Can an $18 trillion dollar economy keep growing at a fairly steady rate, despite a sudden slump in the industrial sector (manufacturing, mining and utilities)?

Here is some recent data for industrial production:

Industrial production grew fairly consistently up to December 2014, but then suddenly began falling slowly.  Now let’s see what happened to real GDP:

Somehow RGDP has maintained a roughly 2% growth rate since 2010, despite a sudden slump in the industrial sector.  Is that even possible?  Yes, services picked up the slack.

Next question:  Can two $18 trillion dollar economies, each of which have the third largest land mass on Earth, continue growing despite a slump in the industrial sector?

Of course the second $18 trillion economy (PPP) is China. And in China, industrial growth has fallen from the 9% to 10% range in 2013 to about 6% in 2015:

And yet China’s RGDP growth has only slowed slightly, from roughly 7.5% to 8.0% in 2013, to about 7% today:

However there is one very important difference between the two cases.  Lots of people believe the Chinese GDP data can’t possibly be correct, given the big reduction in the growth rate of industrial production.  But I don’t recall anyone questioning the US figures, despite an even larger slowdown in the growth rate of industrial production.

PS.  After I wrote this post I noticed that Tyler Cowen is predicting Chinese growth will soon fall to zero.  I think growth will be closer to 6%, and don’t see how his reasons (excessive debt, etc.) would not have applied equally well in other years.  Indeed he doesn’t mention what I think is the best argument for a Chinese recession, an overvalued exchange rate which is reducing NGDP growth.  In any case, I think the safest prediction is the same one I’ve been making for over 35 years.  Boom! And look at the bright side, if I’m wrong this time then my record will still be better than the Golden State Warriors.  Tyler also mentions slowing Australian growth, and indeed troubles in the mining sector are affecting Australia.  However it’s worth noting that Australia’s unemployment rate actually declined during 2015.

PS.  How can the US and China, both the world’s largest economy (due to a dispute over PPP), also both be the world’s third largest country?  Disputed territories.

Back in early 2009, many economists seemed to move away from New Keynesian ideas, back to the so-called “vulgar Keynesianism” of the 1950s and 1960s.  Recall that by the 1990s, the NKs accepted many ideas from the monetarists:

1.  Monetary policy determines the path of NGDP, and thus fiscal countercyclical policy is useless.

2. Wages and prices are flexible in the long run, and hence the economy eventually adjusts back to LRAS curve.  Demand side policies only have a short-term impact on output.

3.  Sluggish growth in productivity and/or the size of the labor force reflects structural problems, and cannot be remedied by demand stimulus (which can reduce high unemployment).

In 2009, economists like Paul Krugman assured us that the abandonment of NK orthodoxy was temporary, that “everything’s different” at the zero bound.  Fiscal policy can be effective when the Fed is out of ammo.

I was skeptical that this would be temporary, and thus I’m not surprised that the old-style Keynesian revival has survived into the post-zero bound period.  Here’s Alan Blinder in the WSJ:

Let’s look at some of the agreement’s main provisions. The budget for fiscal year 2016 and beyond blows through the spending caps put in place in 2013. (Remember the fiscal cliff and the sequester?) Furthermore, Congress extended more than 50 special tax breaks, often called “extenders,” without paying for them. So if your Christmas wish was further deficit reduction, you ended up with a lump of coal.

But the federal deficit that President Obama proposed for fiscal 2016 was merely 2.5% of GDP—a number in line with historical norms. There was no need to shrink it. Furthermore, with a still sluggish economy and the Federal Reserve beginning to raise interest rates, a little fiscal stimulus is welcome, even if the agreement provides very little. The big bucks in the budget deal come in the tax extenders, which everyone knew would be extended regardless. So making some of them permanent does not provide stimulus, nor does it really raise future deficits.

Blinder seems to defend some outrageous and inefficient (GOP) tax breaks, on the grounds that they provide fiscal stimulus.  But how can that be?  The inflation targeting Fed would simply raise rates more quickly, to prevent inflation from rising above their preferred target path (which calls for restoring 2% inflation in about 2 years.)  Keynesians used to argue that monetary offset doesn’t hold at the zero bound. I don’t agree, but that’s a defensible argument.  The current claims being made by Blinder don’t even seem defensible, or at least I’ve never seen a plausible defense.  In any case, it’s now clear that Krugman was wrong; the end of the zero bound would not bring an end to calls for fiscal stimulus.  Instead of “everything’s different” we find out that “nothing’s different.”

And Krugman himself seems to be jumping on the old Keynesian bandwagon, claiming that slow long-term growth reflects deficient demand, even though demand deficiencies would slow growth by raising the unemployment rate (in the Keynesian model), not by reducing productivity.  And this claim is being made even though unemployment has fallen from 10% in 2009 to 5% today.  Whatever this is, it’s not New Keynesian economics.  It almost seems like economists have decided they want more fiscal stimulus, and then simply assume there must be a model that endorses their policy preferences.

You might complain that it’s unfair to tie Keynesians to the 1990s version of their model.  Things change, and new hypotheses are dreamed up.  Maybe there are mysterious “hysteresis effects” that allow demand stimulus to boost long-term growth.  It didn’t work in Brazil, but hey, maybe it could work here.  So shall we treat Krugman’s recent musings as an interesting new hypothesis, something to study and discuss?  I’d be happy to, but Krugman himself won’t allow it.  In a mind-boggling tone-deaf post he trashes Timothy Taylor (a moderate who supports fiscal stimulus during recessions). Here’s Taylor’s response:

Paul Krugman was “quite unhappy” with a paragraph in my blog post last Monday concerning “Secular Stagnation: An Update.”  In his characteristic high-decibel mode, Paul manages in a single post to use the phrases “both wrong and, to some extent, cowardly,” “change the subject,” “actually engaged in an act of evasion,” “refusing to take sides is a dereliction of responsibility,” and more.

If that’s how he reacts to Taylor, I sure hope he never reads my posts.  Unlike Taylor, I don’t even think that what Taylor calls the “2009-2012” fiscal stimulus helped, and can’t help noticing that GDP growth accelerated slightly immediately after it ended.

So Paul Krugman creates a new demand-side theory of secular stagnation, and then trashes the character of anyone who doesn’t immediately buy into his model.  A model Krugman himself would have scoffed at in the 1990s.  Indeed did scoff at, even a year after he had written his famous 1998 “Road to Damascus” revisionist model of the liquidity trap:

What continues to amaze me is this: Japan’s current strategy of massive, unsustainable deficit spending in the hopes that this will somehow generate a self-sustained recovery is currently regarded as the orthodox, sensible thing to do – even though it can be justified only by exotic stories about multiple equilibria, the sort of thing you would imagine only a professor could believe. Meanwhile further steps on monetary policy – the sort of thing you would advocate if you believed in a more conventional, boring model, one in which the problem is simply a question of the savings-investment balance – are rejected as dangerously radical and unbecoming of a dignified economy.

Will somebody please explain this to me?

So apparently the Paul Krugman of the 1980s and 1990s, the one who did research that later resulted in a Nobel Prize, was also a “cowardly” and “evasive” person who refused to take responsibility for demanding fiscal stimulus.   Just like poor Timothy Taylor.  Should the Nobel Prize be returned?  Or was it awarded in anticipation of his later heterodoxy, just as President Obama’s 2009 Nobel Peace Prize was awarded for all the drone strikes, Libyan bombings, Syrian bombings, etc., that he was undoubtedly going to avoid doing during his Presidency.

HT:  TravisV

Britonomist recently left this comment, in response to my claim that the demand for cash is negatively related to the market interest rate (and the demand for reserves is negatively related to the market interest rate minus IOR):

Do you mean cash here? I think for almost everyone the demand for cash is extremely inelastic in a modern economy. Lowering interest rates won’t cause people to rush to their bank account to withdraw money.

Classic error, often made by people on the left.  There’s a tendency to underestimate the degree to which people respond to incentives.  Interest rates are the opportunity cost of holding cash.  If you lower interest rates, people will choose to hold more cash.  And yes, that means lower interest rates are contractionary, as I said in a number of recent posts. Here’s a graph showing the relationship between the demand for currency (as a share of GDP) and T-bill yields:

Notice that the two variables tend to move inversely.  After 2008, the yield on T-bills fell close to zero, and the demand for cash soared from just over 5% of GDP to just over 7%. Today’s currency demand is about 40% larger than it would be had interest rates stayed at the levels of 2007.

Over the previous several decades, interest rates had been trending downwards from their 1981 high point, while the demand for currency had been trending upward from its 1981 low point.  Prior to 1981, interest rates had trended upwards for many decades, while currency demand had trended downwards.

This isn’t to say that the two variables are perfectly (negatively) correlated.  Other factors such as tax rates also impact currency demand.  And it is costly for currency hoarders to quickly adjust their stocks of currency, as most currency demand is for things like tax avoidance.  Thus the stock demand for currency responds gradually to changes in the opportunity cost of holding currency.  It’s a much smoother time series.

To summarize:

1.  The business cycle in the US is mostly caused by fluctuations in NGDP.

2.  Fluctuations in NGDP are mostly caused by changes in interest rates, which impact base velocity.  Lower interest rates reduce base velocity, causing NGDP to decline, and if wages are sticky (and they are), also causing RGDP to decline. Ironically the lower interest rates that cause recessions are themselves often caused by a failure to cut rates quickly enough in the face of a drop in the Wicksellian rate.

Higher interest rates tend to raise base velocity, causing NGDP and RGDP to rise. Of course changes in the base also influence NGDP; but as a practical matter changes in velocity are usually more important.  The graph below inverts Cash/GDP, to give us cash velocity against interest rates:

Those drops in cash velocity during the recessions (grey bands) are lower rates causing currency hoarding causing recessions.  And the last graph replaces currency with the monetary base, which is obviously distorted once the program of IOR began:

Whenever I claim that low interest rates cause recessions, I get misunderstood.  So let me try to clarify the remark, while explaining why both the Keynesians and the NeoFisherians are wrong.

The Keynesians would say that the counterfactual policy that would prevent recessions is even lower interest rates.  That’s mostly wrong.  The proper counterfactual policy to prevent recessions would actually lead to higher interest rates, on average, during the formerly recessionary period, which is no longer a recession.  Keynesians would also say that low rates don’t cause recessions, recessions cause low rates.  I get that, but what they don’t get is that there really is causation from lower rates to lower base money velocity to recessions.  That’s because they tend to ignore M and V, and think in terms of false non-monetary models of “spending”.  (Barsky and Summers understood the point I’m making.)

But the NeoFisherians are wrong in assuming that the proper instruction to central banks is “higher interest rates to prevent deflation”.  That’s because central banks interpret that command as “raise rates via the liquidity effect from a contractionary monetary policy”, which is deflationary.

Much of macro is balancing two seemingly incompatible ideas in your mind at the same time.  For instance, printing money doesn’t create growth and printing money does create growth.  Both ideas are true (or false), in the right context. The same is true of interest rates.  There’s a sense in which lower rates are contractionary, and another sense in which they are expansionary.  Only a few economists (notably Nick Rowe) seem able to get the proper balance right, for these two seemingly incompatible ideas.

As you know, I often argue that inflation doesn’t play a useful role in macroeconomics.  In places where economists put inflation into their models, NGDP growth would be much more useful.  Obviously lots of people don’t agree with me, and this post is aimed at those people.  Here’s my question:

Which inflation rate is appropriate in NK models?  The average change in the price of goods sold, or the average change in the quality-adjusted price of goods sold? I.e., according to NK theory, what role should hedonics play in the construction of price indices?  Why?  What specific aspect of the NK model points to the need for a specific hedonic adjustment?

I hope it goes without saying that in NK models there is no role for the concept of a price index that in some sense accurately reflects changes in the ‘cost of living’, whatever that nebulous terms means.  So then what is the optimal price index, according to the NKs?  In addition, how would your optimal index treat the cost of housing?  What about monthly payments made under long-term rental agreements?  Are they “prices”?  How about payments made to pay off long-term car loans?  Are they “prices”?  (Hint:  The BLS treats apartment rents as prices, but not payments on car loans.)

In other words, what the hell is this “inflation” concept (which you think is so important) actually trying to measure?

Second hint:  Think about things like menu costs, and then also think about how they relate to the way the government actually measures the (quality-adjusted) cost of living.

I’m not worried about perfection—I understand that no data series are perfect.  I’m just trying to figure out what you think “inflation” should be trying to measure, in a perfect world.  In case my question still is not clear, suppose there were no new products being invented, but existing products rose in price at 4% per year in unit terms, and 2.5% per year in quality-adjusted terms.  That’s because the quality of each product improved at 1.5% per year.  In that case, which inflation number belongs in NK models, 4% or 2.5%?

PS.  I have a new post at Econlog.

Update:  Roger Farmer has an interesting comment below, which discusses his version of what I call the “Musical Chairs” approach to macro.  Thus I thought it might be a good time to update the graph:

Yup, it’s still working fine.  Indeed most of the variation probably reflects measurement errors.  If nominal wages are very sticky (and they are) then NGDP shocks largely explain variations in the unemployment rate.

The graph shows wage rate/(NGDP/population) in blue and the unemployment rate in red.  The wage rate is actually total compensation per hour.