Scott Sumner has a great new post on reallocation over at Econlog. He has an amazing mind to be able to take parts and pieces from various schools of thought and put them together to make sense of the world, and then present them in a way that can be easily understood.
In the post he presents the following points about reallocations that appear to have occurred in the latter half of the 2000’s decade:
Housing starts fell by more than 50%, from a bit over 2.1 million (annual rate) to a bit over 1.0 million.
If the reallocation model is correct, then the decline in housing related industries should have been partially offset by a rise in non-housing related industries. And that’s what happened. RGDP growth average 1.27%/year over that 9 quarters, which was positive but somewhat below trend. Non-housing industries expanded.
Reallocation can be viewed as an adverse supply shock, so inflation should have been relatively high. And indeed the GDP deflator rose at a 2.45%/year rate, above the Fed’s target of 2%.
Total employment would probably have risen, but at a slower than normal rate. Unemployment would rise slightly. And indeed that’s what happened, as total employment rose and the unemployment rate crept up from 4.7% to 5.3%.
These points present some fascinating food for thought for me in particular:
1) May point to a partial explanation to my mystery of why the late 1980’s came with a better feeling of wellbeing to it compared to today even though the average level of headline unemployment and inflation were higher. Higher headline unemployment may have been due to more churn and possibly faster turnover. Higher inflation rate of the time has two possible implications: 1) inflation was not being targeted and reallocation was allowed to take place naturally, or 2) the Fed’s reaction function included a higher implicit inflation target.
2) Raises another question about the soundness of inflation rate targeting in practice because, obviously, if there is a major reallocation happening in the economy leading to above target inflation, the expected result would be pro-cyclical inflation management that complicates supply side recessions by adding an element of demand shock to solve problems that are not related to excess aggregate demand. Simply put, it’s not consistent with the Fed’s mandate to take a supply side recessionary issue and expand it. It is particularly harsh when target rate is low. And I wonder whether the proponents of hardcore inflation rate targeting understand that this is what is being advocated. I would guess not.
3) If there were a better way to debunk the “too low for too long” argument as a cause of the Great Recession, I’ve not seen it. If this is the way events related to housing played out, if the level of interest rates in the earlier part of the decade had any relation to the housing boom, the natural victims of it had already been claimed by 2008; and the only reasonable explanation for the Great Recession is the Fed’s exacerbation and spreading of the supply side recession caused by reallocation in the following ways:
1) Having an implicit target rate of inflation that was too low to accommodate natural reallocation
2) Not tolerating a period of above target inflation due to recessionary supply shocks.
The bottom line here is that there is no “easy button” that leaves everyone better off when it comes to IT. Sorry, but it is what it is, and if this sort of policy is what is to be accepted from the Fed, and in some cases even demanded even though illegal, we have to live with the consequences for which the value judgment will need to be left to each individual (I think living like this is unnecessary and cruel). But I don’t think that the reasonable or honest way to explain them to the public is to spread misleading propaganda about it and ignore the elephant in the room regarding how we get to the ZLB. It is all natural manure of the monetary policy choices that have been made, and it should be explained that way.