Since this argument has been getting a lot of airtime recently—from Jared Bernstein and Gerald Friedman, to name two examples—I wanted to explain why I think we should be skeptical about this piece of evidence and others like it, and to explain what kind of evidence we should find persuasive.
The deep underlying economic question is: Under what conditions can we make inferences about structural relationships from cyclical patterns?
We see that productivity growth is correlated to the output gap. In fact, it is not only labor productivity but also total factor productivity that behaves in this way. Does that mean that running small output gaps would raise the long-run rate of productivity growth? Not necessarily.
Here is a counterexample. Suppose that firms must split their workers between two activities, production and maintenance. When firms allocate more workers to production, they make more money. When they allocate more to maintenance, they make less.
It makes sense for firms to defer maintenance to times when more production is less beneficial to them on the margin, as in recessions. But no firm can defer maintenance forever. Despite a cyclical relationship, it is not true that a policymaker could permanently raise productivity by keeping the output gap low. One can make similar arguments about firms' use of overtime or firms' willingness to shift capital investments through time.
The problem with these endogenous-supply explanations is that, if given too much power, become hard to square with what we know about economic growth in the long run. If it were true that countries could raise productivity growth by maintaining high aggregate demand, output should be only weakly related to fundamentals. In fact, the cross-country evidence on economic growth points to the opposite conclusion. One can predict output quite well from simple structural facts about an economy, like the capital stock, education, technology, and institutions.
Growth economics should limit what kind of long-run gains we can rightly expect. Yet it shouldn't eliminate them. For compelling evidence that short-run economic activity has long-run consequences, look to work by Larry Summers and Antonio Fatás as well as by Lawrence Ball.
Eurozone countries that applied the harshest austerity from 2009 to 2011, Summers and Fatás show, saw the largest declines in economic growth expected in the long run as well as the short run. Fiscal consolidations that create output gaps, they conclude, also have disturbingly large effects on long-run output. Ball shows that, across developed countries, the size of a country's output gap is extraordinarily predictive of the loss in potential output.
Both of these findings seem to require a universe in which long-run output depends on keeping the economy near full employment. The growth literature, on the other hand, should warn us about extending this conclusion too far, and convincing ourselves we can engineer sustainable supply-side booms by boosting aggregate demand.
from Evan Soltas http://ift.tt/1QF6UEL Boom, Bust, and Inference - Entrepreneur Generations
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