In the past Paul Krugman has expressed sympathy for me, deserted by most of my fellow right-wingers as I try to re-shape Milton Friedman’s ideas for the 21st century.  Now I get to sympathize with Krugman, tangling with the extremely frustrating MMTers.  Here’s how it goes.  The MMTers say X.  You show that X is not true.  They get outraged, claiming you misrepresented their views.  They never said X, they said Y!  Then you show that Y isn’t true.  Now they are even more outraged, “we never said Y, we said Z.”  And so on.   I feel a little less stupid about not understanding their views, as even a Nobel-Prize winner is apparently too dense to understand.  And yet hundreds of followers, many of whom seem to have little education in economics, have no trouble at all understanding what the MMTers are all about.  It makes you wonder.

In any case, here is Paul Krugman:

But what happens next?

We’re assuming that there are lending opportunities out there, so the banks won’t leave their newly acquired reserves sitting idle; they’ll convert them into currency, which they lend to individuals. So the government indeed ends up financing itself by printing money, getting the private sector to accept pieces of green paper in return for goods and services. And I think the MMTers agree that this would lead to inflation; I’m not clear on whether they realize that a deficit financed by money issue is more inflationary than a deficit financed by bond issue.

For it is. And in my hypothetical example, it would be quite likely that the money-financed deficit would lead to hyperinflation.

In the comment section, Scott Fullwiler:

Fourth, no, a deficit financed by “money” is NOT more inflationary than a deficit financed by bonds. There’s a very simple reason for this–it is operationally impossible to finance a bond issue with “money” unless you have a zero interest rate target, in which case in your own paradigm you are in a liquidity trap.

Here’s how I’d respond to Mr. Fullwiler:  Argentina, Turkey, Brazil, Bolivia, Israel, Chile  . . . . case after case of countries experiencing extremely high inflation and extremely high nominal interest rates, all because they were monetizing their debts.  Not only is it possible, it happens almost every time a country tries to rely on money creation to pay its bills, at least for any extended period of time.  Very easy money usually makes interest rates rise.

Here’s Keynes:

“If you are held back [i.e. reluctant to buy bonds], I cannot but suspect that this may be partly due to the thought of so many people in New York being influenced, as it seems to me, by sheer intellectual error.  The opinion seems to prevail that inflation is in its essential nature injurious to fixed income securities.  If this means an extreme inflation such as is not at all likely is more advantageous to equities than to fixed charges, that is of course true.  But people seem to me to overlook the fundamental point that attempts to bring about recovery through monetary or quasi-monetary methods operate solely or almost solely through the rate of interest and they do the trick, if they do it at all, by bringing the rate of interest down.” (J.M. Keynes, Vol. 21, pp. 319-20, March 1, 1934.)

Keynes didn’t believe in a Fisher effect, unless inflation reached hyperinflationary levels.  Joan Robinson (an MMTer before her time) was even more extreme.  They were both wrong.  But modern Keynesians like Krugman have lived through decades in very high trend rates of inflation in lots of fiat money countries.   They’ve seen the Fisher Effect in action.  They’ve read Cagan’s research on money demand during hyperinflation.   That’s why they (and I) are impervious to the MMTers siren song that we can print money to pay the government bills.  Perhaps they will have more success attracting a younger economists to their, er . . . group, as the younger generation has experienced little hyperinflation, and several examples of large increases in the monetary base leading to no inflation at all (at near-zero nominal rates.)

Karl Smith has a new post on sticky wages that makes the following claim:

So growing up in the New Keynesian paradigm I learned that sticky wages don’t make sense because the real wage is pro-cyclical. That is, in contrast to Keynes’s suggest labor is actually cheaper during recessions than during booms.

This moved the story to sticky-prices.

Not so fast.  It’s true that Keynes’s original model implied real wages should be countercyclical.  But that’s not the implication of the standard AS/AD model, with sticky wages.  Instead, the AS/AD model predicts that wages will be countercyclical when the economy is hit by demand shocks, and procyclical when the economy is hit by productivity shocks.  And a paper I wrote with Steve Silver (Journal of Political Economy, 1989) showed that this is the case.  Real wages are strongly countercyclical in the face of demand shocks, and strongly procyclical in the face of supply shocks.  I’d add that real wages rose especially sharply in some of the most easily identifiable adverse demand shocks (1920-21, 1929-32, 1937-38.)  Most researchers simply look for “the” cyclicality or real wages, just like they look for “the” fiscal multiplier, and lots of other unicorn-like parameters.

Since that time I’ve come to believe that “inflation” is pretty much a meaningless concept, just a number pulled out of the air by those who calculate price indices in Washington.  But I’m in the minority, most economists watch core inflation very closely, even though it is 39% housing, and even though the CPI showed housing prices rising during the greatest housing price crash in American history–even in relative terms.  To each their own.  In any case, I look at the ratio of the nominal hourly wage rate to per capita NGDP, which seems like a better indicator of how nominal shocks effect the labor market.

In the comment section to the previous post, many people don’t quite understand how strong the evidence is for nominal wage stickiness, and how big a problem it is for New Classical models.  Yes, one can explain some wage stickiness in a New Classical model.  And yes, one can explain why workers might be reluctant to accept real wage cuts.  But the real problem is the distribution of NOMINAL wage adjustments.  The sharp discontinuity at zero percent is extremely hard to explain.  The basic problem is that in New Classical models nominal variables shouldn’t matter, except perhaps to the extent that there might be menu costs to adjusting wages and prices.  But the problem is that given that wages are being adjusted, there is no difference between the menu cost of raising someone’s wage 1% and cutting someone’s wage by 1%.  The number zero doesn’t have magical, talisman-like qualities in New Classical models.  But in the real world it apparently does.

Could it be money illusion?

This is a response to Tyler Cowen.  Take a simple example.  Nominal wages are fixed for the employed.  NGDP falls 5%, and 5% of workers are laid off.  Now the unemployed workers lower their wage demands by 20%.  Why not by even more?  Because of minimum wage laws, unemployment insurance, fear of loss of prestige, etc.

Suppose companies are not worried about workers making invidious comparisons (a big if, but I’ll grant this point to my opponents.)  In the best case scenario firms lay off 4% percent of their workers and hire back the 5% who are unemployed at the same total wage bill.  The excess unemployment is now 4% instead of 5%.  The total unemployment rate falls from 10% to 9% (assuming 5% is the natural rate.)  No big deal, we are still deep in recession.  Thus wage flexibility among the unemployed doesn’t really help very much.  If all employed workers accepted a 5% pay cut (or if the government ordered such a cut) and the Fed kept targeting inflation, we’d experience rapid economic growth.  BTW, I’m not advocating an incomes policy, I favor monetary stimulus.

Now you might claim that this process would keep repeating, and eventually we’d reach full employment.  But that would violate the assumption that wages are sticky for the employed.  I.e. could firms really say “You are all fired; now we’ll hire you back for 20% less?”  I suppose so, but then there’d be no wage stickiness for the employed, and we have lots of evidence that there is wage stickiness for the employed.  Indeed one piece of evidence (this pay increase dispersion graph from a Paul Krugman post, plus quotation) is so overwhelmingly persuasive that it should be considered, by itself, a 100% conclusive refutation of New Classical economics.  There is no possible New Classical explanation for this graph.  None.

So as I see it, we’re in a state of censored wage deflation; underlying forces are trying to make wages fall, but thanks to the combination of dispersion and rigidity actual average wages are still rising slowly.

And that’s all we need, empirical evidence that wages are sticky for the employed.  It is a bit puzzling that wages are so inflexible.  But remember that 2008-09 wasn’t the only adverse nominal shock.  We had another in 2009-10, and then another in 2010-11.  It’s possible that wages have now adjusted to the 2009 shock (although I doubt they’ve fully adjusted) but haven’t adjusted to the more recent adverse shocks.  And of course there are also lots of adverse supply shocks that are slowing the adjustment.  Adverse supply shocks partly caused by the adverse demand shock.  That’s why the sticky wage hypothesis seems implausible when looking at the world from a micro perspective—it is implausible from a micro perspective.  Lots of the problem is supply side, when viewed from a micro perspective.   But macro can’t be understood at a micro level.  For instance there is no way I can explain to someone at the micro level why if the Fed buys a $1,000,000 T-bill from me for $1,000,000 in cash it will create more AD.  But it will.

Here’s Joseph Cotterill:

Anyone for Fed targeting of nominal GDP futures?

Are  we gaining converts?

Here’s Clive Crook of the FT:

But what more can monetary policy do now? Plenty. Look at it this way. Can a central bank engineer high inflation if it chooses to? Yes, always. If it prints enough money – they call it “quantitative easing” nowadays – it can cause inflation. But if it can always cause inflation, it can always stimulate demand: the second is a necessary condition for the first.

Admittedly, the limits to the Fed’s efforts to stimulate the economy are partly prudential. At the recent meeting of its policy committee, dissenters questioned whether it was right to promise explicitly, as the central bank has, two more years of very low interest rates. Inflation hawks resist the idea of further QE. Here is the central point, however: this is a disagreement about whether further stimulus would be wise, not whether it is possible.

In my view, it is both possible and necessary. The recent revisions to the figures for growth make the economic argument so strong that I wonder if politics is not influencing the dissenters. The problem is that the Fed has to explain itself, both to Congress and to the public at large. Conditions demand what critics would call an “inflationary” monetary stimulus. The Fed’s vague mandate, which calls for both price stability and full employment, is not much help. It is a fight the Fed would rather avoid.

To make the case for new stimulus, the Fed needs better arguments. The past few weeks have settled, to my satisfaction at least, a long-running debate on this very topic. Rather than targeting inflation, central banks should keep nominal incomes growing on a pre-announced path: say 5 per cent a year. Nominal gross domestic product is the sum of inflation and growth in real output – and is the variable that monetary stimulus directly drives.

Samuel Brittan made the case for this approach decades ago on this page. The crucial point – how an increase in nominal GDP breaks down between output and inflation – is not something the Fed can determine, or should have to explain. There are pros and cons to this approach, but that is the decisive political virtue of casting the target this way.

When nominal GDP falls below track, monetary stimulus pushes it back. If inflation rises temporarily during catch-up, that is tolerated. In current conditions, this makes all the difference. The new GDP figures showed demand has fallen much further below trend than had been appreciated. With a nominal GDP target, that announcement would have led investors to expect new monetary stimulus. With the implicit inflation target that the Fed is assumed to use, it did not.

Interestingly, unlike the Fed, the Bank of England has an explicit inflation target – one it has missed so conscientiously of late that many observers believe it is following an unannounced nominal GDP target. If so, it is to be congratulated, and one day its operating mandate should be adjusted accordingly.

The Fed should move in the same direction – not, obviously, at the direction of Congress, which has its hands full getting fiscal policy wrong – but at its own initiative. Exploit that bounded independence a little more. Move to a nominal GDP regime and let the markets know, in Fed-speak, that this is what you are about. You already keep telling people, quite rightly, that monetary stimulus is not and never can be a spent force. Now would be a good time to prove it.

Exactly.  I’d add that if the British really do believe inflation is too high, then ipso facto they think demand is too high.  And this means that the policy of expansionary fiscal contraction has succeeded.  Of course it hasn’t, but not because of fiscal contraction, rather because the Bank of England was pressured to “do something” about inflation.  If the BOE is fighting inflation then nominal growth will be disappointing, regardless of what fiscal policymakers do.

HT:  Marcus Nunes