What would a pure nominal shock look like? (comment on Cowen)

This post is a sort of response to a recent post by Tyler Cowen, which was skeptical of whether the “nominal AD” shock model could provide an adequate explanation of our current crisis.  To explore this issue I would like to start by asking what a pure nominal shock would look like.

Let’s suppose that the economy is in equilibrium at the natural rate of unemployment, and suddenly the Fed tightens monetary policy enough to reduce NGDP growth about 8% below trend.  Also assume wages are sticky.  What would happen?   The answer depends on the structure of the economy.  If all output is one all-purpose good, output of that good might fall modestly, and prices might decline as well.  The total decline in real output and prices would be 8%. 

Does this look like our current situation?  Obviously not.  Some industries have suffered severe declines while other have hardly been touched.  Does this mean that we need a sectoral explanation of the current recession?  No, rather we need need to account for the existence of capital goods, consumer durables, and services.  And we need to recall that the permanent income hypothesis predicts that during a recession there will be a sharp decline in capital investment and consumer durables, whereas the output of food, clothing, and many services will decline by a relatively small amount.  If you had a sharp but temporary decline in your income, would you cut back more sharply on consumption of food, haircuts, or purchases of new cars?  The answer is obvious.  And that is why a pure nominal shock will produce massive sectoral shifts, even if in the absence of a nominal shock the economy needed no sectoral adjustments at all.

Now let’s return to the original assumption that the nominal shock came out of the blue.  How likely does that seem?  In my view monetary policy shocks are not arbitrarily produced by central bankers, but rather reflect a flawed monetary policy process that puts too much emphasis on interest rates as an “instrument” of policy (actually short run target), and inflation stabilization as the goal.  As you know, I favor using NGDP futures as the “instrument,” and expected NGDP as the goal variable.

The monetary policy process suffers from two flaws.  If there is an autonomous decline in the Wicksellian equilibrium interest rate (the rate consistent with macro equilibrium) and the Fed keeps its target rate constant (as it did throughout much of 2008) then NGDP growth expectations may plummet.  This can cause a recession.

A second problem occurs if there is a severe oil shock during a period when NGDP growth falls below trend.  If the central banks focuses on headline inflation instead of NGDP, they may tighten policy, or refrain from cutting the target rate when needed.  This also occurred in mid-2008.

When both of these errors occur at the same time you can have a severe recession.  Just to be clear, here I am only trying to explain the severe recession that began in mid-2008.  So let’s go back and look at the early stages of the recession, the first half of 2008.  There were three problems:

1.  A sectoral shift out of housing and related activities that had been occurring since mid-2006.  This sort of sectoral shift did not and typically does not cause a recession.

2.  A severe energy shock began to develop in 2007 and worsened in early 2008.  This type of shock will hurt energy intensive industries, but will not generally cause a recession.  Most economists were not predicting any sort of severe recession as of mid-2008, despite the fact that they already knew of the sub-prime fiasco and the $147 oil.

3.  In the first half of 2008 there was a mild AD shock, as NGDP growth slowed from its usual 5% down to below 3%.  Even the combination of all three shocks was not able to produce a major rise in unemployment, nor did most economists expect a major rise in the future, despite the fact that they knew about all three problems.  Let’s just stand back and marvel for a moment at the astounding resilience of the US economy.  It takes three hammer blows and it is still standing. 

But then in just a few months it all started to unravel.  The culprit?  Something as seemingly innocuous as a decline in NGDP caused by the sort of flaws in our monetary system described earlier.  In other words these massive real shocks did relatively little damage to our economy (or our financial system for that matter) but as soon as M*V started falling everything fell apart.  What can explain this?  Any principles of macro text can explain what happens when NGDP falls.  I prefer texts like Cowen and Tabarrok, which define AD growth as a given increase in NGDP.  Suppose NGDP growth falls 8% below trend.  Because wages are sticky, relatively few workers will get hourly wage increases 8% below trend.  Instead, three things will happen:  Profits will fall sharply, bonuses will fall sharply, and hours worked will fall sharply.

What makes macro so endlessly fascinating is that the none of this will appear to have been caused by the factors I describe.  Even in an economy with only one good, no one can “see” a fall in M*V, so it will appear that some other mysterious factor will have caused the recession.  But in an economy with heterogenoeous goods and sticky wages my explanation will seem even more counterintuitive.  Some sectors (especially capital goods) will decline sharply.  Many prices will be relatively sticky, but asset prices will crash.  It will look like the wealth destroyed in the asset price crash and the sectoral shocks are the two prime causes of the recession.  But according to mainstream macro theory both are actually symptoms of falling nominal spending/income. 

How could my hypothesis be disproved?  If the Fed pegs the price of NGDP futures and we continue to see events similar to what we observed in late 2008, then I’ll throw in the towel. 

Where does policy go from here?  There is one additional problem.  Not only do real shocks such as financial turmoil and/or energy shocks often trigger bad monetary policy, but the resulting recession often leads to bad supply-side responses.  By far the worst example was the NIRA in July 1933.  But even in this recession we have a dramatic lengthening of the duration of unemployment benefits, from 26 weeks to as much as 73 weeks.  (I also recall reading that Obama planned to reverse Clinton’s welfare reform, but I haven’t followed the issue closely.)  In a normal recession workers who have exhausted unemployment benefits are more willing to accept any job at any wage rate.  This increase in labor supply puts downward pressure on wage rates. In the current recession wages have been stickier than in 1921, and thus the unemployment will be more prolonged.  FYI, 1921 was probably the purest nominal shock in American history.  It is worth studying intensively if you want to see what the AS/AD model purports to describe. 

[As an aside, many people get confused when some workers accept big wage cuts and still get laid off.  The problem is that if you are in a highly cyclical industry, it is not enough that you accept wage cuts.  Instead, to prevent high unemployment in cyclical industries it is necessary for everyone in the economy to accept big wage cuts, even government workers.  I know people working for high tech firms who haven't yet had any wage cuts in this recession.  We are far from the sort of wage flexibility required to make nominal shocks neutral, despite all the reports of wage cuts you might have read about.  And wage cuts mean cuts in hourly wage rates, not annual income.]

BTW, I hate the term “aggregate demand” as I have no idea what it means, and when I read other economists I immediately realize they mean something much different than I do.  I prefer to define AD as NGDP, an approach adopted in the new macro text by Cowen and Tabarrok.  But Cowen also recognizes that economists often mean something very different by ‘aggregate demand’ and thus discusses ”real AD” shocks in his recent post:

If someone wants to insist that “this is really an AD shock, not a sectoral shift,” I’m not so keen on fighting to keep one term over the other.  I would insist, however, on an issue of substance, namely that not all AD shocks are alike.  If we are going to switch terminology, it could be said that this is a real AD shock and not just a nominal AD shock.  (Though there have been nominal AD shocks too.)  A nominal AD shock can be offset more easily by goosing up some mix of M and V and restoring the previous level of nominal demand. 

Thus Tyler Cowen correctly observes that real AD shocks are essentially sectoral shocks.  Thus a fall in wealth may make people shift their consumption away from some goods and towards others.  It doesn’t make people want to work less, but I think both Tyler and I agree that during a transition period it causes frictional or structural unemployment that cannot easily be papered over by printing money.  Where we may disagree a bit is that I think the fall in wealth due to the sub-prime fiasco was not severe enough to cause even a small a recession, and the much bigger fall in wealth after mid-2008 was caused by sharply falling NGDP expectations—i.e. by a nominal shock. 

Would reversing this nominal shock be able to reverse all the negative effects I described?  I can’t say for sure.  We have structural problems like extended unemployment benefits that we didn’t have in mid-2008.  But I still think it would do a lot of good.  More NGDP could help because asset prices are highly volatile and forward-looking, while nominal wage rates are very sticky.  A strong increase in 2011 NGDP expectations would sharply raise asset prices, but hardly budge current nominal wages (given 10% unemployment.)  This would boost employment and output.

Every day that goes by my preferred policy response becomes slightly less effective in reducing the problems we currently face.  But oddly a decision to “be irresponsible,” i.e. to have “excessive” NGDP growth in order to catch up to the 5% trend-line, would make it far less likely that NGDP growth expectations would collapse in the next crisis.  This time they collapsed because the markets guessed the Fed would not try to correct its error and return NGDP to the old trend line.  And as each day brings new stories of a Fed itching to tighten policy even as the fiscal authorities are contemplating new stimulus (a policy mix showing our government is approaching  “banana republic” level of incompetence) it becomes more and more evident that the bearish speculators of late 2008 were right—NGDP is going to stay on a new and permanently lower growth track.  There will be no nominal recovery.  And with the lengthened unemployment benefits the real recovery will take longer than normal.

PS.  This was a frustrating decade at times, and ended with me missing my flight home on the last day.  But at least humanity had its best decade ever, at least if you believe economic development and peace makes people happier.  So I guess I shouldn’t grumble.

My new year’s resolution?  How about full RSS feeds?  I have only a vague idea of what they are, but I’m told I should want one.  And that means I want one.

Happy New Year!


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20 Responses to “What would a pure nominal shock look like? (comment on Cowen)”

  1. Gravatar of StatsGuy StatsGuy
    31. December 2009 at 23:15

    I hate being the first commenter on such a complicated post, but I have to raise (yet again) the issue of distribution of wage cuts and insolvency, particularly in relation to unemployment extension.

    The notion is simply this – let’s assume that monetary policy was held constant (Congress has no control, or pretends to). Do we anticipate that we’d currently be better off without the extensions? Recognize that without the extensions, we’d likely see many more employees – perhaps as many as 1% of the workforce – having failed to make mortgage payments this past year. Do you think that – holding monetary policy constant at last year’s levels – we’d be better off if we’d massively intensified the liquidationist cycle? Do you think removal of the extensions would have yielded a relatively even reduction in wage rates across sectors/professions/tasks? Do you think that rejection of an extension bill in Congress would have not had psychological effects on consumer confidence as the media amplified the event?

    The issue goes back to asset prices and insolvency as mechanisms for demand transmission. In an active asset price collapse (e.g. the housing market), what would have been the demand-side effect of intensifying the asset price collapse? (And you can’t plead the Fed could have done a better job intervening, because the Fed didn’t want to intervene.) This is very hard to anticipate, but I do not think there is ANY mathematical macro model that accounts for the sort of non-linearities (e.g. insolvency threshhold effects, feedback to housing and loan asset price levels) inherent in this dynamic.

    Empirically, previous successful episodes of removal of wage support mechanisms largely occurred in situations with supportive monetary/fiscal policy and/or not in the middle of a mortgage crisis/housing price collapse/bank insolvency crisis and/or in countries in which export led growth was a major mechanism of escape from a recession/depression.

    Your argument proports that the wealth reduction is an intervening variable, not the primary policy variable – that may be true. But once M*V triggers an asset price collapse, if we then hold monetary policy constant (e.g. the Fed is intransigent), then asset prices/wealth can become an independent driver, and a liquidation cycle can become self-sustaining even if wages rapidly adapt – this is because of the nominal debt issue.

    Unemployment extension certainly isn’t a long-term solution (it’s a pure transfer payment with the worst sort of incentives), and expected NGDP targeting would have been a better response, but it could act as a brake on the liquidation cycle to allow the backwards-looking monetary policy target algorithm to catch up to future reality.

  2. Gravatar of Doc Merlin Doc Merlin
    1. January 2010 at 02:09

    I agree that this recession (I mean second half 2008-2009) is a lot like the 1921 recession. I made a point in an earlier thread that this one was also preceded by a food bubble.

    I have also been thinking a lot about the Fed’s odd behaviour that has contributed to the problem. Their attempts to re-inflate the housing bubble and prop up banks seem to give us some of the negative effects of loose monetary policy without a lot of the benefits.

    Its also strange now that the fed is involved in fiscal policy, and through fanny-mae, freddy-mac, and sally-mae the treasury is now involved in monetary policy.

    “This time they collapsed because the markets guessed the Fed would not try to correct its error and return NGDP to the old trend line.”

    I thought things started collapsing way before that point? Just a massive PPI shock then a collapse.

    “And as each day brings new stories of a Fed itching to tighten policy even as the fiscal authorities are contemplating new stimulus (a policy mix showing our government is approaching “banana republic” level of incompetence)”

    If the goal was to improve the economy, then I would agree that this is an incompetence signal. However, as far as I can tell, the Fed’s goal seems to be protecting its large stock holders, and Congress’s goal is to pay off various groups.

    “And with the lengthened unemployment benefits the real recovery will take longer than normal.”

    Completely in agreement with that sentence.

  3. Gravatar of Doc Merlin Doc Merlin
    1. January 2010 at 02:23

    @statsguy:

    “but it could act as a brake on the liquidation cycle to allow the backwards-looking monetary policy target algorithm to catch up to future reality.”

    I don’t agree here. I am sympathetic to the Austrian view that the pain and liquidation is necessary in order to form a lasting recovery. In other words we have to destroy some debt before we can move forward for real. There are three ways to destroy debt inflation, liquidation, and paying it down. Some Austrians see Monetarist monetary policy as an attempt to destroy the debt by inflating it away, this however creates long term problems of its own. When we inflate the debt away (by holding interest rates below the natural rate or the rate of inflation) we end up, in the long term, increasing the leverage ratios throughout the economy (even if we decrease them in the short term) and make the next de-levering cycle even more painful.

  4. Gravatar of Tom Hickey Tom Hickey
    1. January 2010 at 08:07

    “There are three ways to destroy debt inflation, liquidation, and paying it down.”

    That’s the conundrum. It seems like the Fed would like to reflate asset prices and let creditors take a haircut through inflation but keep them solvent, while giving debtors a break through inflation but requiring them to pay off their nominal debts.

    The powers-that-be decided that straight up liquidation was too dangerous because of systemic risk after Lehman. Paulson and Bernanke really freaked out over this, and held a gun to the head of Congress to get the rescue package approved overnight. This option is clearly still off the table with some many financial institutions insolvent and held up only by government assistance and regulatory forbearance. If there is to be liquidation of debt that can’t be paid down fully, it will be engineered to take place over time, instead of forcing write downs and write offs that risk insolvency for systemically interlinked major institutions. There is also the derivative bomb to consider here.

    The option of paying down the debt overhang is seriously limited by the time frame required, even under the most optimistic scenario, and the prevailing question involves whether it is possible for the economy to absorb and recover while deleveraging is in full force.

    Also, this is not a purely economic problem that can be approached based on efficiency. It’s a political problem in a country where a large number of people fell that they have been unjustly ripped off and an oligarchy controls the reins of power through campaign finance. Fooling around with the possibility of deflation would be politically suicidal, as well as career-ending for a lot of people. Geithner, Summers and Bernanke are having nightmares about this possibility, not inflation.

    There seems to be no simple solution using monetary policy as the principal tool. Nominal AD needs to be sustained with fiscal policy while the economy recovers perceptibly, i.e., the output gap closes, and unemployment goes down. The public wants and needs to deleverage and build savings, the CAD isn’t going away, and business isn’t going to make up the difference in an environment where AD is faltering. That leaves government to take up the slack, while needed reforms are being implemented to prevent a reoccurrence. The financial system is still very sick.

  5. Gravatar of Mark A. Sadowski Mark A. Sadowski
    1. January 2010 at 12:01

    I have a hard time accepting Tyler’s quibbling over “real” versus “nominal” AD shocks. In my opinion if it’s an AD shock then strictly speaking it’s a nominal shock.

    In reference to the paper by Valletta and Cleary, three important facts stand out in the determination of whether the unemployment the economy is currently experiencing is primarily structural or cyclical.

    1) Employment Dispersion
    If the source of unemployment were structural we should see great dispersion between sectors in terms of employment growth such as we saw in the 1974-1975 recession. That is not the case. Every sector with the exception of utilities, educational and health services, and government, has suffered large declines in employment (about 7%-23%). Employment growth dispersion in this recession is unusually small lending strong evidence that current unemployment is overwhelmingly cyclical, not structural.

    2) Job Openings Rate
    Not surprisingly, given the lack of disperson in job growth, employers are having little difficulty filling openings. The job vacancy rate has plummeted in this recession from 3.4% in mid 2007 to 1.8% in July 2009 (an all time low) before rising to its current rate of 1.9% as of September. This is hardly consistent with the sectoral imbalance point of view.

    3) Unit Labor Costs
    Given that employers are having little trouble filling vacancies it should come as no surprise that compensation is no longer rising faster than productivity as would be consistent with a positive inflation rate target. ULC rose by 1.6% annually on average in the ten years through the fourth quarter of 2008. It has fallen every quarter since, down 1.9% as of the third quarter of 2009. This also is not consistent with the structural hypothesis.

    It’s hard to see this as anything other than a huge nominal AD shock given it’s effects on the labor market.

  6. Gravatar of StatsGuy StatsGuy
    1. January 2010 at 12:10

    Tom:

    “The powers-that-be decided that straight up liquidation was too dangerous because of systemic risk after Lehman.”

    While agreeing with much of what you say, there is a tendency to assume that the present status quo is the proper status quo in relation to the debt overhang. Please recognize that the current debt overhang reflects an off-trajectory price AND NGDP decline due to failure of the Fed to meet expectations. So, a large part of that “reduction in debt overhang due to reflation” is merely restoring some semblance of a previous trajectory. I say this because the definition of the status quo always carries and implicit moral weight.

    Doc:

    “I am sympathetic to the Austrian view that the pain and liquidation is necessary in order to form a lasting recovery.”

    I’m sympathetic to the view that a stable, sustainable recovery requires less debt overhang due to the instability/risk this adds to the system (as well as the reduction in long term spending power). BUT, I disagree that using mild inflation to do this simply _must_ result in long term divine punishment for our sins. Austrians are far too eager to discount the efficacy of very simple administrative mechanisms – increasing capital asset ratios permanently (to limit the rise in V when activity picks up), phasing in stricter underwriting standards and collateral requirements for mortgages, imposing other costs on leverage, and addressing TBTF by limiting bank size and aggressively enforcing solvency rules. Implementing these rules actually liberates the Fed to wield monetary policy more aggressively, and now is the time to do so – but this must be accompanied by direct monetary injections (getting money into the real economy without relying on financial institutions as the primary intermediary).

    The argument that we can’t effectively use very simple administrative tools seems to be a favorite of people who don’t want those rules – “Hey, it can’t possibly work, so let’s not try!”

    an interesting view:

    http://www.huffingtonpost.com/david-paul/a_b_341458.html

    The failure in the US is not a failure of capability, it’s a failure of will. (Though some programs, like buying > 1 tril MBS to drop rates and allow qualifying homeowners to refinance at subsidized rates, are effectively monetary injections.) Summers et. al. simply do not believe in more base money/less debt and a less convoluted financial system, but prefer to rebuild a money supply with a composition that is heavily skewed toward money-as-debt rather than money-as-currency. The belief among many financial engineers is that this system _ought_ to be more efficient than a less leveraged system because private banks do a better job at allocating resources through their money injections than other actors (either the Federal govt, state govts, local govts, or individual taxpayers). The supporting belief is that the system of extensive derivatives and hedging is eminently fixable, such that it can be made both stable and more efficient than a cruder financial system.

    In other words, if you keep layering on more and more markets, with more and more liquidity, then the EMH will fix everything… If you read Goldman Sach’s summary recommendations for better “regulation”, this is their central hypothesis.

    In practice, this has caused more instability, not stability.

    We’re caught in a fight between the Financial Engineers and the Austrians. Both dismiss the pragmatic middle, which seems to have worked pretty well in places like Canada, Singapore, etc.

    And while Ssummers is right that none of this should prevent the Fed from achieving 5% NGDP growth, the broken financial ssytem does mean that the composition of this growth will involve a worse paretor frontier between unemployment and inflation.

  7. Gravatar of Mark A. Sadowski Mark A. Sadowski
    1. January 2010 at 13:09

    Tyler Cowen’s hairsplitting over “real” versus “nominal” AD shocks (something of an absurdity in my opinion) seems to me to be partly based on the notion that AS shocks can have an effect on AD. This reminded me of something else I’ve given some thought to: the possible influence of AD on AS.

    My views on this are partly influenced by an old book (1957) called “The American Economy” by Harvard economist Alvin H. Hansen. The section of the book I am thinking of is aptly titled “The Case for High-Pressure Economics.” He argued that keeping GDP near potential increases the rate of potential GDP growth.

    It’s my casual observation that faster potential GDP growth seems to be correlated with lower relative unemployment, and that the causality seems to be directed from employment towards potential output. I think a major part of this is due to hysteresis. When people are unemployed they lose valuable skills. Thus it is better to keep the labor force as fully employed as possible.

    There’s also probably an effect on physical capital. I’ve read several anecdotal accounts of how plant and equipment have been dismantled in this recession simply due to lack of demand. This can’t be good for potential GDP growth.

    Let me illustrate with a simple example. FRED of course maintains the CBO data on potential GDP growth and NAIRU in the US dating back to 1948. Here are some observations.

    If you look for long periods of above average and below average periods of potential GDP growth four periods in particular stand out.

    The two high growth periods were 1949-1952 and 1963-1969. They had potential GDP growth rates of 4.7% and 4.9% respectively. The two low growth periods were 1991-1996 and 2004-2008 (so far). They had potential GDP growth rates both of 2.6% each.

    Both of the high potential GDP growth periods were characterized by low unemployment relative to NAIRU. They were 4.9 and 5.4 on average versus 5.3 and 5.7 on average in temporal order. Both of the low potential GDP growth periods were characterized by high unempoyment relative to NAIRU. They were 6.4 and 5.1 versus 5.5 and 4.8 on average in temporal order.

    Of course this demands that you accept that the CBO’s data on potential GDP and NAIRU as meaningful, which I do.

    The bottom line is that, in my opinion, AD has an influence on AS. As long as Tyler is talking about “real” AD shocks maybe I should raise the spector of “nominal” AS shocks. ;)

  8. Gravatar of D. Watson D. Watson
    1. January 2010 at 13:54

    Thank you.

    So the links are from Fed action to stock prices to employment. I’ll buy the first link, but I’m rather concerned about the move from higher asset prices (largely stocks) to employment. It’s in the second link that I’m rather more skeptical.

    There is another element, though, that I find quite inspiring. Most people are stuck fighting the last war. A few visionaries fight the current one. You’re worrying about the next war. Hats off.

    [Re: But oddly a decision to “be irresponsible,” i.e. to have “excessive” NGDP growth in order to catch up to the 5% trend-line, would make it far less likely that NGDP growth expectations would collapse in the next crisis.]

  9. Gravatar of Tom Hickey Tom Hickey
    1. January 2010 at 15:42

    StatsGuy wrote: “So, a large part of that “reduction in debt overhang due to reflation” is merely restoring some semblance of a previous trajectory. I say this because the definition of the status quo always carries and implicit moral weight.”

    Agreed. Thanks for adding the clarification.

  10. Gravatar of Mark A. Sadowski Mark A. Sadowski
    1. January 2010 at 17:57

    D. Watson,
    Allow me to address your comment.

    When you refer to the effect of asset prices on employment you’re implicitly refering to the “wealth effect” Generally speaking it is any change in spending that accompanies a change in perceived wealth. It is a fairly well accepted concept in economics although measuring its precise effect is difficult.

    Here’s a a popular article from June 2008 that helps address some of what I’m going to say:

    http://www.slate.com/id/2193287/

    The bottom line is ignore the wealth effect at your own peril.

    I would say that a good rule of thumb for the wealth effect is that spending changes by 4% of perceived change in wealth. The amount appears to be dependent on total wealth (more wealth=lower effect) and the lag is dependent on asset type (less volatile(e.g. housing)=smaller lag).

    I’ve been looking at Federal Reserve flow of funds data lately. Net assets in the household non-profit sector have trended upward from about 300% of GDP in 1945 to about 480% of GDP in 2006. It plunged to about 350% of GDP in 2008. It’s hard to say what an appropriate level would be but note that using my rule of thumb a 130% of GDP decline in net asset values yields a 5.2% of GDP decline in spending. This was almost certainly a huge drag on the economy in 2008, comparable to the huge decline in asset values during the stock market crash in 1929-1933.

    Now for some anecdotal evidence (the fun stuff).

    I’m an odd person living in an odd community. I live in Hockessin, Delaware, one of the highest income communities in the US with a population over 10,000 according to Wikipedia. I’m an all but dissertation economist with not much current income but a fair amount of inherited real estate wealth. Hockessin has had a great deal of appreciation in real estate wealth this decade but there has been no large decline since the peak in the real estate bubble. Although nationally real housing prices have declined by about 30% according to Shiller, according to Zillow nominal housing prices in Hockessin have barely budged since peak (about 7%).

    To get to my point, I had dinner at a popular local restaurant called “The Back Burner” on my birthday in June. I (and my date) were virtually the only people there (so consequently service was fantastic). In fact there was speculation at that time that many of our local restaurants would close down due to lack of business.

    More recently I noticed an ad for many more staff (cooking and service) at The Back Burner. I mentioned this to my brother in a quizzacle vein. My brother, who has no economics training but has a large amount of native intelligence responded with one word: “401k’s.”

    Housing wealth in Hockessin has barely budged throughout this crisis. On the other hand stock wealth plummetted between late 2007 and early 2009 but rebounded healthily the rest of the year. Needless to say the local economy here seems to be humming once again, i.e. “the wealth effect.”

  11. Gravatar of thruth thruth
    1. January 2010 at 18:38

    Statsguy said: “This is very hard to anticipate, but I do not think there is ANY mathematical macro model that accounts for the sort of non-linearities (e.g. insolvency threshhold effects, feedback to housing and loan asset price levels) inherent in this dynamic.”

    What about the financial accelerator models, which Bernanke was one of the pioneers? (ironically enough)

    For example, look at some of Geanokoplos’ recent stuff: http://cowles.econ.yale.edu/~gean/publications.htm

    This class of models clearly highlight the risks even if they can’t tell you *when* bad stuff is about to happen.

    Scott Sumner said: “There were three problems:
    1. A sectoral shift …
    2. A severe energy shock …
    3. … a mild AD shock

    But then in just a few months it all started to unravel.”

    I think I’ve said this before, but I have a hard time believing all (4) of these events are unrelated. The common thread is a spike in the demand for precautionary liquid assets as fallout from the subprime bust. I can’t remember if someone else said something similar about your old ship steering analogy, but you seem to be working under the assumption that the captain will be as effective keeping the ship on course on a sunny calm day as in a category 5 hurricane. Maybe you’re right, but I think you need to argue the case.

    In particular, in the other thread you said: “They already did far more QE than necessary–they essentially doubled the monetary base. That is enough to double the price level. At that point all they needed to do was to set a price level or NGDP target, level targeting, and AD would have risen fast. Indeed they would have been able to get by with a much smaller QE if they had a more aggressive target.”

    I’d like to see this argument fleshed out a little more. Doubling the monetary base would clearly double the price level in the long run, but wouldn’t it be prone to all sorts of distortions in the short run? (I’m not advancing a long and variable lags argument, I’m only saying that there’s no a priori reason to think doubling the monetary base would necessarily soak up whatever the root driver of the liquidity shock is)

  12. Gravatar of ssumner ssumner
    1. January 2010 at 18:44

    Statsguy, Again, it depends what you mean by hold monetary policy constant. For a given NGDP, higher labor supply would reduce unemployment.

    Also, there are ways of setting up unemployment insurance that have a much smaller effect on incentives. Imagine car insurance worked this way:

    After an accident you get $100 a week until your car is fixed. Not a good system. But that is essentially our unemployment comp. system. We ought to have individual accounts, so that there is no disincentive to find another job. Or else just give one lump sum on the “accident” of losing one’s job. And we certainly shouldn’t lengthen the benefits to 73 weeks during a recession.

    I understand your second best argument for fiscal stimulus, and you may be right. But I just don’t think there is much the fiscal authorities can do to make up for monetary incompetence. If they insist on doing something, please increase the demand for labor by slashing the employer payroll tax. That seems to have had some effect in Europe and Singapore. But not extended benefits.

    Doc Merlin, You said;

    “If the goal was to improve the economy, then I would agree that this is an incompetence signal. However, as far as I can tell, the Fed’s goal seems to be protecting its large stock holders, and Congress’s goal is to pay off various groups.”

    Maybe, but that would also be indicative of a banana republic.

    Things started collapsing in August 2008, which is when the fear of inflation was peaking at the Fed. It led them to adopt an absurdly tight monetary policy. The Fed refused to respond the the Lehman failure, and then tightened policy on October 3 2008, even as AD was in freefall.

    Tom Hickey, where is the evidence that the Fed would like to reflate asset prices? They have just allowed NGDP to fall at the fastest rate since 1938—is that something a Fed would do if it was trying to inflate asset prices? And they are talking about “exit strategies.”

    Fiscal policy cannot boost AD all by itself, as the Japanese proved over the past 20 years.

    Mark, You said;

    “I have a hard time accepting Tyler’s quibbling over “real” versus “nominal” AD shocks. In my opinion if it’s an AD shock then strictly speaking it’s a nominal shock.”

    I agree. I think Tyler was indicating that what people think of as AD shocks may be nominal shocks or real shocks. I think he would agree that the terminology is misleading. I had the impression that he preferred the term ‘sectoral shocks,’ as do I.

    Those specific comments that you make are very significant, I hope others will read them. The only point I would add is that I think some people were thrown off by the period from mid-2006 to mid-2008, when there was a sectoral problem concentrated in housing. But the big increase in unemployment occurred after mid-2008, and it occurred in a wide range of industries. The other data you mention are also very revealing.

    Statsguy, I tend to agree with much of your second comment.

    Mark#2, I tend to agree with your view that AS and AD shocks can be somewhat interrelated in the real world. But one cautionary counterexample; technological change was extremely rapid during the 1930s.

    On the other hand it’s hard to argue with the observation that dismantled factories slow things down for at least a while.

    D. Watson. I got so bogged down in certain issues relating to Tyler’s post that I never really gave you a complete answer. By asset prices I meant stocks (corporate capital), and commodities, and real estate (both residential and commercial.) So I meant something broader than merely stocks.

    Mark#3, Yes, the wealth effect is a factor, but I was also thinking of something like the Tobin Q; higher stock prices raise the raise of the market value of corporate assets relative to the book value (or replacement cost.) This encourages the contruction of new corporate assets.

    EVERYONE, I just got back from vacation and have a lot of catching up to do, hence the short replies. Thanks for the excellent comments to this post.

  13. Gravatar of ssumner ssumner
    1. January 2010 at 18:56

    thruth, You said;

    “I think I’ve said this before, but I have a hard time believing all (4) of these events are unrelated. The common thread is a spike in the demand for precautionary liquid assets as fallout from the subprime bust. I can’t remember if someone else said something similar about your old ship steering analogy, but you seem to be working under the assumption that the captain will be as effective keeping the ship on course on a sunny calm day as in a category 5 hurricane. Maybe you’re right, but I think you need to argue the case.”

    I definitely think energy and the housing bust were unrelated issues. In fact I’d expect a housing bust to lower energy prices (as happened after mid-2008.) I still insist the commodities boom was due to heavy third world demand. And further evidence for this is that a significant (but far from complete) recovery in commodity prices was closely correlated with a signficant recovery in Asian economies after March 2009. I think many people focus too much on the US when trying to explain commodity prices.

    No matter how severe the storm, the captain can always keep the expected direction of the ship on course, if he has an infinitely powerful engine. The Fed can print virtually an infinite amount of money. So while actual NGDP may miss in “heavy weather”, expected NGDP should always be kept on target.

    Regarding your last comment, I’m not saying that they should try to double the price level, I am merely saying that if that wa stheir goal, they already printed enough money to get the job done. In people expected NGDP to be 30 trillion in 5 years, the expected nominal return on all sorts of assets would soar right now, and the “liquidity trap” would vanish overnight. Obviously that is too much inflation. But there is some happy medium between that thought experiment and what they actually did. I think many people have trouble visualizing this because they are used to the “low interest rate” transmission mechanism for monetary stimulus. But if the stimulus is truly effective, interest rates don’t have to be that low, and the monetary base doesn’t have to be that high because the demand for base money falls when NGDP is expected to rise rapidly. People have better places to put their assets.

  14. Gravatar of Simon K Simon K
    1. January 2010 at 23:15

    Scott – I’m not sure the gas price rises and the initial housing bust in 2006 were unrelated. Personally I think the causality was reversed from what some people seem to think. The initial rise in gas prices above $3/gallon coincided with the beginning of the sub-prime crisis and I suspect its no coincidence. The newly developed housing areas in the bubble states with the most inflated prices and least sustainable LTV ratios and worst loan underwriting were also furthest from the urban cores, making their residents more than averagely sensitive to gas prices. When gas and food prices spiked, those people started to miss payments and that set of the cascade of defaults and falling prices that ultimately rippled out to other markets. If you look at the pattern of house prices declines in California now, distance from the urban core is a pretty big factor.

  15. Gravatar of StatsGuy StatsGuy
    2. January 2010 at 08:54

    Thruth – I’ve seen the collateralization issue discussed elsewhere, but those papers are more detailed. Thanks.

  16. Gravatar of scott sumner scott sumner
    3. January 2010 at 11:29

    Simon K, That’s a very plausible theory. I think the crackdown on immigration also hurt the southwestern housing markets.

  17. Gravatar of Doc Merlin Doc Merlin
    3. January 2010 at 13:43

    On a side note, Simon and Scott: the subprime meltdown didn’t start with subprime it started with ARMs when the fed raised interest rates.

  18. Gravatar of Simon K Simon K
    3. January 2010 at 19:31

    Doc – Can you provide a cite for that? Someone else posted a link a while back to a paper arguing that the fundamental problem was ARMs and not sub-prime at all, but in my view the paper was deeply flawed. The two ideas are not really exclusive – almost all sub-prime loans are ARMs.

  19. Gravatar of ssumner ssumner
    4. January 2010 at 07:19

    Doc, Simon had the same reaction as I did, wasn’t there considerable overlap between subprime and ARMs?

  20. Gravatar of TheMoneyIllusion » Questions for readers TheMoneyIllusion » Questions for readers
    7. January 2010 at 08:48

    [...] This post is sort of a response to Scott Sumner, Tyler Cowen, and Arnold [...]

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