I’m not sure – the large scale “demand” that did occur must have stemmed from a belief that the countries future capacity to produce was greater than it was. The fall in asset prices (which cannot be attributed to credit constraints or expectations) implies that future productive capacity is lower than it was previously expected to be.

Maybe the capacity to produce is undiminished – but in that case it may have previously been overestimated …

Well I guess we really have to ask people – prior to the crisis did you think that the relative value of your assets (over your lifetime) was higher then you would view them now. If we find that people do feel that their lifetime wealth is lower – and if their new expectations are consistent (they won’t suddenly find that they are way richer in the future) then I would take this as a permanent shock.

As a result, like you have said, if peoples wealth is going to reach the level they expected there is no permanent shock. However, if peoples claim on resources is lower than they thought, the realisation will look like a “permanent shock”.

Expectations are so very very powerful – if our expectations have been wrong for so long, then potential output in our future could easily be lower than we expected.

I would also note that there are other countries who should come out in a strong position – all over Asia there has been high savings rates and high capital accumulation, once the dust settles they may start to consume some of the huge increases in wealth they have experienced over times.

He has used the term very widely, and in a number of speeches. It also fits well with the CBO forecast of potential and economic activity.

I agree that there is a way of taking his statement in a different context – but the economic context is definitely there to some degree (says the horrendously biased economist 😉 )

Shock to wealth argument

I absolutely agree with you, that there has been a shock to wealth in the short term but is it really likely to lead to a change in expectations in wealth over the long term ? I suppose there is clear evidence in NZ to a shock leading to a change in long term behaviour, witness the stock market crash of 87, and its long terms consequences on equity participation within the masses in NZ. It would seem to me that alot of this comes down to psychology, the question being ¨..Have I been so scarred that I’m never going to drawn down on my mortgage again..¨ or alternatively ¨My pension is completely stuffed, I’m going to have to save more than I thought!¨ Psychology is hard to measure, surely when the good times arrive the feel good factor will arrive again to cancel out the effect of these shocks?

Over to you Matt

Hmmm, I’m not so sure. Now in tone I am being a little bit facetious so I can see where you are coming from.

However, I think the mention of “capacity” is more than “rhetoric” (I would also note that rhetoric is more than just “rhetoric” – it does still define a position) – it sounds like that word was chosen very specifically to justify the use of government intervention.

Obama seems like an incredibly smart man, and I’m actually very impressed with the statement I quoted – it clearly and succinctly defines an economic position. As a result, I felt that I could discuss it on economic grounds.

My primary thinking is that a change in expectations surrounding US, or even world, capacity has seen agents readjust behaviour. In this setting, even a Kalman Filter would overestimate the true trend as the US will have been borrowing based on future production that will never appear.

Given that current potential output is stating that the US has been running “below potential” for most of the last decade, I get the feeling that this measurement issue is a possibility – although I’m not going to say it is very likely for historical data …

The more likely reason (although it is related in some sense) why potential has fallen is because of structural shocks to the economy. Fundamentally, a realisation that lifetime wealth should lead to a decrease in the current level of potential output, relative to where people think it is.

The shock to lifetime wealth that people have experienced is intense – and it comes from a realisation that their expectations surrounding their lifetime wealth were wrong! In such a situation, society actually has less than it expected – and it has been unwittingly borrowing excessively to fund current consumption.

Also, if we think about the US we know that they are a net borrower. The current crisis has lead to an increase in long-term interest rates as the rate of return required on savings has increased. If we expect this shock to be permanent it will have a negative income effect on net borrowing countries – another factor that will reduce potential output.

Those would be my main structural shocks for the US – therefore they are the factors that have reduced “capacity”.