The Long-Term Cost of Feckless Policy

Jared Bernstein is a senior fellow at the Center on Budget and Policy Priorities in Washington and a former chief economist to Vice President Joseph R. Biden Jr.

Three economists from the Federal Reserve just released an important, long and dense report that after 60 pages of statistical analysis essentially concludes: “Quick!  Somebody do something!!”

What is so important about this study, by Dave Reifschneider, William Wascher and David Wilcox, or RWW, is that it builds on a body of work that suggests the costs of economic policy neglect are steeper, in the sense of causing more lasting damage, than many people realize.  Let me explain.

As usual, we start with supply and demand.  Most economists recognized the demand contraction that was the Great Recession, and even enough members of Congress understood that a policy response in the form of Keynesian stimulus was needed to offset the downturn at least partly. But what RWW show is the impact of the demand contraction on the so-called supply side of the economy.

“Supply side” has come to be associated with tax breaks for rich people, but to macroeconomists, it means the supply of inputs to the economy that are critical for growth, including labor (not just head counts, but quality and skills), capital, energy and even productivity â€" i.e., the technological innovations that allow labor and capital to interact in ways that increase production.

It is often argued that these supply-side factors are “exogenous,” or given, based on resource endowments, demographics and the path of innovation â€" stuff that isn’t much affected by goings-on over in the demand side of the economy, and outside the realm of stimulative monetary or fiscal policy. But RWW posit otherwise, claiming an “endogeneity of supply with respect to demand,” meaning that these growth-inducing or growth-depressing supply-side factors are themselves moved around by the ups and downs in the broader economy.

I made a similar argument about a year ago, fretting about the very results RWW produce:

The distinction between the cyclical and the structural is artificial. Bad cyclical growth begets bad structural growth; persistent cyclical weakness in demand â€" a long recession, long periods of high unemployment â€" reduces potential growth. Workers who experience long-term unemployment thanks to a harsh cyclical downturn can find themselves less employable because of skill deterioration once the market picks up.

A weak-demand economy requires fewer workers and less capital investment. It also dampens forward-looking investment, and thus the supply of productive capital.

One of their key findings is in the chart below.  It plots real growth in gross domestic product, both actual and potential, the latter being the economy’s speed limit given the supply-side factors noted above. It’s roughly what you would expect absent the cyclical fallout from some negative shock, like â€" oh, I don’t know â€" the bursting of a huge housing bubble.

And it has been decelerating.  Potential G.D.P. growth declined after the mild recession of 2001, stabilized for a while, and then fell again in the Great Recession (the nonpartisan Congressional Budget Office found the same thing). RWW show that the recent decline is being driven by diminished contributions from capital investment, labor (especially lower labor force participation), and innovation, as measured by “multifactor productivity,” a critical growth component that slows sharply in their data. (It’s that leftover part of output growth that can’t be explained by all measurable inputs, so it’s thought to reflect innovation, technology, economies of scale â€" good stuff like that.)

Potential and Actual Growth in Gross Domestic Product

Source: Reifschneider, Wascher, and Wilcox, Figure 1.1.  Shaded area is 95 percent confidence interval around their estimate of potential growth in gross domestic product.

If this all sounds pretty airy-fairy, let me try to bring it down to earth. We had a wicked housing bubble. When it burst, demand cratered and lots of families lost jobs, incomes and even their homes. Business formation, an essential ingredient of a robust recovery, slowed; long-term joblessness grew to unprecedented heights; wages for most workers stagnated; investment at both the household and company levels (e.g., research and development) trailed off.

If these had been brief, temporary disruptions, the pain they engendered would have been deep but fleeting, as in the V-shaped recessions of the old days. But if RWW are correct, these problems are morphing from cyclical to structural. People’s connections to the job market have been lastingly diminished. Capital investment and its related contribution to innovation and productivity have been set on a lower path; the rate at which start-ups come online has decelerated. G.D.P. will continue to slog along at subpar rates and the unemployment rate will not get back to the low levels it hit toward the end of the last two expansions.

All of which leads to the crucial question: Can policy help, or are we simply stuck here? To put it in RWW’s mellifluous language: “endogeneity of supply with respect to demand provides a strong motivation for a vigorous policy response to a weakening in aggregate demand.” That is: Yes! Policy can help. RWW simulate aggressive monetary stimulus and find that it helps repair gaps in capital deepening, labor force participation, unemployment and growth a lot more quickly than policy passivity.

Alas, those are merely simulation results. In the real world, Congress is administering austere fiscal policy that is perfectly analogous to medieval leeching: by keeping demand weak, they are invoking the very threats RWW warn of. The Fed has been pushing pretty hard the other way, but it’s contemplating doing less, not more.

It may seem as if these bouts of dysfunction we have been going through are painful while they last but forgotten once they are over.  The lesson I take from this paper is that in fact, policy neglect hurts not just for the short term, but also for years afterward.  The longer this period of weak job growth, elevated long-term unemployment, tepid G.D.P. growth, low capital investment and so on lasts, the more the distinction between cyclical and structural blurs and the more we shave off potential G.D.P. growth.

I can’t imagine a deeply nerdy and technical document like this will get that message through to those who could do something about it. But I will continue to harangue them and anyone else who will listen. It’s too important not to.