Undoing the Structural Damage to Potential Growth

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.

What follows is macroeconomics, but I’ll start with the micro â€" a microcosm, in fact, of the larger idea I’m hoping to get at here.

I think it was around 1998, and I was on a tram between terminals at O’Hare Airport in Chicago. Two young men, who clearly worked for the airport (they had a bunch of badges dangling around their necks) were trying to figure out how they knew each other, while I eavesdropped. Turned out they had met each other in prison.

At the time, I was beginning a research project on the benefits of full employment, and my first thought was, “Aha â€" another example of how tight labor markets pull in the hard-to-employ.”  This was also the era of work-based welfare reform, and while analysts worried that employers would avoid those with welfare histories, strong demand turned out to an antidote to such preferences.

Basically, profiling based on gender, race and experience is a luxury that employers can’t afford when the job market is really tight. That is not to imply, of course, that employers broadly discriminate, but there is strong evidence that many do, most recently against the long-term unemployed. In tight markets, however, they face a choice of indulging their preferences or leaving profits on the table, and profits usually win.

Now, put this story aside for a second and let’s turn to the macro.  A few months ago, I reported on a study by a few Federal Reserve economists with pretty striking results of the damage done to the economy’s future growth rate by the deep and protracted downturn known as the Great Recession.  The Congressional Budget Office just published a similar analysis, resulting in the chart below showing growth in gross domestic product as projected in 2007, before the recession, and a revised projection from this year.  By 2017, the budget office predicts that the new and decidedly not-improved level of G.D.P. will be 7.3 percent below the old projection.

Sources: Congressional Budget Office, Bureau of Economic Analysis

What does 7.3 percent of lost gross domestic product actually mean?  Well, last year G.D.P. amounted to about $16.8 trillion, and 7.3 percent of that comes to around $1.2 trillion.  Conventional estimates translate that into more than 10 million jobs.

It would be very good to avoid that fate. The thing is, both the Fed economists and the Congressional Budget Office basically argue that while their estimates are admittedly uncertain, that fate cannot be avoided â€" it’s baked into the economic cake by the assumption that once your trend growth rate slows as ours has, it does not come back barring some positive, unforeseen shock.  Here is how the Fed guys put it:

Policy makers cannot undo labor market damage once it has occurred, but must instead wait for it to fade away on its own accord; in other words, there is no special advantage, given this specification, to running a high-pressure economy.

I disagree!  I think the damage can be at least partly reversed precisely by running “a high-pressure economy.”  I saw it myself that day in the airport.

Technically, I’m talking about “reverse hysteresis.” When a cyclical problem morphs into a structural one, economists invoke the concept of hysteresis. When this phenomenon takes hold, the rate at which key economic inputs like labor supply and capital investment enter the economy undergoes a downshift that lasts through the downturn and well into the expansion, reducing the economy’s speed limit. But what I’m suggesting here is that by running the economy well below conventional estimates of the lowest unemployment rate consistent with stable inflation, and doing so for a while, we can pull workers back in, raise their career trajectories, improve their pay and their living standards, and turn that downshift to an upshift that raises the level and growth rate of G.D.P.

Won’t that be inflationary? Three points. First, if anything, the current economy is suffering from inflation that is too low (same with Europe), so near-term growth-oriented policy seems clearly safe in this regard. Second, the precise relationship between full employment and inflation is poorly understood. When that latter-1990s story above was taking place, economists frequently and incorrectly warned that full employment would dangerously juice inflation. Third, the correlation between these two variables â€" inflation and labor market tightness â€" has become far weaker in recent years (i.e., the Phillips Curve has flattened, for those who like the jargon).

How do we reverse the hysteresis process (which is to ask: How do we get back to very tight labor markets)?  In earlier posts, I’ve suggested a number of policies that would help, including investment in public goods, direct job creation, reducing the trade deficit and work-sharing.  Still, you may well be wondering, “Wait a minute â€" this dude wants us to go with him down this path because of a conversation he overheard 16 years ago?”

O.K., I’ll admit that the economic journals are not busting with evidence in support of reverse hysteresis.  But those of us who closely monitored full-employment economies have observed and documented significantly positive labor supply and investment outcomes. (True, a lot of that investment has flowed into bubbles; I’m not saying this idea solves every problem.)

The employment rates for young African-American adults, like the guys I saw in the airport, averaged around 70 percent in the 1970s and ’80s, but hit 80 percent in the late 1990s; they are in the mid-60s now.  The employment rates for single mothers also hit new highs in those years.  The labor force participation rate, itself an important victim of hysteresis right now, hit its all-time high at the end of the 1990s expansion.  In other words, full employment pulled a lot of new people into the job market.

As part of the full-employment project I’m running at the Center on Budget and Policy Priorities (and have written about before on this blog), a number of top economists are looking into the relationships between fiscal policy, and hysteresis and reverse hysteresis. They are coming up with some compelling findings, which I’ll share once they are ready. For now, allow me to assert the following: We have shown we can do a lot of economic damage. With the political will, sorely lacking these days, it can also be undone.