Last week we had to teach Robert Samuelson about inflation. He noted that the wealth of households was back to its pre-recession level, but spending was not. This led him to think that the wealth effect no longer applied. However, when we adjusted the data for inflation and then brought in Mr. Arithmetic it turned out that people were spending more than would be predicted by the wealth effect, not less.
This week it looks like we have to teach Mr. Samuelson about supply and demand. His column is a warning that "cheap money" (e.g. the quantitative easing and low interest rate policy pursued by the Fed) may do more harm than good. This comes in the context of the drop in world stock markets following Ben Bernanke's indication of a pullback from these policies.
Never mind that the drop in world stock markets is exactly what would be predicted if cheap money actually was helping the economy (in that case, the pullback would be expected to lead to lower growth and likely lower profits, therefore we would expect to see lower stock prices), let's deal with the rest of his story. The basic problem in the column is an inability to distinguish clearly between supply and demand.
This first comes up when he complains that in spite of cheap money:
"the speed of the U.S. recovery (about 2 percent annually) is roughly half the average of all recoveries from 1960 to 2007. As for the global economy, it grew 2.5 percent in 2012, down from the 3.7 percent average from 2003 to 2007, says IHS Global Insight."
This one is easily explained by lack of demand. Housing bubbles in the United States and elsewhere had been driving the economy prior to the downturn. Those bubbles have mostly burst, although Canada, Australia, and the UK have seen bubbles reemerge. The fact that the downturn was caused by a collapsed bubble instead of the Fed raising interest rates meant that the recovery would be much slower and more difficult than in prior recessions. There was no easy way to replace the consumption and construction demand created by these bubbles. Some of us were yelling this at the top of our lungs back at the start of the recession, but apparently Samuelson didn't hear us and is therefore surprised by the weakness of the recovery.
Okay, so the simple and obvious explanation for the weak recovery is lack of demand. (Samuelson sort of makes this argument, but because he still hasn't learned about inflation he repeated his line from last week that attributed a falloff in consumption to a lack of confidence as opposed to the more obvious explanation of a lack of wealth.)
He then flips over to the supply side. Citing work about the long-term prospect for productivity growth by Robert Gordon and a new study from the Fed he tells readers:
"from 1995 to 2004, labor productivity — a measure of efficiency — in the nonfarm business sector increased 3.1 percent a year, with about half the gain coming from IT. From 2004 to 2012, average annual gains dropped to 1.6 percent, with IT providing slightly more than a third."
There are two points to note about this one. First the timing on productivity growth is always erratic. We always see unusual patterns year to year that are much more likely just measurement issues rather than real changes in the rate of productivity growth. For example, productivity grew at a 3.5 percent annual rate from the fourth quarter of 1990 to the fourth quarter of 1992. It then fell in the next year. The Samuelsons of the world may think we had great technological breakthroughs in this two year period followed by a sudden dearth. The rest of us would likely attributable this to timing quirks.
If we want to time the slowdown as beginning in 2004 it is probably worth noting that productivity growth averaged 3.5 percent from 2000 to 2004. This might look like another timing issue rather than a sudden ending of productivity growth. Of course after 2007 we did have a different story of weak demand growth. In this context many workers who can't get good-paying high productivity jobs instead turn to low productivity low-paying jobs.
In this sense, weak productivity growth can be seen as a direct outgrowth of weak demand. One way to distinguish the demand and supply side story is that if productivity was being limited by the ability of firms to produce goods and services then we should be seeing substantial inflationary pressures in at least some sectors of the economy as firms are up against constraints in terms of their ability to produce goods and services. Since we don't see price pressure in any substantial segment of the economy, the demand story seems much more plausible.
It is also worth noting that the weak productivity story is 180 degrees at odds with the robots will make us all unemployed story. Think this one through, unlike our elites, you cannot believe both if you understand the arguments.
Then Samuelson comes back to the demand side, although surprisingly with a discussion of the aging of the population:
"Finally, demographics may hurt. As Americans age, they may restrain their spending. (In 2000, the 65-and-over population was 12 percent of the total; by 2025, it is projected to be nearly 19 percent.)"
Note Samuelson is not making the supply-side argument that aging will limit the growth of the workforce and therefore reduce growth. (It will.) He is instead saying that we might expect to see lower consumption as a share of disposable income because of aging, a demand side story. Of course we see no evidence of this to date, as wealth adjusted spending is actually higher than before the downturn, but Samuelson's story will explain slower growth in future years if savings rises.
In short, Samuelson might be confused about the weakness of the recovery but there is no reason the rest of us should be. A bubble was driving demand, the bubble is gone. There is nothing to replace the bubble. It's all very simple.
Finally it is worth noting one of Samuelson's other complaints against cheap money. Citing Stephen Cecchetti, an economist at the Bank of International Settlements (BIS), Samuelson tells readers:
"he argues that low interest rates might even be counterproductive. They make it easier to finance large budget deficits and may delay needed, though unpopular, cuts. ... Cecchetti’s preference for deficit reduction is controversial; economists disagree about the need to cut deficits."
While it may be true that economists disagree about the need to cut deficits, it is worth pointing out that almost all of the predictions of the deficit cutters have been proven wrong over the last 5 years. Long-term interest rates have not soared, the dollar has not plummeted, and there has been no runaway inflation of the sort they predicted. In fact inflation has fallen. And the 90 percent debt-to-GDP cliff that was popular among the deficit hawk crowd proved to be an artifact of an Excel spreadsheet error.
Some economists may still adhere to the need to cut deficits story in the same way that there could be an astronomer who argues the sun revolves around the earth, but they maintain this position in spite of the evidence. In a context where economies face demand shortages, as is the case today, deficit reduction means less demand and higher unemployment. It's hard to see why any reasonable person would want to see even more hardship.
Note: Paul Krugman deals with the BIS case for further austerity.
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