Are We Stuck With Low Growth Forever?

by: Mark Thoma

Here are three graphs showing the gaps in output, consumption, and employment that have opened up since the recession:

Real GDP

Gap2 Real Consumption

Gap3 Employment

In all three cases, we appear to be growing along a lower growth path than before. The question is whether we are stuck on these lower growth paths forever. Will we ever recover the old growth path, in full or in part? That is, how much of the change in the GDP growth path is permanent, and how much is temporary?

This is important because the level of employment is a function of the level of output. If we stay on the lower growth path, then we will have a permanent gap in employment -- most of the 14+ million unemployed will have little hope of finding work. We can share the jobs that exist, something like that, but we won't ever recover the jobs that were lost.

However, graphs like the next one point to temporary changes as the dominant feature of output fluctuations. Sometimes the deviations from trend are highly persistent, as in the Great Depression, but eventually we recover. The trend has not varied much for over 100 years. It does vary slightly over time, but the variance in the red line is small relative to the overall variance in output:


But as Brad DeLong notes:

I ... find the picture impressive. But the U.S. is exceptional. Other countries do not show the same pattern: for example, the United Kingdom never recovered to trend after its post-World War I recession.

And past performance is no guarantee of future results...

So it's not 100% certain that we will bounce back to the long-run trend. This time could be different (Brad shows that Britain has had permanent shocks).

The argument that variation in GDP, consumption, employment, and other macroeconomic variables is due to permanent shifts in the trend rather than cyclical variation around the trend is precisely the argument used by Real Business Cycle theorists and adherents to the classical school more generally to undermine the case for countercyclical monetary and fiscal policy. The more of the variation in output that can be explained by variation in trend (i.e. by supply-shocks), the less that is left over to be explained by aggregate demand shocks. With less variation caused by demand, there is less need for demand stabilization policies.

(This is also what is at issue in the structural versus cyclical unemployment debate. The more that the variation in unemployment is attributed to structural change, and hence to variation in trend, the less that is left over to be attributed to cyclical factors. With less cyclical variation, the case for policy is weakened.)

Now, none of the above implies that the argument that some of the variation in output is due to variation in the trend is wrong (see here for a summary of the debate). I believe that some of the variation in output is, in fact, due to permanent changes in the trend rate of output. The trend is not a perfectly straight line. The question is the size of the variation in trend relative to the size of the variation due to demand shocks (a question that has not been very decisively answered in the empirical literature, e.g. see the early work on this by Stock and Watson, and Blanchard and Quah). My read of the evidence is that the amount of variation in trend relative to cycle is nowhere near large enough to undermine the case that demand shocks are important components of aggregate fluctuations.

The point I want to make is that the "it's all explained by a new normal" story adopts the conservative point of view that variation in output is mostly due to supply shocks rather than fluctuation in demand. In this case, there's little room for monetary or fiscal policy to help. However, there are good theoretical, empirical, and -- if you are into such things -- ideological reasons to be wary of making the "it's the new normal" or, equivalently, the "shocks are mostly permanent" argument. The persistence of the trend in output is evident in the graph above, and while this time may, in fact, be different, those making the argument -- some of whom are on the left -- should be fully aware of the conservative viewpoint this argument embraces. The argument that we are on a permanently lower growth path is an argument that there's nothing we can do, nothing we need do, and nothing we should do (except, perhaps, measures such as sharing the jobs we have more broadly). This is the new normal and you may as well get used to it.

My view is different. I believe we will eventually recover to a new growth path that is near, but a bit lower than the old one. The recovery will be slow, but we will get there eventually. How long it takes depends, in part, upon how aggressively we attack the problem with monetary and fiscal policy measures ( or how much we make things worse with mistakes in either area such as premature deficit reduction or interest rate hikes).

There is plenty of evidence in the historical record to suggest it's possible to largely recover from the recession, and I am not ready to accept the conclusion that we must resign ourselves to a growth path so far below the historical norm. If it eventually turns out that we are on such a disheartening long-run path and there's no way to change it, so be it, but I'm not ready to give up just yet.