(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 severalrecentpapers. 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.
Line goes down, and up. Last week, I wrote out a post arguing that the inflation problem is largely over, and the Fed had little to do with it. Yesterday, the new CPI numbers were released and they showed a sharp rise in inflation — a 4 percent rate over the past three months, compared with 2 percent when I wrote the piece.
Obviously, I’m not thrilled about this. It would be easier to make the arguments I would like to make if inflation were still coming down. But it doesn’t really change the story. Given that the spike last month is entirely energy, with growth in other prices continuing to slow, almost everyone seems to agree that it has nothing to do with demand conditions in the US, or anything the Fed has been doing or ought to do.
Here is an updated version of the main figure from the piece. You can see the spike at the far right – that’s the numbers released yesterday. You can also see that it is all energy costs (the pink bar). Everything else is still coming down.
Here is a table presenting the same data, but now comparing the high inflation of June 2021-June2022 with the lower inflation of the past yer. The last column shows how much each category has contributed to the change in inflation between the two periods. As you can see, the fall in inflation is all about goods, especially energy and cars. Services, which is where you’d expect to see any effects of a softening labor market, have not so far contributed to disinflation.
One thing the figure brings out is that we have not simply had a rise and then fall in inflation over the past couple of years. We’ve had several distinct episodes of rising prices. The first, in the second half of 2020, was clearly driven by reopening and pandemic-related shifts in spending. (One point Arjun and I make in our supply-constraints article is that big shifts in the composition of spending lead to higher prices on average.) The next episode, in the second half of 2021, was all about motor vehicles. The third episode, in the first half of 2022, was energy and food prices, presumably connected to the war in Ukraine. Finally, in later 2022 and early this year, measured inflation was all driven by rising housing costs.
Even though they may all show up as increases in the CPI, these are really four distinct phenomena. And none of them looks like the kind of inflation the Fed claims to be fighting. Energy prices may continue to rise, or they may not — I really have no idea. But either way, that’s not a sign of an overheated economy.
It’s the supply side. Of course I am not the only one making this point. Andrew Elrod had a nice piece in Jacobin recently, making many of the same arguments. I especially like his conclusion, which emphasizes that this is not just a debate about inflation and monetary policy. If you accept the premise that spending in the economy has been too high, and workers have too much bargaining power, that rules out vast swathes of the progressive political program. This is something I also have written about.
Mike Konczal makes a similar argument in a new issue brief, “Inflation is Down. It’s a Supply-Side Story.” He looks at two pieces of evidence on this: different regression estimates of the Phillips curve relationship between unemployment and inflation, and second, expenditure and price changes across various categories of spending. I admit I don’t find the regression analysis very compelling. What it says is that a model that used past inflation to predict future inflation fit the data pretty well for 2020-2022, but over predicted inflation this year. I’m not sure this tells us much except that inflation was rising in the first period and falling in the second.
The more interesting part, to me, is the figure below. This shows quantities and prices for a bunch of different categories of spending. What’s striking about this is the negative relationship for goods (which, remember, is where the disinflation has come from.)
It is literally economics 101 that when prices and quantities move together, that implies a shift in demand; when they move in opposite directions, that implies a shift in supply. To put it more simply, if auto prices are falling even while people are buying more automobiles, as they have been, then reduced demand cannot be the reason for the price fall.
Larry Summers, in a different time, called this an “elementary signal identification point”: the sign the price increases are driven by demand is that “output and inflation together are above” their trend or previous levels. (My emphasis.) Summers’ point in that 2012 article (coauthored with Brad DeLong) was that lower output could not, in itself, be taken as a sign of a fall in potential. But the exact same logic says that a rise in prices cannot, by itself, be attributed to faster demand growth. The demand story requires that rising prices be accompanied by rising spending. As Mike shows, the opposite is the case.
In principle, one might think that the effect of monetary policy on inflation would come through the exchange rate. In this story, higher interest rates make a country’s assets more attractive to foreign investors, who bid up the price of its currency. A stronger currency makes import prices cheaper in terms of the domestic currency, and this will lower measured inflation. This is not a crazy story in principle, and it does fit a pattern of disinflation concentrated in traded goods rather than services. As Rémi Darfeuil points out in comments, some people have been crediting the Fed with US disinflation via this channel. The problem for this story is that the dollar is up only about 4 percent since the Fed started hiking — hardly enough to explain the scale of disinflation. The deceleration in import prices is clearly a matter of global supply conditions — it is also seen in countries whose currencies have gotten weaker (as the linked figure itself shows).
Roaring out of recession. I’ve given a couple video presentations on these questions recently. One, last Friday, was for Senate staffers. Amusingly —to me anyway — the person they had to speak on this topic last year was Jason Furman. Who I imagine had a rather different take. The on Monday I was on a panel organized by the Groundwork Collaborative, comparing the economic response to the pandemic to the response to the financial crisis a decade ago. That one is available on zoom, if you are interested. The first part is a presenation by Heather Boushey of the Council of Economic Advisors (and an old acquaintance of mine from grad school). The panel itself begins about half an hour in, though Heather’s presentation is of course also worth listening to.
[Thanks to Caleb Crain for pointing out a mistake in an earlier version of this post.]
(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.)
(This is the extended abstract for a piece I am writing for “The Great Turnaround,” a collection of essays on the economics of decarbonization from ZOE-Institute for Future-fit Economies and the Heinrich Böll Foundation.)
In the world in which we live, large-scale cooperation is largely organized through payments of money. Orthodox economics conflates these money flows, on the one hand with quantities of real social and physical things, and on the other hand with a quantity of wellbeing or happiness. One way of looking at Keynes’ work is as an attempt to escape this double conflation and see money as something distinct. Eighty years later, it can still be a challenge to imagine our collective productive activity except in terms of the quantities of money that organize it. But this effort of imagination is critical to address the challenges facing us, not least that of climate change.
The economic problems of climate change are often discussed, explicitly or implicitly, in terms of the orthodox real-exchange vision of the economy, in which problems are conceived of in terms of the allocation of scarce means among alternative ends.
In the real-exchange framework, decarbonization is a good which must be traded off against other goods. From this point of view, the central question is what is the appropriate tradeoff between current consumption and decarbonization. The problem is that since climate is an externality, this tradeoff cannot be reached by markets alone; the public sector must set the appropriate price via a carbon tax or equivalent. In general, more rapid decarbonization will be disproportionately more costly than slower decarbonization. A further problem is that since the climate externality is global, higher costs will be borne by the countries that move more aggressively toward decarbonization while others may free-ride.
This perspective does leave space for more direct public action to address climate change. Public investment, however, faces the same tradeoff between decarbonization and current living standards that price-mediated private action does. It is also limited by the state’s fiscal capacity. Governments have a finite capacity to generate money flows through taxation and bond-issuance (or equivalently to mobilize real resources) and use of this capacity for decarbonization will limit public spending in other areas.
The claims in the preceding two paragraphs may sound reasonable at first glance. But from a Keynesian standpoint, none are correct; they range from misleading to flatly false. In the Keynesian vision, the economy is imagined as aa system of monetary production rather than real exchange, with the binding constraints being not scarce resources, but demand and, more broadly, coordination. From this perspective, the problem of climate change looks very different. And these differences are not just about terminology or emphasis, but a fundamentally different view of where the real tradeoffs and obstacles to decarbonization lie.
In this paper, I will sketch out the central elements that distinguish a Keynesian vision of the economics of climate change. For this purpose, the Keynesian monetary-production framework can be seen as involving three fundamental premises.
1. Economic activity is coordination- and demand-constrained, not real resource-constrained.
2. Production is an active, transformative process, not just a combining of existing resources or factors.
3. Money is a distinct object, not just a representative of some material quantity; the interest rate is the price of liquidity, not of saving.
These premises have a number of implications for climate policy.
1. Decarbonization will be experienced as an economic boom. Decarbonization will require major changes in our patterns of production and consumption, which in turn will require substantial changes to our means of production and built environment. In capitalist economies, these changesare brought about by spending money. Renovating buildings, investing in new structures and equipment, building infrastructure, etc. add to demand. The decommissioning of existing means of production does not, however subtract from demand. Similarly, high expected returns in growing sectors can call forth very high investment there; investment can’t fall below zero in declining sectors. So even if aggregate profitability is unchanged, big shift in its distribution across industries will lead to higher investment.
2. There is no international coordination problem — the countries that move fastest on climate will reap direct benefits. While coordination problems are ubiquitous, the real-exchange paradigm creates one where none actually exists. If the benefits of climate change mitigation are global, but it requires a costly diversion of real resources away from other needs, it follows that countries that do not engage in decarbonization can free-ride on the efforts of those that do. The first premise is correct but the second is not. Countries that take an early lead in decarbonization will enjoy both stronger domestic demand and a lead in strategic industries.This is not to suggest that international agreements on climate policy are not desirable; but it is wrong and counterproductive to suggest that the case for decarbonization efforts at a national level is in any way contingent on first reaching such agreements.
3. There is no tradeoff between decarbonization and current living standards. Real economies always operate far from potential. Indeed, it is doubtful whether a level of potential output is even a meaningful concept. Decarbonization is not mainly a matter of diverting productive activity away from other needs, but mobilizing new production, with positive spillovers toward production for other purposes. The workers engaged in, say, expanding renewable energy capacity are not being taken away from equal-value activity in some other sector. They are, in the aggregate, un- or underemployed workers, whose capacities would otherwise be wasted; and the incomes they receive in their new activity will generate more output in demand-constrained consumption goods sectors.
4. Price based measures cannot be the main tools for decarbonization.There is a widely held view that the central tool for addressing climate should be an increase in the relative price of carbon-intensive commodities, through a carbon tax or equivalent. This make sense in a vision of the economy as essentially an allocation problem where existing resources need to be directed to their highest value use. But from a Keynesian perspective there are several reasons to think that prices are a weak tool for decarbonization, and the main policies need to be more direct. First, in a world of increasing returns, there will be multiple equilibria, so we can not think only in terms of adjustment at the margin. In the orthodox framework, increasing the share of, say, a renewable energy source will be associated with a higher marginal cost, requiring a higher tax or subsidy; but in an increasing-returns world, increasing share will be associated with lower marginal costs, so that while even a very large tax may not be enough to support an emerging technology once it is established no tax or subsidy may be needed at all. Second, production as a social process involves enormous coordination challenges, especially when it is a question of large, rapid changes. Third, fundamental uncertainty about the future creates risks which the private sector is often unwilling or unable to bear.
5. Central bank support for decarbonization must take the form active credit policy. As applied to central banks, carbon pricing suggests a policy to treat “green” assets more favorably and other assets less favorably. This is often framed as an extension of normal central bank policies toward financial risk, since the “dirty” asset suppose greater risks to their holders or systematically than the “green” ones. But there is no reason, in general, to think that the economic units that are at greatest risk from climate change are the same as the ones that are contributing to it. A deeper and more specifically Keynesian objection is that credit constraints do not bind uniformly across the economy. The central bank, and financial system in general, do not set a single economy wide “interest rate”, but allocate liquidity to specific borrowers on specific terms. Most investment, conversely, is not especially sensitive to interest rates; for larger firms, credit conditions are not normally a major factor in investment, while for smaller borrowers constraints on the amount borrowed are often more important.Effective use of monetary policy to support decarbonization or other social goals requires first identifying those sites in the economy where credit constraints bind and acting to directly to loosen or tighten them.
6. Sustained low interest rates will ease the climate transition. A central divide between Keynesian and orthodox macroeconomic theory is the view of the interest rate. Mainstream textbooks teach that the interest rate is the price of saving, balancing consumption today against consumption in the future — a tradeoff that would exist even in a nonmonetary economy. Keynes’ great insight was that the interest rate in a monetary economy has nothing to do with saving but is the price of liquidity, and is fundamentally under the control of the central bank. He looked forward to a day when this rate fall to zero, eliminating the income of the “functionless rentier”. As applied to climate policy, this view has several implications. First, market interest rates tell us nothing about any tradeoff between current living standards and action to protect the future climate. Second, there is no reason to think that interest rates must, should or will rise in the future; debt-financed climate investment need not be limited on that basis. Third, while investment in general is not very sensitive to interest rates, an environment of low rates does favor longer-term investment. Fourth, low interest rates are the most reliable way to reduce the debt burdens of the public (and private) sector, which is important to the extent that high debt ratios constrain current spending.
7. There is no link between the climate crisis and financial crisis. It is sometimes suggested that climate change and/or decarbonization could result in a financial crisis comparable to the worldwide financial crisis of 2007-2009. From a Keynesian perspective, this view is mistaken; there is no particular link between the real economic changes associated with climate change and climate policy, on the one hand, and the sudden fall in asset values and cascading defaults of a financial crisis, on the other. While climate change and decarbonization will certainly devalue certain assets — coastal property in low-lying cities; coal producers — they imply large gains for other assets. The history of capitalism offers many examples of rapid shifts in activity geographically or between sectors, with corresponding private gains and losses, without generalized financial crises. The notion that financial crises are in some sense a judgement on “unsound” or “unsustainable” real economic developments is an ideological myth we must reject. This is the converse of the error discussed under point 6 above, that measures to protect against the financial risks from climate change and decarbonization will also advance substantive policy goals.
8. There is no problem of getting private investors to finance decarbonization. Many proposals for climate investment include special measures to encourage participation by private finance; it is sometimes suggested that national governments or publicly-sponsored investment authorities should issue special green bonds or equity-like instruments to help “mobilize private capital” for decarbonization. Such proposals confuse the meaning of “capital” as concrete means of production with “capital” as a quantity of money. Mobilizing the first is a genuine challenge for which private businesses do offer critical resources and expertise not present in the public sector; but mobilizing these means paying for them, not raising money from them. On the financing side, on the other hand, the private sector offers nothing; in rich countries, at least, the public sector already borrows on more favorable terms than any private entity, and has a much greater capacity to bear risk. If public-sector borrowing costs are higher than desired, this can be directly addressed by the central bank; offering new assets for the private sector to hold does nothing to help with any public sector financing problem, especially given that such proposal invariably envision assets with higher yields than existing public debt.
These eight claims mostly argue that what are widely conceived as economic constraints or tradeoffs in climate policy are, from a Keynesian perspective, either not real or not very important. Approaches to the climate crisis that frame the problem as one of reallocating real resources from current consumption to climate needs, or of raising funds from the private sector, both suffer from the same conflation of money flows with real productive activity.
I will conclude by suggesting two other economic challenges for climate change that are in my opinion underemphasized.
First, I suggest that we face a political conflict involving climate and growth, this will come not because decarbonization requires accepting a lower level of growth, but because it will entail faster economic growth than existing institutions can handle. Today’s neoliberal macroeconomic model depends on limiting economic growth as a way of managing distributional conflicts. Rapid growth under decarbonization will be accompanied by disproportionate rise in wages and the power of workers. There are certainly reasons to see this as a desirable outcome, but it will inevitably create sharp conflicts and resistance from wealth owners that has to be planned for and managed. Complaints about current “labor shortages” should be a warning call on this front.
Second, rapid decarbonization will require considerably more centralized coordination than is usual in today’s advanced economies. If there is a fundamental conflict between capitalism and sustainability, I suggest, it is not because the drive for endless accumulation in money terms implies or requires an endless increase in material throughputs. Rather, it is because capitalism treats the collective processes of social production as the private property of individuals. (Even the language of “externalities” implicitly assumes that the normal case is one where production process involves no one but those linked by contractual money payments.) Treatment of our collective activity to transform the world as if it belonged exclusively to whoever holds the relevant property rights, is a fundamental obstacle to redirecting that activity in a rational way. Resistance on these grounds to a coordinated response to the climate crisis will be partly political and ideologically, but also concrete and organizational.
The other day, I put up a post arguing, on the basis of my analysis of the income data in the Current Population Survey, that the economic disruptions from the pandemic had not led to any reduction in real income for the lowest-income families. This is the opposite of the Great Recession, and presumably earlier recessions, where the biggest income losses were at the bottom. The difference, I suggested, was the much stronger fiscal response this time compared with previous downturns.
My numbers were rough — tho I think informative — estimates based on a data set that is mainly intended for other purposes. Today I want to call attention to an important paper that reaches similar conclusions on the basis of far better data.
The paper is “Earnings Shocks and Stabilization During COVID-19” by Jeff Larrimore, Jacob Mortenson and David Splinter.1 If you’re following these debates, it’s a must-read.
The question they ask is slightly different from the one I did. Rather than look at the average change in income at each point in the distribution, they ask what fraction of workers experienced large declines in their incomes. Specifically they ask, for each point at the distribution of earnings in a given year, what fraction of workers had earnings at least 10 percent lower a year later? They include people whose earnings were zero in the second year (which means the results are not distorted by compositional effects), and do the exercise both with and without unemployment insurance and — for the most recent period — stimulus payments. They use individual tax records from the IRS, which means their sample is much larger and their data much more accurate than the usual survey-based sources.
What they find, first of all, is that earnings are quite volatile — more than 25 percent of workers experience a fall in earnings of 10 percent or more in a typical year, with a similar share experiencing a 10 percent or more increase. Looking at earnings alone, the fraction of workers experiencing large falls in income rose to about 30 percent in both 2009 and 2020; the fraction experiencing large increases fell somewhat in 2009, but not in 2019. See their Figure 1 below.
Turning to distribution, if we look at earnings alone, large falls were more concentrated at the bottom in 2020 than in 2009. This is shown in their Figure 2.(Note that while the percentiles are based on earnings plus UI benefits, thevertical axis shows the share with large falls in earnings alone.)This pattern is consistent with the concentration of pandemic-related job losses in low-wage sectors.
But when you add unemployment insurance in, the picture reverses. Now, across almost the whole lower half of the distribution, large falls in earnings were actually less common in 2020 than in 2019. And when you add in stimulus payments, it’s even more dramatic. Households in the bottom 20 percent of the distribution were barely half as likely to experience a larger fall in income in the crisis year of 2020 as in they were in the normal year of 2019.
The key results are summarized in their Table 1, below. It’s true that the proportion of low-wage households that experienced large falls in earnings during 2020 was greater than the proportion of high-wage households. But that’s true in every year — low incomes are just much more volatile than high ones. What’s different is how much the gap closed. Even counting the stimulus payments, households in the top fifth of earnings were somewhat more likely to experience a large fall in earnings in 2020 than in 2019. But in the bottom fifth, the share experiencing large falls in income fell from 43 percent to 27 percent. Nothing like this happened in 2009 — then, the frequency of large falls in income rose by the same amount (about 6 points) across the distribution.
One thing this exercise confirms is that the more favorable experience low-income households in the pandemic downturn was entirely due to much stronger income-support programs. Earnings themselves fell even more disproportionately at the bottom than in the last recession. In the absence of the CARES Act, income inequality would have widened sharply rather than narrowed.
The one significant limitation of this study is that tax data is only released well after the end of the year it covers. So at this point, it can only tell us what happened in 2020, not in 2021. It’s hard to guess if this pattern will continue in 2021. (It might make a difference whether the child tax credit payments are counted.) But whether or not it does, doesn’t affect the results for 2020.
While the US experienced the most rapid fall in economic activity in history, low-wage workers experienced much less instability in their incomes than in a “good” year. This seems like a very important fact to me, one that should be getting much more attention than it is.
It didn’t have to turnout that way. In most economic crises, it very much doesn’t. People who are saying that the economy is over stimulated are implicitly saying that protecting low-wage workers from the crisis was a mistake. When the restaurant workers should have been left to fend for themselves. That way, they wouldn’t have any savings nowand wouldn’t be buying so much stuff. When production is severely curtailed, it’s impossible to maintain people’s incomes without creating excess demand somewhere else. But that’s a topic for another post.
The point I want to make — and this is me speaking here, not the authors of the paper — is that the protection that working people enjoyed from big falls in income in 2020 should be the new benchmark for social insurance. Because the other thing that comes out clearly from these numbers is the utter inadequacy of the pre-pandemic safety net.In 2019, only 9 percent of workers with large falls in earnings received UI benefits, and among those who did, the typical benefit was less than a third of their previous earnings. You can see the result of this in the table — for 2009 and 2019, the fraction of each group experiencing largefalls in earnings hardly changes when UI is included. Before 2020, there was essentially no insurance against large falls in earnings.
To be sure, the tax data doesn’t tell us how many of those with big falls in earnings lost their jobs and how many voluntarily quit. But the fact that someone leaves their job voluntarily doesn’t mean they shouldn’t be protected from the loss of income. Social Security is,in a sense, a form of (much more robust) unemployment insurance for a major category of voluntary quits. The paid family and medical leave that, it seems, will not be in this year’s reconciliation bill but that Democrats still hope to pass, is another.
Back in the spring, people like Jason Furman were arguing that if we had a strong recovery in the labor market then we would no longer need the $400/week pandemic unemployment assistance. But this implicitly assumes that we didn’t need something like PUA already in 2019.
I’d like to hear Jason, or anyone, make a positive argument that before the pandemic, US workers enjoyed the right level of protection against job loss. In a good year in the US economy, 40 percent of low-wage workers experience a fall in earnings of 10 percent or more. Is that the right number? Is that getting us the socially optimal number of evictions and kids going to bed hungry? Is that what policy should be trying to get us back to? I’d like to hear why.
The coronavirus crisis has been different from normal recessions in many ways, but one of the most important is the scale of the macroeconomic response to it.
Thanks to the stimulus payments, the pandemic unemployment insurance, the child tax credit, and a raft of other income support measures, this is the first recession in history in which household income actually rose rather than fell, and households ended up in a stronger financial position than before — with bankruptcies, for instance, running at half their pre-pandemic rates. It’s this that’s allowed spending to come back so quickly as the pandemic recedes. It wasn’t written in stone that the economic problem at the end of 2021 would be labor “shortages” and inflation, rather than double-digit unemployment and mass immiseration. The rising wave of hunger, homelessness and bankruptcies that people feared at the start of the pandemic hasn’t shown up. But that doesn’t mean that it couldn’t have. Without the stimulus measures of the past year and a half, it most likely would have.
This extraordinary success story is the missing context for today’s macroeconomic debates. It’s somehow becoming conventional wisdom that the economy is “overstimulated,” as if the economic disruptions of the pandemic could have been managed some other way. As Claudia Sahm observed last week, the choice facing policymakerswas either to repeat the mistakes of the Great Recession or to go big. Fortunately, they went big.
The aggregate dimension of this story is familiar, even it’s sometimes forgotten these days. But I’ve seen much less discussion of the distributional side. Disposable income has held up overall, but what about for people at different income ranges?
For detailed statistics on this, we will have to wait for the American Community Survey produced by the Census. The ACS comes out annually; the first data from 2020 will be released in a month or so, and 2021 numbers will take another year. For real-time data we depend on the Current Population Survey, from the Bureau of Labor Statistics. This is the source for all the headline numbers on unemployment, wages and so on.
The CPS is mainly focused on labor-market outcomes, but it does have one question about income: “What was the total combined income of all members of your family over the past 12 months?”1 The answer is given as one of 15 ranges, topping out at $150,000 or higher.
Compared with what we get from the ACS (or other more specialized surveys like the Survey of Consumer Finances or the Survey of Income and Program Participation) that’s not very much information. But it’s enough to get the big picture, and it has the major advantage of being available in close to real time.
I have not seen anyone use the CPS to look at how real (inflation-adjusted) income changed across the distribution during the pandemic, compared with in the previous recession. So I decided to look at it myself. The results are shown in the figure nearby.
What I’ve done here is construct a household income measure by distributing households evenly within their buckets. Then I adjusted that income for inflation using the CPI. Then I compared family income at each point in the distribution in September 2021 — the most recent available — with September 2019, and then did the same thing for September 2009 and September 2007. I used the CPI for the inflation adjustment because the PCE index isn’t available yet for September.2 Using two-year periods ending in September seemed like the best way to make an apples-to-apples comparison and avoid seasonal effects.3 The idea is to see what happened to income across the distribution during the pandemic as compared to a similar time period during the Great Recession.
What you see here, for instance, is that a household at the 10th percentile — that is, whose income was higher than 10 percent of households and lower than 90 percent — had an income 4 percent higher in September 2021than in September 2019. Over the 2007-2009 period, by contrast, real income at the 10th percentile fell by 8 percent. Real income the 80th percentile, on the other hand, fell by about 3 percent in both periods.4
As the figure makes clear, the difference between this recession and the previous one is not not just that disposable income fell last time but has been stable this time. The two crises saw very different patterns across income levels. The overall stability of personal income over the past two years is the result of substantial gains at the bottom combined with modest falls in the upper two-thirds. Whereas the fall in aggregate income during the Great Recession — as in most recessions — combines a much larger fall at the bottom with relative stability at the top.
This seems to me like a very important and very under-appreciated fact about the past two years. This is not just the first recession in which household income didn’t fall. It’s the first recession — in modern times, if not ever — that hit higher income families harder than low-income ones. So far, it looks less like a K-shaped recovery than a C-shaped one.
Let’s look at it another way. Between December 2007 and December 2009 — the period of the Great Recession — the share of households who reported a total income under $30,000 rose from 26.3 percent to 28.6 percent. Incomes rose over the next decade, so that by December 2019, a similar roughly one-quarter share of households reported total income of under $35,000. But over the next two years, this share fell by almost two points, from 25.7 to 23.9 percent. The fraction reporting incomes under $30,000 fell from 20.5 to 18.8 percent, while the fraction reporting incomes under $20,000 fell from 16.3 percent to 14.6 percent. This suggests a substantial decline in the number of families facing serious material hardship.
You might say: But real income did fall across most of the distribution. That is true.5 But think about it: We have just lived through a pandemic that, among other things, caused the most rapid fall in economic activity in US history. 20 million jobs disappeared overnight, and millions of them still have not come back. Of course income fell! What’s surprising is that it didn’t fall by more — that the short-term disruption was followed by a rapid bounce back rather than the long jobless recovery we’ve had after previous crises. What’s also a departure from previous downturns is whose incomes fell and whose didn’t.
Because the CPS income data is top-coded at $150,000 — about 15% of US households are above this — and the bucket below that is quite wide, the CPS isn’t informative about income at the top end. That’s why the figures cut off at the 80th percentile. I don’t see any obvious reason why high-income families should have had very different experiences in the two recessions, but we will have to wait for other data to be released to find out for sure.
There are certainly problems with measuring income with a single question. It’s not always clear what households are counting as income, especially at the low end where transfers make up a higher portion of the total. But it’s the same question in all four years. I find it hard to believe that the contrasting shifts in the numbers don’t reflect a genuine difference in the experience of low-income families over the two periods.
After all, this is consistent with what we know from other sources. Wage gains have been stronger at the bottom than at the top, by a growing margin. In the Household Pulse survey that the Census has been conducting regularly since the start of the pandemic, the dog that didn’t bark is the lack of any increase in most measures of material deprivation. In the most recent survey, for example, 9 percent of families reported that in the past week, they sometimes or often didn’t have enough to eat. That’s a shockingly high number — but it is a somewhat lower number than in April 2020. And of course, what’s all the talk about labor shortages but complaints — sometimes in so many words — that people no longer feel they have to accept underpaid drudge work out of sheer desperation?
Maintaining or improving access to necessities for the most vulnerable through an economic catastrophe is a major accomplishment. Yet what’s striking about the current moment is how little anyone is taking credit for it.
Of course there are reasons why the focus is where it is. It’s easier to talk about the problems we are actually facing than the much worse crisis we didn’t have. (There ought to be a name for the fallacy where a timely response to head off some danger is retroactively treated as a sign there was no danger in the first place.) Conservatives obviously don’t want to acknowledge the success of a massive public spending program, especially when Democrats are in office (and don’t necessarily approve of making poor people less poor in the first place.) Progressives are more comfortable criticizing bailouts than celebrating economic success stories. (And of course there is plenty to criticize.) And with the Build Back Better agenda on the line, one might worry that talking about how the measures of the past year and a half have raised up the bottom will feed a dangerous complacency, a sense that we’ve done enough already.
As it happens, I’m not sure that last worry is justified. Back when I did political work, one of things that came though most clearly talking to organizers, and to people at doors myself, is that for most people the biggest obstacle to political engagement isn’t satisfaction with the way things are, but doubt that collective action can change them. Most people,I think, are quite aware that, as we used to say, “Shit is fucked up and bullshit.” What they lack is a sense of the connection of politics and policy with the concrete problems they face. Even among political professionals, I suspect, doubt that things can be very different is often a more powerful conservative force than a positive attachment to things as they are. Remembering how policymakers made the choice go big during the pandemic might, then, strengthen, rather than undermine, the case for going big today.
Be that as it may, if it is in fact the case that during a period when unemployment spiked to 15 percent, incomes at the bottom end actually rose, that seems like an important fact about the world that someone ought to be talking about.
UPDATE:
Some people have asked whether the apparent rise in incomes at the bottom might be due to changes in family size — maybe more people moved in together and pooled their income during the pandemic? To address that, here’s another version of the figure, this one showing the change in real income divided by household size.
As it turns out, average household size actually shrank slightly over 2019-2021. This was not the case in 2007-2009, so adjusting for household size makes the recent performance look a bit better relative to the previous one. But as you can see, the broad picture is essentially the same.
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.
Mike Konczal and I have a piece in the New York Times arguing that the next few years could see a historic boom for the US economy, if policy makers recognize that strong demand and rising wages are good things, and don’t get panicked into turning toward austerity.
Mike and I and our colleagues at the Roosevelt Institute are planning a series of papers on “planning for the boom” over the coming year. The first, asking how high employment could plausibly rise under conditions of sustained strong demand, will be coming out later this month. In the meantime, here are some things I’ve written over the past few years, making the case that there is much more space for demand-led growth in the US economy than conventional estimates suggest, and that the benefits from pursuing it are broader than just producing more stuff.
In my recent post on the economics of the Rescue Plan, I highlighted the way in which the expansive public spending of the Biden administration implicitly embraces a bigger role for aggregate demand in the longer term trajectory of the economy and not just in short-run fluctuations:
Overheating may have short-term costs in higher inflation, inflated asset prices and a redistribution of income toward relatively scarce factors (e.g. urban land), but it also is associated with a long-term increase in productive capacity — one that may eventually close the inflationary gap on its own. Shortfalls on the other hand lead to a reduction in potential output, and so may become self-perpetuating as potential GDP declines.
I’ve continued making this argument in an ongoing debate with the University of Chicago’s Harold Uhlig at this new site Pairagraph. I also discussed it with David Beckworth on his excellent macroeconomics podcast.
In many ways, this story starts from debates in the mid 2010s about the need for continued stimulus, which got a big impetus from Bernie Sanders first campaign in 2016. I tried to pull together those arguments in my 2017 Roosevelt paper What Recovery? There, I argued that the failure of per-capita GDP to return to its previous trend after 2009 was a striking departure from previous recessions; that an aging population could not explain the fall in labor fore participation; that slower productivity growth could be explained at least in part by weak demand; and the the balance of macroeconomic risks favored stimulus rather than austerity.
In a more recent post, I noted that the strong growth and low unemployment of the later part of the decade, while good news in themselves, implied an even bigger demand shortfall in the aftermath of the recession:
In 2014, the headline unemployment rate averaged 6.2 percent. At that time, the benchmark for full employment (technically, the non-accelerating inflation rate of unemployment, or NAIRU) used by the federal government was 4.8 percent, suggesting a 1.4 point shortfall, equivalent to 2.2 million excess people out of work. But let’s suppose that today’s unemployment rate of 3.6 percent is sustainable—which it certainly seems to be, given that it is, in fact, being sustained. Then the unemployment rate in 2014 wasn’t 1.4 points too high but 2.6 points too high, nearly twice as big of a gap as policymakers thought at the time.
I made a similar set of arguments for a more academic audience in a chapter for a book on economics in the wake of the global financial crisis,“Macroeconomic Lessons from the Past Decade”. There, I argue that
the effects of demand cannot be limited to “the short run”. The division between a long-run supply-side and a short-run demand-side, while it may be useful analytically, does not work as a description of real world developments. Both the size of the labor force and productivity growth are substantially endogenous to aggregate demand.
This set of arguments is especially relevant in the context of climate change; if there is substantial slack in the economy, then public spending on decarbonization can raise current living standards even in the short run. Anders Fremstad, Mark Paul and I made this argument in a 2019 Roosevelt report, Decarbonizing the US Economy: Pathways toward a Green New Deal. I made the case much more briefly in a roundtable on decarbonization in The International Economy:
The response to climate change is often conceived as a form of austerity—how much consumption must we give up today to avoid the costs of an uninhabitable planet tomorrow? … The economics of climate change look quite different from a Keynesian perspective, in which demand constraints are pervasive and the fundamental economic problem is not scarcity but coordination. In this view, the real resources for decarbonization will not have to be withdrawn from other uses. They can come from an expansion of society’s productive capabilities, thanks to the demand created by clean-energy investment itself.
If you like your economics in brief video form, I’ve made this same argument about aggregate demand and climate change for Now This.
The World War II experience, which Mike and I highlight in the Times piece, is discussed at length in a pair of papers that Andrew Bossie and I wrote for Roosevelt last year. (Most of what I know about the economics of the war mobilization is thanks to Andrew.) In the first paper, The Public Role in Economic Transformation: Lessons from World War II, we look at the specific ways in which the US built a war economy practically overnight; the key takeaway is that while private contractors generally handled production itself, most investment, and almost all the financing of investment, came from the public sector. The second paper, Public Spending as an Engine of Growth and Equality: Lessons from World War II, looks at the macroeconomic side of the war mobilization.
Among the key points we make here are that potential output is much more elastic in response to demand than we usually assume; that both the labor force and productivity respond strongly to the level of spending; that the inflation associated with rapid growth often is a sign of temporary shortfalls or bottlenecks, which can be addressed in better ways than simply reducing aggregate spending; and that strong demand is a powerful force for equalizing the distribution of income. The lessons for the present are clear:
The wartime experience suggests that the chronic weak demand the US has suffered from for at least the past decade is even more costly than we had realized. Not only does inadequate spending lead to slower growth, it leads to lower wage gains particularly for those at the bottom and reinforces hierarchies of race and sex. Conversely, a massive public investment program in decarbonization or public health would not only directly address those crises, but could also be an important step toward reversing the concentration of income and wealth that is one of the great failures of economic policymaking over the past generation.
I also discuss the war experience in this earlier Dissent review of Mark Wilson’s book Destructive Creation, and in a talk I delivered at the University of Massachusetts in early 2020.
Alternative approaches to inflation control isn’t something I’ve written a lot about —until recently, the question hasn’t seemed very urgent. But Mike, me and our Roosevelt colleague Lauren Melodia did write a blog post last month about why it’s a mistake to worry about somewhat higher inflation numbers this year. One aspect of this is the “base effect” which is artificially increasing measured inflation, but it’s also important to stress that genuinely higher inflation is both a predictable result of a rapid recovery from the pandemic and not necessarily a bad thing.
A few years ago, Mike and I wrote a paper arguing for a broader toolkit at the Fed. Our focus at the time was on finding more ways to boost demand. But many of the arguments also apply to a situation — which we are definitely not in today, but may be at some point — where you’d want to rein demand in. Whichever way the Fed is pushing, it would be better to have more than one tool to push with.
Another important background debate for the Times piece is the idea of secular stagnation, which enjoyed a brief vogue in the mid 2010s. Unfortunately, the most visible proponent of this idea was Larry Summers, who … well, let’s not get into that here. But despite its dubious provenance, there’s a lot to be said for the idea that recent decades have seen a persistent tendency for total spending to fall short of the economy’s productive potential. In this (somewhat wonkish) blog post, I discussed this idea in terms of Roy Harrod’s model of economic growth, and suggested a number of factors that might be at work:
for secular, long-term trends tending to raise desired saving relative to desired investment we have: (1) the progressive satiation of consumption demand; (2) slowing population growth; (3) increasing monopoly power; and (4) the end of the industrialization process. Factors that might either raise or lower desired savings relative to investment are: (5) changes in the profit share; (6) changes in the fraction of profits retained in the business sector; (7) changes in the distribution of income; (8) changes in net exports; (9) changes in government deficits; and (10) changes in the physical longevity of capital goods. Finally, there are factors that will tend to raise desired investment relative to desired saving. The include: (11) consumption as status competition (this may offset or even reverse the effect of greater inequality on consumption); (12) social protections (public pensions, etc.) that reduce the need for precautionary and lifecycle saving; (13) easier access to credit, for consumption and/or investment; and (14) major technological changes that render existing capital goods obsolete, increasing the effective depreciation rate. These final four factors will offset any tendency toward secular stagnation.
Hysteresis — the effect of demand conditions on potential output — and secular stagnation are two important considerations that suggest that big boost in spending, as we are looking at now, could permanently raise the economy’s growth path. A third, less discussed consideration is that demand itself may be persistent. I discuss that possibility in a recent blog post.
An important aspect of an economic boom which we unfortunately could not fit into the op-ed is the way that faster growth and moderately higher inflation reduce the burden of debt for both the private and public sector. Historically, growth rates, inflation and interest rates have had a bigger effect on the household debt ratio than household borrowing has. This is a major focus of my scholarly work — see here and here. The same thing goes for public debt, as I’ve discussed in a blog post here. The degree to which both the past year’s stimulus and a possible future boom has/will strengthen balance sheets across the economy is seriously underappreciated, in my view.
The question of public debt has moved away from center stage recently. Criticism of public spending lately seems more focused on inflation and supposed ”labor supply constraints.” But if the anti-boom contingent shifts back toward scare stories about public debt, I’ve got pre-rebuttals written here and here.
Finally, I want to highlight something I wrote about a year ago: The Coronavirus Recession Is Just Beginning. There, I argued that the exceptional reduction in activity due to the pandemic would probably be followed by a conventional recession. You will note that this is more or less the opposite of the argument in the Times piece. That’s because my post least year was wrong! But I don’t think it was unreasonable to make that prediction at the time. What I didn’t take into account, what almost no one took into account, was the extraordinary scale of the stimulus over the past year. Well ok! Now, let’s build on that.
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 Ballpapers, 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. Arealistic 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 thatsufficient 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 withpersistence 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.
Some people are frustrated about the surrender on the minimum wage, the scaled-back unemployment insurance, the child tax credit that should have been a universal child allowance, the fact that most of the good things phase out over the next year or two.
On the other side are those who see it as a decisive break with neoliberalism. Both the Clinton and Obama administrations entered office with ambitious spending plans, only to abandon or sharply curtail them (respectively), and instead embrace a politics of austerity and deficit reduction. From this point of view, the fact that the Biden administration not only managed to push through an increase in public spending of close to 10 percent of GDP, but did so without any promises of longer-term deficit reduction, suggests a fundamental shift.
Personally, I share this second perspective. I am less surprised by the ways in which the bill was trimmed back, than by the extent that it breaks with the Clinton-Obama model. The fact that people like Lawrence Summers have been ignored in favor of progressives like Heather Boushey and Jared Bernstein, and deficit hawks like the Committee for a Responsible Federal Budget have been left screeching irrelevantly from the sidelines, isn’t just gratifying as spectacle. It suggests a big move in the center of gravity of economic policy debates.
It really does seem that on the big macroeconomic questions, our side is winning.
To be clear, the bill did not pass because some economists out-argued other economists. It was a political outcome that was driven by political conditions and political work. Most obviously, it’s hard to imagine this Biden administration without the two Sanders campaigns that preceded it. (In the president’s speech after signing the bill, Bernie was the first second person credited.) If it’s true, as reported, that Schumer kept expanded unemployment benefits in the bill only by threatening Manchin that the thing would not pass the House without them, then the Squad also deserves a lot of credit.
Still, from my parochial corner, it’s interesting to think about the economic theory implied by the bill. Implicitly, it seems to me, it represents a big break with prevailing orthodoxy.
Over the past generation, macroeconomic policy discussions have been based on a kind of textbook catechism that goes something like this: Over the long run, potential GDP grows at a rate based on supply-side factors — demographics, technological growth, and whatever institutions we think influence investment and labor force participation. Over the short run, there are random events that can cause actual spending to deviate from potential, which will be reflected in a higher or lower rate of inflation. These fluctuations are more or less symmetrical, both in frequency and in cost. The job of the central bank is to adjust interest rates to minimize the size of these deviations. The best short-term measure of how close the economy is to potential is the unemployment rate; at any given moment, there’s a minimum level of unemployment consistent with price stability. Smoothing out these fluctuations has real short run benefits, but no effects on long-term growth. The government budget balance, meanwhile, should not be used to stabilize demand, but rather should be kept at a level that ensures a stable or falling debt ratio; large fiscal deficits may be very costly. Finally, while it may be necessary to stabilize overall spending in the economy, this should be done in a way that minimizes “distortions” of the pattern of economic activity and, in particular, does not reduce the incentive to work.
Policy debates — though not textbooks — have been moving away from this catechism for a while. Jason Furman’s New View of Fiscal Policy is an example I often point to; you can also see it in many statements from Powell and other Fed officials, as I’ve discussed here and here. But these are, obviously, just statements. The size and design of ARPA is a more consequential rejection of this catechism. Without being described as such, it’s a decisive recognition of half a dozen points that those of us on the left side of the macroeconomic debate have been making for years.
1. The official unemployment rate is an unreliable guide to the true degree of labor market slack, all the time and especially in downturns. Most of the movement into and out of employment is from people who are not officially counted as unemployed. To assess labor market slack, we should also look at the employment-population ratio, and also at more direct measures of workers’ bargaining power like quit rates and wage increases. By these measures, the US pre-pandemic was still well short of the late 1990s.More broadly, there is not a well defined labor force, but asmooth gradient of proximity to employment. The short-term unemployed are the closest, followed by the longer-term unemployed, employed people seeking additional work, discouraged workers, workers disfavored by employers due to ethnicity, credentials, etc. Beyond this are people whose claim on the social product is not normally exercised by paid labor – retired people, the disabled, full-time caregivers – but might come to be if labor market conditions were sufficiently favorable.
2. The balance of macroeconomic risks is not symmetrical. We don’t live in an economy that fluctuates around a long-term growth path, but one that periodically falls into recessions or depressions. These downturns are a distinct category of events, not a random “shock” to production or desired spending. Economic activity is a complex coordination problem; there are many ways it can break down or be interrupted that result in a fall inspending, but not really any way it can abruptly accelerate. (There are no “positive shocks” for the same reason that there are lots of poisons but no wonder drugs.) It’s easy to imagine real-world developments that could causes businesses to abruptly cut back their investment plans, but not that would cause them to suddenly and unexpectedly scale them up. In real economies, demand shortfalls are much more frequent, persistent and damaging than is overheating. And to the extent the latter is a problem, it is much easier to interrupt the flow of spending than to restart it.
3. The existence of hysteresis is one important reason that demand shortfalls are much more costly than overshooting. Overheating may have short-term costs in higher inflation, inflated asset prices and a redistribution of income toward relatively scarce factors (e.g. urban land), but it also is associated with a long-term increase in productive capacity — one that may eventually close the inflationary gap on its own. Shortfalls on the other hand lead to a reduction in potential output, and so may become self-perpetuating as potential GDP declines. Hysteresis also means that we cannot count on the economy returning to its long-term trend on its own — big falls in demand may persist indefinitely unless they are offset by some large exogenous boost to demand. Which in turn means that standard estimates of potential output understate the capacity of output to respond to higher spending.
4. A full employment or high pressure economy has benefits that go well beyond the direct benefits of higher incomes and output. Hysteresis is part of this — full employment is a spur to innovation and faster productivity growth. But there are also major implications for the distribution of income. Those who are most disadvantaged in the labor market, are the ones who benefit most from very low unemployment. The World War II experience, and the subsequent evolution of the racial wage gap, suggests that historically, sustained tight labor markets have been the most powerful force for closing the gap between black and white wages.
I’m not sure how much people in the administration and Congress were actually making arguments like these in framing the bill. But even if they weren’t explicitly argued for, some mix of them logically follows from the willingness to pass something so much larger than the conventional estimates of the output gap would imply. Some mix of them also must underly the repeated statements that we can’t do too much, only too little, and from the recognition that the costs of an inadequate stimulus in 2009 were not just lower output for a year or two, butan extended period of slow growth and stagnant wages. When Schumer says that in 2009, “we cut back on the stimulus dramatically and we stayed in recession for five years,” he is espousing a model of hysteresis, even if he doesn’t use the word.
On other points, there’s a more direct link between the debate over the bill and the shift in economic vision it implies.
5. Public debt doesn’t matter. Maybe I missed it, but as far as I can tell, in the push for the Rescue Plan neither the administration nor the Congressional leadership made even a gesture toward deficit reduction, not even a pro forma comment that it might be desirable in principle or in the indefinite long run. The word “deficit” does not seem to have occurred in any official statement from the president since early February — and even then it was in the form of “it’s a mistake to worry about the deficit.” Your guide to being a savvy political insider suggests appropriate “yes, buts” to the Rescue Plan — too much demand will cause inflation, or alternatively that demand will collapse once the spending ends. Nothing about the debt. Things may change, of course, but at the moment it’s astonishing how completely we have won on this one.
6. Work incentives don’t matter. For decades, welfare measures in the US have been carefully tailored to ensure that they did not broaden people’s choices other than wage labor. The commitment to maintaining work incentives was strong enough to justify effectively cutting off all cash assistance to families without anyone in paid employment — which of course includes the poorest.The flat $600 pandemic unemployment insurance was a radical departure from this — reaching everyone who was out of work took priority over ensuring that no one was left better off than they would be with a job. The empirical evidence that this had no effect on employment is informative about income-support programs in general. Obviously $300 is less than $600, but it maintains the priority of broad eligibility. Similarly, by allowing families with no wages to get the full benefit, making the child tax credit full refundable effectively abandons work incentives as a design principle (even if it would be better at that point to just make it a universal child allowance.) As many people have pointed out, this is at least directionally 180 degrees from Clinton-era “welfare reform.”
7.Direct, visible spending is better than indirect spending or spending aimed at altering incentives. For anyone who remembers the debates over the ARRA at the start of the Obama administration, it’s striking how much the Rescue Plan leans into direct, visible payments to households. The plan to allow the child tax credit to be paid out in monthly installments may have some issues (and, again, would certainly work better if it were a flat allowance rather than a tax credit) but what’s interesting here is that it reflects a view that making the payments more salient is a good thing, not a bad thing.
In other areas, the conceptual framework hasn’t moved as far as I would have hoped, though we are making progress:
8. Means testing is costly and imprecise. As Claudia Sahm, Matt Bruenig and others have forcefully argued, there’s a big disconnect between the way means testing is discussed and the way it actually operates. When the merits of income-based spending are talked about in the abstract, it’s assumed that we know every household’s income and can assign spending precisely to different income groups. But when we come to implement it, we find that the main measure of income we use is based on tax records from one to two years earlier; there are many cases where the relevant income concept isn’t obvious; and the need to document income creates substantial costs and uncertainties for beneficiaries. Raising the income thresholds for things like the child tax credit is positive, but the other side of that is that once the threshold gets high enough it’s perverse to means-test at all: In order to exclude a relatively small number of high-income families you risk letting many lower-income families fall through the cracks.
9. Weak demand is an ongoing problem, not just a short-term one. The most serious criticism of the ARPA is, I think, that so many of its provisions are set to phase out at specific dates when they could be permanent (the child tax credit) or linked to economic conditions (the unemployment insurance provisions). This suggests an implicit view that the problems of weak demand and income insecurity are specific to the coronavirus, rather than acute forms of a chronic condition. This isn’t intended as a criticism of those who crafted the bill — it may well be true that a permanent child tax credit couldn’t be passed under current conditions.
Still, the arguments in support of many of the provisions are not specific to the pandemic, and clearly imply that these measures ought to be permanent. If the child tax credit will cut child poverty by half, why would you want to do that for only one year? If a substantial part of the Rescue Plan should on the merits be permanent, that implies a permanently larger flow of public spending. The case needs to be made for this.
10. The public sector has capacities the private sector lacks. While Biden’s ARPA is a big step forward from Obama’s ARRA in a lot of ways, one thing they have in common is a relative lack of direct public provision. The public health measures are an exception, of course, and the aid to state and local governments — a welcome contrast with ARRA — is public spending at one remove, but the great majority of the money is going to boost private spending. That’s not necessarily a bad thing in this specific context, but it does suggest that, unlike the case with public debt, theinstitutional and ideological obstacles to shifting activities from for-profit to public provision are still formidable.
My goal in listing these points isn’t, to be clear, to pass judgement on the bill one way or the other. Substantively, I do think it’s a big victory and a clear sign that elections matter. But my interest in this particular post is to think about what it says about how thinking about economic policy is shifting, and how those shifts might be projected back onto economic theory.
What would a macroeconomics look like that assumed that the economy was normally well short of supply constraints rather than at potential on average, or was agnostic about whether there was a meaningful level of potential output at all? What would it look like if we thought that demand-induced shifts in output are persistent, in both directions? Without the assumption of a supply-determined trend which output always converges to, it’s not clear there’s a meaningful long run at all. Can we have a macroeconomic theory that dispenses with that?
One idea that I find appealing is to think of supply as constraining the rate of growth of output, rather than its level. This would fit with some important observable facts about the world — not just that demand-induced changes in output are persistent, but also that employment tends to grow (and unemployment tends to fall) at a steady rate through expansions, rather than a quick recovery and then a return to long-run trend. The idea that there is a demographically fixed long-run employment-population ratio flies in the face of the major shifts of employment rates within demographic groups. A better story, it seems to me, is that there is a ceiling on the rate that employment can grow — say 1.5 or 2 percent a year — without any special adjustment process; faster growth requires drawing new people into the labor force, which typically requires faster wage growth and also involves various short run frictions. But, once strong growth does generate a larger labor force, there’s no reason for it to revert back to its old trend.
More broadly, thinking of supply constraints in terms of growth rates rather than levels would let us stop thinking about the supply side in terms of an abstract non monetary economy “endowed” with certain productive resources, and start thinking about it in terms of the coordination capabilities of markets. I feel sure this is the right direction to go. But a proper model needs to be worked out before it is ready for the textbooks.
The textbook model of labor markets that we still teach justifies a focus on “flexibility”, where real wages are determined by on productivity and a stronger position for labor can only lead to higher inflation or unemployment. Instead, we need a model where the relative position of labor affects real as well as nominal wages, andin which faster wage growth can be absorbed by faster productivity growth or a higher wage share as plausibly as by higher prices.
Or again, how do we think about public debt and deficits once we abandon the idea that a constant debt-GDP ratio is a hard constraint? One possibility is that we think the deficit matters, but debt does not, just as we now think think that the rate of inflation matters but the absolute price level does not.To earlier generations of economists, the idea that prices could just rise forever without limit, would have seemed insane. But today we find it perfectly reasonable, as long as the rise over any given period is not too great. Perhaps we’ll come to the same view of public debt. To the extent that we do care about the debt ratio, we need to foreground the fact that its growth over time depends as much on interest, inflation and growth rates as it does on new borrowing. For the moment, the fact that interest rates are much lower than growth rates is enough to convince people past concerns were overblown. But to regard that as a permanent rather than contingent solution, we need, at least, to get rid of the idea of a natural rate of interest.
In short, just as a generation of mainstream macroeconomic theory was retconned into an after-the-fact argument for an inflation-targeting central bank, what we need now is textbooks and theories that bring out, systematize and generalize the reasoning that justifies a great expansion of public spending, unconstrained by conventional estimates of potential output, public debt or the need to preserve labor-market incentives. The circumstances of the past year are obviously exceptional, but that doesn’t mean they can’t be made the basis of a general rule. For the past generation, macroeconomic theory has been largely an abstracted parable of the 1970s, when high interest rates (supposedly) saved us from inflation. With luck, perhaps the next generation will learn macroeconomics as a parable of our own time, when big deficits saved us from secular stagnation and the coronavirus.
