Economics One

Last Thursday I published an oped in the Wall Street Journal criticizing the new “secular stagnation” view as put forth by Larry Summers in a talk at an IMF conference in November. The topic was also the focus of debate at a session in which Larry and I appeared over the weekend at the AEA meetings with Marty Feldstein, Dale Jorgenson, and Ed Prescott.  At the heart of Larry’s thesis is the view that there has been a secular decline in the past decade in the “real interest rate that was consistent with full employment,” and that decline is what I addressed in the oped. (I also gave a paper at the meetings with my views on the subject.)

In the meantime, Jared Bernstein decided that my oped was “worth a brief response” because it goes “after an argument that has resonated with many in recent weeks: secular stagnation.”

A number of people have asked me about Jared’s response. But to my surprise, I see that he does not even mention the decline in the equilibrium interest rate which is at the heart of the view that Larry put forth.  So Jared’s response has missed the main point of the argument between Larry and me, and I’m disappointed that there’s not much to respond to in that regard.

Rather Jared seemed to be defending another secular stagnation thesis.  Apparently it’s a thesis that he has talked about, as he puts it, “for years under the rubric of slack labor markets, which have led to diminished bargaining power and stagnant real earnings for many in the workforce.  It is also a contributor to increased inequality.”  I did not address this thesis in my oped. But in trying to defend it, Jared throws out several incorrect and misleading statements about my policy evaluation research.

First, my criticism of policy does not pertain only to policy in the post 2008 period as Jared suggests. It is a critique that includes fiscal, regulatory, and monetary actions taken from 2003 through 2008 as well as from 2009 to the present.”  Second, I am not trying to disprove, as Jared also suggests, that the economy did “better in the 1990s” than in the past decade . Indeed, in my view, economic performance during the 1980s, 1990s and early 2000s was better than in much of the past decade. 

Research by Christopher Erceg and Andrew Levin is providing solid evidence that the decline in the labor force participation rate since 2007 has been due to cyclical factors–the recession and slow recovery–rather than to demographic factors.  In other words, the fact that such a large number of people have dropped out of the labor force is associated with the weak economy rather than to their reaching their retirement years–or some other typical demographic trend.  Because the unemployment rate does not count the people who dropped out of the labor force it no longer gives a good reading of the state of the labor market. The unemployment rate would be much higher without this large decline in labor force participation.

In the latest version of their paper Chris and Andy estimate how large the US unemployment rate would be without this abnormal decline in the labor force, and they produced this amazing chart which summarizes their findings (I tweeted about this yesterday).

That the actual unemployment rate has become such a poor indicator of labor market trends is one reason why many economists have focused on the employment to population ratio.  Here is an update of a chart I have been using for several years to illustrate the lack of progress in employing the working age population compared to recoveries from previous deep recessions, such as the recovery from the recessions in the early 1980s.  It too is an amazing chart.

There is no longer debate that the labor market performance in this recovery–and the recovery itself–is unusually weak.  The debate is now over why. I have argued that it is the economic policy.

Larry Summers’ recent talk on what ails the US economy  at the November 8 IMF conference is getting a lot of attention. I first heard Larry present his argument at the October 1 Brookings-Hoover conference organized by Martin Baily and me, and it got a lot of attention at that conference too.

Here are the basic elements of the Summers argument:

• In the years before the crisis and recession, easy money and related regulatory policies should have shown up in demand pressures, rising inflation, and boom-like conditions.  But the economy failed to overheat and there was significant slack.
• In the years since the crisis and recession, the recovery should have been quite strong, once the panic was halted.  But the recovery has been very weak. Employment as percentage of the working age population has not increased and the gap between real GDP and potential GDP has not closed. 
• A decade long secular decline in the equilibrium real interest rate explains both the lack of demand pressures before the crisis and the slow growth since the crisis.  This decline in the equilibrium real interest rate offset any positive demand effects of the low interest rate policy before the crisis. And, with the zero interest rate bound, the low equilibrium interest rate leaves the economy weak even with the current monetary policy.

The first point is inconsistent with some important facts.  Inflation was not steady or falling during the easy money period from 2003-2005. It was rising. During the years from 2003 to 2005, when Fed’s interest rate was too low, the inflation rate for the GDP price index doubled from 1.7% to 3.4% per year.  On top of that there was an extraordinary inflation and boom in the housing market as demand for homes skyrocketed and home price inflation took off, exacerbated by the low interest rate and regulatory policy. Finally, the unemployment rate got as low as 4.4% well below the natural rate, not a sign of slack.

I completely agree with Larry’s second point that the recovery has been weak. I have been writing about this weakness on EconomicsOne.com since the so-called recovery began. The book by Lee Ohanian and me published last year shows the distressing picture of the employment to population ratio on the cover. But the factual problem with Larry’s first point sheds doubt on the whole “low equilibrium real interest rate” explanation.

Fortunately, another explanation fits the facts. I summarized this explanation in my presentation at the Brooking-Hoover conference at which I was on the panel with Larry Summers as well as Sheila Bair and Kevin Warsh. The explanation is detailed in my 2012 book First Principles.  In my view, deviations from good economic policy have been responsible for the very poor performance over the past decade. Such policy deviations created a boom-bust cycle, and were a significant factor in the crisis and slow recovery.

Examples include the Fed’s low interest rate policy in 2003-2005 and the lax enforcement of financial regulations—both deviations from rules-based policies that had worked in the past.  These were largely responsible for the boom and the high level of risk taking, which ended in the bust in 2007 and 2008.  Other more recent examples are the hundreds of new complex regulations under Dodd-Frank, the vast government interventions related to the new health care law, the temporary stimulus packages such as cash for clunkers which failed to sustain growth, the exploding federal debt that raises questions about how it will be stopped, and a highly discretionary monetary policy that has generated distortions and uncertainty.

In sum, the view that “policy is the problem” stands up quite well compared to the view that “a secular decline in the equilibrium real interest rate is the problem.”