that would be required under different assumptions about persistence, to explain the actual deviation from trend. They are answering this question: Given your beliefs about how persistent demand is, what must you think GDP would have been in subsequent years in a world where the Great Recession did not take place? (Or maybe better, where the fall in demand form the housing bubble was fully offset by stimulus.)

The first graph, with persistence = 0, is easiest to understand. If there is no carryover of demand shocks from one period to the next, then there must be some factor reducing demand in each later period by the full extent of the gap from trend. If we move on to, say, the persistence=0.1 figure, that is saying that, if you think 10 percent of a demand shock is normally carried over into future periods, that means that there was something happening in 2012 that would have depressed demand by 2 percent relative to the earlier trend, even if there had been no Great Recession. 

Because people are used to overcomplicated economics models, I want to stress again. What I am showing you here is what you definitionally believe, if you think that in the absence of the Great Recession, growth in the 2010s would have been at about the same rate it was, just from a higher base, and you think that whatever fraction of a change in spending in one year is carried over to the next year. There are no additional assumptions. I’m just showing what the logical corollary of those beliefs would be for the pattern of demand shocks,

Another important feature of these figures is how large the initial fall in demand is. Logically, if you think demand is very persistent, you must also think the initial shock was smaller. If most of the fall in spending in the first half of 2008, say, was carried over to the second half of 2008, then it takes little additional fall in spending in that period to match the observed path of GDP. Conversely, if you think that very little of a change in demand in one period carries over to the next one then the autonomous fall in demand in 2009 must have been larger.

The question now is, given what we know about the forces impacting demand a decade ago, which of these figures is most plausible? If there had been sufficient stimulus to completely eliminate the fall in demand in 2007-2009, how strong would the headwinds have been a few years late? 

Based on what we know about the Great Recession, I think demand persistence in the 0.15 – 0.25 range most plausible. This suggests that a reasonable baseline guess for total spending required to return to the pre-2007 would be around 50 percent of GDP, spread out over a number of years. With an output gap of 15 percent of GDP, a multiplier of 1.5, and demand persistence of 0.2, we have 15 / (1.5 * 0.2) = 50 percent of GDP. This is, obviously, a very rough guess, but if you put me on the spot and asked how much spending over ten years it would take to get GDP permanently back to the pre-2007 trend, $10-12 trillion would be my best guess.

How do we arrive at persistence in the 0.15 – 0.25 range?

On the lower end, we can ask: What are the factors that would have pushed down demand in the mid 2010s, even in the absence of the Great Recession Remember, if we use demand persistence of 0.1, that implies there were factors operating in 2014 that would have reduced demand by 2 percent of GDP, even if the recession had not taken place. What would those be?

I don’t think it makes sense to say housing — housing prices had basically recovered by then. State and local spending is a better candidate — it remained quite depressed and I think it’s hard to see this as a direct effect of the recession. Relative to trend, state and local investment was down about 1 percent of GDP in 2014, while the federal stimulus was basically over. On the other hand, unless we think that monetary policy is totally ineffective, we have to include the stimulative effect of a zero policy rate and QE in our demand shocks. This makes me think that by 2014, the gap between actual GDP and the earlier trend was probably almost all overhang from the recession. And this implies a persistence of at least 0.15. (If you look back at the figures, you’ll see that with persistence=0.15, the implied shock reaches zero in 2014.)

Meanwhile, on the high end, a persistence of 0.5 would mean that the demand shock maxed out at a bit over 3 percent of GDP, and was essentially over by the second half of 2009. This seems implausibly small and implausibly brief. Residential investment fell from 6.5 percent of GDP in 2004 to less than 2.5 percent by 2010. And that is leaving aside housing wealth-driven consumption. Meanwhile, the ARRA stimulus didn’t really come online until the second half of 2009. I don’t believe monetary policy is totally ineffective, but I do think it operates slowly, especially on loosening side. So I find it hard to believe that the autonomous fall in demand in early 2009 was much less than 5 percent of GDP. That implies a demand persistence of no more than 0.25.

Within the 0.15 to 0.25 range, probably the most important variable is your judgement of the effectiveness of monetary policy and the ARRA stimulus. If you think that one or both was very effective, you might think that by mid-2010, they were fully offsetting the fall in demand from the housing bust. This would be consistent with  persistence around 0.25. Conversely, if you’re doubtful about the effectiveness of monetary policy and the ARRA (too little direct spending), you should prefer a value of 0.2 or 0.15. 

In any case, it seems to me that the implied shocks with persistence in the 0.15 – 0.25 range look much more plausible than for values outside that range. I don’t believe that the underlying forces that reduced demand in the Great Recession had ceased to operate by the second half of 2009. I also don’t think that they were autonomously reducing demand by as much as 2 points still in early 2014. 

You will have your own priors, of course. My fundamental point is that your priors on this stuff have wider implications. I have not seen anyone spell out the question of the persistence of demand in the way I have done here. But the idea is implicit in the way we talk about business cycles. Logically, a demand shortfall in any given period can be described as a mix of forces pulling down spending in that period, and the the ongoing effect of weak demand in earlier periods. And whatever opinion you have about the proportions of each, this can be quantified. What I am doing in this post, in other words, is not proposing a new theory, but trying to make explicit a theory that’s already present in these debates, but not normally spelled out.

Why Is Demand Persistent?

The history of real economies should be enough to convince us that demand can be persistent. Deep downturns — not only in the US after 2007, but in much of Europe, in Japan after 1990, and of course the Great Depression — show clearly that if the level of spending in an economy falls sharply for whatever reason, it is likely to remain low years later, even after the precipitating factor is removed. But why should economies behave this way?

I can think of a couple of reasons.

First, there’s the pure coordination story. Businesses pay wages to workers in order to carry out production. Production is carried out for sale. Sales are generated by spending. And spending depends on incomes, most of which are generated from production. This is the familiar reasoning of the multiplier, where it is used to show how an autonomous change in spending can lead to a larger (or smaller) change in output. The way the multiplier is taught, there is one unique level of output for each level of autonomous demand. But if we formalized the same intuition differently, we could imagine a system with multiple equilibria. Each would have a different level of income, expenditure and production, but in each one people would be making the “right” expenditure choices given their income. 

We can make this more concrete in two ways. First, balance sheets. One reason that there is a link from current income to current expenditure is that most economic units are financially constrained to some degree. Even if you knew your lifetime income with great precision, you wouldn’t be able to make your spending decisions on that basis because, in general, you can’t spend the money you will receive in the distant future today.

Now obviously there is some capacity to shift spending around in time, both through credit and through spending down liquid assets. The degree to which this is possible depends on the state of the balance sheet. To the extent a period of depressed demand leaves households and businesses with weaker balance sheets and tighter financial constraints, it will result in lower spending for an extended period. A version of this idea was put forward by Richard Koo as a “balance sheet recession,” in a rather boldly titled book. 

Finally there is expectations. There is not, after all, a true lifetime income out there for you to know. All you can do is extrapolate from the past, and from the experiences of other people like you. Businesses similarly must make decisions about how much investment to carry out based on extrapolation from the past – on what other basis could they do it?

A short period of unusually high or low demand may not move expectations much, but a sustained one almost certainly will. A business that has seen demand fall short of what they were counting on is going to make more conservative forecasts for the future. Again, how could they not? With the balance sheet channel, one could plausibly agree that demand shocks will be persistent but not permanent. But with expectations, once they have been adjusted, the resulting behavior will in general make them self-confirming, so there is no reason spending should ever return to its old path. 

This, to me, is the critical point. Mainstream economists and policy makers worry a great deal about inflation expectations, and whether they are becoming “unanchored.” But expectations of inflation are not the only ones that can slip their moorings. Households and businesses make decisions based on expectations of future income and sales, and if those expectations turn out to be wrong, they will be adjusted accordingly. And, as with inflation, the outcomes of which people form expectations themselves largely depend on expectations.

This was a point emphasized by Keynes: 

It is an essential characteristic of the boom that investments which will in fact yield, say, 2 per cent in conditions of full employment are made in the expectation of a yield of, say, 6 per cent, and are valued accordingly.

When the disillusion comes, this expectation is replaced by a contrary ‘error of pessimism’, with the result that the investments, which would in fact yield 2 per cent in conditions of full employment, are expected to yield less than nothing; and the resulting collapse of new investment then leads to a state of unemployment in which the investments, which would have yielded 2 per cent in conditions of full employment, in fact yield less than nothing. We reach a condition where there is a shortage of houses, but where nevertheless no one can afford to live in the houses that there are.

He continues the thought in terms that are very relevant today:

Thus the remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.