Teaching the Macro History of 2005-2012: "Long Run" and "Short Run"
While procrastinating this morning--delaying sending in the data points for Figures 2.1, 4.1, 4.2, and 4.3 to my editor Mike Treadway (yes, it's done now)--I ran across Evan Soltas commenting on Matthew Yglesias commenting on me.
Evan Soltas writes:
The Recession and Its Causes: In a post today, Matt Yglesias borrows Brad deLong's graph to show that[:]
the back-and-forth swing of business investment has been the main motor of the recession...But the chart also shows us that contrary to a lot of myth-making, the recession is not identical to the downturn in housing.
Nevertheless, Yglesias says, the lack of recovery in housing has kept the level of real output below what would be consistent with full employment.
This is a very important point… economists, journalists, and other observers assign excessive blame to the housing bubble as the cause of the recession. The "housing story" seems, at face value, to work. But the support in the data is weaker than the proponents of the housing story admit….
Private residential fixed investment peaked in 2006, whereas the rate of growth in real output did not begin to decline sharply until 2008…. Why did macroeconomic conditions seem able to withstand significant contraction in residential investment for two years, and then suddenly it could not?… Structural problems "lurking" under the surface make for a good movie or novel -- but no so much for cogent economic reasoning….
The direct contribution of residential construction to the rate of real output growth never exceeded +/- 1 percent from 2000 to 2012….
To make housing their sufficient cause of the recession, they often end up incorporating in other causes through the back door… transmission mechanisms -- the financial system, wealth effects, expectations for nominal income growth, unemployment, etc. -- and though they are not incorrect in doing so, they fail to appreciate that they've diluted their own argument…
We all agree that the economy was hit by a big adverse shock starting in late 2005: the recognition that housing had been overbuilt, that buyers were not going to see the price increases they had been expecting, that there was a great deal more risk involved in holding securitized mortgages than buyers had realized, and that in the future financing for nonconforming mortgages would not be available on easy if indeed it was available on any terms. And as that shock hit housing construction began to fall--back to normal levels within nine months, and to seriously sub-normal levels by mid-2007 as the economy attempted to work off the overhang created by overbuilding.
Normally, when we teach macro, we analyze the effects of a contractionary shock to a sector or a spending category in three steps:
- The impact.
- The short-run consequences, as price stickiness means that inflation continues on its previous trend and as other nominal spending flows do not adjust, in which employment, incomes, and production fall below full-employment levels.
- The long-run consequences, as prices exhibit flexibility, inflation falls, other spending flows adjust, and in which employment, incomes, and production return to their full-employment levels--but with a different distribution of spending and economic activity across sectors and spending categories.
But over 2005-2012, this sequence appears reversed.
First came the impact.
But then in the short-run of late-2005 to mid-2008 we saw employment, incomes, and production in the economy as a whole remain at their full-employment levels--but with a different distribution of spending and economic activity across sectors, as spending on residential construction fell and spending on exports rose. Foreigners who would before 2006 have taken their dollar earnings and spent them buying mortgage-backed securities that funded construction took a look at the market, and switched their spending to buying American exports. And as of mid-2007 the judgment in the circles I moved--and my judgment--was that we had in all likelihood dodged the deflation-of-the-housing-bubble bullet, that the economy was either going to suffer a weak recession or no recession, as exports were smoothly standing up as residential construction sat down.
The long-run smooth adjustment came first.
Then, in the second half of 2007, things began to change and the balance of probabilities began to shift. Financiers began trying to deleverage and move their assets into safer portfolios--and, in collectively doing so, did nothing but make all of their portfolios more unsafe. Rising credit spreads made risky borrowers think twice about leveraging up, and business equipment investment began to fall alongside the continuing decking in residential construction. By mid-2008 it was clear that we were in for a financial crisis and downturn of uncertain magnitude, and that it was time to start pushing the Big Red Policy Buttons.
And so at last, long delayed, in the third and fourth quarters of 2008 and the first quarter of 2009, the short run came.
And employment, incomes, and production fell off a cliff.
Moreover, the short run has stuck around for four years now--and looks likely to stick around for at least six.
With the passing of the credit crunch and the maintenance of short-term safe interest rates at their zero lower bound, exports and business equipment investment have now recovered in sum to their late-2007 shares of potential GDP. But their is no sign that the post-2009 fall in government purchases has crowded-in any other form of spending--as, indeed, we would not expect there to be, for the crowding-in from falling government purchases works through the reduction in interest rates it induces, and nominal interest rates at least cannot fall further. And housing construction shows no signs of returning to anything like normal even though when you do the math you have to conclude that the expected rental-equivalent cost of buying a house financed by a conforming mortgage is negative, and that by continuing to live in their sisters' basements the unhoused of America are throwing away expected income as well as annoying their siblings.
So how do we teach this? What I have taught before--the triad of (1) impact, (2) short-run effects that last for one, two, or maybe at a stretch three years, and (3) long-run effects on the sectoral distribution of economic activity thereafter--that simply will not cut it anymore.
If it ever did.
