Controversial Issues About the Recession and Recovery
Robert J. Gordon
Northwestern University and NBER
CIRET Conference, New York City
October 14, 2010

The Plan: From Long-Run to Short-Run to Policy




The reasoning behind my pessimistic long-term US growth forecast, recently summarized in Business
Week
Graphs on dimensions of the weak labor market.
The labor market is in worse condition than the product market.
New research on the “Demise of Okun’s Law” and the near-term division of output growth between productivity, hours, and employment growth
– Why is the labor market in such bad shape compared to the product market?
The policy debate: what more can monetary and fiscal policy do?

The Pessimistic Long-run
Conclusion





Comparing 2007-2027 forecasts with 1987-
2007 actual:
Output growth will slow from 2.9 to 2.4
Output per capita growth will slow from
1.74 to 1.4
That is the slowest growth of income per capita “since George Washington”
Compare to 2.16 1929-2007 or 2.02 1891-
2007

Growth in MFP vs. Ypc by
Time Interval, 1891-2027
Growth in MFP and Real GDP per capita, selected intervals, 1891-2027
3
2.5
2
1.5
1
0.5
0
1891-1928 1928-1950 1950-1972 1972-1987 1987-2007 2007-2027
MFP
GDP/Pop

1.5
1
0.5
0
2.5
2
Components of Growth in Y/H,
1987-2007 vs. 2007-27
Components of Growth of Labor Productivity, Two Intervals
1987-2007
2007-2027
Output/Hour Capital Deepening Labor Quality MFP

2.5
2
1.5
3.5
3
1
0.5
0
From Y/H to Y/N, the Role of Falling LFPR
Components of Output Growth, Two Intervals
1987-2007
2007-2027
Output Output/Hour Output/Person Hours Population

Possible Further Room for
Pessimism


These projections are based on the historical record of growth between years of
“normal” utilization (1987, 2007)
No allowance here for long-run “tainting” effects of the current abysmal economy
– Loss of skills and human capital
– Years of low investment will increase the age of the capital stock and reduce the growth of both capital quantity and capital quality

Policy Prescriptions for
Long-Run Growth Problem




Slowdown reflects aging of population and stagnation of educational attainment
Solve the first by immigration, particularly of high-skilled people
Work on the second by better governmentrun student loan programs and direct measures to address the rising relative price of college education (“higher education cost disease”)
Stimulate demand to avert long-run supply sclerosis



Next We’ll Look at Graphs of
Raw Numbers for Current
US Labor Market
Now We’re Looking at
– Magnitudes: How Severe Is This Episode?
– Timing: Do Labor Market Indicators Change at the Same Time as Output (Real GDP)?
– Which Measures Are the Most Different from
1980-82?
We Consider 1980-82 as a Single Recession and also as two back-to-back recessions
– (Jan-July 1980 and Jul 81 to Nov 82)

Output Gap vs. Gap in
Aggregate Hours of Work

Conclusion to this point



Comparing the 9.6 level of U rate now to 10.8 in
Nov & Dec 1982 is misleading
– U rate in July 81 or even Jan 80 started higher
– Overall increase in 2007-09 is greater
– Much more incidence this time of long-term unemployment and forced part-time
The emergence of long-term unemployment: is the
US becoming more like Europe’s two decades 1985-
2005?
Stylized fact: If the empl/pop ratio was the same today as in 2000, there would be 14 million more jobs (9 million from lower unemployment rate, 5 million from higher LFPR) “New Normal” for LFPR?
For U Rate?


Documenting and Explaining the Change in Cyclical
Labor-market Behavior
Documenting
– A new approach to disentangling trends and cycles

Use of “outside information” from inflation equation to determine the unemployment rate gap
– A new approach to data


Total Economy not NFPB Sector
Conventional vs. Unconventional Measures
– Initial finding as reported before: hours gap > output gap in 2008-09, the reverse of 1980-82

The Output Identity: Simple
Version and Conventional
Version
Y

Y
H

H
E

E
L

L
N

N
Y
P 
Y
P
H
P

H
P
E
P
E
P

E
H

E
H
L

L
N

N

Conventional Compared to
Unconventional Identity
Y
P 
Y
P
H
P

H
P
E
P
E
P

E
H

E
H
L

L
N

N
Y
I 
Y
I
H
H

H
H
E
H

E
H
L

L
N

N

Kalman Trends, Conv vs.
Unconv Output

Aggregate Hours

Total Economy Labor
Productivity (Y/H)

Output Gap vs. Gap in
Aggregate Hours of Work

Close-up for Period since
1986

Regression Analysis

Changes in hours gap regressed on
– Own lags
– Current and lagged changes in output gap
– Error-correction term (lagged level of hours gap)
– “End of expansion” dummy variables
(capture overhiring end of expansion, underhiring beginning of recovery)
“Early recovery productivity bubble”

Long-run Coefficients: The
“Demise of Okun’s Law”

Explanations Offered in My Research




The “Disposable Worker” Hypothesis
Similar sources as rising US inequality
Increased market power of managers and highly paid professionals
– Increased share of executive incomes coming from stock options
Reduced market power of workers due to:
– Declining unions, declining real minimum wage, low-skilled immigration, and imports

Implications for the
Unemployment Rate




Translate forecast growth in hours into the hours gap
Regression coefficients imply roughly 60% of an improvement in hours gap flows into employment rate gap
Optimistic path, output gap shrinks 0.8 points per year (3.3 vs. 2.5)
Pessimistic path, output gap stays where it is forever (2.5 percent growth forever)

12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
1986
Implied Unemployment
Paths
Unemployment Rate: Actual and Projected
Optimistic and Pessimistic Outlooks
1992 1998 2010
Optimistic Projection
Pessimistic Projection
Actual
2016 2004
Year

Reasons This May Be
Too Optimistic




Why does pessimistic U Rate decline even though output gap is fixed?
– Error-correction term implies mean reversion both of negative hours gap and positive productivity gap
Division of predict real GDP growth between productivity and hours: mean reversion may be delayed
– Much publicized “reluctance to hire”
– Matched with “reluctance to invest”
– Firms are not expecting the 3.3 growth scenario
If the 3.3 growth rate actually happened, short-term outcome would be more productivity growth and less hours and employment growth
But will that output scenario happen?

Reasons To Be Skeptical of Optimistic Scenario



Reinhart-Rogoff. Recoveries after financial crises are slower than after garden-variety recessions
Ineffectiveness of monetary policy
Political paralysis just as Obama stimulus is about to be withdrawn

The Fed is Out of
Ammunition




Textbook IS-LM model still taught in intermediate undergrad macro
Monetary policy is ineffective if:
– Horizontal LM curve
– Vertical IS curve
The Fed now is plagued by both
Why should QE2 work since QE1 didn’t?

The Fed Can’t Control the
Cost of Business Borrowing

Fundamental Causes of
Weak Recovery (Vertical IS)


Consumption
– Collapse of Household Net Worth
– Record-high indebtedness
Residential Construction
– Foreclosures and Under-water Mortgages
– People walk away from under-water
– Their credit is tainted for years
– Their houses add to supply but not to demand
– My mortgage broker’s story, 3 vs. 80

Consumption Problem:
Household Balance Sheet
The Twin Peaks of Household Net Worth
800
750
700
650
600
Total Assets
550
500
450
Net Worth
400
100
50
0
-50
Total Liabilities
-100
-150
1970 1975 1980 1985 1990 1995
Sources : Federal Reserve Board Flow of Funds Accounts and Bureau of Economic Analysis NIPA Tables . Details in Appendix C-4.
2000 2005 2010

Housing Starts Used to be a
Leading Indicator, but Not
Any More
Quarterly Housing Starts, 1970-2010
1500
1000
500
2500
2000
0
1970 1975 1980
U.S. Census Bureau Manufacturing, Mining and Construction Statistics
1985 1990 1995 2000 2005 2010

Where is Fiscal Policy?



Krugman NYT Monday: it wasn’t tried.
Look at government employment excluding census workers
The Obama stimulus was too small and too much was wasted on tax cuts and capital-intensive infrastructure spending

30
25
20
15
10
5
0
1929
What Ended the Great Depression?
Chart Extends 1929-41 Quarterly
1931 1933
Transfer Payments/GDP
1935
Federal Spending/GDP
State and Local Spending/GDP
1937 1939 1941

20
15
10
30
25
5
0
1980
How Does the Obama
Stimulus Measure Up?
1985 1990
Transfer Payments/GDP
Federal Spending/GDP
1995
State and Local Spending/GDP
2000 2005 2010






The Current Debate,
What About Inside vs.
Outside Govt Debt?
Monetary Policy is parralized but still can support fiscal expansion
A fiscal stimulus does not raise outside debt
(“held by the public”) if the Fed buys the bonds
This is the classic Milton Friedman
“heliocopter drop” of money
In today’s terminology, QE2 supports a fiscal stimulus
But where is the political will?

Conclusions





A Real GDP path of 3.3 brings the U rate down to 6 percent by early 2014
Reasons this may be too optimistic
Pessimistic path leaves U rate at 8 percent in 2016,
Europe déjà vu 1985-2005
Model has mean-reversion built in, underhiring in
2009-10 will be reversed, productivity bubble will be reversed.
Basic problems: Reinhart-Rogoff, ineffective monetary policy, lack of political will on fiscal policy, about to become much worse after the elections