Do high inflation economies have fewer “structural” problems?
Ryan Avent quotes from a very interesting paper by Guillermo Calvo, Fabrizio Coricelli, and Pablo Ottonello:
This paper documents that, for a sample of post-war recession episodes in advanced and emerging market economies (EMs), financial crises tend to be followed by jobless recoveries in the presence of low inflation and by “wageless” recoveries in the presence of high inflation…
In advanced economies, where inflation in the post-war era has been relatively low, financial crises have been followed by jobless recoveries of intensity significantly stronger than “normal” recessions…
In EMs, heterogeneity in inflation allows us to divide the sample in “high” and “low” inflation episodes. We find again a sluggish adjustment of labor markets during the recovery from financial crises, but the nature of such adjustment depends on inflation. “High inflation” recession episodes are not associated jobless recoveries but wageless recoveries. This is consistent, empirically, with the findings in Calvo et al (2006), in which EMs that suffer a systemic sudden stop experience wageless recoveries, and, theoretically, with the model by Schmitt-Grohé and Uribe (2011), whereby in the presence of nominal wage rigidities, economies that generate inflation (for instance through a nominal exchange rate depreciation) are able to restore full employment in the labor market. In contrast, low inflation EMs display a pattern similar to the one observed in advanced economies, with financial crises associated to more intense jobless recoveries.
In the low-inflation rich world, recessions associated with financial crises produce jobless recoveries. In the emerging world, low-inflation episodes after such recessions look like rich-world recoveries while in high-inflation scenarios wages are stagnant but employment bounces back quickly.
Ryan comments as follows:
In the low-inflation rich world, recessions associated with financial crises produce jobless recoveries. In the emerging world, low-inflation episodes after such recessions look like rich-world recoveries while in high-inflation scenarios wages are stagnant but employment bounces back quickly.
So financial crises tend to lead to slow recoveries only when accompanied by tight money. One more nail in the conventional wisdom about the recent recession. Ryan also makes the following observation:
My mental model of the link between jobless recoveries, post-crisis, and low inflation is a bit different than the one used in the paper. My supposition has been that the main link between the two is the zero lower bound.
That’s certainly possible (although it didn’t seem to be a big problem for FDR in 1933), but I don’t recall many cases of developing countries hitting the zero bound in the post-war data. Perhaps someone can help me; prior to 2008 were there many developing countries facing the zero interest rate bound? I’m inclined to see the problem as simply tight money, nothing more.
Unless you think the slow recoveries are structural. I.e., unless you believe those developing countries with high inflation are remarkably free of structural problems. Given what you know about developing countries with high inflation that are recovering rapidly from financial crises (say Argentina post-2002), does that explanation seem intuitively plausible?
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25. October 2012 at 14:58
The developed/developing world bit plays hell with the comparison, although it certainly does favour Cowenian “we’ve picked all the low-hanging fruit” hypotheses over normal market-policy failures. Those are almost always worse in the developing world.
25. October 2012 at 15:02
e: oh, “EM” is emerging markets. Okay, scratch my comment. Still, quite a bit of endogeneity in what causes high inflation in emerging markets.
25. October 2012 at 17:43
So another unsustainable inflationary boom can take place after a prior recession hits?
I’m shocked.
25. October 2012 at 18:07
But those financial crises still are bringing down underlying RGDP growth for a time, hence the wage stagnation, right?
25. October 2012 at 20:11
The structural argument appears very weak. I dislike it also as it suggest there is nothing to do but sit around and suffer.
I understand government intrusion is often worse than do-nothingism (especially in the affairs of foreign nations).
The structural argument crowd also seems to fall into that sullen school of economic thought that prosperity is dangerous as it leads to inflation, so better we forego prosperity.
25. October 2012 at 21:54
Benjamin Cole,
You got it, I must say! 🙂
25. October 2012 at 22:46
Bogdan-
Whoever you are, thank you.
26. October 2012 at 01:00
[…] on a recent post by Ryan Avent, who discusses a new working paper by Calvo, et. al., Scott Sumner writes, So financial crises tend to lead to slow recoveries only when accompanied by tight […]
26. October 2012 at 02:45
The typical financial crisis is a rapid net capital outflow. That is going to reduce real incomes in the country facing the outflow.
With a floating exchange rate, there will be a currency depreciation and an increase in the prices of imports–inflation.
If the exchange rate is defended in the face of the net capital outflow, or if there is an effort to avoid added inflation due to exchange rate depreciation, then nominal incomes (including nominal wages) will have to fall.
And so, jobless recovery.
If nominal GDP is maintained, the exchange rate falls, and the prices of imports rise, then there is a wageless recovery. Real wages (and presumably other real incomes) fall as prices rise and nominal wages remain unchanged.
None of this applies if there is a financial crisis with no net capital outflow.
26. October 2012 at 04:05
Saturos, It probably works both ways. The financial crisis causes lower RGDP, and also reflects other factors reducing real GDP (say less foreign investment.)
Bill seems to have it about right.
26. October 2012 at 08:19
This post implicitly implies that higher inflation is not as bad as higher unemployment. That is a very debatable point and it appears that this assumption came in without any questioning.
26. October 2012 at 08:24
I think it really is a debatable issue whether higher inflation is worth lower unemployment and to what extent. An economy with a higher than natural rate of unemployment will obviously be operating below potential but an economy with high inflation will also fall below potential because they will be losing out on the true source of growth which comes from savings. I’d argue that a country with higher unemployment and lower inflation has a better chance of improving living standards from one generation to the next other things being equal.
26. October 2012 at 08:33
John, according to the paper, the higher inflation is temporary.
26. October 2012 at 08:39
‘So financial crises tend to lead to slow recoveries only when accompanied by tight money.’
That’s exactly what I thought, when I read, at the paper’s end;
‘The evidence reported in the paper suggests that a sharp dosage of price inflation for a limited period of time may go a long way to restoring full employment after financial crises….’
I think the paper is much better written than anything from Reinhart and Rogoff, but still, I don’t see how the circular reasoning isn’t obvious.
26. October 2012 at 09:00
“Bill seems to have it about right.”
He usually does.
26. October 2012 at 09:38
This sort of research should be making bigger waves than Reinhart & Rogoff’s research on financial crises.
26. October 2012 at 10:15
Benjamin Cole:
The structural argument appears very weak. I dislike it also as it suggest there is nothing to do but sit around and suffer.
Is that what the over one hundred million people are doing every day in the economy? Just sitting around suffering?
Why do you monetarists equate action only with the government’s action? You do realize that there are hundreds of millions of actors in the US, right?
I understand government intrusion is often worse than do-nothingism (especially in the affairs of foreign nations).
So you dislike do nothingism, but you understand it’s better than government intrusion. Hmmm.
The structural argument crowd also seems to fall into that sullen school of economic thought that prosperity is dangerous as it leads to inflation, so better we forego prosperity.
Which “structural argument” people do that?
26. October 2012 at 16:02
How are we measuring inflation? Are we measuring only CPI? Does the measure of inflation include asset prices? Does the measure of inflation measure cost of living expenses?
Inflation is something that is very difficult to actually measure. We can measure CPI, but money is not neutral and has a real effect on an economy. Different types of goods behave differently to inflation.
From a policy standpoint, inflation really doesn’t make any sense to target and targeting any measure of inflation that doesn’t include asset prices can cause major problems.
27. October 2012 at 05:46
John:
Inflation over the generations causes reduced saving and investment?
The situation is a one off increase in the price level. The period when the price level incresaes to its higher level entails inflation.
If there is already trend inflation, the price level moves to a higher growth path. The period where the growth path of prices shifts up is one of transitionally higher inflation.
The trend rate of inflation (over the generations) impacts nominal interst rates (higher inflation, higher interest rates.) The only sort of “saving” that is discouraged is holding hand-to-hand currency.
As for the one off shifts in the price level, anticipating that possibility does reduce saving by lending, but to a large degree, the alterative is saving by purchasing equity–stocks. A regime that prevents inflation caused to supply side factors (like foreigners choosing to pull their money out,) artificially encourates saving by lending and discouages saving by pruchasing stocks as well as investment.
Saving is only valuable to the degree it generates investment. It does not lead to growth or improvements in standards of living unless it leads to the purchase of additional capital goods. A policy aimed at reversing supply side inflation discourages investment.