Bob Murphy continues his thought experiment
In this hypothetical scenario, potential GDP would have gone up 10% in one year. Then real GDP would have crashed 10% (or so) the next year. So if the CBO looked at output in the year that the drills etc. were being produced, they would have plotted a dotted line from that point to the right, and then wondered what the heck happened to Aggregate Demand in the subsequent year to make real GDP crash. After all, the economy would have had the same number of workers and machines.
In this scenario, there’s no “technology shock” or “resource shock” or anything like that. What happened is that people falsely valued goods produced in the boom year. The economy actually wasn’t capable of producing $1.1 trillion of real GDP that year. Yes, businessmen paid $150 billion for the infrastructure to be created and installed, and yes consumer prices in the economy didn’t shoot up to offset the rise in nominal GDP. But those businessmen paid too much for the equipment.
There are at least a few important things to note
1) There is a clear aggregate demand story here. When the oil as discovered there was a positive wealth shock. Indeed, it would be recorded as such in the Flow of Funds report. When the oil was found not to be there there would be a negative wealth shock.
These can and do happen and are recorded. Here for example, is Total Assets of Households and Nonprofits over the last two business cycles.
You can see the asset value run-up from both the dot-com and housing bubbles and the tiny fall from dot-com and serious collapse from housing bust. So from the point of view of explaining the series of events through traditional AD-AS lense there is no problem.
Interestingly if you extend out the circa 1995 slope you run right into where we are now. But, that’s a story for another day.
2) The other issue is that potential GDP and maximum possible GDP are not the same. The BEA attempts to estimate sustainable GDP and it is possible to exceed that. That is the output gap can be negative.
As you can see the BEA estimated the economy to be running well above sustainable levels in the late 1990s and only slightly above sustainable levels in the mid-2000s.
3) Now why only slightly above in the mid-2000s. Wasn’t the housing bubble huge? In prices yes. In output, no.
Here is construction spending as a fraction of GDP over the same period
This is a theme I talk about it a lot so I can go into it more but the boom in housing construction was not actually that big. It peaked around 2005. It was offset by a decline weakness in commercial construction. That picked up in 2005 but was in decline by 2007. And public construction ran low right up until 2007.
Combine that with the fact that construction is not that big a part of the economy to begin with and the bubble wasn’t really that big.
It looks big in part because prices were so distorting and because single family suburban construction really was moving like gangbusters. That’s where a lot of us live but its not where all Americans live and its not where most Americans work. Urban and rural construction was in the dumpster.
There is a strong argument that this was classic crowding-out though I am not totally convinced. In any case the boom was small and nothing compared to the bust.
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Thursday ~ September 15th, 2011 at 1:20 pm
todd
Why wouldn’t we consider prices when thinking about the boom vs. bust? Isn’t that what you were talking about in the “wealth-shock” scenario? In a situation with roundabout production processes, don’t prices or money measurements of wealth provide meaningful information about “real” production to the extent that contractual commitments are part of the “real” production process? How do we evaluate which is more important: the number of people making mistakes relative to the population or the size of the mistakes relative to the economy?
Thursday ~ September 15th, 2011 at 7:09 pm
Matt (@MeCampbell30)
This is also puzzling to me. Wouldn’t that additional (perceived) equity in a person’s home manifest itself in other sectors? For example, if I thought I had a great deal of equity in my home would that give me greater incentive to go out and buy that new 52-inch plasma?
If GDPPOT prices that in, the measure seems useless. How is GDPPOT determined?
Thursday ~ September 15th, 2011 at 2:45 pm
Curt Doolittle
Karl,
We need to get you on a major newspaper as the rational moderate.
You don’t handle the political side (or don’t value or appreciate it) but your the best and most prolific analyst. And that might be a good play right now. Especially because you directly engage the other side (yes, my side) and you don’t drop into ideology, but remain a skeptical empiricist.
Curt
Thursday ~ September 15th, 2011 at 2:56 pm
Curt Doolittle
Karl,
People are not only price oriented, but future (opportunity) oriented. Their willingness to spend is based not only on prices but on meta-level discourse, and their ability to flock or school to opportunities.
I know you know this, but how does that play into your model? If people see an uncertain future (like before an expected war, or loss of national competitiveness) then simply reducing interest rates won’t work. If they don’t trust their government (from either pole) then they won’t allow government to grow. The only thing left is a great deal of strategic spending on competitive industries that people will politically support. There are plenty of avenues for that investment. And simply channeling the political discourse to direct investment will eliminate both the irritation with the government and the uncertainty, allowing people to flock/school toward those investments (creating new patterns of sustainable specialization and trade so to speak), and creating demand.
Demand comes from schooling/flocking toward opportunities. I realize that in a neutral polity, lower rates allow people to chase status-oriented consumption. But in a non-neutral, hostile polity, status-chasing can come from destroying the economy itself.
You’re right that we need stimulus. You’re wrong that we can take the lazy way out. That stimulus must go into increasing the international competitiveness of the private sector and productive returns. The population will support that. They wont support aggregate spending, or political expansion. THey just won’t and you won’t convince them.
So what’s stopping you from solving the problem through the third axis? Is it knowledge of what to invest in? (Maybe.) Is it time (you’re losing time anyway by tilting at the political windmill). SO WHO IS BEING IRRATIONAL? In effect, you are.
THe people have decided. And no, your desire for totalitarianism so that you can use your two preferred methods in stead of the third is just not a good idea in the long term.
Curt
Thursday ~ September 15th, 2011 at 2:58 pm
Curt Doolittle
(argh. “you’re” not “your”. Can’t edit grammer and spelling using standard comments.)
Thursday ~ September 15th, 2011 at 3:27 pm
Wonks Anonymous
Casey Mulligan sometimes tells a crowding out story about commercial vs residential construction. But I don’t recall him mentioning suburban vs rural & urban.
Thursday ~ September 15th, 2011 at 3:27 pm
Bob Murphy
Karl, good stuff (as usual). But now I see you hustled me during the debate: You were asking me to provide empirical evidence that output was unsustainable during the housing boom years. It looks like the BEA agreed with me for 2005-06.
Thursday ~ September 15th, 2011 at 5:06 pm
Johnnie Linn
If the people falsely valued the value of the drilling equipment would they have not also falsely valued the factors whom were diverted to produce the drilling equipment? Suppose a different scenario. The oil deposits are real. That makes no difference to the factors that were diverted to produce the equipment. Their job is over and they are sent back to their old occupations and their lower productivity. The time series of compensation of the factors would be the same in either case.
Thursday ~ September 15th, 2011 at 6:56 pm
Matt (@MeCampbell30)
“The BEA attempts to estimate sustainable GDP and it is possible to exceed that. That is the output gap can be negative.”
That should say the output gap can be positive when it exceeds GDPPOT or negative when it falls below sustainable levels.
Thursday ~ September 15th, 2011 at 7:06 pm
Karl Smith Says The Boom Wasnt All That Big, But The Bust Has Been Huge | Capitalism V3
[...] into the economy through redistribution. That’s his hammer and everything looks like a nail. In today’s posting, he finds another nail: This is a theme I talk about it a lot so I can go into it more but the boom [...]