the continuing crisis – Page 2

Good News on the Economy, Bad News on Economic Policy

(Cross-posted from the Roosevelt Institute blog. I am hoping to start doing these kinds of posts on new economic data somewhat regularly.)

On Friday, the the Bureau of Labor Statistics released the unemployment figures for May. As expected, the reported unemployment rate was very low—3.6 percent, the same as last month. Combined with the steady growth in employment over the past few years, this level of unemployment—not seen since the 1960s—suggests an exceptionally strong labor market by historical standards. On one level this really is good news for the economy. But at the same time it is very bad news for economic policy: The fact that employment this low is possible, shows that we have fallen even farther short of full employment in earlier years than we thought.

Some skeptics, of course, will cast doubts on how meaningful the BLS numbers are. The headline unemployment rate, they will argue, understates true slack in the labor market; many of the jobs being created are low-wage and insecure; workers’ overall position is still weak and precarious by historical standards.

This is all true. But it is also true that the unemployment numbers are not an isolated outlier. Virtually every other measure also suggests a labor market that is relatively favorable to workers, at least by the standards of the past 20 years.

The broader unemployment measures published by the BLS, while higher than the headline rate, have come down more or less in lockstep with it. (The new release shows that the BLS’s broadest measure of unemployment, U-6, continued to decline in May, thanks to a steep fall in the number of people working part-time because they can’t find full-time work.) The labor force participation rate, after declining for a number of years, has now started to trend back upward, suggesting that people who might have given up on finding a job a few years ago are once again finding it worthwhile to look for one. The fraction of workers voluntarily quitting their jobs, at 2.3 percent, is now higher than it ever got during the previous business cycle. The quit rate is a good measure of labor market tightness—one of former Fed chair Janet Yellen’s preferred measures—because it shows you how people evaluate their own job prospects; people are much more likely to quit their current job if they expect to get a better one. Reported job openings, a longstanding measure of labor market conditions, are at their highest level on record, with employers reporting that nearly 5 percent of positions are unfilled. Wage growth, which was nowhere to be seen well into the official recovery, has finally begun to pick up, with wage growth noticeably faster since 2016 than in the first six years of the expansion. In the nonfinancial business sector—where the shares of labor and capital are most easily measured—the share of value added going to labor has finally begun to tick up, from a steady 57 percent from 2011 to 2014 up to 59 percent by 2017. Though still far short of the 65 percent of value added claimed by labor at the height of the late-1990s boom, the recent increase does suggest an environment in which bargaining power has at last begun to shift in favor of workers.

For progressives, it can be a challenge to talk about the strengthening labor market. Our first instinct is often to call attention to the ways in which workers’ position is still worse than it was a generation ago, and to all the ways that the labor market is still rigged in favor of employers. This instinct is not wrong, but it is only one side of the picture. At the same time, we need to call attention to the real gains to working people from a high-pressure economy—one where aggregate demand is running ahead of available labor.

A high-pressure economy is especially important for those at the back of the hiring queue. People sometimes say that full employment is fine, but that it doesn’t help people of color, younger people, or those without college degrees. This thinking, however, is backwards. It is educated white men with plenty of experience whose job prospects depend least on overall labor market conditions; their employment prospects are good whether overall unemployment rates are high or low. It is those at the back of the hiring queue—Black Americans, those who have received less education, people with criminal records, and others discriminated against by potential employers—who depend much more on a strong labor market. The Atlanta Fed’s useful wage tracker shows this clearly: Wage growth for lower-wage, non-white, and less-educated workers lagged behind that of college-educated white workers during the high-unemployment years following the recession. Since 2016, however, that pattern has reversed, with the biggest wage gains for nonwhite workers and those at the bottom of the wage distribution. This pattern has been documented in careful empirical work by Josh Bivens and Ben Zipperer of the Economic Policy Institute, who show that, historically, tight labor markets have disproportionately benefited Black workers and raised wages most at the bottom.

Does this mean we should be satisfied with the state of macroeconomic policy—if not in every detail, at least with its broad direction?

No, it means just the opposite. Labor markets do seem to be doing well today. But that only shows that macroeconomic performance over the past decade was even worse than we thought.

This is true in a precise sense. Macroeconomic policy always aims at keeping the economy near some target. Whether we define the target as potential output or full employment, the goal of policy is to keep the actual level of activity as close to it as possible. But we can’t see the target directly. We know how high gross domestic product (GDP) growth is or how low unemployment is, but we don’t know how high or how low they could be. Everyone agrees that the US fell short of full employment for much of the past decade, but we don’t know how far short. Every month that the US records an unemployment rate below 4 percent suggests that these low unemployment rates are indeed sustainable. Which means that they should be the benchmark for full employment. Which also means that the economy fell that much further short of full employment in the years after the 2008-2009 recession—and, indeed, in the years before it.

For example: 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, which is nearly twice as big of a gap as policymakers thought at the time. Again, this implies that the failure of demand management after the Great Recession was even worse than we thought.

And not just after it. For most of the previous expansion, unemployment was above 5 percent, and the labor share was falling. At the time, this was considered full employment – indeed, the self-congratulation over the so-called Great Moderation and “amazing success” of economic policy reached a crescendo in this period. But if a perofrmance like today’s was possible then — and why shouldn’t it have been? — then what policymakers were actually presiding over was an extended stagnation. As Minnesota Fed chair Narayan Kocherlakota – one of the the few people at the economic-policy high table who seems to have learned something from the past decade – points out, the US “output gap has been negative for almost the entirety of the current millenium.”

These mistakes have consequences. For years now, we have been repeatedly told that the US is at or above full employment—claims that have been repeatedly proved wrong as the labor market continues to strengthen. Only three years ago, respectable opinion dismissed the idea that, with sufficient stimulus, the unemployment could fall below 4 percent as absurd. As a result, we spent years talking about how to rein in demand and bring down the deficit, when in retrospect it is clear that we should have been talking about big new public spending programs to boost demand.

This, then, is a lesson we can draw from today’s strong unemployment numbers. Strong economic growth does improve the bargaining position of workers relative to employers, just as it has in the past. The fact that the genuine gains for working people over the past couple years have only begun to roll back the losses of the past 20 doesn’t mean that strong demand is not an important goal for policy. It means that we need much more of it, sustained for much longer. More fundamentally, strong labor markets today are no grounds for complacency about the state of macroeconomic policy. Again, the fact that today’s labor market outcomes are better than people thought possible a few years ago shows that the earlier outcomes were even worse than we thought. The lesson we should take is not that today’s good numbers are somehow fake; they are real, or at least they reflect a real shift from the position of a few years ago. Rather, the lesson we should take is that we need to set our sights higher. If today’s strong labor markets are sustainable—and there’s no reason to think that they are not—then we should not accept a macroeconomic policy consensus that has been willing to settle for so much less for so long.

Video: Monetary Policy since the Crisis

On May 30, I did a “webinar” with INET’s Young Scholar’s Intiative. The subject was central banking since the financial crisis of a decade ago, and how it forces us to rethink some long-held ideas about money and the real economy — the dstinction between a demand-determined short run and a supply-determined long run; the neutrality of money in the long run; the absence of tradeoffs between unemployment, inflation and other macroeconomic goals; the reduction of monetary policy choices to setting a single overnight interest rate based on a fixed rule.My argument is that the crisis — or more precisely, central banks’ response to it — creates deep problems for all these ideas.

The full video (about an hour and 15 minus, including Q&A) is on YouTube, and embedded below. It’s part of an ongoing series of YSI webinars on endogenous money, including ones by Daniela Gabor, Jo Mitchella nd Sheila Dow. I encourage you, if you’re interested, to sign up with YSI — anyone can join — and check them out.

I didn’t use slides, but you can read my notes for the talk, if you want to.

Macroeconomic Lessons from the Past Decade

Below the fold is a draft of a chapter I’m contributing to an edited volume on aggregate demand and employment. My chapter is supposed to cover macroeconomic policy and employment in the US, with other chapters covering other countries and regions.

The chapter is mostly based on material I’ve pulished elsewhere, mainly my Roosevelt papers “What Recovery?” and “A New Direction for the Federal Reserve.” My goal was something that summarized the arguments there for an audience of (presumably) heterodox macroeconomists, and that could also be used in the classroom.

There is still time to revise this, so comments/criticisms are very welcome.

Continue reading Macroeconomic Lessons from the Past Decade

What It’s About

Shortly after Syriza’s victory in January 2015, Yanis Varoufakis is traveling around Europe for his first official meetings with various and economics ministers. Here’s an interesting conversation with one of them:

Pier Carlo Padoan, Italy’s finance minister and formerly the OECD’s chief economist, is in many ways a typical European social democrat: sympathetic to the Left but not prepared to rock the boat… Our discussion was friendly and efficient. I explained my proposals, and he signalled that he understood what I was getting at, expressing not an iota of criticism but no support. To his credit, he explained why: when he had been appointed finance minister a few months earlier, Wolfgang Schäuble had made a point of having a go at him at every available opportunity…

I enquired how he had managed to curb Schäuble’s hostility. Pier Carlo said that he had asked Schäuble to tell him the one thing he could do to win his confidence. That turned out to be “labour market reform” – code for weakening workers’ rights, allowing companies to fire them more easily with little or no compensation and to hire people on lower pay with fewer protections. Once Pier Carlo had passed appropriate legislation through Italy’s parliament, at significant political cost to the Renzi government, the German finance minister went easy on him. “Why don’t you try something similar?” he suggested.

“I’ll think about it,” is Varoufakis’ diplomatic reply.

A couple days later, he has a meeting with the German finance minister himself, perhaps the most important single figure in the Euroepan establishment. Schauble brushes off Varoufakis’ suggestions for strengthening the Greek tax authorities, insisting instead on

his theory that the “overgenerous” European social model was no longer sustainable and had to be ditched. Comparing the costs to Europe of maintaining welfare states with the situation in places like India and China, where no social safety net exists at all, he argued that Europe was losing competitiveness and would stagnate unless social benefits were curtailed en masse. It was as if he was telling me that a start had to be made somewhere and that that somewhere might as well be Greece.

I’m supposed to be writing a review of Adults in the Room.That right there is the story, I think. Debates over fiscal arrangements were a pretext, the real agenda has always been restoring the rule of market over society, over labor in particular. And Greece was just a convenient place to start, or to make an example of. Despite the constant framing of Eruope’s divisions in national terms, I think it’s clear that for German conservatives like Schauble, the real target has always been their own working class.

What Recovery: Reading Notes

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

[2] I made similar arguments here.

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

The Big Question for Macroeconomic Policy: Is This Really Full Employment?

Cross-posted from the Roosevelt Institute’s Next New Deal blog. This is a summary of my new paper What Recovery? The Case for Continued Expansionary Policy, also discussed in Neil Irwin’s July 26 article in the Times.

“Right now,” wrote Senator Chuck Schumer in a New York Times op-ed on Monday, “millions of unemployed or underemployed people, particularly those without a college degree, could be brought back into the labor force” with appropriate government policies. With this seemingly anodyne point, Schumer took sides in a debate that has sharply divided economists and policymakers: Is the US economy today operating at potential, with enough spending to make full use of its productive capacity? Or is there still substantial slack, unused capacity that could be put to work if someone — households, businesses or governments — decided to spend more? Is there an aggregate-demand problem that government should be trying to solve?

It’s difficult to answer this question because the economic signals seem to point in conflicting directions. Despite the recession officially ending in June 2009 and the economy enjoying steady growth for the past eight years, GDP is still far below the pre-2008 trend. If we compare GDP to forecasts made before the recession, the gap that opened up during the recession has not closed at all — in fact, it continues to get wider. Meanwhile, the official unemployment rate — probably the most watched indicator for the state of aggregate demand — is down to 4.4%, well below the level that was considered full employment even a few years ago. But this positive performance only partially reflects an increase in the number of Americans with jobs; mostly it comes from a decline in the size of the labor force — people who have or are seeking jobs. The fraction of the adult population employed is down to 60 percent from 63 percent a decade ago (and nearly 65 percent at the end of the 1990s).

Is this decline in the fraction of people employed the inevitable result of an aging population and similar demographic changes, or is it a sign that, despite the low measured unemployment rate, the economy is still far short of full employment? The Federal Reserve — one of the main sites of macroeconomic policy — has already indicated its belief that full employment has been reached by raising interest rates 3 times since December 2016. Fed Chair and Janet Yellen are evidently convinced that the economy has reached its potential — that, given the real resources available, output and employment are as high as can reasonably be expected.

Other policymakers have been divided on the question, in ways that often cut across partisan lines. Senator Schumer’s statement — that the decline in employment is not an inevitable trend but rather a problem that government can and should solve — is a sign of new clarity coming to this murky debate. Along with his call for $1 trillion in new infrastructure spending, it’s an important acknowledgement that, despite the progress made since 2008, the country remains far from full employment.

In a new paper out this week, we at the Roosevelt Institute offer support for the emerging consensus that the economy needs policies to boost demand. The paper reviews the available data on where the economy is relative to its potential. We find that the balance of evidence suggests there is still a great deal of space for more expansionary policy.

We offer several lines of argument in support of this conclusion.

GDP has not recovered from the recession. GDP remains about 10 percent below both the long-term trend and the level that was predicted by the CBO and other forecasts prior to the 2008–2009 recession. There is no precedent in the postwar period for such a persistent decline in output. During the sixty years between 1947 and 2007, growth lost in recessions was always regained in the subsequent recovery.

The aging population does not explain low labor force participation. It is true that an aging population should contribute to lower employment, since older people are less likely to work than younger people. But this simple demographic story cannot explain the full fall in employment. Starting from the employment peak in 2000, aging trends only explain about half the decrease in employment that has actually occurred. And there are good reasons to think that even this overstates the role of demographics. First, during the same period, education levels have increased. Historically, higher education has been associated with higher employment rates, just as a share of elderly people has been associated with less employment; statistically, these two effects should just about cancel out. Second, the post-recession fall in employment rates is not concentrated in older age groups, but among people in their 20s — something that a demographic story cannot explain.

The weak economy has held back productivity. About half the shortfall in GDP relative to the pre-2008 trend is explained by exceptionally slow productivity growth — that is, slow growth in output per worker. While many people assume that productivity is the result of technological progress outside the reach of macroeconomic policy, there are good reasons to think that the productivity slowdown is at least in part due to weak demand. Among the many possible links: Business investment, which is essential to raising productivity, has been extraordinarily weak over the past decade, and economists have long believed that demand is a central factor driving investment. And slow wage growth — a sign of labor-market weakness — reduces the incentive to adopt productivity-boosting technology.

Only a demand story makes sense. The overall economic picture is hard to understand except in terms of a continued demand shortfall. If employment is falling due to demographics, that should be associated with rising productivity and wages, as firms compete for scarce labor. If productivity growth is slow because there aren’t any more big innovations to make, that should be associated with faster employment growth and low profits, as firms can no longer find new ways to replace labor with capital. But neither of these scenarios match the actual economy. And both stories predict higher inflation, rather than the persistent low inflation we have actually encouraged. So even if supply-side stories explain individual pieces of macroeconomic data, it is almost impossible to make sense of the big picture without a large fall in aggregate demand.

Austerity is riskier than stimulus. Finally, we argue that, if policymakers are uncertain about how much space the economy has for increased demand, they should consider the balance of risks on each side. Too much stimulus would lead to higher inflation — easy to reverse, and perhaps even desirable, given the continued shortfall of inflation relative to the official 2 percent target. An overheated economy would also see real wages rise faster than productivity. While policymakers often see this as something to avoid, the decline in the wage share over the past decade cannot be reversed without a period of such “excess” wage growth. On the other hand, if there is still an output gap, failure to take aggressive steps to close it means foregoing literally trillions of dollars of useful goods and services and condemning millions of people to joblessness.

Fortunately, the solution to a demand shortfall is no mystery. Since Keynes, economists have known that when an economy is operating below its potential, all that is needed is for someone to spend more money. Of course, it’s best if that spending also serves some useful social purpose; exactly what that should look like will surely be the subject of much debate to come. But the first step is to agree on the problem. Today’s economy is still far short of its potential. We can do better.

Links and Thoughts for March 15, 2017

Do you guys know The Death Ship? B. Traven’s first novel, the only one not set in Mexico? It begins with an American sailor who goes ashore in the Netherlands, gets distracted as you do, his ship leaves. The Dutch don’t want him, they send him across the border to Germany. The Germans don’t want him, send him to Belgium, the Belgians send him to France. The French send him back to the Netherlands, where he ends up on the eponymous ship. It’s a good book. I was just thinking of it the other day, for some reason.

Against the sonderweg. Here is a fascinating article on the pre-history of Swedish social democracy. Contrary to claims of Swedish “sonderweg”, or special path, toward egalitarianism, Erik Bengtsson convincingly shows that until the 1930s, Sweden was not especially egalitarian relative to other West European countries or the US. Both economically and politically, it was at the unequal end of the European continuum, and considerably less equal than the US. “In 1900, it was one of the countries in Western Europe with the most restricted suffrage, and wealth was more unequally distributed than in the United States. …The more likely explanation of Swedish twentieth-century equality, rather than any deep roots, is the extraordinary degree of popular organization in the labour movement and other popular movements” in the 210th century. Income and wealth distribution were similar to France or Britain, while the franchise was more restricted than in any other major West European country. Up through World War One, Swedish politic was dominated by the same kind of “iron and rye” alliance of feudal landowners with big industrialists as Bismarkian Germany. “The exceptional equality of Swedish economy and society c. 1920-1990 did not arrive as the logical conclusion of a long historical continuity”; rather, it was the result of an exceptionally effective mass mobilization against what was previously an unusually inegalitarian state.

More speculatively, Bengtsson suggests that it was precisely the exceptionally strong and persistent domination by a small elite that created the conditions for Swedish social democracy: “the late democratization of Sweden” may have “fostered a liberal-socialist democratizing alliance … [between] petit bourgeois liberals and working-class socialists … unlike Germany, where the greater inclusion of lower-middle class men meant that middle class liberals and haute bourgeois market liberals could unite around a program of economic liberalism.” It’s a neat inversion of Werner Sombart’s famous argument that “the free gift of the ballot” prior to the appearance of an organized working class was the reason no powerful socialist party ever developed in the United States. Bengttson’s convincing claim that Swedish egalitarianism was not the result of a deep-rooted history but of a deliberate political project to transform a previously inegalitarian society, has obvious relevance for today.

High productivity in France. While we are debunking myths about social democracy, here is Thomas Piketty on French productivity. “If we calculate the average labour productivity by dividing the GDP … by the total number of hours worked … we then find that France is at practically the same level as the United States and Germany, … more than 25% higher than the United Kingdom or Italy.” And here’s a 2014 post from Merijn Knibbe making the same point.

Against Hamilton. In The Baffler, Matt Stoller argues that Hamilton is overrated. Richard Kreitner makes a similar case in The Nation, with an interestingly off-center focus on Paterson, New Jersey. Christian Parenti (my soon-to-be colleague at John Jay College) made the case for Hamilton not long ago in the Jacobin; he’s writing an introduction to a new edition of Hamilton’s Report on Manufactures. This is not a new debate. Twenty years ago, as the books editor of In These Times, I published a piece by Dan Lazare making a similar pro-Hamilton case; it was one of the things that Jimmy Weinstein fired me for.

My sense of these arguments is that one side says that Hamilton was a predecessor of today’s Koch brothers-neocon right, an anti-democratic militarist who believed the country should be governed by and for the top 1 percent; his opponent Jefferson must therefore have been a democrat and anti-imperialist. The other side says that Jefferson was a predecessor of today’s Tea Party right, an all-in racist and defender of slavery who opposed cities, industry and progress; his opponent Hamilton must therefore have been an abolitionist, an open-minded cosmopolitan and a liberal. I am far from an expert on early American politics. But in both cases, I think, the first half of the argument is right, but the second half is much more doubtful. There are political heroes in circa-1800 America, but to find them we are going to have look beyond the universe of people represented on dollar bills.

Against malinvestment. Brad Delong has, I think, the decisive criticism of malinvestment theories of the Great Recession and subsequent slow recovery. In terms of the volume of investment based on what turned out to be false expectations, and the subsequent loss of asset value, the dot-com bubble of the late 1990s was much bigger than the housing bubble. So why were the macroeconomic consequences so much milder?

Selective memory in Germany. Another valuable piece of political pre-history, this one of German anti-Keynesianism by Jörg Bibow. Among a number of valuable points, he describes how German economic debate has been shaped by a strangely selective history of the 20th century, from which depression and mass unemployment – the actual context for the rise of Nazism — have been erased. Failures of economic policy can only be imagined as runaway inflation.

The once and future bull market in bonds. Here is an interesting conversation between Srinivas Thiruvadanthai of the Levy Center and Tracy Alloway and Joe Weisenthal of Bloomberg, on the future of the bond market. Thiruvadanthai’s forecast: interest rates can fall quite a bit more in the coming decades. He makes several interesting and, to me, convincing points. First, that in an environment of large balance sheets, we can’t analyze the effects of things like interest rate changes just in terms of the real sector. The main effect of higher rates today wouldn’t be to discourage borrowing, but to raise the burden of existing debt. He also makes the converse argument, which I’m less sure about — that after another round or two of fiscal expansion and unconventional monetary policy, public sector debt could make up a large share of private balance sheets, with proportionately less private debt. Under those conditions, an increase in interest rates would be much less contractionary, or even expansionary, creating the possibility for much larger rate hikes if central banks continue to use conventional policy to stabilize demand.

More generally, he points out that, historically, the peacetime inflation of the 1970s is a unique event over the hundreds of years in which bond markets have existed, so it’s a little problematic to build a whole body of macroeconomic theory around that one episode, as we’ve done. And, he says, capitalism doesn’t normally face binding supply constraints — the vast majority of firms, the vast majority of the time, would be happy to sell more at their current prices. And he expresses some — much-needed, IMO — skepticism about whether central banks can in general hit an inflation target, reliably or at all.

Positive money? Here is a vigorous critique of 100 percent reserve backed, or positive, money. (An idea which is a staple of monetary reformers going back at least to David Hume, and perhaps most famous as the Chicago Plan.) I don’t have a settled view on this idea. I do think it’s interesting that the reforms the positive money people are calling for, are intended to produce essentially the tight link between public liabilities and private assets which MMT people claim already exists. And which Thiruvadanthai thinks we might inadvertently move toward in the future.

Captial flows: still unstable. Here’s a useful piece in VoxEU on the volatility of capital flows. Barry Eichengrreen and his coauthors confirm the conventional wisdom among heterodox critics of the Washington Consensus: free movement of finance is the enemy of macroeconomic stability. FDI flows — which are linked to the coordination of real productive activity across borders — are reasonably stable; but portfolio flows remain as prone to sudden stops and reversals as they’ve always been.

Killing conscience. Over at Evonomics, Lynn Stout makes the important point that any kind of productive activity depends on trust, norms, and the disinterested desire to do one’s job well – what Michelet called “the professional conscience.” These are undermined by the creation of formal incentives, especially monetary incentives. Incentives obstruct, discourage, even punish, the spontaneous “prosocial” behavior that actually makes organizations work, while encouraging the incentivized people to game the system in perverse ways. under socialism, to speak of someone’s interests will be considered an insult; to give someone incentives will be considered an act of violence.

It’s a good piece; the one thing I would add is that one reason incentives are used so widely despite their drawbacks is that they are are about control, as well as (or rather than) efficiency. Workers’ consciences are very powerful tools at eliciting effort; but the boss who depends on them is implicitly acknowledging a moral claim by those workers, and faces the prospect that conscience may at some point require something other than following orders.

The deficit is not the problem. Jared Bernstein makes the same argument about trade that I made in my Roosevelt Institute piece a few months ago. The macroeconomic-policy question posed by US trade deficits should not be, how do we move our trade towards balance? It should be: how do we ensure that the financial inflows that are the counterpart of the deficit, are invested productively?

We simply do not know. Nick Rowe has always been one of my favorite economics bloggers – a model for making rigorous arguments in a clear, accessible way. I don’t read him as consistently as I used to, or comment there any more — vita breve and all that — but he still is writing good stuff. Here he makes the common-sensical point that someone considering investment in long-lived capital goods does not face symmetric risks. “A recession means that capital services are wasted at the margin, because the extra output cannot be sold. But booms are not good, because a bigger queue of customers does nothing for profitability if you cannot produce more to meet the extra demand.” So uncertainty about future economic outcomes — or, what is not quite the same thing, greater expected variance — will depress the level of desired investment. I don’t know if Nick was thinking of Keynes — consciously or unconsciously when he wrote the post, but it’s very much in a Keynesian spirit. I’m thinking especially of the 1937 article “The General Theory of Employment,” where Keynes observes that to carry out investment according to the normal dictates of economic rationality, we must “assume that the present is a much more serviceable guide to the future than a candid examination of past experience would show it to have been hitherto.”

The health policy tightrope. The Republican plan health care plan, the CBO says, would increase the number of uninsured Americans by 24 million. I don’t know any reason to question this number. By some estimates, this will result in 40,000 additional deaths a year. By the same estimate, the Democratic status quo leaves 28 million people uninsured, implying a similar body count. Paul Ryan’s idea that health care should be a commodity to be bought in the market is cruel and absurd but the Democrats’ idea that heath insurance should be a commodity bought in the market is not obviously less so. Personally, I’m struggling to find the right balance between these two sets of facts. I suppose the first should get more weight right now, but I can’t let go of the second. Adam Gaffney does an admirable job managing this tightrope act in his assessment of the Obama health care legacy in Jacobin. (But I think he’s absolutely right, strategically, to focus on the Republicans for the Guardian’s different readership .)

On other blogs, other wonders.

I’m looking forward to reading Ann Pettifor’s new book on money. In the meantime, here’s an interview with her in Vogue.

Towards the Garfield left.

The end of austerity is perfectly feasible in Spain.

“Underfunded” doesn’t mean what it sounds like. Based on the excellent Sgouros piece I linked to earlier.

Uber is doomed.

The decline of blue-collar jobs. I admit I was surprised to see what a large share of employment manufacturing accounted for a generation ago.

Perry Anderson: Why the system will win. Very worth reading, like everything Anderson writes. But too sympathetic to anti-immigrant politics.

The ECB should give money directly to European citizens.

Manchester by the Sea is a good movie. But Margaret is a great movie.

Two Papers in Progress

There are two new papers on the articles page on this site. Both are work in progress – they haven’t been submitted anywhere yet.

[I’ve taken the debt-distribution paper down. It’s being revised.]

The Evolution of State-Local Balance Sheets in the US, 1953-2013

Slides

The first paper, which I presented in January in Chicago, is a critical assessment of the idea of a close link between income distribution and household debt. The idea is that rising debt is the result of rising inequality as lower-income households borrowed to maintain rising consumption standards in the face of stagnant incomes; this debt-financed consumption was critical to supporting aggregate demand in the period before 2008. This story is often associated with Ragnuram Rajan and Mian and Sufi but is also widely embraced on the left; it’s become almost conventional wisdom among Post Keynesian and Marxist economists. In my paper, I suggest some reasons for skepticism. First, there is not necessarily a close link between rising aggregate debt ratios and higher borrowing, and even less with higher consumption. Debt ratios depend on nominal income growth and interest payments as well as new borrowing, and debt mainly finances asset ownership, not current consumption. Second, aggregate consumption spending has not, contrary to common perceptions, risen as a share of GDP; it’s essentially flat since 1980. The apparent rise in the consumption share is entirely due to the combination of higher imputed noncash expenditure, such as owners’ equivalent rent; and third party health care spending (mostly Medicare). Both of these expenditure flows are treated as household consumption in the national accounts. But neither involves cash outlays by households, so they cannot affect household balance sheets. Third, household debt is concentrated near the top of the income distribution, not the bottom. Debt-income ratios peak between the 85th and 90th percentiles, with very low ratios in the lower half of the distribution. Most household debt is owed by the top 20 percent by income. Finally, most studies of consumption inequality find that it has risen hand-in-hand with income inequality; it appears that stagnant incomes for most households have simply meant stagnant living standards. To the extent demand has been sustained by “excess” consumption, it was more likely by the top 5 percent.

The paper as written is too polemical. I need to make the tone more neutral, tentative, exploratory. But I think the points here are important and have not been sufficiently grappled with by almost anyone claiming a strong link between debt and distribution.

The second paper is on state and local debt – I’ve blogged a bit about it here in the past few months. The paper uses budget and balance sheet data from the census of governments to make two main points. First, rising state and local government debt does not imply state and local government budget deficits. higher debt does not imply higher deficits: Debt ratios can also rise either because nominal income growth slows, or because governments are accumulating assets more rapidly. For the state and local sector as a whole, both these latter factors explain more of the rise in debt ratios than does the fiscal balance. (For variation in debt ratios across state governments, nominal income growth is not important, but asset accumulation is.) Second, despite balanced budget requirements, state and local governments do show substantial variation in fiscal balances, with the sector as a whole showing deficits and surpluses up to almost one percent of GDP. But unlike the federal government, the state and local governments accommodate fiscal imbalances entirely by varying the pace of asset accumulation. Credit-market borrowing does not seem to play any role — either in the aggregate or in individual states — in bridging gaps between current expenditure and revenue.

I will try to blog some more about both these papers in the coming days. Needless to say, comments are very welcome.

Demand and Productivity

I’m picking up, after some months, the project I was working on over the summer on potential output. Obviously the political context is different now. But the questions of what potential output actually means, how tightly it binds, and how close the economy is to it at any given moment, are not going away. Previous entries: one, two, three, four, and five.

You’ve probably heard the story about Ed Rensi, the former McDonald’s CEO who claimed the company’s move to replace cashier’s with self-serve kiosks was a response to minimum wage increases.

“I told you so,” he writes. “In 2013, when the Fight for $15 was still in its growth stage, I and others warned that union demands for a much higher minimum wage would force businesses with small profit margins to replace full-service employees with costly investments in self-service alternatives.”

Is this for real? Maybe not: The shift toward kiosks has been happening for a while, so it’s not just a response to the recent minimum wage hikes; and it may not end up reducing labor costs anyway.

But let’s say the move is as as Rensi claims. Then we should call it what it is: an increase in labor productivity. With fewer workers McDonald’s will produce just as many hamburgers; in other words, production per worker will be higher. [1]

As I’ve suggested, this sort of thing is a real problem for a certain strand of minimum wage advocacy. Advocates like to point to productivity gains in response to higher wages as an argument in their favor. (The gains are usually imagined in terms of loyalty, motivation, lower turnover, etc. rather than machines, but functionally it’s the same.) But productivity gains can only reduce the job losses from a minimum wage increase if those losses are large; they are not consistent with a story in which employment stays the same. [2]

But at the macro level, this dynamic has different implications. If the McDonald’s case is typical — if higher labor costs regularly lead to higher productivity — then we need to rethink our idea of supply constraints. There is more space for expansionary policy than we usually think.

Let’s start at the beginning. Suppose there is some policy change, or some random event, that boosts desired spending in the economy. It could be more government spending, it could be lower interest rates, it could be a rise in exports. What happens then?

In the conventional story, higher spending normally leads to greater production of goods and services, which in turn requires higher employment. This leaves fewer people unemployed. Lower unemployment increases the bargaining power of workers, forcing employers to bid up nominal wages. [3] These higher wages are passed on to prices, leading to higher inflation. When inflation reaches whatever level is considered price stability, then we say the economy is at full employment, or at potential output. (In this story the two are equivalent.) If spending continues to rise past this point, the responsible authorities (normally the central bank) will intervene to bring it back down.

This is the story you’ll find in any good undergraduate macroeconomics textbook. It’s a reasonable story, as far as these things go. In the strong form it’s usually given in, it implies a hard limit to how much demand can increase before inflation starts rising unacceptably. Once the pool of unemployed workers falls to the “full employment” level, any further increase in employment will lead to rapid increases in money wages, which will be passed on one for one to inflation.

One place this chain can break is that new workers are not necessarily drawn from the ranks of the currently unemployed — that is, if the size of the laborforce is endogenous. Insofar as people counted as out of the laborforce are in fact available for employment (or net immigration responds to demand), an increase in output doesn’t have to reduce the ranks of the officially unemployed. In other words, the official unemployment rate may underestimate the space available for raising output via increased employment. This motivates the question of how much the the fall in laborforce participation since 2007 is due to demographics, and how much is due to weak demand.

The conventional story can also break down at two other places if productivity growth is endogenous. First, output can increase without a proportionate increase in employment. And second, wages can rise without a proportionate rise in prices.

It’s useful to think about this in terms of a couple of accounting identities, which in my opinion should be part of every macroeconomics textbook. [4] The first is obvious (but worth spelling out), the second a little less so:

(1) growth in demand = percent change in labor productivity + percent change in employment + inflation

(2) percent change in nominal wages = percent change in labor productivity + percent change in labor share + inflation

The standard story is that productivity change on its own due to technology, and the labor shared is fixed and can be ignored in this context. If productivity and labor share can be taken as given, then an increase in demand (money spent on final goods and services) must lead to higher inflation if either employment fails to rise, or if it rises only with higher wages. In this story, if nominal wages rise thanks to a lower unemployment rats, that will pass on one for one to inflation. Pick up an advanced undergraduate textbook like Blanchard or Krugman or Carlin and Soskice, and you will find a Phillips curve of exactly this form, with exactly this story behind it. [5] Policy discussions at central banks conducted in same terms.

This is what underlies idea of hard supply constraints. Output growth is dictated by the fixed, exogenous growth of the laborforce and of productivity. If changes in demand push the economy off that fixed trajectory, all you’ll get is higher or lower inflation. Concretely: To keep inflation at 2 percent, unemployment must be such as to generate nominal wage growth 2 points above the technologically-determined growth of productivity.

But an alternative story is that variation in demand can lead to adjustment in one of the other terms. One possibility is that the laborforce adjusts, as participation rates vary in response to demand conditions. This is what is most often meant by hysteresis: persistent deviations in unemployment from the “natural” level lead to people entering or exiting the laborforce. That implies that even when headline unemployment rates are fairly low, further increases in employment may be possible without a rise in wages. Another possibility is that while higher employment will lead to (or require) higher wages, the wage increase is not passed on to prices but comes at the expense of profits instead. This is Anwar Shaikh’s classical Phillips curve; I’ve written about it here before.

A third possibility is that higher wages are accompanied by higher productivity. Again, this appears as a problem when we are talking about wage increases from legislation, union contracts, or similar developments. But it’s not a problem if the wage increases are thanks to low unemployment. In this case, the joint movement of wages and productivity just means that output can rise higher — that supply constraints are softer. That’s what I want to focus on now.

There are a number of reasons why productivity might rise with wages. Some of them simply amount to mismeasurement of employment — it appears that output per worker is rising but really the effective number of workers is. Others are more fundamental. If productivity responds strongly and persistently to demand, it blurs the distinction between aggregate supply and aggregate demand, to the point that it’s not clear what “potential output” even means.

Suppose we do find a consistent pattern where, if demand is strong, unemployment is low, and wages are rising rapidly, then productivity growth is high. What could be happening?

1. Increased hours. If we measure productivity as output per worker, as we usually do, then an increase in average hours worked will show up as an increase in productivity. There is a cyclical component to this — in recessions, employers reduce hours as well as laying off workers. According to the BLS, seasonally adjusted weekly hours fell from 34.4 prior to the recession to a low of 33.7 in summer 2009. While a 2 percent fall in hours might seem small, it’s a big change in less than two years, especially when you consider that real output per worker normally rises by less than 2 percent a year.

2. Workers moving into real jobs from pseudo-employment or disguised unemployment. In any economy there are activities that are formally classified as jobs but are not employment in any substantive sense — you can take these “jobs” without anyone making a decision to hire you, and they don’t come with a wage or any similar claim on any established production process. Joan Robinson’s examples were someone who gathers firewood in a poor country, or sells pencils on streetcorners in a richer one. You could add work in family businesses and various kinds of self-employment and commission-based work to this category. In countries with traditional rural sectors — not the US — work on a family farm is the big item here. These activities absorb people who are unable to find formal jobs; the marginal product of additional workers here is normally very low. So if higher demand draws people from this kind of disguised unemployment back into regular jobs, measured productivity will rise.

3. Workers may be more fully utilized at their existing jobs. Because hiring and firing is costly, business don’t immediately adjust staffing in response to changes in sales. when demand falls, businesses will initially keep some redundant workers because paying them is cheaper than laying them off and replacing them later; and when demand rises, businesses will first try to get more work out of existing employees rather than paying the costs of hiring more. Some of this takes the form of the hours adjustment above, but some of it simply takes the form of hiring “too little” or “too much” labor for the current level of production. These changes in the utilization of existing labor will show up as changes in labor productivity.

4. Higher wages may lead to more capital-intensive production. This is the McDonald’s story: When labor gets more expensive (or scarcer), businesses use more capital instead. This is presumably what people mean when they say “Econ 101” shows that rising wages lead to less employment (assuming they mean anything at all). This may be seen as a negative when it’s a question of raising wages through legislation or unions, but it shouldn’t be when it’s a question of rising wages due to labor scarcity. Insofar as businesses can substitute machines for labor, rising wages will not be passed on to prices, so there is more space to push unemployment down.

5. Productivity-boosting innovations may be more likely when demand is strong and wages rise. This is a variant of the previous story. Now instead of high wage leading business to adopt more capital-intensive techniques from those already available, they redirect innovation toward developing new labor-saving techniques. Conceptually this is not a big difference, but it implies a different signal in the data. In the previous case we would expect the productivity improvements to be associated with higher investment and to be concentrated at the firms actually experiencing higher wages costs; in this case they might not be.

6. The composition of employment may shift toward higher-productivity sectors. This might happen for either of two reasons. First, higher wages will disproportionately raise costs for more labor-intensive sectors; these higher costs may be absorbed by profits or by prices, but either way they will presumably depress growth in those sectors to the benefit of less labor-intensive, more productive ones. Second, it may so happen that the more income-elastic sectors are also higher-productivity ones. In the short run this is presumably true since durables and investment goods are both capital-intensive and income-elastic. Over the longer run, the opposite is more likely — the composition of demand slowly but steadily shifts toward lower-productivity sectors.

7. The composition of employment may shift toward higher-productivity firms. This sounds similar but it’s a different story. Technical change isn’t an ineffable output-raising essence diffusing across society, it’s embodied in specific new production processes and new businesses — Schumpeter’s new plant, new firms, new men. This means that productivity increases often require new or growing firms to attract workers away from established ones. Given the “frictions” in the labor market, this will require offering a wage significantly above the going rate. And on the other side the fact that the least productive firms can’t afford to pay higher wages will cause them to decline or exit, which also raises average productivity. When wages are flat, on the other hand, low-productivity firms can continue operating. In this sense, higher wages are an integral part of productivity growth. [6]

8. There may be increasing returns in production. It may literally be the case that output per worker rises — at the firm, industry or economy-wide level — when the number of workers rises. Or this may be a more abstract version of some of the stories above. It’s worth noting that increasing returns is an area where the intuitions of people with economics training diverge sharply from people who look at the economy through other lenses. To almost anyone except an economist, it’s obvious that costs normally fall as more of something is produced. [7]

All of these stories imply that higher demand should lead to higher measured labor productivity. But to figure out how strong this relationship is in reality, we’ll look at different data depending on which of these stories we think it works through.

Another important difference between the stories is they imply different domains over which the relationship should operate. The first three suggest a more or less immediate response of productivity to changes in demand, but also one that cannot continue indefinitely. There’s limits to how much hours per worker can rise and how much additional effort can be extracted from the existing workforce, and a limited pool of disguised unemployment to draw from. (The last is not true in developing countries, where the “latent reserve army” in subsistence agriculture may be effectively unlimited.) The other mechanisms are presumably slower, requiring a sustained “high-pressure economy.” With these stories, increased demand may push the economy up against supply constraints, with rising inflation, bottlenecks, and so on; but if it keeps pushing against them, eventually they’ll give. In this case, potential output is a medium-term constraint — over longer periods it can adjust to actual output, rather than the reverse. So in the opposite of conventional story, a temporary increase in inflation can lead to a permanent increase in output. People like Laurence Ball say exactly this about hysteresis, but they are usually thinking of the longer-run adjustment coming on the laborforce side.

If we follow this a step further, we could even say that in the long run, the big problem isn’t that excessively high wages do lead to the substitution of capital for labor but that excessively low wages don’t. People like Arthur Lewis argue that it’s the low wages of poor countries that have led to low productivity there, and not vice versa; there’s a well-known argument that the reason the industrial revolution happened first in Britain rather than in China or India (or Italy or France) is not that that the necessary technical innovations were present only in Britain. They were present many places; it was the uniquely high cost of British labor that made them profitable to adopt for production.

I think that productivity does respond to demand. I think this is a good reason to doubt whether the US economy close to “potential output” today, and to doubt what, if anything, this concept actually means. But I also think we need to be clearer about how they are linked concretely. If we want to tell a story about productivity responding to demand, it makes a difference which of the stories above we have in mind. Heterodox people, it seems to me, are too quick to just invoke Verdoorn’s law (productivity rises with output), and justify it with some vague comments about how labor is used more efficiently when it is scarce. [8] Does this apparent law work via substitution of machines for labor, or through fuller utilization of existing employees’ times, or through reallocation of labor to more productive firms and/or industries, or through a labor-saving-bias in technical change, or pure increasing returns, or what? If you’re just making a formal model it may not matter. But if we want to connect the model to concrete historical developments, it certainly does.

Personally, I am most interested in the reallocation stories. They shift our idea of the fundamental constraint on capitalist economies from biophysical resources, to coordination. The great difficulty for any program of raise or transform production — industrialization, wartime mobilization, decarbonization — isn’t the limited supply of “real” resources, but the speed at which people’s productive activity can be redirected in a coordinated way. This connects with the historical fact that the more rapid and the larger scale is economic development, the more it requires some form of central planning. And it implies that at the most basic level, what the capitalist provides is not money or means of production, but cooperation.

To tell this story, it would be nice if big shifts in productivity growth took the form of changes in the composition of employment, rather than higher output per worker in given jobs. That may or may not be there in the data. For the more immediate question of how much space there is in the US for further expansion, it doesn’t matter as much which of these stories is at work, as long as we can show that at least some of them are. [9]

In the next post or two — which I hope to write in the next week, but we’ll see — I will ask what we can say about the link between demand and productivity based on historical US data. In particular, it’s fairly straightforward to decompose changes in output per worker into three components: within-industry output per hour, within-industry hours per worker, and shifts in the employment between industries. Splitting up productivity growth this way cannot, of course, directly establish a causal link with demand. but it can help clarify which stories are plausible and which are not.

[1] Throughout this discussion, I use “productivity” to mean labor productivity — output per worker or per hour. There is also “total factor productivity,” which purports to be a measure of output for a given input of labor and capital. This concept, which IMF chief economist Paul Romer memorably called “phlogiston,” is measured as the residual from a production function — the output growth the function does not explain. Since construction of the production function requires several unobseravable parameters, total factor productivity cannot be derived even in principle from economic data. It’s a fun toy for economic theory but useless for describing the behavior of actual economies.

Nonetheless it is widely used — for instance by the CBO as discussed here. As Nathan Tankus pointed out to me the other day, under the ARRA Medicare payments to hospitals are reduced each year based on an estimate of TFP growth for the economy as a whole. It’s a great example of the crackpot wonkery of the law’s authors.

[2] Unless productivity improvements all take the form of higher quality, rather than higher output per worker.

[3] This unemployment-money wages relationship was the original Phillips curve, but it’s better now to refer to it as a wage curve.

[4] It’s a topic for another time, but I think it would be very natural to replace the “aggregate supply” framework of the textbooks with these two identities.

[5] Other textbooks, like Mankiw, base the wage-unemployment relationship on a labor-supply curve rather than a bargaining relationship. Graduate textbooks, of course, replace the institutional detail of workers and employers with a single representative agent, in order to make more space for playing with math.

[6] Andrew Glyn and his coauthors have a good discussion of this in the context of the postwar boom in Capitalism Since 1945 (p. 122-123).

[7] For example, here’s Laurie Winkless in Science and the City, which happens to be sitting nearby:

Bessemer’s system rapidly began to change the world of steel manufacturing, and by 1875, costs had dropped to $32 (£23) per tonne. as always, in the supply-and-demand equation, the availability of cheap, high-quality steel made it immensely popular, leading to another huge drop in the price per tonne.

Winkless has made the mistake of studying the actual history of the steel history. If she were an economist, she would know that in the world of supply and demand, immense popularity makes prices rise, not fall!

[8] In Shaikh’s Capitalism, for example, there are a number of models that rely on the claim that productivity rises with output. It’s a big book and I may well have missed a part where he explains more fully why this is true. But as far as I can tell, all he says is that higher unit labor costs “provide a strong incentive for firms to raise productivity.”

[9] The politics of this question under Trump are for another time. But certainly Jeff Spross is right that we don’t want to oppose Trump’s (dubious) plans for a big stimulus by embracing the politics of austerity. We should not respond to Trump by reflexively insisting that the US is already at full employment, and by mocking “vulgar Keynesians” who think there might still be problems for macro policy to solve.

EDIT: Fixed the footnote numbering, which was garbled before.

Can We Blame Low Labor Participation on Past High Unemployment?

Fifth post in a series. Posts one, two, three and four.

We know that US GDP fell sharply in 2008-2009. We know that none of that decline has been made up by faster growth since the recession: GDP today is about 14 percent below the pre-2008 trend, a gap that shows no sign of closing. We also know that one-third of that shortfall is accounted for by slower productivity growth, and the remaining two-thirds by slower employment growth.

To put numbers on it: Over the past decade, US employment rose by a total of 6 percent, or about 0.5 percent per year. This is about half the rate of employment growth over the last ten years before the recession, and less a quarter the average rate for the postwar period as a whole. 2000-2010 was the first decade since the Depression in which US employment actually fell. Since the unemployment rate today is very close to that of ten years ago, this whole slowdown is accounted for by a decline in laborforce participation.

Employment growth, unlike productivity growth, was already slowing prior to the recession, and pre-recession forecasts predicted a further slowdown comparable to what actually occurred. This is consistent with a widely-held view that the slowdown in employment is the result of demographic and other structural factors, not of the recession or demand weakness in general. In the next couple posts, I want to take a critical look at this claim. How confident should we be that employment would be the same today in a counterfactual world where the 2008-2009 didn’t happen? How responsive might employment be to stronger demand going forward? And more broadly, how much do changes in laborforce participation seem to be explained by more or less exogenous factors like demographics, and how much by demand and labor-market conditions?

The rest of this post is about an approach to this question that did not produce the results I was hoping for. So I probably won’t include this material in whatever paper comes out of these posts. But as we feel our way into reality it’s important to note down the dead ends as well as the routes that seem promising. And even though this exercise didn’t help much in answering the big questions posed in the previous paragraph, it’s still interesting in its own right.

Can the fall in laborforce participation be explained as a direct, predictable effect of the rise in unemployment during the recession? It seems like maybe it can. The starting point is the observation that unemployed workers are much more likely to drop out of the laborforce than people with jobs are. You can see this clearly in the BLS tables on employment transitions. As the figure below shows, about 3 percent of employed people exit the laborforce each month, a fraction that has been remarkably stable since the data begins in 1990. Meanwhile, about 20 percent of unemployed people drop out of the laborforce each month.

On the face of it, this 17-point difference suggests an important role for the unemployment rate in changes in labor force participation. All else equal, each year-point of additional unemployment should reduce the labor-force participation rate by two points. (0.17 x 12 = 2.) So you would think that much of the recent fall in laborforce participation could be explained simply by the rise in unemployment during the recession.

When I thought of this it seemed very logical. It would be easy to do a counterfactual exercise, I thought, showing how laborforce participation would have evolved simply based on the historical transition rates between employment, unemployment and out of the laborforce, and the actual evolution of employment and unemployment. If you could show that something like the actual fall in laborforce participation was a predictable result of the rise in unemployment during the recession, that would support the idea that demand rather than “structural” factors are at work. And even if it wasn’t that strong positive evidence, it would suggest skepticism about similar counterfactual exercises using historical participation rates by age and so on.

I mean, it makes sense, right? Unemployed people are much more likely to leave the workforce than employed people, so a rise in unemployment should naturally lead to a decline in laborforce participation. But as the figure below shows, the numbers don’t work.

What I did was start with the populations of employe, unemployed and not-in-the-laborforce people at the end of the recession in December 2009. Then I created a counterfactual scenario for the remaining period using the actual transition rates between employment and unemployment but the pre-recession average rates for transitions between not in the workforce and unemployment and employment. In other words, just knowing the average rates that people move between employment, unemployment and out of the workforce, and the actual shifts between employment and unemployment, what path would you have predicted for laborforce participation over 2010-2016?

The heavy gray line shows the historical fraction of the population aged 16 and over who are not in the laborforce. The black line shows the results of the counterfactual exercise. Not very close.

There turn out to be two reasons why the counterfactual exercise gives such a poor fit. Both are interesting and neither was obvious before doing the exercise. The first reason is that there are surprisingly large flows from out of the labor force back into it. Per the BLS, about 7 percent of people who report being out of the labor force in a given month are either employed or unemployed (i.e. actively seeking work) the following month. This implies that the typical duration of being out of the workforce is less than a year — though of course this is a mix of people who leave the workforce for just a month or two and people who leave for good. For present purposes, the important thing is that exogenous changes to the employment-population ratio decline quickly, with a half-life of only about a year. So while the historical data suggests that a rise in unemployment like we saw in 2008-2009 should have been associated with a large rise in the share of the population not in the laborforce, it also suggests that this effect should have been transitory — a couple years after unemployment rates returned to normal, participation rates should have as well. This is not what we’ve seen.

The large gross movements in and out of the laborforce mean that sustained lower participation rates can’t be straightforwardly understood as the “echo” of high unemployment in the past. But they do also tend to undermine the structural story — if the typical stint outside the laborforce lasts less than a year it can hardly be due to something immutable.

The second reason why the counterfactual doesn’t fit the data was even more surprising, at least to me. I constructed my series using the historical average transition rates into and out of the workforce. But transition rates during the recession and early recovery departed from the historical average in an important way: unemployed workers were significantly less likely to exit the workforce. This turns out to be the normal pattern, at least over the previous two business cycles — if you look back to that first figure, you can see dips in the transition rate from unemployed to out of the workforce in the early 1990s and early 2000s downturns as well. The relationship is clearer in the next figure, a scatter of the unemployment rate and the share of unemployed workers leaving the workforce each month.

As you can see, there is a strong negative relationship — when unemployment was around 4 percent in 1999-2000 and again in 2006-2007, about a quarter of the unemployed exited the laborforce each month. But at the peak of the past recession when unemployment reached 10 percent, only 18 percent of the unemployed left the laborforce each month. That might not seem like a huge difference, but it’s enough to produce quite different dynamics. It’s also a bit surprising, since you would think that people would be more likely to give up searching for work when unemployment is high than when when it is low. The obvious explanation would be that the people who are out of work when the unemployment rate is low are not simply a smaller set of the same people who are out of work when the rate is high, but are different in some way. The same factors that keep them at the back of the hiring queue may make also be likely to push them out of the laborforce altogether. Extended unemployment insurance might also play a role.

It would be possible to explore this further using CPS data, which is the source for the BLS tables I’m working with. No doubt there are papers out there describing the different characteristics of the unemployed in periods of high versus low unemployment. (Not being a labor economist, I don’t know this literature.) But I am going to leave it here.

Summary: The fact that unemployed people are much more likely to leave the laborforce than employed people are, suggests that some part of the fall in laborforce particiaption since 2008 might be explained by the lingering effects of high unemployment in the recession and early recovery. But this story turns out not tow work, for two reasons. First, the rapid turnover of the not in the laborforce population means that this direct effect of high unemployment on participation is fairly shortlived. Second, the rate at which unemployed people exit the laborforce turns out to be lower when unemployment is high. Together, these two factors produce the results shown in the second figure — the fall in participation you would predict based simply on high unemployment is steeper but shorter-lived than what actually occurred. The first factor — the large flows in and out of the laborforce — while it vitiates the simple story I proposed here, is consistent with a broader focus on demand rather than demographics as an explanation for slow employment growth. If people are frequently moving in and out of the laborforce, it’s likely that their decisions are influenced by their employment prospects, and it means they’re not determined by fixed characteristics like age. The second factor — that unemployed people were less likely to give up looking for jobs during 2009-2011, as in previous periods of high unemployment — is, to me, more surprising, and harder to fit into a demand-side story.