Low Potential?

One of the raging debates among economists and investors these days concerns the size of output gaps in the major developed economies. If output gaps are smaller than widely believed, central banks will need to tighten monetary policy earlier than expected, which could trigger a selloff in equity and bond markets.

The IMF estimates that the output gap will reach 2.2% of potential GDP in advanced economies in 2014, down from a high of 4.9% in 2009.

What is often overlooked is that output gaps would be much larger today had it not been for a significant decline in potential GDP growth. Chart 1 shows the growth of real potential GDP in a variety of countries and regions since 2008. Each panel contains two series: one drawn from the IMF’s April 2008 World Economic Outlook database; the other from the most recent projections released in April 2014. (The IMF did not make output gap projections back in 2008, so I assumed that whatever output gap the IMF estimated for 2008 would eventually converge to zero in 2014; this allowed me to back out projected potential GDP growth).

Low Potential? - Chart 1

The numbers are striking. For advanced economies as a whole, the IMF estimates that real potential GDP will be 7% lower in 2014 than what it projected in 2008. For some countries, the drop in potential GDP growth is immense: for example, the IMF estimates that real potential GDP in Spain will be 21% lower in 2014 than what it had projected in 2008. In the case of the U.K., potential GDP is likely to be 10% lower.

Are these estimates correct? To be sure, potential growth must have slowed over the past six years relative to what the IMF had expected before the crisis. The Great Recession led to a steep drop in capital spending, which sapped productivity. It also undoubtedly caused many people to flee the labor market, some of whom are unlikely to return.

Yet, the sheer magnitude of the downward revisions to potential GDP strikes me as excessive. The weakness in capital spending has likely pushed up the rate of return on capital (this is one reason why profit margins are so high), which should give a nice cyclical boost to capital spending going forward. In addition, a large share of youth who dropped out of the labor market will eventually return (quite a few decided to stay in college, which is not necessarily a bad thing). And perhaps most importantly, many workers who remained in the labor force have ended up in substandard jobs that do not fully utilize their skillsets. Stronger labor demand over the next few years should allow them to transition to jobs where they are more productive, helping to boost potential GDP.

Back in the 1930s, many commentators argued that the economy had suffered a permanent loss of capacity. Yet, as Chart 2 shows, real per capita GDP eventually returned to its pre-Great Depression trend by the 1950s. If this happens again, it would imply that today’s estimates of potential GDP are too low, which is another way of saying that the output gap may be bigger than widely estimated. In that case, tightening too early because of a fear of diminished spare capacity would be a huge mistake (just as it was in 1937).

Low Potential? - Chart 2

I suspect that Janet Yellen is quite sympathetic to this line of thinking, and as such, she will want to see a meaningful burst of inflation before she starts to hike rates. But if the output gap is bigger than commonly believed, as I think is the case, that burst of inflation may not occur for several more years at least. This calls into question the widely-shared view that the Fed will start raising rates next year.

The Two Pikettys

Thanks to Peter Berezin, Chief Strategist of The Bank Credit Analyst, for taking the time to provide us with a few timely comments on Thomas Piketty’s controversial new book, Capital in the Twenty-First Century. 

Thomas Piketty ReviewBy my count, there are already over a dozen reviews of Thomas Piketty’s book from a variety of big thinkers, so I won’t endeavor to write yet another one (Here’s Paul Krugman’s review, and from the right, here’s one from Clive Crook; also, do check out this hilarious piece from Carlos Lozada at the Washington Post).

Rather, let me make an analytical point that I think has been largely lost in the discussion. At the core of Piketty’s book is the idea that the difference between the rate of return on capital, r, and the economy’s growth rate, g, has a significant bearing on the economic and political landscape. Specifically, Piketty argues that a decline in g will cause wealth to increase more quickly than income (Y).

It is not hard to see why this might be the case. Imagine a situation where g is zero. In such a case, as long as there is more than enough savings to cover the depreciation of the capital stock, the capital-income ratio (K/Y) will rise. Piketty convincingly shows that capital income is less evenly distributed than labor income. Since there are reasons to think that g will fall in the future (lower labor force growth, fewer productivity gains, etc.), the implication is that inequality will continue to increase.

However, notice what Piketty is not arguing. He is not saying that r is going to fall in the future. In fact, if the capital-income ratio increases, then the law of diminishing returns implies that r will decline. All he is saying is that the decrease in r will not be enough to prevent the capital share of income from rising over time. But if you are a wealthy capital owner, what do you really care about: the return on your own wealth, or the ratio of wealth-to-GDP? Now, Piketty would argue that even if the wealthy care more about the rate of return that they themselves receive, this may not matter. As long as the share of overall income accruing to capital rises, political institutions will evolve in a way that protects the wealthy at the expense of the working class.

Maybe, but I have my doubts. Here’s a concrete example. Higher immigration would cause g to increase; by Piketty’s logic, this would dilute the influence that the wealthy have over decision-making. I suppose this explains why the U.S. Chamber of Commerce and the Wall Street Journal are so adamantly against easing immigration restrictions. Oh, wait, they’re not…

Next, consider the saving rate. Standard economic models, such as the one developed by Robert Solow in the 1950s that forms the bedrock of Piketty’s analysis, predict that an increase in the saving rate will drive up the capital-income ratio, reduce the rate of return on capital, and increase average real wages along with per capita output. However, as economists have long known, if an increase in the capital stock leads to a proportionately smaller change in the rate of return on capital (i.e., in technical language, if the elasticity of substitution between capital and labor is greater than one), then capital’s share of income will increase. But is that really such a bad thing? As Solow himself points out in an otherwise glowing review of Piketty’s book, “you eat your wage, not your share of national income”.

Admittedly, in the current environment of deficient aggregate demand, more savings would indeed be undesirable. But, this isn’t Piketty’s argument. After all, his book is all about structural, rather than cyclical, trends.  It’s also possible that an economy can save too much. However, in the simplest formulation of Solow’s model, …. where the production function is assumed to be Cobb-Douglas with constant returns to scale, the saving rate that maximizes the steady-state level of consumption – the so-called “Golden Rule” – is equal to the capital share of income. The gross saving rate for the U.S. is only half that level, suggesting that once the economy returns to full potential, a higher saving rate would be welcome. The point is that one can easily justify a higher saving rate if it leads to faster growth in average real wages, even if the income distribution worsens in the process.

This brings me to the title of this post: there are “two Pikettys” in full display in this wonderful, but ultimately, flawed book. On the one hand, there is Piketty the economist, who has done an exemplary job of gathering and analyzing the historic data on the distribution of wealth and income from days gone by, as well as creating an intellectual framework for thinking about how this distribution varies over time. On the other hand, there is Piketty the policy entrepreneur, who often seems to place greater importance on redistributing income away from the wealthy, rather than stressing the goal of creating an economic environment that would allow real incomes for everyone to grow more quickly. I like the first Piketty a lot more than the second one.