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ON THURSDAY, my colleague laid out the case for the argument that America's potential output has been permanently reduced by the Great Recession. He didn't say that the bought it, exactly; he just explained what that case might look like. That case rests on three observations: slow growth in recovery, a relatively fast decline in unemployment given slow growth, and surprisingly robust inflation. My colleague notes that there are plenty of good alternative explanations for these dynamics, and he's right. The alternatives, in my view, are considerably better than the hypothesis that America has suffered permanent damage from the downturn.
Slow growth is perfectly consistent with an economic recovery amid too-tight monetary policy. As many economists have pointed out, the Americna economy shows many signs of insufficient demand growth. That's not surprising given that interest rates long ago approached zero, that rule-recommended policy rates have long been significantly negative, and that the central bank has only grudgingly and intermittently aimed to move actual interest rates closer to the recommended policy rate via inconventional policy. If a Taylor rule had been consistently recommending a 2% fed funds target rate over the past 4 years and the Fed had instead kept its target rate at 6% over that time, not a single economics writer in America would wonder why growth had been so abysmal.
What about unemployment? As I discussed here, it's quite possible that current too-fast employment declines are merely the flipside of the earlier, too-slow employment declines that prompted widespread hand-wringing over the possibility of structural unemployment. And after the experience of the past few years, we should be very aware of the possibility that significant revisions to the data may loom ahead.
As for inflation, I see no puzzle at all. Commodity price rises have nudged inflation up periodically over the course of the recovery. Experience also tells us that, thanks to wage and price stickiness, disinflation tends not to accelerate. What we'd expect to see given a prolonged, large output gap is precisely what we have seen—wage growth that is virtually flat and inflation that remains fairly dormant even during bursts of rapid output growth. It is possible that there has been some secular erosion in potential or some permanent hit from the recession. The most parsimonious explanation for the figures we have is that the economy is suffering from a large demand shortfall that has been inadequately treated by the central bank. Most members of the labour force are now employed. If the economy were operating close to potential, we would expect to see fairly energetic wage rises. We haven't; on the contrary, we've seen rapid employment growth and wage growth that is stable at low rates. Indeed, the year-on-year rise in nominal hourly wages was the same in February of 2012 as it was in February of 2011—1.9%—and down from 2.1% in December of 2011.
There is always a strong temptation to see a poor economy has resulting from negative structural developments. That was a common view in the 1930s. It has nearly always proven dramatically overstated. I'd be surprised if this time is different.
I think it's also important to reject the kinds of arguments Felix Salmon makes here, when he argues that America has used ever more debt to generate growth, such that a shortfall in borrowing must lead to a fall in potential output. This makes no sense, and indeed, Mr Salmon doesn't begin to discuss just how debt came to occupy such a large role in the production process. It would be hard for him to do so, because it doesn't. I suppose he might be thinking that growth has relied on "overconsumption"; that implies, however, that America was underproducing during its boom and must overproduce now to pay back its debt. One might then argue that there are structural barriers that prevent America from increasing output to pay back this debt, but one is then assuming what one wishes to prove.
It is common to look at the laggardly performance after debt crises and conclude that such recoveries are necessarily slow, or that they prove that when financialisation of the economy generates a bust that something real and permanent has been lost. It's striking to note, however, that when barriers to effective monetary policy are stripped away in such circumstances (like, for instance, the constraints of the gold standard) the inevitably laggardly recoveries often transform into historic booms.
UPDATE: Let me put my contention this way. In 1984, real output grew by 7.4% and the CPI rose at more than 4% for the entire year. I'd be surprised if the American economy could grow by 7.4% now without inflation rising to over 4%. And I'd be surprised if America's real output didn't grow at close to 7% if inflation were over 4%. The Fed doesn't want the one and so it doesn't get the other
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