More evidence that U.S. economists are particularly ill-suited to run the U.S. economy comes via the fascinating exchange in recent days between St. Louis Federal Reserve President James Bullard and a small army of bloggers with PhDs in economics, nearly all of the latter ganging up on Bullard after he suggested that the “output gap” theory for what ails the U.S. economy may be fundamentally flawed and that attempts to boost overall demand to close that gap through freakishly low interest rates and other super accommodative Federal Reserve policies might end up doing more harm than good.
Bullard threw a cat amongst the pigeons in this speech(.pdf) when he noted the following:
The recent recession has given rise to the idea that there is a very large “output gap” in the U.S. The story is that this large output gap is “keeping inflation at bay” and is fodder for keeping nominal interest rates near zero into an indefinite future. If we continue using this interpretation of events, it may be very difficult for the U.S. to ever move off of the zero lower bound on nominal interest rates. This could be a looming disaster for the United States. I want to now turn to argue that the large output gap view may be conceptually inappropriate in the current situation. We may do better to replace it with the notion of a permanent, one-time shock to wealth.
Recall that I’ve railed on this subject a number of occasions over the years, the last time being this offering from about six months ago when it was noted:
The theory posits that it is not important what level of overall demand an economy has reached or how it got there, but that, when all the wheels fall off the wagon as they did back in 2008, the imperative is for the government to somehow restore that level of demand. Otherwise, you get another Great Depression.
It makes no difference if, back in 2005, people making $40,000 a year were buying no money down $500,000 homes and then, after the home’s value went up to $600,000 in 2006, pulling out their $100,000 in brand new home equity to put in a pool, buy a motor home, and install big screen TVs in every room of the house because, once you reach a certain level of demand and it begins to drop like a rock because everyone has become indebted up to their eyeballs, it must be restored.
At that point, it simply becomes a question of how much taxes must be cut or how much money must be borrowed or printed to accomplish that goal.
Of course, I don’t have any models to back up the contention that an unusually large portion of economic output we saw in the middle of the last decade was “artificial” due to the housing bubble, but economists do have models, and that’s the crux of the problem.
As Bullard noted, the models economists use to determine the “potential” of the U.S. economy, in essence, extrapolates from the pre-2007 period to the post housing bubble period and, as a result, you end up with a big gap between potential and actual output that policy makers are now seeking to close by borrowing and printing money on a scale never before witnessed by Mankind.
For those of you preferring pictures to words, the chart below by Neil Irwin from this neat little interactive graphic at the Washington Post might be helpful.

Being more detached from reality than the population at large, economists seem to prefer the idea of debating ways to close the gap that has developed in recent years rather than thinking about whether the output gap even makes sense as Bullard has suggested.
The failure to deal with the real world rather than how that reality is reflected in models and the reluctance to venture outside of their analytical comfort zone to embrace common sense (as Bullard clearly has) have clearly produced yet another example where models – whether they’re good, bad, or indifferent – rule.
Models tell economists one thing, but common sense tells the rest of us something very different about what is going on here.
I’d go so far as to argue that the output gap theory is about the absolute worst way to think about an economy because the means become unimportant relative to the end – and that’s a very dangerous policy for an economy such as ours, prone as it is to asset bubbles.
Though few economists would read it this way, non-economists might argue that the chart above shows how the small output gap created by the bursting of the internet bubble was addressed under the Greenspan Fed by creating a housing bubble that has now left behind an even bigger output gap.
And this explains why we didn’t see big excesses in the economic data five or six years ago – because all our bubble economy was doing at the time was pushing output back to its “potential” from the 1990s that was also artificial, that is, to the extent that companies like Pets.com aren’t around anymore.
To a growing number of observers like Bullard, it appears that policy makers could now be in the process of creating an even bigger and more destructive asset bubble to close the current output gap, not considering the possibility that what they’re really doing is trying to artificially boost demand yet again to have it meet up with a level of potential that is now even more artificial than when the internet bubble burst.
A list of links are included below for anyone wanting to pursue this further. One can be hopeful that there are individuals like Bullard who are asking tough questions about what passes for conventional wisdom amongst the dismal set, but his self characterization of being “an army of one” doesn’t bode well for the future.
What output gap? – MacroManiac
Jim Bullard chucks the Solow growth model!- Noahpinion
Bubbles and Economic Potential – Krugman
A loss in wealth should boost economic growth – The Money Illusion
The trend is your friend (until it ends) – MacroManiac
It’s Worse Than You Think – Fed Watch
Bullard On Duy On Bullard On Potential Output – Econospeak
James Bullard Responds to Tim Duy – Economist’s View
Again With Potential Output – Fed Watch









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Great post!
Economists have largely lost their minds. They keep coming up with ways to completely ignore the basis of free market capitalism. The “output gap” is just another version of the idea that “supply creates demand.”
“If you build it, they will come” is a great movie idea but it’s just fantasy in the real world.
Supply does not always create demand. Krugman, AG, BB and their ilk think that anything that boosts production will work to increase demand and thereby ‘prime the pump’ to ‘jump start’ the economy. (You need all the quote marks because, frankly, all these metaphors are inapt and stupid.)
It doesn’t take a PhD in econ (in fact that just gets in the way) to see that you can’t force people to buy excess production no matter how cheap you make credit and no matter how much free money you give them. Even the people you put to work making EXCESS crap, cannot be forced to spend their take home pay on crap they don’t want/need. The normal cycles of expansion and contraction must be left alone or you will get wild distortions as we see now.
Every business person would love it if the only issue they faced were production. But, sadly, you also have to worry about SALES! Marketing became my number one job as the owner of a small business. I had no problem at all producing as much of my wares as I wanted. SELLING IT, however, is not nearly as easy. Overproduction leads to bankruptcy. It’s called inventory control for a reason…
These morons seem to have no real world experience to temper their so-called thinking and they do not understand the word “EXCESS.” It’s this kind of Bass-Ackwards thinking that is killing the economy and will be our ruin.
Simply put, no one will admit the party is over and it’s time to clean up the mess.
very well said sir
Demand is a function of income plus the change in debt. Aggregate debt doubled in the 1980s, doubled again in the 1990s and doubled again in the 2000s. The rate of increase in the change in debt has exceeded the rate of increase in income. Of course, the math doesn’t work at some point.
Debt fueled demand caused an increase in supply. Housing is the prime example. When the debt could no longer be serviced, the real estate bubble burst. As a result, demand has declined and productive capacity is in the process of adjusting to new level of demand, which will reflect incomes and serviceable debt.
Economists often seem to miss the role debt plays in establishing a level of demand. An output gap trend line based on a level of production (i.e. think supply) that has been built to meet demand driven by unsustainable credit creation will always show material underperformance as does the chart in the article above.
This analytical error will cause untold human suffering because the same dynamic is at work when one looks at the sovereign debt crises around the world. A sustainable level of GDP growth is less than recognized because governments have been financing current consumption with permanent debt in the post-WWII era, which takes us back to my first paragraph.
GDP = C + G + I + (X-M)
Today, the US government is spending approximately 10% of GDP in deficits (i.e. think debt) to “buy” 2% GDP growth. An advanced degree in math is not needed to see the problem of sustainability. In fact, the real economy likely never fully recovered.
So far, the answer has been more government. I would argue that the answer lies elsewhere, but what to do is another topic. Bullard is right that attempts to stimulate demand via unsustainable credit creation by government to meet an output gap that was itself a function of unsustainable credit creation will lead to larger, more destructive outcomes.
I’ve been following this.
I don’t remember where, but in one of the related posts someone said, “But where’s his model? He doesn’t have a model!”
As if, it can’t exist in the real world unless it can be modeled.
Yes, this is a great post. I’ve said it a thousand times myself — “output” was artificially inflated by the bubbles, particularly the Housing Bubble. As you say, this is just common sense.
And yet the piled-high-and-deeper economists have yet to incorporate the bubbles into their models. More debt will solve a debt problem. Humans are rational. And a thousand other mistakes. The models are so at odds with Reality at this point that we can only conclude that neo-Keynesian economics (Steve Keen’s term) is a secular religion and economists are its high priests, worshiping those models.
I don’t have a model either. But then again there are poor people living in my neighborhood, which is not something Paul Krugman ever sees in Princeton, New Jersey.
[...] judge of newly uncovered Countrywide fraud database (Reuters) • When Models Trump Common Sense (Tim Iacono) • Citigroup Whistle-Blower Says Bank’s ‘Brute Force’ Hid Bad Loans From U.S. (Bloomberg) [...]
Yes, at the peak of the bubble demand was inflated.
But the economy was able to meet that “inflated” demand without significant inflationary or upward wage pressures. Consequently, the output level at the peak was not inflated. Rather it represented what the economy was capable of producing, so using it as the point to establish a trend in output is perfectly rational and there is no reason to discount the output at the peak of the bubble.
Remember, potential output measures what the economy is capable of producing, not what demand is.
You’re saying that the hundreds of billions of dollars in home equity money sucked out of houses and spent on cars, boats, and big screen TVs back in 2005 and 2006 didn’t make output go higher than it otherwise would have been?
You’ll have to explain that one.
[...] judge of newly uncovered Countrywide fraud database (Reuters) • When Models Trump Common Sense (Tim Iacono) • Citigroup Whistle-Blower Says Bank’s ‘Brute Force’ Hid Bad Loans From U.S. (Bloomberg) [...]
[...] When Models Trump Common Sense. Economics is the “science” most ripe for revolution right now. [...]
[...] judge of newly uncovered Countrywide fraud database (Reuters) • When Models Trump Common Sense (Tim Iacono) • Citigroup Whistle-Blower Says Bank’s ‘Brute Force’ Hid Bad Loans From U.S. (Bloomberg) [...]
I don’t think the output gap theory is wrong, per se. It assumes that the entire economy is running at full employment and production.
But I also agree that aggregate demand was artificially inflated in an attempt to close the output gap.
The problem is that we have too many people and not enough *useful* work for them to do. So we end up making fake jobs to close the output gap. This doesn’t work very well. In order to safely close the output gap we need real jobs for these people to do.
The problem may be that while at the aggregated level there does indeed exist a large output gap, but by achieving growth as the Fed as attempted to do, via the wealth effect, i.e.via inflating asset prices, investment and overcapacity gets built into the assets segments of the economy involved even whilst a very large output gap continues to exist in the rest of the economy. The aggregate data may suggest that the Fed should do more to close the gap where in reality for the assets segments involved, there already exists overcapacity and mal-investment. I believe we have very poorly balanced growth on hand, leading to popular observations that the “99%” who are not involved in the asset side of the economy see no benefits flowing from this round of growth and indeed, the Fed should not attempt to grow the US out of this slow mo recovery by repeatedly stimulating the asset side of the economy via ever lower interest rates.
[...] When Models Trump Common Sense Tim Iacono (hat tip reader May S). He’s not right here. The big problem with focusing on demand creation is that the quick and easy ways to create it leak unduly into asset speculation. This is what happens when you have no labor bargaining power (or high income inequality, which is what you get after a prolonged period of no labor bargaining power). You need to fix that first. [...]
What would the author say in response to Krugman? He says that total potential output has only to do with the amount the economy can actually produce and has nothing to do with what people are willing to spend. He also points out that an asset bubble bursting has nothing to do with actual production, save through whatever effects the washout has to on demand, which therefore leads to less production.
In other words, what does “artificial” value in the potential output actually mean if it’s a figure to be calculated without regard to demand? Am I missing something obvious here?
“He says that total potential output has only to do with the amount the economy can actually produce and has nothing to do with what people are willing to spend.”
I’ve read this “you’re confusing supply with demand” argument in support of the output gap thinking before and, to me (and Bullard, apparently), it just doesn’t make sense.
During a deleveraging cycle following the bursting of an asset bubble, you just don’t have enough demand for the “bubble level” of production, and, as we’ve seen in recent years, you get a major adjustment downward in demand.
Unless you either create a new asset bubble quickly or have the government borrow/Fed print money to take the place of demand that vanished with the asset bubble, you’re not going to have enough buyers to support the “bubble level” of production.
It’s as if you’re trying to artificially increase demand in order to meet an artificially high output potential and you have to ask, does it make sense to do that?
What would this look like if you started the graph at 1990 or any other date further in the past? Would it show that we were in a bubble in the 1990’s? Mite we be in the normal post WW II range?
Economic “science” is the only “science” that accepts, prima facia, theories promulgated by well regarded economists (i.e., members of the exclusive academic economic club) – backed up by sophisticated mathematics and terminology – without any means whatsoever of subjecting the proposed theory to any sort of controlled experiment.
In NO field of engineering or science – no matter how sophisticated the reasoning or mathematics – are theories just accepted AND APPLIED !!!! without some sort of testing; but they are in economics.
In economics, all that is required to justify a course of action (the guinea pigs being the citizenry) is to appeal to an economic “god;” to wit, “according to Keynes (or Friedman) etc.. And this, in the world of economics is all the justification needed to embark on a course of action.
The result has been the dot-com bust, the great depression or the 30s, the housing bust, the great inflation of the late 70s , the debasement of the dollar, the disaster of the euro, etc; all policies that have been originated and encouraged by academic economists that have destroyed the lives of millions of people.
By the way, economists are still !! arguing about the causes and remedies of the Great Depression – an event that occurred 80 years ago.
Further, the joke that is today’s economics is also evidenced by the existence of “conservative” and “liberal ” economists. What the hell is this all about ?? Tell me please, in which “scientific” or engineering field does the POLITICAL PERSUASION of the practitioner DICTATE the theories and policies that should be followed ??
The Nobel Prize winning physicist, Richard Feynman (a real scientist) originated the concept of a “cargo cult science;” a science that has all the trappings of a real science – mathematically “proven” theories, complex terminology, etc. – but is simply a fraud, a fake, a joke; simply a “science” on par with astrology or that of a witch doctor divining the meaning of chicken entrails.
That folks, is today’s economic “science;” where nothing can be verified under controlled conditions and where listening to these charlatans ALWAYS leads to misery and ruined lives. (Please notice that economists NEVER, EVER concede that their theories, when applied, can be wrong when the intended result is contrary to that predicted; no matter how often the results conflict with the theory)
Of course, these economists just go back to their tenured academic positions and rejoin their group-think, well paid academic club and suffer ZERO repercussions from the misery they have inflicted upon average folks.
Murderers and pedophiles usually destroy the lives of dozens of people; maybe even several dozens. Economists destroy the lives of millions of people they need to be ostracized, ignored and shunned – just like pedophiles or murderers. They are a deadly cancer in society.
And don’t forget that, despite the conventional wisdom elsewhere, official Fed orthodoxy is that low rates were not a major cause of the housing/credit bubble and financial market meltdown that followed it a few years back…