Replies to My Critics

Last week, I argued that the short run is short—that there is good reason to believe that we’re now past the point where monetary stimulus can do much to help the economy. Again, I am broadly friendly to market monetarism and not especially hawkish on inflation. I am not so much against QE3 as skeptical that it will work. I think that the broad facts and a lot of mainstream macro theory back me up.

My post garnered a fair bit of criticism around the blogosphere. Let me make one quick empirical point to get everyone on the same page, and then I will try to respond to my critics point by point.

The empirical point is summed up in the graph below. NGDP grew around 5 percent per year until around 2008, and then it fell, and then it grew at around 5 percent—or slightly less—per year again beginning in mid 2009. These facts are well known, but I bring them up here because they do constrain the kind of stories we can tell about the economy. Any story you tell has to contain a one-time shock that ended years ago, and it has to be consistent with NGDP that has grown at about the same rate over the last 3 years as it did before the shock arrived.

OK, now with that out of the way, let’s take the criticisms one by one.

Bryan Caplan and ADP unemployment

Bryan cites Akerlof, Dickens, and Perry on long-run unemployment as a reason why QE3 might boost employment in spite of the fact that we are out of what we would conventionally call the short run. The ADP model assumes heterogeneous firms and workers with money illusion. At any given time, some firms need to cut real wages, and since nominal cuts hurt morale, higher inflation helps those particular firms cut wages instead of jobs. Consequently, in a low-inflation environment, monetary stimulus can help lubricate the employment market.

This argument is a good one as far as it goes. Unfortunately, I don’t think it goes very far given the stylized facts. As I noted above, NGDP is growing at a rate of 4-5 percent per year, not that different from before the crash. So any long-run ADP-style unemployment should be about the same now as it was before the crash unless there was a structural change in the economy. You can’t have it both ways—if we’re in a low-inflation environment for ADP purposes now, then we were in a low-inflation environment for ADP purposes before the crash as well.

Furthermore, assuming QE3 is a temporary policy, then if unemployment is long-term ADP unemployment, the effect of QE3 on unemployment will be temporary. I would regard a temporary dip in unemployment as a result of QE3 as good but underwhelming, given the claims of many market monetarists. There may of course be interactions between short-run unemployment and ADP unemployment, and for that reason, the dip in unemployment may not literally be temporary, but I would be surprised if QE3 could fix the economy through this channel.

Bryan makes an interesting linkage between my views on the ZMP hypothesis and ADP unemployment. If there is a decreasing secular trend of low-skill labor productivity, then ADP unemployment will become more serious over time. I think this is a good point, and it pushes me at the margin to favor a higher long-run NGDP target than I otherwise would. I was previously inclined to believe that the exact value of the target doesn’t matter once you get to levels of around 3 percent, but now I see more merit in a higher target.

Insider-outsider models

Bryan and some of the commenters at MR say that it is a mistake to focus on the wage demands of the unemployed. Rather, it is the wage demands of the employed that are especially sticky. The failure of insider wages to adjust downward to long-run levels means that there’s no ability to hire outsiders at below long-run levels, either because companies can’t afford to do it or because they are afraid of hurting insider morale.

The problem is that even if this story is true, we are probably, again, out of the short run. NGDP is almost 10 percent higher now than it was at the pre-crash peak. The number of people employed, even with population growth, is still below the pre-crash peak. Even assuming that insider nominal wages are totally inflexible, nominal output per worker has grown fast enough that insider real wages have probably adjusted. Furthermore, in five years, a non-trivial fraction of insiders retire or change jobs.

More generally, I’ve never been a fan of insider-outsider models, at least not for the United States in recent times. Maybe it makes sense as a model of Europe or Detroit in the union heyday. But today in the US, “labor” is less homogeneous than ever, private sector unions have declined, and fewer workers have an expectation of lifetime employment. Yet the past three recoveries have been increasingly jobless! How can you square the fact that at a time when the insider-outsider distinction is weaker than ever, labor hoarding has basically ended and labor market adjustment has become more difficult? I do it by assuming that the insider-outsider mechanism does not play that big of a role.

But again, even if the insider-outsider story was true at the beginning of the recession, there is little reason to believe that it is still true.

Ryan Avent and corporate profits

At the Economist, Ryan Avent focuses on my point that corporate profits are at record highs.

Firms could be enjoying high profits simply because revenues have stabilised while costs are low, perhaps because low expectations for future nominal spending growth have discouraged investment.

First, note that in the series I cited, corporate profits are adjusted for inventory valuation and capital consumption. The purpose of these adjustments is to make the series less responsive to exactly the kind of behavior Ryan posits. If firms decide not to invest in production and simply sell out of inventory instead, that can increase profits, but it doesn’t increase profits adjusted for inventory valuation. Likewise, a firm can temporarily increase profits by making inefficient use of existing equipment, which could lead to faster depreciation. Are these adjustments perfect? No. But they do offset some of Ryan’s concerns. Corporate profits are high even when you subtract some of the temporary gains firms get from not investing. The unadjusted series is here, by the way; I avoided it because I anticipated Ryan’s argument.

Second, whatever firms’ expectations were, as I’ve said repeatedly, nominal spending growth has not been especially low in the last three years. A better story, if you are trying to resist structural theories, might be that firms are wary of investing due to fears of shocks from Europe or Asia, which monetary easing now does little to help. It would be great if the Fed would commit now to keeping NGDP growing at 4-5 percent when those shocks do hit, but in the meantime, I am not expecting a lot out of QE3.

Ryan also makes a couple of other points, but none of them cut to the heart of my critique of QE3 optimism. He gestures to the New Keynesian literature, but of course even the New Keynesians don’t argue that the short run lasts forever. And Mankiw, who is one of the authors Ryan cites, is a well-known proponent of the unit root hypothesis. I do not read Mankiw as expecting a return to trend, no matter what monetary policy is, although I of course do not speak for him and am happy to be corrected. Ryan also quotes Weitzman on how increasing returns creates unemployment, which is true, but tautologous: if there were no increasing returns, anyone who was unemployed could start his own firm and be just as productive as when he was employed.

Bill Woolsey

Bill Woolsey cordially welcomes me, despite my heterodoxy, to the market monetarist club. I am glad to make the cut.

I think that I failed to make myself clear in my original post. Bill says, “Dourado’s version of how shifts in nominal GDP impact real output and employment is based upon an assumption of market clearing.” This is not what I intended to convey. I think that part of the effect of nominal shocks propagates through market-clearing monetary misperceptions (Lucas islands), and the rest through non-market-clearing nominal rigidities, or as I wrote in the original post, “because some wages, prices, and contracts don’t adjust instantaneously.” I am not as New Classical as Bill seems to think. I like some elements of the New Classical school, but in the end I think the correct theory of macro for now is pluralism.

In the long run, I do think that markets mostly clear. And I think that Bill must agree, for he writes at the end of his post:

On the other hand, most of us do believe that firms eventually cut prices and wages in the face of persistent surpluses of output and labor. Most of us remain puzzled by the slow adjustment.

This is my point. If our problems were purely cyclical, “eventually” would have happened already, so our problems must not be purely cyclical. Time to start looking at structural explanations.

Scott Sumner and cutting-edge research

I was pleased to get a reply from the high priest of market monetarism himself, Scott Sumner.

I addressed the plausibility of sticky wages here, and in numerous other posts in reply to Tyler Cowen and George Selgin. I’d also point out that there is lots of cutting-edge research that tells us that the “common sense” approach to the wage stickiness hypothesis is not reliable. By common sense I mean; “Come on, wouldn’t the unemployed have cut their wage demands by now.” Yes, they would have, but that doesn’t solve the problem.  This is partly (but not exclusively) for reasons discussed in this recent Ryan Avent post.

Well ok, I followed the first link, which gives the usual argument and then ends with the line, “Until we get a more plausible theory of unemployment, I’m sticking with stickiness.” This is honest, and it certainly is a common view, but I don’t think it’s a good idea to rely so heavily on a theory just because we don’t understand competing theories well yet. Macro of the gaps, I call it.

We have a long way to go in macro, so I’m glad that Scott brings up the issue of cutting-edge research. If he has particular examples of recent work that undermines the common sense approach, he should write about them at greater length. I assume that when he says “cutting-edge” he is not referring to the papers cited in Ryan’s post, since those are both from the 1980s.

Speaking of cutting edge research, let me point everyone to a paper, “Countercyclical Restructuring and Jobless Recoveries,” by David Berger, a new PhD from Yale, and now a professor at Northwestern. Berger creates a model in which firms grow fat during expansions and respond during recessions by laying off their least productive workers. His model creates jobless recoveries and matches the new stylized facts (they have changed since the 1980s) about business cycles pretty well.

One thing that I like about the Berger paper is that it shows why some nominal shocks, if not addressed immediately, are not easily reversible by monetary authorities. Once a firm has fired its least productive workers, it is not going back. If the monetary authority wants to prevent a recession, at least post-1984, it needs to act before firms lay off their workers. This perspective actually bolsters the case for NGDP targeting, because it means that the Fed should have an apparatus in place now so that the economy will be automatically stabilized when the next shock hits. Here is Tyler on Berger.

My question for Scott, since he’s so interested in cutting-edge research, is: “What do you think about Berger’s paper?” I assume that Scott is familiar with the changes in business cycles that Berger documents. Does he not think that Berger’s model accounts for some significant fraction of our current unemployment better than simply sticky wages forever?

The bottom line

None of my critics seem to be willing to make any sort of broadly falsifiable claim about how long the short run lasts. (I should say that Bryan is not arguing that we are necessarily in the short run in the bulk of his post). There is a lot of assuming trend stationarity, talk about output gaps, and pointing to literature I am well aware of—in short, a lot of question begging.

I would like to see a greater emphasis in the blogosphere on understanding stylized facts about recessions, a greater willingness to explore micro phenomena (even if we are not using fully microfounded models), and more macro-ecumenicism. No one school of macro has it all figured out, and that includes market monetarism. There is enough ambiguity in our current situation that reasonable people can disagree about what is going on. But I don’t think that reasonable people can be totally certain that all we need is more nominal stimulus.

20 replies to “Replies to My Critics

  1. Joshua Wojnilower


    Fascinating posts that seem to generate more questions than they answer (which I take as a good thing). Couple questions for you:

    1) In your graph you begin the time series in the late 1990’s rather than using an earlier date. If memory serves me correctly, NGDP was growing an average of ~6% for the previous couple decades before that start date. Why did you pick 1997 as the start date? If a longer term perspective altered average NGDP growth so that the current ~4% was offsetting previous excess, would that change your view?

    2) Why does any story about the economy have to include a one-time shock that ended years ago? Is it not conceivable that the market process was misallocating resources for a lengthy period, which then began to correct with falling housing prices and culminated in a financial crisis a few years later that was met with massive fiscal and monetary stimulus. I’m thinking of a story in which the market process is much more fluid.

    On the whole I tend to agree that monetary stimulus will not be particularly effective at this time, but seemingly for different reasons. I tend to favor a story that involves the build up in private debt relative to income (and distribution) as leading to a debt deflationary crisis. In this scenario the best policies would reduce the level of private debt outstanding instead of encouraging growth in the means by which the crisis was brought about it. Hopefully you will continue to pursue answers to these questions in future posts.

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  3. Eli Post author

    Joshua, I picked 15 years for my graphs because it gives enough history while still being easy to read. I don’t think it really matters if pre-1997 NGDP growth was 6%, because 15 years ago is certainly irrelevant in monetary terms (I hope my critics will grant me that).

    I think the housing bubble and the financial sector is part of the story, but there is always the question of what would have happened if the Fed had kept NGDP growth on target. I am with those who think that the recession would have been much more mild if they had.

  4. Neal

    I wonder if (your recounting of) the Berger paper is not incompatible with sticky nominal wages. Perhaps Berger provides a mechanism by which sticky wages persist into employmentless recoveries.

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  6. DKS

    You ask for a falsifiable claim:

    Sumner, Krugman, etc. believe that right now there’s a favorable unemployment/inflation tradeoff. I.e., that an increase in core inflation will be accompanied by a better-than-average decline in unemployment.

    If you’re right and we really are “out of the short run”, then going forward we should see core inflation rising (or falling) accompanied by only the historical average improvement (or worsening) in unemployment.

    If you’re asking for a falsifiable claim that can be tested even without a change in inflation expectations, then Sumner, Krugman, etc. would probably reply that you’re asking for a test of the effects of monetary policy change in the absence of any meaningful change in monetary policy.

    However, there remains corporate survey evidence: e.g., the National Federation of Independent Businesses survey, where companies continue to report “poor sales” as their most important problem at well above historical averages.

    So if and when companies report “poor sales” as their top problem with merely average frequency, it would be straightforward to believe that we were “out of the short run” and there would no longer be a better-than-average inflation/unemployment tradeoff. We’re much closer to that point than in 2010. But we’re not there yet.

    For a historical comparison, American unemployment remained steeply elevated for four years after the Panic of 1893, then improved rapidly on the monetary expansion from the Klondike Gold Rush starting in 1897. So we have cases, beyond the Great Depression, of an economy remaining “slack” and responsive to nominal stimulus for several years after a banking crash.

    Conversely, I know of no cases of post-crash unemployment remaining high once inflation expectations were returned to pre-crash levels. The economies that have stagnated indefinitely, like Japan, appear to be precisely those economies whose central banks have insisted on not returning to pre-crash inflation expectations.

    It’s surprising that economies stay sensitive to nominal factors so long after a banking crash, but the historical data say they do. Politicians may like to ignore confounding data, but economists shouldn’t.

  7. OGT

    I question whether long and short run distinctions are relevant here. The salient facts, it seems to me, is that we are still at the ZLB and private sector deleveraging still has a ways to go.

    If we are in the ‘long run,’ does that mean that real interest rates are at their ‘natural’ rate all of the sudden? Does that mean that household credit constraints and financial sector balance sheets are instantaneously no longer effecting demand?

    In a reality, we are always in the short run, the long term is always a day a way. Any change in monetary policy tomorrow will be as non-neutral as any change in 2008. The question is whether in the current short term whether expansionary monetary policy would have real growth effects, the models that make sense to me like, David Glasner’s Fischer Effect, Woodford’s interest rate models, and, more importantly, the markets all seem to indicate that it would.

  8. Charlie

    Also, why are firms sitting on so much cash? It’s not just labor, capital markets have to clear as well. You can’t have ZMP capital.

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  10. Grad student

    Berger’s paper is not very good evidence, to say the least.

    First of all, it’s a paper on “joblessness” that doesn’t actually include joblessness. Look at the specification for households in section 4.3, on page 18: taking the wage w as given, the representative household chooses the optimal level of hours L. The utility function certainly looks as if it’s specifying an intensive labor-leisure margin, not an extensive one. (The curvature in L doesn’t make sense if you interpret L as total employment rather than hours.) And then there’s a “labor market clearing” condition on the next page! Not something you see in most studies of unemployment.

    Indeed, footnote 23 on page 25 observes that there is a 1-1 mapping between the equilibrium quantity of labor supply and the equilibrium wage. Thus the paper, by design, offers no insight as to why we might see various changes in the level of employment associated with a certain change in the wage; it’s a bijective correspondence, with the exact mapping determined by the assumption on the Frisch elasticity (which is barely even discussed).

    How does the market for labor clear in the model? This is the weirdest part: there seems to be a hyperactive free entry margin for new establishments, which flood into the market to scoop up displaced workers. (See page 25: “As a result of free entry, labor demand becomes perfectly elastic—there is one wage level that is consistent with the labor market equilibrium, regardless of the level of employment. Given the assumption of linear utility for consumption, the wage depends only on aggregate TFP and is not affected by the labor demand of incumbents. Aggregate shocks affect the wage only through the value of entry.”) To the extent that the equilibrium quantity of labor ever changes in the model, therefore, it’s only because the value of entry by new establishments changes — which means that the key mechanisms are a whole lot more less direct and intuitive than you might imagine.

    For instance, why does the model with worker heterogeneity tend to produce more of a “jobless recovery” than the model without it? To the best I was ever able to glean (I saw this presented twice, though that didn’t help my understanding much), the mechanism is the following. With worker heterogeneity, the value of entry today includes the option value of selectively firing unproductive workers tomorrow. This option value is relatively low in the early stages of a recovery, since it is likely that new entrants will want to increase their employment going forward (to take advantage of the coming upswing in TFP) rather than selectively firing unproductive workers. (You’re not allowed to do both at the same time.) Thus, relative to the model without worker heterogeneity, the WH model will have lower entry value near the beginning of a recovery, which implies lower wages and labor in equilibrium.

    But, hey, maybe this interpretation is completely wrong! I don’t really have a clue what’s going on — and that’s the problem. Most people glancing at the paper will have the same naive, partial equilibrium intuition for the results that you did, but once you really dig into the model you realize that everything is far more convoluted. This is why Berger’s job search was ultimately a disappointment. He had flyouts from MIT, Harvard, Berkeley, Stanford, Stanford GSB, and Chicago GSB — making him one of most celebrated candidates on the market ex ante — but didn’t get a job from any of them. The reason is that as the faculty at these places looked more carefully at the paper, they became steadily less satisfied with what they saw. At the MIT flyout, Daron blasted the paper for its lack of empirical seriousness and failure to use appropriate microdata, even when the hypothesis had obvious testable micro implications. At the Harvard flyout, Emmanuel blasted the paper for its bizarre approach to modeling “joblessness”, and its generally odd modeling choices.

    (Why, then, did he get the offer at Northwestern? Well, overall he still has many positives; he has coauthored papers at several top field journals already, plus an active research pipeline that combines data and theory in an attractive way. He is an energetic, smart, and nice, and has a good chance of becoming a solid macro researcher. I might have hired him myself. But this particular paper is still a disaster.)

    Perhaps the lesson here is to never, ever cite a job market paper…

  11. Fmb

    The Evans rule is a sort of falsifiable prediction: more/better easing will lower UE without raising inflation above 3%.

    I agree “do what we recommend and it will work” is not the most satisfying falsifiable prediction, though.

    Or I could have just said +1 @DKS

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  13. Ray Lopez

    @DKS: “Conversely, I know of no cases of post-crash unemployment remaining high once inflation expectations were returned to pre-crash levels. ” – false premise. If you look at the labor participation rates in the USA after WWII, you’ll find they peaked in the 1990s when more women entered the workforce. Now they are back to 1970s levels. Why should worker participation rates go back to the peak? Is it possible that the US economy needs to rebalance out of the overextended retail and finance sectors? Yes it is. Therefore your question is flawed.

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  15. DKS

    @Ray Lopez, we definitely need to remember that “labor participation” doesn’t behave the same way as “unemployment.” I know the names sound similar, but the non-participators are a separate pool of people from the unemployed.

    “Unemployment” measures how many people who don’t have jobs are looking for them.
    “Labor force participation” measures how many people aren’t looking for jobs at all.

    Someone who loses their job becomes part of unemployment.

    Someone who gives up on finding a next job and retires early stops being counted as unemployment, and becomes counted as a fall in labor force participation.

    You can have a surge in unemployment with zero change in labor force participation, or a fall in labor force participation with zero change in unemployment. They’re related but different groups of people.

    Unemployment is strongly responsive to “the short run” and to changes in aggregate demand.

    Labor participation, unlike unemployment, is largely driven by long-run changes like, as you note, women entering the work force.

    In consequence, a lot of things are true about unemployment that aren’t true about labor force participation, and vice versa. My remark, above, is true about unemployment but not true, as you point out, about labor force participation.

    It’s true that even unemployment has some longer-term changes. In 2000, at the end of the benign 1990s, unemployment bottomed out at just under 4%. In 2007, on the eve of the crash, unemployment bottomed out at about 4.5%.

    So you could argue that even when you control for inflation expectations, the economy in 2007 wasn’t as good at matching workers with jobs as the economy in 2000.

    But that’s a 0.5% difference between best unemployment figures, and right now we’re at about 8%, or about 3.5% above the 2007 level. That’s a much larger surge in unemployment. Between the two hypotheses:

    H1: “Unemployment is 3.5% above recent best performance because NGDP expectations have been low”
    H2: “Unemployment is 3.5% above recent best performance because people are trained for different jobs than are available”

    The evidence matches H1 much better than H2.

    In particular, H2 implies that job loss would be unevenly distributed – some industries shedding far more jobs than others – but in fact, job loss has been pretty evenly distributed. More detailed studies have likewise failed to find the kind of surge in worker skill mismatch required by H2.

    On the other hand, H1 simply implies that wherever you have a plunge in NGDP expectations (or inflation expectations – usually equivalent though not always), you get a surge in unemployment, and wherever you then have a comparable rise in NGDP expectations unemployment returns to near the long-term average. And our historical cases repeatedly show exactly that result.

    Eli above makes the point that sticky wages feels like an incomplete, or at least not very detailed, explanation for why the economy is so sensitive to NGDP expectations. But the outcome is pretty clear even if the mechanism is not.

    We still don’t quite know why gravity exists, but you can count on gravity in your physics just the same. NGDP expectations (or inflation expectations) appears to have the same strong power.

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