The Goldilocks model

Two extreme models of the macroeconomy have recently been discussed on the internet.  On the extreme right you have Casey Mulligan, arguing that demand shocks can’t explain high unemployment, and that our economy is faced with a supply problem.  If workers cut wage demands we could return to full employment.  On the extreme left people like Paul Krugman argue that wage cuts won’t boost employment at all; instead they will simply depress AD even further.

In the middle is the sensible AS/AD model, with downward-sloping AD curves and upward sloping AS curves.  The textbook workhorse.  This is the model that accurately describes the US economy.  If AD declines, output will also decline (due to the upward sloping SRAS curve.)  If workers accept pay cuts, then SRAS will shift right and output will increase.

Neither the Mulligan nor the Krugman models are consistent with the empirical evidence.  We know that autonomous increases in wages do reduce AS and employment, as with the NIRA.  So we can’t assume that the effect of wages on AD (if any), will offset the effects of wages on AS.  Indeed the opposite is likely to be true.  Imagine a central bank targets inflation.  Now lower wages and shift AS to the right.  What happens?  Prices would fall if the central bank did nothing, so it will increase the money supply enough to shift AD to the right by enough to maintain stable prices.  Of course real world central banks do not succeed in hitting their inflation targets precisely (as I showed in my previous post.)  But they certainly pay enough attention to inflation to prevent an increase in AS from actually decreasing output.

Mulligan’s approach is also inconsistent with the empirical evidence.  When there is a large exogenous negative monetary shock, which reduces NGDP, you will observe a rise in the rate of unemployment, rather than simply a fall in the price level.  If labor markets are flexible, output will recover within a year or two (as in 1921-22.)  If wages are sticky, output will recover much more slowly (2009 – ???)

Both Krugman and Mulligan are partly right.  More monetary stimulus really would reduce unemployment (at least if it succeeded in raising NGDP.)  Krugman’s right about that.  And cutting the minimum wage and reducing maximum UI benefits really would reduce unemployment.

A competent government would do all of those things.  An incompetent government would do none of them.  Which one are we?

PS.  I haven’t actually read enough of Mulligan to know that he thinks demand stimulus wouldn’t help.  He says Keynesian theory should be discarded, which I took as meaning demand-side theory should be discarded.  But perhaps he’s just attacking the more extreme Krugmanian version of Keynesian theory, as Tyler Cowen argues.  If someone finds a link where he supports demand stimulus I’ll add an update.


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32 Responses to “The Goldilocks model”

  1. Gravatar of Rien Huizer Rien Huizer
    18. August 2011 at 06:50

    Scott,

    Chapeau!

  2. Gravatar of Scott Sumner Scott Sumner
    18. August 2011 at 07:00

    Rien, Thanks, it’s the first time I’ve ever been complimented in French. My French is so rusty I had to look it up.

  3. Gravatar of Disgrunt Disgrunt
    18. August 2011 at 07:18

    Casey Mulligan’s entire theory is tongue-in-cheek. He says what he says so people like you will suddenly realize that both supply and demand matters, not aggregate demand only (which, admit it or not, is the only thing you seem to talk about, whether or not you believe supply also matters).

    This post is his success.

    That said, I don’t go around blogging that conservative frontrunners are evil.

  4. Gravatar of Donald Pretari Donald Pretari
    18. August 2011 at 07:28

    1. Should Charity be taxed, since helping the out of work is a disincentive?
    2. What percentage of people losing UI benefits will be able to find work?
    3. Isn’t a Payroll Tax Cut effectively lowering the Minimum Wage?

  5. Gravatar of Tom Grey Tom Grey
    18. August 2011 at 08:03

    a large exogenous negative monetary shock,
    How can a monetary shock, like the worthlessness of AAA rated MBS bonds, be “exogenous”?

    Isn’t that the whole problem with such models, that on the margin of what really drives changes, the important variables are NOT part of the model.

    There has been a HUGE reduction in the wealth of Americans, who may have thought they had 50k, 100k, or 500k USD of fairly liquid wealth in their home equity. The housing bubble pop showed them that they had personally miscalculated (related to Kling’s Great Recalculation) — and the reduced spending of millions of Americans is NOT a Fed-monetary effect as much as the biggest real wealth decrease effect ever in history. Bigger than the Great Depression wealth reduction effect.

    AS/AD models don’t capture the (usually unimportant) wealth effects.

    Naturally, I offer a policy to reduce the problem: convert Mortgage Interest Deduction into House payment credit of 50% for the first $1,000/month ($12,000/yr) with the next $1000 month at a 25% credit, and nothing for more payments.

    Plus, the IRS would track the Lifetime maximum house credit of 10 years of median taxpayer income (about $400 000 now), which would slowly rise. This helps house buying and selling now, with a reduced influence in the future.

    Plus, house payment of interest and principal, not just interest, so there is much less incentive to refinance/ borrow more, just to get the increased tax break (deducting more interest). The goal of home ownership tax support is to create more owners with equity, not merely folks “buying”/ renting/ speculating, with the bank the real owner.

  6. Gravatar of Morgan Warstler Morgan Warstler
    18. August 2011 at 08:05

    I have a small yard, at $20 I’ll pay somebody to do it. At $35, I won’t.

    Here is a FACT: As long as unemployment is at 8%, if I don’t have a $20 lawn mower, the problem is structural.

    Craigslist of course is the clearinghouse, which proves to us all daily, that technology can solve this problem.

    If the government isn’t running unemployment like Ebay / Paypal, we can’t really be sure about the jobless situation.

  7. Gravatar of Morgan Warstler Morgan Warstler
    18. August 2011 at 08:08

    Disgrunt,

    The folks here know that if Sumner has to choose between Perry and Obama…

    Sumner is a GUARANTEED Perry vote.

  8. Gravatar of marcus nunes marcus nunes
    18. August 2011 at 08:29

    Scott Not quite but comes close:
    http://home.uchicago.edu/~cbm4/

  9. Gravatar of Jon Jon
    18. August 2011 at 08:32

    Morgan, even after Sumner called Perry evil?

  10. Gravatar of TallDave TallDave
    18. August 2011 at 08:38

    You’re gradually convincing me on the monetary stimulus notion, but I’m also increasingly thinking our problems may be partly a result of our position on the Rahn curve — i.e. a monetary fix may help us overcome a fiscal problem, but the latter would remain.

  11. Gravatar of Wonks Anonymous Wonks Anonymous
    18. August 2011 at 09:22

    My impression is that Mulligan only discusses extreme Keynesianism most of the time in his blogging, which makes an easy target. He then only has to prove that supply “still matters”. If unemployment would be 1% lower once we adopted all his favored policies, he can then declare victory.

    Here’s an example quote:
    “The hypothesis that recession employment is less than optimal, and that people cannot find work at the going wage, is quite different from the hypothesis that supply has little marginal effect on aggregate employment during a recession”
    It’s the latter hypothesis he’s focused on critiquing. That’s from a paper discussing shocks to both labor supply (summer break) and demand (Christmas). He acknowledges the latter demand shock increases employment, but argues that it doesn’t do so any more in recessions than non-recessions.

  12. Gravatar of Wonks Anonymous Wonks Anonymous
    18. August 2011 at 09:23

    I should have linked to the paper I was referencing:
    Does Labor Supply Matter In a Recession? Evidence From the Seasonal Cycle

  13. Gravatar of Morgan Warstler Morgan Warstler
    18. August 2011 at 09:34

    “He then only has to prove that supply “still matters”. If unemployment would be 1% lower once we adopted all his favored policies, he can then declare victory.”

    He can declare victory. He is right.

    Before we do any monetary stuff, it is more important to use this GREAT OPPORTUNITY to kick the price supports out from under labor. Cut off regulations with a cleaver. Auction of the time of those receiving UI.

    It’s not very wonky to miss this logic.

  14. Gravatar of Morgan Warstler Morgan Warstler
    18. August 2011 at 09:34

    Jon, yep.

  15. Gravatar of Wonks Anonymous Wonks Anonymous
    18. August 2011 at 09:36

    Morgan, Scott has been arguing that UI has not been exogenous. It increased precisely because labor demand crashed. Increase labor demand, and there will be less political demand for policies like extended UI.

  16. Gravatar of Morgan Warstler Morgan Warstler
    18. August 2011 at 11:14

    Wonks,

    Uhm, Scott is WRONG. He said two years ago that’d the crash was going to buy us another New Deal.

    I said, NO. I was right. See Tea Party. I KNEW we are a far smarter people than during the GD, who have been trained since 1980 to hate taxes and not trust government.

    Again, we are seeing DEMS (Claire McCaskill) say NO to any more UI.

    I’m not concerned with going from 99 weeks to 52 weeks.

    I’m concerned with ending UI and replacing it with some version of my Guaranteed Income program – call it Internet auction based private workfare, whatever.

    If there is “excess capacity” then you just auction it. That’s the definition of what you do with excess capacity, you put it on Ebay and sell it for cheap.

    You aren’t being wonky. You are resisting the KIND OF CHANGE Clinton delivered on Welfare (so it is possible).

    I have said all along, Obama’s mistake was that he was SUPPOSED to be Clinton II. He was supposed to be the guy who ended UI as we know it, not the guy who tried to give non-voters more safety net.

    In the same vein, Obama can also be the guy who kicks the wage supports out from under the public sector. See Wisconsin hiring more teachers and paying them all less.

    Both of these would lead to strong free market gains. Since Obama is not doing his job, Perry will come in and do both those things.

    These are WONKY real solutions. Wonks want things to work, and only one approach works best – see Clinton on Welfare, productivity gains = do more for less.

    If you aren’t delivering productivity gains you are not a wonk.

  17. Gravatar of spencer spencer
    18. August 2011 at 13:03

    How about getting away from thus discussion of theory and look at a little economic history.

    What drives growth in a capitalist economy is some big new product –the computer, canals, railroads, interstates, electric motors, gasoline engines, steam engines, etc.etc.– that induces new investments and/or consumption and generates a leading economic sector.

    The problem is that we do not currently have some growth sector to bull the economy along behind it.

    Maybe we could do something like a massive program for energy independence via a large tariff on oil and subsidies for oil substitutes. The problem with this approach is that the new energy sources are probably too expensive and was just absorb resources instead of generating a dynamic leading economic sector that changes economics throughout the economy and leads to secondary investments and growth.

    The reason I believe your idea to target nominal GDP growth would not make any difference is that there is nothing in it to generate real growth like new investments or ideas that shift economic incentives and/or resources and so generate growth. Without that, promising 5% nominal GDP growth will not lead to new investments or new consumption and will have no impact.

  18. Gravatar of Wonks Anonymous Wonks Anonymous
    18. August 2011 at 13:16

    I searched for the phrase “another New Deal” on this blog and came up with this post:
    https://www.themoneyillusion.com/?p=1458
    From two years ago, but doesn’t sound like Scott is making the claim you thought he was.

    Clinton had an economy already starting to recover at the end of Bush I, and the recession wasn’t as severe (though today’s is still much better than the GD). So he hardly counts as evidence against the idea trap.

  19. Gravatar of spencer spencer
    18. August 2011 at 13:16

    The approach I’m suggesting is why the field of economics has made a massive error in neglecting economic history and allowing the entire discipline to virtually die. Any graduate student interested in economic history is virtually guarantee a career that will be spent in obscurity at some backwater school.

    But without some grounding in history we end up with a bunch of scholars arguing about how many angels can dance on the head of a pin.

  20. Gravatar of Morgan Warstler Morgan Warstler
    18. August 2011 at 13:36

    Wonks, ask him. I’m telling you he’ll admit it. He missed the Tea Party.

    Spencer,

    With every boom, something else dies.

    The public sector is 20% of the US economy, the next boom is GOV2.0.

    Imagine a dashboard that you access government through, imagine policies CHOSEN because they can be administered online. Can’t do them online? We don’t do them.

    Imagine half as many public employees. No postal service. Half as many teachers. Half as many publicly owned buildings.

    Until my drivers license, soc security card, taxes, fishing license all of it is on my smart phone, and I don’t EVER have to go stand around a public office – we need more productivity gains.

    The public sector owes years 20+ years of productivity gains at 2-5% per year.

    THAT IS YOU BOOM.

    Stop letting the left hide it under their skirt.

  21. Gravatar of David C David C
    18. August 2011 at 15:15

    My guess is both Krugman and Mulligan are trying to have it both ways. When Mulligan writes Keynesian theory should be discarded, what he means is to imply that AD arguments in the popular press should be ignored while still being able to claim in academia that he believes in the AS/AD model. Similary, Krugman never actually wrote that AS isn’t a problem. Instead, he responded to an argument that Mulligan never made. He’s trying to imply that AS isn’t an issue without explicitly stating AS isn’t an issue. This is similar to Krugman’s subterfuge when responding to Cowen’s Zero Marginal Worker argument. I think it might have something to do with the NYT general writing style. They probably sell more newspapers this way.

  22. Gravatar of Scott Sumner Scott Sumner
    18. August 2011 at 16:33

    Disgrunt, All you seem to do is call me a piece of s***, and then complain I say mean things about poor little Rick Perry. If you had actually followed my blog you’d know I’ve mentioned supply problems like extended UI dozens and dozen of times. Rarely does a week go by without a mention. I’ve been a supply-sider since 1978.

    Do you plan to remain permanently disgruntled?

    Donald. 1. Charity should not be taxed because they already have an incentive to take the work disincentive of charity into account. That’s why charities rarely just had cash to poor people. They do other things.

    2. UI should not be abolished, it should be reformed along the lines proposed by Romney. But for now we need to (gradually) go back to the normal 26 week limit. It will lead to more jobs being created, and hence jobs will be easier to find.

    3. They screwed up the payroll tax cut–they cut the employee share, whereas even Christina Romer admits it should have been the employer share.

    Tom Grey, You are confusing real and nominal variables. the housing crash reduced real wealth, but the Fed can prevent that from impacting nominal spending. There’s no reason for people to take long “vacations” just because they are poorer. They should work harder.

    It is often hard to identify exogenous monetary shocks, but with pre-war data it’s marginally easier.

    Morgan, It’s the only reason I put up with all your stupid abuse, you actually do have good ideas for reforming welfare.

    Thanks for the link Marcus.

    TallDave, What’s the Rahn curve?

    Wonks, Thanks for the info. I don’t agree with Mulligan on that. Demand shocks raise output more during recessions.

    There is no way the 1933 dollar devaluation would have boosted IP by 57% in 4 months, if we hadn’t been in recession.

    spencer, Are you denying demand shocks matter? That’s nuts.

    Morgan and Wonks. I thought the “new” New Deal would be worse. We did get the extended UI, the bailout of GM, the Obamacare, but Morgan’s right I missed the Tea Party. Although in fairness by mid-2009 I already saw the shift to the right, and switched my prediction before some other bloggers.

    David, Krugman did say wage cuts wouldn’t help; I consider that an extreme old Keynesian position. And Mulligan seems to think AD raises output just as much in booms as in recessions.

  23. Gravatar of TGGP TGGP
    18. August 2011 at 17:32

    A problem with Mulligan’s method in that paper is that during a recession when people are strapped for cash, the size of the Christmas demand shock should decrease accordingly. The Bush cut-a-$200-check-to-everybody mini-stimuli would make for comparable shocks if they recurred as regularly, but from what I’ve heard the scholarly consensus is that there was no impact on AD seen in the data.

    Looking in a little, he even acknowledges that spending has a smaller spike during recessions, but he seems to be normalizing employment spikes by that measure.
    “I measure the seasonality of the incidence parameter as seasonality of aggregate log labor activities (employment, etc.) per unit seasonality of retail sales, with retail sales normalized by a seasonally adjusted measure of national labor income.”

  24. Gravatar of Lorenzo from Oz Lorenzo from Oz
    18. August 2011 at 17:49

    Spencer: I think you need to read Hayek on knowledge in the economy and Popper on not being able to predict the future of technology. As Scott says so pithily in response, all those folk did not become suddenly unemployed due to lack of a new leader technology/idea/area of investment. It is not as if Oz, (unemployment 5%) is doing much better by being some technological leader.

  25. Gravatar of OGT OGT
    18. August 2011 at 19:14

    Tom Grey: Interesting article on wealth effects from Roger Farmer

    In my research over the last decade (see Farmer 1999 to 2010) I have proposed a new paradigm that reconciles rational behaviour and high unemployment with microeconomic theory. In a recent paper (Farmer 2011), I extend my earlier work to explain asset price bubbles. I show that for every value of the stock market, there is a higher value that is consistent with a rational-expectations equilibrium. This cannot occur in conventional economic models in which there is a single rational value for an asset price.

    This work opens the door to a class of theories that integrate market psychology with economics in a new way. Market psychology explains how the animal spirits of investors cause booms and crashes in asset values. The theory explains how asset price movements are translated into swings in the unemployment rate, by implication, provides an asset price management policy, as an alternative to conventional fiscal policy, to restore full employment.1

    http://www.voxeu.org/index.php?q=node/6882

    Sumner, Krugman’s claim about the effect of real wages rests on the conditions of a deleveraging event without “complete financial markets.” Given that the idea of “complete financial markets” are an empirical joke, I don’t think that can be dismissed.

    Also, given the economic incidence of payroll taxes, I don’t quite get the claim that cutting one side rather than the other would make a significant difference.

  26. Gravatar of Donald Pretari Donald Pretari
    18. August 2011 at 21:01

    Scott,
    The point is that Aid is what causes the Disincentive. Anything that allows me to avoid work in any way is a Disincentive. You cannot get UI Benefits w/o trying to find a job in CA, where I received them. It doesn’t have anything to do with cash, except that people might prefer cash.
    UI needs a Cost/Benefit Analysis. You only give the benefit: Lower Unemployment. But there’s a Cost: Some people who cannot find work will be forced to endure unnecessary hardship. If you can’t figure out the percentages, then you’re just saying Unemployment is all that matters. You can say that, but I can’t accept that.
    My point about the Payroll Tax was simply that you can effectively cut the Minimum Wage without cutting the Minimum Wage. For example, you could subsidize employment. Cutting the Minimum Wage is not, in itself, the only means of accomplishing the same goal.
    We don’t have a lot of disagreement, but I need a bit more justification and clarity before I accept your recommendations.

  27. Gravatar of Doc Merlin Doc Merlin
    19. August 2011 at 06:55

    “In the middle is the sensible AS/AD model, with downward-sloping AD curves and upward sloping AS curves. The textbook workhorse. This is the model that accurately describes the US economy. ”

    No it doesn’t. Suppliers don’t care what they produce, they just want to make income, so its fine (over the long run) to model AS as a function of only RGDP. However demanders care not just how much stuff they get, but they also care deeply abou the makeup of the basket of goods. This means that when we aggregate over the basket of goods bought, we are assuming that there are no distortions in the market (say in the form of subsidies, government spending, etc etc) This is an obviously false assumption (as being conservative, roughly 40% of the economy is centrally planned, not market driven).

    Without the assumption I gave, AS and AD are endogenous and the entire model becomes nonsense.

  28. Gravatar of Doc Merlin Doc Merlin
    19. August 2011 at 07:00

    “If wages are sticky, output will recover much more slowly”

    I think stickiness is a bad excuse here, as wages (both nominal and real) have actually been increasing, not decreasing during the crisis. Stickiness would imply that nominal wages would still fall during this sort of recession, but they haven’t. Instead we just saw firms cut employment heavily and deepen capital stock.

    This is consistent with increased price floors and increased fixed costs to employment, but not with sticky wages.

  29. Gravatar of Doc Merlin Doc Merlin
    19. August 2011 at 07:06

    Sorry, in the above “would still fall” should read “would still fall or hold steady”.

  30. Gravatar of Scott Sumner Scott Sumner
    19. August 2011 at 17:10

    TGGP, As I recall the Bush cut had a small impact on retail sales for about a month or two.

    OGT, You said;

    “Sumner, Krugman’s claim about the effect of real wages rests on the conditions of a deleveraging event without “complete financial markets.” Given that the idea of “complete financial markets” are an empirical joke, I don’t think that can be dismissed.”

    My critique did not rely in any way on complete financial markets, so this criticism doesn’t affect my view at all.

    You are right about the incidence of taxes in the long run, but in the short run nominal wages are sticky, which is exactly why we are in this mess in the first place.

    Donald, I don’t agree. Suppose a charity gives free vaccines to people, or provides aid for the blind and disabled. Or free libraries (like Carnegie.) Or supports Catholic high schools. I don’t see how that’s a big disincentive to work.

    You mischaracterized my view on UI. I never said I was opposed, and indeed I have ideas for reforming the system to make it better (similar to Romney’s idea.) I just said I thought 99 weeks was too long, it’s making it harder for workers to find jobs.

    Doc Merlin, No, the AS/AD model doesn’t assume what you claim it assumes.

    You said;

    “I think stickiness is a bad excuse here, as wages (both nominal and real) have actually been increasing, not decreasing during the crisis. Stickiness would imply that nominal wages would still fall during this sort of recession, but they haven’t. Instead we just saw firms cut employment heavily and deepen capital stock.”

    No it doesn’t, as Krugman pointed out in a post a few weeks back (search for it under wages). Different workers have different labor market shocks. If it’s hard to cut wages, then the overall average can rise even as wages are above equilibrium.

  31. Gravatar of OGT OGT
    20. August 2011 at 08:48

    Scott, just for my own understanding of you and Romer on the payroll tax, given nominal wage stickiness, why is cutting the employer side more beneficial than the employee side?

    If it is the unemployed who are reluctant to accept lower wages then arguably cutting their with holding may spur them to accept a lower offer. If it is current employees they arguably would be willing to accept a lower increase/cut if their take home actually went up. Is the argument that employees only, or primarily, focus on the headline wage? That seems like a significant departure from RATEX, right?

    Then there is the spending side, if I understand correctly, corporate savings has significantly risen the Great Recession/Contraction, or, Lesser Depression. So, in the old M * V framework, that would seem to be the less optimal side to cut.

  32. Gravatar of Scott Sumner Scott Sumner
    20. August 2011 at 14:35

    OGT, Suppose workers are working on long term nominal contracts. If you cut the employee side, there is no immediate change in labor costs. If you cut the employer side, labor costs immediately fall by x%. It’s just as expansionary as a Fed policy of boosting the price level by X%, except that payroll taxes top out at about $100,000.

    I agree that the sticky wage/money illusion theory does seem at odds with ratex. Especially the money illusion part.

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