A few more comments on the previous post. Just as one should never reason from a price change, one should never reason from a wealth change. If there is a shock worth thinking about, it’s the shock that caused wealth to change.
First example: The huge 1987 stock market crash was almost identical to the 1929 crash, but the “effects” could not have been more different. The 1929 crash was followed by the Great Depression, whereas the 1987 crash was followed by years of smooth and placid economic growth. Not even a ripple to real GDP. Yes, stocks are skewed more towards the rich than houses, but if wealth was really that important, then a gigantic stock market crash should have had at least a small impact on output. Instead, unlike 1929 the Fed kept NGDP chugging along, so naturally RGDP kept chugging along. Wealth in and of itself has no effect on output, although the things that cause wealth to change may have an impact.
To consider why wealth is surprisingly unimportant, consider an island country that holds its wealth in the form of British consols. Each consol pays 100 British pounds per year, forever. Consumption is also 100 pounds per year. Now assume interest rates double from 5% to 10%. The value of the consols (i.e. wealth) will fall in half, from 2000 to 1000 pounds. Yet consumption will remain at 100 pounds per year. That’s not a bad model of the 1987 crash–corporate profits didn’t fall, rather the P/E ratio fell (and the E/P ratio rose—which is a sort of interest rate for stocks.)
Next consider a sudden massive drop in housing demand. There are two possibilities. One possibility is that the Fed keeps NGDP growing at 5%, and in that case the drop in demand for housing will lead to more demand for other goods and services. Unemployment will remain unchanged. That’s sort of what happened between the peak of the housing boom in January 2006, and April 2008, a period which saw about 70% of the Great Housing Construction Crash. During that period unemployment rose from 4.7% to 4.9%, as resources shifted out of residential construction into other types of construction, and exports. And even that tiny rise in unemployment was mostly due to a slowdown in NGDP growth.
A drop in housing wealth might reduce overall wealth, or it might be offset by higher stock prices (as happened until late 2007, when NGDP growth really started to slow.) If the Fed allows NGDP to collapse, then of course all sorts of other industries will suffer, and unemployment will skyrocket. They can prevent this with a technique called “level targeting.” An NGDP crash will sharply reduce all sorts of wealth, including residential and commercial real estate, as well as stock values. But the drop in wealth itself doesn’t cause a recession (as we saw in 1987) rather it is the rise in the ratio of nominal hourly wages to NGDP that causes mass unemployment. The job market is like a game of musical chairs. Falling NGDP removes several chairs from the game.
The US economy is really good at re-allocating resources. After WWII we produced lots less military stuff and lots more houses, cars, etc. The public is never satiated, as most people want to live like Hollywood millionaires. If the NGDP is there, the demand will be there, and our nimble firms will rush in to supply more of whatever Americans decide they want after deciding they want fewer houses. But of course the demand wasn’t there. Indeed even the last half of the housing slump itself was caused by plunging NGDP. The latter half of the housing crash wasn’t a reflection of American preference for less housing, but rather recession, as newly-poor 20 somethings lived with their parents. Only the first half of the slump represented the drop-off from the over-inflated housing boom of 2005-06. That slump was healthy, and only caused unemployment to rise from 4.7% to 4.9%.
As I pointed out earlier, we don’t have mini-recessions in America (since WWII.) That’s because real shocks don’t cause recessions; we are really good at re-allocating resources in the face of a real shock. If we weren’t good at it then mini-real shocks would cause mini-recessions, and big real shocks would cause big recessions. Since we don’t have mini-recessions, we can infer that recessions aren’t caused by real shocks.
Tyler Cowen added an update pointing out that he wasn’t endorsing Bullard’s argument (as Matt Yglesias suggested.) I may have also left that impression—although I tried not to, but perhaps didn’t word it very well. I meant to imply that Tyler found the argument intriguing enough to link to, whereas I found it completely mystifying. That’s what I was really driving at; I couldn’t even understand the connection between lower wealth and lower potential output. Tyler’s update suggests that output may have fallen because it was inflated above trend during the housing bubble. That might be the case, and seems a much more respectable argument that claiming less wealth might somehow cause potential output to fall. (In fairness to Tyler, that claim was only made explicit in the following paragraph, which Tyler did not quote.)
I doubt we were very far above potential in 2006, as the paths of NGDP and the unemployment rate weren’t showing any sort of highly unusual behavior. At worst, we might have been 1% or 2% above potential. Of course that can’t explain the Great Recession. I think Tyler’s strongest argument would be that if we did adopt a suitable AD policy, it would be likely to produce more impressive results on the employment front than the RGDP front. Indeed I believe the recent unemployment/RGDP data already point in that direction (although we still are suffering an AD shortfall.)