The Potential Output Debate And the Older Natural Rate and NAIRU Debates

So, Mark Thoma has Tim Duy on again, http://economistsview.typepad.com/economistsview/2012/02/fed-watch-again-with-potential-output.html , with Krugman chiming in with his semi-goofy "Duy on Bullard on Duy on Bullard on Tinker to Evers to Chance." I agree with Duy that Bullard understates the various ways that the bubble crash messed up the financial system, but I want to note the link between this debate and an older one that we have heard less of lately. Some of the links are curious. In particular, although he avoids the language of those debates, I see Bullard in effect supporting views of people who disagree with the old conventional consensus, although in this he may have been following Alan Greenspan as well as Jamie Galbraith circa 1996 analytically, even if not in terms of policy.

So, Arthur Okun coined the idea of NAIRU, which arguably was linked to the old textbook Keynesian story of a clearly defined potential output, with AS curves flat out to that level of output and then suddenly going vertical, in contrast to the one described by Keynes in the GT chapter on prices that had bottlenecks setting in well before then and "reducing elasticity" as one approached the "classical" zone where that elasticity went to zero. While I have never seen a coherent argument why NAIRU should coincide with this, when Milton Friedman posed the idea of the natural rate of unemployment, which simply swept the profession, most observers tied the NAIRU level of output to the level of output associated with Friedman's natural rate of unemployment, a level of output the economy supposedly goes to if there are no particular shocks and policy is more or less neutral, presumably an equilibrium level of frictional unemployment, hence only voluntary. Some would go further and link this with the old Wicksellian (picked up by some of the Austrians) natural rate of interest as well holding, a nice across the board general equilibrium level of output that could be identified in some sense with the supposedly clearly defined potential output of the old Keynesian textbook stories.

But then a funny thing happened on the way to Broadway, namely the mid-to-late 90s. As unemployment fell through what many thought was its natural rate and no acceleration of inflation appeared, indeed the opposite happened, Greenspan sent his minions to the basement of the Fed and decided that productivity was improving sufficiently rapidly that we did not need to tighten monetary policy to avoid crashing into NAIRU. While this did not fundamentally upend the concept, it coincided with critiques coming from people such as Galbraith who argued that the concept was profoundly flawed and fundamentally useless. And Greenspan's continued loosening of policy without any inflation happening burnished his image.

Indeed, from the very beginning of the natural rate discussion there had been people such as Phelps and later Summers who annoyingly pointed out the substantial endogeneity of the natural rate to past unemployment, how long spells of unemployment can make it harder for people to operate in the labor market, something that we are hearing again as voices are now being raised to claim that the natural rate has gone back up, although it remains unclear that if output were to rise sufficiently to push unemployment below that rate we would see an acceleration of inflation.

Now, Bullard's position on this seems to have two contradictory parts. On the one hand, while eschewing the language, he seems to recognize the very weakness and fuzziness of the whole natural rate/NAIRU argument. This is an implication of his valid arguments regarding the fuzziness of the concept of potential output. As with Friedman, it is supposed to be the outcome of a general equilibrium of the economy. However, what the general equilibrium is or should be depends on a bunch of things such as the number of effective sectors in the economy and the degree of price stickiness, and so on. It is not well-defined, implying that these other concepts are also not well defined. OTOH, it sort of appears that he is using this fuzziness, along with the legitimate concern that potential output, however measured or defined, will be growing at a lower rate due to the outcome of the bubble crash (for my part due to reduced capital investment, even if that is not his argument), that then we may need to worry about crashing up against it and should avoid doing so just in case it might also turn out to be NAIRU, despite the lack of any apparent inflationary pressure in the economy, not to mention still low levels of employment relative to working age population and substantial measured excess capacity of the capital stock.

For my part, to the extent the problem is indeed ultimately one of insufficient aggregate demand holding down real capital investment and thus the growth of the natural rate of unemployment output/potential output, etc., then the answer is most certainly not to tighten up any time soon on the macro policy levers, unless somehow Bullard is one of those folks who thinks that AD might actually be stimulated by higher interest rates. But I have not seen him claim that and doubt that this is what he is advocating.