–The economist Greg Mankiw had an essay in the NYT last week on five theories as to why growth has been so sluggish for so long (Greg’s focus was on the US, but it could have applied to Europe as well). Mankiw, a Harvard professor and writer of widely used textbooks, has long been at the top of the field. Almost a decade after a deep recession that “no one saw coming” (as is widely claimed) and seven years of a tepid recovery, he presents five different diagnoses, ranging from mismeasurement to weak demand to “policy missteps.” With honesty and candor, he concludes: “Unfortunately, I have no idea which one is right.”
–Take a look at the figure below. It is a series of forecasts of world GDP growth by IMF economists. The solid line is actual inflation-adjusted GDP growth and the dashed lines are forecasts conducted in different years. As you can see, they optimistically kept predicting GDP to turn around, failing to correct their model for persistent forecast errors. But let’s not pick on the IMF, since…
Source: Jay Shambaugh, CEA
–…Interest rate projections by various administrations show the same pattern, as do inflation projections by the members of the Federal Reserve board (see first figure below). To their credit, however, if you look at the Fed’s predictions for 2015q4 real GDP growth starting in 2012, by June of that year they’d finally downgraded their forecast (second figure below).
Notwithstanding the Fed’s markdown, something seems quite wrong with contemporary economics. If your car failed to accelerate, even as you hit the gas (i.e., held rates at zero for years), you’d bring it to a mechanic. And if, after seven years of weak expansion, that mechanic (along with most of his fellow mechanics) couldn’t explain the problem, you might legitimately conclude: mechanics don’t understand cars.
Could it be the case that economists don’t understand economies?
Well, there are a lot of different economists out there. Dean Baker quite clearly diagnosed and wrote extensively about the housing bubble well before it burst (so “no one saw it coming” isn’t correct). Paul Krugman long ago correctly diagnosed the crippling problem of austere fiscal policy when economies are not fully recovered and the federal funds rate is stuck at zero.
But broadly speaking, we must ask ourselves not just why we’ve underperformed around the Great Recession and recovery, but why, according to CBO numbers, we’ve been at full employment only around a third of the time since 1980. Given the damage slack labor markets do to the wages, incomes, and opportunities of middle and low-income working households, that’s a tremendous, though too rarely cited, indictment.
Here are a few thoughts about what’s gone wrong:
Old habits correlations die hard. The latest Economic Report of the President included a revealing set of figures showing that a correlation at the heart of macroeconomic analysis and a guidepost for Fed policy—that between labor market slack and inflation—has grown increasingly hard to reliably estimate. Relatedly, the ERP showed that the confidence interval around the “natural rate of unemployment” right now runs from less than zero to about six percent. That implies that economists still operating from this model are likely to get important things wrong.
That word “temporary.” I don’t think it means what you think it means. The Fed keeps talking about temporary headwinds, like the negative spike in energy prices, the strong dollar, slow growth abroad, capital inflows, and wage and price growth that have been largely unresponsive to the tightening job market. But variants of these problems have been around for years now, and the assumption that soon the model will be right again, as in the IMF figure above, is another source of the problem.
Globalization ideology. The assumption that more international trade is always a plus has led too many economists to miss problems in global macro. Most importantly, some of our trading partners suppressed their consumption, boosted their savings, and exported those savings to us such that their trade surpluses become our trade deficits. The need to offset that macro drag, in tandem with large inflows of cheap capital, led to destabilizing bubbles that were missed by most economists.
Finance is much more than an intermediary. Though we’re getting better at this one, for years, macro models treated the finance sector as an intermediary that simply distributed excess savings to its most productive uses. Thus, we mostly missed the fact that the sector was instead misallocating capital to “innovative” financial schemes that systematically underpriced the true risks they engendered, thus both undermining productivity growth and inflating bubbles.
Politically motivated bad ideas posing as economic analysis. This one has become very serious. Most Republicans, mindless budget hawks (those who are always hawkish, regardless of the timing), and anti-government ideologues pushed economic arguments about the “failed stimulus” and the need to pivot to budget austerity. Mankiw, e.g., argues that the Keynesian interventions in 2009 may have been a policy misstep (Blinder/Zandi strongly disagree). Such arguments prompted a shift to budget austerity well before the economy was ready for it. Look, for example, at the following figure from EPI’s research director Josh Bivens, showing per capita government spending (at the federal, state, and local levels) over the past six business cycles. This cycle is a clear, negative outlier which somehow gets missed by the “failed stimulus” crowd. It also brings me to the final point.
Demand, demand, demand. In response to Mankiw, Dean writes, “…there’s not much complicated about the story. We lost a huge amount of demand when the housing bubble collapsed and there is nothing to replace it.” Bivens, Krugman, Summers and many others agree. Greg talks about this under the rubric of “secular stagnation: a persistent inability of the economy to generate sufficient demand to maintain full employment.” One can see it in interest rates that are hitting historic lows across advanced economies and in persistently low inflation. We’re still, seven years into an expansion, nursing a sizable output gap and elevated underemployment. Wage trends, the most reliable—maybe the only reliable—measure of labor market slack, are strengthening a bit but remain well below target growth levels.
So I think Dean’s right and I don’t really understand why that isn’t obvious (though, to be clear, I respect Mankiw’s uncertainty, which is much better than confidence in an incorrect diagnosis). That could be my own limitation and intellectual blinders, but it strikes me as a simple diagnosis with strong evidence to support it, and one with straightforward prescriptions. We need to create more demand through, for example, infrastructure investment, patience on interest rates, and trade policy focused on lowering the trade deficit.
If I’m right, it’s very important to move on these issues. Because most economists have been having such difficulty spotting bubbles or convincingly diagnosing what’s wrong with the economy and prescribing effective solutions, we’ve lost credibility to the point where Trump’s walls and tariffs, Brexit, supply-side tax giveaways to the wealthy, and congressional attempts to control Fed policy are all gaining traction.
And that is all very dangerous.