Tag Archive for 'Menzie Chinn'

Output gaps, inflation and totally awesome blogosphere debates

I love the blogosphere.  It lets all sorts of debates happen that just can’t happen face to face in the real world.  Here’s one that happened lately:

James Bullard, of the St. Louis Fed, gave a speech in which (I believe) he argued that wealth effects meant that potential output was discretely lower now after the crash of 2006-2008.  David Andolfato and Tyler Cowen both liked his argument.

Scott Sumner, Noah Smith, Paul Krugman, Matt Yglesias, Mark Thoma and Tim Duy (apologies if I missed anyone) all disagreed with it for largely the same reason:  A bubble is a price movement and prices don’t affect potential output, if for no other reason then because potential output is defined as the output that would occur if prices didn’t matter.

Brad DeLong also disagreed on the same grounds, but was willing to grant that a second-order effect through labour-force participation may be occurring, although that was not the argument that Bullard appeared to be making.

In response, Bullard wrote a letter to Tim Duy, in which he revised his argument slightly, saying that it’s not that potential output suddenly fell, but that it was never so high to start with.  We were overestimating potential output during the bubble period and are now estimating it more accurately.

The standard reply to this, as provided by by Scott SumnerTim DuyMark Thoma and Paul Krugman, takes the form of:  If actual output was above potential during the bubble, then where was the resulting inflation?  What is so wrong with the CBO’s estimate of potential output (which shows very little output gap during the bubble period)?

Putting to one side discussions of what the output gap really is and how to properly estimate it (see, for example, Menzie Chinn here, here and here), I’ve always felt a sympathy with the idea that Bullard is advocating here.  Although I do not have a formal model to back it up, here is how I’ve generally thought of it:

  • Positive output gaps (i.e. actual output above potential) do not directly cause final-good inflation.  Instead, they cause wage inflation, which raises firms’ marginal costs, which causes final-good inflation.
  • Globalisation in general, and the rise of China in particular, meant that there was — and remains — strong, competition-induced downward pressure on the price of internationally tradable goods.
  • That competition would induce domestic producers of tradable goods to either refuse wage increases or go out of business.
  • Labour is not (or at least is very poorly) substitutable.  Somebody trained as a mechanic cannot do the work of an accountant.
  • Therefore, the wages of workers in industries producing tradable goods stayed down, while the wages of workers in industries producing non-tradable goods were able to rise.
  • Indeed, we see in the data that both price and wage inflation in non-tradable industries have been consistently higher than those in tradable sectors over the last decade and, in some cases, very much higher.

The inflation was there.  It was just limited to a subset of industries … like the financial sector.

(Note that I’m implicitly assuming fixed, or at least sticky, exchange rates)

As it happens, I also — like Tyler Cowen — have a sneaking suspicion that temporary (nominal) demand shocks can indeed have effects that are observationally equivalent to (highly) persistent (real) supply shocks.  That’s a fairly controversial statement, but backing it up will have to wait for another post …

Some brief thoughts on QE2

  • Instead of speaking about “the interest rate” or even “the yield curve”, I wish people would speak more frequently about the yield surface:  put duration on the x-axis, per-period default risk on the y-axis and the yield on the z-axis.  Banks do not just borrow short and lend long; they also borrow safe and lend risky.
  • Liquidity is not uniform over the duration-instantaneous-default-risk space.   Liquidity is not even monotonic over the duration-instantaneous-default-risk space.
  • There is still a trade-off for the Fed in wanting lower interest rates for long-duration, medium-to-high-risk borrowers to spur the economy and wanting a steep yield surface to help banks with weak balance sheets improve their standing.
  • By keeping IOR above the overnight rate, the Fed is sterilising their own QE (the newly-injected cash will stay parked in reserve accounts) and the sole remaining effect, as pointed out by Brad DeLong, is through a “correction” for any premiums demanded for duration risk.
  • Nevertheless, packaging the new QE as a collection of monthly purchases grants the Fed future policy flexibility, as they can always declare that it will be cut off after only X months or will be extended to Y months.
  • It seems fairly clear to me that the announcement was by-and-large expected and so “priced in” (e.g. James Hamilton), but there was still something of a surprise (it was somewhat greater easing than was expected) (e.g. Scott Sumner).
  • Menzie Chinn thinks there is a bit of a puzzle in that while bond markets had almost entirely priced it in, fx-rate markets (particularly USD-EUR) seemed to move a lot.  I’m not entirely sure that I buy his argument, as I’m not entirely sure why we should expect the size of the response to a monetary surprise to be the same in each market.

In which I respectfully disagree with Paul Krugman

Paul Krugman [Ideas, Princeton, Unofficial archive] has recently started using the phrase “jobless recovery” to describe what appears to be the start of the economic recovery in the United States [10 Feb, 21 Aug, 22 Aug, 24 Aug].  The phrase is not new.  It was first used to describe the recovery following the 1990/1991 recession and then used extensively in describing the recovery from the 2001 recession.  In it’s simplest form, it is a description of an economic recovery that is not accompanied by strong jobs growth.  Following the 2001 recession, in particular, people kept losing jobs long after the economy as a whole had reached bottom and even when employment did bottom out, it was very slow to come back up again.  Professor Krugman (correctly) points out that this is a feature of both post-1990 recessions, while prior to that recessions and their subsequent recoveries were much more “V-shaped”.  He worries that it will also describe the recovery from the current recession.

While Professor Krugman’s characterisations of recent recessions are broadly correct, I am still inclined to disagree with him in predicting what will occur in the current recovery.  This is despite Brad DeLong’s excellent advice:

  1. Remember that Paul Krugman is right.
  2. If your analysis leads you to conclude that Paul Krugman is wrong, refer to rule #1.

This will be quite a long post, so settle in.  It’s quite graph-heavy, though, so it shouldn’t be too hard to read. 🙂

Professor Krugman used his 24 August post on his blog to illustrate his point.  I’m going to quote most of it in full, if for no other reason than because his diagrams are awesome:

First, here’s the standard business cycle picture:


Real GDP wobbles up and down, but has an overall upward trend. “Potential output” is what the economy would produce at “full employment”, which is the maximum level consistent with stable inflation. Potential output trends steadily up. The “output gap” — the difference between actual GDP and potential — is what mainly determines the unemployment rate.

Basically, a recession is a period of falling GDP, an expansion a period of rising GDP (yes, there’s some flex in the rules, but that’s more or less what it amounts to.) But what does that say about jobs?

Traditionally, recessions were V-shaped, like this:


So the end of the recession was also the point at which the output gap started falling rapidly, and therefore the point at which the unemployment rate began declining. Here’s the 1981-2 recession and aftermath:


Since 1990, however, growth coming out of a slump has tended to be slow at first, insufficient to prevent a widening output gap and rising unemployment. Here’s a schematic picture:


And here’s the aftermath of the 2001 recession:


Notice that this is NOT just saying that unemployment is a lagging indicator. In 2001-2003 the job market continued to get worse for a year and a half after GDP turned up. The bad times could easily last longer this time.

Before I begin, I have a minor quibble about Prof. Krugman’s definition of “potential output.”  I think of potential output as what would occur with full employment and no structural frictions, while I would call full employment with structural frictions the “natural level of output.”  To me, potential output is a theoretical concept that will never be realised while natural output is the central bank’s target for actual GDP.  See this excellent post by Menzie Chinn.  This doesn’t really matter for my purposes, though.

In everything that follows, I use total hours worked per capita as my variable since that most closely represents the employment situation witnessed by the average household.  I only have data for the last seven US recessions (going back to 1964).  You can get the spreadsheet with all of my data here: US_Employment [Excel].  For all images below, you can click on them to get a bigger version.

The first real point I want to make is that it is entirely normal for employment to start falling before the official start and to continue falling after the official end of recessions.  Although Prof. Krugman is correct to point out that it continued for longer following the 1990/91 and 2001 recessions, in five of the last six recessions (not counting the current one) employment continued to fall after the NBER-determined trough.  As you can see in the following, it is also the case that six times out of seven, employment started falling before the NBER-determined peak, too.

Hours per capita fell before and after recessions

Prof. Krugman is also correct to point out that the recovery in employment following the 1990/91 and 2001 recessions was quite slow, but it is important to appreciate that this followed a remarkably slow decline during the downturn.  The following graph centres each recession around it’s actual trough in hours worked per capita and shows changes relative to those troughs:

Hours per capita relative to and centred around trough

The recoveries following the 1990/91 and 2001 recessions were indeed the slowest of the last six, but they were also the slowest coming down in the first place.  Notice that in comparison, the current downturn has been particularly rapid.

We can go further:  the speed with which hours per capita fell during the downturn is an excellent predictor of how rapidly they rise during the recovery.  Here is a scatter plot that takes points in time chosen symmetrically about each trough (e.g. 3 months before and 3 months after) to compare how far hours per capita fell over that time coming down and how far it had climbed on the way back up:


Notice that for five of the last six recoveries, there is quite a tight line describing the speed of recovery as a direct linear function of the speed of the initial decline.  The recovery following the 1981/82 recession was unusually rapid relative to the speed of it’s initial decline.  Remember (go back up and look) that Prof. Krugman used the 1981/82 recession and subsequent recovery to illustrate the classic “V-shaped” recession.  It turns out to have been an unfortunate choice since that recovery was abnormally rapid even for pre-1990 downturns.

Excluding the 1981/82 recession on the basis that it’s recovery seems to have been driven by a separate process, we get quite a good fit for a simple linear regression:


Now, I’m the first to admit that this is a very rough-and-ready analysis.  In particular, I’ve not allowed for any autoregressive component to employment growth during the recovery.  Nevertheless, it is quite strongly suggestive.

Given the speed of the decline that we have seen in the current recession, this points us towards quite a rapid recovery in hours worked per capita (although note that the above suggests that all recoveries are slower than the preceding declines – if they were equal, the fitted line would be at 45% (the coefficient would be one)).

Demand for sex in Japan

Mentioning sex in a blog post is a great way to generate some interesting traffic.  The last time I filled some time writing about it (on the rise of public sexuality, the rationality of prostitution and the extent of human trafficking), I got hits via some very odd queries on Google.

Titillation aside,  prostitution is a tremendously interesting topic in economics .  As John Hempton discussed initially in July 2008 and more extensively in May 2009, the price of prostitution is enormously flexible, unlike prices (and wages) in most industries.  That means that when, as John discussed, a country is operating under a fixed exchange rate and only prices can adjust in response to a macroeconomic shock, the sex industry will almost certainly move both first and furthest.

But because prostitution has very flexible wages and prices, that also makes it a candidate proxy for estimating changes in the potential output of an economy — the output that would occur if all prices were perfectly flexible.  (Remember there are differences between potential and natural levels of output)

I mention this after reading that the Bank of Japan is conducting surveys to estimate changes in demand in the Japanese sex industry:

The survey of sex shops and restaurants was designed to better gauge demand for services, an area of the economy that’s becoming more important as exports slump. “Any study into services is most welcome,” said Martin Schulz, senior economist at Fujitsu Research Institute in Tokyo. “We’ve got hundreds of studies on exports and manufacturing. What’s needed is creative thinking on services and if that includes brothels, so be it.” … While services including restaurants and retailing make up about 60 percent of gross domestic product, Japan’s economy has risen and fallen with the strength of its exports.

(Hat tip:  Tyler Cowen).

On China

Menzie Chinn emphasises that for the purposes of estimating country shares in global GDP, it is necessary to think of them in nominal terms.  On that basis, China is large, but only half the size of the Euro zone and well under half the size of America.  Therefore, he implies, an increase in demand from China won’t really contribute as much to global growth as people might be hoping.

Nevertheless, people do seem to be wondering about China as an engine of global growth in demand.  The reason is simple:  Despite a near catastrophic collapse in world trade, China’s economy is still growing while those of  other export-oriented countries like Japan or Germany are falling precipitously.

Clearly part of the reason for the continued Chinese growth, like in Australia, is the successful use of a fiscal stimulus to boost local demand (the Australian rebound was also helped by the fact that, by not manufacturing much, their decline in investment was offset by a fall in imports and (price) changes in natural resource exports occur with a significant lag).

Brad Setser has explored the Chinese stimulus a little.  He writes:

I initially underestimated the magnitude of China’s stimulus by focusing on the (fairly modest) change in the government’s fiscal balance. It is now clear that the majority of China’s stimulus has been off-budget: the huge increase in lending by state owned banks mattered far more than the change in the budget of the central government. The expected loss on these loans can be considered a form of fiscal stimulus.

Which is a fascinating way to conduct government business.