David Henderson quotes from a email by Jeff Hummel:
Most explanations for the current persistence of high unemployment fall into one of three broad categories:
1. Insufficient aggregate demand. This is the position of the Sumnerites who advocate more monetary stimulus and the Keynesians who advocate more fiscal stimulus. While I agree with Scott Sumner that Bernanke’s monetary policy was too tight when the crisis hit during 2007-2009, I think that is irrelevant now. Why hasn’t there been sufficient time for inflexible wages or prices to adjust?
A few points in response:
1. Most other explanations (such as policy uncertainty) also require sticky wages to explain high unemployment.
2. The 2008-09 slump was different from all other deep recessions in one key respect. After the severe 1907, 1921, 1929-33, 1937-38, 1957-58, 1974-73, and 1981-82 slumps, NGDP recovered rapidly. This time the recovery was very slow. Hummel seems to accept my view that the big crash in NGDP (due to bad monetary policy) pushed unemployment from 4.5% in 2007 to 10% in late 2009. Can that explanation explain why unemployment has only fallen to 8.3%?
From a common sense perspective the answer is no. Common sense would suggest that wages and prices should have adjusted by now to the negative nominal shock. But there’s another way of thinking about the problem that makes my argument much more plausible. Let’s start with the fact that we really don’t understand wage stickiness very well. Most people visualize long term contracts that get renegotiated, but it’s also about things like minimum wages (which were raised sharply), government unions, money illusion at the zero rate increase point, protected sectors like education and health care, etc. It’s a very complex labor market. So let’s consider sticky wages a sort of black box that we don’t fully understand.
Now let’s consider the stylized facts:
1. Nominal shocks have real effects, just as the sticky wage theory would predict.
2. Big nominal shocks have big real effects, just as the sticky wage theory would predict.
3. Fast NGDP growth during recoveries is associated with fast recoveries in employment, just as the sticky wage theory would predict.
4. The extremely slow recovery in NGDP after 2009 was associated with an unusually slow recovery in employment, just as the sticky wage theory would predict.
5. Wage growth slowed sharply after 2008, just as the sticky wage theory would predict.
6. Aggregate wage growth never fell below zero, which is hard to explain from long term contracts alone, but can perhaps be explained by combining all the factors discussed above, especially money illusion.
7. Given the combination of very slow recovery in NGDP, and wage growth only slowing from about 4% to 2%, you’d expect a very slow recovery. And that’s what we got.
8. But we did get some recovery, despite the fact that NGDP has been growing at below trend during the recovery. So there has been some wage adjustment.
Given that other theories like “policy uncertainty” also require wage stickiness, I’m not really sure what’s gained from moving away from demand-side models. Bernanke experimented with a historically slow recovery in AD (i.e. NGDP), and he got a historically slow recovery. What else would you expect?
In comment sections of recent posts people pushed back against my claim that the collapse in housing didn’t cause the recession, but most didn’t seem to understand the issues at stake. Lots of people talked about how it wasn’t the fall in home-building alone, but that there were also bubbles in areas like commercial real estate. No, commercial RE did fine until the second half of 2008 when NGDP collapsed. Or they said it was the hit to consumers from mortgage defaults, or the hit to banking. But those are channels that would reduce aggregate demand. And if it’s an AD problem, then ipso facto it’s a tight money problem. It’s the Fed’s job to stabilize AD. If you are going to argue against monetary explanations of the crash, you need a non-AD mechanism, such as misallocation of labor into housing construction. One commenter even mentioned the strong dollar in late 2008. That was supposed to be a counterargument to the Fed causing the crash, as if a strong dollar has nothing to do with tight money!