Opinion | Wonking Out: Hitch Your Wagon to R-Star
By Paul Krugman
Economics is the most mathematical of the social sciences. That’s not because economists are smarter than, say, sociologists or political scientists; trust me, it’s quite possible to say stupid things with equations. It’s because the subject matter of economics — basically getting and spending — is cruder and hence easier to measure than the subject matter of our sister fields.
Yet even though economics lends itself to number-crunching, getting or even defining the numbers we crunch can be problematic. Back in 1936, John Maynard Keynes had his doubts about the whole idea of estimating what we would now call real gross domestic product, although the term wasn’t yet in widespread use:
To say that net output to-day is greater, but the price-level lower, than ten years ago or one year ago, is a proposition of a similar character to the statement that Queen Victoria was a better queen but not a happier woman than Queen Elizabeth — a proposition not without meaning and not without interest, but unsuitable as material for the differential calculus.
Today’s economists don’t generally have the same qualms, although it would probably be a good thing if we stopped now and then to ask whether official data really measure what they’re supposed to measure. But policymakers have an even deeper problem. Getting policy right often seems to depend on the values of economic parameters that we more or less know must exist, but have no good way of estimating.
In particular, the Fed would very much like to know how high it needs to keep the interest rate — or more precisely, the interest rate minus expected inflation — to avoid overheating the economy and reigniting inflation. This “natural rate of interest,” a term invented in 1898 by the Swedish economist Knut Wicksell, is often referred to as r* or r-star.
Back in 1968, Milton Friedman, in a deliberate echo of Wicksell, argued that there is also a “natural” rate of unemployment consistent with stable inflation. Since referring to any level of unemployment as natural raises some people’s hackles, this is often referred to as the NAIRU, for non-accelerating inflation rate of unemployment — and often denoted as, you guessed it, u*.
Do these theoretical concepts correspond to anything real? In the case of r*, the answer is surely yes: If the Fed persistently sets rates too low, it will cause inflation, while if it sets them too high, it will keep the economy depressed, so there is some interest rate that is just right.
The case for u* is more problematic. Clearly there are limits on how low you can push unemployment — even the most rabid Keynesians would, I think, agree that we’d have inflation problems if policymakers aimed for 2 percent unemployment. It’s much less clear that Friedman’s concept works in the opposite direction, that is, that high unemployment leads to ever-falling inflation and eventually deflation. In fact, many economists, myself included, believe that the U.S. economy suffered from unnecessarily high unemployment for a decade or so after the 2008 financial crisis, yet inflation remained stable at just a bit below the Fed’s target of 2 percent.
But even if the stars exist, can we locate them?
Economists certainly try. Both the New York Fed and the Richmond Fed have models they use to estimate r* and publish the results on a regular basis. Before the pandemic, these models more or less agreed, saying that r* was very low. Recently, however, they have diverged: Richmond says that r* has risen substantially, while the rich men north of Richmond — OK, actually the New York Fed pays well, but not that well — say that it is receding back to prepandemic levels:
What do the fundamentals tell us? Many of us thought we had a pretty good understanding of the forces behind low r* before Covid struck. Investment demand is largely driven by expectations about future economic growth, and prospects for U.S. growth seemed low in part because of demography — growth in the working-age population has stalled — and in part because despite all the hype about technology, productivity has grown slowly since the mid-2000s.
The demographic story hasn’t changed — in fact, unless we get a lot more immigration, it can’t change, because the work force for the next 20 years has already been born. Productivity growth might take off because of A.I., but nobody knows.
There are a couple of other forces that might have increased r*. Budget deficits have gotten bigger, which could be providing a fiscal boost. But as Matt Klein has pointed out, most of the increase in the deficit reflects higher interest payments and lower receipts from capital gains taxes, neither of which is likely to have much effect on consumer spending (in part because many of the beneficiaries are foreigners).
Possibly more important, the Biden administration’s industrial policies seem to be catalyzing a boom in manufacturing investment. This is a big deal in many ways, but when all is said and done, manufacturing investment isn’t that big a part of overall investment spending, so it’s not clear how much this matters for interest rates.
Now, one possible reason to think that r* may have risen is the surprising resilience of the economy in the face of Fed rate hikes. But will this resilience last? Is the economy slowing down, or is growth actually accelerating?
Based on the available data, you can believe whatever you want to believe. Take the red pill and you can go with the Atlanta Fed’s GDPNow, a tracker that is currently estimating a crazy growth rate of 5.9 percent:
Take the blue pill and you can go with S & P Global’s Purchasing Managers’ Index, which shows the U.S. economy stalling:
I don’t think I believe in either story, but who knows?
Oh, and a word about u*. Last year some prominent economists argued, based on the high level of unfilled job openings, that the natural rate of unemployment had risen substantially in the aftermath of the pandemic, to something like 5 percent. But with wage growth and inflation falling despite low unemployment, that now looks like a false alarm.
It would be nice to throw up our hands and say that r* and u* are meaningless if we can’t reliably estimate them. Unfortunately, policy must be made, and policymakers must make the most educated guesses they can about what interest rate and which unemployment goal are appropriate — which means, in effect, making guesses about r* and u*, even if they avoid using the terms.
And inevitably some of those guesses will turn out to have been wrong, leading to policy errors. Such is life. And while it may not be much consolation, it does seem worth pointing out that sometimes, when we get policy wrong, the fault lies not in ourselves but in our stars.
Paul Krugman has been an Opinion columnist since 2000 and is also a distinguished professor at the City University of New York Graduate Center. He won the 2008 Nobel Memorial Prize in Economic Sciences for his work on international trade and economic geography. @PaulKrugman
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