Arnold Kling  

Wealth and the Output Gap

Another Frustrating Education ... W. Allen Wallis: An Appreciati...

Tyler Cowen writes,

There is still not enough talk of wealth effects in current macro debates, as they are invoked only selectively.

Scott Sumner writes,

I'm missing something blindingly obvious, as Jim Bullard, David Andolfatto and Tyler Cowen (who also links to this argument) are very bright people. It's just that I don't see the argument. And the argument is stated in such a way that it seems like one of those "needs no explanation" points. As if the fall in wealth would obviously reduce consumption (I agree) and obviously that fall in consumption would reduce output. But why?

I am not sure I am comfortable with just tossing around a term "wealth effect."

Suppose that a foreign government confiscates some of our citizens' assets. Then domestic potential output is not affected. There may be less domestic consumption. But the that would make the output gap larger, not smaller.

Take a completely different example. Suppose that some of our capital becomes suddenly and unexpectedly unproductive. (I think this is closer to what Tyler has in mind.) Then we have lower potential output along with lower wealth. The effect on the output gap is ambiguous, but I could imagine consumers not adjusting so much right away, which would make the output gap smaller at first. Moreover, if macroeconomists fail to account for the reduced capital productivity on potential GDP, they will over-estimate potential GDP.

Of course, the PSST perspective finesses all this. The concept of potential GDP does not carry any weight. When we see unemployment, we do not see a shortfall in aggregate demand. Instead, we see an economy where some unsustainable patterns of specialization and trade have been shut down and entrepreneurs have yet to discover more sustainable patterns.

In the AS-AD paradigm, the unemployment of the Great Depression seems entirely unnecessary. The slump was a mistake, caused by bad luck and, above all, by incompetent macroeconomic management.

From a PSST perspective, one has to ask how full employment could have been maintained. Should the patterns of specialization and trade that were in place in 1929 been kept in place for ten or twenty years longer? This could not have been reconciled with the innovation in production methods that took place. On the other hand, could the patterns of specialization and trade in 1950 have been adopted sooner? That would have required incredible foresight and coordination on the part of entrepreneurs.

Or look at today's economy. If we were at so-called potential GDP, what would we be producing? As many mortgage originations and securities as in 2007? More manufactured goods, by returning to 2007 levels of employment and multiplying by 2012 levels of productivity? The set of goods and services that we will be producing in 2016?

Once you ask the question of what we should be producing, you realize that nobody knows the answer. The next logical step is to discard the concept of potential GDP.

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CATEGORIES: Macroeconomics

COMMENTS (5 to date)
andy writes:

What is output gap? It's the output, the people/firms counted into GDP could produce, if... if what?

Glen S. McGhee writes:

I appreciate the link to the PSST paper -- which looks like an argument for sustained unemployment.

All the reasons for which Adam Smith praises the Wealth of Nations at the dawn of the industrial revolution amount to an argument for the superfluousness of workers.

Becky Hargrove writes:

Irrational as they were, the wealth that those mortgage-backed securities tried to represent was a vital piece of this 'missing' production puzzle. After all no one was holding a gun to the heads of those who bought such financial instruments, and the fact that they didn't work out continues to impact lives. In other words, if we were at 'potential' GDP, we would be able to (affordably) produce the knowledge-based services that people were trying to purchase for their futures, through the equity of millions of homes. It is not easy to create real monetary links from physical production to services based production for they operate in different economic universes, but we have to keep trying. To be sure, optimal wealth is somewhat confusing, but if we do not shine a laser beam on the mystery of the capital we need for our futures, how will any definition of GDP, or other measurement of economic activity, ever hold water?

Charlie writes:


Isn't the end of WWII a big counter example to PSST? The patterns of trade that ended in 1945 were completely different than those that endured after. There wasn't much private consumption growth during the war. No one could be sure how consumer preferences would be changed, what products would be demanded. You had women in the labor force, are they leaving are they staying, which is more productive home production or using those skills in the labor force? You have men coming back from fighting a war, how can they best be employed? According to PSST, this should have been a very bad time. It should have been hard for entrepreneurs to figure out how to use resources productively.

It seems like PSST is a just so story. If the economy is doing poorly it must be that entrepreneurs have a hard time figuring out how to use resources. But if you start with times where it seems like figuring out how to use resources should be hard, it doesn't seem to correlate well with economic downturns.

Steve Sailer writes:

Back during the Housing Bubble, my barber used to take cash out of his home equity for a half dozen trips to Las Vegas per year. Then his home equity shrank, so he stopped going to Vegas. Thus, using him as an example of what a lot of people stopped doing in 2008, the $5 billion Echelon hotel project was mothballed in 2008 and remains a rusting hulk on the Strip in 2012.

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