Real theories of the business cycle predict that the public would feel worse off if inflation rose (due to supply shocks.)  In contrast, demand-side models predict that an unanticipated fall in inflation would make the public feel worse off.  That’s because demand shocks reduce inflation by shifting AD to the left, which also reduces real GDP, and hence real national income.  Even though inflation falls, NGDP growth falls even more rapidly.  With low demand for investment goods, real interest rates also tend to fall.

The following article suggests that the public regards this as a demand-side recession, where lower inflation actually seems like higher inflation:

WASHINGTON (AP) — Inflation spooked the nation in the early 1980s. It surged and kept rising until it topped 13 percent.

These days, inflation is much lower. Yet to many Americans, it feels worse now. And for a good reason: Their income has been even flatter than inflation.

Back in the ’80’s, the money people made typically more than made up for high inflation. In 1981, banks would pay nearly 16 percent on a six-month CD. And workers typically got pay raises to match their higher living costs.

No more.

Over the 12 months that ended in February, consumer prices increased just 2.1 percent. Yet wages for many people have risen even less — if they’re not actually frozen.

Social Security recipients have gone two straight years with no increase in benefits. Money market rates? You need a magnifying glass to find them. . .

The median U.S. inflation-adjusted household income — wages and investment income — fell to $49,777 in 2009, the most recent year for which figures are available, the Census Bureau says. That was 0.7 percent less than in 2008.

Incomes probably dipped last year to $49,650, estimates Lynn Reaser, chief economist at Point Loma Nazarene University in San Diego and a board member of the National Association for Business Economics. That would mark a 0.3 percent drop from 2009. And incomes are likely to fall again this year — to $49,300, she says.

Just to be clear, I am referring to the entire three year long recession and sluggish recovery, not the last couple months.  During recent months there has been a modest supply shock, due to events in Libya and then more recently in Japan.  It’s too soon to know the severity of these two shocks.

In the comment sections of posts there is a disturbing tendency of people to make the following mistake.  They notice that monetary stimulus often raises commodity prices more than other prices.  They notice that supply shocks often raise commodity prices more than other prices.  They infer that monetary stimulus can cause a supply shock.  In fact, monetary stimulus raises commodity prices if and only if it raises expected future output.  There is no other mechanism.  In contrast, supply shocks reduce expected future output.  Don’t confuse AS and AD shocks.

Update 3/20/11:  I obviously meant “real commodity prices” when I referred to commodity prices in the preceding paragraph.  Several commenters pointed out that one could find theoretical mechanisms by which QE could raise commodity prices and reduce AS.  In macroeconomics one can find theoretical arguments for almost any proposition.  In my reply to Statsguy I provided numerous reasons why I don’t think those contractionary mechanisms would be empirically important.

Matt Yglesias recently had this to say about the decline in workplace injuries since  OSHA:

All-in-all, though, it looks like an impressive achievement to me and one the hard-working folks at the National Institute for Occupational Safety and Health deserve some credit for, along with overall economic progress and structural shifts into safer occupational categories.

Update 3/20/11:  Matt pointed out in the comments that I didn’t read his post very carefully:

The agency I actually mentioned in my post is the National Institutes of Occupational Safety and Health (part of the CDC) not OSHA.

NIOSH is an agency dedicated to collecting and disseminating information about workplace industries. They do statistics, they do some of the “information brochures being distributed to workers” stuff you recommend, and they do some kind of training.

[So whatever value the rest of my post might or might not have, it shouldn’t be viewed as a comment on Yglesias.]

This reminded me of a graph I saw years ago in a paper by John Leeth and Tom Kniesner:

They look at a wide variety of evidence (much of which is in other papers, not this one) and conclude that OSHA should be cut back, or perhaps abolished.  Just so you don’t think they are mindless anti-government libertarians, they also argue that workplace compensation insurance is somewhat effective in reducing injuries.  They argue that compensating wage differentials (a market force) is the single most effective deterrent to injuries:

Alternatives to OSHA

In light of its ineffectiveness, giving OSHA more money, personnel, and power is not the way to cost-effective workplace safety. Most protection on the job comes from state workers’ compensation insurance programs and market-determined compensating wage differentials.

State-run workers’ compensation insurance programs are currently the most influential public attempt to promote workplace safety. Insurance premiums that take account of workplace safety encourage firms to establish safe and healthy work environments. As the frequency of claims rises, the price of workers’ compensation insurance increases, thereby penalizing firms for poor safety records. Michael Moore of Duke University and W. Kip Viscusi of Harvard University estimate that, without workers’ compensation insurance, the number of fatal accidents and diseases would be 48 percent higher in the United States.

BTW, there is no obvious “market failure” that would call for regulation.  (And please don’t drag out the tired old argument that companies know the risks, but workers don’t.  That’s not true, and if it were it would call for government information brochures being distributed to workers, not OSHA.)  I find a lot of safety regs to be very annoying.  When I was young I often worked up on ladders.  The newer Skilsaws required two hands to operate, presumably so you wouldn’t cut off some fingers.  That necessitated gripping the ladder with one’s knees.  Power mowers can no longer be operated without holding the handle–forcing contorted body positions when trying to clear debris in the mower’s path.

Matt Yglesias also has a very interesting post on the similarities between some “big government” models (such as the Nordic states) and some “small government” models, such as Singapore, Hong Kong and Chile.  He points out that Singapore’s mandatory savings plan, which has a 35.5% rate, is something like a tax, and the money is deposited in a government run investment fund. I don’t entirely agree with his post (he underestimates the difference between taxes and forced saving), but it’s hard to disagree with the general thrust of his argument .  There isn’t all that much difference between the Nordic economies and the economy cited by the Heritage Foundation as the second most economically free country in the world (and number one if one recalls that HK isn’t really a “country.”)  My initial reaction is to despair that the US is simply too big to adopt either model.  But maybe that’s giving up too easily.

Update:  Commenter Joe pointed to a Bryan Caplan post that cited a David Henderson encyclopedia entry that discussed some Kip Viscusi research on OSHA (did I miss anyone?)

Fun facts from Kip Viscusi‘s article on “Job Safety” in David Henderson’s encyclopedia:

Annual OSHA penalties for safety violations (2002): $149,000,000

Annual Workers Compensation Premiums (2001): $26,000,000,000

Estimated Annual Wage Premiums for Risky Activities (2004 dollars): $245,000,000,000

Bryan suggests that OSHA probably has little effect on injuries.

Gregory Barr sent me an excellent paper by Greg Mankiw and Matthew Weinzierl :

Conclusion

The goal of this paper has been to explore optimal monetary and fiscal policy for an economy experiencing a shortfall in aggregate demand. The model we have used is in many ways conventional. It includes short-run sticky prices, long-run flexible prices, and intertemporal optimization and forward-looking behavior on the part of firms and households. It is simple enough to be tractable yet rich enough to offer some useful guidelines for policymakers.

One clear implication of the analysis is that how any policy is used depends on which other policy instruments are available. To summarize the results, it is fair to say that there is a hierarchy of instruments for policymakers to take off the shelf when the economy has insufficient aggregate demand to maintain full employment of its productive resources.

The first level of the hierarchy applies when the zero lower bound on the short-term interest rate is not binding. In this case, conventional monetary policy is sufficient to restore the economy to full employment.  That is, all that is needed is for the central bank to cut the short-term interest rate. Fiscal policy should be set based on classical principles of cost-benefit analysis, rather than Keynesian principles of demand management. Government consumption should be set to equate its marginal utility with the marginal utility of private consumption. Government investment should be set to equate its marginal product with the marginal product of private investment.

The second level of the hierarchy applies when the short-term interest rate hits against the zero lower bound. In this case, unconventional monetary policy becomes the next policy instrument to be used to restore full employment. A reduction in long-term interest rates may be sufficient when a cut in the short- term interest rate is not. And an increase the long-term nominal anchor is, in this model, always sufficient to put the economy back on track. This policy might be interpreted, for example, as the central bank targeting a higher level of nominal GDP growth. With this monetary policy in place, fiscal policy remains classically determined.

The third level of the hierarchy is reached when monetary policy is severely constrained. In particular, the short-term interest rate has hit the zero bound, and the central bank is unable to commit to future monetary policy actions. In this case, fiscal policy may play a role. The model, however, does not point toward conventional fiscal policy, such as cuts in taxes and increases in government spending, to prop up aggregate demand. Rather, fiscal policy should aim at incentivizing interest-sensitive components of spending, such as investment. In essence, optimal fiscal policy tries to do what monetary policy would if it could.

The fourth and final level of the hierarchy is reached when monetary policy is severely constrained and fiscal policymakers rely on only a limited set of fiscal tools. If targeted tax policy is for some reason unavailable, then policymakers may want expand aggregate demand by increasing government spending, as well as cutting the overall level of taxation to encourage consumption. In a sense, conventional fiscal policy is the demand management tool of last resort.  (Italics added.)

I agree, and would just add a few observations:

1.  Between the Big Bang and 2011, there has never been a central bank that promised to create inflation, and was not believed.  At least not in the Milky Way.  So there is really no need to go beyond step two.

2.  If we add sticky wages to the model, then I think that the investment tax credit could be augmented with a payroll tax cut–employer share only— as a way of moving the labor market closer to its flexible wage–Walrasian equilibrium level of employment.

As you know, I’d like to eliminate the inflation and the price level from business cycle theory, and use NGDP as my nominal aggregate (where the price level is currently used, such as the Fisher equation and the AS/AD diagram.)  Real wages would be nominal wages over nominal GDP per capita.  A negative nominal shock like 2008-09 would cause (sticky) nominal hourly wage rates to rise as a share of NGDP, causing fewer hours worked. (Hours worked replace RGDP in the AS/AD model.)  Since prices can be affected by both supply and demand shocks, they are an unreliable indicator of nominal shocks.

I just noticed that Paul Krugman commented on this paper:

Now bear in mind that in order to make a commitment to inflation work, central bankers not only have to stand up to the pressure of inflation hawks “” which is much harder when you’re having to testify to Congress than it is if you’re a Harvard professor “” but, even harder, they need to convince investors that they’ll stand up to that pressure, not just for a year or two, but for an extended period.

Now, the thing about fiscal expansion is that people don’t have to believe in it: if the government goes out and builds a lot of bridges, that puts people to work whether they trust the government’s commitment to continue the process or not. In fact, to the extent that there’s some Ricardian effect out there, fiscal policy works better, not worse, if people don’t believe it will continue.

On a personal note: I supported fiscal expansion in 2008-2009 precisely because I didn’t believe that the kind of commitment-based unorthodox monetary policy that works in the models could, in fact, be implemented in practice. Nothing I’ve seen since has changed my views on that subject.

Where does one start?  With the fact that the Dems controlled Congress during the Great Recession and would have welcomed more monetary stimulus?  With the fact that meaningful fiscal stimulus was also not politically feasible (according to Krugman it never happened.)  With the fact that unemployment was 7.8% when Obama took office and 9.8% in November 2010, when QE2 was announced?  With the fact that rumors of QE2 in September and October 2010 affected all sorts of asset prices (including TIPS spreads) in exactly the way us quasi-monetarists predicted?  How can Krugman say nothing he’s seen has changed his views on the relative political feasibility of fiscal and monetary stimulus?  The reason the Fed didn’t do more wasn’t Ron Paul, it was pushback from regional Bank presidents within the Fed.  Oh, and Obama “forget” and left two or three seats empty for over a year.

Krugman seems to misunderstand the role of pundits.  It’s our job to explain what needs to be done, in order to make it more politically feasible.  In early 2009 politicians would have been elated if someone told them there was a way to boost AD without running up big deficits.  But they didn’t know because just about the only people making that point forcefully and loudly were us quasi-monetarists.

In contrast to Krugman, this very wise pundit does understand the role of bloggers is to push the Fed to be more aggressive:

So why am I even slightly encouraged? Because the critics did, at least, succeed in moving the focal point. Not long ago gradual Fed tightening was the default strategy; but as I said, at this point the Fed realized that continuing on that path would have unleashed both a firestorm of criticism and a severe negative reaction in the markets.

What we need to do now is keep up the pressure, so that at the next FOMC meeting the members are once again confronted by the reality that not changing course would be seen as dereliction of duty. And so on, from meeting to meeting, until the Fed actually does what it should.

I know: it’s a heck of a way to make policy. In a better world, the Fed would look at the state of the economy and do what was right, not the minimum necessary. But wishing for that kind of world is like wishing that Ben Bernanke were running the place.

The statement was made in August 2010, just days before the first Bernanke speech hinting that more needed to be done.  Who was this prescient blogger?  Click here and find out.

(And you thought it was going to be me.)

PS.  Neither the Boston Fed nor any local universities have ever asked me to present a paper on how NGDP targeting–level targeting–targeting the forecast, could have greatly reduced the severity of the asset price collapse of late 2008, the associated banking crisis, and the recession itself.  I’ve put together a persuasive group of PowerPoint slides, have honed my presentation at the AEA meetings and elsewhere, and am ready to go if anyone wants an interesting and controversial take on the Great Recession.  I’ve debated countless economists, including some pretty distinguished ones, and found no holes in my logic.  Don’t expect me to be a pushover just because I come from a small school.

My recent post on the yen triggered a number of interesting comments.  For instance, Miguel Sanchez responded to my claim:

“For those who don’t follow the yen closely, 77 is an insanely high level.”

with the following reply:

Aptly worded, though probably not in the way you intended. For those who do follow the yen closely, the real effective exchange rate is historically quite low, though it’s been off its all-time lows since the financial crisis.

I know there’s a huge and ongoing debate about how to gauge ‘fair’ value, but I would’ve thought the very basic test of whether a currency is overvalued is whether the country is running a trade deficit. Japan has and continues to run a massive trade surplus.

This is a widespread view, but it contains two misconceptions.  First, there is an implicit assumption that trade accounts should balance.  In fact, countries with good demographics (like Australia) would be expected to run current account deficits, and countries with bad demographics (like Japan and Germany) would be expected to run a surplus.  And that’s exactly what happened.  Indeed with optimal fiscal policy Japan’s surplus might well be much larger.

The second mistake is to assume that the real exchange rate is the correct variable for my analysis.  Monetary policy affects nominal exchange rates, and has no long run effect on real exchange rates. The way to tell if a currency is under or over-valued is not to look at trade balances, but rather NGDP.  By that measure monetary policy in Japan is too tight and the yen is too strong in nominal terms.

Miguel didn’t say this, but some proponents of “fairly valued” exchange rates claim that a weak yen actually hurts the rest of the world, by stealing jobs from others.  But as we saw today, the rest of the world actually gains from a weaker yen, at least when a strong yen is severely hurting the Japanese economy.

BANGKOK (AP) — Asian markets posted gains and European shares were headed higher Friday as the yen retreated from historic highs after the world’s seven leading industrial nations pledged to rein in the currency to help earthquake-stricken Japan.

This market response supports my “monetary view” of the overvalued yen, and goes against the “trade surplus view,” which implies the yen was undervalued even before the recent steps taken to depreciate it further.  As with China’s policy of fixing the yuan in late 2008 and 2009, an expansionary monetary policy during a worldwide recession helps all countries.  Macro is not a zero sum game.

Those of us born in the mid-50s still can recall the Great Depression of 1963-73.  The trigger was obviously the Kennedy assassination.  A wave of sympathy led the federal government to go on an orgy of spending, taxes, regulation, inflation, and price controls.  Medicare and Medicaid was passed in 1965.  The War on Poverty was launched.  Affirmative action was imposed on business.  Inflation soared, pushing people into higher tax brackets.  Then LBJ raised income tax rates in 1968.  OSHA began imposing burdensome regulations on business.  Ditto for the EPA.  The US left Bretton Woods, causing enormous uncertainty over monetary policy.  By 1971 there were wage and price controls on the entire economy.  What a god-awful mess!

Of course the period from 1963-73 was actually one of the greatest boom periods in all of human history.  The question is why?

One answer is Adam Smith’s famous maxim: “There is a great deal of ruin in a nation.”

Or perhaps monetary policy drove NGDP up at a fast and accelerating rate.  And it is monetary policy, not structural factors, that explains the business cycle.

Karl Smith recently expressed similar sentiments:

I don’t think Krugman is doing this, but it is easy to get too caught up in thinking the macroeconomy is an extension personal finance. Having bought a house you couldn’t afford seems like a really bad situation to be in, and if everyone is in that situation then it seems like that ought to be really bad for the economy.

However, keep always in the front of your mind that a recession is not simply a series of unfortunate events.  A recession is when the economy produces less. For example,  the AIDS epidemic in Botswana is a horrible event for millions of people that uprooted lives and destroyed families and promises to leave a generation of orphans.

However, Botswana’s GDP growth didn’t turn negative until Lehman Brothers went under.

That a Global Financial Crisis could do what rampant death and disease could not, is an important indicator of the nature of recession.

A recession isn’t when bad things happen, whether that’s loosing your house to foreclosure or your parents to AIDS. A recession is when the economy produces less.

Somehow you have to make a link between the bad thing happening and the economy producing less. I maintain that, that link almost always runs through the supply of money and credit.

Still think “the problem” is the cost imposed on business by Obamacare?  Obamacare is “a problem,” as are many of the policies from 1963-73.  In the long run they may be more important than the business cycle.  But let’s not confuse policies that reduce the efficiency of the economy, with those that create business cycles.