Recession and recovery, Krugman and Mankiw, evil and wonkish

There are a few things I want to comment on today, but I'll start with a quick analysis of the latest Krugman-Mankiw debate.

The Obama administration projects that when the recession ends, growth will be faster than the long-term average, as the economy catches up with its permanent trend. This is called the trend-stationary assumption - Paul Krugman supports it and Greg Mankiw disagrees, citing an alternative hypothesis called unit-root.

Though I often disagree with Mankiw, this time I fear he is right. Both parties are citing different analyses of historical data. In economics, data is always easy to argue about, especially macroeconomic time series data of which there are rarely enough to make unambiguous inferences. Neither are going into detail about their answer in terms of an underlying theoretical model. Of course, models are also easy to argue about, but in this case it seems relatively easy to at least expose the implicit assumptions, if not to know which are right.

The question can be posed as follows:
  • Assume that trend growth is 2.5%
  • Then assume that we have an 18-month recession, during which growth averages -1%
  • By the end of the recession, GDP is 7% lower than it would otherwise have been
  • Growth then resumes
  • Does it catch up with the trend again - as in chart 1 below - or not - as in chart 2?
Chart 1: Actual catches up with trend

Chart 2: Actual does not catch up with trend

Krugman's and the CEA's argument is that if it does not catch up with trend, employment will never return to normal levels. But this makes a big assumption about the capacity of the economy.

Does the underlying capacity of the economy continue to grow at 2.5% even during a recession?

I would love to think that it does, but I don't really believe it. In some models, capacity growth comes from growth in the economy's stock of investment; in which case it seems unlikely to be growing right now, with net corporate borrowing falling and investment low. In others, it comes from innovation and knowledge spillovers; and if innovation is reduced in the recession then it won't continue.

In this case, the graph looks like the following, and underlying capacity never reaches the same level as in the first two scenarios:

Chart 3: Trend is hurt by the recession, and actual catches up to it

If innovation is mainly responsible for growth, will we keep innovating in a recession? Maybe innovation will actually increase, as unemployed entrepreneurs or programmers try new things. But if you like this model, you have to accept that productive innovation may actually have fallen in the last few years, when we had high utilisation of resources and effort was diverted into speculation on property and finance. In which case underlying capacity has not been growing, and the recession may simply be the result of overheating demand reaching its limit, and unemployment returning to its natural rate.

In this case, demand may have overshot capacity (financed either by foreign loans, or by running down the capital stock - disinvestment), and the graph looks like this:

Chart 4: Trend was hurt before the recession, and actual overshoots, undershoots and then converges on it

Krugman's assertion that capacity keeps on rising might be correct - but that probably depends on one of the following conditions:
  • The recession is short enough not to significantly affect innovation and investment
  • Growth depends on factors that are not (negatively) affected by recessions
  • Underlying capacity growth will accelerate beyond trend as the recession ends
The first we can yet hope for, but it's looking less likely every month.

The second depends on your model. There is a literature of growth theory on which I am not an expert, but most of the modern work aims to model endogenous growth, arising from factors like intellectual property investment that arise within the economic system. That given, it seems likely that these would be affected by a recession. But you could argue that the effect of a 7% recession is only a 7% reduction in intellectual investment; thus capacity growth falls only from 2.5% to 2.33%, hardly a crippling fall. On the other hand, this type of investment might be proportional to corporate profits instead of revenue, in which case a recession has a disproportionate impact on it.

(Incidentally, one of the main exponents of new growth theory is Paul Romer, who is not married or related to Christina Romer, who as head of the CEA produced the administration's trend-stationary growth forecasts.)

The third assumes that capacity can grow at well over trend for a few years in a row; but my own feeling is that this growth is asymmetric. It can certainly fall below trend but it's harder for it to rise above. But I am hesitant to write off this option completely without evidence.

After all this speculation, either view could be right - and indeed, the truth is probably in between. It seems likely that much, but not all, of underlying capacity growth is dependent on current economic performance. Thus, a recession will be a brake on capacity growth, and the rebound will not be quite as strong as Krugman hopes - but it will indeed be faster than long-term average growth.

So I hope Mankiw's unit root hypothesis is wrong, but I fear Krugman's trend stationary alternative is also incorrect. We'd like Mankiw to be more wrong than Krugman in this case. I won't stir the pot by suggesting what the long-term trend looks like on that question.

Update: Greg Mankiw responds:
The theory behind the unit root empirical results remains murky.  There are several mechanisms that might be working together.  Innovation is one, as you suggest.  Another is the impact on workers, who lose experience and job skills in downturns.


reason said…
Why don't you look at historical data for what is basically an empirical question. Surely the long term rate of growth depends on a combination of population growth, resource exploitation, investment and technological progress. It is not obvious that a recession slows anything but investment and it is quite possible that a higher propensity to save will follow the recession allowing higher rates of investment.
Nick Rowe said…
Great simple clear post there Leigh, with good economics behind it.
Leigh Caldwell said…
Thanks Nick!

reason: I agree that historical data is useful too. In this post however I was exploring theoretical explanations for the phenomenon.

I had neglected to consider population growth - it would be interesting to get some of these figures in GDP-per-head terms (or even GDP-per-employable-adult) instead of absolute GDP. That factor probably supports the trend-stationary position.

I do think it's plausible that resource exploitation and technological progress are slowed by recession (even if not by as much as investment is).
Anonymous said…
I'm a little concerned by the use of absolutes here by all three parties: Will return, will not return.... What about "likely" or "may" or "could" in decreasing order of likelihood?

I don't think there is any certainty one way or another. I think your modified economic capacity is closer to reality, but I don't see any reason why, at some point after economic growth reaches potential, growth might not actually accelerate to (or above) pre-crisis levels. I think the Krugman argument is the least likely.

Appreciate your article and, at least, another perspective on real vs. potential growth.
Anonymous said…
Well written, nice graphs.

Unfortunately, you proceed on the mistaken assumption that innovation is the sole determinant of capacity growth. "Reason" above nailed it.

Here's a primer:

Further, your assertion that "technological progress" is slowed by recession turns the standard view on its head.

Instead of being a determinant of the business cycle, you are saying that technological innovation is controlled BY the business cycle.

I look forward to you supporting this argument with some actual evidence in future posts.
knzn said…
"Underlying capacity growth will accelerate beyond trend as the recession ends"

It seems pretty obvious to me that this will be true. The population, and therefore probably the "cyclically adjusted" labor force, is growing at a rate that is more or less independent of the recession. As long as there is some complementarity between labor and capital, the expanding labor force will create an incentive to invest (more than usual) in new capital once demand begins to recover. In a simple model (e.g. the Solow growth model, if we assume the residual is independent of the recession) I think this will eventually lead growth to catch up with the ongoing trend in population.

You can throw in various wrinkles that will imply that it doesn't quite catch up. For example, the Solow residual might go down during a recession and might never catch back up, if it is explained by innovation and innovation declines during a recession and then does not rise above trend once the recession is over. I'm more inclined to think that the residual is mostly unmeasured capital -- human capital, intellectual capital, and stuff like that -- that will be complementary with labor and will therefore, just like physical capital, accelerate above normal and catch up with its long-term trend if the long term trend in labor force remains intact.

And so on: there are arguments and counterarguments too numerous for this little space. I would like to throw out one more wrinkle, though, that I don't think anyone has mentioned: when jobs are not available, the opportunity cost of education goes down. This might mean that human capital investment is higher during a recession than normally.
Anonymous said…
"trend" is a strange way to look at this, like talking about the seasonal variation in daylight when comparing a child to a dying man.

the asset and credit bubbles were pretty extreme measures to achieve "trend" returns. krugman's been wondering for months now how "the economy" will live without bubbles. we look to be up against "zero bounds" also in planetary systems, with pollution becoming its own cause and new fossil fuel investment "pushing on a string."

with all the error bars and incomplete reporting related to planetary resources it's hard to call it accurately but instead of the economy "falling off a cliff" maybe it would be better to say we're now the cartoon coyote discovering it overran the start of the overshoot downslope and falling comically "back to earth."
Leigh Caldwell said…
Terry: absolutely. Theory is uncertain and empirical projections are uncertain. No forecast can ever be made with complete confidence and I trust that no economist means to imply a level of firmness that is unrealistic!

Anonymous: thanks for the pointer, that's a useful summary. When I discuss innovation I actually mean to include productivity of labour under that heading. Capital stock is the same as investment in my discussion. I don't think resource exploitation is a major variable any more, though I could be proved wrong on this. I did neglect population growth.

knzn: my instinct is that the complementarity of capital will lead capacity to move towards the population line but at most it will be asymptotic to it and never catch it. But as you say, there are so many factors here it's hard to be confident about the overall effect.

hapa: that is quite possible - this would be closest to the scenario of chart 4 I think. I am not sure how comical the crash to earth will actually be, but it's always useful to keep a sense of humour.
Anonymous said…
comedians turn emotions inside out and physical so the metaphor of the hard landing in the cartoon is one of humiliation, not death.

the possibility for a soft landing exists. it's the humiliation we can't avoid and can't seem to keep from shaping our response to the larger situation.
Anonymous said…
Mankiw's reservations about why the return to trend might be (more)less with those workers:
" (Innovation is one, as you suggest.) Another is the impact on workers, who lose experience and job skills in downturns."

And I suppose one has to admit that we are not back in the cave hoping the saber tooth tiger is not outside ...waiting. (for petite Econometrian...such an improvement on Angus).
But considering the job skills and experience that accounted for the upturn, (deadly upturn, I make it) there is also the strong possibility, (possibly even a unit root) that those "illegal aliens" will have to be re-invited (no sense tryin to get the financial mavericks back now that ordinary folks have been tuned up with the Madoff lesson) and the hordes of lesser recognized real estate employees will actually have to work...possibly banging nails.
calmo mulls ova the "skills and experience" lost in this "upturn" (that would be to Dec 07 apparently) and considers whether GDP growth was greatly exaggerated (can we have those international comparisons again?)...whether we are skipping over our confidence in "trend".
Eventually, the saber tooth tigers go away and the cave dwellers resume their berry picking ways...that was the trend, for awhile.

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