I define monetary policy in terms of NGDP growth. So tight money occurs when NGDP (or expectations of NGDP) are falling. I also claim that tight money causes most recessions. Some commenters argue this is a tautology. That complaint is actually really stupid. Just think about Zimbabwe, where RGDP plunged as NGDP rose by zillions of a percent. But it’s also an unintentional compliment, as we’ll see.
I frequently point out that the unemployment rate is strongly correlated with the ratio of wages to NGDP. Some people argue that this is a tautology. That’s actually a somewhat more reasonable complaint, although it’s not accurate. I say reasonable, because a slightly different version of the “musical chairs model” (MCM) would be a tautology. This version:
1/employment (in hours) = W/Aggregate nominal labor income.
I replaced unemployment with 1/employment (in hours), and I replaced NGDP with total labor compensation, which is well over half of NGDP, and highly correlated with NGDP.
So what’s going on here? Is this a model or a tautology? And if it is a model, how do we falsify it?
Here it would be helpful to think about how a real business cycle (RBC) economist, AKA “new classical” economist, would criticize the MCM, if one of them actually took the time to examine my pathetic little model.
They’d clearly accept the fact that NGDP and RGDP growth are highly correlated in the US, and that unemployment is highly correlated with W/NGDP. That’s not the issue. The issue is the policy counterfactual. We observe that NGDP is often more volatile than W, especially during periods like 2008-09, where NGDP suddenly fell by 3%, or roughly 8% below trend, and wage growth only slowed very slightly. So W/NGDP rose sharply, as did unemployment.
My counterfactual is that had NGDP kept growing at 5% in 2008-09, then RGDP would have also kept growing (although it would have slowed slightly for supply-side reasons) and I claim that wages would have continued growing at about 4%. An RBCer would not agree. In their view the counterfactual result would be high inflation and high nominal wage growth, indeed wages soaring at perhaps 10%/year, or something like that. And because wages would have soared by 10%, the stable 5% NGDP growth would lead to 5% fewer hours worked, and the unemployment rate would soar from 5% to 10%. RBCers don’t believe than nominal shocks have real effects. The Great Recession was caused by real factors, in their view.
The math fits, but how plausible is that counterfactual? And keep in mind, BTW, this is the ONLY possible counterfactual to my claim that stable NGDP growth would have maintained high employment in 2008-09, (or at least that stable growth in nominal aggregate labor income would have worked, if you want to be picky.) Even if you are not a RBCer, but blame it on “reallocation”, this HAS TO BE your theory. For the RBCers to be right:
1. Wages must be highly flexible, and that flexibility is cleverly hidden by Fed policies that, de facto, keep equilibrium nominal wage growth fairly stable.
2. It must be true that with a 5% NGDP growth counterfactual, wage growth would soar much higher in a period of fast rising unemployment like 2008-09, all because, well because fast rising wages are mathematically required to produce the big drop in hours worked that the RBCers insist is the “equilibrium” outcome of some mysterious hard to identify technology shock that causes workers to want to take long vacations. Or something like that.
Can you tell that I don’t find the RBCers counterfactual to be particularly plausible?
Other possible flaws in the musical chairs model? There really aren’t any. When we get to the policy implications, you can certainly question my claim that:
NGDP = stance of monetary policy,
or that the Fed is capable of stabilizing NGDP growth at 5%, or ask whether fiscal policy is needed too. But those policy issues are entirely separate; here I’m just trying to figure out what causes business cycles.
And basically it’s fluctuations in W/NGDP. Which are mostly caused by NGDP shocks. Period, end of story. It’s a really ugly model, and kinda stupid. I wish it weren’t true. But it’s also incredibly robust, just unbelievably robust. Unlike New Keynesians who utilize the Phillips Curve, I can go to sleep at night with serene confidence that I won’t wake up to Bob Murphy or Arnold Kling, or anyone else having some sort of empirical evidence that refutes the model. At best someone might find an episode where it doesn’t fit it quite as well as usual.
The more interesting question is whether the rest of the profession should take this seriously as a model. I’m too close to give an objective answer. Take a look at these graphs, in a blog post by “Robert“:
Now take a look at the bottom graph. See that spike at zero? The RBC model predicts no spike there at all, because there in no money illusion allowed in the RBC model. So immediately we know that the RBC model is wrong. But all models are wrong, even mine. The real question is how wrong. Maybe they are wrong in assuming no wage stickiness, but in fact there’s only a small amount of wage stickiness, and the RBC model is almost true.
Fair enough. But then they need to convince the rest of the profession on empirical grounds. And go back and read my points #1 and #2 above. Good luck convincing the rest of the profession that those counterfactuals are even remotely plausible.
If we can dismiss the RBC critique of the musical chairs model (which no one has made, AFAIK, but it’s the critique that would be made, by anyone who believed the RBC model) then what’s left for me to defend? Mostly monetary policy.
So let’s say we agree that NGDP shocks cause recessions. OK, that’s not very controversial; indeed it’s pretty much Keynes’s General Theory (I’ll do a post soon explaining why the General Theory is basically the musical chairs model.) So I can’t really claim to have invented anything here. But somehow we’ve drifted away from the General Theory, which focused on NGDP and average hourly wages and employment, to NK models that focus on interest rates and inflation and output. And that’s obscured Keynes’s musical chairs model. Instead of using NGDP shocks to explain employment fluctuations, we use interest rates and government output and technology shocks and price shocks to explain output. It all becomes very confusing, when in fact demand-side recessions are very simple—not enough NGDP to pay the workers.
Maybe if we had an NGDP futures market we could start thinking of NGDP as a policy choice for the central bank, a tool, a lever, and then the musical chairs model would be right in front of us, staring us in the face. Unavoidable.
No matter how hard you try to focus on something else like price stickiness or technology or investment shocks or whatever, W/NGDP is right there, right in front of you. It’s the sine qua non of demand side macroeconomics. If the causation doesn’t go from NGDP, to W/NGDP, to employment, then the RBCers are right. And they ain’t right.
PS. Robert relied on this paper by Mary Daly and Bart Hobijn.