How large is the output gap really?

Via Mark Thoma, and drawing upon James Bullard at the St. Louis Fed, MacroMania writes:

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 its original growth path). The implication is that the so-called “output gap” (the difference between actual and “trend” GDP) may be greatly overstated by conventional measures.

There is still not enough talk of wealth effects in current macro debates, as they are invoked only selectively.  Note by the way that if you see the output gap is somewhat smaller, you will think today’s recovery is somewhat better, not in absolute terms, but relative to potential.

Here are some interesting observations about  Bullard.

Addendum: Here is comment from Scott Sumner, and Matt Yglesias.  You’ll note my post is itself non-committal, though I certainly do not dismiss this argument.  Simplest response to Sumner and Yglesias is that we may have had a biased estimate of the previous trend, for bubble and TGS-related reasons.


Does the same argument apply to the 1930's depression?

As to the last link you can bet that as a career central banker Bullard he's exploited the FED's very generous Thrift matching saving plan and pension plans to the max. Since those aren't reported on the form referred to the (tongue in cheek?) notion he's living paycheck to paycheck is bogus. And uninteresting.

I'm not clear on why Bullard's argument on potential GDP is so novel. Isn't it generally accepted that the housing bubble had us operating beyond "potential" because people felt wealthier than they were? Aren't we looking at potential benchingmarking from a period before that? Can it that we were that far over potential -- were resources somehow tricked into being supplied? Consistently? I don't see that he has a convincing story that we understated the natural rate of unemployment.

But I'm not a macroeconomist.

No wealth evaporated in the housing collapse! There are the same number of houses today as before! It's just that old people will sell them to young people for lower prices. It's bad for old people but good for their kids. There is no change in net real housing wealth!!! The kids are now able to spend more on iPhones even as their grandparents are spending less on denture cream...

It's a bad deal for the kids - most of these cheap houses are located in the back-of-beyond. They're totally worthless.

You're nuts

I don't think I'm nuts - he says this is good for kids because they can buy houses cheaply. That might be true but most of those houses were built far out in the Florida swamps or Nevada deserts. Most young people today aren't interested in living in exurbs - remember the first law of Real Estate: Location, Location, Location - if the location sucks the house is worthless.

It's great for young people like me who don't care about impressing anyone by the fact that they live in a crappy studio apartment "really close to Manhattan".

You are just 100% wrong. Housing prices are way down everywhere in every category. I know I personally live in the D.C. suburbs and rented 2007-2009 and then snatched up three houses for almost 50% off peak prices. Even the places where the housing market is doing the best like Dallas, which tended to be the most affordable anyway, are down over 10% now.

Dallas...I spent a month there one night

It's not about impressing people those places are intrinsically great - and you can get a pretty good place in New Jersey for not too much money. I know a few people from school who got jobs in New York - one of them moved back to Toronto and now is forced to spend significantly more money on his cost of living. New York can be much cheaper then people would believe.

"It’s not about impressing people those places are intrinsically great"

Ah yes, and anyone who disagrees is an ignorant philistine, I'm sure.

Right - now you're starting to understand

Most young people-and myself included when I was young-wanted to be in proximity to other young people. Houses in the Inland Empire region of California are cheap-but good luck finding work out there, much less a social life.

In some part of the country houses sell for their actual replacement value.

Prices in New York are way down now

Well, I think All state has an insurance pricing center in Nebraska. Many customer service call centers have moved out there already. Things may change in the near future.

I don't understand your point here? Nebraska - that's nowhere near New York City or Coastal California - so it's just the back of beyond.

Nebraska didn't have much of a housing bubble at all.

How Austrian of you!

Disagree. My hometown is close Atlanta and has been growing like a weed for 25 years. The foreclosure rate is also high. But people are definitely buying foreclosed homes. The prices are a lot lower, but they're not sitting vacant for long.

A related thought: all the "wealth" created during the housing bubble wasn't really there, so it couldn't really disappear. Only if you bought/sold during the bubble did you lose/gain.

For example, I bought my house in 1981. Any changes in its value in the last 31 years, and until I sell it, have not been of any consequence to me and certainly don't affect my current spending. When I sell it, money moves to me from somebody else, but whether than amount of money is $30,000 or $300,000 it's just me with a little/lot more money and them with a little/lot less money.

"Only if you bought/sold during the bubble did you lose/gain."

Home equity loans: For example, I believe the Obamas took cash out three times when refinancing their mortgage on their condo.

Which suggests that anyone who lives like a Kenyan anti-colonial socialist must be an anti-American idiot and true American patriots would pay cash for housing, or at worse borrow as little as possible to buy the smallest house they can and pay it off as quickly as possible.

What I never understood is why bankers got the religion of over indebted bank customers as a virtue during the Reagan administration - before Reagan I struggled hard to pay for a credit card that I had to pay off within 25 days of the bill arriving (AMEX, Diners) and my local banks didn't offer credit cards because the risk of easy personal debt was too high. I borrowed a $1000 to buy a new car ($2200) with more than three thousand in the bank just to build up a credit history. Granted that was back in the days of crushing liberal government regulation circa 1970, but somehow the economy boomed, and the idea of going bankrupt after running up lots of consumer debt was a real black mark socially. Why did the nation becoming more conservative result in bankruptcy resulting in almost hero worship for Donald Trump who solves his problems with bankruptcy.

Donald Trump has exquisite taste in women which makes up for all his financial mishaps.

In all fairness most men have about the same taste in women - Donald Trump just has the money to get them - and yeah it's the money because it certainly isn't that roadkill face or head of "hair"

Because Trump et al are not "conservatives"--they provide icons for those who believe the "chosen people" have a natural right to game the system. The "conservatism" being espoused is no more than a claim by a given group that their praxes are natural law; and their wealth is a "natural" entitlement, rather than a "governmental" one. "Bain capital" and "food stamp fraud" are merely the 2 sides of that coin.

The output gap measures the difference between national income and the *productive capacity* of the economy. A permanent decline in the path of consumer spending should mean higher a investment share in GDP, a higher amount of net exports, or a higher government deficit. It shouldn't mean that potential real GDP itself is any lower.

How does this fit with the high unemployment rate?

"Here are some interesting observations about Bullard."

Before anyone rushes to judgment about Bullard, they should read some of the scathing comments below Felix Salmon's article.

Regarding Jim Bullard himself, he is the only person either a Fed bank prez or on the Board of Govs who is not only a member of an academic journal editorial board (quite a few are that, including Gentle Ben), but a coeditor of a journal, in his case, the Journal of Economic Dynamics and Control, which means that he is spending quite a bit of time dealing with academic research in a journal editorial capacity. Prior to becoming St. Louis Fed prez, he was its Director of Research. Smart guy indeed, although I have no idea how he is handling his private finances.

"we may have had a biased estimate of the previous trend, for bubble and TGS-related reasons."

Yes, that's true. But I fail to see what it has to do with the "wealth effect" argument. If you think the actual trend is lower, fine, it's certainly plausible, but it doesn't change the fact that a collapse in asset prices doesn't affect the country's potential output.

dbeach, Suppose households and lenders overestimated the productive capacity of the economy? That is they were overconfident about their income growth (treating the recent slow down as more temporary than it was...TGS argument) or they expected strong economic growth to keep house prices rising forever (bubble argument). To put it simply, the (debatable) argument is that the collapse in wealth might be telling us that the productive capacity was not as high as we previously thought.

This is one of the things that sounds very weird for a non-economist. I mean, we had this recession for a reason. One assumes that the reason is somehow related to the fact that our economic growth was not sustainable. So to look at the previous trend and say that our goal is to return to it is like trying to deny reality. Actually, try to define how much we should be growing is already trying to deny reality. We will grow whatever is possible and we can see the trend after the fact. Trying to estimate that before it happens sounds backwards to me.

Economists are weird. You've got it just about right, or at least you know what's wrong.

So...we're not as rich as we thought we were?

The wealth effect is an illusion. What we observed was an expansion of cheap credit that fueled retail purchases with home equity and cash out refinancing. Debt secured by real estate had lower interest rates and interest was deductible. I doubt anyone seriously thought or acted as if appreciation was part of permanent income.

When people sold near the peak, they had an increase in wealth, but this was directly offset by the debt of the buyer. As house prices fell, the housing wealth or, rather, the value of mortgage assets, vanished. The adjustment over the ensuing years was merely a battle over whether borrowers or lenders would eat the losses.

Lending continued apace on commercial property for a while before that bubble burst. The destruction of money through asset devaluation precipitated the recession. Labor displaced from the FIRE sector had no place else to go because of the decline in money supply as well as skill mismatch. The overhang in durable goods meant the displacement of resources would last a very long time. The high wages of people from the FIRE, construction, and manufacturing sectors were effectively borrowings from the future. If they didn't save, they had nothing for the drought years.

This is the best synopsis of what happened, I've read for a while.

I always think that this is really a useful website....

I don't get the argument. First, we saw two sharp drops in net worth in the last decade, why did only the second one have this effect? See the first figure here:
Second, a drop in wealth should have the opposite effect on supply if leisure is a normal good. So I don't get it.

First, there are two possible interpretations of Bullard's argument: 1) potential output or trend growth has declined to the point where we are now at or close to potential trend growth now (i.e. no catch up growth to reduce UE); 2) potential output or trend growth has declined maybe to the point where the natural UE rate is 6% (wheras in the 90s maybe 5-5.5%) - certainly some leeway for catch-up growth. Both due to the weath effect. Now

It would appear to me the point is #1 (thats how many people interpreted it). Not #2, which some people might find plausible, but still implies we are long way from normal.

Sticking to #1, there are a lot of reasons I can think of why potential growth might be lower. Some of them include: more regulation, higher expected future taxes, skills mismatch in the labor force (or negative productivity shock), less labor mobility (maybe due to negative home price equity supressing mobility), higher leverage (capital) ratios required by banks. All except the technology/skills argument are plausible in my mind. None have anything to do with the weath effect. And its not even plausible that any of these have an impact on the order of the level of UE we are seeing (15% including the long term unemployed) plus the dropouts in the labor force, nor can we associate any with the timing of the recession. Some are fixable with monetary policy.

The "weath effect" explains why the price of items would decline, not the Q, and only explains temporary (cyclical) UE. "wealth" might have been destroyed, but machines, houses, and people were not (mostly). Real potential output is a function of the Q not the P! Maybe past trend growth was estimated wrong - biased high, but that really does not explain why the economy is incapable of producing the same Q at a lower P right now, and why we cannot get back to 5% to 5.5% UE. Maybe some of the items I listed above slow the rate of adjustment (e.g. of wages), but that still does not explain why all those unemployed people cannot produce the same Q at a lower P. Nothing explains the inability to "catch up" and do much better than 8% UE. Housing demand is endogenous - the rate of household formation crashed with the economy, once the UE declines kids can move out (and: the rental market and multifamily real estate is doing just fine and rental prices are going up). Las Vegas is poised for record sales (lower P, higher Q, people paying cash). Moving vacant homes to the rental category will go a long way to adjusting the imbalance. Again, no reason we cannot get back to 800k or so new homes annually once the excess is sucked up. Thats a temporary phenomemon.

I know others are looking for an economic rationale. Stop looking. in my mind its purely political: please don't blame Bullard for bad monetary policy. It's all CYA.

Non committal. I hope so since Bullard is talking nonsense. But then you ruined it with the "sympathetic."

Comments for this post are closed