Tuesday, February 7, 2012

Taylor's graphs

John Taylor wrote a very nice blog post, "Reassessing the recovery". He made two graphs, reproduced here. On the top you see the current recession and recovery. On the bottom you see the typical pattern, exemplified by the biggest previous postwar recession in 1982.

We usually bounce back to the trend line. Now, we're not.

The difference betwen "levels" and "growth rates" accounts for a lot of confusion in popular discussions. "Recessions" are pretty much defined as times in which GDP is declining -- negative growth rates, the level is going down. GDP stopped going down in early 2009.

Yet, as many commentators point out, if the recession is over, why does it feel so glum out there? Answer: because prosperity is measured in levels. Employment responsds to levels. 

The big macroeconoimc question for our time is this: Just why are we stuck at a much lower level? What do we need to do to get back to the trend line? Or is that trend line illusory?

There are two stories -- and I use that word advisedly.

1) "Demand." We're about a trillion dollars below trend, so the government needs to borrow an additional $750 billion a year (I'm usuing the Keynesian 1.5 multiplier) and blow it on whatever is handy; Solyndras, high speed rail, windmills, any old rathole will do so long as it's "spent." (Sorry, I'm not doing a very good job of expounding this position. Not my job.) Or just let it be stolen, as thieves have high marginal propensities to consume. The problem is the intractable thriftiness of American consumers, so the government just needs to spend more, or borrow or tax money and give it to people who will.

Monetary policy is close to powerless now, but promising zero percent interest rates for a decade helps; those 3.5% mortgages that are strangling credit could be brought down to 3.4%.

2) "Supply." Companies are skittish about using incredibly low rates to build new houses or factories. Over-regulation, uncertainty, fear of political interference, labor-market mismatches are holding us back. (Steve Davis, Scott Barker and Nick Bloom have a nice paper that tries to quantify this story.) Boeing's efforts to start a factory in South Carolia writ large. As a little recent example, the collected attorneys general of several states have got the banks to cave and send foreclosed homeonwers big checks. The banks are certainly going to learn to be much more careful about who they lend to in the future, which has something to do with 3.5% mortgages that nobody seems to qualify for.  There are also stories about housing problems spilling over to the real economy, which I don't agree with, but are still basically "supply" stories.

The uniting features of "supply" stories is that, even if you think fiscal/monetary stimulus works in general, they won't work now.
In short, is our problem "micro" or "macro," "supply" or "demand," a mysteriously lingering business cycle, or the outbreak of a long-term growth slowdown?  I lean to "supply," but the stories are not really quantified let alone easy to distinguish. Hence the repeated "micro vs. macro" thoughts on this blog.

This matters for all sorts of reasons. All of the projections that show our fiscal problems getting better in the near term before the entitlement bomb hits rely on our quickly closing the gap. If we don't close the gap, we never make progress on the deficit, and our future looks like Greece a lot sooner.

Monetary policy might help "gaps" but it can't fight "trends" or "supply." Jim Bullard, President of the St. Louis Fed, gave an interesting  speech  in Chicago yesterday pointing this out. Though I disagree with his analysis of why we might never get back to trend (housing prices as a "wealth shock"), his basic point is deeper: If the "trend" is illusory, if it represents "supply" that the Fed can do nothing about, then we are in danger of repeating the mistakes of the 1970s, in which the Fed kept chasing optimistic "potential" calculations that were in fact unrealizable by monetary policy.

And of course it matters for people. 5 percent of everybody's income is a lot of prospertity; 10 more years of slow growth adds up to a lot of lost prosperity.


  1. The 1981 recession was completely different. It was the result of deliberate Fed policy. When the Fed changed its policy the recession ended.

    The "trend" in the period 2002 to 2006 was illusory - a bubble resulting from "mis-pricing" of financial assets and the use of home equity loans to pump up consumption. The unemployment and labor force participation rates do tell us that the economy is still in trouble.

    You talk about investors fearing political interference. Since you brought it up: I am an investor and what I fear is a Republican party hell on destroying the economy just to spite the President. What I fear is a Republican party where Newt Gingrich and Ron Paul could be treated as serious candidates.

    1. Maybe you should turn off your MSNBC/CNN/Fox News etc, Ron Paul is definitely a serious candidate, how is that Obama 'change' coming along?

      im not even from the US and that last sentence infuriates me

    2. Ron Paul is trading at 2% on intrade to win the candidacy. Doesn't sound like a "serious candidate" to me.

    3. Absalon, what we've seen is a Democratic party hell bent on destroying the economy in the name of class warfare.

    4. Jason -

      Corporate profits and the incomes of the top 1% are both at record levels as shares of the total economy and the taxes they pay as a percentage of that income is well below what it was in the past.

      The only class warfare going on is the continuing Republican attack on the middle class that started around 1980. What you see as class warfare is just a little belated, and quite timid, push back.

  2. "Monetary policy is close to powerless now, but promising zero percent interest rates for a decade helps; those 3.5% mortgages that are strangling credit could be brought down to 3.4%."

    What does this mean? Can monetary policy increase NGDP? Can monetary policy increase inflation?

    If the answer is yes, then monetary policy can make up any shortfall on the demand side.

    If the answer is no, then the Fed should just buy up all the outstanding treasury debt. I happen to think that will create inflation, because I answer "yes." But for someone answering no, we can avoid the fate of Greece by trading all our debt for green pieces of paper.

    1. a green piece of paper is debt...I don't think the two should be separated so easily. It seems to be the fuller nuance of what Cochrane talks about in his 2009 paper (but I'm sure he could say better)


      The sections "A demand for all treasury debt..." and "The end game" are what I am talking about

  3. JC
    Independently I posted on the same "Taylor Topic", and also mentioned Bullard´s speech.

  4. The Correct Comparison would be with the 1930s, but pick any old graph you want. The Chicago Plan of 1933 worked. In other words, QE plus a Reinforcing Stimulus/Govt Borrowing worked in the 30s, &, to the extent that it has been used here, it has worked. The Plan is to keep Short Term Rates Low as a Disincentive to Investment, & have Rising Longer Term Rates as an Incentive for Investment. Indeed, you might want to look at how the Economy has done over the Last 3 Years when that has happened. Also, for Heaven's Sake, you might want to recall the S & L Debacle & see how it influenced Investment in the Mid 1980s.

    The bottom line is whether you think Irving Fisher's Debt-Deflation explains our current crisis, & whether or not you accept that the Chicago Plan of 1933 works to help end it. I do, & I defy anyone to produce a better explanation. BTW, look up any of my comments or my blog since Sept of 2008. I stand by everything I wrote then & since then, including Explaining in Dec of 2008 why Unemployment would remain high during any recovery unless the Chicago plan was adopted full tilt.

    Finally, there have been numerous polls explaining what businesses are worried about. I notice that many people never bring those up, but pick one study or say that the businessmen they talk to say x. I find that bizarre unless your scouring like Diogenes for what you want to find. The point should be to back the plan that gets us out of this mess, not be worried by side issues like how big government is. If that's your worry, then you should study Special Interests & how They determine the size of our govt, & what to do about it. You might start with those Businessmen who hilariously claim they want smaller govt. & Less Regulation.

  5. This is disappointing, that economists of the stature of Cochrane and Taylor could even think about comparing the 1982 recession to today's. Everything is different between the two: the causes, interest rates going in, labor force, labor organization, inflation, the global economy and exchange rates, levels of education, etc. Really disappointing that there is no mention of any of this. Maybe economists should stop blogging and get back to doing serious analysis.

  6. John, someone hacked your site

    You couldn't seriously think this time is like the early 1980s?

    1. ...you forgot the contrast part of a compare and contrast...

  7. I am confused by the following:

    I lean to "supply"

    Why? If these are just stories, not backed by conclusive evidence, why lean one way or another ?

    Why not acknowledge that both "supply" and "demand" and their interaction terms are most likely driving this whole recession thing together

    Why the reluctance to admit that demand clearly could be a factor, at least to some extent ?

    Is it so inconceivable that investors don't want to invest in risky projects in the US at least in part because they think that there will be no demand for the product of that investment?

    1. I'm with IndependentVoter. Supply and Demand are tied together and difficult to separate logically.

      Businesses won't ramp up production and hire new workers unless they think someone will buy their products. Consumers won't increase spending to buy new products unless they feel comfortable that businesses are going to increase the workforce enough that they can be confident in a steady income. A large party of the country is trapped in "the prisoner's dilemna".

    2. As a tautology, insufficient demand means that people are having their needs and wants largely met. If this were the case, there would be no problem. There currently being a problem, it is obviously therefore not the case.

  8. John, I, like Charlie, would like to know what you think of NGDP targeting as a new framework for monetary stimulus (as advocated by Scott Sumner, and endorsed by Christy Romer, Jan Hatzius, and Paul Krugman)? And what about good old-fashioned QE?

    Didn't Greg Mankiw also endorse the idea that slightly increased inflation would have a stimulative effect on the economy? If you oppose this, why, especially given that inflation has been so low since 2008?

  9. Very educative article and equally contributing comments Overall good blogs. Cheers!

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  10. why do you disagree with the wealth shock story? We are obviously 30% poorer, unless everybody knew that houses were overvalued.

  11. First of all I would like to congratulate you for your blog. It is always an interesting reading! But I think in this post you are making a mess.
    I mean, you said that monetary stimulus will not work at this point due the fact that we are in the zero lower bond and the recovery is not happening. But, in the other hand, it is not clear for me why you think fiscal stimulus won't work. What makes you think that people with a high marginal propensity for consumption won't consume after fiscal stimulus and start a virtuous cicle?
    I mean, business people wants to make business, if people starts consuming more, they will increase production to attend this demand and by doing this jobs will be created, the newly employed people will also have a high marginal propensity for consumption hence once working, they are richer than before. This means the cycle will reestart - changing societie's budget constraint to somewhere closer to the so called "fictional potential product".
    I don't know, Christy Romer said that the question is not if QE worked, it is where would we be of it had not existed.
    I believe you are tergiversing the main point. You are attacking "supply" when the whole discussion seems to be about "demand".

  12. Market Monetarism has the answer. Fhe fed is not powerless.

  13. I'm confused. If the economy were held back by supply constraints, wouldn't that necessarily be inflationary? Especially with ~0% Fed Funds rate, QE1, QE2, and forward guidance for more of the same until 2014?

  14. A whole string of conservative economists--Allan Meltzer, Milton Friedman, John Taylor, Ben Bernanke--all advised Japan to engage in QE (John Taylor gushed about the success of a 2005-era Japan QE program, in a paper he published in 2006, on his website).

    Obviously, right-wing economists believe in QE, and the power of printing money, and even monetizing the debt. They all advised it for Japan, evidently without the moral qualms we hear raised do often today.

    So why now does Cochrane say the Fed has no more ammo? It has plenty of ammo, more than it could ever need. It has to power to buy bonds and dump cash back into the economy, and keep doing it until we get growth followed by inflation. Friedman specifically addressed naysayers in a piece he authored for the WSJ and reprinted by the Hoover Institution.

    See: http://www.hoover.org/publications/hoover-digest/article/6549

    Is it partisan sentiments that prevent right-wingers from advocating QE today? Have the Gold Nuts intimidated GOP economists into submission? Is it no longer politically correct to advocate QE, even if it will work?

    Will Cochrane come out for QE when Romney is president?

    1. Hasn't the monetary base already tripled? How much more cash do we need to dump onto banks who are just going to hold it?

      On the other hand if you are talking about purchasing up quality private debt, I am pretty sure Cochrane has advertised this before.

      His major qualm was that in not having a diverse portfolio (holding only the "toxic assets" we got from the banks) when they try to use their large cash holdings to buy new assets, all the government would have in inventory to offer is the same garbage assets that were the problem to begin with.

    2. 1. Stop paying interest on reserves.

      2. Start level targeting, if you miss an target, aim for a higher target next time.

  15. From Main Street: It's regulation that we are overlooking. I had a client - an eye surgeon - tell me he's returning to his homeland to open a practice. It took him two years to get licensed and his facility approved, at great cost here in the US. At home, he said, he can be up and running in a couple of months. He's from Lebanon. LEBANON! One more example: in downtown Las Vegas Art District, there wasn't one bar, tavern or nightclub two years ago. Tavern licenses cost $50,000 and the city would not allow slot machines (too close to casinos). Last year, the city suspended the license fee and also now allow limited gaming. Four bars have opened, five more are in application stage. The missing component to fixing this crisis is relaxed regulation, even if only temporary. Low rates and taxes aren't enough. The reason we don't hear anything about this is because it's in the local level. There is no national stage to talk about cutting the cost of a city license. But we need to turn the dialogue in that direction, otherwise, Krugman is right - Keynesian will be the only ugly option left.

    1. Yes because relaxed regulation hasn't had anything to do with the obscene amount of debt the country has run up since Reagan, Enron's shady trading, or the mortgage crisis. The repeal of Glass Steagall is probably the number one cause of the situation we are in now.

    2. 1. Glass Steagall would not have prevented Lehman from buying securitized mortgages. In fact, repeal of Glass allowed BofA to buy Merrill and thus helped save the system from crashing. Enrons collapse was caused by accounting fraud and had nothing to do with energy deregulation. Our response to Enron was more regulation, Sarbanes Oxley, which added costs to businesses, sending more business overseas, and do very little to prevent fraud. 2. Small business startups account for more job creation, so I'm talking about local regulations much more than national ones. You can't possibly object to repealing, for instance, a requirement that warehouses install expensive heating equipment in Las Vegas where winter days are in the 70s.

    3. Ok, good points Pat. I do agree on the small business local regulations. But I also believe the repeal of Glass Steagall contributed to risk-taking culture within commercial banks that otherwise wouldn't have felt the need to leverage up and take such risks as they were competing with newly formed mega-banks. And then taxpayes were stuck bailing out the megabanks. As for Enron, I was referring specifically to their energy trading in the deregulated markets in California, in which they were able to influence derivaties by controlling the supply of energy.

      Perhaps we need smarter regulation instead of more or less. The more I think about it, it's not over-regulation or under-regulation that's the problem, it's proper regualation. I can't help but think how different the last 9 years would be if we had a rule that required 20% equity to get a mortgage. That's it, one simple rule.

  16. I don't buy either story.

    #1 is of course preposterous as you stated it. (Like you said, not your job to defend it, really.)

    #2 doesn't fit facts. Was there a sudden change in "over-regulation, uncertainty, fear of political interference, labor-market mismatches" in the last year of the Bush administration? No; if these problems exist, they have existed (or grown slowly) for decades. If we accept your premise that the economy now sits at a different "level," nothing in your list accounts for this quantum level jump.

    Better stories needed!

    Two off-the-cuff candidates: (1) We aren't really at a different level; this is just a _really_ slow recovery. (2) Burned by such a large recession, and now in a collective mindset of fear, businesses (especially the financial industry) now have a much lower tolerance for leveraged growth.

    Those may both be wrong, but I think they deserve addressing.

  17. Pat-
    I often point out, it is state and local governments that are the worst abusers of commercial freedom, usually doing the work of powerful business interests or sometimes local unions, or homeowner groups.

    Everyone believes in free enterprise until they don't.

    1. And they are the easiest to fix because we have so much more control over local politics than we do over Washington. But we need to have a public discussion to make people aware.

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