“Secular Stagnation! Larry Summers is wrong”

Roger Farmer posts: “Secular Stagnation! Larry Summers is right

Larry Summers has once again been advancing the secular stagnation hypothesis. David Andolfatto responds with this tweet which plots GDP per person in the United States since the late nineteenth century. I’m with Larry on this one.

Why does this matter and what does it have to do with secular stagnation? Those who would deny the secular stagnation hypothesis want you to believe that the economy has a very strong tendency to revert to a mean growth path which is independent of shocks. Leave the economy to itself, and the recuperative powers of the market will restore us to the social optimum. The secular stagnationists, and I am one of them, disagree.

We believe that, in the absence of corrective policies by the central bank or the treasury, the economy will never recover after a shock. The unemployment rate will not revert to its social optimum and, associated with that fact, the economy will never revert to its optimum growth path. After a shock, the data do not revert to the same trend that they followed before the shock hit.

GDP per person has a unit root. That is accepted by everyone who has studied these data. The interesting question is why?

If, as Robert Gordon believes, it is caused by random technology shifts then there is not much that monetary policy or macro prudential policies can do about it. If, as I believe, it is caused by random movements from one inefficient equilibrium to another, we should be thinking very hard about how to design a monetary/macro-prudential policy that keeps the economic train on the tracks.

I´m closer to Andolfatto. Furthermore, Farmer´s allegation that “a unit root in GDP per person is accepted by everyone is false! He links to a Cochrane 1988 paper. These two links (here and here) indicate “everyone” is not really everyone!

The chart below takes the post WWII years. I estimate the trend from 1950 to 1994 and project for the next 20 years. GDP per person remains on trend up to 2007, after which it drops AND stays down.

Farmer SS_1

During the late 1960s and throughout the 1970s, the economy was buffeted by significant demand (fiscal) and real (oil) shocks. Monetary policy was lousy (the reason behind the period getting named “Great Inflation”). Nevertheless, the chart indicates that real GDP per person always reverted to trend, contrary to what Farmer presumes.

During the “Great Moderation”, output per person hugged very closely to the trend, with little oscillation. That was broken in 2008 and for the past 7 years GDP per person has evolved far below trend. It´s not really a “Great Stagnation”, but a “depression” (even if it´s not “Great”).

I agree with Farmer that we should “thinking very hard about how to design a monetary policy that keeps the economic train on the tracks”. Market Monetarist´s suggestion is that monetary policy should strive to obtain nominal stability, in other words, keep NGDP evolving close to a level trend path.

The NGDP growth chart illustrates

Farmer SS_2

Update: Jérémie Cohen Setton at Bruegel has a take:

What’s at stake: The question of whether capitalist economies are self-correcting and will eventually revert to mean growth has received renewed interest given the underperformance of most economies six years after the onset of the Great Recessions. While the idea of persistent high unemployment was central to Keynes’ General Theory, it was quickly abandoned by the neoclassical synthesis.

Tyler Cowen writes that the most crucial issue is whether economies will return to normal conditions of steady growth, or whether we are witnessing a fundamental transformation, unveiled in bits and pieces. One relatively optimistic view is that observed deficiencies — like slow growth in real wages and the overall economy, persistently low interest rates and low levels of labor participation — are merely temporary.  Another commonly heard view is that we made the mistake of letting the last recession linger too long, allowing some of its features to become entrenched.