Economic Bias

Noah Smith has an excellent post on the political biases baked into conventional macroeconomic models, especially DSGE. His view that the principal source of bias comes from the assumptions needed to make the models tractable accords with my take on microeconomics, particularly the ideological significance of convenient second-order conditions. I think we agree that these assumptions are not made out of explicit political motivation, but simply because they make life easier. Still, the bottom line is the same: bias is bias. Perhaps where the politics comes in is in the inclination not to worry about it.

Playing With Fire With Oil And Iran

Juan Cole is listing 10 reasons why the US sanctions against Iran making money from exporting oil are not working at http://www.juancole.com/2012/02/top-ten-ways-iran-defying-us-oil-sanctions-and-how-you-are-paying-for-it-all.html . While indeed Iranian oil sales have fallen, the impact of this has been at least partly offset by the rising price of oil due to all the war talk associated with the sanctions, along with the failure of Saudi oil production to increase to fill the cutbacks, along with declines in oil production in Nigeria, Syria, and Sudan for various reasons, as well as the decisions by India, China, Japan, South Korea, and others to repudiate the US policy. All of this threatens Obama's reelection as gas prices are heading up and Republicans are claiming it is due to Obama blocking the Keystone pipeline project, even as they call for an even more hawkish policy against Iran (see Jim Hamilton for the latest analysis of the Keystone project at http://www.econbrowser.com/archives/2012/02/workarounds_for.html ).

I largely agree with Cole on most of his points, with some minor variations. He argues that it is the "Israeli lobby," particularly AIPAC, that is responsible for the sanctions policy, although I would think that the lobby is responding to the Israeli government rather than being an independent source for this policy push. Israeli political leaders are fearful of a possible Iranian nuclear bomb, and according to the NY Times today, are probably not able to actually bomb out fully the four sites involved in the Iranian nuclear program, which may be why they are pushing even harder on the US, despite Israeli military intel reportedly agreeing with US intel and DOD that Iran does not have an active nuclear weapons program.

The US and UK have reportedly urged Israel not to bomb Iran as this would be "destabilizing." They may not do so for the reason noted in the previous paragraph, but it strikes me that Netanyahu may not mind encouraging destabilization by engaging in war talk and pushing the sanctions that have Iran engaging in talk of blocking the Strait of Hormuz. Bibi does not like Obama and would be perfectly happy to see him lose an election due to a bad economy driven by high oil prices, and all that applause he got in the US Congress may make him think he can get away with this, and he probably can, although maybe the economic recovery is just too strong to be overcome by the negative effect of rising oil prices.

I note some caveats on Juan Cole's post. He says that "Iran is sitting pretty." Not so. While oil prices have indeed gone up with all the war talk, the Iranian rial has declined by something like 60% against the USD. This is not helping the standard of living in Iran for people used to relying on imports of many consumer goods.

OTOH, this decline in living standards, hoped by the US to put pressure on the Iranian regime, is backfiring, just as the economic embargo against Cuba has for a full half century now. Reportedly Iranian citizens are rallying to support the regime against the US actions against their economy.

This fits in with another delusion pandered about in Washington, that we could get Iran to "stop its nuclear weapons program" by more vigorously supporting the Green movement opposition. First of all, any action to openly support the opposition would simply discredit that movement. Second, the opposition has long made it clear that it supports the peaceful civilian nuclear program of Iran. Getting them into power might make Israel slightly less paranoid, but it will not alter the nuclear program itself one bit.

The key to the nuclear program remains as it has been for a long time, the position of Supreme Leader Ali Khamene'i, although an article yesterday in WaPo by Ray Takeh [sp?] argues that there is a new "war generation" led by Ahmadinejad that wants nuke weapons. It is true that these young guys will outlive him and could move the existing program into one that does lead to nuclear weapons, but he has repeatedly issued fatwas against nuclear weapons, and as Juan Cole has pointed out repeatedly, Iran has not attacked another nation since the 1700s. These minor facts, supported by official US intel reports, somehow get lost in all the hysteria and pushing of economically damaging sanctions programs. To the extent these sanctions programs are being put into place to keep the Israelis from bombing Iran, the report today in the NY Times may have removed even that half-baked rationale for this stupidity.

In Some Circles, Economics Is Anathema

A pattern I find disturbing is that much of the left, at least in the English-speaking world, regards economics simply as a source of intellectual and moral corruption. Those who take this view make sweeping pronouncements on economic topics, but they pride themselves in not polluting their understanding by consulting economists or reading what economists have written.

Want an example? Check out the Uneconomics initiative and its “exposé” of how banks create money. Who could have imagined: private banks actually create money out of thin air when they make loans, and this creates the potential for economic volatility due to over- and undersupply. These secrets, supposedly covered up by sneaky economists and other elitists, are revealed by radical social critics, and we should be shocked, shocked.

Banking is a system that runs on make-believe and survives on ignorance.

Does it matter that a significant swath of the left thinks that standard stuff in a money and banking course is a great discovery that will shake capitalism to its foundations? And if I complain, am I just defending my own privileges as a so-called expert? Funny, I thought the reason to spend years of my life learning an intellectual speciality was to be able to make a contribution. Sorry about that.

Stranger than Friction

Barry Schwartz argues in this morning’s New York Times that capitalism is all about efficiency, and the problem is that too much efficiency can be a bad thing.  A more profitable company, he says, is a more efficient one, and capitalists are right to pursue profit, but maybe we should slow them down a bit—add some friction to the process.

I am reminded of the students I have every year, and there are a lot of them, who just can’t accept the idea that “equilibrium” in a market does not necessarily imply “good”.  You can have equilibrium in a market for slaves, or for nuclear weapons, or simply for your ordinary neighborhood drone.  How markets work and whether we are better off because they work that way are two entirely different questions.

So also with profit.  A more profitable company is not necessarily more efficient in any sense other than better at making profit.  Transferring more of the value added from paychecks to dividends is not more efficient than the other way around, but it is more profitable.  To be more precise, to be sustainable a business has to be profitable, but a more profitable business does not necessarily contribute more to society than a less profitable one.  (Note: in a stakeholder economy the goal of business would be to maximize the probability of being profitable over a given time horizon, not to maximize profit per se.)

It is distressing that Schwartz can muse on the implications of the financial crisis for his notion of profit-seeking but never consider the concept of risk.  Higher profit purchased at greater risk is not always such a great bargain, especially in a world of limited liability, not to mention bailouts of the systemically hyperconnected.

How did it come to be that conventional wisdom, which was once skeptical of profit—maybe even too skeptical—has now embraced the assumption that more profit means more better?

Which Half?

From the abstract for "Your Right Arm for a Publication in AER?" by Arthur E. Attema, Werner Brouwer and Job Van Exel:

The time tradeoff (TTO) method is popular in medical decision making for valuing health states. We use it to elicit economists’ preferences for publishing in top economic journals and living without limbs. The economists value the journals highly, and have a clear preference between them, with American Economic Review (AER) the most preferred. Their responses imply they would sacrifice more than half a thumb for publishing in AER.

Housing and Net Imports Revisited

Readers of EconoSpeak with very good memories may recall that I raised this issue in late 07/early 08 (see here and here).  Now Karl Smith has again pointed out the connection between US current account deficits and its housing bubble.  His FREDgraph is intriguing:

Two words of caution, however.  First, the trade balance in this graph is net, while residential consumption is gross.  In reality, the capital inflows that financed our trade deficit were apportioned between housing and other loci of borrowing.  Second and far more important, it is dubious to assume, with Smith (and Bernanke and Obstfeld), that the primary direction of causality was from differential savings propensities (low in the US, high in China) to trade imbalances, when it was the other way around.  As far as I know, no one has ever rebutted the argument I made in Challenge five years ago.  If it’s right, trade is primary.

The Potential Output Debate And the Older Natural Rate and NAIRU Debates

So, Mark Thoma has Tim Duy on again, http://economistsview.typepad.com/economistsview/2012/02/fed-watch-again-with-potential-output.html , with Krugman chiming in with his semi-goofy "Duy on Bullard on Duy on Bullard on Tinker to Evers to Chance." I agree with Duy that Bullard understates the various ways that the bubble crash messed up the financial system, but I want to note the link between this debate and an older one that we have heard less of lately. Some of the links are curious. In particular, although he avoids the language of those debates, I see Bullard in effect supporting views of people who disagree with the old conventional consensus, although in this he may have been following Alan Greenspan as well as Jamie Galbraith circa 1996 analytically, even if not in terms of policy.

So, Arthur Okun coined the idea of NAIRU, which arguably was linked to the old textbook Keynesian story of a clearly defined potential output, with AS curves flat out to that level of output and then suddenly going vertical, in contrast to the one described by Keynes in the GT chapter on prices that had bottlenecks setting in well before then and "reducing elasticity" as one approached the "classical" zone where that elasticity went to zero. While I have never seen a coherent argument why NAIRU should coincide with this, when Milton Friedman posed the idea of the natural rate of unemployment, which simply swept the profession, most observers tied the NAIRU level of output to the level of output associated with Friedman's natural rate of unemployment, a level of output the economy supposedly goes to if there are no particular shocks and policy is more or less neutral, presumably an equilibrium level of frictional unemployment, hence only voluntary. Some would go further and link this with the old Wicksellian (picked up by some of the Austrians) natural rate of interest as well holding, a nice across the board general equilibrium level of output that could be identified in some sense with the supposedly clearly defined potential output of the old Keynesian textbook stories.

But then a funny thing happened on the way to Broadway, namely the mid-to-late 90s. As unemployment fell through what many thought was its natural rate and no acceleration of inflation appeared, indeed the opposite happened, Greenspan sent his minions to the basement of the Fed and decided that productivity was improving sufficiently rapidly that we did not need to tighten monetary policy to avoid crashing into NAIRU. While this did not fundamentally upend the concept, it coincided with critiques coming from people such as Galbraith who argued that the concept was profoundly flawed and fundamentally useless. And Greenspan's continued loosening of policy without any inflation happening burnished his image.

Indeed, from the very beginning of the natural rate discussion there had been people such as Phelps and later Summers who annoyingly pointed out the substantial endogeneity of the natural rate to past unemployment, how long spells of unemployment can make it harder for people to operate in the labor market, something that we are hearing again as voices are now being raised to claim that the natural rate has gone back up, although it remains unclear that if output were to rise sufficiently to push unemployment below that rate we would see an acceleration of inflation.

Now, Bullard's position on this seems to have two contradictory parts. On the one hand, while eschewing the language, he seems to recognize the very weakness and fuzziness of the whole natural rate/NAIRU argument. This is an implication of his valid arguments regarding the fuzziness of the concept of potential output. As with Friedman, it is supposed to be the outcome of a general equilibrium of the economy. However, what the general equilibrium is or should be depends on a bunch of things such as the number of effective sectors in the economy and the degree of price stickiness, and so on. It is not well-defined, implying that these other concepts are also not well defined. OTOH, it sort of appears that he is using this fuzziness, along with the legitimate concern that potential output, however measured or defined, will be growing at a lower rate due to the outcome of the bubble crash (for my part due to reduced capital investment, even if that is not his argument), that then we may need to worry about crashing up against it and should avoid doing so just in case it might also turn out to be NAIRU, despite the lack of any apparent inflationary pressure in the economy, not to mention still low levels of employment relative to working age population and substantial measured excess capacity of the capital stock.

For my part, to the extent the problem is indeed ultimately one of insufficient aggregate demand holding down real capital investment and thus the growth of the natural rate of unemployment output/potential output, etc., then the answer is most certainly not to tighten up any time soon on the macro policy levers, unless somehow Bullard is one of those folks who thinks that AD might actually be stimulated by higher interest rates. But I have not seen him claim that and doubt that this is what he is advocating.

Is Bullard Rejecting the Bush Boom?

Certain diehard believers of the Laugher Curve likely enjoyed Jerry Bowyer’s The Bush Boom thinking that the 2001 and 2003 tax cuts lead to an explosion in potential GDP just like the Reagan 1981 tax cut allegedly did. I hope (but do not expect) that they realized that the latest from James Bullard contradicts their sacred supply-side silliness:

I think it is plausible that such a line would be lower than the CBO potential line in Irwin's picture, and thus that the current output gap even by a production function metric would be smaller than the one in the picture.

Bullard essentially claimed that before the latest recession we were already beyond potential GDP. Now I’m not buying this argument and I applaud The Money Illusion for an excellent discussion that I wish I had penned.

Now admitting that estimating potential GDP is hard but also admitting that no one of us necessarily has a better series than the one put forth by CBO, I decided to look at the annualized growth rates in potential output implied by their series by decade. For the 1950’s we had 3.68% growth per year with the growth rate for the 1960’s being 4.2%. And yes growth in the 1970’s slowed to 3.25%.

Of course, the Reagan years changed all that and we had potential GDP growing at a 3.03% per year in the 1980’s. Oh wait – I thought there was supposed to be some supply-side miracle. For those roaring 1990’s, CBO is claiming that potential GDP grew by 3.15% per year.

But to my main point – the CBO estimates of potential output suggest annualized growth of only 2.36% during the alleged Bush boom. And Mr. Bullard thinks CBO was overestimating potential GDP? And the Republican recipe for faster GDP growth is a return to the policies of Reagan and George, Jr.? OK!

Poor Economics

Not as far behind the curve as usual (less than a year), I just finished reading Poor Economics by Banerjee and Duflo.  It’s well-written and certainly worth a close look by anyone interested in global poverty, which should be everyone.  Here are some reactions on my part:

1. At times the perspective of the book flirts with nominalism.  It seems to claim that only bottom-up perspectives and actions can meaningfully change the world: the search for a better “health policy” may be a chimera, for instance, while there is much we can do to improve the performance of this particular clinic in this region.  My guess is that the authors would not go this far and would say that they are simply redressing an imbalance—that previous analysts of health and other policies were too prone to make sweeping judgments at an altitude too far above ground level, and that it is time to become more fine-grained.  Fine, but I would like them to say this more clearly.  To put it a bit differently, interventions are needed at all levels, from the village (or even lower) to the international, and in an ideal world our experiences in each would inform how we go about the others.  To continue the example, just as national health policies should reflect what one has learned from the close study of a particular clinic, one would go about health policy at the village level differently depending on decisions taken higher up (for instance regarding what kinds of investments to make in training health professionals).  Maybe this wider view will show up in their next book.

2. The book works best in the later chapters that are more traditionally “economic”, such as those on insurance and credit; the early chapters are less successful.  The reason is not hard to find: the authors are rather narrowly trained as economists, and they do not cite much literature outside their own field.  An instructive example is their misuse of the term “iron law of oligarchy”, which dates to Michels’ study of the organizational structure of syndicalism.  It is not nitpicking to point this out: Michels is one of the canonical texts in the field of political sociology, and almost every sociologist knows his theory.  Inadvertently, B&D are telling us they do not have a background in social theory.  Of course, everyone cannot know everything, and we need a division of labor in the study of poverty, just as in any other domain.  But economists should know their limitations going in and make an effort to at least acquaint themselves with the thinking of other specialists on the topics they are studying.  The chapters on education and health, for instance, would have been much stronger if there were more attention given to what education and public health analysts have been saying and doing.

3. Even within economics the authors are rather narrow.  This is striking, because their spirit and instincts are generous, even though their analytical toolkit is not.  One telling example which runs through the entire book is their depiction of the “poverty trap”.  They present it as the hypothesis that there are increasing returns to some kinds of investment, so that at low levels of investment there is insufficient incentive to invest more.  This is good as far as it goes, but it doesn’t acknowledge other mechanisms.  If you think about a poverty trap as a kind of multiple equilibrium, you would expect three different varieties.  There are two kinds of static multiple equilibrium processes, increasing returns (the B&D hypothesis) and interaction (sufficiently strong cross-effects between the elements of an interactive system).  In addition, there is a third, dynamic basis, adjustment processes that alter the initial conditions (hysterisis).  The first of these, the B&D version, is the most widely “approved” within the economics profession; the third has made inroads beginning with the Sonnenschein-Debreu-Mantel intervention of the 1970s and the subsequent equilibrium unemployment literature, but is still on the margins; the second remains utterly heretical and is confined to cranks and misfits like me.  How does this translate to poverty?  Hysterisis is about how the coping mechanisms of poor people, which may be necessary to alleviate the worst effects of their situation, can also reinforce their situation.  Fatalism as a psychological strategy illustrates this.  Interactive traps would be those in which multiple economic, social and political factors combine to entrap individuals in poverty and are mutually reinforcing, so that it is not possible to make progress on any one front alone.  These are not idle speculations.

4. The authors are self-aware culturally but not politically-economically.  They are refreshingly honest about their preconceptions as outsiders from a much more prosperous background, and their learning process is one of the main themes of the book.  At the same time, there is no discussion at all about where their funding comes from, why some projects are funded and not others, who funds their local partners and why, etc.  This is important not only because there really are competing agendas in the world of development research and policy (surprise), but also because their approach is expensive.

5. Although B&D don’t seem to recognize it, their core recommendation regarding policy, that it be based on careful, ongoing assessment of outcomes, adheres to one of the major practitioner traditions of recent decades.  Its roots go back at least as far as Dewey’s “intelligent action”; another theoretical foundation is cybernetic theory, e.g. Stafford Beer.  (Schön’s reflective practitioner is not far from this either.)  The idea is that effective management requires a feedback loop incorporating information-gathering, analysis and plan revision, one that is built in from the beginning and operates continuously.  The idea has really taken hold in the “adaptive management” of natural resources, for instance in ecological restoration.  Academic readers of this blog may be familiar with it through the emphasis on assessment in effective teaching.  (You design your classes so that you get a continuous stream of information, in real time, on how students are learning, and you adjust your methods and content accordingly.)  I think the book would have benefitted enormously by making the connection between poverty policy and broader perspectives in management and the professions.

Potential Output

The recent debate between Bullard, Smith, Duy, our own Barkley Rosser, Krugman and others has been interesting and has caused me to reconsidered some of what I thought I knew on this topic.  In fact, this is the fourth time I have sat down to write a post; my first three are all deleted.

What I now think is this: the purpose of a potential output measure is to offer guidance to macropolicy.  Bluntly put, a sizeable output gap tells us we can and should use monetary and fiscal measures to boost demand; an output surplus tells us to cool it.  This is loosely associated with a notion of productive potential, in the sense that, as an economy approaches or exceeds this potential, extra demand is increasingly diverted into either price level increases, trade deficits or both.  In this sense, what we want from an estimate of potential GDP is that it performs adequately as a guide to demand management.

That said, is there a case that the collapse of the housing bubble in the last decade could lower the trajectory of potential GDP?  The answer, I think, is yes, possibly.  The reason is that potential output can well be altered by changes in the pattern of demand.  The extreme poster child for this is Eastern Europe post-1989: they had a capital stock poorly suited to producing internationally competitive goods, and the sudden opening of their economies precipitated a change in demand resulting in a collapse in potential output.  This is why their transitional slumps could not be cured solely by augmenting aggregate demand, for instance through fiscal deficits; the result would have been only some mix of more inflation and more trade deficits.

The deflation of the housing bubble may have revealed a similar mechanism.  Perhaps the mix of physical and human capital in our society was tilted toward a product mix (lots of suburban tract development) that will change under the new, post-bubble demand regime.  It is true that unemployment in construction is not elevated over that in other sectors, but that doesn’t answer the question of what level sectoral employment will rise to once aggregate demand shortfalls dissipate.  For this story to be statistically meaningful, however, two things need to be true.  First, the change in the pattern of demand has to be substantial and persistent: Americans must continue to demand less new housing for the foreseeable future.  This is not the same as saying, as Bullard has, that prices cannot resume their previous trajectory.  (We can experience a change in the price-quantity relationship.)  Second, our capital (physical and human) allocated to housing has to be on the clay rather than putty side of things, not just instantaneously, but over the span of many years.

Putting it this way makes the issue empirical.  You can embed these questions in various models (Solow, DSGE, your home brew), but whether the deflation of the housing bubble has caused a trajectory shift will come down to these two judgments.  Someone should look into this.

Under the North Star

I’ve just finished reading this classic Finnish trilogy by Väinö Linna.  It’s many things at once, a well-told story of three generations in a small village, a panorama of twentieth century Finnish history, and a Tolstoyan meditation on the themes of individual character, political principles and the gap between what we strive for and what our lives ultimately mean.

Volume II, The Uprising, is the most powerful of the three.  Its account of the socialist revolution of 1918 and the massacre that followed its suppression will be difficult to forget.  Much of its force, however, comes from the careful development of its human context in volume I; each individual sent before the firing squad is vivid, someone the reader knows and cares about.

The final volume, Reconciliation, is less effective, perhaps because, covering more decades in the same number of pages, it sacrifices depth.  None of the victims of the wars against Russia are really developed personalities (except for the first to die, whose portrait is an elaborate exercise in irony).  Even so, the account of the rise of fascism in Finland is detailed enough to permit comparisons to fascist movements in other times and places.

Under the North Star is gripping reading, but it is also a work of ideas.  It belongs on the shelf devoted to sagas of development, where the transformation from traditional to modern society—economic, political and cultural revolution—is lived by people whose frame of reference is the past, and who cannot begin to imagine where the future will take them.

(Exception to the final generalization: the author permits one character to speak for him, so there is a consistent voice for reason and humanitarianism amid the turmoil.  An interesting question is whether this is an effective rhetorical strategy.)

A Job Market Story

Noah Smith tells his economics job market story over at Noahpinion, and it inspires me to tell one of mine.  (Bravo, Noah, not just for landing a good job, but for doing it nonrobotically.)  I have a lot of stories, because I was on the market a long, long time.

In this case, the time was December 1987, the place was Chicago, site of the annual economics meetings that year.  I had just completed my dissertation, a theoretical treatment of wage compensation for dangerous work.  (My chair was Herb Gintis, an extraordinarily generous and helpful advisor.)  I had sent out a whole slew of applications but had landed hardly any first interviews.

My plane landed in Chicago just as a powerful snowstorm was blanketing the city.  Since O’Hare closed for a while, the beginning of the meetings was disrupted, and the entire event felt a bit surreal.  I had some extra time the first morning—OK, with few interviews I had a lot of extra time all the way through—so I decided to get some exercise.  My hotel’s fitness room was shut down for renovations, and they were giving away vouchers for a health club down the street.  I went down to the concierge desk to pick up mine.

Standing next to me was a woman of about my age, also picking up a voucher.  Since neither of us quite knew where we were going, and the snow was blowing furiously in the wind, we decided to find our way together.  I asked where she was from; she said the Duke school of public policy, and she was at the meetings to recruit.  Amazing, I said, since I’m on the market, and I had applied to Duke public policy, and I was sure I would get an interview, since I am really a policy person, but I didn’t.

She asked about my dissertation, and I described it.  (The snow was fierce.)  She seemed very interested.  Why hadn’t they scheduled me, she wondered.  Then she asked what school I was from.  UMass-Amherst, I said.  There was an uncomfortable silence.  You could see her face simply drop, as if it were about to fall off.  “Um, don’t they have a lot of Marxists there?”

Well, that was that: no last minute possibility at Duke.  And it went downhill for the next half-dozen years, desperate and unproductive job-hunting with a smattering of amusing stories along the way.

The best comeback lines occur to you too late.  I wish I had calmly replied, “Don’t worry, it’s sort of like AIDS.  You can’t get it from casual contact.”

Bullard On Duy On Bullard On Potential Output

Mark Thoma at economists view has provided a reply by James Bullard, President of the St. Louis Fed, to Tim Duy's commentary on his speech at the Union League Club in Chicago on how he thinks that the housing bubble collapse could have reduced the growth of potential output, along with his criticisms of the standard public projections of potential output, http://economistsview.typepad.com/economistsview/2012/02/james-bullard-responds-to-tim-duy.html . I would like to comment on this given the nearly universal perception (including posts here by several folks) that Bullard does not seem to understand that the projections are based on the Solow growth model, particularly given that Bullard is one of the more open-minded and knowledgeable figures involved in decisionmaking at the Fed. What is going on here?

To get at this one needs to read the links Bullard provides, most notably the 2009 paper by Basu and Fernald published by the St. Louis Fed on potential output. He notes that they argue that there are competing definitions of potential output. One is essentially long run growth, which should be tied to a growth model of some sort. The other is a shorter run one that they argue should be the equilibrium of a flexible price New Keynesian DSGE model. They argue that rather than the standard one-sector Solow model, what fits the data better is a two-sector model that focuses on technological change the capital goods sector (although they do a lot of handwaving about aggregate Frisch labor elasticities). In effect, they offer four different alternatives within the short-run case: one-sector vs two-sector and flexible price versus sticky prices models, ultimately supporting the two-sector-flexible price one. This plethora of choices lies behind Bullard's unhappiness with most projections of potential output.

OK, so let us grant that there is a lot of fuzziness with regard to what the proper projection of potential output is from this perspective. But does this translate to a reasonable argument that the potential may be a lot lower than the standard one-sector Solow model projection in the recent period due to the bubble and its collapse? This seems to boil down to the claim that the projections most are using amount to being based on unsustainable growth rates based on the bubble period. Well, maybe, although Basu and Fernald do not directly address this, nor do they offer how to estimate how potential output calculations should be made to overcome this problem.

As it is, I think there is a case to be made that the collapse of the bubble did reduce the growth of potential output, by most methods of estimation. I note that I do not see Bullard making the argument I am making specifically or explicitly in either his original talk or in his reply to Tim Duy, but perhaps it or some variation of it was lying behind his arguments.

The basis of this argument is that the fall in output following the collapse of the bubble has reduced the rate of real capital investment. Of course, the sharpest decline was in the real estate construction sector, the part of the economy that was most severely distorted by the housing bubble, and we should expect that part of investment to remain reduced for some time. However, it is not clear that reducing this will damage the productivity of investment in factories, machinery, and equipment, which is the real core of the growth of capital stock that increases potential output. Nevertheless, the sharp reduction of aggregate demand has almost certainly reduced the rate of this sort of potential-output-increasing investment.

So, the massive and sustained reduction of aggregate demand following the collapse of the housing bubble and its impact on the financial sector, has reduced the growth of factories, machinery, and equipment, which in turn has reduced the growth rate of potential output below what it would have been if the housing bubble had been ended without all the unpleasant impacts on aggregate demand that accompanied it (beyond the reduction in demand for housing construction).

I do not know if this is what Bullard was trying to get at in his various attempted explanations of what he has said, but I think that it is a more or less coherent story that does fit with his general argument.

Welcome to the Future—It’s Just Starting Now

Like many of you, I have had a queasy feeling about the loss of privacy in the digital era.  Every online transaction and communication is out there for monitoring, profiling, packaging and retailing, and no promise by a company or government is going to change this.  The commercial implications are troubling enough, but what about the future?  What happens when a really bad government comes along and uses this information for outright repression?

Well, the future is now.  Read this chilling report on the use of new surveillance technologies to control what you can read about such matters as state-sponsored torture (the Kiriakou case) and corrupt insider contracts in the “war on terror” (Sterling).

If it had been Obama and not Google that campaigned on the slogan “Don’t be evil”, we could accuse him of breaking a promise.

Bullard and How We Measure GDP Gaps

Noah Smith had an early and excellent take down of Jim Bullard that included:

So, basically, what we have here is Bullard saying that the neoclassical (Solow) growth model - and all models like it - are wrong. He's saying that a change in asset prices can cause a permanent change in the equilibrium capital/labor ratio.

Tim Duy had another excellent take down of Mr. Bullard that included:

Estimates of potential GDP are not simple extrapolations of actual GDP from the peak of the last business cycles. They are estimates of the maximum sustainable output given fully employed resources. The backbone of the CBO's estimates is a Solow Growth model. So I don't think that Noah Smith is quite accurate ... Bullard can't be saying the Solow growth model is wrong because he doesn't realize that such a model is the basis for the estimates he is criticizing.

I was curious as to how much difference this makes so I extrapolates 2007QIV real GDP by assuming growth equal to 0.5% per quarter for the next four years and compared the GDP gap predicted this Bullard approach (GAP*) to the GDP gap one would get using the CBO estimate for potential GDP. Either way – we are still far below full employment.