The fundamental problem with the U.S. economy is that nominal expenditure has fallen below its trend growth path. During the "Great Moderation," total final sales of domestic product grew at slightly more than 5 percent per year. While it wasn't perfectly stable, it was close.
The "Great Recession" appears obvious. Nominal expenditure has fallen far below its trend growth path during the last two years. The solution is obvious as well. Return total final sales of domestic product to its trend growth path.
The growth rate and the trend growth rate of nominal expenditure is shown below.
The trend growth rate during the Great Moderation was a bit over 5 percent. During most of the Great Recession, nominal expenditures has increased, but substantially less than its 5% trend growth rate. However, during the fourth quarter of 2008 and first quarter of 2009, it decreased--at 5.3 percent and then 2.4 percent annual rates respectively.
Unfortunately, growth rates can be misleading. During the third quarter of 2009, the growth rate of nominal expenditure was 2 percent. While well below the trend growth rate of 5 percent, it was very close to the growth rate of the CBO's estimate of potential income, of 1.9 percent.
What is important, however, is that in the third quarter of 2009, nominal expenditure remains 9.3 percent below its trend growth path. Even if nominal expenditure began growing at the trend growth rate of 5 percent, it would never return to its trend growth path.
Real income has fallen far below its trend growth path from the "Great Moderation." In the third quarter of 2009, real GDP is 9.4 percent below its trend growth path.
However, the CBO's measure of potential output (adjusted to 2005 prices) is 4.3 percent below the trend growth path of real GDP. Real GDP is 5.1 percent below potential output.
During the Great Moderation, the trend growth rate of real income was 3 percent. The average growth rate of the CBO's measure of potential output was close, 2.9%. However, it has been growing below trend since the second quarter of 2003, and its level is currently substantially below the trend growth path for real GDP.
Arnold Kling claims that the Great Recession has been caused by a recalculation. While his explanations are not always consistent, all real business cycle theorists explain both the level and growth rate of real GDP by the level and growth rate of potential output. Prices adjust to clear markets, and real income remains equal to the productive capacity of the economy.
According to the CBO, nearly half of the deviation of the level of real income today from its growth path of the Great Moderation is due to lower potential output. And slightly more than half represents an output gap, a deviation of real income from potential output.
Employment, as measured by the household survey, is currently 9.4% below its trend growth path. Instead of the 152 million jobs consistent with the trend, there were slightly fewer than 138 million jobs. The percent discrepency is very close to both the deviation of nominal expenditure and real GDP from their trend growth paths.
The trend growth rate of employment was a bit less than 1.35 percent per year. Again, the misleading nature of a focus on growth rates is obvious. Even if employment quit shrinking and began rising at its long term trend growth rate, it would remain far below an acceptable level forever.
What about the price level? As measured by the GDP deflator, the price level is currently 1.12 percent below the long run trend of the Great Moderation.The inflation rate and its trend as measured by the GDP deflator is below.
The trend inflation rate during the Great Moderation was 2.4 percent. Clearly, the inflation rate during the Great Recession has been below trend. How could a Great Recession be caused by inflation being slightly below trend for less than a year? Perhaps the answer is that the relationship between inflation and expected inflation is the wrong approach. Look at the relationship of nominal expenditure to trend, real output to trend, and employment to trend.
Is the price level related to the problem? Yes, but its most important relationship is counter-factual. What price level would have resulted in real expenditure remaining at trend, given the 9.3% drop in nominal expenditure? Instead of its current value of approximately 110, the GDP deflator would need to be approximately 101. Instead of dropping a bit more than 1 percent below its long term trend, it would have to drop an additional 8%.
Since firms will not produce what they cannot sell, the only way for real income to be at its long term trend given the current value of nominal expenditures would be for the price level to be approximately 9.3% below its long term trend, or approximately 8% below its current level.
In order for the price level to have fallen enough to keep real expenditure equal to its long run trend, substantial deflation was necessary-- a 2 percent annual rate of deflation in the third quarter of 2008. For the fourth quarter of 2008, the needed annual deflation rate was 8.4 percent. During the first quarter of 2009, the needed deflation rate would have been 5.5 percent. The needed deflation rate in the second quarter 2009 was 2.4 percent. And finally, deflation would need to be approximately 1 percent in the third quarter of 2009.The problem was not too much deflation, it was rather too little deflation!
If nominal expenditure falling 9 percent below trend was responsible for real income falling below trend in proportion, why didn't prices fall more than 1.12 percent below trend? Why wasn't there more deflation? One possible explanation is that if prices had fallen more, the result would have been shortages of goods and services. Perhaps the productive capacity of the economy has fallen. The CBO's measure of potential output is an estimate of how far the productive capacity of the economy has fallen below the trend growth path of real income.
Given the actual value of nominal expenditures, what price level would be consistent with keeping real expenditure equal to the CBO's estimate of potential output?
As measured by the GDP deflator, the current price level should be 4 percent lower for real expenditure to equal the CBO's estimate of potential output.
What are the implications for the inflation rate?
For real expenditure to remain equal to the CBO's estimate of potential output, the deflation rate should have been 1.5 percent in the third quarter of 2008, 7.7 percent in the fourth quarter, 4.3 percent in the first quarter of 2009, and 1.5 percent in the second quarter of 2009. In the third quarter of 2009 (assuming all of the previous deflation,) a .07 percent inflation rate would have been appropriate, more or less price stability.
Why didn't the price level adjust in this fashion? Why aren't prices perfectly flexible? Is it nominal wages? Or are prices and wages perfectly flexible, and the CBO greatly underestimated the drop in productive capacity?
Rather than discuss sticky prices at this time, suppose instead that the Fed had managed to keep nominal expenditure on its trend growth path.
Obviously, this would be consistent with real expenditure and the price level remaining on their long run growth paths as well. More interesting is the scenario where the CBO's estimate of potential income is correct. Given the trend growth path of nominal expenditure, what price level would be necessary to keep real expenditure equal to this estimate of the productive capacity of the economy?
The price level, as measured by the GDP deflator would have been 116, about 5.7 percent higher than its actual value of 110 in the third quarter of 2009. That would be about 4.4 percent above the trend for the price level.
Clearly, a stable growth path for nominal expenditure, given the CBO's estimates for potential output, would be more inflationary. How much more inflation?
This calculation suggests that if the CBO's estimates of the degree to which potential output growth was depressed are correct, then if nominal expenditure continued growing on trend, the inflation rate would have increased from its 2.3 percent trend to 3 percent starting in 2004. During the second and third quarter of 2009, the inflation rate would have increased to 3.5 percent.
It is also clear that the variation of inflation isn't much different with a stable growth path of nominal expenditure, though the timing of the deviations of inflation from trend would have been different.
If the "recalculation" or real business cycle approach is correct, then the CBO's estimate must be wrong. The reason the price level only fell 1.12 percent was because any further decreases would have led to shortages of goods and services. The actual decrease in real GDP shows the decrease in the productive capacity of the economy. If that is true, and nominal expenditure had remained on its trend growth path, what would have happened to inflation?
The "market clearing" approach shows that if nominal expenditure had grown along its trend growth path, inflation would have varied tremendously. Most importantly, there would have been double digit inflation during the fourth quarter of 2008, 11 percent and worse, 12 percent inflation during the first quarter of 2009.
The drop in nominal expenditures below trend is almost exactly in proportion to the drop in real GDP below its trend and the drop in employment below its trend. The drop in nominal expenditure with only a slight 1.12 percent decrease in the price level below trend is perfectly consistent with the matching drop in production and employment. The only puzzle is why didn't prices drop more?
If the Fed could have kept nominal expenditures on its trend growth path, (and the first step would be to publicly commit to that target and then try,) then an old Keynesian approach that treats potential income as being the trend growth rate of real GDP would have left real output growing at trend and inflation remaining at its trend rate of slightly more than 2 percent. If potential income is subject to change, and the CBO's estimates are correct, then keeping nominal expenditure at trend would have resulted in slightly more inflation, and a "growth recession" and something close to stagnant employment. Finally, if the "market clearing" approach is correct, then output and employment would have decreased the same amount, reflecting some kind of recalculation, and there would have been several quarters of double-digit inflation.
I believe that the Fed should attempt to target a growth path of nominal expenditure. Rather than the 5 percent growth rate from the Great Moderation, a more modest rate of 3 percent would be appropriate. That would result in price level stability on average, though if the CBO's estimates of potential output are correct, the inflation rate would currently be about 1.5 above that trend, or 1.5 percent.
Will it work? It is impossible to be certain. But it is worth a try.