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 ?