More on the very-sharp Ryan Cooper’s gotten one mostly wrong…
The two questions are (a) how much higher could expansionary fiscal and cooperative monetary policy permanently push annual GDP up above its current trend without triggering massive inflation, and (b) how large would the expansionary policies have to be to push the economy up that far? My guesses are 5% to (a)–that we could permanently raise annual GDP $800 billion relative to our current trajectory without triggering an upward spiral in inflation–and that we would need $300 billion more of annual government purchases. to get us there to (b).
Who’s Afraid of John Maynard Keynes?: “Does the economy have room to grow?…:
…Could we create many more jobs and wealth if we really tried, or have we reached the limits of what we can produce? This… is at the heart of a recent dispute among academic economists… nominally centered on Bernie Sanders’ economic plan, but also illustrates a major fault line in the practice of theoretical economics today…. [Gerald] Friedman… assumed a model in which Sanders’ huge stimulus would push the economy up to full capacity (meaning full employment and maximum output), after which it would stay permanently at a higher level…. However, the key assumption behind the mainstream model is that an economy always tends towards full employment…. [But] even by conservative assumptions we are still something like $500 billion under total economic capacity, productivity has been consistently very weak, and there is absolutely nothing on the horizon that looks like it will return us to the level of employment we had in 2007, let alone 1999…. What’s more, a Friedman-style model in which a stimulus delivered to a depressed economy returns it to full capacity, after which it stays there, is not ridiculous…
Let’s start with one of my favorite workhorse graphs:
Starting in 2006 residential construction fell to the very bottom of the chart, and it has stayed there: more than 1.5%-points of GDP below its 2007-peak share of potential GDP. Starting in 2008 business investment fell to the very bottom of the chart, and then took a long tine to recover from its nadir of 2.5%-points below its 2007-peak share of potential GDP. Between 2007 and, say, the end of this year the cumulative shortfall has been some 18%-point years of residential construction not undertaken, and some 8%-point years of business investment not undertaken.
In a world with a capital-output ratio of 3 and a capital share of income of 30%, that shortfall would generate (under somewhat heroic analytical assumptions) a reduction of some 2.6%-points of GDP in the cumulative growth of potential output relative to what it would otherwise have been. That is the damage done to growth in America’s long-run economic potential from the investment shortfall since 2007. And then there is the equal or larger reduction in the growth in America’s long-run economic potential from the labor shortfall–workers not trained, workers not gaining experience, the breaking of ties to people who might hire you or might know of people who might higher you. Add up those two, and I get a 6%-point reduction in what our productive potential is relative to the pre-2008 trend. Thus 6%-points of the current gap between production now and the pre-2008 trend has been lost to the years that the locust hath eaten. And 5%-points remains as a gap that could quickly be closed by expansionary fiscal policy.
And we should close that gap. But a mere $140 billion or so of increased government spending is very unlikely to get us there. That would require a multiplier of nearly six–that only 17.5% of dollars earned as income from higher government spending leak out of the flow of spending on domestically-produced commodities either as savings or as spending on imports. And we know that it’s more like 33%-40% of dollars that so leak. That gives us a multiplier of 2.5-3. And that gives me my desire to see $300 billion more of government purchases.
What if we don’t get that extra spending? Well, perhaps we will get a residential construction boom to return us to economic potential. But don’t bet on it. Perhaps we will get an export boom to return us to economic potential. But don’t bet on it. Perhaps businesses will become wildly more optimistic about the future and a business investment boom will return us to economic potential. But don’t bet on it. Perhaps consumers will decide–after just living through 2007-2016–that they have not borrowed enough, and go on a spending spree to run their debts up further. But don’t bet on it.
No, if we don’t take active steps to boost spending, what will happen is not that economic growth will accelerate to return us to an economic potential that is itself growing at 2+%/year. What will happen is that low investment and underemployment will continue to do damage to the growth of potential and our economic potential will grow at 2-%/year until actual output is once again at potential output. But that will not be because actual has sped up its growth to catch up to potential. It will be because potential has slowed down to fall back to actual.
And the claim that in the long run (in which we are all dead) the economy’s actual level of output converges to potential? Four things can cause this to happen:
- Potential can slow.
- Something–a spending boom by somebody–can boost actual.
- Deflation can lead to lower interest rates as deflation carries with it a decline in the intensity of demand for a stable nominal stock of money. But in the modern world we certainly do not have inflation. We double-certainly do not have central banks that keep the nominal stock of money stable. And we triple-certainly have no room for interest rates to fall further
- The gap between potential and actual production can lead the central bank to lower interest rates. That cannot happen. It could lead the central bank to resort to additional extraordinary stimulative measures. But that is not going to happen either.
You may ask: Why can’t we recover more than 5%-points of the 11%-point gap between current production and what we thought back in 2007 was our trend growth destiny? If a low-pressure economy can reduce potential, why won’t a high-pressure economy increase potential? The key is easily recover. Easily. When a lack of markets or a lack of financing keeps investments that had obvious payoffs from being made, the costs are large. When a boom encourages investments to be made that look profitable only as long as the boom and the exuberance that accompanies it lasts, the long-run benefits are smaller. We as a country did benefit from MCI-WorldCom’s investments in the fiber-optic backbone in 1998-2000. But we did not benefit by nearly as much as MCI-WorldCom was calculating in its irrational exuberance bordering on fraud.
I would love to be wrong. I would love to discover that a high-pressure economy with spending more than halfway back to the pre-2008 trend would be consistent with relatively-stable inflation and with rapid-enough growth of economic potential to quickly catch us back up to that trend. But I don’t expect that that would be the case.