Tuesday, February 14, 2012

Bullard On Duy On Bullard On Potential Output

Mark Thoma at economists view has provided a reply by James Bullard, President of the St. Louis Fed, to Tim Duy's commentary on his speech at the Union League Club in Chicago on how he thinks that the housing bubble collapse could have reduced the growth of potential output, along with his criticisms of the standard public projections of potential output, . I would like to comment on this given the nearly universal perception (including posts here by several folks) that Bullard does not seem to understand that the projections are based on the Solow growth model, particularly given that Bullard is one of the more open-minded and knowledgeable figures involved in decisionmaking at the Fed. What is going on here?

To get at this one needs to read the links Bullard provides, most notably the 2009 paper by Basu and Fernald published by the St. Louis Fed on potential output. He notes that they argue that there are competing definitions of potential output. One is essentially long run growth, which should be tied to a growth model of some sort. The other is a shorter run one that they argue should be the equilibrium of a flexible price New Keynesian DSGE model. They argue that rather than the standard one-sector Solow model, what fits the data better is a two-sector model that focuses on technological change the capital goods sector (although they do a lot of handwaving about aggregate Frisch labor elasticities). In effect, they offer four different alternatives within the short-run case: one-sector vs two-sector and flexible price versus sticky prices models, ultimately supporting the two-sector-flexible price one. This plethora of choices lies behind Bullard's unhappiness with most projections of potential output.

OK, so let us grant that there is a lot of fuzziness with regard to what the proper projection of potential output is from this perspective. But does this translate to a reasonable argument that the potential may be a lot lower than the standard one-sector Solow model projection in the recent period due to the bubble and its collapse? This seems to boil down to the claim that the projections most are using amount to being based on unsustainable growth rates based on the bubble period. Well, maybe, although Basu and Fernald do not directly address this, nor do they offer how to estimate how potential output calculations should be made to overcome this problem.

As it is, I think there is a case to be made that the collapse of the bubble did reduce the growth of potential output, by most methods of estimation. I note that I do not see Bullard making the argument I am making specifically or explicitly in either his original talk or in his reply to Tim Duy, but perhaps it or some variation of it was lying behind his arguments.

The basis of this argument is that the fall in output following the collapse of the bubble has reduced the rate of real capital investment. Of course, the sharpest decline was in the real estate construction sector, the part of the economy that was most severely distorted by the housing bubble, and we should expect that part of investment to remain reduced for some time. However, it is not clear that reducing this will damage the productivity of investment in factories, machinery, and equipment, which is the real core of the growth of capital stock that increases potential output. Nevertheless, the sharp reduction of aggregate demand has almost certainly reduced the rate of this sort of potential-output-increasing investment.

So, the massive and sustained reduction of aggregate demand following the collapse of the housing bubble and its impact on the financial sector, has reduced the growth of factories, machinery, and equipment, which in turn has reduced the growth rate of potential output below what it would have been if the housing bubble had been ended without all the unpleasant impacts on aggregate demand that accompanied it (beyond the reduction in demand for housing construction).

I do not know if this is what Bullard was trying to get at in his various attempted explanations of what he has said, but I think that it is a more or less coherent story that does fit with his general argument.


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