Are we losing long run output?
Does failure to restore demand lead to lower output in the long run?
By now it must be clear, at least to most economists, that the stimulus was too small, as Krugman claimed, that the GOP opposition to all things Obama undercut further stimulus, and that there is still room for demand-led expansion. Predictions of inflation have failed, and failed, and failed. Why? Because in a demand-constrained economy, added demand translates into added output, not into higher prices.
This is good old Keynesian old-time religion. One might make arguments as to other possible interpretations (a subject for another post) but at this point the presumption is that a Keynesian model makes sense when the economy is well short of long run equilibrium, and every indication is that we are in such a time. Until unemployment drops at least another two percent, and housing is close to demographically sound levels of new home sales, that interpretation will keep looking good.
So it raises the question: what about the long run? Are we just increasing the recessionary gap, so that the recovery will have considerable "spring" back in its step? Or has the long-run equilibrium output level suffered from all this slump, so that it can in some sense never be made up?
There are some reasons to think prolonged slump damages supply. First is the obvious lack of investment. People learn to get used to old storefronts and to hang on to their cars longer. The investment hasn't been there to depreciate less advanced capital, and lack of investment has led to a lower base to add further investment to, so that the standard notions of investment being a percentage of the capital stock translate into lower investment because the capital stock is less than it would have been.
If you focus on education, some of this effect materializes, but mixed with forces working the other way. First, if people can't afford college and its debts, there will be less investment in human capital, and so less human capital to use in creating further human capital investment. However, as is well known, the opportunity cost of studying is lower in a recession, so education formation will not fall by as much as overall output does.
The lag in investment is more likely to show up in lack of critical skill-formation among new employees who would have been hired in a real recovery, but were not. Speculation focuses on these young people becoming "structurally unemployed" with a stigma of "slacker" on them, but I think they have just delayed the entry-level skill acquisition.
The tougher and more interesting question is whether students have avoided investing in specialist degrees out of concern for demand growth - specialists are more vulnerable to shifts in demand than generalists are, and it is impossible to diversify your investment in a degree. There is no obvious reason why a prolonged recession should increase the likelihood of demand shifts, but it may increase the downside risk of what happens to you if your specialty loses its luster. Instead of having a decent chance of retreating to generalist jobs, the specialist may find all those are taken by better prospects, who trained as generalists in the first place.
A standard neo-classical analysis would suggest that all the opportunities accumulating from advancement in technology remain waiting out there, and the economy will make up for lost time when demand does return. This is the "closing of the recessionary gap" by long-run equilibration. I am deeply skeptical of it, and believe that concern about "pushing on a string" is a sensible analysis, but in 1992 the economy did snap back from the recession that began with the end of the cold war. On the other hand, interest rates did not fall to zero and stay there for years, in 1992.
I am inclined to think that opportunities are generated by local capital stock, not just by technology. Allthough the impact is not as great as the impact of changing technology, we know that there are "interaction" effects in capital investment, so that within a region, investment by one industry helps to make investment by other industries more profitable. This is an amorphous conglomeration of spillover effects due to production linkages, added profitability of infrastructure investments, consumption linkages (valuable homes make other homes nearby more valuable), and enhanced specialization. Roughly speaking, these are the famous "agglomeration" external economies of scale.
Furthermore, I suspect that the most recent vintage of capital has the most significant spillover effects on related industries, stimulating problem-solving and idea exploration that carries over into upstream, downstream and cross-stream industries. So if you pass up some of that investment, you pass up some stimulus to further investment, and some portion of the opportunities are permanently delayed, rather than accumulating.
In theory this is partially offset by cheaper factors of production for the opportunities that do get exploited. The question of long run effects might be boiled down to whether these "price adjustment" stimuli can overcome the "spillover" sources of drag. But my reading of the Philips Curve evidence is that it isn't close - that price adjustment simply cannot create much stimulus, and in a serious slump, with interest rates all the way down to zero for more than six months, it may never catch up with continuing negative demand spillovers as people adjust to having less savings to dip into, less prospect of finding jobs that actually use their skills, and generally, an assumption that the long term will be bleak becomes a self-fulfilling prophecy.
In the face of all of those pressures, whether they seem ephemeral, like loss of optimism, or might actually be measurable, like loss of reinforcing productivity spillovers from new investment, I think you have to be a true believer to hold with zero effect on long-term prospects.
By now it must be clear, at least to most economists, that the stimulus was too small, as Krugman claimed, that the GOP opposition to all things Obama undercut further stimulus, and that there is still room for demand-led expansion. Predictions of inflation have failed, and failed, and failed. Why? Because in a demand-constrained economy, added demand translates into added output, not into higher prices.
This is good old Keynesian old-time religion. One might make arguments as to other possible interpretations (a subject for another post) but at this point the presumption is that a Keynesian model makes sense when the economy is well short of long run equilibrium, and every indication is that we are in such a time. Until unemployment drops at least another two percent, and housing is close to demographically sound levels of new home sales, that interpretation will keep looking good.
So it raises the question: what about the long run? Are we just increasing the recessionary gap, so that the recovery will have considerable "spring" back in its step? Or has the long-run equilibrium output level suffered from all this slump, so that it can in some sense never be made up?
There are some reasons to think prolonged slump damages supply. First is the obvious lack of investment. People learn to get used to old storefronts and to hang on to their cars longer. The investment hasn't been there to depreciate less advanced capital, and lack of investment has led to a lower base to add further investment to, so that the standard notions of investment being a percentage of the capital stock translate into lower investment because the capital stock is less than it would have been.
If you focus on education, some of this effect materializes, but mixed with forces working the other way. First, if people can't afford college and its debts, there will be less investment in human capital, and so less human capital to use in creating further human capital investment. However, as is well known, the opportunity cost of studying is lower in a recession, so education formation will not fall by as much as overall output does.
The lag in investment is more likely to show up in lack of critical skill-formation among new employees who would have been hired in a real recovery, but were not. Speculation focuses on these young people becoming "structurally unemployed" with a stigma of "slacker" on them, but I think they have just delayed the entry-level skill acquisition.
The tougher and more interesting question is whether students have avoided investing in specialist degrees out of concern for demand growth - specialists are more vulnerable to shifts in demand than generalists are, and it is impossible to diversify your investment in a degree. There is no obvious reason why a prolonged recession should increase the likelihood of demand shifts, but it may increase the downside risk of what happens to you if your specialty loses its luster. Instead of having a decent chance of retreating to generalist jobs, the specialist may find all those are taken by better prospects, who trained as generalists in the first place.
A standard neo-classical analysis would suggest that all the opportunities accumulating from advancement in technology remain waiting out there, and the economy will make up for lost time when demand does return. This is the "closing of the recessionary gap" by long-run equilibration. I am deeply skeptical of it, and believe that concern about "pushing on a string" is a sensible analysis, but in 1992 the economy did snap back from the recession that began with the end of the cold war. On the other hand, interest rates did not fall to zero and stay there for years, in 1992.
I am inclined to think that opportunities are generated by local capital stock, not just by technology. Allthough the impact is not as great as the impact of changing technology, we know that there are "interaction" effects in capital investment, so that within a region, investment by one industry helps to make investment by other industries more profitable. This is an amorphous conglomeration of spillover effects due to production linkages, added profitability of infrastructure investments, consumption linkages (valuable homes make other homes nearby more valuable), and enhanced specialization. Roughly speaking, these are the famous "agglomeration" external economies of scale.
Furthermore, I suspect that the most recent vintage of capital has the most significant spillover effects on related industries, stimulating problem-solving and idea exploration that carries over into upstream, downstream and cross-stream industries. So if you pass up some of that investment, you pass up some stimulus to further investment, and some portion of the opportunities are permanently delayed, rather than accumulating.
In theory this is partially offset by cheaper factors of production for the opportunities that do get exploited. The question of long run effects might be boiled down to whether these "price adjustment" stimuli can overcome the "spillover" sources of drag. But my reading of the Philips Curve evidence is that it isn't close - that price adjustment simply cannot create much stimulus, and in a serious slump, with interest rates all the way down to zero for more than six months, it may never catch up with continuing negative demand spillovers as people adjust to having less savings to dip into, less prospect of finding jobs that actually use their skills, and generally, an assumption that the long term will be bleak becomes a self-fulfilling prophecy.
In the face of all of those pressures, whether they seem ephemeral, like loss of optimism, or might actually be measurable, like loss of reinforcing productivity spillovers from new investment, I think you have to be a true believer to hold with zero effect on long-term prospects.