Sunday, 28 February 2016

Bernie Sanders, Social Democracy, and Economic Growth - Part I

By now you've probably heard about the controversy caused by economist Gerald Friedman's paper estimating the economic impacts of Bernie Sanders' policy proposals.

Regardless of this month's outcomes in the primaries, the question of the implications for the US economy of Sanders' comprehensive social democratic program remains an essential one. As I'll argue, a set of policy actions and reforms of the sort Sanders is advocating is the best hope for rejuvenating the US economy - as well as for making American society more just. That remains true whether he becomes President or not. (I won't be discussing Sanders' hugely beneficial healthcare proposal below, as I've already written a post on the weak criticisms and objections being made to that.)

The major point of contention - and as we'll see in a moment that's putting things mildly - in the Friedman controversy is the claim that if the full Sanders agenda were to be enacted, the US economy would grow by an average of 5.3% over the next decade (2017-2026). That average, we should note from the outset, incorporates a very high spike in growth in 2017, owing largely to Sanders' heavily front-loaded proposal for $1 trillion in government spending on infrastructure. The average over 2018-2026 is 4.4%.

The storm around Friedman's work began when four former chairs of the President's Council of Economic Advisors denounced the report as unsupported by any credible economic research, lacking in evidence, and filled with irresponsible arithmetic. The report has since elicited cries of "voodoo" from Paul Krugman, been condemned as an abandonment of "analytical standards" by Brad Delong, and described as a "fantasy" by Jordan Weissmann in Slate and a trip to "Neverland" by Kevin Drum in Mother Jones - though Mr. Drum has recently thought better of his initial assessment, and made some good observations which we'll return to below.

Much of the critical response to Friedman's analysis can be dealt with swiftly. As Friedman himself, James K. Galbraith, and William K. Black have all pointed out: Friedman uses entirely mainstream macroeconomic models and assumptions to arrive at his conclusions, while the CEA chairs' letter contains no evidence or argument whatsoever - it resembles nothing so much as an authoritative proclamation issued by the members of a priestly caste.

Krugman, DeLong, and a host of economic journalists do no better, apparently believing that an incredulous stare (or the written equivalent of one) suffices as a response to Friedman's projections.

Krugman's counter-attack does come in for special mention, in virtue of how intentionally misleading it is. He uses the term "voodoo" to draw a comparison between Friedman's work and the standard practice in GOP Congressional budgets of using "magic asterisks" to mark savings from unspecified spending cuts, and increases in tax revenue resulting from cutting taxes on the wealthy (as predicted by supply-side - aka "voodoo", and here the moniker is entirely appropriate - economics). Nothing - absolutely nothing - comparable is to be found in Friedman's work, as the above linked responses make clear.

All of this puts anyone who is really interested in this issue - and the issue, in the most general sense, is the possibility for a bold and wide-ranging set of social democratic policies and reforms to have a major positive impact on the performance of the American economy - in a challenging position. We need to figure out what actual reasons there are for thinking that this could not or would not be the case - the reasons the public critics of this idea are failing to give - and then determine whether or not there are better reasons for thinking that it would.

J.W. Mason, writing in Jacobin, helpfully divides the general issue into three parts: 1) Could any set of policy actions and reforms have such an effect? 2) Could Sanders-style social democratic policies have such an effect? and 3) Would Sanders' specific policies have the specific effect projected by Friedman?

Mason also puts his finger on the overarching reason for answering question 1) in the negative: "The argument against Friedman's piece comes down to the claim that the economy is already close to potential."

I'll refer to Mason's writings on this controversy - as well as to the writings of a number of other economists and economic journalists - in what follows. But no one has yet provided a single, integrated, big-picture view of what is going on in this debate over the US economy's potential. That will be my goal in this post. We'll find that there are many strong reasons for giving an affirmative answer to both of the first two questions.

In a separate post, I'll discuss some general reasons, beyond the ones that can be gleaned from Friedman's work, for thinking that social democratic policy proposals of the type Sanders is advocating are exactly the right sort for fostering stable and robust economic growth. I'll also offer some reflections on the cultural implications of the dynamics of the controversy itself.

I'll leave it to others to get into the nitty-gritty of question 3). As Galbraith acknowledges, the finer aspects of a number of Friedman's assumptions are open to question. Let's hope they get the detailed and intellectually responsible attention they deserve soon.

1. Prospects for US Growth I - Production and Productive Investment in Capital

The question of whether the US economy is currently operating at or close to its potential is an ambiguous one. For many of the participants in this debate, it is a question about whether one way of measuring unemployment - the U3 or "official" unemployment rate, which reflects the number of jobless individuals who have actively sought work in the past 4 weeks - is at or close to the U3 NAIRU, or "Non-Accelerating Inflation Rate of Unemployment" - a theoretical level of the U3 rate below which gains in employment would cause inflation. This is a topic we'll return to.

First, however, we should observe that there are senses of our question about whether the economy is at potential to which the answer is clearly or plausibly "No." 

Let's look, for instance, at the rate of productive capacity utilization across all industries:

At 77% and situated on a downward trend since late 2014, this is low historically (where the average is approximately 81.5%), and low for any context other than the midst of a recession or an upward trend shortly after the end of a recession. (It is also well below the rate at which concerns about inflation begin to emerge, which is > 82%, at least). 9 years out from the technical end of the last recession, and it is still almost 4% below where it stood at the end of 2007 - a neighborhood where it has spent almost all of its time since 2012.

Further plausible reasons for thinking the economy is not operating at potential are that the growth of the value of the Capital Stock has not yet managed to return to its pre-recession trend;

and that US Gross Fixed Capital Formation as a % of GDP, which was slightly above the OECD average in 2006, has not yet closed the gap which opened up after its steeper decline during the recession.

The US currently stands in need of $3.6 trillion of infrastructure investment, according to the American Society of Civil Engineers, which gives the current state of US infrastructure a grade of D+. The low quality of the US public capital stock points toward the possibility of significant gains in total factor productivity, and thus, GDP growth, given a large investment in infrastructure. Recall that just such an investment is a major plank of Sanders' policy plan, and is responsible for the huge front-loaded GDP gains in Friedman's analysis which drive up the 10-year average.

Of course, the most significant trend the US economy has failed to return to is the real GDP trend itself; and as FT's Matthew Klein has pointed out, Friedman's projections would merely have put the economy back on trend as of the middle of 2023:

As we would expect given the terrain we've covered so far, decreases in government spending have a lot to do with this shortfall.

Now, none of this will persuade you that the US economy has room for the kind of growth Friedman countenances if you don't think it currently has the potential - or would have the potential, given any remotely feasible set of policy actions - to revert to historic norms with respect to the levels and trends we've looked at. If that's the case, you almost certainly think that such a return is prevented for reasons having to do with the US labor force - there is no other remotely plausible explanation.

Prospects for US Growth II - Employment and the Labor Force

Perhaps the current US economy's long-term GDP growth trend is simply lower than it had been in the second half of the 20th century. In fact, there is very good evidence that since the end of the last recession, the US GDP long-run growth trend has dropped to 2.25%.

If that is the current situation, there are obviously two questions we need to ask: (1) Why? and (2) Is this permanent?

Friedman's critics, at the very least, do not believe the kind of GDP growth trend he projects is possible any more in developed capitalist economies like the US - so they're answer to (2) is at least a qualified yes. They're answer to (1) is complicated, but at its core are demographic shifts. 

The populations of these economies are growing more slowly (graph via Gavyn Davies);

and they are also aging - or more to the point, less and less of that population growth is accounted for by the working-age population (graph via Wikinomics):

Gavyn Davies also points out that the growth of labor productivity has been slowing:

So: The US and other wealthy countries seem like they're looking at a future of (1) fewer productive people and (2) slower productivity gains.

If you're very impressed by these trends, then you might think that the US economy is operating at potential, or close to it, after all - despite low capacity utilization, the non-recovery of gross fixed capital formation, and growth in the value of the capital stock and GDP below their pre-recession trends - now that the U3 unemployment rate has fallen all the way back to its pre-recession level.

The general idea behind this conclusion would be that the US labor market can no longer sustain capacity utilization levels or GDP growth much above what we're currently seeing, and decreased capital investment is to be expected in this environment.

And if you do think the economy is at potential on account of these limitations of the labor force, then, as Mason stresses, you also think that the U3 unemployment rate is now equal to the NAIRU - the rate of unemployment below which inflation rears its ugly head.

We've spent a good deal of time talking about Friedman's GDP projections; but there's another projected impact of Sanders' agenda which is just as important for this debate: Friedman's estimate that unemployment would drop all the way to 3.8%. For many convinced that less unemployment than we have now would spark inflation, that's a bad thing. Of course, Friedman's critics doubt that it is possible, just as they doubt his GDP projections. But they haven't given any detailed reasons - just more incredulous stares.

So now we've accumulated three questions: 1) Is a big drop in unemployment currently possible? 2) Would that be a good thing? and 3) Even if the answers to the first two questions are both positive, is the declining growth of labor productivity enough of a reason to be less sanguine about growth potential?

3. Unemployment: How Low Can (and Should) We Go?

The first and most important thing to know about the NAIRU is: no one knows what it is.

As we've seen, the case that's been made for the US economy being at or close to its potential, despite some of the data we've looked at above, has mainly to do with structural demographic shifts.

But there are several reasons for thinking, as Friedman himself has pointed out, that these demographic shifts are not all that important, and should not be taken as reasons for believing the economy is anywhere near its potential. 

First and foremost is the point, which Ron Baiman has made, that even taking demographic shifts into account, the US Employment-Population Ratio is still much lower than it was pre-recession, and is taking an incredibly long time to come back up:

That's a shortfall of millions of jobs. The fact is that far fewer Americans are working than would be expected this long after the end of the recession.

Looking just at prime working-age Americans, labor force participation continued falling after the technical end of the recession, and has now been stuck at a relatively low level for two-and-a-half years:

Especially alarming is the fact, pointed out by Michael Gavin at Barclays Capital, that the labor participation of prime working-age women is now starting to decline, after growing through the 70s, 80s, and 90s (participation of prime-age men has been dropping for decades):

The San Francisco Fed has described the decline in prime-age participation as being caused in part by "an increase in people deciding they'd rather have single-income families...For whatever reason, they've traded a second paycheck for spending more time at home, whether it's for child-care, leisure, or simply that it's a better lifestyle fit."

Apparently, there are a few important facts that have escaped their notice.

Like the fact that in many states, childcare is more expensive than rent.

Or more expensive than college tuition.

Of course, that Sanders' policy proposals include plans for more affordable childcareguaranteed paid maternity leave, and addressing the gender pay gap has a lot to do with that low projected unemployment number.

Matthew Klein points out two more reasons to doubt the prevailing pessimism about future growth potential. One is that there is no relationship between the size of the prime working-age population and the number of employed Americans:

The second (which actually originates with none other than Brad DeLong) is that demographic shifts are predictable, and so can fairly reliably be taken into account in forecasting; and yet, the gap between the GDP predictions most economists were making in 2007 and the ones they are making now is "massive and growing".

Yet another reason is the fact that far more senior citizens than ever before are remaining in the labor force - probably, as Yves Smith has suggested, because they've seen their retirement savings evaporate in the financial crisis.

So there are plenty of good reasons for thinking both that the US economy has sufficient potential capacity remaining to employ many more workers, and that there are a great many people available to be put to work. There is a strong case to be made for an affirmative answer to our first question about unemployment. And given that potential capacity, if those many more potential workers were actually put to work, we would expect to see big gains in output.

Everyone should be able to agree that continuing to lower unemployment would be a good thing if it could be done in the absence of inflation. We should also be able to agree that at some level greater than 0% the unemployment rate would be low enough that adding more workers will start to drive prices up.

So let's break our second employment-related question into two parts: a) How near are inflationary pressures? and b) How bad would it really be if unemployment did dip low enough to start spurring inflation?

The first part of our question is just another way of asking whether the Fed's current estimate of the NAIRU, which puts it at the current unemployment rate, is a reasonable one.

Now, it might seem like enough has already been said to cast a great deal of doubt on the reasonableness of that estimate. After all, we've reviewed a lot of evidence for the conclusion that the US economy is not operating close to potential, that there is plenty of room for growth over the next several years. And we started by observing that many of the critics of Sanders' proposals and Friedman's analysis had an understanding of what it means for the economy to operate close to potential which is based in large part on whether the unemployment rate is at the NAIRU.

But we are dealing with two different understandings of "economic potential" here. As J.W. Mason explains in an excellent essay, for unemployment to drop to the level at which it begins to cause inflation is not for it to have dropped to the level at which productivity gains and increases in the wage share cease, and inflation is the only effect of further decreases in unemployment.

The latter level, where there are no further productivity gains to be had from hiring, and real wages cannot further increase with the bidding up of nominal wages, is one way - to my mind, a more defensible way - to denote full employment and to characterize an economy which is operating at its potential, as compared with understanding these concepts in terms of the NAIRU.

That is not to say that full employment/operating at potential in this sense should be the goal - inflation may (almost certainly would) still be much too high for the economy to be stable in this scenario.

But this distinction explains why we still have to ask, at this point in the analysis, both whether it is reasonable to believe that we are at the NAIRU, and whether it would be so bad to go a bit below it.

One source of inflationary pressure is the fact that for businesses, wages are a cost. This is why, when unemployment is low enough, the bargaining position of workers is strong enough to push wages to the point where further increases are passed along in the form of higher prices.

But there are many reasons for thinking there's plenty of room for business to absorb higher wages, most significantly the immense gap between productivity growth and wage growth, and the fact that corporate profits have rebounded since the end of the recession while wages have not.

Another source of inflationary pressure would be a shortage of goods, in the event that unemployment fell far enough for wages to rise high enough to bring demand above the potential capacity to satisfy it.

But based on our examination of the productive potential of the economy, there's plenty of room on this front for wages (and thus demand) to rise.

So based on the evidence we've already reviewed, there are good reasons for thinking the Fed's current NAIRU estimate is too high - a statement many economists would agree with.

And in answer to the second part of our question, we can observe, as Dean Baker recently has, that according to the estimates of the President's Council of Economic Advisers (yes, that Council of Economic Advisers), if the official unemployment rate were to drop from its current 4.9% to 3.9% - assuming that 4.9% equals the NAIRU - and stay there for an entire year, the effect on inflation would be an increase of 0.1 percentage point - from its current 1.6% to 1.7% - by the end of that year.

In other words, even if the Fed's NAIRU estimate is right, Friedman's projections imply a slow and modest increase in inflation - and not an indefinite one either, since the positive effects of Sanders' proposed policies on both investment and demand would likely lower the NAIRU over time.

Two other points are worth mentioning.

The first is that if Sanders' entire policy program were to be enacted, and we found that unemployment began dropping too far too fast and inflation did begin to become a problem, never in modern history has the Fed been in such a strong position to beat it back through monetary policy.

The second is that the Fed's obsession with inflation to the exclusion of full employment, and its low (by historical standards) inflation target of 2%, are the result of the lessons purportedly learned during the 1970s, and these were all the wrong lessons.

4. Labor Productivity Growth, Very Briefly

When we looked at reasons for doubting the US economy's potential for large gains in GDP, we left one issue unresolved: the decline in labor productivity growth. 

There are two main reasons to think Sanders' policy program would boost labor productivity.

In the long term, his plan to make public colleges and universities tuition free and, especially, to institute single-payer healthcare are enormous investments in the development of human capital. Healthier, smarter workers are more productive.

But Friedman also projects a huge boost in labor productivity in the short-term. The force behind this, which Kevin Drum explores in his re-evaluation of Friedman's work, is GDP growth itself. 

Friedman justifies his productivity projections by way of a relationship between output growth and labor productivity growth known as "Verdoorn's Law".

Remember that in Friedman's analysis, big gains in GDP growth are jump-started by a very large front-loaded government investment in infrastructure, as well as a host of other stimulative spending measures. As we've seen, there is plenty of room for the labor market to absorb many more workers in response to this government-created demand. And there is plenty of room for real wages to rise along with employment. That rise becomes a new source of increased demand, which is sustainable given how far below productive capacity the economy is currently operating. That increased demand prompts businesses to invest in replacing aging capital stock, and take advantage of more recent technological developments (whose potential impact on productivity can only be realized if they are installed in the first place), as well as in R&D for new technologies. That new private investment in capital boosts labor productivity - it gives workers the tools to work more productively - and that productivity increase leads to a further increase in output. This is Verdoorn's Law in action: growth leads to greater productivity, which leads to more growth. 

Friedman derives all of the labor productivity growth he projects from projected GDP growth in this way. And as Drum points out, these big productivity gains are not as anomalous, from a historical perspective, as they might at first seem.

Where Drum has failed to do his homework is in his assessment of Verdoorn's law itself, which is well supported empirically in the recent history of the US economy.

Drum also makes an important observation - though unintentionally so - when he criticizes the relationship posited by Verdoorn's law as seeming "a bit circular". Indeed it is, but not viciously so. Verdorrn's law is in fact an example of circular cumulative causation in macroeconomics - an entirely consistent concept developed by the Swedish evolutionary-institutional economist (and Nobel Prize recipient) Gunnar Myrdal.

Drum's comment reveals the dominance in America of one side of an important divide in economics itself, between the general equilibrium approach to understanding the macroeconomy - which major liberal economists like Krugman, DeLong, and Stiglitz share with more conservative economists - and non-equilibrium approaches. This divide will turn out to be significant for the further discussion of Sanders' proposals, and of what the debate over them reveals about American intellectual culture, in Part II of this post.

1 comment:

  1. Great analysis. Economics since the 1980s never made any sense from a business or accounting point of view. (Accounting should be to economics as free body diagrams are to physics.) There is talk of growth as some abstract, not as a combination of increasing wages, revenues, taxes and profits. Equilibrium economics, as Joan Robinson pointed out, bizarrely ignores the passage of time. It is also bizarrely stateless as if people, knowledge, money, materiel, capital can have no effect on dynamics. I often get the impression that quantum physics is much more concrete than economics as it is practiced.

    P.S. Arguing that Verdoorn-Kaldor’s Law is circular is like arguing that compound interest is circular. Surely mainstream economists haven't sunk that far.