Reallocation and growth
By Scott Sumner
I was recently chatting with Caroline Baum about “never reason from a price change” and she mentioned an example from 1986 that I had forgotten. Then I realized it also related to the concept of “re-allocation,” which is frequently discussed by (former Econlog) blogger Arnold Kling.
In her book (Just What I Said, pp. 210-11) Ms. Baum pointed out that back in late 1985 and early 1986 the price of oil plunged from $32 to $10/barrel. The Fed cut rates by 200 basis points. Many pundits predicted an economic boom in 1986, but were shocked when growth came in at only 1.7% in the second quarter. (Yes, in those days 1.7% was far below trend—that was before the Great Stagnation.) She noted that slowing growth in the oil patch states (such as Texas) was a drag on overall GDP growth.
Of course we’ve seen another sharp drop in oil prices during late 2014 and early 2015, and thus far growth in 2015 has again disappointed the pundits. It occurs to me that this is one area where Kling’s re-allocation theory makes a lot of sense. In much of macroeconomics, things are symmetrical. Thus if a Fed rate cut or a tax cut spurs the economy, we assume that a rate increase or a tax increase slows the economy. That’s symmetry.
Re-allocation is different. The act of moving resources from declining sectors to growing sectors is costly and time-consuming–in either direction. Final output declines during the transition (even if individuals are making wise personal “investments” with their time during the re-allocation.) Re-allocation could occur due to falling oil prices, or rising oil prices.
When NGDP continues to grow at a reasonable rate, the impact of re-allocation on RGDP growth is likely to be modest. Thus in 1986 RGDP kept growing slowly and there was no recession. Ditto for the January 2006 to December 2007 crash in residential housing construction. RGDP growth slowed as workers re-allocated out of housing, but no recession. It takes a monetary shock that slows NGDP growth sharply in order to get an outright recession. In the case of the 2008 recession, the key mistake was the Fed’s (perhaps unintentional) decision to adopt a tight money policy in late 2007.