I’m a fan of Scott Sumner, NGDP level targeting, and many of the ideas of market monetarism in general. However, unlike many of those who support these ideas, I am pessimistic that QE3 will fix the economy, and I worry that too much celebration by market monetarists over the structure of easing will only serve to undermine what remains good in market monetarism if and when the economy fails to recover quickly. In particular, I think that many commentators fail to appreciate the mainstream macroeconomic distinction between short run and long run analysis, and that many economists overestimate how long the short run lasts.
The case for stimulus is based in monetary non-neutrality. If we double the money supply, the real productive capacity of the economy does not increase—real productive capacity has nothing to do with monetary factors. However, because people are tricked, and because some wages, prices, and contracts don’t adjust instantaneously, output may go up briefly. Business owners see an increase in nominal demand for their products and mistakenly assume that it is an increase in real demand. They see this as a profit opportunity, so they expand production. As prices, wages, and contracts adjust to the new money supply and their assumption is revealed to be false, they cut back on production to where they were before.
If we view the recession as a purely nominal shock, then monetary stimulus only does any good during the period in which the economy is adjusting to the shock. At some point during a recession, people’s expectations about nominal flows get updated, and prices, wages, and contracts adjust. After this point, monetary stimulus doesn’t help.
Obviously, there is no signal that is fired to let everyone know that the short run is over, so reasonable people can disagree about how long the short run lasts. But I think there is good reason to think that the short run is over—it is short, after all.
My first bit of evidence is corporate profits. They are at an all time high, around two-and-a-half times higher in nominal terms than they were during the late 1990s, our last real boom.
If you think that unemployment is high because demand is low and therefore business isn’t profitable, you are empirically mistaken. Business is very profitable, but it has learned to get by without as much labor.
A second data point is the duration of unemployment. Around 40 percent of the unemployed have been unemployed for six months or longer. And the mean duration of unemployment is even longer, around 40 weeks, which means that the distribution has a high-duration tail.
Now, do you mean to tell me that four years into the recession, for people who have been unemployed for six months, a year, or even longer, that their wage demands are sticky? This seems implausible.
A third argument I’ve heard a lot of is that mortgage obligations have remained high—sticky contracts—while income has gone down. Garett Jones endorses this as a theory of monetary non-neutrality, and I agree. In fact, I beat him to it. But just because debt can make money non-neutral in the short run does not mean that we are still in the short run.
In fact, there is good evidence that here too we are out of the short run. Household debt service payments as a percent of disposable personal income is lower than it has been at any point in the last 15 years.
Yes, this graph includes mortgage payments.
So what is the evidence that we are still in the short run? I think a lot of people assume that because unemployment remains above 8 percent, we must be in the short run. But this is just assuming the conclusion. There are structural hypotheses for higher unemployment, but even if unemployment is cyclical, it doesn’t mean that monetary adjustment has failed to occur—real sector recalculation may just take longer than monetary recalculation.
Again, I favor NGDP targeting, but it is most effective when it is done simultaneously with the nominal shock. Evan Soltas points to the case of Israel, and indeed, the Israelis did it right. But it seems like wishful thinking to assume that four to five years after a nominal shock, you can fix the economy with monetary stimulus.
I would be delighted to be wrong. And I wouldn’t be surprised to see a slight decrease in unemployment as the result of QE3. But I would be surprised if we experience a plummeting of unemployment in the next two years down to what we previously thought of as “normal” levels of around 5 percent. Yes, it is good that the Fed is now using the expectations channel, but it did it four to five years too late, and there’s little theory or evidence its failure can be easily reversed.
UPDATE: I reply to my critics here.