The rising prices of stocks, bonds and, more recently, of homes, have engendered a large increase in the market value of claims which, when converted to cash, are a source of purchasing power. Financial intermediaries, of course, routinely convert capital gains in stocks, bonds, and homes into cash for businesses and households to facilitate purchase transactions.6 The conversions have been markedly facilitated by the financial innovation that has greatly reduced the cost of such transactions.
Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.
The last sentence is wonderful Greenspan-speak for "watch out for bubbles."
The traditional idea is that neoclassical constructs—production functions, consumption demand functions, labor supply functions, embedded in markets that clear—describe the actual operations of the economy in the longer run. There is a *-economy that generates
variables such as y*, called potential GDP, u*, called the natural unemployment rate, r*, called the natural real interest rate, and so on.
Hall then proceeds to knock down each of these concepts. Because so much of the short-term and medium-term movements in GDP are due to productivity changes, he says,
Potential GDP is not a useful guide to making monetary policy.
I think that if Hall were to read my essay on Labor Force Capacity Utilization, he would dismiss that concept, also. But for different reasons, having to do with his pet labor matching model.
If he's right, then the 1970's macro that I have to teach for the AP econ test (I feel like I should come to class in mutton-chop sideburns, with bell-bottoms, and a paisley shirt) is just all the more out of date. Maybe the Jackson Hole conference will come to be known as the The Last Roundup for Macro.