Here’s a passage from a recent AER paper by Pierpaolo Benigno and Luca Antonio Ricci:

This paper offers a theoretical foundation for the long-run Phillips curve, by introducing downward nominal wage rigidities in a DSGE model with forward-looking agents and flexible-goods prices, in the presence of both idiosyncratic and aggregate shocks. .  .  .

Several important implications arise. First, the optimal inflation rate may not be zero, but positive, as inflation helps the intratemporal and intertemporal relative price adjustments, especially in countries with substantial macroeconomic volatility or low productivity growth. Second, the ideal inflation rate could differ across countries (and in particular it would be higher in countries with larger macroeconomic volatility and lower productivity growth), and may change over time. Third, stabilization policies can play a crucial role, as they can improve the inflation-output trade-off.

Additional theoretical implications arise. First, the overall degree of wage rigidity is endogenously stronger at low inflation rates and disappears at high inflation rates, unlike in time-dependent models of price rigidities where prices remain sticky even in a high-inflation environment. This arises from the endogenous tendency for upward wage rigidities (as in Elsby 2009), resulting from forwardlooking agents anticipating the effect of downward rigidities on their future employment opportunities. Second, this endogenous wage rigidity also introduces a trade-off between the volatility of the output gap and the volatility of inflation, as at low inflation adjustments occur mainly via changes in output and at high inflation via changes in wages. Third, the Phillips curve may arise not only from the need for intratemporal relative price adjustments across sectors in the presence of downward rigidities (as in the traditional view), but also from the need for intertemporal relative price adjustments, which open the way for the important role of macroeconomic stabilization policies discussed above. Fourth, nominal shocks can have high persistent real effects, suggesting that introducing downward wage inflexibility in a menu-cost model à la Golosov and Lucas (2007) would likely change their conclusion that nominal shocks have only transient effects on real activity at any level of inflation.

So there are models that predict persistent output gaps as a result of downward nominal wage rigidity, especially near zero inflation.  And remember we have conclusive evidence that nominal wages do exhibit downward rigidity, especially near zero inflation.

In the same issue of the AER, Peter Diamond has some interesting comments on the structural/demand-side debate:

Second, for the current moment, the argument about the aggregate demand side is academic, in the negative sense of the word. Current estimates I have seen of how much of the increase in unemployment from a few years ago is “structural,” rather than due to inadequate aggregate demand, still leaves enough need for aggregate demand stimulation that it is clear what direction is needed for further policies.

Third, I am skeptical of the value of attempting to separate cyclical from structural unemployment over a business cycle. When firms evaluate candidates for positions, they consider the quality of the match of available candidates, projections of the availability of new candidates, and the value to the firm of filling the slot. That is, the willingness to hire for a given quality of match depends on expectations about the profitability of investing in a new worker and about the likely pool of future applicants.

The tighter the labor market and the more valuable the filling of a vacancy, the more a firm is willing to hire a worker who is a less good match and who may need more training. In other words, a worker who might be viewed as structurally unemployed, as facing serious mismatch in the current state of the economy, may be readily employable in a tight labor market. The common practice of thinking about the extent of unemployment as a sum of frictional, structural, and cyclical parts misses the point that the tightness of the labor market affects worker quitting decisions and affects employers’ willingness to hire an applicant who needs more training. In so far as direct measures of frictional or structural unemployment are dependent on the tightness of the labor market, they have limited relevance for the design of demand stimulation policies. The idea that the US economy is not adaptable and capable of dealing with the need for skills and jobs to adapt to each other is peculiar, given the long history of unemployment going up and down.

Those are two themes I’ve emphasized.  Structural and demand-side problems are deeply entangled, indeed I think the problem is even worse than Diamond does–as he puts little weight on the UI benefit extension to 99 weeks.  And second, even if we have major structural problems, there is still a clear need for demand stimulus.

No, that’s not a typo.  And yes, I am good at math.  In this post I’ll try to reconcile two very different perspectives, each of which seems quite plausible:

1.  The problem is obviously aggregate demand.  In 2009 NGDP fell at the fastest rate since 1938.  The recession is closely correlated with that decline, and both theory and history suggests that such a decline is always bad for growth.  Financial markets respond to rumors of monetary easing in a way that suggests they believe it affects real growth.  Countries with more expansionary monetary policies tended to do better, at least in most cases.  (Australia, Poland, and Sweden, but not Britain.)  David Glasner showed that stocks and TIPS spreads are correlated during this recession, but not before.  Paul Krugman has a recent post showing that wages are obviously very sticky at low inflation.  We clearly have an AD problem.

2.  The problem is obviously structural.  Youth and unskilled unemployment is particularly high, presumably partly due to the 40% jump in minimum wages.  When European countries introduced policies like two year UI, their natural rate increased.  Now we’ve done the same.  Manufacturing firms report a shortage of skilled labor.  Nominal wage growth rates and core inflation have stopped falling, suggesting that wages and prices have reached some sort of equilibrium.  There’s an immigration crackdown.  There is rapid growth in occupational licensing laws, making it much more difficult to become self-employed.

Previously I’ve suggested that supply and demand shortfalls might become entangled.  Today I’d like to briefly summarize why, and discuss the implications.

1.  Why do demand shortfalls worsen AS?   I can see several possible reasons.  The nearly 10% drop in NGDP relative to the path expected when minimum wages increases were enacted, has effectively raised the real minimum wage by 10% more than intended.  (Wages should be deflated by NGDP, not prices.)  The demand shortfall caused Congress to extend UI benefits from 26 weeks to 99 weeks.  Since workers suffer from money illusion near 0%, the supply-side may deteriorate when nominal wage cuts are needed.  If public sector wages are sticky, it may place a burden on the private sector.  If the recession leads to big deficits (as ours has) it may lead to expectations of higher future taxes.

2.  Why do structural problems worsen the demand shortfall?  Two possible reasons (only one of which supports fiscal stimulus.)  If the Fed targets interest rates, or is passive at the zero bound, then a falling equilibrium natural rate may unintentionally tighten monetary policy.  Obviously the Fed also cares about things like inflation; otherwise the price level would be indeterminate.  But in the short run (with interest rate targeting) an adverse supply shock could reduce AD, just as fiscal stimulus could raise it.  The other problem is inflation.  Structural problems reduce AS, and raise inflation. If the Fed is targeting inflation, that causes them to do less monetary stimulus.  This channel works against fiscal stimulus.

So far everything seems symmetrical.  But I do think there is an important difference.  In my view monetary policy can solve 100% of the AD problem, but policy reforms can only solve a modest portion of the AS problem.  If we cut the minimum wage back to $5.15, and cut UI back to 26 weeks, it might cut one point off the unemployment rate, say from 9% to 8% (assuming 5% is the natural rate during normal times.)  Other structural problems are harder to address.  On the other hand if the problem is 75% AD, then monetary stimulus alone could cut unemployment from 9% to 6%.  That’s partly because it would reduce the real minimum wage, partly because it would cause Congress to end the 99 week UI program, and partly because it cuts real public sector wages, and partly because it reduces the problem of money illusion at 0%.  (Here I assume that the natural rate went up by 1% (from 5% to 6%) because of other structural problems such as labor re-allocation, which the Fed can do nothing about.)

So even if the problem is both 75% AD, and 75% structural, policymakers should be much more focused on the AD problem, at least in terms of the recovery.  Obviously structural changes like tax reform and better regulation will produce greater long run gains than any demand-side policy.  But we shouldn’t kid ourselves that those can solve the demand shortfall problem.

Deep down even conservatives must understand this.  If a Reaganite was president and doing aggressive supply-side policies, you can be sure the WSJ would be demanding easier money to help facilitate growth, just as they asked for easier money when Reagan himself was president and inflation was 4%.  Recent conservative hysteria about inflation is completely at odds with their relative silence during the Bush years, when inflation was higher than under Obama, and the dollar plummeted in value (it’s been fairly stable under Obama.)

My latest at The Economist’s “By Invitation.”

Yesterday on PBS I heard experts speculating about why recent recoveries have seen disappointing job growth.  So I decided to take a look at the figures, and found that the entire concept of “jobless recoveries” is largely a myth.  I say largely, as a examination of Okun’s Law may be able to find a tiny morsel of truth in the idea, but I found no evidence of any significant mysteries.  Indeed no evidence of any jobless recoveries, mysterious or not.

Here are the data on the first 6 quarters of recovery from the last 4 recessions:

Period            NGDP growth rate    RGDP growth rate    Change in jobless rate

1982:4 – 84:2      11.0%                          7.7%                        – 3.4% (points)

1991:2 – 92:4        5.9%                          3.1%                          +0.8%

2001:3 – 03:1        3.8%                          1.8%                          +1.0%

2009:2 – 10:4        3.9%                          2.8%                          -0.1%

The change in the unemployment rate was for the first 18 months after the cyclical trough.  In the Reagan recovery, RGDP soared and unemployment fell sharply.  In 2002 RGDP growth was well below trend, and unemployment rose.  In 2009-10 RGDP grew at trend, and unemployment was stable.  No surprises there.  Only 1991-92 presents a bit of a puzzle, as RGDP grew at about trend, and unemployment rose 0.8%.  But that’s it.  Where’s the evidence of a recent trend toward jobless recoveries?  What I see isn’t jobless recoveries, but three consecutive recessions where the first 6 quarters saw no recovery at all (relative to trend.)  We fell into three deep holes, and started digging sideways.

So yes, the last three recessions have been quite different, but the difference was that during the first 6 quarters of “recovery” there was no recovery at all.  And 1983 is not an outlier.  We can’t do 1980, because the entire recovery lasted much less than 6 quarters, but previous postwar recessions saw RGDP rise at 5% to 10% rates during the first 6 quarters of recovery.

The real question is why did RGDP rise so slowly during the three most recent recoveries.  If you haven’t guessed yet, you’re obviously new to my blog.

There’s no jobless recovery, there’s a jobless lack of recovery, or more accurately a M*V-less lack of recovery.

I don’t want to suggest that this is always a bad thing.  The previous two recessions were embedded within the Great Moderation.  Perhaps by being relatively stingy during the recovery period the Fed allowed for expansions of greater duration.  But in this severe recession there is no excuse for such a stingy monetary policy.  A 3.9% NGDP growth rate isn’t even digging sideways; it’s digging sideways and slightly deeper. If it weren’t for a certain degree of wage flexibility, 3.9% NGDP growth would have led to even higher unemployment, as real growth would have been well below trend.  Instead, wage growth has slowed just enough to allow this sub-par NGDP growth to produce roughly average RGDP growth.  In real terms we are digging sideways.

Of course the recent data are more upbeat, and if Fed forecasts are right we’ll finally get a recovery in 2011.  Not clear why they couldn’t have provided a bit more NGDP growth in 2010.

Paul Krugman has noted the anomalous recoveries from recent recessions, and discussed structural issues having to do with balance sheets, bubbles bursting, etc.  At some level he may be right, but I think it’s more useful to figure out why those factors led to slow NGDP growth.  Did they disrupt the usual relationship between changes in the fed funds target, and changes in NGDP?  I’d guess the answer is yes.  Perhaps inflation targeting (rather than level targeting) also plays a role.  Price level targeting leads to V-shaped recoveries and inflation targeting leads to L-shaped “recoveries.”

Normally you’d be better off looking at how someone like James Hamilton evaluates economic data, but I’ll take a stab at this one.  In early 2008 when we were in danger of slipping into recession, I got interested in the unemployment rate as a leading indicator (it is usually viewed as a lagging indicator.)  I asked myself how much of an increase in unemployment (during economic expansions) would be needed to indicate something more than just a blip in the recovery and that a new recession was underway.

I noticed that during expansions the unemployment rate never seemed to rise more than 0.6%, before falling again.  That is, unless we were actually going into a recession.  In that case unemployment rose much more, indeed at least 1.9% (in the mild 1980 recession.)  In between was a sort of donut hole, with almost no increases in unemployment of more than 0.6% that did not mean a recession was underway.  (Thus the US doesn’t have mini-recessions, even though all our economic theories predict we should see them more often than regular recessions.)  I say almost, because there was one exception; unemployment rose 0.8% during the 1959 nationwide steel strike, without any recession.  But the US economy is now far more diversified, and such an event is now very unlikely.  The share of employment in unionized industries like autos and steel has fallen sharply.  Here’s what I infer:

1.  Increases in unemployment of more than 0.6% are almost always indicators of recession.

2.  Increases in unemployment of more than 0.6% are ALWAYS economically significant.

The second statement is slightly more definitive, because I consider the 1959 steel strike to be an economically meaningful event.

If I’m right, then any change in the unemployment rate of more than 0.6% over a relatively short period of time, probably indicates that the actual unemployment rate changed—that it wasn’t all statistical noise.

Between November 2010 and January2011 the unemployment rate fell from 9.8% to 9.0%.  Let me emphasize that I strongly believe some of this was noise in the data, perhaps as much as 0.6% of the fall.  Thus the actual rate may have fallen from say 9.5% to 9.3%.  But I don’t think it was all noise, otherwise we would have seen previous episodes where the unemployment rate ticked up by more than 0.6% without triggering a recession.  And over the past 63 years (more than 750 months) we just don’t see meaningless blips that large.

Even an actual drop of 0.1% per month would be significant, that is faster than we had in 2010, and even faster than the pace of recovery that most forecasters expect over the next 5 years.  And remember that my argument suggests that 0.2% is the minimum plausible estimate for how much unemployment has actually improved; it may be a bit more.

I think this is why bond prices fell and yields rose.  The bond market knows that the payroll numbers are usually more reliable.  But they also know that both numbers are subject to error, especially with snowstorms disrupting data processing at some firms.  I actually know someone who expects to soon get a job, but the actual hiring has been held up by the recent storms in Boston, which have created a work backlog.  I think the bond market understands that while the payroll number is usually better, a change in unemployment that large is almost always economically significant.

BTW, my recession indicator worked pretty well in the 2008 recession.  By December 2007 unemployment was up 0.6% from the low, and in March 2008 it was up 0.7%.  Yes, the recession had already begun by March, but as late as mid-2008 some prominent forecasters still didn’t expect an outright recession.

PS.  I’ve been very busy and am way behind on comments.  I hope to get to the backlog this evening.

PPS.  Paul Krugman has a new post on the ECB in 2008 that is similar to arguments made by me and other quasi-monetarists about the Fed in 2008—they wrongly focused on high commodity prices.  Of course we tend to look at NGDP.

PPPS.  I just realized there is another (less appealing) possible interpretation.  It may be that the bond market thinks the lower unemployment numbers makes a premature Fed tightening more likely.  Let’s hope not.

Update (2/5/11):  Just as I predicted, James Hamilton’s analysis is better than mine.  He relies heavily on this excellent Rebecca Wilder post.