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

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 forecasts with 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 or

Growth in MFP vs. Ypc by Time Interval,

Components of Growth in Y/H, vs

From Y/H to Y/N, the Role of Falling LFPR

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 government- run 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 ? We Consider 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 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 ? 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 , the reverse of

The Output Identity: Simple Version and Conventional Version

Conventional Compared to Unconventional Identity

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)

Implied Unemployment Paths

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

Housing Starts Used to be a Leading Indicator, but Not Any More

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

What Ended the Great Depression? Chart Extends Quarterly

How Does the Obama Stimulus Measure Up?

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 Model has mean-reversion built in, underhiring in 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