As we're approaching the 5th anniversary of the Lehman collapse, and everyone seems to want to write about the fallout from the financial crisis, now seems a good time to take stock of the macroeconomic consequences of that event. The first chart shows the log of U.S. real GDP, and the linear trend that best fits the whole post-1947 time series.
That's quite stunning. In terms of our standard measure of aggregate economic activity, the U.S. economy did not "recover" from the previous recession in the usual sense. Real GDP is far below the post-World War II trend, and is growing at a rate less than the average growth rate over the period 1947-2013. If you have read Reinhart and Rogoff's book, maybe this doesn't surprise you. Reinhart and Rogoff tell us that recoveries from financial crises tend to take a long time - financial crisis shocks have very persistent effects. So, if we think that Reinhart and Rogoff know what a financial crisis is, and all those previous crises really have something in common with our experience in 2008-09, then that gives us something to go on. Maybe what we're seeing in the above chart is related to financial factors.
But what exactly are the financial shocks associated with a financial crisis, and how do those shocks propagate themselves? Unfortunately, Reinhart and Rogoff aren't going to tell us much about that. What's going on? I think most economists recognize that policy played some role in causing the financial crisis - if only through poor regulation - but does our current sluggish growth path represent some dramatic failure of economic policy post-crisis? Are policymakers such dummies that they have failed to implement obvious solutions? Is there some unusual market failure at work that we have failed to understand? Or is what we're seeing actually the best possible outcome we could have hoped for, given what happened in 2008-09?
Old-Keynesian IS-LM AD-AS macroeconomists, who still exist, much to the surprise of many of us, think they have an answer. However, I've found the arguments based on that paradigm turn into a
web of contradictions, so there's not much point in taking those arguments seriously. As George Bernard Shaw said
Never wrestle with pigs. You both get dirty and the pig likes it.
New Keynesians, on the other hand, are serious people. They have models, which incorporate bits and pieces of well-accepted economic theory, and they fit those models to data. The New Keynesian story about the recent recession is that there is a shorthand for a financial crisis shock - it's a preference shock. Consumers became much more patient during the financial crisis, and that patience has persisted. Unfortunately, given that type of shock, conventional monetary policy cannot correct the ensuing sticky price problem, because of the zero lower bound on the nominal interest rate. With no movement in anticipated inflation, the adjustment that has to occur is a reduction in consumption and output.
But prices will adjust over time of their own accord, and the sticky-price inefficiency (relative prices out of whack) will go away. The question is, how quickly does this happen? Is this a case of "in the long run, we're all dead," or what? Well, considerable effort has gone into studying price adjustment at the micro level, of late, so we know something about this. The best summary of evidence, to my knowledge, is in Klenow and Malin's
chapter from the recent edition of the Handbook of Monetary Economics. Klenow/Malin conclude, among other things, that the average length of time between price changes is about one year. That's a longer period than what Bils/Klenow reports, which was a period of four months. The difference seems to be due to the fact that Klenow/Malin choose to exclude price changes from sales, for example. Toothpaste could be priced at $2.00, go on sale for a week at $1.50, then go back to $2.00, and Klenow/Malin would not count that as a price change. So they seem to be bending over backward to make prices look more sticky. But even if all prices change once every year, if we suppose that there was one financial-crisis shock that occurred in the fall of 2008, then five years later we won't have much residual inefficiency due to price stickiness. Further, Klenow/Malin report that prices are more flexible for goods that are cyclically sensitive, i.e. sectors of the economy for which employment and output are more variable relative to trend. Since those are the sectors where the friction would have to matter in delivering the large drop in output we're seeing in the first chart, it's hard to see why a New Keynesian sticky price mechanism is explaining what we're seeing.
Further, what we should be seeing, according to New Keynesian models, is real GDP returning to the post-war trend, and a gradual increase in the inflation rate as that happens, as we should be climbing the New Keynesian Phillips curve. But that's not what's happening. People at the Fed and elsewhere are using New Keynesian models as forecasting tools - that's in part why they've been over-optimistic. In a New Keynesian model, a shock hits, and there is some direct effect from the shock (what the frictionless model delivers) and the indirect effect from the sticky price friction. Ultimately the indirect effect dies out, and the economy returns to it's TFP-growth-driven trend. Whether the nominal interest rate is at the zero lower bound will make a difference, as away from the zero lower bound monetary policy can give quicker adjustment of relative prices. But sellers are not going to change their prices any more or less quickly because the nominal interest rate is zero than otherwise, everything else held constant.
There's an additional puzzle associated with that idea. The next chart shows my crudely constructed measure of TFP (total factor productivity), using annual capital stock data (available only up to 2011), and household-survey employment.
There's no particular problem with TFP growth. Indeed, TFP grew at a relatively high rate in 2010 and 2011. The average rate of growth from 2000-2011 is about 0.9%, which is lower than the post-WWII average of about 1.2%, but that's not bad, given the effects of two recessions over that period. Thus, the U.S. economy is very productive, but the quantity of labor input is really low, as we all know.
Speaking of employment, it's useful to look at what is happening across sectors of the U.S. economy. The next chart shows some selected components of employment, for the period 2000-2013.
I've normalized each time series to 100 at the first observation. The key message here is dispersion - employment growth has differed markedly across sectors over this period. Employment in durables and nondurables manufacturing fell by about 30% over the thirteen-year period while, at the other end of the spectrum, employment in education and health care grew by almost 40%, and in leisure and hospitality by more than 20%. Construction, which was an employment-growth sector until 2006, suffered the largest employment decline during the recession. Thus, some of the dispersion in employment growth is the result of the recession (construction), but a good part is the result of secular changes in the composition of employment. This is important, as we want to understand more about these long-run changes in sectoral activity - what is due to technology, what is demand shifts, what might be due to the financial factors at work during the recession.
I've written before about
how it is difficult to square the experience we've had with sectoral shifts with sticky price theory. Relative stickiness in prices has implications for secotoral employment over the business cycle, but those implications are not consistent with the above picture.
What about wage stickiness? That's certainly important in the Keynesian narrative, though New Keynesians tend to think more about sticky prices. Suppose, for the sake of argument that a particular worker's wage had been stuck at its pre-financial crisis nominal level until now. How much would that worker's wage have declined in real terms by mid-2013? The answer depends on when the worker's wage became stuck. If it was in January 2007, the decline would be 12% (using pce inflation); if in December 2007, 9%; and if when Lehman went down, 6%. That's large in any case, and that's with zero adjustment over 5 or 6 years. You think wage stickiness matters over that length of time, or that wage stickiness somehow explains the drop in employment we saw in the construction sector? I don't think so.
Another useful exercise is to look at the time series for the components of GDP since pre-recession times. The next chart shows these, leaving out net exports.
Then, compare that to what we see for the 1981-82 recession. In the next chart, I've made the sample period the same length as in the first chart, and the first observation is the same number of quarters before the beginning of the recession, the way the NBER dates it.
First, focus on government expenditure. At the turning point in the recession, that's actually higher, relatively, in the recent recession than in 1981-82. You can see the effects of the stimulus and, if you believe in stabilization policy, the timing is really good - government expenditure is high at the turning point, and until mid-2010, before declining. That decline is interesting, as you might think - if you listen to people who argue that the multiplier is really large - that this would have been a disaster. But I don't see the multiplier at work when I stare at that chart. Consumption just keeps growing at a steady rate, though that rate is lower than what we usually see coming out of a recession - for example, look at what happened in the 1981-82 recession.
Probably the most important feature of the data in the two charts is the difference in the behavior of investment. In 1981-82, investment declines by about 12% from the first observation, then rebounds significantly, to the extent that it grew more than consumption and output by mid-1983. In the last recession, investment declined by more than 30% from the beginning of 2007 to mid-2009, and in second quarter 2013 was still about 5% lower than in first quarter 2007. Thus, if there is something we should be focusing on, it's not multipliers and consumption, but why investment is so low. That low level of investment, over a five year period, has now had a significant cumulative effect on the capital stock. Thus, we've got OK growth in TFP, but growth in factor inputs is low. That's the key story, from a growth accounting point of view.
So, what to make of this?
1. There are many frictions to think about. (i) There are financial frictions. Limited commitment and private information, coupled with a low supply of safe assets, can lead to the misallocation of capital and labor in the economy, for example. (ii) There are distortions caused by inefficient taxation and subsidies - for example in the housing sector. (iii) There is inefficient regulation at work, particularly in the financial sector, as we know well. (iv) Heterogeneity and private information in the labor market creates matching frictions, which can be exacerbated by sectoral shifts, and by financial frictions. With all that to think about, why focus on sticky wages and prices? Some people want to take the persistent level decline in GDP, and the persistently low GDP growth rate, as indications that sticky wages and prices are really important, when they should be thinking the opposite. As sluggishness persists, this casts further doubt on sticky wage and price frictions as being the source of the problem. People who cling to those sticky ideas, particularly the Old Keynesians, are either being lazy, or are simply unimaginative.
2. What should policy be doing? This is not a problem for monetary policy. The real effects of Fed actions, outside of crisis periods, are small and transitory at best. Whether by accident or design, the Fed has been doing a good job of controlling inflation, and should focus on that. If there are remedies to the poor real-side performance of the U.S. economy, those are fiscal remedies. There are plenty of things to think about: (i) further financial reform; (ii) housing and mortgage market reform - get rid of housing subsidies, Fannie Mae, and Freddie Mac, for example; (iii) health care: Congress should stop fussing about Obamacare - which is imperfect, but nevertheless an improvement - and do something useful for a change; (iv) education: If you believe the cross-country test results, the quality of American education in K-12 is declining, and we know there are huge disparities in access to good education. Some work points to a big payoff from early childhood education; (v) the problems in the north side of St. Louis, and in many other American cities, look very similar to those in the poor countries of the world. The problems may seem intractable, but we should be putting more effort and resources into solving them.
