Everyone seems to think it does, so naturally I’ll argue the other side.  What surprised me is how easy it is to make the argument.  As you look at the following data, ask yourself what you’d expect to happen to unemployment if there were no lags.  Keep in mind that the trend rate of RGDP growth is around 3%:

2008:1 and 2008:2 — RGDP falls at about 0.1%

2008:3 through 2009:2 — RGDP plunges 4.1%

2009:3 — RGDP rises at a rate of only 1.6%

2009:4 and 2010:1 — RGDP rises at a 4.35% rate

2010:2 and 2010:3 — RGDP rises at only a 2.15% rate

I’d expect unemployment to rise modestly in early 2008, soar in late 2008 and early 2009, rise a bit more in the 3rd quarter of 09, fall in late 2009 and early 2010, and then rise a bit in the summer of 2010.  Here are the actual unemployment rates:

December 2007 (cyclical peak) — 5.0%

July 2008 — 5.8%

July 2009 — 9.5%

October 2009 (unemployment peak) — 10.1%

May 2010 (euro crisis begins) — 9.6%

November 2010 — 9.8%

Too early to know where it goes next, but I expect RGDP growth to pick up over the next few quarters, and unemployment to trend downward (although the recent 9.4% figure may have been a blip.  But in general isn’t that exactly the unemployment pattern you’d expect if there was no time lag at all between output and the unemployment rate?

I think the problem here is that during the last three recessions unemployment has not fallen significantly during the early stages of recovery.  One explanation for that raises no problems; growth has been slow.  The last rapid recovery we saw was in 1983, and unemployment fell almost immediately from the moment the economy started recovering.  The other issue is more complicated, productivity growth seems unusually high during recent recoveries.  Still I think it is possible to overdo this difference.  This table shows that while productivity during recent recessions has been much stronger than 1974 and 1982, there were also some fairly strong productivity numbers in garden variety recessions like 1957-58 and 1948-49.

Perhaps productivity growth was a bit higher in the early stages of recent recoveries for reasons unrelated to AD.  In that case the baseline job growth might be a bit lower, but even so any extra AD would show up as more jobs.  That could explain the close correlation in timing for the high frequency fluctuations in output and jobs discussed above, and the disappointing overall job growth.  And I still insist that this recovery is fairly weak in terms of both real and nominal GDP

Tyler Cowen has a slightly different view:

The AD-only theories, taken alone, encounter major and indeed worsening problems with the data.  Year-to-year, industrial output is up almost six percent, sales up more than six percent, but the labor market has barely improved.  How does that square with the AD-only hypothesis?  Has it been seriously addressed?

I think he is misreading the recent data on output.  Elsewhere in his post he cites productivity data showing very strong gains in 2009.  But the past 4 quarters only show 2.65% productivity growth.  If productivity growth is not high, and jobs aren’t being created, how can I explain the rapid output growth observed by Tyler?  I’d like to stick my head in the sand and deny it, but I guess that won’t do.  Seriously, I think the problem is that the industrial production data is not representative.  RGDP growth over the past 4 quarters in 3.25%.  That’s not horrible, but on the other hand it’s not that much above trend.  And unemployment has fallen a bit since the 10.1% peak of October 2009.  He’s got a point about productivity being somewhat unusual in this recession, especially 2009; but the 6% industrial production figure may overstate things.   Productivity gains in manufacturing tend to be much higher than in services, so even 6% manufacturing growth could coexist with both 2.65% overall productivity gains and also a relatively small gain in total jobs.

My previous critique of Tyler Cowen’s ZMP post was focused on one issue; I didn’t think the data supported his argument.  After reading his recent post, I don’t want to argue against the general idea that there may be some workers who (in the short run) have MPs much lower than the wage rate.  Some of the quarterly observations he discusses are very suggestive.  And I don’t have a good feel for this issue, indeed I may have read too much into his earlier post.  Tyler Cowen points out that Krugman once offered a similar hypothesis, and now rejects it out of hand, so I think Krugman may have also misread Tyler.

In earlier posts I argued that the sticky wage theory is often misunderstood.  If the Fed suddenly imposes 10% fall in NGDP, it is not true that factory workers can keep their jobs by accepting 10% wage cuts.  Why not?  Because other workers may not.  Suppose half of workers take 10% pay cuts (factory workers, etc) and half do not (teachers, health care workers, public employees, etc.)  The aggregate wage will fall 5% and we’ll have a severe recession.  During recessions people cut back on car purchases much more than health care (often paid for by insurance or Medicare), so it will be the factory workers losing their jobs, despite their willingness to take pay cuts.  Now see if that argument reminds you of Tyler Cowen’s point 7:

What does the zero MP hypothesis add?  First, the zero MP hypothesis explains why wage adjustments can’t do the trick for a lot of the unemployed, as wages won’t fall below zero.  Second, the zero MP hypothesis explains why you need steady real growth, boosting the entire chain of demand, to reemploy lots of workers and reflation alone won’t do the trick.  (I still, by the way, favor reflation because I think it will do some good.)  Those predictions are not looking terrible these days.

I agree the “entire chain” may need a boost, but I think reflation can do the trick.  On the other hand if we can’t get more people to buy cars, wage cuts for windshield makers in Toledo are not going to restore their jobs.

I completely agree with the following by Arnold Kling:

I want to reiterate that I would like to see the Fed behave as if this were an AD-caused recession. However, we should be prepared for the possibility that it is not, in which case expansionary policies will cause price bubbles in some sectors without doing much for employment and output.

What would get me to give up my AD-only explanation (actually 80% AD and 20% AS)?  Evidence that more NGDP would not result almost one for one in more RGDP.  How could we discover who’s right?  It would be simple—just create NGDP and inflation (or NGDP and RGDP) futures markets, and watch how they react to monetary shocks.  How do we identify monetary shocks?  Look for major Fed announcements, and see if the press interpretation is confirmed by market responses.  Example: Bernanke gives a speech strongly hinting at QE3.  The dollar plunges and stocks soar.  That’s a good indication the speech increased the expected future monetary stimulus.  To see how much of the recession is real and how much is demand-side we’d merely have to watch the reactions in the NGDP and inflation markets.  I say NGDP expectations would rise much more than inflation expectations.

This would be incredibly useful information to policymakers, and it would cost peanuts for the US government to set up and subsidize trading in such a market.  Why don’t they?  My wholesome and naive personality says they are well-intentioned, and just don’t know about my ideas.  Many would argue that Robin Hanson has a more clear-eyed and realistic take on what makes people tick.

What do you guys think?  Do elite macroeconomists and Fed officials enjoy presiding like high priests over a mysterious macroeconomy, or do they actually want to discover the truth?

PS.  One reason I hold my views so strongly is that even though we don’t have a NGDP futures markets, we do have enough reasonable proxies that I am pretty sure monetary stimulus “works.”

A few months back a great deal was made of a letter signed by 24 mostly conservative intellectuals.  Some people drew the conclusion that conservative economists were opposed to QE2.  Undoubtedly many are, including some that did not sign the letter.  But the letter itself shows almost nothing.  Many of the signers were not economists.  A grand total of 5 had jobs at American universities.  One more taught at a college.  Four were at Stanford, meaning a total of one American economist teaching at a university not named Stanford signed the letter.  Let’s take a look at that one, the distinguished monetary economist Charles Calomiris, who teaches at Columbia University.

Noah Kristula-Green emailed Calomiris to ask him why he opposed QE2:

Charles W. Calomiris of the Columbia University Graduate School of Business told FrumForum in an email that he favored keeping interest rates were they currently were:

“There are many reasonable alternative views on how to target monetary policy. I favor Ben McCallum’s proposal to target nominal GDP growth at about 5%. Since we were on track with that target before QE II, at least for the moment, I would neither be raising or lowering interest rates.”

Though he also stated that he would be in favor of a looser monetary policy if the evidence could convince him the circumstances warranted it:

“If there were evidence of a need for further loosening to raise the growth of nominal GDP to that target rate, then some quantitative easing might be a reasonable proposal.”

This puzzled me on several levels.  First, I also support 5% NGDP growth targeting, and I thought QE2 was far too weak.  The easiest way to explain this discrepancy is that I favor level targeting, which requires us to make up for at least some of the previous NGDP shortfall, whereas Calomiris may support a sort of “memory-less” growth rate targeting.  Let bygones be bygones.  I feel pretty strongly that level targeting is better after a serious slump, and also when monetary policy is up against the zero bound, but let’s put that issue aside.

What I find most perplexing about Calomiris’s statement is that even if you accept growth rate targeting, and even if you buy his argument that QE2 should only be adopted if there were signs that NGDP growth was likely to be inadequate, there is no logical reason why Charles Calomiris should have opposed QE2.

A few weeks ago I suggested that the early indications are that QE2 had raised NGDP growth expectations up from about 3.5% to 4.0% in late summer, to around 5.0% to 5.5% today.  Isn’t that what Calomiris wants?  But those were just my hunches, from reading various news stories.  So I looked for a table that averages the various forecasts.  The Economist  magazine provides monthly estimates of the consensus forecasts for RGDP and inflation.  They don’t provide separate NGDP forecasts, but NGDP growth is usually similar to the sum of RGDP growth plus CPI inflation, if not slightly lower (as the GDP accounts use a more conservative technique for estimating inflation.)

Here are the numbers for the last 8 months of The Economist:

Issue date     RGDP growth        CPI inflation    Sum of growth plus inflation

June 3                   3.0%                   1.8%                              4.8%

July 8                    2.9%                   1.5%                              4.4%

Aug. 5                   2.8%                    1.5%                             4.3%

Sept. 9                  2.4%                    1.5%                             3.9%

Oct.  7                  2.4%                     1.5%                             3.9%

Nov.  4                 2.3%                     1.5%                             3.8%

Dec.  9                  2.6%                     1.5%                             4.1%

Jan. 6                   3.0%                     1.5%                             4.5%

A few comments on the numbers.  The date refers to the issue of the Economist magazine.  Because these changes lag a couple months behind changes in many market indicators, my hunch is that the actual forecasts were made somewhat earlier.  The Economist may have surveyed forecasts that had already been published elsewhere by professional forecasters.  But either way, whether you think NGDP growth forecast hit bottom at the time QE2 was announced, or whether you believe (as I d0) that they hit bottom right before the intense flurry of QE2 rumors in September and October, it is clear that NGDP growth expectations were falling well below 5%, and QE2 seems to have raised them back up closer to Calomiris’s target.

I don’t know about you, but even if these numbers are slightly off, I don’t see any reason for someone who favors 5% NGDP targeting to write a highly public letter complaining about Fed policy on the basis of this sort of pattern.  Perhaps Calomiris looked at actual NGDP growth.  But NGDP growth had only averaged about 4% during the recovery, and if anything was slowing slightly in the summer of 2010.

Now it may be that actual NGDP growth in 2011 will come in at a tad more than 5%.  Perhaps we’ll get 4% RGDP growth and 1.8% inflation.  And Calomiris can claim that vindicates his opposition.  But even in that case I don’t think I’d write a letter complaining about Fed policy being too easy, particularly if I had not signed any letters complaining it was too tight from mid-2008 to mid-2009, when growth was 8% below trend, or mid-2009 to mid-2010 when it was 1% below trend.  Indeed I don’t recall any letters from conservatives complaining about tight money, unless you count us quasi-monetarists as “conservatives.”

My hunch is that Calomiris was asked to sign the letter, had recalled reading someone forecast roughly 3% growth, added on an assumption of 2% inflation, and thought “things are fine, we don’t need that.”  I think if he had looked closely at the data, and noticed that the recent increases in forecasts for 2011 occurred precisely when QE2 rumors began swirling around, and precisely because of QE2 rumors, he might not have signed the letter.  I hope he provides more clarifying remarks.

PS.  I notice Ben McCallum did not sign the letter.

I generally don’t argue that the efficient markets hypothesis is true, rather I argue it is useful, and that anti-EMH theories are not useful.  I should say that I just focus on those anti-EMH theories that assert one can spot bubbles in real time, which imply one can predict markets (to some extent) over a longer period of time.  (Researchers like Rajiv Sethi analyze market inefficiency that doesn’t imply prediction.)

One famous argument against the “markets are predictable” anti-EMH view is that mutual funds that do well one year tend to do about average the next, indicating that it was more a question of luck then skill.  A popular retort is that the smart money isn’t managing mutual funds, which are an investment for suckers.  I don’t agree with this view, as successful stock picker Peter Lynch was highly beneficial to Fidelity Investments.  Mutual funds have an incentive to forecast well.   But let’s say I’m wrong.

A recent Boston Globe article sent to me by Miguel Barredo suggests that bubble forecasting success by economists is also pure luck:

That economist was New York University’s Nouriel Roubini. And since he called the Great Recession, he has become about as close to a household name as an economist can be without writing “Freakonomics” or being Paul Krugman. He’s been called a seer, been brought in to counsel heads of state and titans of industry “” the one guy who connected the dots while the rest of us were blithely taking out third mortgages and buying investment properties in Phoenix. He’s a sought-after source for journalists, a guest on talk shows, and has even acquired a nickname, Dr. Doom. With the effects of the Great Recession still being keenly felt, Roubini is everywhere.

But here’s another thing about him: For a prophet, he’s wrong an awful lot of the time. In October 2008, he predicted that hundreds of hedge funds were on the verge of failure and that the government would have to close the markets for a week or two in the coming days to cope with the shock. That didn’t happen. In January 2009, he predicted that oil prices would stay below $40 for all of 2009, arguing that car companies should rev up production of gas-guzzling SUVs. By the end of the year, oil was a hair under $80, Hummer was on its way out, and automakers were tripping over themselves to develop electric cars. In March 2009, he predicted the S&P 500 would fall below 600 that year. It closed at over 1,115, up 23.5 percent year over year, the biggest single year gain since 2003.  . . .

But are such people really better at predicting the future than anyone else? In October of last year, Oxford economist Jerker Denrell cut directly to the heart of this question. Working with Christina Fang of New York University, Denrell dug through the data from The Wall Street Journal’s Survey of Economic Forecasts, an effort conducted every six months, in which roughly 50 economists are asked to make macroeconomic predictions about gross national product, unemployment, inflation, and so on. They wanted to see if the economists who successfully called the most unexpected events, like our Dr. Doom, had better records over the long term than those who didn’t.

To find the answer, Denrell and Fang took predictions from July 2002 to July 2005, and calculated which economists had the best record of correctly predicting “extreme” outcomes, defined for the study as either 20 percent higher or 20 percent lower than the average prediction. They compared those to figures on the economists’ overall accuracy. What they found was striking. Economists who had a better record at calling extreme events had a worse record in general. “The analyst with the largest number as well as the highest proportion of accurate and extreme forecasts,” they wrote, “had, by far, the worst forecasting record.” . . .

Their work is the latest in a long line of research dismantling the notion that predictions are really worth anything. The most notable work in the field is “Expert Political Judgment” by Philip Tetlock of the University of Pennsylvania. Tetlock analyzed more than 80,000 political predictions ventured by supposed experts over two decades to see how well they fared as a group. The answer: badly. The experts did about as well as chance. And the more in-demand the expert, the bolder, and thus the less accurate, the predictions. Research by a handful of others, Denrell included, suggests the same goes for economic forecasters. An accurate prediction “” of an extreme event or even a series of nonextreme ones “” can beget overconfidence, which can lead to making bolder and bolder bets, and thus, more and more errors.

So it has gone with Roubini. That one big call about the Great Recession gave him an unrivaled platform from which to issue ever more predictions, and a grand job title to match his prominence, but his subsequent predictions suggest that his foresight may be no better than your average man on the street. The curious nature of his fame calls to mind two of economist Edgar Fiedler’s wry rules for economic forecasters: “If you must forecast, forecast often,” he wrote. And: “If you’re ever right, never let ’em forget it.”

There’s no great, complex explanation for why people who get one big thing right get most everything else wrong, argues Denrell. It’s simple: Those who correctly predict extreme events tend to have a greater tendency to make extreme predictions; and those who make extreme predictions tend to spend most of the time being wrong “” on account of most of their predictions being, well, pretty extreme. There are few occurrences so out of the ordinary that someone, somewhere won’t have seen them coming, even if that person has seldom been right about anything else.

But that leads to a more disconcerting question: If this is true, why do we put so much stock in expert forecasters? In a saner world than ours, those who listen to forecasters would take into account all their incorrect predictions before making a judgment. But real life doesn’t work that way. The reason is known in lab parlance as “base rate neglect.” And what it means, essentially, is that when we try to predict what’s next, or determine whether to believe a prediction, we often rely too heavily on information close at hand (a recent correct prediction, a new piece of data, a hunch) and ignore the “base rate” (the overall percentage of blown calls and failures).

And success, as Denrell revealed in an earlier study, is an especially bad teacher. In 2003 he published a paper arguing that when people study success stories exclusively “” as many avid devourers of business self-help books do “” they come away with a vastly oversimplified idea of what it takes to succeed. This is because success is what economists refer to as a “noisy signal.” It’s chancy, fickle, and composed of so many moving parts that any one is basically meaningless in the context of the real world. By studying what successful ventures have in common (persistence, for instance), people miss the invaluable lessons contained in the far more common experience of failure. They ignore the high likelihood that a company will flop “” the base rate “” and wind up wildly overestimating the chances of success.

To look at Denrell’s work is to realize the extent to which our judgment can be warped by our bias toward success, even when failure is statistically the default setting for human endeavor. We want to believe success is more probable than it is, that it’s the result of a process we can wrap our heads around. That’s why we’re drawn to prophets, especially the ones who get one big thing right. We want to believe that someone, somewhere can foresee surprising and disruptive change. It means that there is a method to the madness of not just business, but human existence, and that it’s perceptible if you look at it from the right angle. It’s why we take lucky rabbits’ feet into casinos instead of putting our money in a CD, why we quit steady jobs to start risky small businesses. On paper, these too may indeed resemble sucker bets placed by people with bad judgment. But cast in a certain light, they begin to look a lot like hope.

Yep.

The Fed releases minutes of their meetings with just a few weeks delay.  But the full transcript is kept secret for “an extended period” to insure more candor in the discussions.  Matt Yglesias recently suggested I look at the recently released FOMC transcript from February 2005, which contains an extended discussion of the pros and cons of inflation targeting.  There’s a lot of interesting stuff:

1.  There is pretty general agreement about the Fed’s long term inflation objective.  They’d like to see about 1% actual inflation.  Because they believe the PCE overstates inflation by 0.5% and the CPI overstates inflation by about 1.0%, they’d like to see about 1.5% PCE inflation or 2.0% CPI inflation.  I was quite surprised by the uniformity of views on this issue.  I don’t recall anyone who put forward a different number, just a few who discussed the advantages of ranges (1% to 3%) rather that point targets.

2. The committee does not favor a hard inflation target.  About half the members (led by Bernanke) favor giving the public a specific quasi-official number as a sort of goal, with the understanding that the Fed might have to deviate in the short run due to financial crises and/or supply shocks.  Other readers might disagree with this characterization, as they danced around the issue in a very tentative way, knowing it was actually Congress’s prerogative to set any formal policy goal.  The FOMC was obviously a bit distrustful of having Congress get heavily involved in monetary policy.

3.  I now feel much more confident in asserting that the Fed’s implicit target is 1.5% PCE and 2.0% CPI inflation.  Period.

4.  They also clearly indicated that a higher than 2% inflation rate might be appropriate under one of two conditions:

a.  Financial crisis

b.  Adverse supply shock

And they clearly acted on that belief in 2007 and 2008 when they cut the Fed funds rate during the sub-prime crisis, despite above 2% inflation.  However, I think they may have tragically misunderstood the implications of their supply shock arguments, and that’s the issue I’d like to focus on.  Consider the following quotation from Cathy Minehan.

So my policy preference for a given level or path of inflation would not be identical all the time. It would depend on what is happening in the real economy, just as in the first half of 2004 we tolerated rather rapid price growth on the basis of our calculation of the degree of excess capacity in the real economy and the temporary nature of the energy price increases. I know that over the long run there’s no tradeoff between growth and inflation and that price stability, however defined, is the best contribution monetary policy can make to economic prospects. But in the short run, when supply shocks can dominate, there can be  tradeoffs.

She is saying that if unemployment is sort of high, say 7%, and inflation was 3% due to energy price increases, you would not try to immediately bring inflation down to 2% if it meant pushing unemployment up to 9%.  And I am pretty sure that everyone at the Fed agrees with that.  However the inescapable implication of the argument is that if you have 9% unemployment and 2% inflation, you’d be better off pushing inflation up to 3% if it would reduce unemployment down to 7%.  The argument is completely symmetrical.

I saw no signs that the Fed understood this implication in 2005, and I still don’t.  Indeed when Brad DeLong asked Bernanke in 2009 why they don’t raise their inflation target to 3% to boost growth, Bernanke said it would be a very bad idea.

The problem here is that either there is a dual mandate, or there isn’t.  If there is, then the Fed would want to allow slightly higher than 2% inflation during adverse supply shocks (and vice versa.)  And I think they do.  If not, they should aim for 2% inflation come hell or high water.  And that’s clearly not what they do.  But this dual mandate idea also implies that if unemployment is extremely high due to deficient demand, the Fed should try to aim for above 2% inflation to try to bring it down.  Yet the Fed seems to vehemently deny any intention of aiming for above 2% inflation during a period of 9.5% unemployment.  Why?  What sort of social welfare function allows for accommodating supply shocks (or financial crises) but doesn’t allow for an aggressive move against deficient demand?

Of course all this confusion would be eliminated with . . . NGDP targeting.

Fun quotations:

[William Poole] The one other case is not a U.S. case but Japan. I think the Japanese have also suffered from not being very clear that they do not want deflation, particularly as the situation developed in the early 1990s. The markets were left quite at sea in trying to figure out where Japanese monetary policy was going to go.

CHAIRMAN GREENSPAN. I think they still are.

MR. POOLE. Yes, they probably still are.

And this probably describes September 2008:

A third potential cost could arise if your credibility were seen to be diminished when inflation differed from the stated objective. Finally, a commitment to an explicit price objective could constrain future actions of the FOMC in an unhelpful manner. For example, the Committee might feel inhibited in responding as aggressively as it would like to a financial crisis if inflation were already to the high side of the Committee’s objective. [Wilcox, et al.]

I don’t quite agree with this, but it is interesting:

[Gramlich] There’s an old experiment that I learned about in graduate school from Richard Ruggles, who used to be a professor at Yale: Offer somebody $10,000 and the choice of ordering from a catalog of all goods and services made this year or five years ago, and take a poll on which option they vote for. Try it. You all give talks to Chambers of Commerce and so forth. I’vebeen doing it for years, and people will consistently vote for the current menu. Obviously, this experiment has to be done at a much higher level of scientific rigor. But I think in the utility sense, even core PCE rates as high as 3 percent may be more or less consistent with price stability, given the great difficulty we have in dealing with technological change in price indexes.

The problem is that consumption is a social activity.  Do they mean you have the old catalogue and everyone else has the new one, or everyone has the old catalogue and their current nominal income.

And I’m guessing that someone like Bob Murphy won’t agree with the claim by Greenspan that they “lucked out” after easy money was pursued in 2004 despite the fact that the inflation target called for tightening:

Take the spring of 2004, when we were sitting there with a significant acceleration in core inflation. With a targeted range for inflation, conceivably we would have breached one of the limits of the target range. And the question would have automatically arisen, “Well, what are we going to do about this?” My answer would have been””and indeed at the time was”””nothing.” The reason was that I viewed the rise in prices as wholly the consequence of a rise in profit margins. But that rise in profit margins was sufficiently quick to result in a projection of core final goods prices that would be above any reasonable target we’ve been discussing today.

The point is this: That was a particular case where we knew that unit costs were not moving and that the rise in inflation was wholly a mechanical result of a one-shot event, which couldn’t continue unless unit costs started to accelerate. We lucked out.

I think people overstate the role of easy money in the sub-prime fiasco, but I included this quotation because I know that most people disagree with me.

On other topics, Tyler Cowen recently made this observation in response to data showing brisk growth in industrial output:

Yet the labor market is still “eh.”  Here is more, but again note it is wrong to reject the AD factor altogether, though it seems to be becoming less relevant over time.  Arguably AD and AS are interacting in unusual and presumably deleterious ways.

I have read too many blog posts attacking a caricatured version of either RBC theory or a narrowly defined notion of “structural unemployment” which requires excess demand for labor in significant parts of the economy.  As Arnold Kling points out, the labor market shock can be asymmetric in its effects.

From a different direction, here is Scott Sumner criticizing the recalculation argument.  I read Scott as establishing the conclusion that both AD and AS must be at work.

I don’t quite agree with the first part, where Tyler discusses the weak labor market.  I’ll simply link to my previous post, which explains why.  I do agree that our problems are partly real/structural/supply-side.  But I still think it is mostly demand-side, and that demand stimulus would even indirectly improve the supply-side (i.e., UI would be reduced below 99 weeks more quickly, which would further normalize the labor market.)

I was flabbergasted to see my first positive link from Paul Krugman.  Of course our views on the need for demand stimulus are similar, but we always seem to tangle on the nuances of some issue.  Indeed perhaps 1.5 positive cites, as this Krugman post is probably referring to me and Beckworth.  I recently published something in the National Review, and Beckworth published in the Wall StreetJournal.

Now I have a sudden fear I will lose all my right-wing friends.  I can just imagine what Bob Murphy will do with this.  And of course I’m way too right-wing to ever be embraced by the left.  I’ll be in limbo, along with Bartlett, Frum, Lindsey, Wilkinson, etc.

Oh well, que sera, sera.

PS.  My consolation is that if Milton Friedman were alive, he’d be in the same awkward position.

PPS:  I got a Business Week mention.

Arnold Kling has responded to my recent critique of reallocation theories.  He begins by pointing out (correctly) that my housing start data is not optimal, as it lags a few months behind housing activity.  But we both agree there is still something of a mismatch between the timing of the housing bust and the severe phase of the recession.  Instead, Kling focuses his attention on other alleged weaknesses in my argument.  Not surprisingly, I will deny my argument has any serious weaknesses.

Here is Kling, and then Ed Leamer:

The other point I would make is that it is unfair to compare almost any variable to employment over the past 2+ years. That is the point of Brad DeLong’s post. In terms of explaining weak employment, the aggregate production function approach falls short also. Or, as Ed Leamer puts it,

“the national job markets certain structural problems that have created a mismatch between what employers are looking for and what unemployed workers have to offer. These structural issues include the loss of manufacturing jobs to a variety of “competitors” both technological (robots, microprocessors) and human (foreign workers and recent immigrants willing to work for less) and the housing crisis that continues to jeopardize the construction sector. Unlike in previous recessions, Leamer opines, workers today are not easily returning to the jobs they lost and as a result the economy must find a way to create jobs for millions of workers whose skills lend themselves more suitably to manufacturing and construction.”

I see no problem here at all.  The drop of GDP, both real and nominal, was one of the most severe since the Great Depression.  If in 2007 you had told me nothing but the future path in NGDP and RGDP, I would have said that tight money sharply reduced AD and created a severe recession.  I would have predicted some of the highest unemployment of the entire post-war period.  There is no mystery at all as to why so many people are without work.  The mystery is why RGDP fell so sharply.  Given that fall, you’d expect high unemployment.  None of this has anything to do with technological progress.  Our Econ 101 models tell us that when AD shifts sharply left you will get high unemployment, and that’s exactly what happened.  If we had more AD, most of the workers would return to service sector jobs.  A few would return to manufacturing and construction.  There has been a long term shift from manufacturing to services, but that shift is unrelated to the business cycle, and it occurs without any rise in the unemployment rate, as long as NGDP growth is adequate.

Then Kling claims that there are 5 outstanding issues, and that I have only addressed numbers 1 and 5:

1. The big drop in GDP occurs after most of the drop in home construction.
2. The financial indicators, including risk spreads, stock prices, and bank profits, recover fairly nicely, but real GDP does not.
3. Whatever recovery shows up in GDP is not matched by a recovery in employment.
4. A simple linear Phillips Curve of the form inflation = 7.0 – unemployment would say that we should have prices falling at an annual rate of 2 percent now, rather than rising. (Admittedly, this is not a powerful point, because inflation can be measured in various ways, and nobody said that the Philips Curve was linear.)
5. In my recollection (which may be wrong), steep recessions tend to be followed by brisk recoveries. Not so this time.

In short, there is a lot about this recession that I think is puzzling. Sumner has a story for (1) and (5), but it is hard to reconcile with (2) and sidesteps (3) and (4).

I think that the behavior of macroeconomic variables in this recession poses some awkward issues for everyone.

Let’s take #3 first, by far the easiest.  In the 1983-84 recovery, Volcker allowed 11% annual NGDP growth over the first 6 quarters.  RGDP rose 7.7% annual rates and inflation rose about 3.3%.

This time the Fed allowed closer to 4% NGDP growth over the first 6 quarters of recovery, and the split was close to 3% real and 1% inflation.  I’d say those splits are similar, the difference is the Fed simply didn’t provide enough fuel to allow for fast RGDP growth.  It’s implausible to expect 8% RGDP growth if doing so requires negative 4% inflation.

Once we understand why RGDP growth has been weak during the recovery, the employment numbers make lots of sense.  The trend rate of growth is around 2.5% to 3%, and you’d expect no change in the unemployment rate if growth is at trend.  Our growth may have been a tad above trend (it’s hard to know for sure) but it’s also true that unemployment has fallen slightly since the 10.1% peak in 2009.  No significant mystery to be solved, although I acknowledge that each recession is slightly different in terms of Okun’s Law, Beveridge curves, etc.

Number four is slightly tougher.  It does seem that Phillips curves flatten out a bit near zero, and we don’t know exactly why.  There are theories such as the alleged reluctance of workers to take nominal pay cuts.   We’ve also seen a big rise in the minimum wage rate (40% over a couple years) and the 99 week unemployment benefits.  I don’t know if these made the labor market slightly less flexible, but it’s possible.  But even without these factors I’d expect the Phillips Curve to flatten at very low inflation rates.  Other countries observe similar patterns.  “Further research is needed . . . ”

I’m not as puzzled by #2 as Kling.  Stocks are still far below their 2007 peaks, while RGDP has returned back to roughly pre-recession levels.  So at first glance it looks like Kling has things exactly backward.  In fairness, RGDP is still well below the trend line, and there is still an output gap, albeit not as large as crude trend extrapolation would suggest (I’m not that naive!)  On the other hand stocks also trend upward over time, so if stocks are 18% below the peak, they may be 28% below the trend line.  That’s a lot, and not inconsistent with the effects of a big recession with a slow recovery.  And of course there are still lots of debt problems out there, the foreclosure mess, a continuing overhang of commercial real estate problems, state and local government distress, etc.  It’s not like the financial system is back to normal.  Also recall that many US companies are earning a large share of their profits overseas, and the developing world is growing very fast.  That explains some of the strength in equities.

The hardest thing for me to explain is not the level of equity prices, but the rapid increase since March 2009.  And the same applies to the health of our financial system.  The only hypothesis I can think of is that in March 2009 investors feared an outright depression, and this worry sent asset prices to (what is now known as) unjustifiably low levels.  And these falling asset prices severely hurt the financial system.  Banks bounced back somewhat when an economic recovery in Asia, and then the US, showed that an outright depression was unlikely.

Is there evidence for this view?  The IMF does periodic forecasts of RGDP growth, inflation, and total banking system losses for the US.  The following graph shows that IMF estimates of banking losses got much worse until early 2009, and then much better.  And that pattern is inversely related to the IMF’s estimates of growth and inflation over the two year period from 2008 to 2010.  Note how bearish these IMF economic projections were at the low point.

Note:  Left scale is total estimated banking losses in billions.  Right scale is total estimated RGDP and price level growth between 2008 and 2010.