In his recent post, Eli Dourado raises a number of interesting points:
The empirical point is summed up in the graph below. NGDP grew around 5 percent per year until around 2008, and then it fell, and then it grew at around 5 percent””or slightly less””per year again beginning in mid 2009. These facts are well known, but I bring them up here because they do constrain the kind of stories we can tell about the economy. Any story you tell has to contain a one-time shock that ended years ago, and it has to be consistent with NGDP that has grown at about the same rate over the last 3 years as it did before the shock arrived.
To be precise, NGDP has grown at a 4.1% rate over the last three years. Normally NGDP would grow faster than trend during a recovery, which means the Fed added insult to injury. If NGDP had grown at 5%, then RGDP would have also grown faster, and unemployment would be lower than 8.1%. But I accept Dourado’s broader point—you’d have expected wages to have mostly adjusted by now, and thus you’d have expected more progress on unemployment, even with a 4.1% NGDP growth rate. But the fact of the matter is that nominal wage growth has not slowed in tandem with NGDP growth. The facts are incontrovertible:
Take a close look at that graph (courtesy of George Selgin.) That’s not just roughly what the sticky wage theory would have predicted, it’s EXACTLY what the sticky wage theory would have predicted. The
ratio of NGDP to nominal wages ratio of nominal wages to NGDP soared in 2008-09, and unemployment soared from 5% to 10%. Then nominal wage growth slowed modestly, and this slightly reduced the ratio of wages to NGDP. And of course unemployment fell slightly, from 10% to 8.1%. The theory fits the data perfectly.
[The post initially got the W/NGDP ratio backwards.]
That’s leaves Dourado with just one valid complaint; market monetarists haven’t explained why nominal wage growth fell only modestly, despite high unemployment. But here’s the problem, the brightest minds in macro have been unable to find plausible microfoundations for the standard macro model. I’ve offered several suggestions:
1. The zero lower bound produced by money illusion, combined with the fact that wages are still rising in healthy sectors, or sectors shielded from market forces.
2. The 40% boost in the minimum wage at the beginning of the recession.
3. The unusually long extension of UI benefits, which made our labor market more “European.”
4. A long term trend toward a growing share of national income going to capital, which makes the need for wage reduction even greater. This also helps explain why corporate profits are doing well in the recession.
But even I don’t think these are completely persuasive. So I try to take a pragmatic view of all this. If the best minds in the profession can’t come up with plausible microfoundations, then how am I supposed to do so? Why should I even try? I can’t even figure out why the NFL says that wasn’t an interception last night!
Given our limited knowledge, what sort of advice should we give our monetary policymakers? Let’s break the problem down into pieces:
A policy of NGDPLT is a nice safe choice when there’s lots of uncertainty about which macro model is correct. I gather that Dourado agrees on this point.
That means the entire debate is on where to start the new trend line, if the Fed adopts that sort of plan. Some favor going all the way back to the pre-2008 trend line, which would call for a period of rapid NGDP growth. Critics say that would risk another destabilizing boom.
Others say start the new trend line right here, and aim for 5% NGDP growth going forward. To that group I say that under current policy we are likely to fall a bit short of 5% NGDP growth. So if that’s your position then you should not only favor QE3, you should be calling for QE4.
I believe the balance of factors suggests that the safest choice is to go about 1/3 of the way back to the old trend line, and then level off at 5%. That’s based on the following pragmatic judgments:
1. I fully accept that the natural rate of unemployment might have risen to 8.1%, as it has in France, Spain, and Italy. But it’s by no means clear this has occurred. In the US the natural rate has probably been in the 4.5% to 6.5% for over 70 years. It’s never been close to 8.1%. So I regard 8.1% as very unlikely.
2. If it did rise to 8.1%, the most likely explanation is that the policies I mentioned above (minimum wage increase, extended UI, etc) caused the increase. But monetary stimulus would help on both fronts; reducing the real minimum wage (which never would have been passed had Congress know how little NGDP growth we were going to get) and also causing Congress to reduce the maximum UI benefit more quickly, as they do after every previous recovery from a recession.
3. David Glasner showed that equity markets are clearly rooting for higher inflation. That was true in the 1930s, but generally is not true during periods when the economy is close to the natural rate.
4. Ten year bonds yield 1.7%, suggesting we are much more likely to err on the side of excessively slow NGDP growth, a la Japan, than excessively rapid growth.
5. We know that nominal wages are very sticky, and that unemployment closely tracks the ratio of wages to NGDP. It is POSSIBLE that faster NGDP growth would merely lead to higher wages, and no gain in jobs, but how likely does that seem in this sort of labor market?
6. Level targeting calls for a catch-up period, and NGDP growth over the last 4 years has been the slowest since Herbert Hoover was President, about 2% per year. Admittedly the case for “catch-up” gets weaker as time goes by (a point on which I agree with Dourado) but I don’t think that the catch up argument has completely gone away.
That’s why I end up favoring going 1/3 of the way back to the old trend line. I balance Dourado’s very good arguments for caution, with what I see as very powerful arguments that the economy is still depressed by a lack of demand.
Ultimately it’s a judgment call, and I’d like to reiterate that in the long run the issues we agree on, (NGDP targeting) are far more important than the issues where we disagree (where to start the trend line.)
Regarding the Berger paper mentioned by Dourado, I don’t have time tonight to take a close look, but here are a few initial reactions:
The previous two recessions saw small drops in NGDP growth, and slower than normal recoveries. So there’s really no big mystery to explain, except to the extent that productivity behaved abnormally. I’ll accept Berger’s claim that it did, but it really doesn’t explain much, at least in this recession. The unemployment rate is not surprisingly high, it’s surprisingly low given the sub-3% RGDP growth since unemployment peaked at 10%. Indeed it’s not clear why unemployment fell at all. (I’ve had posts called “our job-filled non-recovery.”) And in the 2001 recession unemployment peaked at 6.3%, which probably isn’t much above the natural rate. I wasn’t complaining about tight money in 2001, it’s the recent recession that is the outlier.
So yes, things change over time and cycles today are different from the 1950s, just as they were different from the 1920s. But I fail to see how sudden drop in NGDP and RGDP could not be quickly reversed. It’s a mistake to think in terms of firms rehiring the workers they laid off. My understanding is that this doesn’t occur all that often. In a normal year where there is a net job creation of 1 million, you might have 29 million jobs lost and 30 million jobs gained. Most laid off workers go on to different firms. With that massive churn, it’s not at all difficult to create a couple million more net jobs if the economy starts from a depressed condition and the Fed makes sure we have rapid NGDP growth, as in 1983-84.
P.S. Eli also had this to say:
I assume that when he says “cutting-edge” he is not referring to the papers cited in Ryan’s post, since those are both from the 1980s.
Well at least he’s more polite than other bloggers. For a dinosaur like me who went to grad school in the 1970s, anything after 1980 is “cutting-edge research.” Remember that Steven Wright joke; “About 20 years ago . . . no wait, it was just last week.” That’s me—in reverse.
PPS. Ramesh Ponnuru has one of the best pieces on NGDP targeting that I’ve ever seen by a journalist.