In his speech, Benoît Cœuré, Member of the Executive Board of the European Central Bank, reflects on five years after the crisis: “Perhaps the biggest mystery facing policymakers today – and especially central bankers – is what is happening on the supply side of the economy.” Subdued price and wage pressures globally are raising questions about both the true level of supply capacity, and about how much it is being lifted by strong current demand. Given that the supply side was traditionally thought to be determined by structural factors alone – Say’s law in short – this is sparking many questions in the current public debate about the outlook for the economy, the likely path of inflation and the appropriate stance of macroeconomic policies.
At a deeper level, this discussion appears to even challenge the traditional view of the business cycle and whether deviations of actual economic output from its potential level – the “output gap” – can still meaningfully inform policy discussions. To paraphrase Winston Churchill, the output gap is a riddle, wrapped in a mystery, inside an enigma, but perhaps there is a key. And that key is the impact of demand fluctuations on supply capacity. To bring some clarity to this debate, in my view we need to distinguish between two different ways through which demand and supply can interact.
Two different ways through which demand and supply can interact
The first is the normal effect of business cycles on supply, which comes about, among other things, through people entering and exiting the workforce in response to changes in demand, through firms delaying and restarting investment in new capacity, and through firms’ pro-cyclical investment in research and development. Such effects are in principle temporary, and their scope depends in part on a country’s product and labour market institutions, but they typically have no long-run impact on the economy’s growth potential. The second is what are known as hysteresis effects – the notion that recessions can do lasting damage to the growth potential that does not automatically unwind as the economy improves. This understanding of hysteresis is much along the lines first laid out by Blanchard and Summers, who noted the tendency of unemployment in Europe to rise during recessions and to remain elevated thereafter.
If such effects are at play – that is, if workers become permanently detached from the labour market as a result of a temporary slump – it may be the case that only targeted structural reforms or a “high-pressure” economy created by unusually loose macroeconomic policies can provide a solution. The impact of a long period of above-potential growth on the supply side would in turn constitute “reverse hysteresis”.
The distinction between persistence and permanence is important because it can help us better explain the developments we are seeing in the economy today and how macroeconomic policies should react to them. In particular, if we are primarily seeing normal effects of the cycle, there is no real mystery about why inflation is so low in many economies, and there is also no need to run the economy hot to undo the damage of the crisis.
Hysteresis versus measurement
The lows of the crisis years were, at the time, thought to represent a “new normal” of low growth and secular stagnation that only determined policy action could overcome. Now, some believe that structural reforms coupled with above-potential growth are healing the scars of the crisis. The implication of this view is that, as the global expansion strengthens, supply is expanding in tandem with demand and the output gap does not close. That is, we are chasing a moving target of potential output that keeps inflationary pressures in check. The other view is that, during the crisis, potential growth never fell by as much as what canonical estimates would tend to suggest in the first place, and that these estimates may have mistaken temporary shocks for more permanent ones. A crude reference point for understanding the consequences of this second hypothesis is to look at trend real GDP growth over a long period of time, abstracting from any models and their underlying assumptions.
(…) Of course, in reality the trend is neither linear nor exogenous – this is why we can’t use such simple charts for informing policy. It instead depends on the potential of the economy to generate sustained economic growth. And the factors generating growth – for example, the rate of technological progress, the institutional framework or the working-age population – do change over time, which is an issue I will return to later. The question, however, is whether booms or recessions themselves affect the trend, and by how much – the hysteresis view. Recent research suggests that many of our current models may overestimate the effects that changes in demand can have on our economies’ supply potential, beyond the normal effects of the cycle. These models tend to produce potential GDP estimates that may be overly sensitive to transitory shocks. They may therefore compound problems that are related to statistical measurement issues, such as the well-known failure of HP filters to capture end-of-sample effects.
This suggests that a portion of the revisions to potential growth that we have seen in recent years, both upwards and downwards, may have exaggerated the impact of transitory factors. This may also put earlier findings into a different light. For example, Olivier Blanchard and co-authors have shown that revisions in long-run potential growth estimates are strongly correlated with movements in consumption and investment.11 To the extent that these correlations are misperceptions about the impact of transitory shocks, they tend to corroborate the view that potential growth estimates are too sensitive to normal cyclical fluctuations in output. To be clear, like many others I do believe that deep recessions can have effects on the supply capacity of the economy that may take some time to unwind. For example, the crisis has affected the “intensive margin” of the euro area labour market – that is, people working involuntarily in part-time or temporary positions. But it is not plausible that those effects could be as dramatic and long-lasting as the “hysteresis view” would suggest. Since these workers remained attached to the labour market, they represented a broader definition of slack rather than a new category of structurally unemployed workers – and indeed, measuring slack in this way helps explain recent low inflation outcomes better. (…)
I would argue that there are two, largely complementary, reasons for cautious optimism. Both are related to the fourth industrial revolution, or the digitisation and automation of our economies. The first factor relates to the time it usually takes for new technologies to reach critical mass. History suggests that technology usually takes considerable time. We all remember Robert Solow’s famous statement back in 1987 that “you can see the computer age everywhere but in the productivity statistics”. The “Solow paradox” became less of a paradox when productivity started to accelerate measurably in the 1990s.
Researchers have attempted to quantify this assertion. According to one study, over the past two centuries, it took countries about 45 years on average to adopt new technologies.18 Adoption time has declined over the past 50 years, but the McKinsey Global Institute estimates that it still takes some eight to 28 years from commercial availability to 90% adoption rates. All of this suggests that it could be less of a concern that we are not yet seeing the effects of digitisation in our productivity figures. It may simply be a matter of time. This brings me to my second factor.
Transformation of business models
A more fundamental transformation of business models along the lines of digitisation is typically more difficult in periods of weak demand, such as after the great financial crisis. New technologies often come with large fixed costs or may even cannibalise the way businesses operate today. If demand is weak, these costs may easily exceed the benefits of adoption in the short run, causing firms to delay investment plans. This is different from hysteresis effects, where some observers argue that we are permanently entering a “1% economy” of low growth, low inflation and low neutral rates of interest as firms invest less in new capacity and technology, causing productivity growth to stabilise at lower levels and weak potential growth to become self-fulfilling. This is rather about the timing of investment: the coincidence of a protracted period of weak demand and major transformative technological breakthroughs may have further delayed closing what some call the “innovation gap” – the distance to the technological frontier. In the euro area, for example, the double dip of the great financial crisis and the sovereign debt crisis may have delayed investment in new technologies. Indeed, research finds that Europe operates at only 12% of its “digital potential”, and the United States at only 18%.21 For example, the share of retail e-commerce in Europe was less than 9% last year, compared to 15% in the United States.
For monetary policy, I see two implications.
The first is that our current monetary policy stance is appropriate. It has been calibrated on the view that the uncertainty around canonical output gap estimates is considerable and that slack could be larger. Ample monetary policy accommodation therefore continues to be necessary for inflation to reach levels closer to 2% sustainably.
However, and this is my second point, the possibility of larger-than-estimated slack does not mean that monetary policy will have to remain unchanged. If potential growth has not fallen by as much as we thought, it may imply that the neutral rate of interest – the level that determines the degree of accommodation our policies provide – might be higher than is commonly estimated.
This could help explain why our current measures have been so effective in stoking the recovery: they may have been more expansionary than many believed. And if confirmed in the future, a higher than believed neutral rate would allow us to recalibrate our monetary policy as the expansion continues, while still providing the accommodative stance that is necessary for inflation to converge sustainably towards our aim. Meanwhile, we continue to expect our key interest rates to remain at their present levels for an extended period of time, and well past the horizon of our net asset purchases.
You can read the whole speech on the website of the BIS.