Here’s a story on found on Tyler Cowen’s blog:

They are a cornerstone of Chrysler’s unlikely comeback: 900 employees turning out a Jeep Grand Cherokee sport utility vehicle every 48 seconds of the working day at an assembly plant here.

Nothing distinguishes them from other workers at the Jefferson North plant, except their paychecks. The newest workers earn about $14 an hour; longtime employees earn double that.

…the advent of a two-tier wage system in Detroit is spiking employment for one of the country’s most important manufacturing industries.

Here’s what we know for certain about the US business cycle:

1.  If nominal wages are highly sticky, then NGDP slowdowns will raise unemployment.

2.  Nominal wages are highly sticky for at least some workers.

3.  The period after mid-2008 saw the largest NGDP growth collapse since the Great Depression.

4.  The period after mid-2008 saw a huge rise in unemployment.

Here’s what we don’t know:

1.  Why didn’t Chrysler cut all wages to $14?  Fear of strikes?  Efficiency wages?

BTW, I do realize that long time employees are more skilled on average.  But that sort of huge pay gap didn’t exist in the 1960s or 1970s, and thus I think we can assume at least a big part of it is “artificial” in some sense.

Marxists would argue that further pay cuts for infra-marginal workers would merely raise profits.  I believe some of the money would go to extra employees.  And as Nick Rowe showed, in the public sector all of it could go to additional jobs.  I’d also note that health care is practically the public sector.

In an earlier post Tyler Cowen asks this question:

1. For how long “” in today’s America “” can an AD-driven recession last?  At what point do even the Keynesians toss in the towel and say “By now it is a growth and structural problem, not mainly AD”?  After all, the private sector had a chance to create more M2 and it failed.  How sharp is the distinction between the short run and long run?

Great question.  If I were forced to argue against my theory of the recession in an Oxford debate, my top three arguments would be:

1.  Natural rate hypothesis.

2.  Natural rate hypothesis.

3.  Natural rate hypothesis.

It’s a great model, I believe in it, and it suggests nominal shocks shouldn’t last for more than a few years.  I’ve already argued for the “entanglement theory” of this recession (between structural and AD factors), but let me provide three reasons why I think that monetary stimulus would help three years after the 2008 crash, but would not have helped (much) three years after the mid-1981 collapse in NGDP growth:

1.  The problem of 99 week extended UI benefits.  Powerful monetary stimulus would lead to a quick repeal.

2.  The problem of money illusion.  It’s much easier to slow the rate of increase in nominal wages, than to cut wages outright.  In 1982 we needed to slow the rate of increase in wages.  Now we need to actually cut many wages, which is far harder even if the consequences for real wages are exactly the same.  After I made this comment in a previous post lots of commenters wrote in trying to provide a rational explanation for worker reluctance to accept nominal wage cuts.  I thought all their arguments were bogus, and it just confirmed my view that money illusion exists.  My commenters are really smart.  If even they have money illusion I think it’s safe to assume the broader public does as well.

3.  The problem of reallocation out of fields like housing.  More NGDP would reduce the debt burden and raise real housing prices.  This would reduce unemployment caused by construction workers having a hard time finding other jobs.  Of course I’ve argued that housing is not the main problem with the recession, but it is a problem.

None of these applied to the 1983-84 recovery, which was the best example of the natural rate in action.  The UI wasn’t raised from 26 to 99 weeks, there was higher trend inflation, and hence less need to cut nominal wages, and there was no big housing/debt crisis.  Even the minimum wage situation was slightly different.

I would take Tyler Cowen’s challenge, and direct it at Keynesian fiscal policy advocates.  Originally fiscal policy was justified on the basis that NGDP was growing slower than Ben wanted, but Ben would not fix the problem on his own.  On the other hand, he wouldn’t stop fiscal stimulus from fixing it.  I never quite bought the argument, although I find it defensible.  But for how long?  After all, it is a fairly convoluted way of looking at monetary policy, isn’t it?  Is it still true?  Is monetary policy still not reacting at all to NGDP growth trends?

PS.  I don’t follow Tyler’s M2 comment.  I think he means NGDP.  But the private sector can’t create NGDP, only the Fed can.  And they haven’t created enough to support many jobs without massive wage cuts.  And it’s hard to cut wages, as we’ve seen at Chrysler.

When I began blogging in early 2009 I made a number of claims that seemed almost preposterous.  One of those was the claim that people had reversed causation; the housing crisis didn’t cause the recession, it was mostly a product of the recession.  This seemed crazy, as the housing crisis began well before the recession.

I distinguished between two phases of the housing crisis.  The first phase occurred during 2006-08, and was concentrated in the 4 subprime states.  It did lead to a modest slowdown in growth, and unemployment rose from 4.7% in January 2006 to 4.9% in April 2008.  But nothing severe.  The second phase of the housing collapse was much more severe.  When NGDP started falling rapidly due to tight money, housing prices fell all across America.  This triggered the severe banking crisis of late 2008, and was associated with a worsening of the recession—unemployment reached 10.1% by October 2009.

Day by day, month by month, opinion is imperceptably shifting in my direction.  Indeed so much so that a news article that basically proves my point seems to have elicited little surprise.  “Of course a severe recession would hurt the housing market.”

Let’s consider the original conventional wisdom, and then my heretical view of early 2009.

1.  The conventional wisdom was that we built way too many houses, and that the housing slump was a hangover from this effect.  If true, housing construction over the past 10 years ought to have been way above normal.  In fact, it has been way below normal.  Which leaves the puzzle of why we have so many empty houses.

2.  My view was that the severe recession greatly reduced the demand for housing.  Since very few Americans are homeless (in percentage terms), a reduction in demand for housing should imply an increase in average household size.  And that’s exactly what we’ve seen:

The number of people living under one roof is growing for the first time in more than a century, a fallout of the recession that could reduce demand for housing and slow the recovery.The Census Bureau had projected the average household size would continue to fall to 2.53 this year. Instead, the average is likely to hit 2.63, a small but significant increase because it is a turnabout.

“A funny thing happened on the way to the future” says Arthur C. Nelson, director of the Metropolitan Research Center at the University of Utah. “Household size increased.”

.  .  .

USA could end this decade with up to 4 million excess housing units because of the reversal in household size, he says.

A key factor: “The Great Recession has forced doubling up among both family and non-family members,” Nelson says.

Multi-generational households are on the rise: 49 million, or 16% of the population, live in a home that had at least two adult generations in 2008. In 1980, there were 28 million, or 12%.

According to a recent Pew Research Center report, the growth is due to demographics, cultural shifts and high unemployment.

“I think it’s the young adults,” says Dowell Myers, housing demographer at the University of Southern California. “Residential mobility has slowed down and when it slows down, they’re back in their parents’ houses or living with roommates.”

Household size began inching up in 2005, before the recession, a trend that might have been driven by the real estate boom that made housing unaffordable to many. Now, it’s more likely to be caused by the poor economy.

“There are a lot of trends going on,” Nelson says. Among them:

– Older Americans.They’re moving in with children and grandkids and vice versa. About 20% of people 65 and older live in multi-generational households

– High unemployment. It’s keeping young adults out of the job market and back home with their parents.

“Clearly, a lot of people are not forming households when they’re getting out of school,” says Karl Case, economics professor at Wellesley Collegewho helped create the Standard & Poor’s/Case-Shiller Home Price Index.

It’s not just that people are not buying homes. They’re not renting either, a sign that more people are squeezing into one unit.

“I can document this with my own students,” Case says. “Rental vacancy is the highest it’s ever been.”

– Immigrants. They have higher fertility rates and a cultural acceptance of extended families living together. Despite a decline in the influx of Hispanics since the economy soured, household size inched up.

“It’s going to have huge implications for the housing market,” Nelson says.

If it lasts. Many economists and demographers are convinced that as soon as the recession ends and jobs open up, Americans will return to their old ways. “I see it as temporary,” Myers says.

“The economy is the most important thing,” says Stephen Melman, director of economic services at the National Association of Home Builders. “Projecting lifestyles is a really tricky business.”

Hayek warned that if the Fed let NGDP fall you’d get a “secondary deflation.”  And that’s exactly what we got.   The first (small) part of the housing crash was a necessary adjustment.  The second much bigger part of the collapse was clearly the result of tight money reducing NGDP.  NGDP is the money people have to buy houses—it’s national income.  With less NGDP there will be less demand for housing.  You’ll have empty houses at the same time as people doubling up because they can’t afford houses.  Just as during the Great Depression you had farmers unable to sell their food, and hungry people who couldn’t afford to buy food.

We were a little poorer in 2008 than in 2006 because we misallocated resources into foolish housing construction.  We were a lot poorer in 2010 than 2008 because the Fed made us a lot poorer.

HT:  John Quiggin, Tyler Cowen.

PS.  The recession also reduced immigration, which reduced housing demand even further.

PPS.  Notice the headline of the USA Today article is still reversing causation.

This blog title is a response to thousands of comments I’ve received over the past two years.  I would often reply that banks did very poorly when the Fed drove NGDP lower in 2009.  I wonder whether recent events call into question the widely held view that tight money helps banks.

And how about gold?  Still think that high gold prices mean high inflation ahead?

I’m reluctant to even do this post, as the GDP figures keep getting revised downward, suggesting my former comments are “inoperative.”  Fortunately for me the revisions keep strengthening my argument.  First the BEA said NGDP fell about 2% between 2008:2 and 2009:2.  Then last year the figures were revised sharply lower, especially for 2008:3, which showed that the recession got much worse before Lehman.  NGDP fell 3% between 2008:2 and 2009:2.  Now we have another revision, and the fall is nearly 4%!  (minus 3.85% to be precise)  What was already the worst AD collapse since 1938 just got even deeper.

What’s up with the BEA?  It isn’t just that they are revising RGDP data from years ago (I suppose a new price index formula could explain that), but they are also sharply revising nominal GDP data from years ago.  They are still getting new reports of nominal output!  Even more bizarre, the nominal numbers are being revised downward by massive amounts, more than $100 billion.  So they are getting new reports that nominal output for early 2009, which they still thought existed a year later in early 2010, did not in fact exist.  I’m pretty sure that I would be horrified by seeing what goes on inside the BEA—I’d rather visit the Oscar Meyer factory in my hometown, to see how hot dogs are made.  Employment numbers are probably our best “real” indicator.

So we now have a nice three year data set.  NGDP fell nearly 4% from 2008:2 to 2009:2, and has risen at a tad over 4% a year for the next two years.  We are up by only 4.1% in 3 years, that’s a little over 1% per year.  In other words, per capita NGDP has barely risen in 3 years!  To maintain full employment everyone would have had to go nearly three years without a pay rise.  But with soaring minimum wage rates, that wasn’t too likely.  I’m sure lots of people in government, health care, education, etc, got raises.  I did (even with one year of no raise), as did my wife (a scientist.)  So with almost no extra NGDP to go around (per capita), we essentially have a game of musical chairs.  The lucky ones get pay increases, the other 9.2% are sitting on the floor.

Now I’ve got to revise my papers.  I’ve been saying NGDP fell 8% below trend during the contraction, actually it was 9%.  And we are 11% below trend over the three year period.  Obviously we are never going all the way back, nor would I advocate that.  But we are 5% below Bill Woolsey’s quite conservative 3% NGDP target, starting from mid-2008.  A target most ultra-conservative inflation hawks would have grabbed in a heartbeat, if offer the chance in mid-2008.

There’s a bit of good news for those pushing the structural problems argument.  Previously the real/nominal split during the recovery was estimated at 2.8%/3.9%.  Now it’s estimated at 2.5%/4.1%.   So we have a tad more stagflation that we thought, but still not very much.  More worrisome is the split over the last two quarters, 0.85%/3.4%.  That may reflect the effects of the oil shock, but we need to watch that carefully to see how severe the economy’s structural problems really are.  I am a moderate on this issue, and believe we have some structural problems in the labor market, but that it’s mostly demand-side.  The new figures haven’t led me to revise this view, but if they continue for several more quarters, I will definitely revise this view.  Although I won’t revise my monetary policy recommendations, which don’t depend at all on real variables.)

I see lots of discussion in the press about how the housing bubble made Americans poorer, and that this explains the low level of AD.  Yet the conclusion doesn’t follow from the premise.

Every bone in my body tells me the conventional view is correct.  We built too many houses and got too deeply in debt.  Now we need to spend less, and that means we need to produce less (as trade is too small a share of GDP to make up the gap.)  Intuitively this seems true, but it’s actually false.  To see why, consider the following parable:

A pioneer family in the American Midwest has run into trouble.  Locusts ate their wheat crop, and now they can’t pay back the local moneylender for the loan they used to get started in farming.  He threatens to burn down their house if they don’t repay within another 12 months.  What do they do?  I’d argue they need to tighten their belts and consume less.  They also need to work much harder.  But in a closed economy (they are self-sufficient) how can this be?  They consume what they produce.  No, they consume part of what they produce.  They need to consume less consumer goods.  Since they are self-sufficient, money plays no role (and that means, THANK GOD, no NGDP shocks.)  They need to “spend” less on clothing and pots, by spending less time making clothing and pots.  And they need to spend more time clearing another 40 acres of land, by cutting down trees.  They need to actually work harder, and plant twice as many crops as the year before.

You may not like the exports of wheat that are implicit in this example.  Then assume the problem is poverty caused by locusts eating one half of their crops.  Now they need to clear twice as much land to feed themselves, knowing the locusts will eat half of whatever they produce.  Either way, they need to invest more.  In an open economy they also made need to export more (depending on the situation in other “countries.”)

What’s true of the pioneer family is also true of the modern US economy.  We need to tighten our belts by saving and investing more.  But the Keynesians are wrong in assuming that more saving means less GDP.  We need to have the Fed stabilize NGDP growth, so that more saving means more investment (and exports.)

A more sophisticated argument accepts this analysis as a long run proposition, but rejects it’s applicability for the US in 2008.  People like Tyler Cowen and Arnold Kling might argue that a modern sophisticated economy can’t easily switch from producing one type of good to producing another.  During the re-allocation of resources, and retraining of workers, there may be a good deal of unemployment.  I accept this in principle, but believe the effect is so tiny as to not have important cyclical implications.

Perhaps the most famous example of the US finding itself producing the wrong set of goods occurred in late 1941.  We had been producing lots of cars and other consumer products in our factories (the economy had mostly recovered from the Depression by December 1941.)  And suddenly in late 1941 we realized that we needed to entirely stop producing any cars, and start producing tanks, airplanes, etc.  And even worse, we had to do so with a largely untrained workforce, as a large share of our regular workforce was drafted into the military, and replaced by housewives, unskilled rural workers, etc.

So if re-allocation led to recession and high unemployment, then 1942 should have been the mother of all recessions.  Obviously it wasn’t.  And the reason is also obvious—NGDP rose sharply.  Some might argue that we knew the new products we needed in 1942, but not in 2008.  But I can’t see why that would be.  The price system gives us the signals telling us what to produce, even without the sort of central planning we had in 1942.  Keep NGDP growing at a steady rate, and booms will burst out in non-housing sectors.  I said booms, not bubbles.  This re-allocation is efficient, just like clearing land was efficient.

Another objection is that the Fed can’t prevent a fall in wealth from decreasing NGDP.  So even if reallocation is not a problem, falling AD is.  We had a near perfect laboratory test of this hypothesis in 1987.  But first a bit of history.  In 1929 there was a big stock market crash, and consumer spending fell sharply in 1930.  This led many Keynesians to hypothesize that the stock crash actually caused the fall in AD during 1930.  We now know that hypothesis is false, thanks to Alan Greenspan.  This is because the 1987 crash was almost identical is size to 1929; if you overlay the two graphs for September/October, they line up almost perfectly.  And because Greenspan kept NGDP growing at a steady rate, there was no collapse in consumer spending, and not even the teeniest slowdown in economic growth.  Thus 1988 and 1989 were the two most prosperous years of the entire decade.  Even the first half of 1990 saw very low unemployment.  So the Keynesians were wrong about the Great Contraction.

Many people will send in comments to the effect that 1987 was different due to blah, blah, blah.  And 1942 is not a good example of reallocation due to blah, blah, blah.  Maybe you are right.  But it won’t affect my views, because no one can point to a counterexample, that would disprove my “NGDP drives the cycle” hypothesis.

Someone needs to find a counterexample to the two following “it’s funnies”:

1.  It’s funny that big drops in wealth never seem to result in recessions, unless the Fed lets NGDP growth slow sharply.

2.  It’s funny that major episodes of re-allocation never seem to result in recessions, unless the Fed lets NGDP growth slow sharply.

For me, those two claims are the bottom line.  We know what classical economics says should happen; I say it will happen if NGDP growth is stable.  A commenter named Skip linked to an interview with Bob Lucas.  Skip made the following observation:

In his interview when asked about his thoughts on Real Business Cycle theory he essentially says that he thinks RBC theory is basically right WHEN MONETARY POLICY IS GOOD.

Yep.

PS.  Here’s the link Skip provided:

http://media.bloomberg.com/bb/avfile/Economics/On_Economy/vv9VRoc8DQl8.mp3

PPS.  This exercise has made me a bit more accepting of the Keynesian argument that it’s time for lots more infrastructure.  I was initially skeptical, as I assumed that good monetary policy would raise real rates back up to normal.  Now I think they’d only go part way back to normal, at least for a while.  Of course I’d hope we follow the Swedish lead and have the private sector build and operate as much of that infrastructure as possible.  (So don’t worry Morgan, I’m not going soft.)