Why has output expanded slowly in this cycle? A market monetarist perspective

To many, this fact remains a puzzle, especially because the unemployment rate has returned to pre-crisis levels.

Maybe by looking at another “deep recession moment” we may “solve” the puzzle. The 1981-82 recession and ensuing recovery comes to mind as a possible control.

The first chart compares the two downturns. The 1981-82 downturn was much more acute. That contrasts with the 2007-09 downturn, which was initially quite tame.

Why the “delayed” reaction?

A possible answer looks to what was happening to monetary policy (NGDP growth).

Initially, in both instances, NGDP didn´t change much. However, keep in mind that just prior to the recessions; NGDP was growing at a rate of 14% in 1981 and only 4.4% in 2007. Therefore, the NGDP “brake” in 1981 was pressed much harder than in 2007. The 2007-09 recession only became deep when the Fed forcefully pressed on the NGDP brake after mid-2008. By that time in 1981-82, the Fed had already begun to “step on the gas”.

Let´s look at the corresponding expansions, not forgetting that the 2007-09 contraction was deeper, in which case conventional wisdom says the recovery should be steeper.

The chart shows the opposite happened, with the recovery more rapid following the 1981-02 recession.

Why the difference?

Again, look at monetary policy (NGDP growth)

A perfect correspondence. The conventional wisdom about “plucking” is broken because monetary policy was much less expansionary during the 2009-14 recovery, despite the deeper contraction.

The behavior of unemployment, in particular the fact that in the present cycle unemployment has gone back to what it was before the crisis notwithstanding the weak recovery, also has a monetary explanation.

Sticky wages result in an increase in the Wage/NGDP ratio when NGDP growth falls during recessions. With NGDP growth turning strongly negative after mid-2008, unemployment shoots up. During the recovery, unemployment falls in tandem with the drop in the W/NGDP ratio.

It could be argued that in the present expansion, unemployment falls by more than would be justified by the drop in the W/NGDP ratio. This is where the big drop in labor force participation since late 2008 comes into play, helping push unemployment lower.

In our view, therefore, monetary policy explains both the deep contraction and the weak recovery in this cycle.

Contrary to this view, “The disappointing Recover of Output after 2009”, finds that the growth shortfall is entirely due to structural (supply side) factors:

U.S. output has been expanding only slowly since the recession trough in 2009 even though unemployment has declined as fast as previous recoveries.

We use a quantitative growth-accounting decomposition to explore explanations for the output shortfall, giving full treatment to cyclical effects that, given the depth of the recession, should have implied unusually fast growth.

We find that the growth shortfall has almost entirely reflected two factors: TFP has grown slowly and labor force participation fell. Both factors reflect powerful adverse forces largely—if not entirely—unrelated to the financial crisis and the U.S. recession.

On the other hand, consistent with this view, “Aggregate Supply in the United States: Recent Developments and Implications for the Conduct of Monetary Policyconcludes:

While the available indicators are still inconclusive, some indicators suggest that hysteresis (i.e. history dependence) should be a more present concern now than it has been during previous periods of economic recovery in the United States.

We go on to argue that a significant portion of the recent damage to the supply side of the economy plausibly was endogenous to the weakness in aggregate demand—contrary to the conventional view that policymakers must simply accommodate themselves to aggregate supply conditions. Endogeneity of supply with respect to demand provides a strong motivation for a vigorous policy response to a weakening in aggregate demand, and we present optimal-control simulations showing how monetary policy might respond to such endogeneity in the absence of other considerations.

In other words, bad monetary policy has “broken” the system. Monetary policy still has a role in fixing it, especially because it will facilitate structural or supply side adjustments. The Fed, however, doesn´t seem interested in making this possible.


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