Is a flexible labour market a problem for central bankers?

Recessions and milder economic downturns are typically a result of insufficient aggregate demand for goods. The only way to end them is to stimulate demand in some way. That may happen naturally, but it may also happen because monetary policymakers reduce interest rates. How do we know we have deficient aggregate demand? Because unemployment increases, as a lower demand for goods leads to layoffs and less new hires.

A question that is sometimes posed in macroeconomics is whether workers in a recession could ‘price themselves into jobs’ by cutting wages. In past recessions workers have been reluctant to do this. But suppose we had a more prolonged recession, because fiscal austerity had dampened the recovery, and over this more prolonged period wages had become less rigid. Then falling real wages could price workers into jobs, and reduce unemployment. [1]

This is not because falling real wages cure the problem of deficient aggregate. If anything lower real wages might reduce aggregate demand by more. But it is still possible that workers could price themselves into jobs, because firms might switch to more labour intensive production techniques, or fail to invest in new labour saving techniques. We would see output still depressed, but unemployment fall, employment rise and stagnant labour productivity. Much as we have done in the UK over the last few years.

It is important to understand that in these circumstances the problem of deficient demand is still there. Resources are still being wasted on a huge scale. Quite simply, we could all be much better off if demand could be stimulated. How would central bankers know whether this was the case or not?

Central bankers might say that they would still know there was inadequate demand because surveys would tell them that firms had excess capacity. That would undoubtedly be true in the immediate aftermath of the recession, but as time went on capital would depreciate and investment would remain low because firms were using more labour intensive techniques. The surveys would become as poor an indicator of deficient aggregate demand as the unemployment data.

What about all those measures of the output gap? Unfortunately they are either based on unemployment, surveys, or data smoothing devices. The last of these, because they smooth actual output data, simply say it is about time output has fully recovered. Or to put it another way, trend based measures effectively rule out the possibility of a prolonged period of deficient demand. [2] So collectively these output gap measures provide no additional information about demand deficiency.

The ultimate arbiter of whether there is demand deficiency is inflation. If demand is deficient, inflation will be below target. It is below target in most countries right now, including the US, Eurozone and Japan. (In the UK inflation is above target because of the Brexit depreciation, but wage inflation shows no sign of increasing.) So in these circumstances central bankers should realise that demand was deficient, and continue to do all they can to stimulate it.

But there is a danger that central bankers would look at unemployment, and look at the surveys of excess capacity, and look at estimates of the output gap, and conclude that we no longer have inadequate aggregate demand. In the US interest rates are rising, and there are those on the MPC that think the same should happen here. If demand deficiency is still a problem, this would be a huge and very costly mistake, the kind of mistake monetary policymakers should never ever make. [3] There is a fool proof way of avoiding that mistake, which is to keep stimulating demand until inflation rises above target.

One argument against this wait and see policy is that policymakers need to be ‘ahead of the curve’, to avoid abrupt increases in interest rates if inflation did start rising. Arguments like this treat the Great Recession as just a larger version of the recessions we have seen since WWII. But in these earlier recessions we did not have interest rates hitting their lower bound, and we did not have fiscal austerity just a year or two after the recession started. What we could be seeing instead is something more like the Great Depression, but with a more flexible labour market.

[1] Real wages could also be more flexible because the Great Recession allowed employers to increase job insecurity, which might both increase wage flexibility and reduce the NAIRU. Implicit in this account is that lower nominal wages did not get automatically passed on as lower prices. If they had, real wages would not fall. Why this failed to happen is interesting, but takes us beyond the scope of this post.

[2] They also often imply that the years immediately before the Great Recession were a large boom period, despite all the evidence that they were no such thing outside the Eurozone periphery

[3] J.W. Mason has recently argued that such a mistake is being made in the US in a detailed report.

Why recessions followed by austerity can have a persistent impact

Economics students are taught from an early age that in the short run aggregate demand matters, but in the long run output is determined from the supply side. A better way of putting it is that supply adjusts to demand in the short run, but demand adjusts to supply in the long run. A key part of that conceptualisation is that long run supply is independent of short run movements in demand (booms or recessions). It is a simple conceptualisation that has been extremely useful in the past. Just look at the UK data shown in this post: despite oil crises, monetarism and the ERM recessions, UK output per capita appeared to come back to an underlying 2.25% trend after WWII.

Except not any more: we are currently more than 15% below that trend and since Brexit that gap is growing larger every quarter. Across most advanced countries, it appears that the global financial crisis (GFC) has changed the trend in underlying growth. You will find plenty of stories and papers that try to explain this as a downturn in the growth of supply caused by slower technical progress that both predated the GFC and that is independent of the recession caused by it.

In a previous post I looked at recent empirical evidence that told a different story: that the recession that followed the GFC appears to be having a permanent impact on output. You can tell this story in two ways. The first is that, on this occasion for some reason, supply had adjusted to lower demand. The second is that we are still in a situation where demand is below supply.

The theoretical reasons why supply might adjust to demand are not difficult to find. (They are often described by economists under the jargon word 'hysteresis'.) Supply (in terms of output per capita) depends on labour force participation, the amount of productive capital in the economy, and finally technical progress, which is really just a catch all for how aggregate labour and capital combine to produce output. A long period of deficient demand can discourage workers. It can also hold back investment: a new project may be profitable but if there is no demand it will not get financed.

However the most obvious route to link a recession to longer term supply is through technical progress, which connects to the vast literature under the umbrella of ‘endogenous growth theory’. This can be done through a simple AK model (as Antonio Fatas does here), or using a more elaborate model of technical progress, as Gianluca Benigno and Luca Fornaro do in their paper entitled ‘Stagnation traps’. The basic idea is that in a recession innovation is less profitable, so firms do less of it, which leads to less growth in productivity and hence supply. Narayana Kocherlakota has promoted this idea: see here for example.

The second type of explanation is attractive, in part because the mechanism that is meant to get demand towards supply - monetary policy - has been ‘out of action’ for so long because of the Zero Lower Bound (ZLB). (The ZLB also plays an important role in the Benigno & Fornaro model.) However for some this type of explanation currently seems ruled out by the fact that unemployment is close to pre-crisis levels in the UK and US at least.

There are three quite different problems I have with the view that we no longer have a problem of deficient demand because unemployment is low. The first, and most obvious, is that the natural rate of unemployment might be, for various reasons, considerably lower than it was before the GFC. The second is that workers may have priced themselves into jobs. In particular, low real wages may have encouraged firms to use more labour intensive techniques. If that has happened, it does not mean that the demand deficiency problem has gone away, but just that it is more hidden. (For anyone who has a conceptual problem with that, just think about the simplest New Keynesian model, which assumes a perfectly clearing labour market but still has demand deficiency.)

The third involves the nature of any productivity slowdown caused by lack of innovation. A key question, which the papers noted above do not directly address, is whether we are talking about frontier research, or more the implementation of innovation (for example, copying what frontier firms are doing). There is some empirical evidence to suggest that the productivity slowdown may reflect the absence of the latter. This is very important, because it implies the slowdown is reversible. I have argued that central banks should pay much more attention to what I call the innovation gap (the gap between best practice techniques, and those that firms actually employ) and its link to investment and aggregate demand.

All this shows that there is no absence of ideas about how a great recession and a slow recovery could have lasting effects. If there is a problem, it is more that the simple conceptualisation that I talked about at the beginning of this post has too great a grip on the way many people think. If any of the mechanisms I have talked about are important, then it means that the folly of austerity has had an impact that could last for at least a decade rather than just a few years.

Types of unemployment

For economists

This post completes a discussion of a new paper by Pascal Michaillat and Emmanuel Saez. My earlier post outlined their initial model that just had a goods market with yeoman farmers, but with search costs in finding goods to consume. Here I want to look at their main model where there are firms, and a labour market as well as a goods market.

The labour market has an identical search structure to the goods market. We can move straight to the equivalent diagram to the one I reproduced in my previous post.

The firm needs ‘recruiters’ to hire productive workers (n). As labour market tightness (theta) increases, any vacancy is less likely to result in a hire. In the yeoman farmer model capacity k was exogenous. Here it is endogenous, and linked to n using a simple production function. Labour demand is given by profit maximisation. Employing one extra producer has a cost that depends on the real wage w, but also the cost of recruiting and hence labour market tightness theta. They generate revenue equal to the sales they enable, but only because by raising capacity they make a visit more likely to result in a sale. The difference between a firm’s output (y) and their capacity (k, now given by the production function and n) the paper calls ‘idle time’ for workers. As y<k, workers are always idle some of the time. So, crucially, profit maximisation determines capacity, not output. Output is influenced by capacity, but it is also influenced by aggregate demand.

Now consider an increase in the aggregate demand for goods, caused by - for example - a reduction in the price level. That results in more visits to producers, which will lead to more sales (trades=output). This leads firms to want to increase their capacity, which means increasing employment. (More employment reduces x, but the net effect of an increase in aggregate demand is higher x, so workers’ idle time falls.) This increases labour market tightness and reduces unemployment.

Here I think the discussion in the paper (bottom of page 28) might be a little confusing. It notes that in fixed price models like Barro and Grossman, in a regime that is goods demand constrained, an increase in demand will raise employment by exactly the amount required to meet demand (providing we stay within that regime). It then says that in their model the mechanism is different, because aggregate demand determines idle time, which in turn affects labour demand and hence unemployment. I would prefer to put it differently. In this model a firm responds to an increase in aggregate demand in two ways: by increasing employment (as in fix price models) but also by reducing worker idle time. The advantage of adding the second mechanism is that, as aggregate demand varies, it generates pro-cyclical movements in productivity. (There are of course other means of doing this, like employment adjustment costs.)

There are additional interesting comparisons with this earlier fixed price literature. In this model unemployment can be of three ‘types’: classical (w too high), Keynesian (aggregate demand too low), but also frictional. This model can also generate four ‘regimes’, each corresponding to some combination of real wage and price. However, unlike the fixed price models, these regimes are all determined by the same set of equations (there are no discontinuities), and are relative to the efficient level of goods and labour market tightness.

For me, this is one of the neat aspects of the model. We do not need to ask whether demand is greater or less than ‘supply’, but equally we do not presume that output is always independent of ‘supply’. Instead output is always less than capacity, just as unemployment (workers actually looking for work) is always positive. One way to think about this is that actual output is always a combination of ‘supply’ (capacity) and demand (visits), a combination determined by the matching function. This is what matching allows you to do. What this also means is that increases in supply in either the goods market (technical progress) or labour market will increase both output and employment, even if prices remain fixed. In Keynesian models additional supply will only increase output if something boosts aggregate demand, but that is not the case here. However, if the equilibrium was efficient before this supply shock, output will be inefficiently low after it unless something happens to increase aggregate demand (e.g. prices fall).

The aggregate demand framework in the model, borrowed from fixed price models, is rather old fashioned, but there is no barrier to replacing it with a more modern dynamic analysis of a New Keynesian type. Indeed, this is exactly what the authors have done in a companion paper. 

The paper ends with an empirical analysis of the sources of fluctuations in unemployment. It suggests that unemployment fluctuations are driven mostly by aggregate demand shocks. (This is also well covered in their Vox post.) This ties in with the message of Michaillat’s earlier AER paper, where he argued that in recessions, frictional unemployment is low and most unemployment is caused by depressed labour demand. What this paper adds is a goods market where changes in aggregate demand can be the source of depressed labour demand, and therefore movements in unemployment.    

Confusing levels and rates of growth

It was entirely predictable. Once growth returned to the UK economy, those with a political axe to grind, but also some who do not, and even some who should know better (uneconomical has a good detailed response), will start saying that any aggregate demand problems have gone away. The simplest argument suggesting otherwise is NIESR’s well known chart, the latest version of which is reproduced below.

Of course this does not prove that the UK still has an aggregate demand problem. Perhaps something unprecedented has happened to UK supply over the last five years. After all, consumer price inflation (CPI) is still above target. Well, as I pointed out here, CPI was above target in 2008, and 2009, and 2010 ….. so unless you want to suggest that the UK never had an aggregate demand problem, the behaviour of the CPI today is not very reliable evidence.

The main point, however, is that aggregate demand problems are about the level of GDP, not its rate of growth. In a demand induced recession, aggregate demand will fall: consumers start saving more; firms reduce the level of investment etc. As a result, resources are underutilised, the clearest indication of which is an increase in unemployment. We start a recovery when aggregate demand starts rising again at a rate that exceeds the rate of growth of underlying supply (labour force growth and technical progress). That might have just started in the UK.  GDP growth in the last quarter was 2.4% at an annual rate, which if you were pessimistic might be above trend. The chart shows the recovery started in 2010 but then stopped, but better late than never.

However that is just the start of a recovery. As the chart again shows, we should really be looking for rates of GDP growth of 4% or more if we are going to start utilising those resources which are currently being wasted (i.e. if we want to reduce unemployment). The aggregate demand problem only disappears when those resources are utilised again, and unemployment goes back to its non-inflationary rate (NAIRU). (And no, CPI inflation does not tell us that has already happened - average earnings are increasing at rates well below CPI inflation, which strongly suggests unemployment is well above the NAIRU.) As yet, falls in UK unemployment have been tiny relative to the increase that occurred during the recession.

UK Unemployment

If this all sounds too ‘Old Keynesian’, we can retell the story in New Keynesian terms. In a recession the natural real rate of interest falls below the level the actual rate can reach. Whatever shock caused the fall in the natural real interest rate (initially a need to adjust balance sheets, later compounded by fiscal austerity and a Euro recession), that shock can gradually dissipate, allowing the economy to grow. However, the aggregate demand problem only disappears when the natural real interest rate rises to equal the actual real interest rate. We should know when that happens because unemployment will fall to the NAIRU. Recessions do not just last as long ‘as it takes prices to adjust’, because we are at the zero lower bound.

The reason why this is so important is that it may be too easy to settle into a political equilibrium, where the economy is growing roughly at trend, but unemployment is not falling. It is a political equilibrium because the unemployed have very little political voice, and sections of the media encourage politicians (I’m being as polite as I can here) to label the unemployed as workshy. This may not have happened in the US since the war, but with fiscal policy being tightened as a result of Tea Party fundamentalism it could well do this time. In the UK there are some similarities with the 1980s, when unemployment stayed above 10% until near the end of that decade. Luckily no one in the UK has started arguing that current levels of unemployment are ‘structural’, but given the rhetoric about strivers vs skivers it will not be long before they do, and of course if you wait long enough to reduce unemployment you are in great danger of creating a structural problem.

So we will stop having an aggregate demand problem when unemployment falls to near pre-recession levels, and (assuming rational monetary policy) nominal interest rates start rising significantly. It would be great if that happened very quickly because of rapid growth, and while I can think of reasons why that might be unlikely, I know enough about forecasting to know it is also quite possible. However that will have no impact on the costs of austerity that have already been incurred, which is why I wrote my ‘final verdict’ on the current Chancellor six months ago.

Even earlier, over a year ago, I wrote this: “come 2015, the spin “we have done the hard work and the strategy has worked” will accord with (relatively) strong growth, while talk of output gaps and lost capacity will have less resonance. True, unemployment will still be high, but not many of the unemployed are Conservative voters, and the immunising spin about lack of willingness to work can be quite effective.” Paul Krugman described this post as ‘remarkably cynical’. I fear it will be one of my better forecasts.