Lots of people are going to be saying lots of things in and around the Federal Reserve Bank of Kansas City's Annual Jackson Hole Conference this weekend. To help me (and you) keep your thoughts from being buffeted by the noise and drifting off into various forms of macroeconomic idiocy, here is an updated version of a graph I have found useful since 2009 in keeping my thoughts clear, coherent, and (I hope) correct.
It plots four major components of real aggregate demand: exports, business investment in equipment and software, Government purchases, and residential construction. All are measured as shares of potential GDP. And all are measured as percentage-point-of-potential deviations from the values they attained at the last business cycle peak. And it teaches nine lessons. Read more
Here it is:
The claim that US employment is low and wages are stagnant because US businesses and workers are uncompetitive in world markets flies in the face of the fact that the export share a potential GDP is significantly higher than of the last business cycle peak (and, moreover, significantly higher than it has ever been).
The claim that US employment is low and wages are stagnant because US businesses fear "uncertainty" of any kind--let alone "uncertainty" produced by ObamaCare--flies in the face of a relatively-healthy pace of real investment in equipment and software (not to mention historically high stock-price valuations).
The claim that Obama administration housing policy has been enough to restore normal functioning to housing finance fails. By the business-cycle peak the housing boom had already cooled off enough to restore housing construction to its normal share of GDP. During the housing bubble, for six years America spent an average of 0.75% of GDP overinvesting in housing relative to its historical trend--a total of +4.5%-point-years of housing overinvestment. Since the peak, America has underinvested in housing relative to its historical trend by 2.0% of GDP times 7 years--a total of 16.0%-point-years of GDP, or $2.6 trillion at today's values. America is now extraordinarily under housed relative to its long-run growth trend. Why doesn't pent-up demand cause a housing recovery as all the people who are living in their sisters' basements move out? Because housing finance continues to be broken.
And in 2013 the austerity shortfall in government purchases crossed residential construction as the major contributor to slack demand for the products of America's workers are businesses. The claim is that reducing the size of government spurs growth in the private economy by crowding-in the private sector. But how does the private sector get crowded in? When government shrinks, interest rates are supposed to fall, and interest-sensitive and future tax-sensitive spending by businesses on investment and by construction companies on housing and other buildings are supposed to rise. But since 2008 interest rates have been unable to fall: there is no channel by which the crowding-in can have taken place.
Add to the netted-out total shortfall of these four components of demand the shortfall in consumption spending relative to trend caused primarily by reduced incomes relative to trend and secondarily by the burden of debt on those households still excessively leveraged, and you have a complete explanation of why the U.S. economy is depressed.
You also have a strong argument that the Federal Reserve would have a very difficult time rebalancing demand: that we need fiscal policy to boost government purchases and housing policy to fix mortgage finance to restore the economy to anything like health.
Moreover, you also have a strong argument that it was the financial crisis and not the collapse of the housing bubble that was the lead violin in this catastrophe. Construction reached its housing-bubble peak in the third quarter of 2005. From then until the third quarter of 2008, through the business cycle peak and out the other side, the market economy adjusted as smoothly to the recognition of a sectoral disequilibrium as the most optimistic of macroeconomists could have hoped: interest rates fell as demand for loans to finance construction eased off, and exports and business investment took up the slack resources released by the shrinking construction sector. The NBER's Business-Cycle Dating Committee did not conclude that the U.S. economy was in a full-blown recession until more than halfway through the fourth quarter of 2008.
The graph points out the extraordinary inadequacy of the Obama administration's Recovery Act to the magnitude of the problem created by the late-2008 shocks to demand of 4% of potential GDP or so. $800 billion of headline "stimulus" included $300 billion of ineffective tax preferences, and was at least half offset by austerity starting in early 2009 at the state and local level. CEA head Christina Romer's estimate at the end of 2008 that a $1.8 trillion three-year stimulus was prudent dwarfs the $250 billion of fiscal stimulus actually provided to the economy. Better than nothing--much better than nothing--but much less than was needed.
And, of course: given that the rest of the government have failed in their jobs (1) to use government purchases to fill in holes in aggregate demand when necessary, and (2) to provide the proper structure of finance for housing so that builders and Americans who ought to be able to get credit can get credit, it is no time for the Federal Reserve to be tapering its asset purchases, let alone actually to be thinking about selling assets to raise interest rates. It is especially no such time given the total absence of any evidence of any present or future upward deanchoring of inflation expectations.
That is all. It should be enough.