Everything that needs to be said has already been said.
But since no one was listening, everything must be said again.

Andre Gide

Wednesday, February 8, 2012

What output gap?

James Bullard
In case you haven't seen it, you may be interested in this speech given recently by Jim Bullard, president of the St. Louis Fed: Inflation Targeting in the USA.

This speech is really about how to interpret the recent performance of the U.S. economy. Is the conventional interpretation, that we are far below "potential" GDP owing to "deficient demand," the correct view? Or should we instead be thinking in terms of a large negative shock to "potential" GDP, with unemployment returning slowly to its natural rate, according to its normal dynamic (see here)?

I think that Bullard makes a persuasive case that the amount of household wealth evaporated along with the crash in house prices should likely be viewed as a "permanent" (highly persistent) negative wealth shock. Standard theory (and common sense) suggests a corresponding permanent decline in consumer spending (with consumption growing along it's original growth path. This part is incorrect given the model I have in mind here.) The implication is that the so-called "output gap" (the difference between actual and "trend" GDP) may be greatly overstated by conventional measures.

The view that one takes here is likely to influence what one thinks about monetary policy. The conventional view seems to support the Fed's current policy of keeping its policy rate close to zero far into the future. In his speech, Bullard worries that this may not be the appropriate policy if, in fact, potential GDP has experienced a level shift down (or, what amounts to the same thing, if conventional measures treat the "bubble period" as the economy being at, and not above, potential). Among other things, he says:
But the near-zero rate policy has its own costs.  If we were proposing to remain near-zero for a few quarters, or even a year or two, one might argue that such a policy matches up well with the short-term business cycle dynamics of the U.S. economy.  But a near-zero rate policy stretching over many years can begin to distort fundamental decision-making in the economy in ways that may be destructive to longer-run economic growth.  
Precisely how such a policy "distorts fundamental decision-making" needs to be spelled out more clearly (though he does offer a couple of examples that hinge on a presumed ability on the part of the Fed to influence long-term real interest rates). I am sure that many of you have your own favorite examples.

At any rate, I think this is a nice speech because it challenges us to think about the recent U.S. recovery dynamic in a different way. And if recent history has shown us anything, it's shown that we shouldn't grow complacent over what we think we understand.

Update available here: The trend is your friend (until it ends)

Update: The "terrifying" James Bullard offers a reply to Tim Duy here.


  1. Mr. Bullard has a very good speech. He's pushing at the borders of the idea of a structural problem although he never does say it. It seems that extrapolating from the 2007 point forward to get potential GDP implicitly includes the given capital structure as at 2007.

    His negative wealth shock sort gets at the idea that the capital structure in 2007 was misaligned when he talks about overvaluation, but again he never really talks explicitly in such terms so it was a little hard to gauge what exactly he has in mind.

    I mean, he is convinced there was a house price bubble, but he talks in terms of the consequences of the bubble bursting as a drop in output. I don't agree to the simplistic terms, but I have a hunch he is keeping it simple because it is a speech. You, David, would know better than I do if Mr. Bullard is sympathetic to the structural problem explanation.

    His point about low interest rates pushing savers out of the market is very well taken. If this carries on too long, the pool of investable funds will get quite shallow.

    1. Prof J: My own interpretation of the low yield on US treasuries is the high world demand for the product, not Fed policy (very much). If this is correct, then the pool of investable funds is shallow because people are skittish, not because the interest rate is low. Could you elaborate on your concluding sentence?

    2. David,

      I understand your point, and upon reflection of my concluding sentence, I think it must be that I was thinking of individual households only. My thinking was that people are saving less and consuming more right now, and the consumption is not in the form of long-run investment. But the consumption is going to businesses that are, more or less, sitting on the money. So the composition of the total pool of savings is changing, but I guess the level is steady.

      Fed policy effects on the yield is hard to interpret, I think. I can't say anything that would be more than partially informed opinion, so I'll refrain.

  2. I seem to recall "you guys" (i.e. the Fed) had some issues with OG estimation in the '70s (cf. Orphanides' work).

    I would be interested to hear / read about how the Fed is measuring the OG. You are likely aware the Riksbank has done a fair amount of work on this issue of late.


    1. No, I am not aware. And I don't personally find the OG concept very useful. But here is something you may find of interest:

  3. You could also start to "think differently" about the US recovery dynamic by "talking" about "spending gaps" instead of "output gaps".

  4. That's lame. The output gap is quite easy to calculate for an economist and it's obvious that if the unemployment rate went back to where it was before the crisis then GDP would increase enough to get back on trend.
    The people who are currently unemployed aren't useless cripples. When demand comes back (for example demand for construction workers because no houses have been built over the last six years) then we'll go back to trend.
    That's not a "persuasive case" at all, it's lazy thinking and outrageous coming from an economist who should know better. We'd stay permanently below trend only if all the unemployed workers disappeared.

    1. Anonymous, I assure you that it's not as "obvious" as you believe. Here is something that may help you along.


    2. Fair enough, let's say "if the labor force participation goes back to where it was before the crisis" instead of the unemployment rate.
      But I still think that all these construction workers laid off aren't useless cripples and once we need to build houses again they'll be back in the workforce; then they'll have incomes, spend their income and relaunch activity in other sectors as well.
      I mean Bullard's position is incredibly cynical: he says that able-bodied men and women who used to be part of the workforce are now useless and that even when housing bounces back (as it will have to even if only because the current housing stock is depreciating with time and will have to be replaced), they won't ever be part of the workforce again.
      By the way isn't that an argument that was already made in the 30s? I'm pretty sure it was - and a few years later the unemployment rate was down to 2%.

    3. Anon, what makes you think the part rate just prior to the crisis is the "social optimal" rate? It has, in fact, been in secular decline since it reached its peak some time ago. And different demographic groups show different trends.

      Bullard does not say any of the things you are attributing to him here. You are making inferences based on god-knows what prior beliefs you have embedded in your brain.

    4. - A sudden decrease in the "social optimal rate" means that a significant part of the workforce becomes useless and unemployable overnight. If you have a technological shock that suddenly wipes out a whole industry it's understandable, but as far as I know no such thing occurred. Unless you assume that construction will disappear forever and that no houses will ever be built again.
      - I'll reverse my argument: let's assume that Bullard is right and that we are now back to trend. Then does it mean that if the labor force participation increases the economy will just overheat and cause inflation until labor force participation goes back to current levels? I find it hard to believe.
      - Why does he compare GDP and NASDAQ? That's just not comparable. The stock market value of a company reflects consensus views on the net present value of its future cash flows. It's an estimate that can be wide off the mark. GDP measures actual past production. It can't be overvalued as the output actually happened.
      - I think he confuses stocks and flows. There is no link between the value of the housing stock and output capacity (GDP or potential GDP). Or there is only a link if you acknowledge that the decrease in the value of the housing stock caused a decrease in demand while output capacity was intact, in which case the problem comes from a lack of demand...

  5. Anon at 12:54:

    Speaking of lazy thinking, when do people like you get tired of riding the 'demand' horse? He's tired! The serious thinking is figuring out why there is high unemployment. You think it is a labor demand problem, but how do you know it isn't a labor supply problem? Casey Mulligan has been doing very interesting work on labor supply issues.

    When someone says 'demand is the problem' I always imagine a store manager asking his employees why revenue is down, and the employees respond by saying customers aren't buying. No shit! Why not?

    1. Because of the above-mentioned wealth shock? I think everybody agrees on that - Americans used to take their houses for ATMs and when the bubble popped they had no money left to spend, which had a chain effect on demand for other goods and services.
      The crazy thing is that you have a lot of people out there who are ready to work and ready to spend the money they would get, but due to economic mismanagement they can't get jobs and they can't spend.
      And if you tell me that a significant part of the workforce just decided to become lazy and stopped wanting to work when the bubble popped then I can't do anything for you.

    2. But households are spending: https://research.stlouisfed.org/fred2/series/PCE?cid=110

      Investment still is lower than the late 2000s, but recovering: https://research.stlouisfed.org/fred2/series/PNFI?cid=112

      Housing is the issue:

      People have stopped spending on housing, so to the extent labor and capital are configured for residential construction, there is a mismatch. This is the capital structure argument.

      I don't think people are lazy, although I do think there is a lot of incentive to not take 'any old job' to pay the bills. 99 weeks of unemployment will do that, as will reduced restrictions on obtaining food stamps.

    3. Just let them eat cake, eh Marie?

      When the elite become too oblivious of the sufferings of the lower orders eventually they will be tossed into tumbrels and brought to the Guillotine or hung from the lampposts. It's a historical fact. The Occupy movement seems like the first stirrings.

      Bullard the President of one of Missouri's two Fed banks says that trend GDP Growth should be measured from 2007 but doesn't the Fed itself, the Congressional Budget Office and most Blue Chip private forecasters use data from the past few decades?

    4. Peter,

      You misunderstand completely. The view taken here has no implication for whether government interventions are desirable or not (e.g., redistribution policies, retraining, education, etc.). The point is that "aggregate demand" policies are not likely to have the effect that one would expect them to have. And this could make the working poor even worse off, for example, by creating a sudden inflation that whittles away the purchasing power of their wages. Or do you not care about the working poor?

    5. so what policy do you porpose given your observations?

  6. Out of curiosity, how many other central banks from rich, developed economies continue to labour under a dual mandate similar to that of the Fed?

    1. I'm waiting for the answer westlope; or do you view me as your personal research assistant? ;)

    2. And here I thought it was a trick question, a delicate way of navigating American exceptionalism.

  7. I don't understand this. We have certain resources. We have certain technology. Given these resources and technology, there is a certain production possibility frontier, and potential output represents the position of that frontier. We know that we were on the frontier (or near it) in 2007 because we were actually producing what we were producing, and we were not straining our resources enough to induce accelerating inflation. There are various stories you can tell about how the recession might destroyed resources or changed technology in such a way as to shift the frontier inward or how the recession might have induced us to choose another point on the frontier where measured aggregate output is smaller. But I don't hear Bullard telling any of these stories. As best I can tell, he seems to be suggesting that we were well beyond the frontier in 2007. That doesn't make any sense, because we can observe that we were actually producing what we were actually producing in 2007, and we can observe that the inflation rate was stable.

    1. Andy,

      To better understand things, do not think of "potential" as an upper limit; it is, instead, supposed to measure "trend" or some conception of "normal."

      Consequently, it is sensible to think of the economy as operating "above potential" in the sense of being "above trend."

      You may not agree with this interpretation, and that is fine. But surely, you cannot claim that is makes no sense, when one interprets potential as trend. I think this is what most people have in mind as well. Otherwise, how to understand statements that make reference to an "overheating" economy?

    2. If you interpret potential to mean "trend," then you need a story about why the trend changes. Otherwise it is just time series analysis, not economics.

      But I don't think this is what most people mean. "Potential" is what an economy can produce on a sustained basis. An "overheating" economy is one that is straining its resources. It is producing more than it is capable of producing on a sustained basis, presumably because factors are being tricked into accepting lower real returns than they would be willing to accept if they knew beforehand what the returns would be. You could say that it is a case of being in a position on the PPF that we would not choose if we had full information, and where measured output is higher than the optimal point (perhaps because we are consuming too little leisure). But economies don't become severely overheated, because it isn't possible to trick people into going far away form the optimal point; instead, you just get accelerating inflation.

      Well, that's a simplified story. I could tell the New Keynesian story where "potential" is limited by monopoly power rather than by the resources physically available. But in any case, I think most people who use the concept have in mind that it has an economic meaning and not just an empirical one. People who believe the economy can temporarily exceed its potential have some kind of story about how it can do so, and this story determines how they interpret the subsequent path of output.

      I suppose you could say, "Output is what it is, and we have no idea how policy affects it, so the concept of an output gap is irrelevant." But in that case I would say we also have no idea of why low interest rates would cause damage (unless we see the damage in the form of excessive inflation), so there's really no basis to choose one policy over another, and we might as well just do what Ben Bernanke says because he's a nice guy.

    3. If you interpret potential to mean "trend," then you need a story about why the trend changes. Otherwise it is just time series analysis, not economics.

      Andy, even if trend does not change, it is desirable to have a theory of trend. In any case, here is one such theory of "trend changes:"


  8. When Bullard talks about a "shock to wealth," what does he mean? I don't see any obvious way in which people become objectively less wealthy, except as a result of the economy's not producing as much (which can't be the explanation, because it would be circular to blame reduced output on something that is the result of reduced output -- unless he's suggesting that there are multiple equilibria with sunspots or something of that nature). The housing stock did not become objectively less productive: they are the same houses; people could receive the same housing services from them if things were arranged such that they were allowed to take advantage of those housing services. What happened is that the dollar value of houses was reduced -- if you happen to measure things in terms of dollars. If you measure things in terms of houses, the value of everything else has gone way up, so wealth has increased. If you measure things in terms of the services that they can produce, then houses are worth what they were always worth, and we have just had a change in preferences where people assign greater relative value to other things besides houses. Where is the shock to wealth?

    1. This comment has been removed by the author.

    2. You are getting close...

      Wealth is an abundance of resources, value is relative worth, determined by the conclusion of negotiations between a seller and a buyer, and money is a portability device to facilitate the trade of wealth.

      The value of wealth can increase or diminish, but no, wealth does not evaporate. Yes, material wealth can be destroyed, but if insured, the resources are available to replenish that material wealth.

    3. Andy,

      Imagine that the housing stock is "over valued" in the sense that it embeds a liquidity premium that, among other things, depends on the underlying liquidity of mortgage backed securities. And then suddenly, the liquidity premium vanishes (bubble pops). Wealth has evaporated. That might be one story (or part of the story). Or, one could think of Zeira asset price dynamics; see:


  9. Thank you for the link, David.

    Any recent set of Riksbank minutes will capture the thrust of the debate, there (e.g. http://www.riksbank.se/Documents/Protokoll/Direktionen/2012/pro_penningpol_111219_eng.pdf). Basically, Svensson thinks the "unemployment gap" is a better measure of un(der)utilised resources than the output gap.


  10. DA wrote: I'm waiting for the answer westlope; or do you view me as your personal research assistant? ;)

    No, I don't view you as my personal assistant. But I do view you as competent macro economist specialized in monetary economics who is probably earning well in excess of 6 digits/year and has a reasonable research budget at your disposal.

    Frankly, I expect you to know the answer even if it is to some approximation given the endless debates possible about which central banks really stick to a price stability mandate as opposed to a CB that claims to prioritize price stability but in reality also focuses on employment.

    To the best of my underfunded knowledge, the USA is the last rich, large OECD country with an explicit dual mandate. China manages a crawling peg to the US dollar. India is flexible. I suppose it could be argued that the EU and the USA are competitively devaluing their respective currencies so the EU is not really following a pure price stability mandate.

    1. No need for testiness.

      In fact lots of countries claim to be pure inflation targetters. They're mostly countries with histories of runaway inflation who are (or were) trying to profess their fidelity to low inflation; see, e.g. the Bank of England. But the BoE as well as other central banks, like the Bank of Canada and the Riksbank have been running very accomodative policies in spite of inflation at (Canada) or very much above (the U.K.) the target rate.

      The ECB has been something of an "inflation nutter" central bank, even raising the policy rate last year as unemployment in Spain was crossing 20 percent in the wrong direction. Of late, however, they're supplying loans elastically to any European commercial bank that wants them. That has probably arrested the collapse of the Euro--for now.

    2. Westslope, did you miss my ;) ?

      Most of the bankers I talk to view price level stability (low and stable inflation rate) as fulfilling the dual mandate. There are obviously some who believe in a short-run trade off between inflation and unemployment. I think these latter types have good intentions, but are hopelessly misguided. If unemployment is a problem, it should be tackled directly via localized fiscal policies.

      See, for example, here:

  11. "Potential Output" seems rooted in an almost "Soviet" concept of factory capacity. How it relates to an economy that is 80%+ services is not very clear.

    Entrepreneurs and managers organize resources to produce based on the activity's returns to capital. If I open a spa alongside my beauty salon, I may find the return to be high, but only because customers are pulling forward consumption by borrowing against their houses. Those customers, in turn, believe the future returns to their housing equity will be quite high. The bankers that lend to them believe the same thing, and they are willing to extend a home equity loan to me to open that same spa. All of the actors in this narrative are marshaling resources with an expectation of a certain return; they could all be, collectively, wrong. If they are wrong, it no longer makes sense to marshal those resources in that way: they lay idle. Unlike a factory, it is not clear that they should again reassemble -- in the same manner -- to produce what they formerly produced. The service economy is chock full of narratives like this one.

    One of the distinguishing features of the Great Recession is that, for the first time, the majority of job losses have occurred in non goods-producing sectors. This makes it even harder to have any faith in the concept of an "output gap".

    1. Right. I hope that you at least understand why some people are annoyed with this line of reasoning - if you look at the core inflation rate and the output gap you can clearly see that fiscal and monetary policies should be targeting a lower unemployment rate. Then Bullard says that in the end the core unemployment rate and the output gap aren't very good measures and that we should really focus on inflation (if you take a look at the US 10-year rate it doesn't look like many people are scared of inflation but anyway).

      I'm ready to be convinced but Bullard doesn't advance any proof of what he says. I think his position would be easy to prove: if the labor force participation rate goes up it should translate into a wage-price spiral and inflation. If it happens I'll concede he's right.

    2. ...
      I meant core #inflation# rate, not core unemployment rate, too bad the comments can't be edited...

    3. The concept of potential output doesn't necessarily have anything to do with factory capacity. Most of the capacity represents human resources, not capital resources, and we can observe changes in the unemployment rate that suggest changes in the utilization of human resources relative to what could potentially be used. We also observe that the rate of acceleration in nominal wages is correlated (inversely) with the unemployment rate (and, except over very long horizons, with the employment-population ratio), which further suggests that there are changes in the rate of labor utilization relative to what is being offered along a given wage growth trajectory.

      Now you (Diego) suggest that, during the boom, people were pulling consumption forward during the boom because they believed themselves to have more wealth than they actually had. That much I agree with, and so would most people. But what happens when they discover they have less wealth than they thought? Presumably, they will now want to push consumption backward into the future. More generally, people and businesses will want to push expenditure into the future. With a well-functioning market, if everyone tries to do that at once, the result is that real interest rates go down until a sufficient number of people decide to shift expenditure back into the present, so that the resources being offered in the present are fully utilized.

      If we had commodity money and perfectly flexible wages and prices, this fall in the real interest rate would take the form of a decline in prices relative to their expected long-run levels. With fiat money, and with a central bank committed to inflation targeting, the fall in the real interest rate has to take the form of a fall in the nominal interest rate. This is exactly the policy that Bullard is criticizing, and yet it is the natural conclusion of the mechanism that he is suggesting (if your interpretation is correct).

  12. Andy,
    My point is that the output gap assumes that the factory is idle, just waiting for the unemployed to stream back in and easily resume their former productive activity. As I pointed out, organizing resources is much more complex than that, and the unemployed depend on that organizing activity to be part of a "gap".

    To your second point, the organizing activities -- PSST, if you will -- are not necessarily sensitive to the real interest rate. This is especially true if certain types of financing -- again, PSST -- are no longer available. For instance, you can drop the real rate to -5%, but if I can't borrow against my house, I may not have the start-up capital to open a restaurant. Further, the increase in tradeables (esp. commodities) prices may not benefit the restaurants forecasted earnings. The more nuance in these organizing activities, the more the Fed will need a "sledgehammer" to get things going to overcome the inertia. That, of course, risks inflation having more momentum than output, and inflation expectations may become unanchored as a result.

  13. I don't get it. Suppose that the price of all real estate dropped 50% today. Tomorrow we would have the same people with the same skills, the same farmland with the same crop-growing potential, the same factories with the same output capacity, the same natural resources sitting in the ground. How could it be said that the potential product per year is permanently reduced?

  14. Ask yourself why real estate prices fell. One interpretation is that they adjusted to a new reality; a change in fundamentals. There was (ex post) an overinvestment in real estate. Asset prices are close to martingales, so the price drop is reasonably viewed as permanent. Lower wealth, lower consumption, lower spending, and lower output (relative to initial trend). The idea of a stochastic trend in output is not a new one, though I understand that it is not the way growth dynamics are usually interpreted.

    1. But, but.... I still don't get it (please forgive me, I'm not an economist). The wealth is the same. Just some bits in a computer flipped overnight. How would we explain it to a Martian looking down on Earth through a telescope? - "Some bits flipped in a computer and so now it is necessary that a lot of people be out of work for a long time even though they desperately want work. What they might have produced must be lost forever."? People are willing and able to work, but can't find employment, and only then is wealth lost - the wealth they might have produced. Surely some smart economists could get together and study this and figure out how to fix it.

    2. No, the wealth is not the same (wealth measured here as the expected discounted value of rental income generating by the housing stock). As expectations of that rental stream get revised downward, wealth drops. The wealth decline impacts on consumer spending.

    3. I have a sinking feeling that if I tried to explain this (the "expected discounted value...") to the Martian, they would conclude it was just more flippin' computer bits.
      And they might ask why, if we have: A) work that needs to be done, and B) otherwise idle people willing and able to do the work, we don't just put the people to work?

    4. We? Why don't YOU put them to work? That's what I would ask you, if I was a Martian.

    5. Believe it or not, that’s exactly what the Martian said!
      And I said, “But I am just one person, and there are so many unemployed.”
      And the Martian said, “No need to worry, surely you have governments. Surely these governments have wise economic advisers. Surely these governments have the best interests of the people at heart. These governments will stop making matters worse by laying off so many government workers, and they will hire others, who are otherwise idle, to do useful work – for starters I can see that you have an awful lot of roads and bridges that need an awful lot of work. And your technology could obviously stand improvement - they will hire researchers to create new inventions. Then with so many more working instead of idle, the economy will be hitting on all cylinders until all those underwater mortgage bits, that everybody seems so worried about, flip back the way they were, and then it will really take off, with all that spanking new infrastructure and technology to whisk people to work and shop.”
      And I said “But regarding those surely’s…”

  15. I don't understand this. Residential investment, i.e new housing, is physical capital but it is not a production enhancement such as business investment, which (combined with full employment) defines, or used to define, potential output. The housing bubble was a demand-side phenomenon -- it called-forth residential investment and provided consumer spending in the form of remodels and cash-out refinancing for other consumer goods. Insofar as that demand was excessive, (and real GDP was above trend before the crash) business investment might have overcompensated with excessive physical investment, thus raising potential output for a few quarters, but the readjustment back down to trend would be just as timely as labor transferred into other sectors during the next recovery. This argues for a persistent output gap, such as we have now, as a demand problem, such as the one animated here: http://www.youtube.com/watch?v=gcVV56QaSlM

    1. Lee,

      I don't understand this. Residential investment, i.e new housing, is physical capital but it is not a production enhancement such as business investment, which (combined with full employment) defines, or used to define, potential output.

      This is not correct. Residential capital produces shelter services, and this flow of newly produced services is counted in the GDP. As for potential output, this is a theoretical construct; we have no idea if it even exists (except in the mind of some economists and their students).

    2. Help me understand this. Doesn't potential output exist at the line above which there is inflation, and below which there is deflation?
      Also, doesn't the GDP count much more in the price of a new house than its shelter value? Yes, housing provides enhancement to human capital such as shelter and efficiencies in raising future little workers and so on. Yet a tin shack would do as well (if you could fit in a washer and dryer). In other words, the largest part of the price of a new house is not related to its value in providing for future potential output, even due to the enhancement of human capital of its occupants. The "wealth" in a house is mostly determined by its expected value as a resellable asset. Consequently if the price goes down, it affects potential output at some tiny margin, but it mostly impairs consumer demand.

    3. Help me understand this. Doesn't potential output exist at the line above which there is inflation, and below which there is deflation?


      Also, doesn't the GDP count much more in the price of a new house than its shelter value?

      I don't think so; just the rental value (which I take primarily to be the price of shelter, but could include the value of other amenities.

      I will have a follow up post, Arnold. That might make things clearer.

    4. I await it. Also please explain in it, why resold houses are not counted in the GDP, if they continue to provide "shelter output" at full resale value.

    5. I've posted Lee. To answer your question, note that the GDP is defined as the value of newly produced goods and services. The sale of an old house does not counted as value added to the economy; it simply represents the transfer of ownership from one person to another.

    6. Then we agree on all the basics but one: I don't see how the price of a house mostly reflects its shelter services, if shelter is to be considered as an investment input to worker output (thus allowing a "wealth shock" to decrease the output gap, as hypothesized); a tin shack would do as well. Moreover, a drop in the price of the house would not affect its real value as shelter. In other words, a fall in house prices does not affect worker output in the same way as a physical depreciation of machinery.

  16. Fortunately, we have Keen to think seriously about these problems.

    The only thing that Bullard is close to understanding is that home equity is the foundation for community and regional bank lending to small business. The $7 trillion +/- collapse in housing prices has destroyed the an extraordinary amount of borrowing capacity for small business

    Bullard shows no understanding of the role that private debt is playing in our lack of a recovery. Private debt is 300% of GDP, +/-, which has created insanity in consumer credit markets. Home loans are at all time lows and credit cards may in real terms be at all time highs because of risk.

    Last, and this is were Bullard's thinking is entirely wrong, if the GAP is monetary, as he thinks it is, then all we need to do is print money.

    We did not experience at War that killed our people and destroyed our plant and equipment. We have all the people and equipment we had before. What we face is the age old problem since man built the Pyramids: how to finance putting everyone back to work.

    People don't understand that Keynes contribution to solving this problem was coercion. When the gov't prints money it forces businesses to buy and invest. Explained simply, assume there is one store. When the first customers arrive with the newly printed money, they buy all the existing inventory. The merchant has a choice: (1) use that money to buy more inventory, causing a rise in factory orders; or (2) go out of business. You want the merchant to fear inflation so much that she over orders.

    That is a Keynesian stimulus. We haven't gotten close to such an event and thus, until the Republicans kill us off with austerity and we have, as someone noted above, macro economists hanging from lampposts, we are going to be a zombie like Japan

    1. Steven Keen, the Australian

      Here is the link from Soros/INET:


      here is his website:


      here is his best paper:

      Household Debt—the final stage in an artificially extended Ponzi Bubble, Australian Economic Review, Vol. 42 No. 3 September 2009, pp. 347–57.

      The Fed's just released White Paper on housing says that private debt is the head wind, holding us back, 300/400 billion in missing spending.

      Also, Angry Bear has had good following papers or posts and Bloomberg Business has reported on several papers confirming, released in November.

      How Household Debt Contributes to Unemployment: Mian and Sufi


    2. Thanks for references. In fact, I have seen the Mian and Sufi article before. They make some interesting and legitimate points.

    3. Mian and Sufi papers were very informative to me

      Of course, none of this makes a difference. Wiser people than us foresaw the coming of the Civil War

      We are doomed. We are going to have "austerity" in 2013 and the Fed is going to jack interest rates for the "savers," at the same time.

      Cantor just lectured Bernanke and Bullard has stated he is on board.

      Each night I pray the Gods will allow me to live long enough to see the street justice that is coming

    4. Looks like Crazy John D made it over here too.

  17. Hey, cool! At this writing, David has a link to a Krugman post which completely demolishes David's post and Bullard's speech. In case the link has been replaced by a later Krugman post, here it is: http://krugman.blogs.nytimes.com/2012/02/11/bubbles-and-economic-potential/#more-28935.

    Krugman wins 99% of the time. How did we ever get along without him?

    1. Oh Sam, if there was no Krugman, I'm sure you'd find some other outlet for your fetish.

  18. Bullard’s claim that “It takes a long time for those displaced by the shock to find new working relationships” just doesn’t tie up with the evidence, far as I can see. These two studies show that those you would expect to be most seriously affected by the collapse in demand for housing (i.e. construction workers) have had no more difficulty finding alternative jobs that those in other industries.

    p.8 here http://www.rooseveltinstitute.org/sites/all/files/stagnant_labor_market.pdf


    My guess is that biggest structural change or “displacement” to use Bullard’s phrase, is precisely the policy pursued by Bullard and the rest of the Washington elite: that is cutting interest rates to zero, while implementing an inadequate amount of fiscal stimulus. That means raising demand for capital equipment since the cost of borrowing to fund the purchase of such equipment is reduced. And employers have certainly been investing big time in labour saving capital equipment. While demand for bog standard household items remains depressed.

    Worse still, the manufacture of capital equipment requires far more skilled labour than serving up meals in restaurants, making and selling cars, and other “bog standard” household items.

    And finally, Bullard adheres to the old canard that government debt is a burden of future generations on p.17 here:


    I don’t have much time for him.

    1. Ralph,

      Thanks for the interesting links. You should keep in mind that the construction sector is a big sector and has several important sectoral interlinkages.

      See: http://andolfatto.blogspot.com/2011/10/great-sectoral-shock-of-2006.html

      So it would not be surprising to me to find that a major sectoral shock has negative impact on the job finding rates in other sectors.

      As for the displacement effect of zero interest rates, well, I do not believe that the Fed has much influence over real rates. The low real interest rates are, in my view, attributable to the huge worldwide appetite for US money/debt. That appetite is a function of the private sector's pessimistic outlook on the future return to investment.

      Still, there may be something to your view. I certainly think we should all keep our minds open to alternative hypotheses.

  19. "I do not believe that the Fed has much influence over real rates"

    Short term real rates were highly positive during the GD, and modestly positive during Japan's "Lost Decade". They are negative now. In all three examples, the private sector has a, "pessimistic outlook on the future return to investment." If not central bank policy, what accounts for the difference in real rates?

    1. A good question, Anon. Short answer is I do not know for sure. But one thing that is surely different today: there is a huge worldwide demand for US dollars and US treasuries for use as collateral in repo, credit derivatives, and also as a safe store of value. I think this huge worldwide demand for safe assets is what is depressing the real interest rate on US debt. If you have another hypothesis, please feel free to share.

    2. there is a huge worldwide demand . . . as a safe store of value.

      let's assume that these markets are "efficient."

      Would it not make sense for economists and the Fed to be conducting powerful public opinion surveys to discover the source of this fear, instead of playing with models?

      Gallop and Jim Clifton published some results in a poorly titled book, The Coming Jobs War, last summer, which it appears macro economists just disregard.

      If the fears are real and justified . . . why does such have to say?

    3. Anonymous,

      Fed presidents and other Fed representatives regularly go out and consult local business and government leaders. As for playing with models, you should look in the mirror: we all have models of the way reality functions embedded in our brains. We just tend to be more explicit than most. And as for that book, I have not seen it. There are a great many books out there, I try to do the best I can to keep up.

    4. regularly go out and consult local business and government leaders.

      opinion takers say that in such situations you don't get honest feed back

  20. Dave: "I do not believe that the Fed has much influence over real rates."

    Well, we have examples where unexpected Fed actions -- QE announcements, for example -- significantly changed bond yields less implied breakeven inflation rates.

    How do we explain that?

    In the absence of a very good explanation, it appears to me that the Fed can change real rates, at least within certain parameters.

    1. Chris,

      Please don't make me write an essay in reply to every question. I believe the quantitatively important effects on the real rate out 5 years and longer on the yield curve are not dominated by Fed actions. How's that? There are other things that determine market interest rates, as you well know.

    2. Dave, I thought that we were agreed that you would respond voluminously to my every question until I was completely satisfied with your answer -- or the sun burned out?

      I thought that I was the implicit referee for your blog.

      Are you trying to back out of that deal now?

    3. Oh yes, that does ring a bell. Now remind me: what was in it for me? :)

  21. David,
    I think the "safe asset" demand for Treasuries determines the nominal rate, not the real one. It seems to me real rates are always function of Fed policy as long as the Fed controls inflation expectations. The 1932 Fed was unable to ease. The '90's BOJ was comfortable with mild deflation. The Fed since 2001 has been committed to fighting it, "at all cost". That accounts for the difference in real rate across each of these prolonged downturns.

    Savers may be comfortable earning 75bps nominal out five years. However, why would want to lose, annually, 1.25% (the 5yr TIPS real rate)? I don't buy the, "nowhere else to go" argument at all: the stock market has doubled since the bottom and regained its historical average P/E; corporate bond spreads are quite low and junk spreads are normal; commodities are in a bull market. Unlike in the '30's, or even in Japan, there is zero sign of ultra-depressed -- or deflationary -- investor expectations.

    BTW, I wish economists would stop using the GD as an analogy for today. Real rates of 10% versus -3%. Is this a difference in degree, or in kind?

    Anonymous from 10:41

  22. LOTS of comments.

    As your follow-up post says, this post did generate a lot of discussion. I found it interesting myself. For me, it's a new interpretation, a new concept. That's always worth a look.

    I was disappointed with the responses on other blogs. There seemed to be too many economists rejecting Mr. Bullard's argument based solely on a supposedly incorrect understanding of potential output. I find that a weak argument, and I think repeating it weakens it further. I had a different take.


    Congrats on the good coverage you got on this. Seems to me your blog has come a long way from where it was when I first visited.

    1. Arthur: Thanks! I took a look at your posts -- you really slap me around! But I think I will add a link to it, and a few other pieces that I think deserve more attention.

    2. A second congrats on your blog

      I test people to see what they are made of.

      You have altitude, perspective, tone, and judgment rarely seen on the part of a person with whom I disagree with, a lot. It comes across that you are doing your work with an open mind. What a rare thing in your profession.

      The contrast between you on the one hand and Williamson and Bullard, for example, is stunning.

      Both are walking incentive bias. Look at the people who read Bullard and dismiss was he says,instantly, as nothing but a position protecton paper. You just sense that he is not up to any good.

      You touch the same subjects but only you seem to be honestly attempting to move the ball forward. That really came through when you mentioned, favorably, Mian and Sufi

      Thus, no more jabs with a sharp stick in the eye from me.

      Please, however, think about a sense of urgency and pay more attention to second and third order effects. And for those of us who are very upset and extremely pessimistic, if you see a reason for a ray of hope (which I don't see at all when someone is talking about savers), or a good survival idea, let us know.


    3. DA
      While everyone else was learning the social graces, I was learning to program. Forgive me if I said anything out of line. I was trying only to be emphatic and clear.

      Thanks for the link!

  23. The return to labor, perhaps more than any other variable, measures the capacity for the average household to service debt. In the first half of the 2000s, creditors are looking at a recent history of relatively robust real wage growth, justifying credit expansion (even into subprime). By 2005, however, evidence of flagging fundamentals (anemic real wage growth) led to a (rational) revision downward in the real wage growth regime. Credit supply and real estate prices soon began to reflect this change in economic fundamentals.

    anemic real wage growth: any thoughts on why?