Bleak Apologists

Federal Reserve economist David Andolfatto says maybe there is no output gap.

The output gap is the gap between where we are and where we ought to be. People who see an output gap think we ought to be on the same GDP path we were on before the crisis. But, Andolfatto says, maybe potential output has collapsed. Maybe "where we ought to be" has collapsed, and maybe where we are today is as good as it gets. Andolfatto, and his boss James Bullard, and their friends Cochrane and Taylor.

Bullard writes:

For those who take the “large output gap” view, the expectation is for real GDP to grow rapidly after the recession comes to an end, as the economy catches up to its potential. It is like a rubber band, there is supposed to be a bounce back period of rapid growth. In fact, most analysts have been looking for exactly this effect since the summer of 2009. It has not happened. This has led to a lot of analysis concerning special factors and headwinds that might be inhibiting the “bounce back” effect.

The wealth shock view puts a different expectation in play. The negative wealth shock lowers consumption and output. But after the recession ends, the economy simply grows from that point at an ordinary rate, neither faster nor slower than in ordinary times. It is more like an earthquake which has left one part of the land higher than another part. There is no expectation of a “bounce back” to a higher level of output after the recession ends. This is closer to what has actually happened since mid-2009.

Taylor's graphs show both circumstances:

Large Output Gap, and Bounce-Back after the 1981 Recession

Wealth Shock, and NO Bounce-Back after the 2008 Recession

Bullard seems to be saying that it's potential output that is wrong, that a realistic evaluation would have us push the red line down to meet the blue, rather than expecting the blue line to bounce back up and meet the red.

Talk about lowering expectations!

What Bullard's "Wealth Shock" view means, if true, is less income all around -- "perhaps 5.5 percent" less, he says. Or, if the proceeds of growth are not evenly distributed, more that 5.5 percent less, for most of us.


Andolfatto writes:

I think that Bullard makes a persuasive case that the amount of household wealth evaporated along with the crash in house prices should likely be viewed as a "permanent" (highly persistent) negative wealth shock... The implication is that the so-called "output gap" (the difference between actual and "trend" GDP) may be greatly overstated by conventional measures.

The view that one takes here is likely to influence what one thinks about monetary policy. The conventional view seems to support the Fed's current policy of keeping its policy rate close to zero far into the future. In his speech, Bullard worries that this may not be the appropriate policy if, in fact, potential GDP has experienced a level shift down (or, what amounts to the same thing, if conventional measures treat the "bubble period" as the economy being at, and not above, potential).

Fair enough. If we think of the housing bubble years as "normal" we are probably overestimating potential output now. And if that's the case, our overestimate does not apply only to the years after the recession.

The housing bubble years. Bubble years are good years -- unsustainable, but good. So the housing bubble years should have been better than normal I should think. After all, housing is the backbone of the U.S. economy. A magnificent boom in housing should have made the whole economy magnificent. And yet Robert Brenner observes

the business cycle that just ended, from 2001 through 2007, was -- by far -- the weakest of the postwar period...

Despite the major stimulus provided by a bubble in housing, the performance of the economy was weak. Weak, when it should have been better than normal.

David Andolfatto wants us to think that our expectations were too great. He is concerned that we'll get policy wrong if we think of the economy in those years as normal rather than bubbly -- "if conventional measures treat the 'bubble period' as the economy being at, and not above, potential." And weak as the economy was in those years, Andolfatto wants us to think of 2001-2007 as above potential.


If DA didn't stop there, I might agree with him. If he was trying to explain why GDP was slumping and why potential GDP was slumping -- because of excessive private debt, for example -- I would have some use for his analysis. But like Bullard, he brushes aside any concern with "special factors and headwinds". David Andolfatto seems to be saying only that things are bleak and we ought not expect anything better.

And Bullard? Good god, Bullard is ready to create another recession right now. In the opening statement of his 6 Feb 2012 paper, he says

At the January meeting, the Federal Open Market Committee (FOMC) took an important step forward by naming an explicit, numerical inflation target for the U.S. of 2 percent, as measured by the personal consumption expenditures (PCE) price index.

We now have an official inflation target of two percent. Next, Bullard says

In a targeting context, inflation means headline inflation... By the headline PCE measure, U.S. inflation is running somewhat above target right now, at 2.4 percent...

We are now ABOVE our official inflation target of two percent. It is time, Bullard implies, time to jack up interest rates and tamp out growth.

This is Part One	[ Part 2 ]	[ Part 3 ]