Price shocks, wages, and NGDP
I almost always agree with Paul Krugman’s views on inflation. We’ve both been skeptical of claims that US monetary and fiscal policy will produce high inflation. Krugman points to the economic slack in the economy, I focus on TIPS spreads. In a recent post, Krugman made the following observation:
. . . if we think of wages as the ultimate core price, I don’t see any mechanism in today’s America whereby rising commodity prices translate into higher wage contracts.
But what does the historical record say? It depends on which era you’re looking at. . . .
The two big commodity price shocks of the 70s did, in fact, feed quickly into core inflation. Since then, however, nada.
Why the difference? The obvious point is that back in the 70s many labor contracts included cost of living adjustments (COLAs). This in turn partly reflected stronger worker bargaining positions and also real doubts about whether monetary policy would contain inflation. Today, none of that: COLAs are rare, and commodity-price fluctuations don’t feed into wages at all.
My only observation here is that we don’t even need to bring COLAs into the picture. Wages respond to trend NGDP growth, and those growth rates were extremely high during the 1970s, even during recession years. For instance, NGDP grew at an 11% rate between 1971:4 and 1979:4, and then grew another 9.6% in 1980, despite a mild recession. Since monetary policy determines the trend rate of NGDP growth, this analysis is consistent with Krugman’s observation that in the 1970s there were “real doubts about whether monetary policy would contain inflation.” But the phrase “contain inflation” is a tad misleading—suggesting that inflation was like a wild animal on the loose and needed to be reined in by the Fed. The Fed caused the Great Inflation.
As you know, I often say “never reason from a price change.” I think we’d be better off talking about the impact of NGDP on wages, which is fairly stable, rather than the impact of prices on wages, which is highly dependent on whether prices are rising because of more demand, or because of supply-shocks. As we saw in mid-2008, high headline inflation doesn’t translate into big pay increases if not associated with fast NGDP growth. The Economist made a similar observation for Britain:
But a jump in inflation caused by higher commodity prices and a rise in VAT””in an economy with spare capacity””is quite different from one caused by excess demand and a pay-price spiral. It intensifies the squeeze on households from other tax rises and curbs consumer spending. Although the central bank is facing calls to tighten monetary policy soon, that would be warranted only if there were signs of inflation getting embedded into expectations and feeding through to higher wages.
Unsurprisingly, households are now expecting inflation to be higher over the coming year. But other official figures published this week showed no sign of a pay-price spiral. Average earnings are rising by just 2.1%, a very muted rate by historical standards. It is difficult to envisage wages taking off when the public sector is shedding jobs and facing a two-year pay freeze and there are 2.5m people unemployed, close to 8% of the labour force. Indeed the youth-unemployment rate has reached 20.3%, the highest since comparable records began in 1992.
The economy clearly retains quite a bit of spare capacity””the main reason why the Bank of England has insisted that the flare-up in inflation will be temporary. The bank has lost credibility as the inflation overshoot has persisted and its forecasts have proved incorrect.
[there was a rogue paragraph in the original version, which I deleted]
Keynesians often focus on economic slack as a determinant of wage gains. That’s a bit too simple (as we saw in the 1970s); the more sophisticated Keynesian models now account for expected inflation. And in fairness, the “slack” model of wages does seem to outperform the NGDP growth rate model during recoveries, when wage gains are often quite moderate, despite fast NGDP growth.
But there’s a good reason why wage gains often trail NGDP growth during a recovery—wage cuts trail declines in NGDP during most contractions. Thus wages are still adjusting to the previous drop in AD during the early stages of a recovery. The Keynesian model is good at explaining cyclical variations in wages, but not so good at explaining long run changes in trend wage growth, and trend NGDP growth. For that you need the quantity of money.
Britain is facing an interesting dilemma. The BOE clearly understands that NGDP, not prices, are the best indicator of demand. They understand that it would be a mistake to react to the 3.7% headline inflation in December (yoy), by tightening monetary policy. But they are constrained by the fact that almost everyone (wrongly) thinks it’s the central bank’s job to control inflation.
In contrast, fiscal policy is almost always evaluated in terms of real GDP growth. This dichotomy makes no sense. There is no macro model of any school of thought that says monetary policy controls inflation by shifting demand, and fiscal policy controls RGDP by shifting demand. Yet when RGDP growth in Britain came in at a disappointing minus 0.5% in Q4, almost all the reports pointed not to the BOE, but to the fiscal austerity of the new British government. Even Brad DeLong, who devoted much of his talk at the recent AEA meetings to emphasizing the importance of NGDP, quotes an article giving a RGDP number for Britain. RGDP numbers tell us nothing about whether demand stimulus is succeeding. In fairness, I believe the UK NGDP numbers come out with a lag, but the problem is much deeper than that. The media overwhelmingly sees fiscal policy as a RGDP issue and monetary policy as an inflation issue. Until both are seen as NGDP issues we will not be able to come up with coherent policy regimes, which assign fiscal and monetary policy their appropriate roles.
There are two ways British policy might fail. First, the BOE might fail to hit its implicit NGDP target. Why would that occur? Not because Britain is in a liquidity trap. They are actually expected to tighten policy this summer. And Britain can always depreciate its currency if it wants to. It could even cut rates another quarter point. No, with 3.7% inflation it’s madness to even talk about liquidity traps. If they fail it will be because fear of politically embarrassing headline inflation numbers caused BOE officials to take their eye off the ball (NGDP.) However if BOE policy does fail to boost NGDP, I predict fiscal austerity will be blamed.
Alternatively, policy might fail because the Gordon Brown government did significant damage to the supply-side of the UK economy, by increasing the size of the state. A supply-side failure would show up as stagflation, i.e. appropriate NGDP growth but high inflation and slow RGDP growth. Although we saw a bit of stagflation in the 4th quarter, it’s too soon to draw any conclusions. Inflation will probably slow over the next few years.
I predict that if policy does fail for supply-side reasons, the failure will be widely attributed to demand-side factors, especially fiscal austerity. That’s because everyone focuses on RGDP, and almost no one pays any attention to NGDP.
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2. February 2011 at 08:18
Your claim that fiscal policy doesn’t impact RGDP isn’t technically backed up by the official definitions of GDP:
Y = C + I + G + (X − M)
If the British government is running the trains and decides to cut back service that is a fall in RGDP. If they are paying for schooling and stop that is a fall in RGDP. If they close hospitals that is a fall in RGDP. If they stop purchases of Navy ships that is a fall in RGDP.
In the long run many of these changes may boost long term growth potential, as your, rather blithe, declaration at the end claims. But essentially the Cameron government is creating a big complex Kling-ish Recalculation problem in the aftermath of a global financial crisis and on top of a significant construction structural shift.
It doesn’t strike me as very plausible that there would not be some rather difficult lags between both NGDP and RGDP and further between RGDP and employment growth in that circumstance.
2. February 2011 at 09:06
OGT, I never said fiscal policy doesn’t affect RGDP. I said fiscal stimulus is supposed to boost RGDP (if at all) by boosting NGDP. I’ve never seen a model where that is not the case.
Now if you want to discuss supply-side models of fiscal stimulus, that’s fine, but I very much doubt big government is going to do much for the supply-side of the UK economy–government spending is already nearly 50% of GDP.
But my post was about demand-side policies, so your comments don’t have any bearing on my argument. Fiscal stimulus is being sold by its proponents as something that boosts AD.
BTW, although I agree that fiscal stimulus can affect RGDP, that equation is merely a definition, it has nothing to say about causality.
2. February 2011 at 09:32
OGT- Scott will probably say this better than me, but you can’t use an accounting equation to explain an economic process. While real government purchases will contribute to real GDP, this doesn’t mean it works through a purely real channel. The government purchases goods and services with money, not barter, so it has to contribute to nominal GDP.
Also, your accounting identity model implicitly assumes the multiplier to be zero. Government spending, if it increases employment, will increase spending on other components of expenditure. So you need to be careful- any serious macro macro has to account for general equilibrium effects.
Scott-“There is no macro model of any school of thought that says monetary policy controls inflation by shifting demand, and fiscal policy controls RGDP by shifting demand.”
Good point, but the central bank will not have control of inflation in a liquidity trap, which is why US inflation is has been below target despite unprecedented expansion of the money base. Inflation can be driven by supply shocks, as you mention, but these are from commodities prices currently. The UK economy is much more open due to its small size, so it is feeling the impacts, but inflation is slightly up in the USA too.
Remember 2006 when inflation started ticking up? This wasn’t caused by a sudden change in Bernanke’s policy, it was because of commodity price increases. This is the supply side impact to look at, though this is a typical blind spot for monetarists.
“Alternatively, policy might fail because the Gordon Brown government did significant damage to the supply-side of the UK economy, by increasing the size of the state. ”
I’d love to see any empirical support for this. The British state is still smaller than the Scandinavian countries which you seem to admire. Is fire privatization really that big of a difference between Denmark and the UK?
The shock here is supply shocks- of input price increases. Just like in the 1970s. Now the slack in the economy will help keep price increases down, but it won’t mitigate the entire impact.
2. February 2011 at 10:02
Pointing at supply-side problems seems like an ad-hoc way to avoid letting an experiment falsify your theory. If NGDP stays on course, but RGDP and employment stay low, that indicates that merely keeping NGDP on course doesn’t fix recessions. I don’t see any reason for supply-side problems caused by an expansion of government to show up suddenly at the same time as the world went into recession, or at the same time as those expansions are reversed by a subsequent government.
2. February 2011 at 11:14
I am not trying to advance an accounting identity uber alles argument, but it is illustrative at least to think of policy in those terms. That’s especially the case in terms of British austerity measures where real services are being cut, this is anti-stimulus, something rather different than discretionary spending measures.
Sumner has previously estimated that the US unemployment increase is 20% structural, IIRC, mainly from construction, mortage finance, and other sectoral shifts one supposes. So in the case of Cameron it would seem that by running pro-cyclical belt tightening they are adding to structural unemployment and reducing RGDP even if the BOE roughly maintains NGDP.
How flexible is the British economy? How fast does the NGDP/RGDP/Employment transfer work? Fast enough to avoid a second dip? That’s not entirely evident.
Justanothereconomists- That’s the same GDP accounting model Paul Krugman uses, and I am fairly certain his explicit multiplier estimate is greater than zero. So I don’t think you’re right about the ‘implicit’ multiplier estimate.
2. February 2011 at 11:25
Scott,
Scott,
Funny, I said something very similar on a Menzie Chinn post on the UK recently. I even used the word “stagflation”, and I wondered outloud why the UK has higher inflation and lower real growth than almost all other advanced nations. Menzie said this:
“…you can get inflation also via a depreciated currency, if there is substantial exchange rate pass through into CPI, or if you are highly energy dependent, and energy prices rise substantially…”
2. February 2011 at 12:51
The last British government did increase their total managed expenditure but they did it by running a deficit rather than significantly increasing taxes. The tax take only increased by half of one per cent during their time in office. I would argue that they tax badly rather than tax too much but that is beside the point.
This was the growth in employment.
http://4.bp.blogspot.com/_tvshDVnXSLc/TFkheQQTGYI/AAAAAAAADLc/ExadY7Fjh-I/s1600/OBR+jobs+growth.gif
This happened to GDP.
http://1.bp.blogspot.com/_tvshDVnXSLc/TCEfhcKU7xI/AAAAAAAAC7o/2hZ22yyoTkM/s1600/gdp+growth.jpg
This happened to the government share of the economy. Although, government spending had risen it only dramatically rose because GDP plunged.
http://4.bp.blogspot.com/_tvshDVnXSLc/TCEv3wUZBDI/AAAAAAAAC8Q/yxIx22x-5io/s1600/balance+budget.jpg
2. February 2011 at 13:05
you say ” .. focus on .” after the Economist quote. What’s the missing word ?
2. February 2011 at 13:49
Is it just me, or has Brad DeLong gotten very reasonable lately?
2. February 2011 at 14:16
jsalvatier: a paragraph is repeated, Scott has put in an earlier and the correct version, so your question is answered in the next paragraph. (The specific answer is “economic slack as a determinant of wage gains”.)
Scott: you failed to remove the earlier version of the paragraph “Keynesians focus on”.
2. February 2011 at 15:00
For an open economy like the UK, it might be true (at least in the short run) that monetary policy (as compared to fiscal policy) disproportionately affects the inflation component of NGDP (especially if interest rates are already near zero, so that the exchange rate is even more important than usual as a monetary policy transmission mechanism). Changes in the terms of trade show up very quickly in the domestic price level, even when NGDP growth is weak, and monetary policy operates (under current circumstances) largely by causing the terms of trade to deteriorate. By contrast, fiscal policy has no direct impact on the price level — possibly no impact at all given the high degree of slack.
On a separate point, I am intrigued by your idea that nominal wages respond to NGDP growth. Is there a theory that explains why that would be the case? Without an underlying theory that ties wages directly to trend NGDP growth, I’m inclined to accept the Keynesian explanation, namely that wages respond separately to the real and price components of NGDP for different reasons.
I would suggest that a big difference between the 1970’s and today is that there is simply a lot more slack in the labor market. Even if you look at comparable unemployment rates, there was a lot more recruitment activity going on in the 1970’s, which suggests that a larger fraction of the unemployment was structural. And in any case, the unemployment rate was not as high, even at its recession peak, and it didn’t remain high for nearly as long. Combine these observations with the difference in COLA prevalence and the fact that the 1970’s were continuing an already established pattern of accelerating inflation (which must have had an impact on inflation expectations), and I think we have a sufficient Keynesian explanation for the difference.
2. February 2011 at 16:13
Justanothereconomist, You said;
“Good point, but the central bank will not have control of inflation in a liquidity trap,”
Yes, but Britain clearly isn’t in a liquidity trap.
You said;
“Remember 2006 when inflation started ticking up? This wasn’t caused by a sudden change in Bernanke’s policy, it was because of commodity price increases. This is the supply side impact to look at, though this is a typical blind spot for monetarists.”
I agree about 2006, but you must be much younger than me. I recall when it was the monetarists who warned about supply-shocks, and the Keynesians who ignored them.
You said;
“I’d love to see any empirical support for this. The British state is still smaller than the Scandinavian countries which you seem to admire. Is fire privatization really that big of a difference between Denmark and the UK?”
You need to hold other things constant. Denmark has a far more efficient policy regime than Britain, it’s not even close. Indeed Denmark scores on the top ten of the heritage rankings, despite its huge government. But compare Denmark to an efficiently run country with a smaller government, say Switzerland or Singapore, and you’ll see that their high taxes do take a toll on RGDP per capita. There’s no real dispute that higher MTRs reduce growth, the question is how much.
You said;
“The shock here is supply shocks- of input price increases. Just like in the 1970s.”
Yes, but that doesn’t have much effect on growth. Indeed even in the 1970s it was bad regulations, price controls and rising MTRs that were the main problem.
JeffreyY, You said;
“Pointing at supply-side problems seems like an ad-hoc way to avoid letting an experiment falsify your theory. If NGDP stays on course, but RGDP and employment stay low, that indicates that merely keeping NGDP on course doesn’t fix recessions. I don’t see any reason for supply-side problems caused by an expansion of government to show up suddenly at the same time as the world went into recession, or at the same time as those expansions are reversed by a subsequent government.”
I’ve never argued that NGDP targeting could prevent all recessions, indeed just today I did a post pointing out that it could not prevent the recession in Iceland (due to recalculation.) My theory has always been that the current US recession is mostly a demand problem. That theory is easily refuted–it we had high inflation and slow RGDP growth. So far it’s the Austrian/monetarist/supply-sider/gold bugs who get getting their theories refuted.
OGT, Yes, there could be some recalculation with government employees being fired. But the number likely to be fired in the next year are far to low to materially affect the British business cycle. Does anyone know how many will be fired? And how many government jobs lost due to attrition in 2011?
Mark, That’s an odd answer, as currency depreciation certainly cannot explain stagflation.
Richard, You said;
“This happened to the government share of the economy. Although, government spending had risen it only dramatically rose because GDP plunged.”
But the flip side of this is that the government share should fall during expansions, by as much as it rises during contractions. Yet government spending in Britain as a share of GDP rose substantially between 2000-06. That was a huge policy error by Brown. That procyclical fiscal policy was basically the same error Krugman accuses Bush of making. But for some reason Krugman really like Brown. I wonder why?
I agree about taxing badly, the increase in the top MTR to 50% was a big mistake, and there are even higher implicit MTRs embedded in the code. Brown was one of the worst PMs in UK history, just a complete disaster in almost all aspects of economic policy.
More to come . . .
2. February 2011 at 16:30
jsalvatier, This isn’t my day, everything seems to be going wrong. That entire paragraph was supposed to be deleted, I don’t know what happened.
James Oswald, probably since he heard my talk at the AEA meetings. 🙂
Thanks Lorenzo, I just made the change.
Andy, You said;
“By contrast, fiscal policy has no direct impact on the price level “” possibly no impact at all given the high degree of slack.”
But if fiscal policy doesn’t raise the price level, then ipso facto it doesn’t raise RGDP. Unless one wants to argue that fiscal policy is a positive supply shock. One could make that argument, but it certainly isn’t the argument Keynesian economists like Krugman make. He makes demand side arguments.
If I was going to move away from a demand-side only model, this is the argument I’d make:
Big government hurts the supply-side of the economy, and hence reduces AS. Thus the optimal policy is to have monetary policy focus on real growth (easy money) and have fiscal policy focus on inflation (tight fiscal policy.) And yet you rarely see people suggest that policy mix. Often it’s the opposite. In Britain it seems people want big government and tight money. That won’t end well.
But the point about import prices is a good one. It is theoretically possible for import prices to rise, but not domestic prices. In that case a monetary expansion that depreciated the currency might not raise AD. As a practical matter, however, when monetary policy depreciates a currency it almost always raises AD. I should mention that the price index that matters in macro (for domestic inflation) is the GDP deflator, not the CPI (which includes import prices.)
I didn’t mean to suggest that the Keynesian model can’t explain the general pattern of unemployment in the 1970s, it can. My point was that the Keynesian model can’t explain variations in the trend rate of inflation and NGDP growth. If Israel average 120% inflation and Turkey averages 60% and Britain average 15% and Switzerland average 5%, the Keynesian model can’t explain those difference. The monetarist model can.
2. February 2011 at 17:51
OTG-
Does Krugman ever say that fiscal policy has purely real effects? I also use Y=C+I+G+X-M, but that doesn’t mean that this equation tells you how fiscal stimulus works economically. That was my point. MV=PY is always true, but does it tell you how money affects prices? No it does not.
“Yes, but Britain clearly isn’t in a liquidity trap.”
We will have to agree to disagree- but if fiscal austerity continues to be a drag on growth despite QE, I hope you will see that as evidence for a liquidity trap. If growth picks up in the midst of fiscal austerity, then I will see that as evidence for your side.
“I agree about 2006, but you must be much younger than me. I recall when it was the monetarists who warned about supply-shocks, and the Keynesians who ignored them.”
“Inflation is always and everywhere a monetary phenomoenon” I thought. Are you saying monetarists (or quasi monetarists whatever) accept cost push inflation? In any case, this wasn’t my experience at all-not that it matters for the arguments.
“Denmark has a far more efficient policy regime than Britain, it’s not even close. Indeed Denmark scores on the top ten of the heritage rankings, despite its huge government.”
I’ll remind you, this is what you said: “Alternatively, policy might fail because the Gordon Brown government did significant damage to the supply-side of the UK economy, by increasing the size of the state. “
I’d love any evidence that *Gordon Brown’s government* did significant damage to the supply side. Seriously, you’re smarter than this. Is this the best you can do to explain why fiscal austerity combines with negative commodity supply shocks causes stagflation? Blame it on the lefties? So again, what’s your evidence?
“There’s no real dispute that higher MTRs reduce growth, the question is how much.”
There’s zero evidence of this in the USA. Compare Brazil to Mexico- they are broadly similar, have had boom and bust periods at roughly the same time, yet Brazil has massively higher tax rates, and neither country is very well run.
” Yet government spending in Britain as a share of GDP rose substantially between 2000-06.”
Yet it was still smaller than the Netherlands in 2006
http://www.taxpolicycenter.org/briefing-book/background/numbers/international.cfm
Netherlands unemployment rate 4.3% in December 2010. Netherlands top marginal income tax rate: 52%
http://data.worldbank.org/indicator/GB.TAX.IMAR.ZS
How can the Netherlands have such low unemployment with such high MTRs? Lemme guess- they’re “well run”? You’ll probably find a way to wiggle out of this one too somehow.
2. February 2011 at 21:58
“But if fiscal policy doesn’t raise the price level, then ipso facto it doesn’t raise RGDP.”
It does if the Phillips curve is locally horizontal, which it would be if it’s highly concave and the output gap is very large.
“Unless one wants to argue that fiscal policy is a positive supply shock.”
I’m arguing that monetary policy (in an open economy) is a negative supply shock. It does raise AD, but it also reduces AS. Empirical Phllips curve models often contain the exchange rate as a shift variable. It will have a direct effect on flexible prices in a way that fiscal policy won’t (or might not, anyhow). For example, hiring people to dig holes in the ground doesn’t necessarily raise the price of anything, but devaluing the currency means that commodity prices go up immediately from international arbitrage. Also, some argue that exchange rate shocks in some economies get incorporated quickly into wage demands.
“Big government hurts the supply-side of the economy, and hence reduces AS.”
I’m not sure what “big government” means. Over-regulation hurts the supply side, but variation in the size of the regulatory apparatus accounts for only a small fraction of changes in the government budget. High tax rates hurt the supply side, but raising tax rates also reduces consumption, which helps the supply side by leaving more resources available for growth-inducing private investment. Public investment can help the supply side, too, though, so government spending isn’t necessarily a negative.
“Thus the optimal policy is to have monetary policy focus on real growth (easy money) and have fiscal policy focus on inflation (tight fiscal policy.)”
I used to think that, but I’ve changed my mind after witnessing the last two business cycles in the US. Low real interest rates make asset prices unstable (sensitive to small changes in expected growth rates) and often end up doing more harm than good. There’s some optimal mix of policy, but it’s not an extreme of tight fiscal policy and easy money.
I would note, also, that tight fiscal policy doesn’t necessarily mean less government, since it can take the form of high taxes. And back in the 1980’s I was troubled by the combination of tight money and easy fiscal policy which took the form of cutting taxes.
“In Britain it seems people want big government and tight money.”
Then why did they just elect a government that ran on a platform of fiscal austerity?
“My point was that the Keynesian model can’t explain variations in the trend rate of inflation and NGDP growth.”
I don’t think most Keynesians would claim to be explaining variations in the trend. But Krugman seemed to me to trying to answer a question about SRAS: why is it flatter now than in the 1970’s? Personally I think structural unemployment — which Krugman didn’t mention — is a large part of the explanation. You seemed to be suggesting that NGDP growth was part of the explanation too, that rapid growth of NGDP was causing workers to demand higher wages.
3. February 2011 at 03:28
Taylor doesn´t miss a chance to promote his name sake “Rule”:
http://johnbtaylorsblog.blogspot.com/2011/02/learning-from-monetary-mistakes-and.html
3. February 2011 at 05:13
Robert Gordon had the best line: Think of WWI, we are in the trenches without amunition, only stones and knifes.
The “geniuses” think it´s going to be slow and painful:
http://www.wbur.org/media-player?url=http://www.wbur.org/2011/01/28/economic-outlook/&title=From+Asteroids+To+Zero-Lower-Bound%3A+Top+Economists+Debate+Economic+Future+At+MIT&segment=economic-outlook&pubdate=2011-01-28&type=
3. February 2011 at 07:19
Justanothereconomist, You said;
“We will have to agree to disagree- but if fiscal austerity continues to be a drag on growth despite QE, I hope you will see that as evidence for a liquidity trap. If growth picks up in the midst of fiscal austerity, then I will see that as evidence for your side.”
The debate in Britain is over whether policy should be tightened. There are currently expectations that the BOE will raise rates this summer. Even Keynesians who believe in liquidity traps would not call that policy environment a liquidity trap. The BOE could do lots of things if they wanted to boost AD, which they are not doing. They could devalue the pound. They could promise not to raise rates. They could cut interest rates. They could do QE. They could raise the inflation target. They could do NGDP targeting. They could do level targeting. They could do negative rates on reserves. How are they “trapped?” I am having trouble even understanding what people are claiming here. What do you see the term “trap” meaning? Do they act like they are trapped?
Inflation is 3.7%. Even if there are errors in the index, there is no deflation in Britain
You said;
“”Inflation is always and everywhere a monetary phenomoenon” I thought. Are you saying monetarists (or quasi monetarists whatever) accept cost push inflation? In any case, this wasn’t my experience at all-not that it matters for the arguments.”
It’s a myth that Friedman said this. He said persistent inflation is always and everyone a monetary phenomenon. Friedman believed supply shocks can raise the price level.
You said;
“I’d love any evidence that *Gordon Brown’s government* did significant damage to the supply side. Seriously, you’re smarter than this. Is this the best you can do to explain why fiscal austerity combines with negative commodity supply shocks causes stagflation? Blame it on the lefties? So again, what’s your evidence?”
There is all sorts of evidence that countries with high levels of “economic freedom” as defined by the various indices do much better. Brown dramatically raised the size of the UK state, although perhaps I should point out that I am including his last few years as Chancellor under Tony Blair. Brown had great influence on economic policy. He was solidly behind the big increase in spending.
If you are surprised my my views you must not know much about my blog. I’m a libertarian, or course I think left-wing big-spending policies are bad for the economy. Have you ever met a libertarian who didn’t think that?
You responded;
“”There’s no real dispute that higher MTRs reduce growth, the question is how much.”
There’s zero evidence of this in the USA.”
Wouldn’t it be more accurate to say there is evidence, but you don’t buy the evidence? If you were right, I’d favor the 98% MTRs that Britain had in 1979. Why not, the rich don’t need all that money. And if it doesn’t hurt the economy then on utilitarian grounds it ought to be redistributed.
The best studies are cross sectional, as it is very difficult to do time series estimates of the effects of MTRs (since the biggest effects are very long term.) All sorts of economists like Barro, Feldstein, Prescott have done research on the incentive effects of MTRs.
You said;
“How can the Netherlands have such low unemployment with such high MTRs? Lemme guess- they’re “well run”? You’ll probably find a way to wiggle out of this one too somehow.”
Yes, there have been academic papers written about how good Dutch labor market policy is. I’m hardly the only one who has this view.
As far as Brazil, why compare them to Mexico, why not to the US?
Andy, The economy contains a mixture of flexible price goods and sticky price goods. For that reason, the local SRAS curve is never flat, there is always some slope. And there is certainly going to be some slope over a range large enough be relevant to policy discussions. Recall that I was discussing the debate over whether the British austerity program was going to put Britain into a double dip recession. Surely if it did, the inflation rate in Britain would slow.
Obviously if you make the shift in AD tiny enough, say a few dollars, there may be no change in the price level large enough to show up in measured price indices, but I think I am on solid ground asserting that more AD raises prices for any meaningful change in policy.
You said:
“I’m arguing that monetary policy (in an open economy) is a negative supply shock. It does raise AD, but it also reduces AS.”
Yes, to the extent it raises input prices it moves the SRAS to the left. But if you move from a closed to an open economy setting, you get both higher import prices and higher export prices. The stronger exports is an unambiguous plus, whereas the higher import prices also discourage imports of final goods, leads to more domestic production of final goods. So the net effect on aggregate demand and output is strongly positive, indeed more so than in a closed economy.
BTW, when I talk about inflation in a macro context I mean inflation domestically produced goods, like the GDP deflator. I agree that the CPI may rise faster when there is an import price spike.
You said;
“Also, some argue that exchange rate shocks in some economies get incorporated quickly into wage demands.”
This is more likely to occur if NGDP rises. At least in the US we don’t see higher wage demands when import prices rise, unless it affects NGDP. But of course fiscal stimulus also affects NGDP, if it works at all. Indeed that’s true even if fiscal policy had no effect on prices, and merely affected RGDP.
You said;
“High tax rates hurt the supply side, but raising tax rates also reduces consumption”
In countries like the US and UK higher tax rates discourage saving and encourage consumption. You are right that some government programs might boost growth, but as a general rule the marginal increase in government spending, from where we are now, is likely to reduce growth. A fiscal regime like Singapore’s is probably much closer to growth maximizing than the US and UK. But obviously this is an empirical question, I’m just giving my own opinion.
You said;
“I used to think that, but I’ve changed my mind after witnessing the last two business cycles in the US. Low real interest rates make asset prices unstable (sensitive to small changes in expected growth rates) and often end up doing more harm than good. There’s some optimal mix of policy, but it’s not an extreme of tight fiscal policy and easy money.”
The Fed has little effect on long term real interest rates, so asset bubbles shouldn’t even be an issue. Indeed if money had been tighter in 2001-02 then it actually was, then the recession would have been deeper and both nominal and rates would have been even lower in 2003. I think that period has been widely misinterpreted. The current commodity spike is mostly driven by Asian demand, not easy money in the US.
I probably shouldn’t have said “easy money,” I should have said a monetary policy that always keeps expected NGDP growth on target. Then let fiscal policy focus on the supply-side of the economy. Doing the reverse won’t get you any better NGDP outcome, but will make fiscal policy suboptimal for growth. I don’t think there is any evidence that easy money caused the housing boom. Money was much easier in the 1960s and 1970s, and there were no housing bubbles. It was bad public policies (such as allowing subprime mortgages–which weren’t allowed when I bought my house in 1991.) And also Fannie and Freddie, and poor decisions by private banks, etc. I can’t see how monetary policy could have created a housing bubble because monetary policy wasn’t particularly easy. At least I’ve never seen anyone present any persuasive evidence that policy was easy in 2002.
You are right about the UK election, I was reacting to all the commentary I see in the UK press.
On your last point: Yes, I think Krugman was confusing SRAS and LRAS. When inflation is rising rapidly, workers catch on pretty quick and wages also go up. We don’t see that now, for the obvious reason that the Fed is targeting inflation at around 2%, so workers don’t expect an uptick like mid-2008 to persist. In the 1970s they did (although of course Keynesian economists didn’t.) It turns out the workers were right and the economists were wrong.
3. February 2011 at 07:23
Marcus. That statement by Gordon is pretty surprising, given it occurred right after QE2 seems to have “worked.”
3. February 2011 at 07:30
On UK government employment forecasts… stats are a bit controversial here; depends how you define “government” (BBC is in… what about those little banks we own?):
http://budgetresponsibility.independent.gov.uk/d/econ_fiscal_outlook_291110.pdf
pages 64-65, forecasting a drop of, wait for it, 40K jobs (austerity, DOOM, etc) by end of FY11-12; and 400K over the next four years in total. But that’s on the basis of c5.5 million total current government employment, which is only 1/5 of the labour force so sounds rather low.
I couldn’t quickly find numbers for the drop in FY10-11 but we are mostly following the Labour budget this FY; the official birthdate for Britain’s Great Age of Austerity is April 1st; mark your diaries.
“Brown was one of the worst PMs in UK history, just a complete disaster in almost all aspects of economic policy.”
It made my day to read that. There is so much denial this side of the pond. The Labour (and in many parts, media) narrative here is that all Labour spending was good, the evil bankers caused the recession, and Labour saved us from them.
It may be unduly cynical, but it seems to many here that Brown cared little for economics; he used fiscal policy primarily as a way to ensare and manipulate voters; trapping low and medium earners in the welfare mindset with expectations of entitlement – low taxes, high spending, cash handouts for all. If we do not see a strong recovery in employment I fear greatly for the survival of our coalition, since those same earners will vote the next Brown right back in if they get the chance.
/- Britmouse, apols for the rambling comment
3. February 2011 at 07:55
I don’t think it’s at all fair to say the UK government ran for election on a platform of fiscal austerity. Its constituent parties ran for election on opposing platforms, for one thing!
There was some talk of “fiscal responsibility” and such like but the party leaders on all sides steered clear of it as much. The (shadow) chancellors were more up front about it.
Several key campaigning themes from the Conservatives were to lower taxes: corporation, undoing a Labour-planned “jobs tax”, tax breaks for married couples, lower inheritance tax. Similarly with the LibDems, they splashed on how the Conservatives would raise VAT (sales tax).
Mostly all three parties ran on promises to cut spending through eliminating waste, some “fairness” rebalancing in the tax/welfare system, and a bunch of gimmicky giveaways.
3. February 2011 at 19:07
Scott-
“There is all sorts of evidence that countries with high levels of “economic freedom” as defined by the various indices do much better.” Sure, but countries with large state sectors are still very prosperous. What’s your point? I don’t think economic freedom is incompatible with a large state, otherwise Mexico would be richer than Denmark. Scandivanian countries, based on any kind of deadweight loss resulting from taxation, should be complete basketcases. Until you can explain why that is, the size of the state is irrelevant to economic performance. It just doesn’t matter.
“Brown dramatically raised the size of the UK state, although perhaps I should point out that I am including his last few years as Chancellor under Tony Blair. Brown had great influence on economic policy. He was solidly behind the big increase in spending.”
Nothing much here. The state is still smaller than the Netherlands and all the scandinavian countries, etc. If France shrunk their state to be smaller than the UK’s, they wouldn’t experience an economic boom either.
“I’m a libertarian, or course I think left-wing big-spending policies are bad for the economy.” I do follow your blog, I was just hoping that you might be a libertarian that trades in facts instead of ideology. It’s increasingly seeming to be the latter.
“As far as Brazil, why compare them to Mexico, why not to the US? ” Because their vastly different countries. But fine, compare Mexico to the USA- tax rates are clearly not a major factor in explaining anything- the state is much much smaller in Mexico and top marginal tax rates are comparable. Mexico went wholeheartedly for neoliberalism by the 1990s, and even before the drug violence, they were not growing converging to the USA’s level of income. What gives?
“If you were right, I’d favor the 98% MTRs that Britain had in 1979.”
I said in the USA, of course 98% MTRs are ridiculous. Even 90 and 70% are crazy, but the economy didn’t collapse. Anything 55% and below is consistent with a well functioning, wealthy, welfare state. Do you disagree?
4. February 2011 at 19:01
Britmouse, Thanks for that data. Only 40k in job cuts by the end of 2011/12? I think that puts to rest the myth that fiscal austerity has anything to do with the slow recovery in the UK.
I agree about Brown. If the public thinks it was the bankers fault, do they ever ask who was in charge of regulating the banking industry?
That was also my impression of the election, but I didn’t know enough to comment.
Justanothereconomist, You said;
“There is all sorts of evidence that countries with high levels of “economic freedom” as defined by the various indices do much better.” Sure, but countries with large state sectors are still very prosperous. What’s your point? I don’t think economic freedom is incompatible with a large state, otherwise Mexico would be richer than Denmark.”
You keep missing the point. Lots of factors help explain a country’s success. In the various rankings of economic freedom, size of government is one out of ten, and taxes are another. Despite Denmark’s large goverment, they rate far higher than Mexico in terms of economic freedom. Mexico has a small government, but in many other respects is very poorly governed. There’s nothing like Pemex in Denmark. So there is no mystery to explain.
No one is claiming that the UK tax increase will suddenly make Britain a poor country. In my view if you want a ballpark estimate of the effect of taxes, compare the Nordic countries (excluding Norway) to well-governed low tax countries like Singapore and Switzerland. I think you’ll find Denmank and Sweden have lower per capita GDPs (in PPP terms) but on order of maybe $5000 less, which is significant but hardly overwhelming. Also recall that although taxes are high, the Nordic tax systems tend to tax capital lightly, which is important.
You say I have no evidence that big government reduces economic growth. I’ve debated dozens of leftists, and I have yet to hear a single one provide a half-way plausible explanation for why American’s per capita GDP (PPP) is far higher than western Europe per capita GDP. Krugman says the French work much shorter hours. Hmmm, I wonder why that is? I have yet to hear a plausible explanation why why Sweden has so many disabled people.
You said;
“I do follow your blog, I was just hoping that you might be a libertarian that trades in facts instead of ideology. It’s increasingly seeming to be the latter.”
You probably don’t know that I am one of the few libertarians on the internet who doesn’t blame the high unemployment on things like Obama’s health care bill imposing costs on businesses. I look at the world the way it is. If I was such a knee jerk libertarian, ignoring the facts, why would I argue that Denmark has one of the best economic systems on earth? How many libertarians make that argument?
You say I ignore the facts; a much more likely explanation is that I know the facts quite well, but interpret them differently.
You said;
“Mexico went wholeheartedly for neoliberalism by the 1990s, and even before the drug violence, they were not growing converging to the USA’s level of income. What gives?”
Check out how Mexico rates on indices of economic freedom. (It’s relatively low.) If you want a Latin American example of neoliberalism, Chile would be a much better example; it scores much higher than Mexico. Chile also happens to be the most successful economic model in Latin America.
You said;
“Anything 55% and below is consistent with a well functioning, wealthy, welfare state. Do you disagree?”
Of course I agree, I’d say the same about 70% rates. But if you adopt Singapore’s fiscal regime, with a top rate around 20%, it will be even wealthier and more successful, and you can still provide a comprehensive welfare state.
My second point is that it depends which country you are talking about. Denmark has a well-functioning government, the US and UK don’t. Raising our top rates to 55% won’t suddenly make us well-functioning. And our top rates will probably be 55% soon, if you include federal taxes, health care taxes, and state and local taxes.
5. February 2011 at 21:42
Justanothereconomist,
Your question about the UK and Netherlands (differences in unemployment and differences in MRT). You might as well have wondered about the counterfactual of the UK having joined the Euro in 2000, the Brits having finally abandoned their dangerous habit of driving on the wrong side of the road.
I doubt that there is a good connection between MTR differences and realized unemployment. Holland and the UK have very different location factors, unemployment policies and supply side conditions (location, specialization, population density) as well as public sector economics (smaller countries tend to have lower overheads). Also: the Dutch MTRs are mitigated by mortgage interest deductibility, absence of a capital gains tax and a very peculiar system of taxing non-work income. They are more of a symbol than a burden, except for “city types”, who would elect to work elsewhere and be replaced by expats who would have a more favorable regime…
Anecdotally, I would say that location, sunk cost and taxation for business, and the tax-and-benefits structure are more relevant than MTRs for individuals and small business proprietors.
5. February 2011 at 21:59
Scott,
“You say I have no evidence that big government reduces economic growth. I’ve debated dozens of leftists, and I have yet to hear a single one provide a half-way plausible explanation for why American’s per capita GDP (PPP) is far higher than western Europe per capita GDP. Krugman says the French work much shorter hours. Hmmm, I wonder why that is? I have yet to hear a plausible explanation why why Sweden has so many disabled people.”
I am hardly a leftist but as someone who has lived and worked in Europe, the US, Asia and Australia and usually with a great deal of enjoyment I doubt that all of the French work these short hours.They tend to be less obese than most of their GDP peers…
However, much more importantly, per capita GDP does not say a lot about the job a gvt (or rather state) is doing for its citizens. So although it might be interesting to find out whether it is the result of policy, structure, endowments etc or simply of flawed statistical work (not too much faith in PPP comparisons or comparative macroeconomics in general), it is more important to know if there is something in the various policy repertoires that consistenly works well or the opposite, and under what circumstances..
7. February 2011 at 12:36
Rien, One needs to separate out two issues:
1. Do high MTRs affect GDP/person?
2. Is GDP/person a good measure of welfare?
I was addressing the first. I agree that the second is also important, but I wasn’t addressing that issue.
7. February 2011 at 23:58
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