No, that’s not a typo. And yes, I am good at math. In this post I’ll try to reconcile two very different perspectives, each of which seems quite plausible:
1. The problem is obviously aggregate demand. In 2009 NGDP fell at the fastest rate since 1938. The recession is closely correlated with that decline, and both theory and history suggests that such a decline is always bad for growth. Financial markets respond to rumors of monetary easing in a way that suggests they believe it affects real growth. Countries with more expansionary monetary policies tended to do better, at least in most cases. (Australia, Poland, and Sweden, but not Britain.) David Glasner showed that stocks and TIPS spreads are correlated during this recession, but not before. Paul Krugman has a recent post showing that wages are obviously very sticky at low inflation. We clearly have an AD problem.
2. The problem is obviously structural. Youth and unskilled unemployment is particularly high, presumably partly due to the 40% jump in minimum wages. When European countries introduced policies like two year UI, their natural rate increased. Now we’ve done the same. Manufacturing firms report a shortage of skilled labor. Nominal wage growth rates and core inflation have stopped falling, suggesting that wages and prices have reached some sort of equilibrium. There’s an immigration crackdown. There is rapid growth in occupational licensing laws, making it much more difficult to become self-employed.
Previously I’ve suggested that supply and demand shortfalls might become entangled. Today I’d like to briefly summarize why, and discuss the implications.
1. Why do demand shortfalls worsen AS? I can see several possible reasons. The nearly 10% drop in NGDP relative to the path expected when minimum wages increases were enacted, has effectively raised the real minimum wage by 10% more than intended. (Wages should be deflated by NGDP, not prices.) The demand shortfall caused Congress to extend UI benefits from 26 weeks to 99 weeks. Since workers suffer from money illusion near 0%, the supply-side may deteriorate when nominal wage cuts are needed. If public sector wages are sticky, it may place a burden on the private sector. If the recession leads to big deficits (as ours has) it may lead to expectations of higher future taxes.
2. Why do structural problems worsen the demand shortfall? Two possible reasons (only one of which supports fiscal stimulus.) If the Fed targets interest rates, or is passive at the zero bound, then a falling equilibrium natural rate may unintentionally tighten monetary policy. Obviously the Fed also cares about things like inflation; otherwise the price level would be indeterminate. But in the short run (with interest rate targeting) an adverse supply shock could reduce AD, just as fiscal stimulus could raise it. The other problem is inflation. Structural problems reduce AS, and raise inflation. If the Fed is targeting inflation, that causes them to do less monetary stimulus. This channel works against fiscal stimulus.
So far everything seems symmetrical. But I do think there is an important difference. In my view monetary policy can solve 100% of the AD problem, but policy reforms can only solve a modest portion of the AS problem. If we cut the minimum wage back to $5.15, and cut UI back to 26 weeks, it might cut one point off the unemployment rate, say from 9% to 8% (assuming 5% is the natural rate during normal times.) Other structural problems are harder to address. On the other hand if the problem is 75% AD, then monetary stimulus alone could cut unemployment from 9% to 6%. That’s partly because it would reduce the real minimum wage, partly because it would cause Congress to end the 99 week UI program, and partly because it cuts real public sector wages, and partly because it reduces the problem of money illusion at 0%. (Here I assume that the natural rate went up by 1% (from 5% to 6%) because of other structural problems such as labor re-allocation, which the Fed can do nothing about.)
So even if the problem is both 75% AD, and 75% structural, policymakers should be much more focused on the AD problem, at least in terms of the recovery. Obviously structural changes like tax reform and better regulation will produce greater long run gains than any demand-side policy. But we shouldn’t kid ourselves that those can solve the demand shortfall problem.
Deep down even conservatives must understand this. If a Reaganite was president and doing aggressive supply-side policies, you can be sure the WSJ would be demanding easier money to help facilitate growth, just as they asked for easier money when Reagan himself was president and inflation was 4%. Recent conservative hysteria about inflation is completely at odds with their relative silence during the Bush years, when inflation was higher than under Obama, and the dollar plummeted in value (it’s been fairly stable under Obama.)