I just noticed that Paul Krugman made essentially the same point. However, the intuition behind what Bullard’s argument is incredibly common place and so it might still be useful to have two posts.

Bullard writes

If households and businesses had ignored the house price developments as a sort of amusing side show, it would not have been so important. But our rhetoric about the decade suggests otherwise.  Households consumed more through cash-out refinancing, developers built more, borrowing increased, Wall Street produced new financially-engineered products to feed the boom, and ancillary industries like transportation thrived.  Output went up, and labor supply was higher than it otherwise would have been.

If I am correct this paragraph is the crux of his point on the output gap.

I want to examine further

1) What the rhetoric actually suggests

2) What the data from the period tells us about that rhetoric and our current situation.


The Rhetoric

Lots of things were said about the boom both during it and immediately after, however, a single phrase stands out to me as particular well used: “Lived beyond their means.”

This was said both about households and about government. It was said about middle-class suburban America in particular and the American polity in general. What does it mean? Or, more precisely what did people mean by it.

I think that they meant consumption was exceeding permanent income. This necessarily implies savings was lower than optimum. Either, too little is being saved in good times, dis-savings is occurring to fast or too soon or there is too much borrowing. I think the last option captures what most people saw and felt.

However, if this is the case and if at some point it were to come to an end then our expectations on both macro and micro levels is that consumption will have to fall, but production will have to rise.

This is key because although we might expect to consume less and in utility terms to be poorer, we should expect output to rise. This seems counterintuitive, but likely because we are so used to equating output with wealth and wealth with higher levels of consumption. But, this of course not the case.

Just as it is possible to live beyond ones means it is possible to live well within ones means. China and Northern Europe – importantly in fact – are the case in a few data points.

The Data

Lets consider the time path of residential investment and consumption as a fraction of GDP. As is well known they began to grow beginning in the late 90s and continued to do so until the peak of the housing bubble in 2005.

FRED Graph

One interpretation is that this represented simple “over-consumption” all the way through.

Another, is that the US had seemingly shifted to a higher productivity regime in the 90s as a result of Information and Communication Technology. The gains, however, were not lasting and a correction set in in 2005.

Another, perhaps in line with your view is that the deviation in the in the 90s may have been consistent with optimal resource allocation but was distorted in the early 2000s.

I offer a fourth interpretation that centers around developments in international finance and trade. In particular, I draw your attention to the correlation between the increase in GDP fraction represented by consumption residential investment with the increasingly negative contribution of Net Exports.

FRED Graph

Note that these are plotted in equal terms on the same axis. Thus the increase in GDP derived from consumption and residential investment was matched nearly exactly with the negative contribution of Net Exports.

There underlying story is involved but I as a baseline interpretation I submit that following the Asian Financial Crisis the United States increasingly took on the roll of global banker, providing Safe Liquid Assets in the form of US Treasuries and Agencies.

Demand for these assets grew rapidly but ironically the US government moved during this same period to reduce its debt-to-GDP ratio. The result was extremely low interest rates and easy financing that would eventually be dubbed “a conundrum.”

US residential investment peaked in 2005 and this process reversed itself. Net exports fell and the consumption/housing/exports deviation moved towards zero.

Importantly, however, though through this entire process, the net pressure on US GDP was close to zero. The process simply shifted US GDP away from net exports and towards consumption and residential investment.

Both the rhetoric and the data surrounding the first decade of the 21st century suggest that the US “lived beyond its means” by supporting ever increasing consumption and residential investment with decreasing net exports.