When is an economic recovery not a recovery?

This post may seem to be unusually pedantic, but please be patient

What do we mean when we say the economy is recovering from a recession? Do we mean it has started growing again, or do we mean it is returning to its pre-recession trend? Brief research suggests there is no standard definition, but Wikipedia is clear it is the latter:

“An economic recovery is the phase of the business cycle following a recession, during which an economy regains and exceeds peak employment and output levels achieved prior to downturn. A recovery period is typically characterized by abnormally high levels of growth in real gross domestic product, employment, corporate profits, and other indicators.”

The second sentence is crucial here. All economies grow on average: they have a positive trend growth rate. An economic downturn (or worse still a recession) involves the economy dipping below trend (or in a recession not growing at all). Typically whenever that has happened in the past, most economies make up for the growth they lost in the downturn, by growing more rapidly than trend once the downturn is over. This had certainly been true for the UK. We expect economies to grow over time because of technical progress, so it seems almost obvious that a recovery must involve above average growth until we return to something like an underlying trend.

Imagine a 5,000 metres race. Suppose an athlete trips and stumbles, leaving the main pack behind. If 5 minutes later I said the athlete was recovering, would you think this meant that they were getting back to their previous pace but still well behind the main group, or that they were getting back in touch with the main pack? I suspect you would think it meant the latter, and you would call a complete recovery when they were back within the main group. If you think about the main group as the underlying trend path of the economy, then a recovery in growth means getting back towards this trend path.

For this reason I would define a recovery from recession as above trend growth, and I think most macroeconomists would do the same. Here is recent quarterly growth in UK GDP per head.

The red line is the pre-crisis trend growth rate. You can see from this that only 2014 could possibly be called a recovery, and even that is a bit of a stretch. The UK is far from unique in this respect, but unlike other countries the UK economy has a pretty clear and unchanged trend growth rate since the 1950s. Until now that is. This global lack of recovery begs many important questions, which those who read economics blogs will be very familiar with: has the financial crisis had a permanent negative effect on productive potential, was the pre-crisis period really a disguised boom, are we suffering from secular stagnation, what role did austerity play?

Yet all of these important issues are sidelined in popular discussion if we misuse the term recovery, and instead describe any positive growth after a recession as a recovery. This is not a problem for economists, who tend to talk numbers, but it does matter for the public debate. I cannot help feeling that calling any positive growth after a recession a recovery also adds to a sense of disconnect people have, particularly when (as in the UK) there has really been a recovery in employment, such that productivity has been virtually flat. People ask how come there has been a recovery and yet my wages are still so much lower in real terms than they used to be?.

When the underlying trend may have slowed or shifted, then it becomes difficult to know what is or is not a recovery, but that is no reason to misuse the term. When we are talking about the past, then things should be clear. Here is the same data for 1981.

It is obvious from this data that the recovery from the 1980 recession only really began in 1983. The two previous years saw as many periods of below trend growth as above trend growth: given normal growth, the economy was effectively standing still. Unless, of course, you have a political point to prove. In 1981 the Conservative government of Margaret Thatcher raised taxes substantially in the Spring Budget, despite just seeing 5 quarters of falling output per head. They increased taxes after falling output because they wanted to reduce the budget deficit. 364 academic economists quickly wrote a letter denouncing the policy - a Brexit like majority at the time.

In 2006 Philip Booth of the Institute of Economic Affairs wrote this:

“The economic recovery that the 364 said would not happen began more or less as soon as the letter appeared.”

This sentence has been repeated time after time by right wing economists and politicians: so often that it is now repeated as fact by BBC journalists. It has become what I call a politicised truth: something that is false but is perceived to be true by journalists who talk to politicians but not academics. And the statement that the recovery began as soon as the letter appeared is simply false if you use the term recovery properly: the recovery began a year and a half later. Had fiscal policy not been tightened in the 1981 budget, the recovery might have begun earlier than the end of 1982. In that sense, the economists were vindicated by subsequent events.

In 2010, George Osborne was warned by many academic economists - almost certainly a majority at the time - that embarking on austerity so soon after the recession was folly. But, just as in 1981, he wanted to reduce the deficit. It is not difficult to imagine that as he pondered these warnings from academics, he thought to himself that Margaret Thatcher got the same advice in 1981 and everything he had read said the advice was wrong because the recovery started immediately after taxes were increased. He would have been emboldened to do the same, with what we now know were disastrous consequences. Just two years later, GDP per head had lost another 3% or more relative to trend.

This is partly a story about the dangers of propaganda that you begin to believe yourself. But it is also about the potential ambiguity of one single word: recovery.

The centrality of policy to how long recessions last

For economists

Paul Krugman reminds us that one of the most misguided questions in macroeconomics is ‘are business cycles self-correcting’. This is a particular case of another mistake, which is to say that the duration of the business cycle depends on the speed of price adjustment. That answer is seriously incomplete, because it only holds for a particular set of monetary policy rules (plus assumptions about fiscal policy).

It is very easy to see this. Suppose monetary policy is so astute that it knows perfectly all the shocks that hit the economy, and how interest rates influence that economy. In that case absent the Zero Lower Bound the business cycle would disappear, whatever the speed of price adjustment. Or suppose monetary policy followed a credible rule that related real interest rates to the output gap rather than excess inflation. Once again the speed of price adjustment is not central to how long business cycles last. As Nick Rowe points out, if you had a really bad monetary policy recessions could last forever.

A better answer to both questions (self-correction and how long business cycles last) is it all depends on monetary policy. Actually even that answer makes an implicit assumption, which is that there is no fiscal (de)stabilisation. The correct answer to both questions is that it depends first and foremost on policy. The speed of price adjustment only becomes central for particular policy rules.

So why do many economists (including occasionally some macroeconomists) get this wrong? Why are textbooks often quite unclear on this point? It could be just an unfortunate accident. We are so used to teaching about fixed money supply rules (or in my case Taylor rules), that we can take those rules for granted. But there is also a more interesting answer. To some economists with a particular point of view, the idea that getting policy right might be essential to whether the economy self-corrects from shocks is troubling. They prefer to think of a market economy as being ‘naturally’ self-correcting, and to think that government intervention only has a role to play if there is some serious ‘market imperfection’. The market imperfection in the case of business cycles is price rigidity.

Focusing on this logic alone can lead to big mistakes. I have heard a number of times good economists say that in 2015 we can no longer be in a demand deficient recession, because price adjustment cannot be that slow. This mistake happens because they take good policy for granted. It is almost certainly true that no recession should last this long, because fiscal policy can substitute for monetary policy at the Zero Lower Bound. But with sub-optimal policy the length of recessions has much more to do with that bad policy than it has to do with the speed of price adjustment.

Just how misleading a focus on the speed of price adjustment can be becomes evident at the Zero Lower Bound. With nominal interest rates stuck at zero, rapid price adjustment will make the recession worse, not better. Price rigidity may be a condition for the existence of business cycles, but it can have very little to do with their duration.        

Microfounded Social Welfare Functions

More on Beauty and Truth for economists

I have just been rereading Ricardo Caballero’s Journal of Economic Perspectives paper entitled “Macroeconomics after the Crisis: Time to Deal with the Pretense-of-Knowledge Syndrome”. I particularly like this quote:

The dynamic stochastic general equilibrium strategy is so attractive, and even plain addictive, because it allows one to generate impulse responses that can be fully described in terms of seemingly scientific statements. The model is an irresistible snake-charmer.

I thought of this when describing here (footnote [5]) Woodford’s derivation of social welfare functions from representative agent’s utility. Although it has now become a standard part of the DSGE toolkit, I remember when I had to really work through the maths for this paper. I recall how exciting it was, first to be able to say something about policy objectives that was more than ad hoc, and secondly to see how terms in second order Taylor expansions nicely cancelled out when first order conditions describing optimal individual behaviour were added.

This kind of exercise can tell us some things that are interesting. But can it provide us with a realistic (as opposed to model consistent) social welfare function that should guide many monetary and fiscal policy decisions? Absolutely not. As I noted in that recent post, these derived social welfare functions typically tell you that deviations of inflation from target are much more important than output gaps - ten or twenty times more important. If this was really the case, and given the uncertainties surrounding measurement of the output gap, it would be tempting to make central banks pure (not flexible) inflation targeters - what Mervyn King calls inflation nutters.

Where does this result come from? The inflation term in Woodford’s derivation of social welfare comes from relative price distortions when prices are sticky due to Calvo contracts. Let’s assume for the sake of argument that these costs are captured correctly. The output gap term comes from sticky prices leading to fluctuations in consumption and fluctuations in labour supply. Lucas famously argued [1] that the former are small. Again, for the sake of argument lets focus on fluctuations in labour supply.

Many DSGE models use sticky prices and not sticky wages, so labour markets clear. They tend, partly as a result, to assume labour supply is elastic. Gaps between the marginal product of labor and the marginal rate of substitution between consumption and leisure become small. Canzoneri and coauthors show here how sticky wages and more inelastic labour supply will increase the cost of output fluctuations: agents are now working more or less as a result of fluctuations in labour demand, and inelasticity means that these fluctuations are more costly in terms of utility. Canzoneri et al argue that labour supply inelasticity is more consistent with micro evidence.

Just as important, I would suggest, is heterogeneity. The labour supply of many agents is largely unaffected by recessions, while others lose their jobs and become unemployed. Now this will matter in ways that models in principle can quantify. Large losses for a few are more costly than the same aggregate loss equally spread. Yet I believe even this would not come near to describing the unhappiness the unemployed actually feel (see Chris Dillow here). For many there is a psychological/social cost to unemployment that our standard models just do not capture. Other evidence tends to corroborate this happiness data.

So there are two general points here. First, simplifications made to ensure DSGE analysis remains tractable tend to diminish the importance of output gap fluctuations. Second, the simple microfoundations we use are not very good at capturing how people feel about being unemployed. What this implies is that conclusions about inflation/output trade-offs, or the cost of business cycles, derived from microfounded social welfare functions in DSGE models will be highly suspect, and almost certainly biased.

Now I do not want to use this as a stick to beat up DSGE models, because often there is a simple and straightforward solution. Just recalculate any results using an alternative social welfare function where the cost of output gaps is equal to the cost of inflation. For many questions addressed by these models results will be robust, which is worth knowing. If they are not, that is worth knowing too. So its a virtually costless thing to do, with clear benefits.

Yet it is rarely done. I suspect the reason why is that a referee would say ‘but that ad hoc (aka more realistic) social welfare function is inconsistent with the rest of your model. Your complete model becomes internally inconsistent, and therefore no longer properly microfounded.’ This is so wrong. It is modelling what we can microfound, rather than modelling what we can see. Let me quote Caballero again

“[This suggests a discipline that] has become so mesmerized with its own internal logic that it has begun to confuse the precision it has achieved about its own world with the precision that it has about the real one.”

As I have argued before (post here, article here), those using microfoundations should be pragmatic about the need to sometimes depart from those microfoundations when there are clear reasons for doing so. (For an example of this pragmatic approach to social welfare functions in the context of US monetary policy, see this paper by Chen, Kirsanova and Leith.) The microfoundation purist position is a snake charmer, and has to be faced down.

[1] Lucas, R. E., 2003, Macroeconomic Priorities, American Economic Review 93(1): 1-14.