Whenever I draw a chart comparing actual growth with the pre-crisis trend, as I did in my last post, I get two kinds of complaints. Some readers complain that that’s not how you do it — that you have to draw a trend through the middle of the past scatter of points, not start at a business cycle peak. Others complain that a year like 2007, or 2000, is a bad choice because output was inflated by a bubble.

But there are actually very good reasons why I’m doing it this way. To understand what’s going on, you need to think about what it means to have a recession. (I’ll offer some caveats at the end.)

Think of the economy as a machine, with a certain amount of productive capacity — a maximum rate at which it can be run safely, if you like. This productive capacity grows over time, at a relatively steady pace. But actual production grows much less steadily, and sometimes shrinks, because sometimes the economy falls far short of operating at its capacity. That’s what it means to have a recession; something has gone wrong that causes the machine not to work right. As Keynes said, we have magneto trouble.

So what we want to do is compare output with what the economy could be producing. And to estimate that, it’s a good rule of thumb to extrapolate from the last business cycle peak. Why? Because at the peak of the business cycle, the economy is usually operating close to capacity — in part because central banks try to throttle growth back when they think the economy is in danger of running too hot, leading to inflation. It’s standard practice to assess economic trends with peak-to-peak interpolation, because the peaks are a reasonable estimate of the economy’s capacity, while other points on the business cycle don’t convey anything like that information.

So I measure my trends from the last business cycle peak.

But, say some readers, what if growth at that peak was inflated by a bubble? OK, that’s confusing supply and demand. Bubbles drive demand — they don’t increase the economy’s capacity (if anything they reduce it). They drive capacity utilization, so that a bubble may drive the economy to a peak; but that peak is still a good indicator of how much the economy can produce, no matter if it’s producing stuff people shouldn’t be buying.

So I know what I’m doing with these trend lines.

OK, the caveat: we don’t really think the economy has a fixed upper limit on output; it’s more of a soft limit, with inflation accelerating as you push unemployment below the NAIRU. That’s why the economy can sometimes operate above standard measures of potential output, which are NAIRU-based. But that just means that when I use, say, 2007 as a base, you need to ask whether there were signs of accelerating inflation back then. There weren’t. And bubbles remain irrelevant.

Why does all this matter? On both sides of the Atlantic, advanced economies have surely seen a significant rise in capacity since 2007 — but they’re still producing significantly less than they did then. That’s the output gap. Now, suppose the gap is 6 percent; I’d say 8, but who’s counting? Suppose also that potential output is growing at 2 percent a year. In that case, how much growth would it take to get back to where we ought to be? If we grow at 3 percent, which many would hail as a success, it would take 6 years. If we grow at 4 percent, it would still take 3 years.

In short, we’re operating hugely under capacity — and I’m both shocked and depressed at the lack of urgency among policy makers about closing that gap.

Listening to the comments of Jean-Claude Trichet and others, you might have the impression that Europe is well on the way to recovering from its slump. So I took a look at the actual numbers, and even though I sort of knew what they said, it was a bit of a shock.

In the figure below, I show an index of eurozone real GDP, from Eurostat, with 2007 fourth quarter — a quarter in which Europe was doing OK, but certainly not experiencing inflationary overheating — set at 100. And I compared it with a trend assuming 2 percent annual growth in potential output, a fairly conservative assumption even for Europe. Here’s what it looks like:

Eurostat, author’s estimate

So a huge gap has opened up between a reasonable estimate of potential output and actual output. Even if you believe that growth in Europe has picked up since the first quarter — and that the pickup will continue — it will take years to close that gap.

The only way you could justify not doing more to promote growth is to assume that potential output has been drastically reduced by the crisis — and if you believe that, you should be working day and night to reverse that decline.

The idea that policy has done enough is just crazy.

Karl Rove now tells us that his “biggest mistake” was not fighting back against the perception that the Bush administration deliberately misled us into the Iraq war. His main evidence that nothing like that happened is the fact that a 2005 commission found no wrongdoing.

Can I say the obvious? That investigation took place amidst a climate of fear. Bush was still riding high; intelligence officials feared retaliation if they spoke out (see Plame, Valerie), and practically everyone inside the Beltway was eager not to open the can of worms involved in admitting that what everyone suspected had actually happened, did.

So what would a real, unintimidated investigation look like? It would look like the inquiry now taking place in Britain. There isn’t much reporting here on this inquiry — but what we’re learning is that Bush and Blair wanted a war, exaggerated intelligence to get it, and disregarded warnings that the war would help, not hurt, Al Qaeda.

Were we lied into war? Yes.

Continuing the Chatauqua on Reinhart-Rogoff: it’s a pretty devastating observation that the only observations of high debt / low growth for the United States come from the immediate postwar years, when post-war demobilization naturally led to falling real GDP. But what about the broader picture?

R-R haven’t released their full data set. But as best I can tell, all or almost all observations of advanced countries with gross debt over 90 percent of GDP come from four main groupings:

1. The US and the UK in the immediate aftermath of WWII
2. Japan after 1995
3. Canada in the mid 90s
4. Belgium and Italy since the late 1980s

We’ve already seen that (1) is a case of spurious correlation. Surely (2) is largely a case of causation running the other way, from Japan’s slide into slow growth and deflation to its rising debt. As for (3), advocates of austerity have been using Canada in the mid-90s as an example of a success story; surely they can’t have it both ways. This leaves (4); but my first take would be that both Belgium and Italy have problems that have both inhibited growth and led to a runup of debt.

I may have missed some small-country examples; but surely they wouldn’t change the picture. There really, truly isn’t anything there.

One of these days someone will write a sequel to Liaquat Ahamed’s Lords Of Finance; where LoF was about the men who helped the Great Depression happen, Lords of Finance: The Next Generation will be about the men who helped turn the financial crisis of 2008 into a lost decade of high unemployment and deflation.

And Jean-Claude Trichet will clearly be among the main protagonists.

His column in today’s FT is almost a caricature of the austerity genre. Trichet’s explanation of why we must fear the invisible bond vigilantes would be funny if it didn’t have such serious consequences:

In extraordinary times, the economy may be close to non-linear phenomena such as a rapid deterioration of confidence among broad constituencies of households, enterprises, savers and investors. My understanding is that an overwhelming majority of industrial countries are now in those uncharted waters, where confidence is potentially at stake. Consolidation is a must in such circumstances.

Ask yourself, what evidence does he present in that passage? None, because the reality is that bond markets don’t look at all worried. What model does he refer to? None; the vague reference to “non-linear phenomena” is a giveaway that there’s no there there. So what are we to rely on for his definitive judgment that “consolidation is a must”? His “understanding” that “confidence is potentially at stake.” This is a basis for policy that affects hundreds of millions of workers?

Meanwhile, I don’t know whether I’m reading too much into this, but Trichet seems to be backing down a bit on the claim that fiscal contraction is actually expansionary — maybe because the alleged evidence for that proposition has been pretty thoroughly debunked, with everyone who’s looked at it seriously realizing that all of the alleged cases involve either an export boom, a sharp fall in interest rates, or both, which makes them irrelevant to our current situation.

But the message is now free-standing, relying neither on theory nor on evidence: austerity now now now.

I’ve received some interesting correspondence on my Rogoff post; basically, it turns out that there’s more controversy than I realized over the dates of past financial crises. More on that when I’ve digested the information. Meanwhile, I thought I could flesh out my critique with a picture.

In the now widely cited paper Growth in a Time of Debt (pdf), R-R claim to find a strong relationship between debt in excess of 90 percent of GDP and slow growth. They specifically highlight the case of the United States. But as I tried to point out, when it comes to the US case, all of the high-debt slow-growth years in their sample come from the post-World-War-II demobilization era.

So here’s a picture that makes the point; data from 1941 to 2001. On the horizontal axis is the ratio of gross federal debt to GDP in the previous year; on the vertical axis the growth rate. (Wanna bet I get comments complaining that the axes aren’t labeled?) I’ve linked the points, with arrows indicating the direction of evolution over time.

As you can see, all — all — of the high debt/negative growth observations come from 1945 (when demobilization started) and the few years thereafter.

You might say that this is just one country — but it’s the country R-R themselves chose to highlight as illustrating their point. And I know that at least one other high debt/slow growth story has similar problems: Japan’s high debt years all lie in the era of deflation, and the natural presumption is that the country’s macro problems caused high government debt, not the other way around.

So this just isn’t careful work. And it should not be coloring policy discussion the way it is.

He calls on the Fed to implement a plan based on the ideas of someone the central bank seems to have been ignoring — a macroeconomist by the name of Ben Bernanke.

We don’t know how well the Gagnon plan would actually work — but there’s no harm in trying, and large potential benefits. The only possible reason for the Fed not to be more aggressive now is fear of embarrassment, of not getting big results. And that’s no reason to sit still while the Fedfail Index keeps deteriorating.

Ben Bernanke’s testimony today, as expected, lacked all sense of urgency. Hey, the economy’s a bit disappointing, and maybe someday we might think about doing something about it …

In my view, the Fed is too optimistic. When Bernanke says that

Most FOMC participants expect real GDP growth of 3 to 3-1/2 percent in 2010, and roughly 3-1/2 to 4-1/2 percent in 2011 and 2012.

he’s telling the truth — but haven’t those forecasts already been overtaken by events? Less than 3 percent growth in the 1st quarter; probably only around 2 in the 2nd; to make more than 3 we’d have to see accelerating growth from here on, and all signs point the other way. Not to mention the fact that stimulus is going into reverse.

But forecasts aside, we really have to bear in mind that the Fed is failing in fulfilling its dual mandate, price stability and full employment. I thought it might be convenient to have a simple measure of just how big the failure is; let’s call it the Fedfail Index. It’s related to the Taylor rule, but instead of offering a rule of thumb for the Fed funds rate, it measures how far unemployment and inflation are from their presumed targets.

The rule I’ve chosen takes its coefficients from the Rudebusch version of the Taylor rule; 1.3 times the deviation of unemployment from 5 percent + 2 times the deviation of core inflation (CPI) from 2 percent. So it’s 1.3* ABS(unemployment – 5) + 2* ABS(core inflation – 2). You can make up your own version; I don’t think it will look very different.

Here’s what you get:

What this little exercise conveys is that the situation is deteriorating, not improving: unemployment is down slightly, but we’re drifting closer to deflation.

Bernanke’s answer to all this seems to be that the Fed is doing a lot. But it’s obviously not enough — the central bank is supposed to deliver results, not get an A for effort. And those results aren’t coming.

After posting a brief note on Ken Rogoff’s piece in today’s FT, I realized that it might be helpful to say a bit more about where I differ from him.

Read more…

This AP story on Bernanke’s testimony contains editorializing disguised as reporting:

Even though the prospects of deflation — a widespread and prolonged drop in prices for goods, the value of stocks and homes and in wages — is remote, some Fed officials are worried about it. Keeping rates low would help prevent deflationary forces from taking hold.

How does the AP know that the prospects for deflation are remote (and note the implicit suggestion that worried Fed officials are a bit strange)?

Here’s what has happened so far:

In the face of high unemployment over the past two years, core inflation has fallen from more than 2 percent to less than 1 percent. All mainstream forecasts call for unemployment staying high for at least two more years, and probably more than that. Maybe that won’t lead to deflation — but it’s surely not outlandish to say that it will.

You keep getting things like this in economics reporting; things that are just opinions – and not even consensus opinions, by a long shot — get reported as fact. And strange to say, it’s always one side of the debate that gets this kind of treatment.

From Alec Phillips at Goldman Sachs (no link):

Congress looks increasingly unlikely to extend ay more fiscal aid to state governments, despite ongoing shortfalls in state revenues, and they have already let several other items lapse. We are therefore removing from our estimates an assumption of further fiscal stimulus beyond the policies in law (including this week’s unemployment extension), though we continue to expect extension of most of the expiring 2001/2003 tax cuts. This adds almost a full percentage point to the drag on growth from Q4 2010 to Q4 2011 to what we had already estimated.

A completely baffling piece in the FT. Leave aside the fact that — in the only number presented in the whole piece — he cites his recent work with Reinhart on debt/growth, which is highly questionable. Where I really lost him was when he says,

The academic evidence on Keynesian growth effects of fiscal deficits is thoroughly inconclusive. Ironically, a lot of the newfound conviction comes from the casual empiricism on the growth effects of the Bush tax cuts …

What? Who’s citing the Bush tax cuts in this debate? Not me, surely; not Brad DeLong; not Christy Romer; not Barry Eichengreen; not Jamie Galbraith. I have no idea where Ken got that, although I suspect that he vaguely imagines that Mankiw citing Romer and Romer had something to do with it, which it didn’t.

Anyway, debate over the biggest policy issue facing the world today should not be based on what you think you heard someone say other people are saying.

There’s a new report out from Ireland’s Economic and Social Research Institute (pdf) calling for even more austerity, arguing that this will lead to faster economic growth. And the report looks authoritative: it’s full of charts and tables, and frequently refers to an underlying quantitative model.

What the careless reader might miss, however, is the fact that the policy conclusions are not, in fact, derived from the analysis — they come out of thin air. The authors simply assert that more austerity now would lead to a lower risk premium and hence higher growth, based on no evidence I can see. They don’t even offer any quantitative assessment of the extent to which more austerity while the economy is still depressed would reduce future debt burdens. In short, it’s a pure appeal to the confidence fairy.

One more thing: a key element in the ESRI analysis is the assumption that the financial crisis has permanently lowered Ireland’s growth track. That may be so — but if it is, a large part of the reason is the effect of a prolonged slump on investment and structural unemployment (the long-term unemployed tend to stay that way even after recovery). Now, some of us would argue that these effects suggest that government should do all they can to avoid prolonging the slump even further, that austerity may be self-defeating. But such concerns don’t even get mentioned.

The state of economic discourse these days, on both sides of the Atlantic, is deeply depressing — in at least two senses.

So I don’t know if readers have been following the Shirley Sherrod affair. It goes like this: Ms. Sherrod was an Agriculture Department official; a right-wing blogger released clips of a video that purportedly showed her making racist remarks; the clips were featured big on Fox News; and the Obama administration promptly fired her.

But whaddya know, the scandal was fake. The clips were taken completely out of context. It was basically as if I said, “Some people say that violence is always the answer; they’re wrong”, Fox ran with the story “Krugman says violence is always the answer”, and the Times fired me.

What’s shocking here isn’t the behavior of the right, which was par for the course. It’s the seemingly limitless credulity of the inside-the-Beltway crowd. I mean, there’s a history here: ACORN, Climategate, Vince Foster, Whitewater, and much much more. (Someone recently reminded me that the GOP held two weeks of hearing on the Clinton Christmas card list.) When the right-wing noise machine starts promoting another alleged scandal, you shouldn’t suspect that it’s fake — you should presume that it’s fake, until further evidence becomes available.

So now Tom Vilsack, the Agriculture secretary, says that he may “reconsider”. I’d lay even odds that the Sherrod firing stands, even though it was totally unjust, because people in DC are so accustomed to cringing in the face of the right that they just don’t know how to stop.

As I noted in this post, the debt-GDP ratio rose much more under Hoover than it did under FDR:

This doesn’t show that FDR was more frugal than his predecessor; it reflects the fact that GDP crashed under Hoover, while rising quite rapidly, from a low base, during the New Deal.

The picture is even more striking if you look at interest payments on federal debt as a percentage of GDP, which were kept down by Depression-era low rates:

By this measure, the debt burden peaked in 1933, and basically declined until the 1938 recession, which was partly due to FDR’s premature embrace of austerity.

Now, none of this is a clean experiment; there were monetary policies going on, and the 1929-33 recession would probably have given way to at least some recovery whoever was in the White House. But the experience of the 30s offers no support to those who worry about the debt consequences of deficit spending in a depressed economy — FDR didn’t do enough stimulus, but the spending he did do was not reflected in a spiraling, or even rising, debt burden. And the evidence is consistent with the view that austerity, Hoover-style, may well be self-defeating even in a narrow fiscal sense.

By the way, the debt and interest data come from the Millennial Edition of Historical Statistics (subscription required).