This is from a paper by Gauti Eggertsson, a very distinguished New Keynesian economist:
Tax cuts can deepen a recession if the short-term nominal interest rate is zero, according to a standard New Keynesian business cycle model. An example of a contractionary tax cut is a reduction in taxes on wages. This tax cut deepens a recession because it increases deflationary pressures. Another example is a cut in capital taxes. This tax cut deepens a recession because it encourages people to save instead of spend at a time when more spending is needed.
Elsewhere he showed that in a deep depression, the NK model suggested that artificial attempts to raise wages, such as FDR’s NIRA, could be expansionary.
Several economists have recently suggested that the NK model has NeoFisherian implications. If the Fed were to raise its fed funds target, the policy shift would be inflationary.
Nick Rowe shows that the NK model implies that a slowdown in the rate of government spending growth is expansionary.
1. The NK model implies that higher taxes on wages can be expansionary.
2. The NK model implies that higher capital gains taxes can be expansionary
3. The NK model implies that raising the aggregate wage level by government fiat can be expansionary.
4. The NK model implies that an increase in the fed funds target can be expansionary.
5. The NK model implies that fiscal austerity can be expansionary, if done by slowing the growth in government spending.
These are claims made by NK supporters, NK opponents, and people in the middle. And what they all have in common is that they suggest that the NK model has preposterous implications. These claims about the world aren’t just wrong, they are borderline absurd. I’ve studied macroeconomics all my life, both the Great Depression and the post-1970 period. I’ve seen hundreds of natural (policy) experiments, and watched how both markets and the broader economy reacted to those natural experiments. And if these claims are true then I might as well stop being an economist, because it would mean I understand nothing about the world, absolutely nothing.
Perhaps merely to keep my sanity, I prefer to find another model, which doesn’t yield one preposterous result after another. Here’s the best I can do:
The Musical Chairs model:
1. In the short run, employment fluctuations are driven by variations in the NGDP/Wage ratio.
2. Monetary policy drives NGDP, by influencing the supply and demand for base money.
3. Nominal wages are sticky in the short run, and hence NGDP shocks cause variations in employment in the same direction.
4. In the long run, wages are flexible and adjust to changes in NGDP. Unemployment returns to the natural rate (currently about 5% in the US.)
This models seems to fit the stylized facts quite well:
In my model, artificial attempts to raise wages are contractionary, because they reduce NGDP/W.
In my model, higher wage taxes are contractionary, because they reduce NGDP/W (“W” is actually hourly labor costs for firms, including employer-side taxes and benefits.)
In my model, capital gains taxes have little impact on employment.
In my model, increases in the fed funds target are achieved via decreases in the base. This reduces NGDP, and thus NGDP/W, and therefore is contractionary.
In my model, a decrease in the growth rate of government spending doesn’t effect employment.
So in all five cases where the NK model has loony implications, my model has implications that are more consistent with what we know about how the world actually works.
Oh, and one other thing, the NK model has enormous academic prestige, whereas my model is ignored, or dismissed as non-rigorous.
I am quite certain that my model will not win out in the long run; it’s too crude. (Even I could do better.) But I’m equally certain that the NK model can’t survive in its current form. It’s time to blow it up, and start over with a completely different framework. Preferably a model that doesn’t focus on inflation, interest rates and output, but rather NGDP, nominal wages, and employment.
PS. I have a new post at Econlog; metaphors run wild.