I once read all the New York Times from the 1930s (on microfilm.)  You can’t even imagine how frustrating it was.  They knew they had a big problem.  Then knew that deflation had badly hurt the economy (including the capitalists.)  They new that monetary policy could reflate.  And yet . . .

Weeks went by, then months, then years.  Somehow they never connected the dots.

“Monetary policy is already highly stimulative.”

“There’s a danger we’d overshoot toward too much inflation.”

“Maybe the problems are structural.”

“There are green shoots, things are getting worse at a slower pace.  The economy needs to heal itself.”

“Consumer demand is saturated.  Even workingmen can now afford iceboxes and automobiles.  We produced too much stuff in the 1920s.”

And the worst part was the way political news kept slipping into the financial section.  Nazis make ominous gains in the 1932 German elections, Spanish Civil War, etc, etc.  In the 1930s the readers didn’t know what came next—but I did.

Thankfully we can learn from their mistakes.

Stocks, oil, and bond yields plunge on investor fear of (high inflation/low inflation.)  Pick one.

This is what tight money looks like.

Two extreme models of the macroeconomy have recently been discussed on the internet.  On the extreme right you have Casey Mulligan, arguing that demand shocks can’t explain high unemployment, and that our economy is faced with a supply problem.  If workers cut wage demands we could return to full employment.  On the extreme left people like Paul Krugman argue that wage cuts won’t boost employment at all; instead they will simply depress AD even further.

In the middle is the sensible AS/AD model, with downward-sloping AD curves and upward sloping AS curves.  The textbook workhorse.  This is the model that accurately describes the US economy.  If AD declines, output will also decline (due to the upward sloping SRAS curve.)  If workers accept pay cuts, then SRAS will shift right and output will increase.

Neither the Mulligan nor the Krugman models are consistent with the empirical evidence.  We know that autonomous increases in wages do reduce AS and employment, as with the NIRA.  So we can’t assume that the effect of wages on AD (if any), will offset the effects of wages on AS.  Indeed the opposite is likely to be true.  Imagine a central bank targets inflation.  Now lower wages and shift AS to the right.  What happens?  Prices would fall if the central bank did nothing, so it will increase the money supply enough to shift AD to the right by enough to maintain stable prices.  Of course real world central banks do not succeed in hitting their inflation targets precisely (as I showed in my previous post.)  But they certainly pay enough attention to inflation to prevent an increase in AS from actually decreasing output.

Mulligan’s approach is also inconsistent with the empirical evidence.  When there is a large exogenous negative monetary shock, which reduces NGDP, you will observe a rise in the rate of unemployment, rather than simply a fall in the price level.  If labor markets are flexible, output will recover within a year or two (as in 1921-22.)  If wages are sticky, output will recover much more slowly (2009 – ???)

Both Krugman and Mulligan are partly right.  More monetary stimulus really would reduce unemployment (at least if it succeeded in raising NGDP.)  Krugman’s right about that.  And cutting the minimum wage and reducing maximum UI benefits really would reduce unemployment.

A competent government would do all of those things.  An incompetent government would do none of them.  Which one are we?

PS.  I haven’t actually read enough of Mulligan to know that he thinks demand stimulus wouldn’t help.  He says Keynesian theory should be discarded, which I took as meaning demand-side theory should be discarded.  But perhaps he’s just attacking the more extreme Krugmanian version of Keynesian theory, as Tyler Cowen argues.  If someone finds a link where he supports demand stimulus I’ll add an update.

Here’s a passage from a recent AER paper by Pierpaolo Benigno and Luca Antonio Ricci:

This paper offers a theoretical foundation for the long-run Phillips curve, by introducing downward nominal wage rigidities in a DSGE model with forward-looking agents and flexible-goods prices, in the presence of both idiosyncratic and aggregate shocks. .  .  .

Several important implications arise. First, the optimal inflation rate may not be zero, but positive, as inflation helps the intratemporal and intertemporal relative price adjustments, especially in countries with substantial macroeconomic volatility or low productivity growth. Second, the ideal inflation rate could differ across countries (and in particular it would be higher in countries with larger macroeconomic volatility and lower productivity growth), and may change over time. Third, stabilization policies can play a crucial role, as they can improve the inflation-output trade-off.

Additional theoretical implications arise. First, the overall degree of wage rigidity is endogenously stronger at low inflation rates and disappears at high inflation rates, unlike in time-dependent models of price rigidities where prices remain sticky even in a high-inflation environment. This arises from the endogenous tendency for upward wage rigidities (as in Elsby 2009), resulting from forwardlooking agents anticipating the effect of downward rigidities on their future employment opportunities. Second, this endogenous wage rigidity also introduces a trade-off between the volatility of the output gap and the volatility of inflation, as at low inflation adjustments occur mainly via changes in output and at high inflation via changes in wages. Third, the Phillips curve may arise not only from the need for intratemporal relative price adjustments across sectors in the presence of downward rigidities (as in the traditional view), but also from the need for intertemporal relative price adjustments, which open the way for the important role of macroeconomic stabilization policies discussed above. Fourth, nominal shocks can have high persistent real effects, suggesting that introducing downward wage inflexibility in a menu-cost model à la Golosov and Lucas (2007) would likely change their conclusion that nominal shocks have only transient effects on real activity at any level of inflation.

So there are models that predict persistent output gaps as a result of downward nominal wage rigidity, especially near zero inflation.  And remember we have conclusive evidence that nominal wages do exhibit downward rigidity, especially near zero inflation.

In the same issue of the AER, Peter Diamond has some interesting comments on the structural/demand-side debate:

Second, for the current moment, the argument about the aggregate demand side is academic, in the negative sense of the word. Current estimates I have seen of how much of the increase in unemployment from a few years ago is “structural,” rather than due to inadequate aggregate demand, still leaves enough need for aggregate demand stimulation that it is clear what direction is needed for further policies.

Third, I am skeptical of the value of attempting to separate cyclical from structural unemployment over a business cycle. When firms evaluate candidates for positions, they consider the quality of the match of available candidates, projections of the availability of new candidates, and the value to the firm of filling the slot. That is, the willingness to hire for a given quality of match depends on expectations about the profitability of investing in a new worker and about the likely pool of future applicants.

The tighter the labor market and the more valuable the filling of a vacancy, the more a firm is willing to hire a worker who is a less good match and who may need more training. In other words, a worker who might be viewed as structurally unemployed, as facing serious mismatch in the current state of the economy, may be readily employable in a tight labor market. The common practice of thinking about the extent of unemployment as a sum of frictional, structural, and cyclical parts misses the point that the tightness of the labor market affects worker quitting decisions and affects employers’ willingness to hire an applicant who needs more training. In so far as direct measures of frictional or structural unemployment are dependent on the tightness of the labor market, they have limited relevance for the design of demand stimulation policies. The idea that the US economy is not adaptable and capable of dealing with the need for skills and jobs to adapt to each other is peculiar, given the long history of unemployment going up and down.

Those are two themes I’ve emphasized.  Structural and demand-side problems are deeply entangled, indeed I think the problem is even worse than Diamond does–as he puts little weight on the UI benefit extension to 99 weeks.  And second, even if we have major structural problems, there is still a clear need for demand stimulus.

You might wonder how I can sleep at night knowing my policy proposal, if enacted, might simply lead to higher inflation, without creating any jobs at all.  My answer is very simple.  Even if I knew that dismal outcome would occur, I’d still favor monetary stimulus.  I believe steady growth in NGDP is optimal, even if fluctuations in NGDP don’t affect employment.  But let me explain my reasoning using the more familiar inflation targeting criteria.

As you know, the Fed has a dual mandate, stable prices and high employment.  They’ve generally assumed that stable prices mean roughly 2% core inflation, for complicated reasons.  And core inflation has been around 2% during recent decades.  If you favor inflation targeting, you’d like it to stay at that level, as inflation instability can cause problems for the economy.  So how’s the Fed doing?  Here’s a graph I found at Stephen Gordon’s web site:

So both measures of core inflation have run below 2% since the end of 2008.  I also tried to estimate inflation expectations from the TIPS market, which isn’t easy.  I found a TIPS yielding negative 1.05%, due January 2014.  Regular T-notes due at that time yield about 0.25%.  So 1.3% seems a ballpark estimate of inflation over the next 2 and 1/2 years.

This, or course, would be what you’d expect if the Fed’s dual mandate were stable prices and high unemployment, not high employment.  If the Fed didn’t care a bit about the suffering of the unemployed, and was a strict inflation targeter, we’d have 2% inflation.  Instead we are in the middle of five years of sub-2% inflation.  Why is that?  One theory is the Fed is sadistic.  It’s willing to miss its inflation target on the low side if it can inflict suffering on the unemployed.  I admit it’s acting as if this were true, but we all know it’s not true.  Another theory is that the Fed is helping the bankers.  But as we saw in recent weeks, slower NGDP growth hurts the banks too.  My theory is that this big, highly sophisticated institution employing many of the brightest monetary economists on the planet, made a big boo boo.  Needless to say I’m the only one who believes this theory.

But whatever your views, the Fed is in a position where if it does more monetary stimulus in an attempt to speed the recovery, and totally fails to create a single new job, the policy will still be smashing success.  It will still move core inflation closer to its 2% target.

And that, my friends, is why I can sleep comfortably at night.  I am proposing a policy that literally cannot fail.

When there are $100 bills on the sidewalk, they should be picked up.  And when printing $100 bills (for 5 cents) and injecting them into the economy might create lots of jobs, and will not increase the national debt, and might reduce the budget deficit, and will definitely move us closer to the Fed’s definition of price stability, why would we not want to print those $100 bills?  Are we a bunch of masochists?