Why the US Government Can't See Economic Bubbles

In yesterday's NY Times, Jared Bernstein (former chief economist to Vice President Joe Biden) wrote a perspective-from-experts piece (here) titled "Undoing the Structural Damage to Potential Growth". Dr. Bernstein presumably gets the attention of policy makers in Washington and in this piece he aligns himself with the Congressional Budget Office (CBO)  for support. What is striking about the piece is that, without saying as much, he completely rejects the ideas that there was a Subprime-Mortgage Bubble which became visible in 2008 and argues that government policy could get us back to the peak level of GDP that was generated by the bubble. Let me try to summarize his argument.

The CBO (in the graphic above) has made two forecasts for "potential output," that is output the economy could maintain under full employment. The first forecast (bold dashed line) was from January 2007, right before the Subprime Mortgage bubble burst. It showed accelerating GDP growth into the foreseeable future. In February 2014, the CBO modified their forecast to show a lower rate of potential GDP  growth, 7.3% below the old forecast line which Bernstein translates into 10 million jobs lost. The Federal Reserve has argued that this labor market damage cannot be undone. Bernstein argues that it could if we ran a "high-pressure" economy fueled by government spending.

The theory underlying all this is an analogy derived from the physical sciences. When a physical system undergoes a permanent change (say the parts start wearing out because the system has been in production for a long time) the effect is referred to as hysteresis. Bernstein describes how the analogy works for economies:

When a cyclical problem morphs into a structural one, economists invoke the concept of hysteresis.  When this phenomenon takes hold...the economy undergoes a downshift that lasts through the downturn and well into the expansion, reducing the economy’s speed limit. 

The bottom line of his argument is that hysteresis can be reversed by "high-pressure" economic policy. He claims that results by "a number of top economists" are about to be published confirming the relationship between fiscal policy, hysteresis and reverse-hysterists.

To me, none of this argument is very clear: (1) If hysteresis is a permanent change how can it be reversed by spending more money rather than replacing the system's parts, the parts that are wearing out? (2) What is it about the Subprime Mortgage crisis that you would call cyclical? This is the worst recession since the Great Crash of 1929. That's a pretty long cycle. (3) What precisely is the mechanism that changes a cyclical problem to a structural problem (but it wasn't a cyclical problem)? What exactly is a structural problem, the parts wearing out? (4) Is the economy "downshifting" because the transmission is wearing out and gears are slipping or because the economy exceeded some speed limit (bubble)? OK, I'm really confused, but maybe this makes sense to Washington policy makers.

What's really going on here underneath all the analogies and mixed metaphors? Let's go back to the original CBO "potential output" forecasts. They use some basically simple equations to make these projections. If employment is a function of output then L = e(GDP), that is, employment is proportional (e) to GDP. If we reverse the equation and we assume some number for full employment, (L*)/e = GDP*, where L* is the assumed full-employment labor force and GDP* is full-employment output. This exercise is really just equivalent to picking some historical date and then drawing lines on graph paper--anyone can do it, not just the CBO.

In the graphic above I've plotted real GDP (GDPC96) over time (the solid black line). The dashed lines are the dynamic attractor paths for US GDP. I've written in more detail about how this plot and the attractor paths above were generated (here and here). The attractor path was basically generated by a state-space model of the US economy. It clearly shows the Subprime Mortgage Bubble and shows that we are currently pretty much on the attractor path in 2014. For understanding what the CBO is doing, you do not really need a model or even a simple equation.

You can pick any historical date and start drawing some lines. If you think 2003 was a reasonable place for the US economy to be, just connect it to another low point such as 2000 and you have a forecast out to 2009. If you think 2008 was a reasonable place for the US economy to be, as does the CBO and Jared Bernstein, then draw line B going off into infinity. If you changed your mind after the Subprime Mortgage Crisis, as the CBO did, draw line C and hope it returns to line B at some point in the future. Or, if you think 2012 was a reasonable GDP level for the US economy, draw line D which corresponds pretty well with the attractor path generated by the USL20 model.

Does anyone else beside the CBO and Jared Bernstein think that 2008 was a reasonable level for GDP? If you do, you do not believe in economic bubbles. You cannot take action to pop bubbles because bubbles do not exist. If you accept the Federal Reserve's argument that the Labor Market damage from the Subprime Mortgage Crisis cannot be undone and your common sense tells you that there was a Subprime Mortgage Bubble, the time to act was sometime between 2004 and 2006. The problem is that among those who accept the common sense idea of economic bubbles, no one can agree on how to identify a bubble (Line A or the USL20 attractor path) so policy makers cannot act. And, those who do not believe in bubbles are left with lines B, C and a comforting theory of potential output--or the harsh reality of line D.