What's wrong with the US economy? A theory, in one blog post

Contrary to popular belief among my fellow liberal economists, the US economy is far from great. The graph below compares Real US GDP relative to its long-run trend. It shows that US RGDP in 2016 was some 25% below its long-run trend. While one might be able to quibble a bit with the trend, it's clear that US economic growth has slowed considerably since 2000, with the bulk of this coming since 2008.


How about US manufacturing? A friend who recently published a paper on manufacturing in a top 20 journal complained how hard it was to publish, despite being one of his better papers. For some reason, the topic seems to bring out the crazy in a lot of economists. Why? I'm not sure, but we economists like to think we know something about manufacturing, and now in the Age of Trump, many economists have a completely understandable desire to try to show that everything Trump says is wrong. Like shooting hair-spray at a flame, this has the effect of making the usual Dunning-Kruger effect even worse than normal when the topic turns to the decline of US manufacturing. The general feeling among many economists is that the decline in manufacturing employment is all about robots, productivity, and sectoral shift toward services. People who think trade are part of the story must be ignorant of economics. I was once taken in by this view as well. However, as I laid out in my own research (Susan Houseman does here and here), the data is not supportive of this assertion as an explanation for the relative decline in manufacturing output and exports, or the decline in the level of manufacturing employment. Productivity growth in manufacturing since the mid-1990s has been, if anything, lackluster. Part of the confusion is that there was a long-term trend decline in manufacturing as a share of the population (even while the level was flat) which is due to productivity growth and sectoral shift. Yet, after the Asian Financial Crisis in 1997, the US dollar appreciated substantially, while Asian countries began hoarding dollar reserves. Add in the rise of China and China's WTO accession, and the Bush tax cuts and 9/11 spending, and you have the perfect confluence of factors to cause a "Surprisingly Swift" collapse in the level of manufacturing employment.

The graph below, of real manufacturing output, does not support the thesis that the problem with US manufacturing employment is simply fast productivity growth. Why would fast productivity growth and the introduction of robots cause a large trade deficit and a decline in real output relative to trend? Inquiring minds would like to know.

However, while the collapse in manufacturing output and employment may have been a chief cause of the initial slowdown in overall GDP growth, GDP was only about 5% below trend in the 2000s. What has made things worse has been the reaction of policy to the shock of the rise of China and the dollar appreciation. First, low interest rates spurred by savings out of Asia and the carnage to manufacturing in the US led to a housing bubble. Then, poor bank regulation of the shadow banking sector meant that the collapse of the housing bubble meant a financial crisis. And then the liquidity trap, and difficulty that central banks apparently have managing the economy at the ZLB meant that this temporary shock had a long-term impact. An impact that ultimately results in the Tea Party congress of 2010 to 2020, and the election of Trump. (Here's a slightly longer version of this old bedtime story.)

In the early days of the zero lower bound, it was believed by many that monetary policy couldn't be effective. I also believed that rates couldn't go negative. Others simply believed that monetary policy was much less effective. However, since then we've learned that ST rates can go negative. Perhaps as low as -1.5%. We've also learned that monetary policy announcements still affect stock, bond, and exchange rate markets in ways consistent with monetary policy being effective. An example of this was when the Fed hiked the discount rate in April 2010, causing the dollar to appreciate. And this was when the economy still deeply depressed -- precisely the opposite of what your Econ 1 textbook would recommend in this situation. I once asked Jeremy Stein, who later served on the FOMC, what in the world the Fed was thinking. He tried to tell me that this never happened.

What we've also witnessed during the past few years is that the Fed has repeatedly decided not to alter its monetary policy stance even as it marks down its own forecasts for economic growth and inflation. This can be seen in the graph below. After the first round of QE in 2008, the Fed did almost nothing again until the end of 2010 -- a gap of two years -- even though the economic recovery was much slower than it anticipated. Then, even though growth was slower in 2011 and 2012, they waited another 2 years -- the end of 2012 -- before acting again. What the Fed has come to decide over time is not that they need to do more stimulative monetary policy, but that the economy can't grow like it used to. And given that the Fed can always make the economy grow slower if it wants, this situation has developed not necessarily to America's advantage. Time to dust off Bernanke's "self-induced paralysis" thesis.