Home > Inequality, Monetary Policy, Wages > Overheat to Raise Potential Growth?

Overheat to Raise Potential Growth?

Update, March 20th: Speaking of ideological biases concerning inflation, Paul Krugman nails it, as usual.

On today’s Financial Times, Phillip Hildebrand gives yet another proof of unwarranted inflation terror. His argument is not new: In spite of the consensus on a weak recovery, the US economy may be close to its potential , so that further monetary stimulus would eventually be inflationary.

He then deflects (?) the objection that decreasing unemployment reflects decreasing labour force participation rather than new employment, by suggesting that it is hard to know how many of the 13 millions jobs missing are structural, i.e.not linked to the crisis. I think it is worth quoting him, because otherwise it would be hard to believe:

However, an increasingly vocal group of observers, including within the Fed, posits that more of the fall in the participation rate appears to have been structural than cyclical, and it was even predictable – the result of factors such as an ageing workforce and the effect of technology on jobs.

(the emphasis is mine). Now look at this figure, quickly produced from FRED data:


The blue line is what interests me for the moment. The employment to population ratio dropped five points in 2008, and stayed constant since then. I am puzzled, and I’d really like Mr Hildebrand to help me here: What extraordinary innovation I missed, that in 2008 made obsolete, overnight,  around 13 millions people, driving them out of the labour force? Maybe the Iphone, introduced in 2007? This would explain why for some people Apple is evil… Or as an alternative, could Mr Hildebrand explain me what happened in 13 million American households 65 years and 9 months before 2008, that generated 13 millions workers all reaching retirement age in 2008? What were they airing on TV that night?

Seriously, the supply side explanation does not hold even casual scrutiny. If we look at the red line, the median duration of unemployment, we find a much better explanation. The crisis that hit in 2007-2008 was hard, and long. This generated a spike in the duration of unemployment that has discouraged workers from looking for a job. The average duration of unemployment has somewhat decreased since the peak, but remains abnormally high. Why disturb aging or innovation? I am afraid that here we have at work one of those ideological anti-inflation biases that drive Paul Krugman crazy.

This said, Hildebrand raises an important issue, even if his conclusion makes very little sense: It is true that long crises have a negative impact on the potential of the economy. After all, negative output gaps and long unemployment spell mean destruction of capital, both physical and human. But does this mean that we need to accept the new and lower potential? If low activity reduces potential growth, why not try to increase it back when the recovery kicks in? Look again at the blue line. A first downwards step happened after the recession of 2001, and then the economy stayed there until the next negative shock. If I were Mrs Yellen I’d ask myself the question whether a central bank should target actual or potential growth, for example artificially overheating the economy so that scarcity triggers investment.  Said differently, if demand shocks have an impact on the potential of the economy, is it not worth investigating whether this could happen, and through which channel, with positivedemand shocks? I don’t have the answer. But I believe it is worth asking the question (that is most probably related to the ongoing discussion on secular stagnation). Or should we resign to have double digit “structural” unemployment, like in Greece and Spain ?

  1. thomas
    March 19, 2014 at 2:39 pm

    This is terrible analysis. Obviously the decline in 2008/09 is due to the recession. Surely it’s the position of this “vocal group of observers” that Mr Hildebrand mentions that it is the lack of a recovery in the blue line in line with the increase in GDP that is due to structural changes in the participation rate. The sudden decline is a straw man, Sir!


    • Amileoj
      May 10, 2014 at 7:32 pm

      So it’s your contention that these structural changes just happened to coincide, not with the recession itself, but with the recovery period following, and that at such a rate, as to just cancel out the effects of what would otherwise have been the expected recovery in the participation rate? That strikes me as no less outlandish a coincidence than the idea that 13 mil workers suddenly chose to drop out of the labor force in the autumn and winter of 2008-9.


  2. RS
    March 31, 2014 at 10:55 am

    I think the world is experiencing a quickly growing economy, but because this is in new IT technology inequality and unemployment is soaring in some countries. The USA has probably the largest accumulated stock of obsolete capital and only deep structural reforms could avoid double digit unemployment. USA is probably the new Japan.


  1. March 31, 2014 at 2:32 pm

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