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Controversial Issues About the Recession and Recovery Robert J. Gordon Northwestern University and NBER CIRET Conference, New York City October 14, 2010 The Plan: From Long-Run to Short-Run to Policy The reasoning behind my pessimistic long-term US growth forecast, recently summarized in Business Week Graphs on dimensions of the weak labor market. The labor market is in worse condition than the product market. New research on the “Demise of Okun’s Law” and the near-term division of output growth between productivity, hours, and employment growth – Why is the labor market in such bad shape compared to the product market? The policy debate: what more can monetary and fiscal policy do? The Pessimistic Long-run Conclusion Comparing 2007-2027 forecasts with 19872007 actual: Output growth will slow from 2.9 to 2.4 Output per capita growth will slow from 1.74 to 1.4 That is the slowest growth of income per capita “since George Washington” Compare to 2.16 1929-2007 or 2.02 18912007 Growth in MFP vs. Ypc by Time Interval, 1891-2027 Growth in MFP and Real GDP per capita, selected intervals, 1891-2027 3 2.5 Percent per Year 2 MFP GDP/Pop 1.5 1 0.5 0 1891-1928 1928-1950 1950-1972 1972-1987 1987-2007 2007-2027 Components of Growth in Y/H, 1987-2007 vs. 2007-27 Components of Growth of Labor Productivity, Two Intervals 2.5 Percent per Year 2 1.5 1987-2007 2007-2027 1 0.5 0 Output/Hour Capital Deepening Labor Quality MFP From Y/H to Y/N, the Role of Falling LFPR Components of Output Growth, Two Intervals 3.5 3 Percent per Year 2.5 2 1987-2007 2007-2027 1.5 1 0.5 0 Output Output/Hour Output/Person Hours Population Possible Further Room for Pessimism These projections are based on the historical record of growth between years of “normal” utilization (1987, 2007) No allowance here for long-run “tainting” effects of the current abysmal economy – Loss of skills and human capital – Years of low investment will increase the age of the capital stock and reduce the growth of both capital quantity and capital quality Policy Prescriptions for Long-Run Growth Problem Slowdown reflects aging of population and stagnation of educational attainment Solve the first by immigration, particularly of high-skilled people Work on the second by better governmentrun student loan programs and direct measures to address the rising relative price of college education (“higher education cost disease”) Stimulate demand to avert long-run supply sclerosis Next We’ll Look at Graphs of Raw Numbers for Current US Labor Market Now We’re Looking at – Magnitudes: How Severe Is This Episode? – Timing: Do Labor Market Indicators Change at the Same Time as Output (Real GDP)? – Which Measures Are the Most Different from 1980-82? We Consider 1980-82 as a Single Recession and also as two back-to-back recessions – (Jan-July 1980 and Jul 81 to Nov 82) Output Gap vs. Gap in Aggregate Hours of Work Conclusion to this point Comparing the 9.6 level of U rate now to 10.8 in Nov & Dec 1982 is misleading – U rate in July 81 or even Jan 80 started higher – Overall increase in 2007-09 is greater – Much more incidence this time of long-term unemployment and forced part-time The emergence of long-term unemployment: is the US becoming more like Europe’s two decades 19852005? Stylized fact: If the empl/pop ratio was the same today as in 2000, there would be 14 million more jobs (9 million from lower unemployment rate, 5 million from higher LFPR) “New Normal” for LFPR? For U Rate? Documenting and Explaining the Change in Cyclical Labor-market Behavior Documenting – A new approach to disentangling trends and cycles Use of “outside information” from inflation equation to determine the unemployment rate gap – A new approach to data Total Economy not NFPB Sector Conventional vs. Unconventional Measures – Initial finding as reported before: hours gap > output gap in 2008-09, the reverse of 1980-82 The Output Identity: Simple Version and Conventional Version Y H E L Y N H E L N P Y P P P H Y H E E L P P H N H E E L N Conventional Compared to Unconventional Identity P Y P P P H Y H E E L P P H N H E E L N I H H Y H E L Y H H N L N H E I Kalman Trends, Conv vs. Unconv Output Aggregate Hours Total Economy Labor Productivity (Y/H) Output Gap vs. Gap in Aggregate Hours of Work Close-up for Period since 1986 Regression Analysis Changes in hours gap regressed on – – – – Own lags Current and lagged changes in output gap Error-correction term (lagged level of hours gap) “End of expansion” dummy variables (capture overhiring end of expansion, underhiring beginning of recovery) “Early recovery productivity bubble” Long-run Coefficients: The “Demise of Okun’s Law” Explanations Offered in My Research The “Disposable Worker” Hypothesis Similar sources as rising US inequality Increased market power of managers and highly paid professionals – Increased share of executive incomes coming from stock options Reduced market power of workers due to: – Declining unions, declining real minimum wage, low-skilled immigration, and imports Implications for the Unemployment Rate Translate forecast growth in hours into the hours gap Regression coefficients imply roughly 60% of an improvement in hours gap flows into employment rate gap Optimistic path, output gap shrinks 0.8 points per year (3.3 vs. 2.5) Pessimistic path, output gap stays where it is forever (2.5 percent growth forever) Implied Unemployment Paths Unemployment Rate: Actual and Projected Optimistic and Pessimistic Outlooks 12.00% 10.00% 8.00% 6.00% Optimistic Projection 4.00% Pessimistic Projection Actual 2.00% 0.00% 1986 1992 1998 2004 Year 2010 2016 Reasons This May Be Too Optimistic Why does pessimistic U Rate decline even though output gap is fixed? – Error-correction term implies mean reversion both of negative hours gap and positive productivity gap Division of predict real GDP growth between productivity and hours: mean reversion may be delayed – Much publicized “reluctance to hire” – Matched with “reluctance to invest” – Firms are not expecting the 3.3 growth scenario If the 3.3 growth rate actually happened, short-term outcome would be more productivity growth and less hours and employment growth But will that output scenario happen? Reasons To Be Skeptical of Optimistic Scenario Reinhart-Rogoff. Recoveries after financial crises are slower than after garden-variety recessions Ineffectiveness of monetary policy Political paralysis just as Obama stimulus is about to be withdrawn The Fed is Out of Ammunition Textbook IS-LM model still taught in intermediate undergrad macro Monetary policy is ineffective if: – Horizontal LM curve – Vertical IS curve The Fed now is plagued by both Why should QE2 work since QE1 didn’t? The Fed Can’t Control the Cost of Business Borrowing Fundamental Causes of Weak Recovery (Vertical IS) Consumption – Collapse of Household Net Worth – Record-high indebtedness Residential Construction – – – – – Foreclosures and Under-water Mortgages People walk away from under-water Their credit is tainted for years Their houses add to supply but not to demand My mortgage broker’s story, 3 vs. 80 Consumption Problem: Household Balance Sheet The Twin Peaks of Household Net Worth Percentage of Disposable Personal Income 800 750 700 650 Total Assets 600 550 500 Net Worth 450 400 100 50 0 Total Liabilities -50 -100 -150 1970 1975 1980 1985 1990 1995 Sources : Federal Reserve Board Flow of Funds Accounts and Bureau of Economic Analysis NIPA Tables . Details in Appendix C-4. 2000 2005 2010 Housing Starts Used to be a Leading Indicator, but Not Any More Quarterly Housing Starts, 1970-2010 2500 Quarterly Housing Starts (thousands) 2000 1500 1000 500 0 1970 1975 1980 U.S. Census Bureau Manufacturing, Mining and Construction Statistics 1985 1990 1995 2000 2005 2010 Where is Fiscal Policy? Krugman NYT Monday: it wasn’t tried. Look at government employment excluding census workers The Obama stimulus was too small and too much was wasted on tax cuts and capital-intensive infrastructure spending What Ended the Great Depression? Chart Extends 1929-41 Quarterly 30 25 Spending/GDP Ratio 20 Transfer Payments/GDP 15 10 Federal Spending/GDP 5 State and Local Spending/GDP 0 1929 1931 1933 1935 1937 1939 1941 How Does the Obama Stimulus Measure Up? 30 25 Spending/GDP Ratio Transfer Payments/GDP 20 Federal Spending/GDP 15 10 State and Local Spending/GDP 5 0 1980 1985 1990 1995 2000 2005 2010 The Current Debate, What About Inside vs. Outside Govt Debt? Monetary Policy is parralized but still can support fiscal expansion A fiscal stimulus does not raise outside debt (“held by the public”) if the Fed buys the bonds This is the classic Milton Friedman “heliocopter drop” of money In today’s terminology, QE2 supports a fiscal stimulus But where is the political will? Conclusions A Real GDP path of 3.3 brings the U rate down to 6 percent by early 2014 Reasons this may be too optimistic Pessimistic path leaves U rate at 8 percent in 2016, Europe déjà vu 1985-2005 Model has mean-reversion built in, underhiring in 2009-10 will be reversed, productivity bubble will be reversed. Basic problems: Reinhart-Rogoff, ineffective monetary policy, lack of political will on fiscal policy, about to become much worse after the elections