Paul Krugman and a horde of other mainstream economists are very upset by something St. Louis Fed president James Bullard said in a breakfast talk to the Union League Club of Chicago on February 6, 2012. Here is the offensive passage.
A better interpretation of the behavior of U.S. real GDP over the last five years may be that the economy was disrupted by a permanent, one-time shock to wealth. In particular, the perceived value of U.S. real estate fell substantially with the 30 percent decline in housing prices after 2006. This shaved trillions of dollars off of the wealth of the nation. Since housing prices are not expected to rebound to the previous peak anytime soon, that wealth is simply gone for now. This has lowered consumption and output, and lower levels of production have caused a significant disruption in U.S. labor markets.
If you're wondering what all the fuss is about, you're right to wonder. What Bullard said strikes me and Tim Iacono and many others as just plain common sense. But contemporary economics is not about common sense. What we non-economists don't understand is potential output.
From Neil Irvin's Why it doesn't feel like a recovery. That steadily rising black line is potential output. Sometimes we are above the line (light blue), sometimes, like now, we are way below the line (pink). It's not entirely clear to me how it is even possible to be above a line which is supposed to represent our "potential" output, but never mind. That first light blue patch must signify the excesses of the Tech Bubble, and that tiny blue patch later on surely signifies the huge excesses of the Housing Bubble. As regular readers know, I often refer to the Bubble Era (1995-2007).
Thus it seems clear in the graph that artificial asset price inflation during the Housing Bubble was merely showing us the way to what we could be doing output-wise right now, but are not. If that strikes you as absurd, you are not an economist. Paul Krugman instructs us further about Bullard's sins against orthodoxy in Bubbles and Economic Potential.
Wow. I often encounter the fallacy of confusing supply with demand, where people say, “spending was boosted by the bubble, so the GDP you see then was greater than potential”; this is a misunderstanding because potential GDP is a measure of how much the economy can produce, not of how much people want to spend. But Bullard goes even further, seeming to say that a drop in asset prices is itself a destruction of output capacity. What?
... OK, first things first. Capital gains are not counted in GDP. The direct effect of a bursting bubble on measured output is zero. Nor, by the way, is a fall in asset prices counted as a decline in the capital stock, which is in principle measured in physical terms. So what are these guys talking about?
Maybe the idea is that the burst bubble reduces demand, and hence leads to lower production. But at that point you’re into a Keynesian world of deficient demand, and you should be talking about ways to close the gap, not accepting it as a fact of life.
Let’s think this through. Imagine that you have a bunch of farmers, whose land is for some reason the object of a speculative bubble. So for a while farmland prices go through the roof. Then those prices slump. Why should this impair the ability of the farmers to keep growing corn? (OK, you can talk about possible impairment of credit channels and stuff, but again this should be something to focus on fixing, not a source of fatalism.)
And guess what — this isn’t a hypothetical example. Here’s the history of US farmland prices:
And here’s the history of US farm output during the 70s bubble and aftermath:
Do you see a permanent reduction in farm production when the bubble burst? I don’t. By the way, if you’re wondering about that dip in 1983, it was about a terrible drought, which is the kind of thing that can reduce potential output.
Did you notice what was absent from Krugman's discussion and tidy little farm prices example? Perhaps you missed it, so let me fill you in. The economic factors not mentioned were easy credit and private debt levels. He also failed to mention stagnant real income for the bottom 80% of Americans over the last 30 years. Many Americans were living debt-financed lives. A lot of the current mortgage debt was incurred to make up for missing income by buying and selling houses during the bubble. Americans took advantage of this get rich quick scheme, using their soon-to-be illusory "equity" in housing to buy more and more stuff, which raised output.
But potential is potential and it doesn't matter to Paul Krugman how we got here. Our job now is to get back to where we were during the Housing Bubble.
Well, you might say, but farmers don’t buy a large fraction of farm output, whereas homeowners buy a large fraction of overall US output. Bzzzt! You’re talking demand-side economics again, and making, whether you know it or not, the case for monetary and fiscal stimulus.
At a basic level, this is all kind of terrifying. If top financial officials and credentialed economists can’t even avoid getting confused about the difference between asset prices and productive capacity, what hope is there for rational policy discussion?
Yes, it is terrifying, what Krugman is describing here. What hope is there of having a rational discussion?
Unfortunately, it is not terrifying in the sense Krugman intended. He wants to invoke the same debt trap that got us here to boost the economy back to potential, as if the Housing Bubble never occurred and all that private debt does not exist.
And that, my friends, is truly terrifying.
Extreme wealth and income concentration as a consequence of increasing debt/GDP and concentration of income gains to rentier income (interest, dividends, capital gains, and passive income from property rents) results in a decline in velocity of income, spending, and investment at labor returns by the top 1-10%. More debt and policies that emphasize increasing asset values and economic rents and further concentration of wealth and income to the rentier caste do not result in increasing investment in production at labor returns.
$19-$40 trillion (4-8 times private US wages) in financial wealth is captive by the top 1-10% of US households in low-velocity speculative instruments seeking unrealistic and unachievable returns many times the necessary labor returns required to sustain labor.
Were it not for costly payroll taxes, debt service (a form of private tax), and 30+ years of decapitalization of labor (deindustrialization and financialization of the US economy), labor would be quite affordable ("competitive") and subject to much higher utilization and perhaps even some wage gains with an increase capital deepening.
Posted by: Timetraveler_2047 | 02/22/2012 at 01:41 PM