Unpacking Casey Mulligan’s argument about strong fundamentals

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University of Chicago economist Casey Mulligan had a provocative piece on the New York Times op-ed page last Friday arguing that, financial crisis or no, the economy would be okay. The reason he’s so sure? The strong performance of a measure he calls marginal product of capital:

Since World War II, the marginal product of capital, after taxes, has averaged 7 percent to 8 percent per year. (In other words, each dollar of capital invested in the economy earns, on average, 7 cents to 8 cents annually.) And what happened during 2007 and the first half of 2008, when the financial markets were already spooked by oil price spikes and housing price crashes? The marginal product was more than 10 percent per year, far above the historical average. The third-quarter earnings reports from some companies already suggest that America’s non-financial companies are still making plenty of money.

The marginal product has accurately reflected hard economic times in the past. From 1930 to 1933, for instance, the marginal product of capital averaged 0.5 percentage points per year less than the postwar average. The profit per dollar of capital was also below average in the year before the 1982 recession and the year before the 2001 recession. Sure, the financial industry has taken a hit, and so have cities like New York that depend on that industry. But the financial system is more resilient today than it has been in the past, because it’s a much easier industry for companies to enter than it was in the 1930s.

When I read that, I immediately wondered: What about 1929? Then I found a blog post by Mulligan that includes an essential detail edited out of the NYT piece:

Compare this to the marginal product of capital in 1930-33 (the years of Depression-era bank panics): 0.5 percentage points per year less than the postwar years and significantly less than in 1929.

I later took a look at a chart Mulligan had made (it’s on page 12 of this paper), and it turns out that marginal product of capital was high throughout the 1920s–higher than it has been in the 2000s. Meaning that the marginal product of capital is perhaps not a flawless predicter of future economic performance. When I called Mulligan and asked him about this, he agreed that if we had severe deflation as in the early 1930s, all bets would be off. He just doesn’t think today’s Fed would allow that to happen. And his data do show that marginal product of capital has in the past fluctuated far less than interest rates. That is, financial markets are far more volatile than the real economy. Which was controversial when Bob Shiller pointed it out back in 1981, but shouldn’t really surprise anybody now.

So Mulligan’s (unstated) argument No. 1 is that this isn’t the 1930s–which is not something that can be inferred from his marginal product of capital charts, but is probably valid.

Argument No. 2 is that, absent complete financial breakdown, the real economy is not as closely tied to the financial economy as a lot of people think. This can be inferred from Mulligan’s charts, but it’s worth noting that his charts represent only the U.S. experience–not that of countries like South Korea or Chile or Sweden that have been through major financial crises in recent decades.

Argument No. 3 is that because marginal product of capital has been pretty high lately, we will sail through the current crisis nearly unscathed. I don’t think Mulligan offers enough evidence to make that prediction with any kind of confidence. But I do agree that measures like marginal product of capital and productivity growth (Mulligan focuses on the former because it’s not nearly as volatile as the latter) say a lot about the ability of the U.S. economy to recover from the current crisis and recession. Which is what I wrote my column about this week.