The Other Output Gap

Has the housing bust reduced our productive capacity? Opponents of fiscal and monetary stimulus argue any pump priming will fail because we simply have too many former construction workers and mortgage brokers ill-suited for the jobs of a post-bubble economy. Until the unemployed pick up new skills, their prior productive capacity will be no more real than the paper wealth created during the boom. To give it a Panglossian spin: this is creative destruction! Interfering with this reversal of bubble-era misallocations will only prolong the admittedly painful process of adjustment -- or so the story goes.

It's an intuitively appealing narrative. Morally, too. We were bad, bad, bad racking up debt during the cheap credit bonanza, and the crash is our penance. Moreover, everyone knows less educated workers have fared the worst during the Great Recession; isn't that prima facie evidence that our unemployment problem is the result of effectively trying to fit a square peg into a round hole? As CNBC's John Carney puts it in an echo of the Efficient Markets Hypothesis:

We're likely performing at exactly the capacity appropriate for a people with the combination of assets, liabilities and skills we actually have. [...] We have relatively less capacity to make what is in demand because so much of our capacity is dedicated to making what's fallen out of favor.

All is for the best! Carney goes on to attack the models of the pointy-headed elites who bemoan the -- in his view, mythical -- output gap between what the economy is and what it could be producing by, of course, introducing his own thought experiment about how the economy works. But what about reality? Is there any evidence to suggest we are suffering from structural unemployment? And -- funny how this works -- if moving labor out of bubble industries is causing unemployment during the bust, why didn't the same happen during the boom, when labor was moving into those industries and out of others?

It's the demand, stupid. Back in the heady days when anyone with a pulse -- and even a few without -- could walk into a bank and walk out with a mortgage, the ranks of the aforementioned construction workers, mortgage brokers and the like swelled. There was no "loss of productive capacity" as people who had previously worked in other fields stampeded into housing related ones, for the simple reason that there was demand for it. Contrast that with the jobs quagmire we now face: unemployment has doubled across nearly all industries since the onset of the Great Recession -- and across all levels of educational attainment as well. With households saving again to pay down their debts, demand for everything has cratered. And those much-maligned construction workers, who don't how to do anything but build houses? They're encountering no greater difficulty in the labor market than the rest of job-seekers. This isn't a case of a skills mismatch; it's a straightforward case of inadequate aggregate demand due to the bursting of a credit bubble.

Which brings us to debt. The paper wealth generated during the housing bubble was certainly a debt-fueled illusion, but the higher output of those years was not. Our workers are no less able; our technical know-how is plainly undiminished. Claiming that we can no longer produce as much because of previous malinvestment is belied by the fact that the downturn has effected every sector of the economy in nearly equal proportion. What has changed is that consumers are deleveraging -- a process, that as Irving Fisher could tell you, can feed on itself. Carney conflates these headwinds on private sector demand with an actual reduction in our productive capacity, which is fine if you are ideologically committed to wishing away government spending, but not so much in the real world.

Fiscal and monetary stimulus can work. Not as much, or as predictably, as we would like, but to insist otherwise is to do so in defiance of facts. Indeed, did workers suddenly learn new skills after FDR took us off the gold standard? Or was it deficit spending that did the trick? Clearly, these are absurd propositions. And yet, mountains of excess reserves coupled with prodigious deficits have stoked fears of (nonexistent) inflation, such that people who should know better have taken to inventing reasons for inaction despite the smoldering jobs crisis. Failure is redefined as success. Ten per cent unemployment is the new "Mission Accomplished"! Warnings of structural unemployment -- despite an absence of any of its markers, like shortages in specific labor markets -- abound. Ideologues, when confronted with changing facts, prefer to change definitions, rather than opinions. The largest "output gap", unfortunately, is between our elites' economic understanding and reality.