ZLB Models?

There was a little interchange between Noah Smith and Paul Krugman a couple of weeks ago on what kind of models could explain Japan’s stagnation, and perhaps by implication the Great Recession. (Original Noah post here, Paul’s response here, and second round here and here.) I thought it was interesting, but it has taken me a bit of time to put my finger on why I thought it was interesting.

Noah began by saying there were two dominant macro models: RBC and New Keynesian (NK). The problem with applying NK models to Japan is that in NK models recessions last for as long as it takes for prices to fully adjust.  So how can NK models explain a lost decade or more? (You see this now in economists asking ‘how can the US, UK or Eurozone still be in a demand induced recession, from a shock that occurred 5 years ago’? Often the implication is that this is implausible, so the explanation must be supply side.) The answer, as Paul pointed out, is the Zero Lower Bound (ZLB). Noah replied that “They [ZLB models] are not yet well-developed or well-explored”.

Now I think Noah makes a lot of valid points, but I was unhappy about how his discussion was framed. I should also say that this framing is common to a lot of macroeconomists, so if I think it is unhelpful it is important to understand why.

It is often said that NK models just add price stickiness to RBC models, and if prices are sticky in the short run, aggregate demand matters in the short run. [1] I like to express it differently. What is the mechanism by which we can or cannot ignore aggregate demand? That mechanism is monetary policy, and how that is influenced by price adjustment. The way NK models can work is that price adjustment induces a monetary policy response, and it is the monetary policy response that ensures demand shortfalls are not persistent. Break the monetary policy response, because you hit the ZLB, and you break the correction mechanism, particularly if the monetary policy regime also involves inflation targets.

The ZLB therefore allows NK models to generate much more persistent recessions, if the recessionary shock is itself large and persistent. But the implications of the ZLB for RBC models are just as profound.  Implicit in their construction is that demand shocks ‘do not matter’, because the correction mechanism to get demand back to supply works sufficiently quickly that we can just focus on supply decisions. If the correction mechanism is broken because of the ZLB, then the foundation on which the model is built becomes problematic. It is no good saying ‘we assume price flexibility’, when even if prices adjust rapidly monetary policy cannot get demand back up. Or to put it another way, you cannot assume that the real interest rate will always be at the natural level if there is no way that real interest rate can be achieved.

That is one of the benefits (there are also costs) of the NK model encompassing the RBC framework. We can see the conditions under which the ‘special case’ of RBC works. And at the ZLB with inflation targets, it does not.

Of course you can ignore this point, and try to use RBC models to explain the current recession or Japan’s lost decade. But there are two huge problems with this. First, it ignores a big piece of evidence - these economies are at the ZLB! Well, that could just be a coincidence, or an inconsequential by-product. But second, the ZLB under inflation targets undercuts a key principle on which RBC models are built. In that sense, the model is not microfounded. [2] Thinking about mechanisms rather than models helps you see that second point. [3]

We can use NK models to analyse the implications of the ZLB, by hitting them with a large and persistent negative demand shock of some sort and adding the ZLB constraint. But what is clearly missing here is any understanding of the large and persistent negative shock. There is much current work looking at ‘financial frictions’, and the balance sheet implications that these may have. This may help explain the persistence of ZLB recessions. But they may also explain much more, and help improve the ability of NK models to track trends before the Great Recession. So to describe this endeavour as ZLB modelling seems inappropriate (or at least premature).

This approach to modelling ZLB recessions still has a unique steady state, and sees prolonged recessions as involving a natural real interest rate below its steady state value. An interesting possibility is that the ZLB constraint can create an alternative steady state, where a positive real interest rate is associated with deflation (see this paper by Mertens and Ravn (pdf), for example). The central bank (unlike Milton Friedman) is not happy with this steady state, because inflation is below target, but cannot shift to its preferred steady state by lowering interest rates. Whether you would call this alternative steady state a recession, and whether it could be applied to Japan, are interesting questions.

I do not think it is very informative to describe both this approach, and the more standard persistent demand shock approach, as ‘ZLB models’? The mechanism behind a persistent recession in either case is very different. But more fundamentally, they both use similar NK models, but just take the ZLB constraint seriously in that model. So it seems very odd to talk about NK models on the one hand, and ZLB models on the other, when the ZLB is an undeniable fact.

Now at this point you may be thinking that I am just being a bit pedantic about labels. I am not sure I should apologise if I am, but I do have another motivation. Talk of different models that can be applied to the same problem harks back to ‘schools of thought’ days in macro. I think macro should be better than that now. For better or worse, the microfoundations project and the new neoclassical synthesis gave us a common language, where we could talk about different mechanisms within a shared approach. That should make the process of matching evidence to theory more straightforward.

[1] Of course NK models often ignore the capital accumulation process, which is much more central to RBC analysis. But the key point is that we can always add sticky prices to any RBC model.

[2] There could be some other mechanism which justifies ignoring aggregate demand, but the whole point of microfoundations is that this mechanism needs to be spelt out. In its absence, all that is left is to just assume that large negative demand shocks never happen. Which is a bit like assuming nominal interest rates can be negative. 

[3] Chris Dillow’s comment that I link to here was really helpful in allowing me to appreciate why seeing macro in terms of competing models can be so confusing. In a way I just had to remember what it felt like learning macro for the first time, but that is easy to forget when you spend the rest of your life building and analysing these things.

Japan and the consumption tax

While most international attention has focused on recent developments in Japanese monetary policy, there are interesting developments on the fiscal side too. A key issue is the proposal to raise the national consumption/sales tax from 5% to 10% in two stages beginning in April next year. Japanese Prime Minister Shinzo Abe says he will wait until probably the autumn to make a final decision, and the macroeconomic outlook will be a key factor. The proposal has the support of Bank of Japan governor Haruhiko Kuroda. However the more interesting question for Kuroda is how the Bank will react to the sales tax increase.

Much of the reporting on this issue is along the familiar lines of whether it is better to focus on reducing the government’s very high level of debt (raise sales taxes) or ending deflation in Japan (don’t raise sales taxes). While this debate is a familiar one, there is an additional twist with a sales tax. An anticipated increase in sales taxes, by raising expected inflation, will - other things being equal - provide an incentive for consumers to bring forward their spending. Macroeconomists would describe this as a real interest rate effect, but in simpler terms it makes sense to buy before prices go up.

This incentive effect has been observed in Japan in the past, and in other countries. (See page 12 of this IMF report on the issue.) The UK cut VAT for just one year in response to the recession in 2009, a measure I have described as New Keynesian countercyclical fiscal policy, and this may have raised consumption by over 1%, in part because consumers anticipated that prices would rise again in 2010. (The over 1% figure comes from here, although this analysis is more conservative.)  

However, this effect only occurs if monetary policy does not react to the sales tax rise, and the increase in headline inflation that this will bring. If every percentage point increase in inflation is matched by the same increase in the nominal interest rate (and we ignore taxes), the effect will disappear. (Prices will rise, but so will the value of my savings so I can afford to wait.) If the Bank of Japan attempts to reverse the increase in inflation by tightening policy still further, then we get a very undesirable outcome.

These considerations suggest two things. First, if they take place, increases in sales taxes should be deferred by long enough to allow any bringing forward of spending to happen. The worst thing you can do in current circumstances is implement an unexpected sales tax hike. Why not raise sales taxes by 1% each year for the next five years? Those who suggest that acting gradually ‘risks losing the credibility of financial markets’ should be ignored. Second, the Bank of Japan should commit to ‘see through’ the impact of sales taxes on inflation, and not tighten monetary policy in any respect (conventional or unconventional) following the increase in inflation that higher sales taxes will bring. It would be good if that commitment can be made publicly before the increase in sales taxes is confirmed.

      

Advertising, Paternalism, Information and Plain Packaging of Cigarettes

This is off the usual macro beat, so probably this point has been made in a much clearer way by others, but it is hardly ever made in the public debate, and I have read economists who argue the opposite. It was prompted by the UK government’s predictable decision to kick ‘plain packaging’ of cigarettes (example below) into the long grass. One of the arguments used against plain packaging is that it represents yet more paternalism by the government. My general thought is this: is banning advertising paternalistic, or is it enhancing our freedom?

A simple definition of paternalism is an action, by a person, organisation or the state, which limits the liberty or autonomy of other people for their own good. So we have individual freedom, interference, and crucially motivation. Advertising is usually portrayed as just providing information so that consumers can make informed choices. Sometimes it may do that. But advertising is often about suggesting associations, which provide no information at all. It is a mild form of brainwashing. Most of the time it is simply annoying.

For some, the information provided by some advertising might be useful. For most it is not. We can try and avoid advertising if we do not want its ‘information’, by turning the page, recording the programme and fast-forwarding through the adverts, averting our eyes, but this requires effort. Why should I have to make that effort? So for most people most of the time, it is advertising that mildly interferes with our freedom. (If I wanted to be clever, I could say that companies who advertise believe their product makes consumers better off, and therefore it is advertising that is paternalistic. However companies advertise to increase profits, not to increase consumer utility.)

So a government that prevents advertising can be seen as allowing individuals to make their own unencumbered choices. It is giving us a little more freedom and autonomy, rather than limiting it. The argument for advertising has to be that the benefits to the few in getting useful information outweighs the costs to the many in either avoiding it, or getting information they do not want. It is not paternalistic to ban advertising, just as it is not paternalistic to stop people being stalked.

That is the general point which hardly ever seems to be made. It applies, for example, to banning food advertising aimed at children, where the nuisance element of the advertising has to outweigh its information provision. However the debate about ‘plain packaging’ is not about either packaging that is plain, or the pros and cons of advertising. The Australian version of plain packaging replaces the logo of the cigarette with a picture of one of the health risks if you smoke these cigarettes (see below). So it is not about banning advertising, but replacing one type of advertising with another.

Those who do not smoke and have no intention of smoking are not forced to look at these adverts, so banning this kind of advertising would not increase their freedom. For those who do not smoke but might smoke, and probably for those who do smoke, the information content of the ‘plain packages’ is clearly much greater than packages that were dominated by a logo. So this is one example where the information content of advertising does dominate any reduction in freedom that the advertising entails.

One final point about information. Mark Littlewood, Director General at the Institute of Economic Affairs, says on their website that following the government’s decision:  “Hopefully this will mark a turning point against the excessive elements of the health lobby whose desire to interfere knows no bounds.” Yes, of course, that strange desire to restrict what companies that sell products that kill people are allowed to do. In the Notes to Editors on that website, it says that “The IEA is a registered educational charity and independent of all political parties.” Now I wonder whether the IEA is funded by the tobacco companies that have lobbied hard against plain packaging? That would be useful information, so why does the IEA not provide it, or even advertise it? 

Crossing the line at the ECB

Just how much should central bankers express views about fiscal policy? One reasonable response is not at all. Yet fiscal actions can have implications for monetary policy, so vows of silence are both difficult to sustain, and potentially withhold important information from the public.

For example, I have recently suggested that it is almost undeniable that fiscal austerity when interest rates are at the Zero Lower Bound (ZLB) makes it more difficult for monetary policy to do its job. If I was a monetary policy maker, I would want to make that clear to the public, if only to avoid getting all the blame when things go wrong. I have praised Ben Bernanke’s recent comments to that effect, which he reaffirmed more recently. Of course, outside the Eurozone, it would be seen as wrong for central bankers to condemn these policies, but it must be right for them to point out that it causes them difficulties.

So there should not be a taboo on central bankers talking about fiscal policy, when it influences their ability to do their job. Policy makers at the European Central Bank (ECB) are particularly fond of talking about fiscal policy and structural reform. Here is just one recent example, but the ECB’s own research confirms that “the ECB communicates intensively on fiscal policies in both positive as well as normative terms. Other central banks more typically refer to fiscal policy when describing foreign developments relevant to domestic macroeconomic developments, when using fiscal policy as input to forecasts, or when referring to the use of government debt instruments in monetary policy operations.”

So why does the ECB stand out here? One hypothesis that appears not to work is that the ECB has been dragged into commenting on fiscal issues by the Eurozone crisis. We could question, as Carl Whelan does (pdf), why the ECB is part of the Trioka? Was it dragged, or did it invite itself? However, as the ECB research cited above shows, the ECB’s unusual interest in making normative statements on fiscal policy predate this crisis period.

One strong clue is the nature of these interventions. Bernanke warns that excessive fiscal tightness could slow down the US recovery, and because of the ZLB the Fed’s ability to counteract this is at least uncertain. The ECB always urges European governments to make fiscal policy more restrictive. That suggests that it either has a completely different view about the macroeconomic conjuncture in the Eurozone compared to the US (unlikely), or that it believes in expansionary austerity (see below), or that it is concerned about something else (much more likely). The something else which many economists would point to is fiscal dominance.

The ECB and many other European policymakers seem obsessed by the fear that monetary policy will not be able to do its job because of excessive budget deficits in individual Euro member states. So how reasonable is this fear, and is the Eurozone special in this respect, so as to explain the ECB’s unusually vocal behaviour compared to other central banks? The answer is I believe quite clear - the ECB has less to fear from fiscal dominance than any other central bank!

It was partly to show this that I wrote two recent posts on budget deficits and inflation. In the first, I made the widely accepted point that monetary policy can always neutralise the impact of higher debt on inflation by raising interest rates, if fiscal policy makers raise taxes or cut spending sufficiently to stabilise debt. Once you eliminate market panics through OMT, then it is absolutely clear that all Eurozone countries are doing that. So there is no present threat of fiscal dominance.

But imagine there was. In a second post I looked at the possibility that a fiscal policy maker might not even attempt to stabilise debt. In that case, a conflict between fiscal and monetary policy could emerge. Yet I argued that in any resulting game of chicken, if the central bank was able and prepared to allow governments to default and not monetise the deficit, it could retain control of inflation. Now in nearly all countries the government has ultimate power, so it could force the central bank’s hand (although at perhaps a very high political cost). However the one exception is the ECB. The ECB is in a better position to resist fiscal dominance than any other central bank.

So we should see much less of a concern about budget deficits from the ECB than from other central banks, yet we actually see the opposite. I can think of only three explanations for this apparent contradiction. The first is that the ECB does not understand its own position. The second is that the ECB is really concerned about the distributional effects if countries pursue different fiscal paths. Yet if that was the case, they should be focusing on relative fiscal positions, rather than always suggesting lower deficits are good. The third possibility is that the ECB is using its position of authority to pursue other economic or political goals that have nothing to do with its mandate. The ECB is also fairly unique in its lack of accountability. Perhaps for that reason, it feels no inhibition in being free with its opinions on economic issues, even when they have no bearing on its ability to control inflation.

This third explanation may also help explain the reluctance of the ECB to act as a sovereign lender of last resort. We had two years of an existential Euro crisis before OMT was introduced. The argument that is generally used to explain this reluctance is the ECB’s fear of fiscal dominance. However, as I have argued, the ECB has much less to fear on this account than others central banks, yet other banks were quick to undertake Quantitative Easing. As this piece reminds us, and as is noted by Peter Dorman here, pressure from the bond market can be very useful in helping achieve certain economic and political goals. So even though these goals have nothing to do with the ECB’s mandate, the ECB might be reluctant to see those pressures reduced by its own actions.

I would like to be wrong about this. But if I am not, I think it is important to understand what it reveals. To quote Peter Dorman: “In their own minds they probably see neoliberal reforms as self-evidently beneficial to the point that there is no need to spell them out or argue for them: everyone they know understands that this has to be the solution.” They are just giving good economic advice, advice that is needed because politicians too often respond to vested interests rather than sound economic reasoning.

If this reading is correct, then we have a serious problem. In this view about what is good economics, Keynes has completely disappeared. Not only the Keynes who showed why cutting government spending at the ZLB was a foolish thing to do, but also the Keynes who emphasised that prices in financial markets may not reflect fundamentals but instead just what market participants thought that other participants would do.[1] This is the Keynes whose ideas (or interpretation of those ideas) feature heavily, and very positively, in every economics textbook, including those used by those teaching in Eurozone countries. So what remains a real mystery to me is how the elite who make policy in the Eurozone can feel it is legitimate to promote a view about what is good economics which contradicts what economists in the Eurozone teach.

For central bankers to give advice on economic issues that are outside their remit but which pretty well every economist would sign up to is one thing. Of course central bankers will have their own private views on more controversial matters. However it seems to me that to give public advice on economic issues that are outside their remit which are also highly controversial (and contradict what is in the textbooks) seems to me to be crossing a line which it is very dangerous to cross.

[1] This is the insight behind the idea, emphasised by De Grauwe, that there may be a ‘bad equilibrium’ in the market for Eurozone government debt, which the ECB through OMT can help avoid. (For those unfamiliar with this idea, a good place to start is this piece by De Grauwe and Li.)  It is interesting that the ECB, in justifying OMT, tends to favour the argument that the market has unjustified fears of Euro break up, rather than that the market is not looking at fundamentals. It is using an argument that remains consistent with Ordoliberal ideas.

Getting unhinged by ‘unhinged’: macroeconomic trade-offs and taboos

Central bankers, and even some of the best economists, sometimes talk about inflation expectations becoming ‘unhinged’. I do not like this term, and have been known to react quite badly to it. Some might say overreact. Let me say why.

But before doing so, I want to make three things clear, lest I be misunderstood. First, I think inflation expectations are really important. Second, I largely believe the great moderation story. As a result of setting inflation targets (explicitly or implicitly), and acting to achieve them, central banks did succeed in stabilising inflation expectations at low levels, and this has made the job of stabilising the economy as a whole rather easier. I may be wrong about this, but that is what I currently think. (I chose this as an example of the achievements of the microfoundations revolution in macro in my mild disagreement with Paul Krugman on this issue.) Third, I think it is more than likely that if inflation stays above/below target for some time, inflation expectations will adjust. 

But I would not call this expectations becoming unhinged. It is all about language. I would have no problem if another term was used. I used the term ‘adjust’ above, but we could also say ‘increase’, or ‘become less predictable’, or even ‘shift’. In fact any of the other words we normally use for macroeconomic variables. When discussing consumption, we do not talk about expectations of future income becoming unhinged. When discussing exchange rates and UIP, we do not obsess about expectations of future rates being unhinged. Whether intentional or not, the use of the term unhinged is designed to create an impression. The impression is of disastrous uncontrollability. If we talked about a person become unhinged, we indicate madness.

It is as if inflation expectations can be in one of two states: either low variance with mean reversion to the inflation target (or something close to it), or as highly volatile and could go anywhere. In this second imagined state, as expectations of inflation drive actual inflation, we could have ‘inflation bubbles’, which would become very costly for the central bank to prick. As we really do not want to go to that second state, we have to do everything we can to stay in the first state.

It is this view of the world that I find very difficult to believe - in fact I find it absurd. Why would inflation expectations become so unanchored from a central bank’s inflation target? They would do so if people thought the central bank had no intention of trying to achieve that target. So the only circumstances in which inflation expectations might become unhinged are when the central bank itself became unhinged. That could happen if the central bank was ordered to permanently monetise growing budget deficits, but that is not the world we are currently in.

When central bankers talk about unhinged expectations, they nearly always mention the 1970s and early 1980s. Do we really want to go through that again, they ask? Yet that was a period, in the US and UK, when it was very unclear what the central bank’s inflation target was, or indeed whether it had one. (This was not the case for Germany, as I note here.) So the lesson of that time is that inflation targets are important, but not that they should never be changed or missed.

I would draw a very different lesson from that period. It is important not to have taboos in macro. If there was a taboo at that time, it was that rising unemployment would mean a return to the 1930s. This prevented many seeing variations in unemployment as a means of stabilising inflation.

Could it be that we have a similar problem today, except roles have become reversed? With nominal rates at the zero lower bound, and doubts over unconventional monetary policy, we could use higher inflation (raised in a premeditated and controlled way) as a means of getting unemployment down. Of course that entails costs, and so we need to do the cost benefit analysis, and look at alternatives (like fiscal policy) that may be less costly. But if raising inflation is taboo we will not have that discussion. In this context, talk of expectations becoming unhinged reinforces that taboo.

In memory of Mel, who showed even as a teenager an appreciation for the absurd by helping me found the LUWS.

How much has austerity cost (so far)?

For those who think I’m exaggerating when I say the intellectual case for austerity is crumbling, have a look at Alan Taylor’s Vox column. His analysis is particularly nice because it demonstrates two key problems with some earlier research. If you ignore the endogeneity of fiscal policy, and you ignore the state of the economy, then his study (joint with Oscar Jorda) replicates the ‘expansionary austerity’ result. If you take account of these things, you get numbers much more consistent with, for example, this widely cited IMF study (although their analysis attempts to improve on that work). So (journalists please note) it is not a matter of X says this and Y says something different: if you do the analysis properly austerity is clearly contractionary in bad economic times.

Alan Taylor also uses his estimates to cost the impact of UK austerity: GDP would be 3% higher today without it. Here the the relevant chart. 

He warns that this number is “likely [to be] a biased underestimate of the effects of current UK austerity. This caveat is the zero lower bound, when fiscal multipliers are known to be much larger in both theory and evidence.” Controlling for booms and slumps makes sense for various reasons, but controlling for monetary policy is at least as important. That also means that the 3% should carry the health warning that if UK GDP had been this much higher, this might have raised inflation, which might have led the MPC to raise interest rates, by more than is implicit in their estimates. But these are all big ifs.

When I did a back of the envelope calculation of the impact of cuts in just UK government spending since 2010, I came up with GDP being around 2% lower by 2013. As this ignored the impact of tax increases (e.g. VAT) and transfer cuts, then this seems quite consistent with Alan Taylor’s 3%. So if we make that 1%, 2% and 3% for 2011, 2012 and 2013, that is a total cost of 6% of GDP so far. Gross National Income was £1,557,503 million in 2012, and there were 26.4 million households, so that gives gross income of £59,000 per household. So the 6% figure implies that austerity has cost the average UK household a total of about £3,500 over these three years. Although all governments like to give the impression that they can have a big impact on people’s prosperity, few actually do. These numbers suggest that the current UK government has managed to do so, but unfortunately by making us all poorer.

Unemployment, the output gap and wage flexibility

This post is about the impact of nominal and real wage flexibility on unemployment and the output gap. It starts in an academic, abstract sort of way, but the policy implications do follow. I try and make the analysis as accessible as I can to non-economists.

Start with an economy with a zero output gap (defined below) and no involuntary unemployment. Everything in the economy is just fine, which is a non-technical way of saying it is efficient. Then a ‘crisis’ happens that leads consumers to consume less and save more, so aggregate demand falls. Normally in these situations the central bank cuts nominal and real interest rates sufficiently to restore aggregate demand. Once this has happened, call everything in this economy ‘natural’, so the real interest rate that restores demand is the natural rate of interest. The natural level of output may not be the same as the pre-crisis level, because for example the new natural rate of interest can have knock on effects on how much people want to work. [1] However the natural level is the level of output that policymakers should aim for. [2]

In the Great Recession this mechanism did not work because nominal interest rates hit zero, and maybe also because monetary policy put a cap on inflation expectations. As a result, actual real interest rates are above the natural level. In addition, fiscal policy is in the hands of people who know nothing about macroeconomics, so there is no help from there. However monetary policymakers still think they could do something ‘unconventional’, so they want to know what to aim for. The answer is that, as long as what they do does not seriously distort the economy, they should try to get to the natural level of output, because that produces an efficient economy.

The difference between the actual level of output and the hypothetical natural level is called the output gap. The traditional way of defining the output gap was the difference between actual output and ‘productive potential’, which was the amount that could be produced if all factors of production were fully utilised. That is still how the gap is often measured in practice, although the measurement problems can still be huge, as Paul Krugman notes here. The problem at a conceptual level is that this approach downplays considerations of optimality, so nowadays theoretical macroeconomics uses the natural level of output to define the output gap. This has the advantage that we know what policy should be aiming to do: achieving the natural level of output.

Now imagine three almost identical economies where an output gap exists because nominal interest rates have hit zero. The level of real interest rates that would eliminate the output gap is the same in all three economies (i.e. they have the same natural levels of output). In the first economy, workers resist nominal wage cuts, so this puts a floor on how much unemployment reduces real wages. (Equally firms may be reluctant to impose wage cuts, as this research suggests - HT Kevin O’Rourke.) If nominal wages stop falling, at some point firms will stop cutting prices to protect their profits. We settle down to a new lower level of demand deficient output, high unemployment, but stable wages and prices. There is plenty for unconventional monetary policy to do, even though inflation is not falling.

In the two other economies nominal wages carry on falling. In the second economy prices get cut pari passu, so real wages remain unchanged, while in the third they do not, so real wages fall. So in the second economy inflation is lower than in the first, but real wages are the same. Does this lower rate of inflation increase or decrease the output gap? That depends only on whether actual output falls or increases because of lower inflation: the natural level of output involves a hypothetical economy which is unaffected by whether nominal wages fall or not in the actual economy [3]. Actual output may fall if negative inflation makes debtors spend a lot less but creditors not much more - this and other mechanisms are discussed in Mark Thoma’s post here. However, if monetary policymakers have been inhibited from doing much because inflation was not falling (which would be one interpretation of UK policy, for example), then as David Beckworth says, lower inflation may raise actual output by encouraging expansionary unconventional monetary policy.

How about the third economy, where real wages have fallen? Suppose firms respond to lower real wages by substituting labour for capital, and this process continues until all those who want to work can find a job. So in the third economy involuntary unemployment goes away. But is the output gap any lower? Once again, the natural level of output has not changed. (It was set in our hypothetical economy where real interest rates fell to their natural level.) So the key question becomes whether lower real wages and lower unemployment reduces or increases aggregate demand, and therefore actual output. It could go either way. So it is perfectly possible that both actual output and therefore the output gap is exactly the same in all three economies, even though unemployment has returned to its natural rate in one, and the other two have very different inflation rates. 

This comparison suggests that those who say unemployment in the first two economies is caused by wage inflexibility kind of miss the point. The basic problem is lack of aggregate demand. You could argue (I would) that the third economy is better off than the other two, because the pain of deficient demand is evenly spread (everyone has lower real wages), rather than being concentrated among the unemployed. But the first best solution is to raise aggregate demand, because that gets rid of the pain.

I started writing this post because of a recent study by Pessoa and van Reenan, who argue that the mysterious decline in UK labour productivity that I have talked about before can in large part be explained by unusually slow growth in UK real wages. The mechanism they have in mind is entirely traditional: if real wages are low firms substitute labour for capital. This in turn may explain (see Neil Irwin here for example) why UK unemployment originally rose by less than in the US (see first chart), even though the UK’s output performance was worse. On this issue looking at consumer price based measures of real wages will be misleading, so below is a very simple measure of real product wage growth in the two countries: compensation per employee less the GDP deflator. Real wage growth in the UK has noticeably fallen since the recession, whereas the fall has at least been less abrupt in the US (2013 is a forecast).

Unemployment in the US and UK: Source ONS and BLS

Growth in compensation per employee less GDP deflator: OECD Economic Outlook

In terms of just the UK economy, whether Pessoa and van Reenan are right is debatable. When I discussed this in an earlier post I referenced a Bank of England paper by MPC member Ben Broadbent, which argued that for the factor substitution story to explain most of what we have seen in the UK, investment should have completely collapsed, which it has not. This difference in view reflects a number of nitty gritty issues, like how you measure the capital stock, and whether the substitution elasticity is one (as implied by the Cobb Douglas production function), or nearer one half.

However most seem to agree that some of this factor substitution is going on in the UK. So my hypothetical discussion above suggests that, by spreading the pain of deficient aggregate demand further, this ‘real wage flexibility’ in the UK has been a good thing, but it does not mean the aggregate demand problem has decreased. If anything, it suggests that looking at unemployment underestimates the size of the output gap. Monetary policy makers please note.

[1] New Keynesian economists sometimes call the natural economy the outcome when all prices are completely flexible. That is OK, as long as we note that flexible prices here has to include the possibility that nominal interest rate can go negative, which in the real world it cannot.

[2] Opinions may differ on whether the crisis itself is a necessary correction for past errors, or whether it is itself a distortion. For example, was risk undervalued before the crisis, or is it overvalued now. In other words, was the pre-crisis economy efficient, or would there be a distortion in the post-crisis economy even without an aggregate demand problem? These are important complications compared to the story I tell here, but they will have to wait for another post.

[3] The idea is that the economies are identical except for the extent of nominal inertia in goods and labour markets. In economy 1 wages are sticky, in economy 3 prices are sticky but wages are flexible, and in economy 2 the degree of wage and price stickiness is such that real wages do not change.