Racism skews our beliefs about what's possible

Racial economic injustices of the past and present do not have to be our future. But that's what tools like potential output assume, so it's time for new tools.

“Fears of a Too Hot Economy Ignore Racial Inequality,” my recent piece for Bloomberg Opinion discusses how “potential output”—an abstract concept that inflation hawks have wielded against economic policies—takes systemic racism in the labor market as immutable. It’s not. I lay out the problem here and suggest three ways to improve our tools and thus improve the economic advice we give.

To be honest, I had never thought about the racial assumptions in estimates of potential output, despite using it throughout my career in macroeconomics. I knew the tool had flaws, as I wrote about in an earlier post. Then Gbenga Ajilore asked me in disbelief about a post he’d seen on its racial assumptions. It took someone outside of macroeconomics, someone who is a Black man economist, to wake me up and get me to dig into the methodology. I am so happy he did. It’s unacceptable.

First, a definition of the concept:

What is “potential output,” and why is it central to the debate over fiscal policy? Simply put, it is an estimate of how much gross domestic product the U.S. can produce given how much people want to work, the capital that businesses have and how effective these inputs are at making stuff, namely, productivity. The conventional thinking is that producing more than potential will “overheat” the economy, leading to much higher inflation.

Olivier Blanchard, a top academic macroeconomist who served as the Chief Economist at the International Monetary Fund, has used estimates of potential output from the Congressional Budget Office to argue recently against Biden’s rescue package. He claims that the latest legislation would push GDP past its potential and reminds us how that had been disastrous in the past:

A relevant comparison here is what happened in the 1960s, shown in the figure below...From 1961 to 1967, the Kennedy and Johnson administrations ran the economy above potential, leading to a steady decrease in the unemployment rate down to less than 4 percent … In 1967, however, inflation expectations started adjusting, and by 1969, inflation had increased to close to 6 percent and was then seen as a major issue. Fiscal and monetary policies tightened, leading to a recession from the end of 1969 to the end of 1970.

Correlation is not causation. Couldn’t other factors be at play? Regardless, one result of the stagflation of the late 1970s was a firm belief among economists that unemployment too low, an economy operating past its potential output, would lead to inflation and then only a severe recession could bring it back under control.

But how do we know how low unemployment can go? Basically we guess and lean hard on history to predict the future. Alex Williams at Employee America calls attention (the post Gbenga mentioned) to racial assumptions in the CBO’s estimate of the natural rate of unemployment, a key component of potential output:

So, CBO assumes unemployment rates in different age and racial groups in 2005 are the lowest we can attain without sparking inflation. Why 2005? The Black unemployment rate then was 10%. How can 1 in 10 Black workers without a job be an economy at its full potential? And before you point to “structural factors” as a cause of racial disparities, remember that Black unemployment was 6% in 2019—well below its level in 2005—and that was a time with low inflation.

The flaws in estimating potential output and the natural rate of unemployment go back to the very beginning. In some ways it started out well. Art Okun, while on staff at Kennedy’s Council of Economic Advisers, developed the measure. He was part of a movement by the CEA led Walter Heller to shifted the economic goal posts from debt sustainability to full employment. That’s good and an ongoing fight.

Ah, but full employment was inextricably linked to inflation even then. That’s an economist ‘innovation’ that now is ‘doctrine.’ In contrast, the goal of the Employment Act of 1946 is “conditions under which there will be afforded useful employment for those able, willing, and seeking to work .” No one wants their paycheck eaten up by rising prices, but for millions of Black families there is no paycheck from which to eat. The 4% unemployment rate that Okun proposed as the best we can do was around 8% for Black workers. That’s better than CBO’s assumptions now but not by much.

To be relevant in the current policy debates, economists must accept the need for new tools and new thinking. Inflation is not what’s holding us back. It’s an economy riddled with racism and injustice. The Administration and Democrats in Congress are pushing policies that are designed to combat inequities in our economy—from a robust recovery for all to clean drinking water to good jobs in care work. These efforts to change the system cannot be evaluated by metrics stuck in the past.

Our thinking should be defining the potential of the economy in terms of future opportunities for all workers, not the historical barriers that some have faced. Using the current approach to potential output to evaluate government programs implicitly accepts that discrimination is embedded in the economy. An unobservable, educated guess based on embedded racism should not be used to judge programs designed to push the economy to full employment and reduce inequality.

The Federal Reserve is feeling its way toward new metrics, though it too lacks a working definition of “maximum employment,” despite it being part of its dual mandate. Even so, to hear Chair Jay Powell and a chorus of Fed officials draw attention to the million jobs lost in this crisis and the crushingly high unemployment rates, especially among Black and Brown workers is notable. The Fed has steadfastly, downplayed the risks of overheating, that is, inflation spiraling out of control. They even changed their framework in an attempt to break their long history of overreacting to inflation. Jay’s test is coming, and he’s ready. But that’s not enough.

Second, we need more timely and more detailed economic data by race, gender, and their intersection that can inform policy. Rhonda Vonshay Sharpe, founder and president of the Women’s Institute for Science, Equity and Race and Bloomberg Opinion contributor, explain that with existing data and standard analysis, we cannot fully grasp the suffering among minorities in this crisis and the challenges they face. Money allocated to statistical agencies to enrich their data would pay off in terms of better policies.

A reader asked why I only discuss disparities among Black and Hispanic workers in my piece. What about Asians like him? That’s a fair point, as is the exclusion of Native Americans, who live with some of the most severe economic conditions in the country. Again, with better data we could pinpoint the groups who are being left behind historically. It’s especially urgent now. We know many people of color have been hard hit in the Covid crisis, with elevated death rates and as essential workers exposed to the virus every day. We are not back on track until everyone is back on track.

Finally, we must understand that discrimination is holding back economic potential. The $180 billion for research and development in the American Jobs Plan won’t attain its maximum impact if we don’t include researchers, such as in sciences, engineering, and medicine, who are also minorities. Lisa Cook, a professor at Michigan State University, found that discrimination and racial violence in the 19th and early 20th centuries led to 60% fewer patents by Black inventors during the period. A recent survey by the Information Technology & Innovation Foundation found that Black people make up 0.3% of innovators, far below their 11.3% share of the population. That lack of diversity reduces GDP and our true potential.

Systemic racism is immoral. It harms people due only to the color of their skin. And it’s an economic disaster. The concept of potential output and how far we are from it is an important, albeit abstract. However, it’s worse than useless if we define it in ways that accept discrimination at work, accept the scientific breakthroughs we never had, and accept economic lives held back as a permanent feature of American life.

Reaching our potential is about getting the last person across the finish line. Thinking “on the margin” is a powerful lens in economics. One we must apply here too. The average worker does not tell us much about how far we are from full employment. It’s the people on the cusp of getting jobs—often come from marginalized groups, economically depressed areas, and have less education—who tell us how close we are. Getting us across the finish line as a country, means getting those people there too. Potential output as we estimate it today using our dismal past is not helping. Applying it ruthlessly to argue against policies that could serve the underserved is self defeating.

It’s time for economists to update our tools and open our minds to what’s possible, and it’s time for policy makers to engage with the economic realities of systemic racism and fight to end it. And we need better tools to do it.