What kind of Great Stagnation?
By Scott Sumner
Paul Krugman likes to mock extremely talented conservative economists every time they make a statement that seems inconsistent with the textbook AS/AD model of demand shock-created recessions. And yet as far as I can tell, the views of people like Krugman and Larry Summers are just as heterodox as those of Lucas, Barro, Cochrane, Fama, etc. Krugman and Summers seem to think the world is stuck in a long-run period of stagnation that has demand-side causes.
Over at TheMoneyIllusion I recently did a post suggesting that there really was a Great Stagnation. I claimed that this could explain two facts. One is the very low 30-year bond yields in developed countries. And second, the fact that real GDP growth in the US has been very slow (about 2%) during a period of rapidly falling unemployment rates. But I had in mind the sort of supply-side stagnation that Tyler Cowen hypothesized, not a problem that could be fixed with more nominal spending (although I also think that’s been a problem in recent years.)
It seems to me that the Krugman/Summers view has three big problems:
1. The standard textbook model says demand shocks have cyclical effects, and that after wages and prices adjust the economy self-corrects back to the natural rate after a few years. Even if it takes 10 years, it would not explain the longer-term stagnation that they believe is occurring.
2. Krugman might respond to the first point by saying we should dump the new Keynesian model and go back to the old Keynesian unemployment equilibrium model. But even that won’t work, as the old Keynesian model used unemployment as the mechanism for the transmission of demand shocks to low output. If you showed Keynes the US unemployment data since 2009, with the unemployment rate dropping from 10% to 6.1%, he would have assumed that we had had fast growth. If you then told him RGDP growth had averaged just over 2%, he would have had no explanation. That’s a supply-side problem. And it’s even worse in Britain, where job growth has been stronger than in the US, and RGDP growth has been weaker. The eurozone also suffers from this problem.
The truth is that we have three problems:
1. A demand-side (unemployment) problem that was severe in 2009, and (in the US) has been gradually improving since.
2. Slow growth in the working-age population.
3. Supply-side problems ranging from increasing worker disability to slower productivity growth
Only the last two can explain the slowing long run trend rate of RGDP growth, as well as the low real interest rates on 30 year T-bonds.
I mentioned that there was a third problem with the Krugman/Summers view. They favor big government Keynesian demand-side remedies for what they see as a sort of permanent liquidity trap. This fits with the newly fashionable anti-neoliberal views on the left. Thomas Piketty’s new book made the wildly implausible claim that neoliberal reforms had not helped countries like Britain. However the countries least likely to be mentioned in discussion of “The Great Stagnation” are precisely those countries that have pretty good supply-side fundamentals, and/or relatively small government. Here’s the Heritage Foundation’s list of the top 10 countries for Economic Freedom:
Now I don’t want to oversell this list. Many of the top 6 countries have fast population growth. It’s hard for any country to completely overcome the slowdown in the rate of global productivity growth. But I think any fair observer would note that (with the exception of Ireland) the “usual suspects” in the stagnation discussion (Japan, the US, Britain, the 18 eurozone members, etc) are conspicuously missing from that list. And while Ireland undoubtedly was hammered by a big demand shock, their RGDP rose 7.7% over the past 12 months, a rate the US could only dream about. So while the top ten countries are not perfect (Denmark’s performance has been mediocre) they’ve clearly done better than most developed countries. That doesn’t provide much support for the progressives’ claim that the eurozone is doing really poorly because while they have the biggest governments on Earth, their governments need to be even bigger to overcome the Great Stagnation.
[The Fraser Institute top 10 list replaces Chile, Ireland and Denmark with the UAE, Bahrain and Finland.]
Also note that the eurozone country that is usually seen as doing best (Germany), greatly liberalized its labor markets in 2003-04. Back in 2007, before any of these problems developed, I did a study of neoliberal reforms in developed countries. I looked at all 32 countries with per capita incomes above $20,000. Guess which one had the least neoliberal economy? (Hint: It was doing well at the time of my study, which puzzled me.)
The answer is Greece.
PS. Below I list everything I know about Mauritius:
It’s in the Indian Ocean.