Endogenous supply and depressed demand

I noted in my last post that without fiscal austerity the US, UK and Eurozone could currently be at output levels that are above current estimates of potential or natural output. (For the US a chart is here.) In other words the output gap would be positive rather than negative. One response to that is to say without any fiscal austerity monetary policy would have raised rates. But are these estimates of potential output really independent of the path of actual output?

In a stylised view of macroeconomics the two are independent. Productive potential calculates how much you could produce if both labour and capital was fully employed using technology that itself is independent of current and past levels of output. You can say the same thing in a more kosher way by talking about natural output involving individuals working the amount they wish given real wages that reflect market clearing etc.

We know that stylised view is wrong for a variety of reasons. Labour that has been unemployed may become deskilled. Firms that are forced to cut back on investment in a recession may take time to rebuild their productive capacity. However there may be other ways it is wrong for reasons that are much more difficult to quantity. In particular, if investment falls in a recession, new technology that has to be embodied in new machines may fail to emerge, so the rate of technological progress may appear to decline.

These processes may not matter too much in normal (mild and short lived) booms and busts. However following a large recession they may become more important. As many have noted (e.g. Larry Ball here), estimates of the growth rate of productive potential made by organisations like the OECD and IMF have been revised down substantially since the Great Recession. The bigger the recession, the larger the fall in potential. As I noted here, to rationalise this as a gradual supply side reduction in the rate of technical progress (i.e. to avoid assuming technological regress), these organisations have had to also revise their view of pre-recession output gaps, to give what are frankly ludicrous numbers. It seems much more probable that estimates of productive potential are strongly influenced by actual levels of output.

If true, this is in one sense very optimistic. The process could be reversible. We could expand the economy by much more than most estimates of the output gap suggest, and estimates of productive potential would to some extent rise too. As I have said many times, given this possibility (and the huge costs of underestimating what potential is) we really should explore it by keeping policy as expansionary as possible until movements in inflation clearly tell us we have gone as far as we can. But this raises another puzzle. If we have the capacity to produce much more, why is demand so weak, when interest rates remain at the Zero Lower Bound (ZLB)? [1]

It is possible to construct sophisticated models of multiple equilibria where beliefs (animal spirits if you like) can shift us between equilibria. Roger Farmer is the most notable example of someone who has explored this possibility (see also David Andolfatto recently). Here I just want to make a simple observation about why we should take such possibilities seriously. The largest component of aggregate demand is consumption, and consumption depends on expected income, which can depend itself on actual output, and therefore on aggregate demand. The macroeconomy is therefore set up to allow self-fulfilling multiple equilibria.

That possibility is plausibly bounded on the up side. Goods have to be produced with capital and labour, and at some point workers at least will start demanding higher wages to work longer, generating inflation, which monetary policy reacts to by reducing demand. But the mechanisms that stop self-fulfilling beliefs on the down side are more problematic. Monetary policy finds it difficult to stimulate demand if interest rates hit the ZLB, particularly in a world of inflation targets. At the ZLB continuously falling inflation would become a liability (pushing up real interest rates), but thankfully inflation may become very sticky near zero. The unemployed may drift out of the labour force, or may become self-employed and produce much less, or real wages may fall such that firms start adopting more labour intensive techniques. For all these reasons, deficient demand may become persistent, to some extent disguised and not obviously self-correcting.

Just think about what has happened in the years following the Great Recession. Central banks and governments have steadily revised down their views of what the long run level of output is. It is hardly surprising in these circumstances, and with real wages stagnant or falling, that consumers would also revise down estimates of their long run income, and adjust consumption accordingly. In that way, demand appears to match a pessimistic view about long run supply.

You should not ask how sure I am about such stories, but how certain you are that they are wrong. If you are not certain, then the moral is the same: after a severe recession which appears to result in a loss of capacity, you use policy to explore the boundaries of just how much capacity has really been lost, and run the risk that inflation may rise as you do so. You do not sit back, tell yourself that below target inflation is probably temporary, and do nothing. And, of course, you do not plan for more fiscal austerity.  

[1] Some central banks, most recently the Bank of England, appear to be revising what they think the actual lower bound is. According to Britmouse, that means I should no longer talk about either the ZLB or fiscal policy. Or as the skipper of the Titanic might have said, that iceberg really shouldn’t have been there.