Economics students
are taught from an early age that in the short run aggregate demand
matters, but in the long run output is determined from the supply
side. A better way of putting it is that supply adjusts to demand in
the short run, but demand adjusts to supply in the long run. A key
part of that conceptualisation is that long run supply is independent
of short run movements in demand (booms or recessions). It is a
simple conceptualisation that has been extremely useful in the past.
Just look at the UK data shown in this post:
despite oil crises, monetarism and the ERM recessions, UK output per
capita appeared to come back to an underlying 2.25% trend after WWII.
Except not any more:
we are currently more than 15% below that trend and since Brexit that gap is growing larger every quarter. Across most advanced countries, it
appears that the global financial crisis (GFC) has changed the trend
in underlying growth. You will find plenty of stories and papers that
try to explain this as a downturn in the growth of supply caused by
slower technical progress that both predated the GFC and that is independent of the recession caused by it.
In a previous post
I looked at recent empirical evidence that told a different story:
that the recession that followed the GFC appears to be having a
permanent impact on output. You can tell this story in two ways. The
first is that, on this occasion for some reason, supply had adjusted
to lower demand. The second is that we are still in a situation where
demand is below supply.
The theoretical
reasons why supply might adjust to demand are not difficult to find. (They are often described by economists under the jargon word 'hysteresis'.) Supply (in terms of output per capita) depends on labour force
participation, the amount of productive capital in the economy, and
finally technical progress, which is really just a catch all for how
aggregate labour and capital combine to produce output. A long period
of deficient demand can discourage workers. It can also hold back
investment: a new project may be profitable but if there is no demand
it will not get financed.
However the most
obvious route to link a recession to longer term supply is through
technical progress, which connects to the vast literature under the
umbrella of ‘endogenous growth theory’.
This can be done through a simple AK model (as
Antonio Fatas does here),
or using a more elaborate model of technical progress, as Gianluca
Benigno and Luca Fornaro do in their paper
entitled ‘Stagnation traps’. The basic idea is that in a
recession innovation is less profitable, so firms do less of it,
which leads to less growth in productivity and hence supply. Narayana
Kocherlakota has promoted this idea: see here
for example.
The second type of
explanation is attractive, in part because the mechanism that is
meant to get demand towards supply - monetary policy - has been ‘out
of action’ for so long because of the Zero Lower Bound (ZLB). (The
ZLB also plays an important role in the Benigno & Fornaro model.)
However for some this type of explanation currently seems ruled out by the
fact that unemployment is close to pre-crisis levels in the UK and US
at least.
There are three
quite different problems I have with the view that we no longer have
a problem of deficient demand because unemployment is low. The first,
and most obvious, is that the natural rate of unemployment might be,
for various reasons, considerably lower than it was before the GFC.
The second is that workers may have priced themselves into jobs. In
particular, low real wages may have encouraged firms to use more
labour intensive techniques. If that has happened, it does not mean
that the demand deficiency problem has gone away, but just that it is
more hidden. (For anyone who has a conceptual problem with that, just
think about the simplest New Keynesian model, which assumes a
perfectly clearing labour market but still has demand deficiency.)
The third involves
the nature of any productivity slowdown caused by lack of innovation.
A key question, which the papers noted above do not directly address,
is whether we are talking about frontier research, or more the
implementation of innovation (for example, copying what frontier
firms are doing). There is some empirical evidence
to suggest that the productivity slowdown may reflect the absence of
the latter. This is very important, because it implies the slowdown
is reversible. I have argued that central banks should pay much more
attention to what I call the innovation gap (the gap between best
practice techniques, and those that firms actually employ) and its
link to investment and aggregate demand.
All this shows that
there is no absence of ideas about how a great recession and a slow
recovery could have lasting effects. If there is a problem, it is
more that the simple conceptualisation that I talked about at the
beginning of this post has too great a grip on the way many people think. If any
of the mechanisms I have talked about are important, then it means
that the folly of austerity has had an impact that could last for at
least a decade rather than just a few years.
