You may not care about NGDP, but NGDP affects what you do care about

A recent article by Josh Barro called for a freeze on public sector wages.  I don’t disagree with anything in the article, but I also think it is important to take a step back and put this issue in a broader context.  Let’s start with this interesting observation:

Since the end of 2006, hourly total compensation (wages plus benefits) has risen 6.5% for private sector workers, essentially keeping pace with inflation. But state and local government workers saw their hourly compensation rise 9.2%.

Federal civilian workers (about 10% of the public sector civilian workforce) are excluded from the above measure, but they did even better, receiving Congressionally-approved wage rises totaling 9.9% over the same period.

Why have public sector wages grown so fast? In some cases, it’s because employees are receiving scheduled raises under contracts negotiated before the economic crisis. New York public employees will see a 4% pay increase in April, under a contract negotiated in the middle of the last decade.

Talk about sticky wages!  Here’s the way I see the problem.  Public employees and employers both know that for several decades the Fed has been allow roughly 5% NGDP growth.  They also know that the workforce grows at about 1% per year, meaning average incomes can grow at about 4%.  So they negotiated pay contracts on that basis.

Now suppose the Fed reduces NGDP 8% relative to trend.  If all wages and prices are flexible, then you would see an 8% reduction in all wages and prices relative to trend, and output wouldn’t be affected.  But wages and prices aren’t very flexible in the short run, and thus output will fall sharply.  You might think that once wage contracts are renegotiated, this problem would be solved.  But you would be wrong:

But in other cases, governments have agreed to pay increases during the recession, or been forced into them by arbitrators. Transit agencies in New York and Washington, D.C., have seen their budget crises exacerbated by arbitrator-mandated pay increases, leading to service cuts. And Congress just approved another 2% pay increase for federal workers, effective this month.

Why don’t public employees get an 8% pay cut relative to trend, once their contracts are renegotiated?  Because that would mean a big cut in their real wage.  Why should employees with secure jobs accept a sharp real wage cut?  In other words, there is a coordination problem.  If you are a factory worker you can’t save you job merely by making your wage flexible, you need to make all wages flexible.  And it will not be easy to get public employees to share your wage cut, unless all companies also reduce all prices 8% below trend.  But why should companies cut prices if workers haven’t cut wages?  More coordination problems.

Is there an easier way out of this mess?  It seems to me we have two choices:

1.  Inflict enough pressure on workers to accept wages rates that are 8% below trend.  This can be accomplished with threats of layoffs, union busting, high unemployment, cuts in unemployment benefits, cuts in the minimum wage, pressure on public employees, etc.  It will also require much lower prices.  The entire process will be painful and will take many years.

2.  Use monetary policy to boost NGDP back up to trend, or more precisely close enough to trend so that with the wage cuts that have already occurred we can regain reasonably full employment.  The entire process will seem much less painful, and will show results almost immediately.

In some ways the two adjustment programs are quite similar.  Indeed the term “money illusion” was coined to describe the inability to see that they were quite similar.   But I think the second option is much easier to accomplish, at it merely requires that we change one price—the price of money.  In addition, my commenter “statsguy” likes to remind me that option 2 also makes it much easier to address the debt crisis.

This isn’t a criticism of Josh Barro, if my bailiwick was fiscal policy I’d be making the same recommendation.  He probably views the downshift in NGDP as a fait accompli, and he is probably right.  But there is a deeper question that we still haven’t addressed, what is our policy toward NGDP?

It seems to me that we have to make up our minds about which way we want to go, lower wages or higher NGDP.  It also seems to me that we haven’t even come close to doing so; indeed most people don’t even know we face this dilemma.  How often have you heard a Congressman (or the President) angrily call on the Fed to sharply boost NGDP, or even the price level for that matter?  I haven’t either.  And have you ever heard a Congressman (or the President) angrily scold the public for making excessively high wages?  Me neither.  They think there is a third way, but there isn’t.

BTW, if you are thinking “Sumner’s just one of those right-wingers who thinks wage cuts are the answer,” then you haven’t understood anything I have been saying.  If you are a liberal, then you have probably read Krugman’s arguments that wage cuts aren’t the answer.  Does that contradict what I am saying here?  Not really, I am not trying to make a causality argument here (although in another setting I’d love to make that argument) rather I am trying to make an accounting argument.  And I very much doubt that Krugman would disagree with my accounting.  Indeed, Krugman is one liberal who has made some very pointed criticism of the Fed, and who clearly understands that there is a problem, and that monetary stimulus is the best way out of the crisis.

Krugman and I do disagree on wages, but we share a sense of exasperation that most of the country, and most policymakers in both parties, are pretty clueless about the situation we face.  You can’t have NGDP downshift 8% and keep the old wage structure.  And yet as far as I can see most politicians and policymakers want to do exactly that, they want to have it both ways.  You may not like what I have to say, or what Krugman has to say, or what Josh Barro has to say, but at least we are all in our own way trying to provide a solution to this problem.   The policymakers in Washington just seem to be crossing their fingers and hoping that the problem will magically go away.

Maybe we will get lucky in 2010 and NGDP will start growing fast, eliminating the need for further wage cuts.  Even if that occurs, I will still be asking this question:

Wouldn’t it have been better if the Fed had boosted NGDP back in October 2008?

BTW,  Tyler Cowen did a post that listed some policies that might be able to help Haiti.  At the end of point 3 (which discussed ways of injecting money into the Haitian economy), came this cryptic remark:

Stabilize Haitian nominal GDP!

What do you guys think?  Is he subtly mocking my increasingly single-minded insistence that NGDP is a magic bullet than can solve all our problems?  If so, lord knows I deserve it.  Or is my paranoia just a disguised form of arrogance?  What makes me think that every time someone mentions NGDP they are thinking about me?  Bennett McCallum, James Tobin and Robert Gordon have all proposed NGDP targeting, what’s so special about me?

I figured I am too close to the issue, so I was wondering what came to mind when you guys read something like that—do you perceive it is a sly dig at this blog, or am I wrong in assuming that the entire planet now revolves around me?

PS.  If I find out he wasn’t making fun of me, I will be very disappointed.



33 Responses to “You may not care about NGDP, but NGDP affects what you do care about”

  1. Gravatar of E E
    19. January 2010 at 13:46

    I think Cowen’s reference was a friendly joke.

    btw Mervyn King says: “Provided monetary growth remains well under control –and remember at present it is undesirably low — inflation should return to target in the medium term.”

    Strange thing is here refers to rates of growth, not levels and he usually emphasises the importance of levels.


  2. Gravatar of D. Watson D. Watson
    19. January 2010 at 13:56

    I read his comment and I looked for a link to your website advocating that very thing.


    I don’t know that it was *mocking*, though. He’s not a development economist, but it wouldn’t be that hard to have some fun at Sachs’, Easterly’s, Collier’s, etc.’s expense also if his primary point was humor. That, and several (in particular, the first and last several) have some real basis, even if he’s writing a little tongue in cheek.

  3. Gravatar of OGT OGT
    19. January 2010 at 14:20

    I view sticky wages as a real economic phenomena, not a primarily political one, which I think goes along with how you’ve characterized the dilemma here. It’s not too dissimilar to the issue of nominal debt and renegotiation, as we’ve seen the loan modification process is hampered by issues of trust and asymmetric information, with lenders reluctant to make modifications even when the end result of foreclosure is worse financially.

    Since we’re a highly indebted country the fall in NGDP is far worse than it would be if sticky wages were our only problem. Since wage cuts won’t increase NGDP, merely redistribute it, you’ve only treated one of the symptoms not the disease.

  4. Gravatar of Contemplationist Contemplationist
    19. January 2010 at 14:27


    I definitely thought of you when I read that point. Maybe its just cos NGDP is a term i read mostly on your blog, and hadn’t seen used that much before your blog started.
    On that note, isn’t Haiti’s situation pretty much a supply side disaster, and hence printing money wont solve any problems?

  5. Gravatar of Mark A. Sadowski Mark A. Sadowski
    19. January 2010 at 14:33

    I read Josh Barro’s article today and just sighed in utter resignation. I agree wholeheartedly with your response. So much so I just quoted and linked this post in Barro’s comment section.

  6. Gravatar of Matthew Yglesias Matthew Yglesias
    19. January 2010 at 14:44

    I think Tyler was having a little fun at the expensive of the entire real shocks (“recalculation”) vs nominal debate by pointing to a clear example of a real shock.

  7. Gravatar of Richard A. Richard A.
    19. January 2010 at 14:46

    Maybe the Fed is not targeting nominal GDP because it has other objectives. For example, they expanded the monetary base to essentially buy mortgage backed securities and are paying banks a modest interest rate to prevent the newly created money from seeing the light of day. What they have done is to borrow short and lend long. If they were to get the economy going again, there would be a dramatic increase in short term interest rates making these MBS less profitable. Furthermost, the increase in long term interest rates would decrease the value of MBS. The Fed could end up with a massive loss on these MBS. This is just speculation on my part.

  8. Gravatar of anon anon
    19. January 2010 at 14:54

    Definitely making a little fun of you. Which means he assumes his readers know you and your arguments. Perhaps the best sign yet that you’ve arrived.

  9. Gravatar of Mark A. Sadowski Mark A. Sadowski
    19. January 2010 at 14:56

    I agree with Yglesias (Cowen’s just being sarcastic). Personally I see nominal shocks almost everywhere (perhaps that’s my monetary “sixth sense” in action) but real shocks are much harder to find. Haiti, however, certainly meets the definition of a real shock.

  10. Gravatar of Partial Spectator Partial Spectator
    19. January 2010 at 15:17

    Tyler Cowen has written earlier about mud pies in Haiti in his Markets in everything post. And his colleague Bryan Caplan has argued that in the face of a real shock it is important to stabilize NGDP anyway in order to prevent “secondary deflation”. Caplan used a fictional collapse of a mud pie industry as example of a real shock. So I am afraid Cowen was not making fun of you.

  11. Gravatar of Mark A. Sadowski Mark A. Sadowski
    19. January 2010 at 15:39

    Partial Spectator’s comment raises an issue that I discussed in an earlier post: the interaction of real and nominal shocks. Are there real AD shocks and nominal AS shocks? (I say yes to both.)

  12. Gravatar of pushmedia1 pushmedia1
    19. January 2010 at 17:34

    Keep the public sector aside, won’t private sector wage contracts being written now have “below trend” NGDP built into them, i.e. won’t nominal wages grow below trend? If so, why is the Fed’s one-time mistake in 2008 still indicative of policy that is too tight today?

  13. Gravatar of scott sumner scott sumner
    19. January 2010 at 18:05

    E, Thanks for the link. I also interpreted it as friendly humor.

    D. Watson, That makes 2.

    OGT, I agree, although I consider sticky wages to be the much bigger problem, as I consider our unemployment problem to be far worse than our banking problem.

    Contemplationist. Yes, it is a supply side problem, and printing money would not help. Dropping US dollars from helicopters might help a lot, after the initial rescue operations are completed. Perhaps even more than traditional foreign aid. But I don’t feel qualified to say anything more.

    So now there are three who agree with me.

    Thanks Mark.

    Matthew, OK, now it’s 3-1.

    Richard, Perhaps, but the Fed is part of the Federal government. The gains to the federal government from faster NGDP growth would be at least 10 times any losses to the Fed.

    anon, OK, 4-1 now.

    Mark, But was the sarcasm directed at me? I hope so.

    Partial spectator, OK, now it’s 4-2.

    Mark, I think some economists deal with real AD shocks. It is not a concept that I have ever found to be useful, so I don’t use the concept. I think wartime spending would be the area where it might be most useful.

    pushmedia1, Private sector wage cuts occur very slowly, perhaps due to the coordination problem. I don’t know anyone who’s nominal hourly wage rate has risen 8% below trend since August 2008. I know lots of people in the private sector who have gotten basically the same wage increase as they would have had if there had been no crisis. For ever person like that, someone else must take a 16% cut relative to trend. Economists don’t fully understand wage stickiness, but it seems to be a big problem.

  14. Gravatar of pushmedia1 pushmedia1
    19. January 2010 at 18:09

    “Private sector wage cuts occur very slowly”

    I promise, I’m not being snarky: What’s the best source to back up this claim? I don’t know the sticky wage literature as well as the sticky price literature (which has become really good with actual micro estimates of price change frequencies, etc).

  15. Gravatar of q q
    19. January 2010 at 19:56

    on the subject of krugman, he has written about spain where they do not have the option of currency devaluation or ngdp targeting, and he has written that they should lower wages. so i think you are correct that he would agree with your accounting.

  16. Gravatar of OGT OGT
    19. January 2010 at 20:02

    I think my difference is the label of sticky wages (and prices) being a problem precisely. I view it more neutrally as a phenomena. One could say that the coordination issue is a ‘problem,’ but overall I think economic actors have pretty good reasons to act the way they do.

    And it’s better that we adapt our economic models to that reality than pretend it can be easily changed.

  17. Gravatar of Jon Jon
    19. January 2010 at 23:23

    Maybe its not possible to ‘target’ NGDP at all. Just because you can bid up the price of real assets does not mean that an imaginary construction regarding new ‘output’ can be so bought…

    Maybe the Fed should buy bushels of wheat and bury them in fort knox for us?

    Now I happen to think that policy can be effect at the zero-bound, but I do not believe that it can be nearly as effective. There is something fishy going on about the money multiplier. The smallness of the monetary base relative to NGDP and assets generally.

  18. Gravatar of Marcos Marcos
    20. January 2010 at 05:45

    Well, Marginal Revolution links to you, the joke could quite well be about you. Now, even if not about you, it is clearly a joke, water isn’t fiat:

  19. Gravatar of Keith Eubanks Keith Eubanks
    20. January 2010 at 08:41

    Prof. Sumner,

    How do you avoid “stagflation” with a significant increase in NGDP? Prices will rise first, thereby lowering real wages (the objective). Might this not be pushing on a string? Why wouldn’t reduced purchasing power slow real gdp before employment has a chance to grow?

    It seems to me that current policy has put us in “no man’s land”. Policy seems to be focused on limiting price declines. Housing policies have focused on slowing foreclosures and limiting the bottom in the housing market. The Fed has done enough to at least limit the fall of prices (i.e.: commodities, especially oil).

    Had prices been allowed to truly bottom out, wouldn’t this have pulled wages down? But there still would have been a lag between prices and wages. Real wages would have risen first, increasing purchasing power (and unemployment I assume). Wouldn’t the increased purchasing power have limited the bottom and created the conditions for growth? This seems to be the pulling on the string scenario. I’m just not convinced that you can push on the string with NGDP (I am convinced that you can lower real wages through either path). But, why wouldn’t the time dimension in the system thwart the objective? Assuming the objective is to grow real GDP.

  20. Gravatar of Marcus Nunes Marcus Nunes
    20. January 2010 at 10:07

    Marty Feldstein does not believe MP was tight in 2008:
    “Unlike previous recessions, the current downturn was not caused by Federal Reserve tightening and therefore couldn’t be reversed by lowering interest rates. President Obama was correct to conclude that boosting economic activity required a fiscal stimulus”.

  21. Gravatar of Gregor Bush Gregor Bush
    20. January 2010 at 11:47

    Yes Scott, this was clearly a dig at you. But in an odd way, I think he’s helping your argument. The Haitian economy has clearly been hit by a massive negative supply shock – one which stabilizing NGDP growth cannot reverse (in terms of quickly restoring the economy to its previous path RGDP). By contrast, there is no evidence that there is any problem on the supply side of the US economy. The productivity and available labour supply data that we have seen firmly argue against the Kling/Cowen ‘recalculation’ thesis and support your view that the US economy has experienced sharp decline in aggregate demand, and nothing more.

  22. Gravatar of Marcus Nunes Marcus Nunes
    20. January 2010 at 13:41

    Brad DeLong says fiscal stimulus should have been much higher. At the very end he says that MP could have been much more cooperative:
    “It is true that as far as normal monetary policy is concerned, the Federal Reserve was tapped out… But there is more in the way of extraordinary monetary policy that could have been attempted in 2009″”including inflation-targeting announcements, the taking of additional risky assets out of the pool to be held by the private sector, larger operations on the long end of the yield curve.
    And I must confess that what the Federal Reserve thought and did in 2009 remains largely a mystery to me”.

  23. Gravatar of Marcus Nunes Marcus Nunes
    20. January 2010 at 13:46

    Michigan is leaning towards following SS advice:

  24. Gravatar of ssumner ssumner
    20. January 2010 at 19:01

    pushmedia1, I honestly don’t recall, but I do know there have been studies. This sort of thing in hard to prove. It might be more accurate to say that aggregate wage rates behave as if wage adjustments occur slowly.

    I don’t mean to suggest it is the only problem (prices are also sticky) but I think it is the biggest.

    q, Yes, thanks. I did a post on Krugman’s Spain post about a month ago.

    OGT, I completely agree. The term “problem” doesn’t mean it is something that should be addressed directly; as you say it is simply an aspect of the economy that must be considered when setting monetary policy.

    Jon, The smallness of the base isn’t important, what is important is that all prices are quoted in terms of base money.

    Marcos, Thanks.

    Keith. The pushing on a string metaphor refers to liquidity traps. There are many papers that discuss all sorts of ways around the zero interest bound. FDR tried one in 1933, and it was highly effective almost immediately.

    Marcus, Thanks. I’ve never agreed with Feldstein on monetary policy. He always seemed like an old-school Keynesian, interpreting monetary policy as changes in interest rates.

    Gregor, That’s a good point.

    Marcus, I still disagree with him on fiscal policy. There is little evidence that the actual stimulus had any discernible effect. A 50% bigger stimulus would have had an effect 50% bigger than little or nothing.

    Marcus, Thanks. Given that Michigan doesn’t have a currency they can devalue, what other option do they have?

  25. Gravatar of Marcus Nunes Marcus Nunes
    20. January 2010 at 19:35

    Michigan certainly doesn´t have a currency it can devalue…but neither do the other states and Pittsburg (less than a state)is trying to move in the opposite direction!
    In the GD Roosevelt “forced” wage increases. Now a central authority would have to force the opposite.

  26. Gravatar of Keith Eubanks Keith Eubanks
    21. January 2010 at 18:14

    Prof. Sumners,

    Thanks for the reply. Perhaps I can re-phrase my question:

    My question relates to whether the effect of pulling real wages down would be the same in an inflationary scenario vs a defationary scenaro?

    In a deflation, prices drop pulling wages behind them. However, there will be a significant delay between falling prices and most wages; a delay generally measured in years not days, weeks or months. This will have many effects on the economy but two very specific ones: 1) because of the delay, real wages will first rise and then fall (perhaps smoothly to their original value, perhaps overshooting and then dampening back, who knows) and 2) because of rising real wages, unemployment will likely increase (assuming productivity is not keeping pace with deflation). In this scenario, aggregate purchasing power could be rising, falling or staying the same depending upon how rising real wages and unemployment balance out.

    In an inflation, prices rise pulling wages with them. However, in this case: 1) the delay causes real wages to first fall and then rise as the inflation reaches wages; 2) the fall in real wages should lead to more employment. Like the deflation, aggregate purchasing power could be rising, falling or staying the same depending upon how real wages and employment balanced out.

    The risk of the deflation is that unemployment runs ahead of the rise in real wages and drives a downward spiral in aggregate purchasing power. If the rise in real wages stays ahead of unemployment, the system eventually rights itself.

    The risk of the inflation is that falling real wages runs ahead of employment creating a downward spiral in aggregate purchasing power but from a different direction. On the other hand, if the rise in employment due to the lower cost of labor stays ahead of falling real wages, you right the ship.

    I suspect the delays in the response of wages and employment would have favored letting deflation right the ship in 2008/9. But I don’t know. When I used the string metaphor, I was really saying I thought there was significant risk in trying to inflate NGDP because falling real wages might get ahead of employment and keep aggregate real purchasing power down (that was my pushing on a string metaphor, not quite the same as the liquidity trap).

    Does this make sense?

    I gather from your comments that you think gains in aggregate purchasing power from increased employment would outpace loses from falling real wages if NGDP were driven upward? Is this a correct statement?

  27. Gravatar of Some useful posts for macro-theory « Freethinking Economist Some useful posts for macro-theory « Freethinking Economist
    22. January 2010 at 06:07

    […] Scott Sumner:  Why nominal GDP is what matters. Scott has made himself famous for his strong belief that monetary policy was way too tight in autumn 2008, and that this is the reason we fell into a recession.  I don’t agree with every aspect of his macro-theories -I find it amazing that he thinks ‘rebuilding balance sheets’ will not affect the pace of recovery. But his insights on how to see monetary policy are genuinely brilliant and forthright.  The expected total future path of rates relative to what people expect NGDP to do is what you need to focus on. […]

  28. Gravatar of Bababooey Bababooey
    22. January 2010 at 17:20

    I think you’re kidding, because surely you know that the multiplicity of worksheets is not caused by something so simple and rational as to give work to tax accountants. That’s organized and straighforward.

    Here is how it works: Every piss-ant congressman harbors an Brilliant idea that he or she is certain will secure reelection. For example, everyone should use waterless heaters(!!!), maybe because a manufacturer is in your district. So you, congressman, trade your vote on the American Recovery and Reinvestment Act of 2009, as long as the speaker agrees to include your stupid idea. She does and the Act adds Section 25D to the Internal Revenue Code.

    The poor Treasury Department, tasked with raising revenue, now has to abort its mission and figure out how to give you money back because 25D provides a credit that looks like a deduction (bad drafting in Congress). And Treasury has to figure out, in advance, how the sliver of CPAs who specialize in abusing credits (e.g., the new home buyer credit) will abuse this one.

    That’s how you get a worksheet to get a credit for your new waterless heater that probably cost more than it would otherwise because of the credit.

    Now, no adult has considered that the Code is meant for raising Revenue that Then, they trade their vote on another politician’s stupid idea to get their pet project jammed it into an existing statutory system (like the tax code, specifically Section 125). Nobody plays adult and looks at all the other stupid ideas already jammed in there. Then, the regulatory agency has to incorporate this stupid idea that is totally irrelevant to the statutory scheme (raising revenue)

  29. Gravatar of scott sumner scott sumner
    23. January 2010 at 06:13

    marcus, That is a scary story.

    Keith, Your last statement is close, but I’d go even further. Wages don’t have any effect on aggregate purchasing power, rather that is determined by monetary policy. The optimal monetary policy is the one that keeps spending at a level where wages don’t need to suddenly adjust, as wages adjustments are very slow, as you noted.

    I agree with most of you post, but again I assume monetary policy determines NGDP, not wage levels.

    bababooey, No, I wasn’t kidding, you misunderstood my point. I was talking about worksheets that don’t favor any special interest group. Worksheets that phase out various deductions and credit, for instance. You might compute your itemized deductions at $18,000, and then do a long worksheet showing you can take only $17,000 of the $18,000 in itemized deductions. The itemized deductions themselves help special interest groups, but not the worksheet slightly cutting them.

  30. Gravatar of Doc Merlin Doc Merlin
    24. January 2010 at 13:53

    “Marcus, Thanks. Given that Michigan doesn’t have a currency they can devalue, what other option do they have?”

    They can lower the minimum wage and lower benefits mandates. This would have a similar effect to devaluating a currency, with the added benefit that it has long run positive benefit through reducing transaction costs in the jobs market.

  31. Gravatar of ssumner ssumner
    25. January 2010 at 08:27

    Doc, I agree on mandates, but they can only lower the minimum wage to the Federal level. Where is it now?

  32. Gravatar of duÅŸakabin duÅŸakabin
    5. June 2010 at 17:24

    Definitely making a little fun of you. Which means he assumes his readers know you and your arguments. Perhaps the best sign yet that you’ve arrived.

  33. Gravatar of ssumner ssumner
    6. June 2010 at 12:09

    Thanks Dusakabin

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