Uncertainty and Large Swings in Activity.

• Author: King, Mervyn
• Position: The 2017 Martin Feldstein Lecture - Viewpoint essay

It is a great honor, as well as a personal pleasure and privilege, to be invited to deliver the Feldstein Lecture. I have known Marty and Kate for almost 50 years. I met Marty in the summer of 1970, when I presented my first ever paper at the Second World Congress of the Econometric Society in Cambridge, England. The subject was investment, and Marty presented a paper, jointly with the late John Flemming, on the same topic. Those were the early days of computer analysis of data, and paper tape had not yet given way to the new technology of punched cards. But the application of rigorous theory to quantitative empirical analysis was a heady and seductive combination.

A year later I was a graduate student at Harvard with Marty as my mentor. A few years after that, Marty took over the National Bureau, and the first Summer Institute was held. "Oh, to be in Cambridge, England now that spring is here" became "Oh, to be in Cambridge, Massachusetts now that summers here" (1)

And here we are at the 40th NBER Summer Institute. In the audience, I see economists who had not yet been born at the time of that first workshop in 1978. So in my lecture I want to trace the path that both Marty and I took from microeconomics to macroeconomics. In particular, I shall ask how far the so-called workhorse or canonical models of modern macroeconomics can help us understand what has been going on in the world economy for the past quarter of a century. My focus will be on uncertainty and large swings in economic activity--of the kind we saw in the Great Depression and more recently in the Great Recession of 2008-09--and the unexpectedly slow and protracted recovery since the financial crisis.

In so doing, I want to draw inspiration from what, in my view, is one of Marty's greatest strengths: his ability to combine a conviction that economics has a great deal to offer in thinking about almost every aspect of our lives--Marty's freshwater characteristic--and an imagination to develop models and new data sources to examine previously unexplored territory--his saltwater dimension.

Introduction

The fundamental question that has divided economists since publication of The General Theory in 1936 is whether a market economy with flexible wages and prices is self-stabilizing. The recent financial crisis should have generated a more serious debate about that question. But it takes a great deal to derail a conventional theory. As John Maynard Keynes wrote in the preface to his great work, "The ideas which are here expressed so laboriously are extremely simple and should be obvious. The difficulty lies, not in the new ideas, but in escaping from the old ones." (2)

The crisis did not lead to an intellectual revolution. Instead, debate focused on the appropriate policy response rather than the theoretical basis of current macroeconomics. (3) Indeed, the workhorse model taught in courses on macroeconomics and used by policymakers survived the crisis better than did our economies. Even adding banks and financial rigidities, with new first-order conditions, did not change its basic properties. The central idea is that the economy moves in response to stochastic shocks around a steady-state or stationary long-run equilibrium.

It is interesting to ask how the stochastic, one-sector models so much in favor today came to dominate macroeconomic thinking. Fifty years or so ago, models of economic dynamics and models of economic growth were quite separate. The former stimulated the construction of econometric models with empirically estimated dynamic responses. The latter were concerned with long-run steady growth and later expanded into multisector models of economic development. (4) The first advance was to incorporate the ideas of Frank Ramsey into the formulation of optimal growth paths based on the maximization of expected utility. (5) The second was the explicit modelling of expectations in a stochastic environment. It was natural to relate expectations to the underlying long-run relationships driving the economy, and so rational expectations came to the fore. Multisector models seemed to add little to the insights into behavior afforded by the rational expectations revolution. Attention switched back, therefore, to one-sector models and the elaboration of stochastic shocks. And so we arrived at today's consensus on the centrality of one-sector DSGE (dynamic stochastic general equilibrium) models.

But these models have their limitations, and two seem to me particularly serious. First, expected utility theory has come to dominate macroeconomic modelling even though its foundations are fragile when analyzing behavior in the presence of large, one-off macroeconomic shocks. Second, the one-sector framework leads policymakers to focus exclusively on the level of aggregate demand rather than on its composition. Both features are, in my view, problematic in understanding the world economy today, as I shall now try to illustrate with a rapid tour of some of the relevant data.

Selected Data

The proposition that the US. economy follows a path described by random shocks around a steady-state growth rate is given some support in Figure 1, which plots GDP per head at constant prices from 1900 to 2016. (6) A trend line with a constant annual growth rate of 1.95 percent captures the upward path of GDP per head rather well. By far the largest deviations from this path were, of course, the Great Depression and the boom experienced in the Second World War. It is noticeable that, despite these large swings in activity, from 1950 onwards GDP per head resumed the path that would have been projected from an estimated trend over the period 1900 through 1930.

Figure 1 also shows data for the U.K. The underlying growth rate is remarkably similar, although, unlike the U.S., the U.K. did not experience the wild swings of the 1930s and 1940s. But at the end of the First World War the U.K. suffered a step down in the level of GDP per head and did not return to the previous trend path. This was when the U.S. took over the mantle of the world's financial leader.

Figure 2 plots the distribution of percentage deviations from trend GDP in the U.S. over the full 1900-2016 period. Whatever else can be said, the chart does not look like a normal distribution. If the underlying distribution of shocks is normal, then it must be shifting over time, suggesting non-stationarity of the shocks.

For the period since 1960, Figure 1 shows the trend growth path for real GDP per capita for the U.S. and the U.K. over the 1960-2007 period--the period up to the beginning of the recent financial crisis. The growth rate is almost exactly the same, just over 2 percent a year, in both countries. (7) Again, a constant trend growth path seems to fit reasonably well until the period beginning with the financial crisis. Since then the pattern of growth has been very different from its earlier path. A persistent shortfall from the previous trend is evident. Something significant has changed--and it is a matter of dispute as to whether the underlying productivity growth trend has fallen or whether there is another reason for the pattern of persistently slow growth.

The most striking evidence of non-stationarity is shown in Figure 3. It plots the world real interest rate at a 10-year maturity, as calculated by David Low and myself from interest rates on government bonds issued with inflation protection, from 1985 to the middle of 2017. (8) From around the time when China and the members of the former Soviet Union entered the world trading system, long-term real interest rates have steadily declined to reach their present level of around zero. Such a fall over a long period is unprecedented. And it poses a serious challenge to the one-sector growth model. In order to salvage the model, much effort has been invested in the attempt to explain why the "natural" real rate of interest has fallen to zero or negative levels. But there is nothing natural about a negative real rate of interest. It is simpler to see Figure 3 as a disequilibrium phenomenon that cannot persist indefinitely.

Part of the explanation lies in saving behavior. Figure 4 shows the gross national saving rates for China and Germany from 1980 through 2016. Their saving rates...