The Output Gap versus the "Wealth Shock"

Missouri gets two Federal Reserve Banks. One is in St. Louis, the other in Kansas City. James Bullard is the President of the St. Louis Bank. (Pizzaman and Lothario Herman Cain had worked at the Kansas City one.) Via Yglesias, Cowen, Thoma, and MacroMania, here is a speech Bullard gave in Chicago on inflation targeting.

The key to the large output gap story is the use of the fourth quarter of 2007 as a benchmark for where we expect the economy to be today. The idea is to take that level of real output, assume the real GDP growth rate that prevailed in the yearsprior to 2007, and project out where the “potential” output of the U.S. should be. By that type of calculation, we are indeed stunningly far below where we should be, perhaps 5.5 percent below, using data through the fourth quarter of 2011.

Is this really the right way to think about where the U.S. economy should be? I do not think it is a defensible point of view. Let me give you some of my perspectives. What is more, we have made little progress in closing the gap defined in this way, because real GDP has only grown at modest rates since the recession ended in the summer of 2009. And furthermore, using current GDP forecasts from, say, the Blue Chip consensus, we have little prospect for closing the gap any time soon.

As I understand it, the trend growth rate used by the Fed, the CBO and Blue Chip private forecaster consensus DOES NOT start in 2007 but starts back many years and even decades. If this is true the economic illiteracy demonstrated by Bullard is both shocking and galling. Or is he a fraud?

Most analysts seem to agree that the middle part of the 2000s was characterized by a “bubble” in the housing sector. Housing prices were high and rising fast compared to nominal GDP. It is not prudent to extrapolate a bubble into the indefinite future and claim that such a calculation provides a good benchmark. Yet, that is what we are doing when we extrapolate fourth quarter 2007 real GDP. Furthermore, we normally have the good sense not to do this in other economic situations.

But they aren't extrapolating from the bubble are they?

For those who take the “large output gap” view, the expectation is for real GDP to grow rapidly after the recession comes to an end, as the economy catches up to its potential. It is like a rubber band, there is supposed to be a bounce back period of rapid growth. In fact, most analysts have been looking for exactly this effect since the summer of 2009. It has not happened. This has led to a lot of analysis concerning special factors and headwinds that might be inhibiting the “bounce back” effect.

The wealth shock view puts a different expectation in play. The negative wealth shock lowers consumption and output. But after the recession ends, the economy simply grows from that point at an ordinary rate, neither faster nor slower than in ordinary times. It is more like an earthquake which has left one part of the land higher than another part. There is no expectation of a “bounce back” to a higher level of output after the recession ends. This is closer to what has actually happened since mid-2009. Output has grown at a moderate rate, but not a rapid rate, since the recession ended.

In the wealth shock view, there is no “large output gap” rationale for keeping interest rates near zero. There is only an economy growing at normal rates following a large shock to wealth.

The growth rates are determined by government policy. They're a political decision. The long term potential growth rate is not a political decision. It's a function of technology, organization, population growth, etc.

But the government determines credit conditions, fiscal stimulus, monetary stimulus, inflation rate, etc. They can bring us to our full potential growth rate more quickly or they can stagnate us at a lower equilibrium.

[I have to take a break. I can't keep reading Bullard's tripe right now.]