Recent events have exposed a hole in the middle of economists’ knowledge of key economic parameters: We know neither the unemployment rate at full employment nor the potential level of gross domestic product (GDP).
That hole is particularly important right now. The combination of the deficit-financed tax cut and the new spending bill are pumping hundreds of billions into an economy that many argue is already at full employment. If so, then much of this extra spending won’t lead to new investment, jobs or higher real pay. When the economy’s human and capital resources are fully utilized (meaning actual GDP is equal to potential GDP), fiscal stimulus just generates inflation and higher interest rates. Even if the extra demand might create some wage pressure, it will be met with higher inflation, so real wages — the paycheck’s actual buying power — won’t change at all.
The problem is that those making that argument are implicitly asserting that they know that the “natural rate of unemployment” — the lowest rate consistent with stable inflation — is roughly equal to the current unemployment rate. That is, they believe we’re at full employment. But the truth is they have no way of knowing that, and one key indicator — inflation — suggests they may be wrong.
It’s true that influential institutions such as the Federal Reserve and the Congressional Budget Office (CBO) believe that the “natural” unemployment rate is above the current one, meaning our labor force is beyond fully employed. Their estimates are 4.6 percent and 4.7 percent, respectively, while the actual rate is 4.1 percent. The CBO also asserts that our current level of GDP — $19.7 trillion — represents full capacity.
But the evidence undermines much confidence in these authoritative-sounding point estimates. First, understand that neither of these measures — the natural rate or potential GDP — can be observed. They must be estimated based on the movements of other variables. For example, the key relationship underlying the natural rate is the one between unemployment and inflation, with the basic insight being that once economic capacity is exhausted, any more demand just shows up as more inflation (note the link between the debate over fiscal spending right now).
But, in recent years, this relationship hasn’t held up. Consider, for example, that unemployment hit the CBO’s natural rate about a year ago and has since fallen further. At the same time, the Fed’s preferred inflation gauge has decelerated, from 1.9 percent to 1.5 percent, a pattern that is totally inconsistent with the theory. This trend is, however, consistent with work by President Obama’s Council of Economic Advisers showing that the margin of error around natural-rate estimates exploded a few years ago (see the key figure here). And in a new paper from the Center on Budget and Policy Priorities’ Full Employment Project, Coibion, et al., show that arguably better estimates of potential GDP are 5 percent above CBO’s. If they are correct, it’s further evidence that we’re not yet at full employment.
So, when I hear economists asserting that all this new fiscal stimulus is going to lead to overheating vs. real economic activity, I cannot share their confidence. They’re going on a hunch, which might well be right, but they’re not going on data, especially considering inflation (as regards expected inflation, see here).
To be clear, I’m no fan of this fiscal push at already low unemployment. The bang-for-the-buck from this spending is surely to be much smaller than if it were a) better targeted, say, at productive infrastructure vs. the heirs of rich estates, and b) coming at a time of high unemployment where “multipliers” associated with such fiscal policy are a lot larger than they are now. That said, if I’m right and we’re not yet at full employment, and if the Federal Reserve allows for even lower unemployment without raising interest rates faster than planned, a lot of disadvantaged people who depend on persistently tight labor markets will benefit.
That is the essence of my larger point about these missing pieces of economic knowledge. I’ve long questioned our ability to reliably hammer out these capacity parameters and have never had much faith in them. For one, it’s clear that they move around a lot, making them unreliable policy guideposts. But my main concern is that the cost to getting them wrong is very steep. If we underestimate capacity, which has been the tendency in recent decades, we leave behind millions of the least advantaged who catch an economic buzz only at chock-full employment. If we overestimate it, we risk overheating.
Our best move is thus to admit the uncertainty, toss the point estimates, and follow the data, particularly inflation. Recognize that we’re driving a car with no reliable indicators of engine overheating, so we’ve got to use our eyes and ears to gauge the heat. That doesn’t call for recklessly pumping the gas or the brakes. It does call for more humility about the limits of our knowledge.