David Beckworth, Scott Sumner, Bill Woolsey, Nick Rowe, among several others (in Germany Kantoos Economics has joined the group) agree on one fundamental point. The recession received the moniker “Great” due to the failure of monetary policy to keep aggregate demand (nominal or dollar expenditures) close to the historical 5% plus growth along a level trend. In other words, the Fed (Bernanke) allowed “monetary disequilibrium” to take hold.
Getting into some details, in his blog Scott Sumner equates nominal expenditures with NGDP (Nominal Income), Bill Woolsey represents nominal expenditure by Final Sales of Domestic Product (FSDP) while David Beckworth favors Final Sales to Domestic Purchasers (FSDPur). The difference between the last two being that FSDP is NGDP less the change in private inventories while FSDPur represents purchases by US residents of goods and services wherever produced (i.e. includes imports). David and Bill are fans of “pictorial” representations while Scott does mostly verbal arguments with a sprinkle of data and numerical tables. For this reason, the comments are mostly geared to David and Bill.
When one goes the “pictorial” way, some housekeeping work is necessary. One is to decide on the “appropriate” period to establish the “trend”. On this account, David has explained in detail his choice of the 1987-1998 period. In essence it contemplates the first 10 years of the Greenspan Fed, a time during which there “were no wide, unsustainable swings in economic activity”. But he goes on to say that: “Moreover, 1998 is when the Greenspan Fed for the first time significantly deviated from past practice by lowering the federal funds rates even though the economy was experiencing robust economic growth”. Maybe, but if so I think the trend period should stop in 1997 so as not to be distorted by the policy “deviation”. Bill favors considering starting the “trend” in 1984 – the beginning of the “Great Moderation” – and extend it to 1998.
For the reason already stated I favor ending the “trend” period in 1997, but I agree with David that the start should be 1987. In addition to the reasons he stated, the 1984-85 years are “distorted” by the strong RGDP growth (far above “potential”) following the end of the long and deep 1980-1982 recession periods. The figure gives a visual representation of the chosen period.
The second chore is to stipulate the nominal aggregate to use in the analysis. Here is where David “stands apart” with his choice of the FSDPur aggregate. I also think this choice strongly influenced his view that Greenspan´s MP during 2002-04 bears significant responsibility for the housing boom and bust and the ensuing financial crisis. To see why, the three pictures below show the 1987-97 trend and the path of nominal expenditures under the three definitions. The “black sheep” immediately stands out (under the assumption that “majorities win”). It is the path of FSDPur relative to trend. Under my choice of breaking the trend defining period in 1997 (instead of 1998), FSDPur stays above trend for the whole 1998-07 period, indicating that MP was consistently too expansionary according to the “rule” Py =Py “star”.
Given that NGDP and FSDP give about the same quantitative information I´ll stick in what follows with FSDP. The next figure gives a good representation of “stability/Instability”, defined as the absolute difference between actual FSDP and what it would be had the economy stayed on trend.
The size of the drop after early to mid 2008 is truly “amazing”, being equivalent to the size of the Brazilian economy (the 7th largest) as shown in the figure (2009 PPP dollars from Groningen). There´s no mystery here as to why unemployment has increased so much!
The 1998-04 is a period of instability in a “sea of stability” comprising 1987-07. And it all started after 1997. (Note that about that time home prices also began the “upswing” according to Case-Shiller, long before the “too low for too long” period).
According to David, 1998 is when Greenspan deviated by lowering the FF rate even though the economy was growing robustly This was likely a reaction to the financial fall-out (LTCM comes to mind) of the Russia crisis in mid 1998, being quickly reversed. More significant, I believe, is the sharp increase that follows. And it did so precisely because the economy was growing “too strongly”.
And I think David will agree with me that it was a “wrong” move! Why? As David has consistently written, inflation targeting tends to “get it wrong” when supply shocks hit, and on several occasions he has written on the effects of positive productivity shocks, which increase real growth and decrease inflation, a situation in which, if the Fed reacts to the low (below “target”) inflation by decreasing rates, or increases rates due to growth “above potential”, the system is destabilized. During 1997/98 lots of voices, including Krugman wearing a “hawkish” hat, complained that the Fed was behind the curve, that the economy had a well defined “speed limit” and that the fall in inflation reflected things like reduced medical costs and falling commodity and oil prices. As the figure shows the 1997-00 period neatly describes David´s scenario of a positive productivity shock, in which the Fed should not “swing” the interest rate “stick”!
But it did and, as David predicts in those situations, instability took hold. In a sense, MP in the 2002-04 period, during which FSDP is below trend, was the right policy to “correct” the previous “mistake”. And the fact remains that in January 2006 Greenspan handed over to Bernanke a newly stabilized economy!
Oh! Yes, the preliminary GDP release was good news, FSDP (more intensely than the other two nominal aggregates) turned in the right direction.