The self-correcting mechanism

Those who teach the AS/AD model may do the example of the big drop in AD after 1929.  Then you are supposed to show two alternatives; either the Keynesian policy of boosting AD to try to speed up the recovery, or merely waiting for the AS curve to shift right as wages and prices adjust downward.

After unemployment hit 10.8% in late 1982, Volcker opted for fast NGDP growth and we got a fast recovery.  This morning the BEA announced that NGDP grew a bit over 4% in the first quarter.  While the rate for the year will probably be somewhat higher, it is clear that the Fed has decided to rely on the self-correcting mechanism this time, and just wait for the long and painful adjustment in wages and prices to play itself out.  If this is the strategy, then it would have been better not to have recently boosted minimum wage rates by 40%, quadrupled the duration of UI, passed a health care tax increase, and cracked down on immigration. 

Let’s hope the euro crisis doesn’t trigger another drop in AD.  (I’m cautiously optimistic it won’t, but we are in uncharted waters.)


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12 Responses to “The self-correcting mechanism”

  1. Gravatar of Don the libertarian Democrat Don the libertarian Democrat
    30. April 2010 at 14:39

    Scott,

    I don’t see it quite that way. Here’s a post about Bernanke’s position:

    http://blogs.wsj.com/economics/2010/04/27/bernanke-us-needs-deficit-reduction-plan/

    I think that he feels constrained by the lack of a Fiscal Plan. Although unlikely, it wasn’t impossible that such a plan could have emerged, so some of the things you are criticizing seem ok to me, but not all. Of course, I favor Milton Friedman’s “Leftist” Plan in Essays in Positive Economics. So, in essence, I agree with Bernanke. Someone has to take a stand on the fiscal future.

  2. Gravatar of If I taught Undergraduate Economics… If I taught Undergraduate Economics…
    1. May 2010 at 06:59

    [...] be discussing this example from Scott Sumner. Posted by Jake economics, education, politics Subscribe to RSS [...]

  3. Gravatar of scott sumner scott sumner
    1. May 2010 at 07:04

    Don, I don’t follow your argument. The fiscal mess strengthens the case for monetary stimulus. Much of our fiscal problem is due to tight money. Tight money depresses NGDP, which makes the deficit balloon. It also led to the $800 billion stimulus, which makes the deficit balloon even more, and it lead to bailouts. If NGDP had kept growing at 5% after mid-2008, our deficit problems would be much smaller.

  4. Gravatar of Don the libertarian Democrat Don the libertarian Democrat
    1. May 2010 at 11:52

    I find your argument convincing. I don’t think he does. In his own terms, he wants to pressure the Congress to address the problems of our budget commitments going forward. It’s this point I agree with him about. For Pragmatic reasons, I think we should try Monetary Policy your way. The Current Way is too iffy. I hope I’m clearer now, but probably no more convincing.

  5. Gravatar of Ted Ted
    1. May 2010 at 12:02

    It seems rather out of character for Bernanke to take this route considering previous positions he has held on monetary stimulus at the zero-lower bound. My conjecture is either that his personality is too timid given the situation and he’s worried about taking the aggressive actions just out of self-doubt. Or, what I think is more plausible, he is constrained by the rather conservative members of the FOMC from credibly committing to future inflation and so he simply doesn’t (yes, I know you prefer NGDP targeting, but for this purpose committing to higher inflation and committing to NGDP growth would have similar structural results). The people on the FOMC board seem remarkably conservative when what we need right now our relatively aggressive players.

    Also, frankly, I have no idea what to think about Obama’s nominees to the FOMC. I was hoping he’d appoint someone who would be fairly dovish and try to push for higher inflation expectations, but I don’t know where any of his nominees really stand. I have no idea what Peter Diamond thinks since his work seems to be in taxation and social security (seems like a better fitted role for a council of economic advisors position but “whatever”) and Sarah Raskin who is a Maryland bank regulator.

  6. Gravatar of Jon Jon
    1. May 2010 at 15:02

    “If this is the strategy, then it would have been better not to have recently boosted minimum wage rates by 40%”

    Made a similar point over at the WCI recently–or more precisely mused that the price of a ‘basic unit of labor’ i.e., the minimum wage anchors the price-level–obviously its only a one-way anchor of course…

    Trouble is that when we have 25% unemployment among potential minimum-wage earners, its quite clear that the minimum wage IS a binding constraint.

    So yes, I do think that the six in ’06 agenda played a tipping point role in the subsequent crisis.

  7. Gravatar of ssumner ssumner
    2. May 2010 at 06:14

    Don, I agree that we need to shrink the deficit, but combined with more monetary stimulus. If Bernanke is committing to not letting deficit reduction slow NGDP growth, then I am with him.

    Ted, I completely agree with both of your comments.

    Jon, Thanks. By the way, what does WCI stand for?

  8. Gravatar of jsalvatier jsalvatier
    2. May 2010 at 19:16

    Worthwhile Canadian Initative

  9. Gravatar of jsalvatier jsalvatier
    2. May 2010 at 19:17

    I assume, anyway.

  10. Gravatar of Doc Merlin Doc Merlin
    2. May 2010 at 22:18

    Hrm, as a side note:

    If fiscal policy has a multiplier smaller than one (as Barro suggests) and the fed thinks the multiplier is larger than one, the fed will not expand enough in response to an adverse AD shock, when the government attempts fiscal stimulus.

  11. Gravatar of scott sumner scott sumner
    3. May 2010 at 05:49

    jsalvatier. Yes, of course that must be it. Thanks.

    Doc Merlin, Very good point. I see this as one reason for the slow recovery. We relied too much on fiscal stimulus, and it’s just not as powerful as most people think.

  12. Gravatar of If I Taught Undergraduate Economics… | Jake Russ If I Taught Undergraduate Economics… | Jake Russ
    6. May 2011 at 20:19

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