Not so fast, Ed

Ed Dolan has an interesting post: “Latest Economic Growth Data Give Cheer to Market Monetarists, or, What is the NGDP Gap and Why do we Care?”, where he writes:

After that long digression, let’s take a look at the recent behavior of NGDP to see why the latest data will be a relief to market monetarists. Let’s start with a chart that shows the levels of actual and potential NGDP during the Great Recession. (The chart uses a version of potential NGDP calculated by the Congressional Budget Office. Some economists might quibble with the CBO methodology. Instead, we could estimate potential NGDP by simply extrapolating its historical trend. That trend would track a little above the CBO measure, but it would not greatly change the general picture.) As the chart shows, actual NGDP plunged well below potential in 2008, opening a big negative output gap. Since about 2010, the lines have run almost parallel. The gap has stubbornly failed to close. We can get a clearer picture by switching to a chart that plots the gap directly. There was clear progress from the bottom of the recession in mid-2009 until late 2010, when it briefly touched the -3 percent mark. The gap then widened again, not getting back to under -3 percent for a full year. After renewed gains in 2011, it again widened. By Q2 2013, the gap was still larger than it had been five quarters before. Only with the latest revision of the data for Q3 2013 has it closed to less than -2 percent.

His use of the CBO measure of potential NGDP is what makes the story weak. And it is not, as Ed says, that “it would not greatly change the general picture.” It does and significantly so.

The next charts track back Ed´s to 1987 and I include the equivalent charts based not on the CBO measure of potential NGDP but on the NGDP trend. This trend was estimated from 1987 to 1997 and projected forward (for the reasons why, see here).

The first thing to note is that, in the CBO potential case, almost all of the time the actual level of NGDP is above the potential level (equivalently, the NGDP gap to potential is almost always positive). Something quite different comes out of the story told using the estimated trend. But why should I prefer the “trend” to the “potential”?

For starters, if the gap had really been consistently positive, inflation should have risen. Nevertheless it fell. And so did unemployment (the reverse of a stagflation scenario). Some of this was due to the positive productivity shock that took place from about 1993 to 2003. Some of it is likely due to the fact that Greenspan had high credibility and managed to keep NGDP close to trend.

Interestingly even the likes of Krugman were worried that the Fed was “behind the curve” so that inflation would soon show its ugly face. Writing in mid-1997, Krugman says:

Most economists believe that the US economy is currently very close to, if not actually above, its maximum sustainable level of employment and capacity utilization. If they are right, from this point onwards growth will have to come from increases either in productivity (that is, in the volume of output per worker) or in the size of the potential work force; and official statistics show both productivity and the workforce growing sluggishly. So standard economic analysis suggests that we cannot look forward to growth at a rate of much more than 2 percent over the next few years. And if we – or more precisely the Federal Reserve – try to force faster growth by keeping interest rates low, the main result will merely be a return to the bad old days of serious inflation.

Greenspan certainly perceived long before Krugman (and most analysts) that productivity growth had increased, so that the expansion should be free to “roll on”. But later, reacting to the Russia crisis (and LTCM) he allowed NGDP to climb above trend. In trying to bring it down he undershot the trend. Interest rates were brought the extremely low level of 1% but it was only when forward guidance was introduced in mid-2003 that the economy began to climb back to trend.

And it was back to trend when the baton was passed on to Bernanke. As an inflation targeting obsessive-compulsive, he quickly lost it!

Quite likely the present gap relative to the “Great Moderation trend” is exaggerated. Likely there has been some reduction in the trend level path (maybe also in the trend growth rate). But even so, the gap is still far wider than the one indicated by comparison to potential NGDP from the CBO.