Thursday, March 2, 2017

What's wrong with the US economy? A theory, in one blog post

Contrary to popular belief among my fellow liberal economists, the US economy is far from great. The graph below compares Real US GDP relative to its long-run trend. It shows that US RGDP in 2016 was some 25% below its long-run trend. While one might be able to quibble a bit with the trend, it's clear that US economic growth has slowed considerably since 2000, with the bulk of this coming since 2008.


How about US manufacturing? A friend who recently published a paper on manufacturing in a top 20 journal complained how hard it was to publish, despite being one of his better papers. For some reason, the topic seems to bring out the crazy in a lot of economists. Why? I'm not sure, but we economists like to think we know something about manufacturing, and now in the Age of Trump, many economists have a completely understandable desire to try to show that everything Trump says is wrong. Like shooting hair-spray at a flame, this has the effect of making the usual Dunning-Kruger effect even worse than normal when the topic turns to the decline of US manufacturing. The general feeling among many economists is that the decline in manufacturing employment is all about robots, productivity, and sectoral shift toward services. People who think trade are part of the story must be ignorant of economics. I was once taken in by this view as well. However, as I laid out in my own research (Susan Houseman does here and here), the data is not supportive of this assertion as an explanation for the relative decline in manufacturing output and exports, or the decline in the level of manufacturing employment. Productivity growth in manufacturing since the mid-1990s has been, if anything, lackluster. Part of the confusion is that there was a long-term trend decline in manufacturing as a share of the population (even while the level was flat) which is due to productivity growth and sectoral shift. Yet, after the Asian Financial Crisis in 1997, the US dollar appreciated substantially, while Asian countries began hoarding dollar reserves. Add in the rise of China and China's WTO accession, and the Bush tax cuts and 9/11 spending, and you have the perfect confluence of factors to cause a "Surprisingly Swift" collapse in the level of manufacturing employment.

The graph below, of real manufacturing output, does not support the thesis that the problem with US manufacturing employment is simply fast productivity growth. Why would fast productivity growth and the introduction of robots cause a large trade deficit and a decline in real output relative to trend? Inquiring minds would like to know.

























However, while the collapse in manufacturing output and employment may have been a chief cause of the initial slowdown in overall GDP growth, GDP was only about 5% below trend in the 2000s. What has made things worse has been the reaction of policy to the shock of the rise of China and the dollar appreciation. First, low interest rates spurred by savings out of Asia and the carnage to manufacturing in the US led to a housing bubble. Then, poor bank regulation of the shadow banking sector meant that the collapse of the housing bubble meant a financial crisis. And then the liquidity trap, and difficulty that central banks apparently have managing the economy at the ZLB meant that this temporary shock had a long-term impact. An impact that ultimately results in the Tea Party congress of 2010 to 2020, and the election of Trump. (Here's a slightly longer version of this old bedtime story.)

In the early days of the zero lower bound, it was believed by many that monetary policy couldn't be effective. I also believed that rates couldn't go negative. Others simply believed that monetary policy was much less effective. However, since then we've learned that ST rates can go negative. Perhaps as low as -1.5%. We've also learned that monetary policy announcements still affect stock, bond, and exchange rate markets in ways consistent with monetary policy being effective. An example of this was when the Fed hiked the discount rate in April 2010, causing the dollar to appreciate. And this was when the economy still deeply depressed -- precisely the opposite of what your Econ 1 textbook would recommend in this situation. I once asked Jeremy Stein, who later served on the FOMC, what in the world the Fed was thinking. He tried to tell me that this never happened.

What we've also witnessed during the past few years is that the Fed has repeatedly decided not to alter its monetary policy stance even as it marks down its own forecasts for economic growth and inflation. This can be seen in the graph below. After the first round of QE in 2008, the Fed did almost nothing again until the end of 2010 -- a gap of two years -- even though the economic recovery was much slower than it anticipated. Then, even though growth was slower in 2011 and 2012, they waited another 2 years -- the end of 2012 -- before acting again. What the Fed has come to decide over time is not that they need to do more stimulative monetary policy, but that the economy can't grow like it used to. And given that the Fed can always make the economy grow slower if it wants, this situation has developed not necessarily to America's advantage. Time to dust off Bernanke's "self-induced paralysis" thesis.






13 comments:

  1. What form of CPI adjustment is used for the real manufacturing output? I'm curious because it seems like (just guessing) most manufactured goods are seeing price declines whereas the CPI-U continues to increase (primarily because it's 40+% housing).

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    1. Good question. I got this series from FRED: https://fred.stlouisfed.org/series/OUTMS

      I assume there is a manufacturing-specific deflator. However, this is unlikely to be the driver of why manufacturing output started growing more slowly after 2000. Using the same deflator, real manufacturing output grew quickly before 2000. Also, this wouldn't explain why US manufacturing exports as a share of total world manufacturing exports fell.

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    2. details on the specific deflators for each time of manufacturing output can be found in the NIPA handbook:
      https://www.bea.gov/national/pdf/allchapters.pdf
      generally, you're looking at component producer price indexes for finished, intermediate and raw goods, depending on stage of production..

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  2. "Time to dust off Bernanke's 'self-induced paralysis' thesis." If we're already in a self-induced paralysis, what will we be in when the Fed raises rates at its March meeting? A deeper self-induced paralysis maybe??

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    1. I'd say, the Fed's tightening is what has prevented the economy from returning to normal growth. At present, if the Fed simply waits to tighten, the economy is likely to return to a normal growth rate. With tightening, it gets more difficult.

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    2. "With tightening, it gets more difficult." Agreed. Too bad that Yellen & colleagues seem determined to take that route.

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  3. Why not analysis with GDP/capita?

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    1. Good thought. The graph using per capita GDP looks similar. Perhaps now we're 20% below trend instead of 25%. And we were only 2-3% off of trend as of 2007. But that was despite a housing bubble, so I don't think it changes the picture. While GDP per capita is probably better to use, it's also a bit endogenous. Severe recessions cause slower population growth, after all, although in this case, so did policy changes after 9/11.

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  4. I am not sure why you think the rapid decline after 2008 in real GDP is due to trade factors (what is your evidence for that) rather than factors related to the financial crisis and housing collapse and decline in investment. Krugman attributes a lot of the decline to low government spending also.

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    1. After 2008, I think the biggest factor was the Fed not doing enough -- "self-induced" paralysis. Fiscal policy also could have been better. Trade factors were my explanation for why the economy was relatively weak in 2007 despite the housing bubble. Ben Bernanke has also pushed this argument.

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  5. Could it be that the problems were just too great rather than the policy was not enough. Too much debt etc. Distribution of income too skewed.

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    1. Well, I don't think the problems were impossible to overcome. The Fed actually shrank its balance sheet in 2009. In 2010, it raised the discount rate. The Obama stimulus, net of the AMT patch, and savage state and local Austerity, was pretty close to zero. I don't see why we couldn't have done better than that.

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  6. Short rates have been basically zero for a long time and federal deficits have been falling but still high. I agree we could have done better but problems were great.

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