Arnold Kling  

Kling vs. Sumner, Continued

Price Discrimination Explains ... Gifts in Kind vs. Gifts in Mon...

Scott Sumner writes,

If NGDP falls 8% below trend, then nominal wages must also fall 8% below trend to maintain full employment, regardless of what is happening to real wages.

So I think his story of the past year really is a sticky-wage story. The Fed tightened (he is not backing down from that view), so that nominal GDP growth went from 5 percent to -3 percent. Meanwhile, nominal wage growth did not drop nearly as far, and therefore unemployment shot up. If we cannot explain the rise in unemployment by showing that real wages increased much faster than productivity, that does not trouble Sumner, because he does not believe the price indexes that are the denominator in real wages. (Note: aggregate wage measures in the numerator are indexes, also. Why do we believe them?)

Here is where I think our views differ. In my view, it is not possible to have a sudden nominal shock. Instead, only long-term changes in monetary policy can affect the trend rate of inflation. So I would explain the sudden slowdown in nominal GDP growth as a reflecting primarily a slowdown in real GDP growth, due to a real shock.

That view puts me in a minority. Most people believe that there was something like a nominal shock last year. However, Sumner is in the minority in attributing the nominal shock to monetary policy. Even though over the last thirty years, the textbooks have described nominal shocks as monetary.

I think the general view is that we had a nominal shock that consisted of the financial crisis. This drove down expectations for inflation, and the Fed could not reduce real interest rates sufficiently in that environment. Therefore, we needed quantitative easing and/or a fiscal stimulus.

Sumner's challenge with me is to get me to believe in nominal shocks again (I used to, back when I was in graduate school). He is welcome to keep trying, but he probably should not get too worked up over it, because (a) what I personally think is not that important in the grand scheme of things, (b) we cannot seem to agree on an empirical way to settle the issue, and (c) I seem to be pretty stubborn.

On the other hand, his challenge with the rest of the profession (I suspect including James Tobin, if Tobin were alive) is to convince them that the nominal shock was tightening of the money supply by the Fed. Maybe folks are just as stubborn and just as unable to settle the issue empirically, but there are a lot more people who have the view that there was some non-Fed source of the nominal shock, and so a lot more minds are at stake.

[UPDATE: Bill Woolsey writes,

In order for the price level to have fallen enough to keep real expenditure equal to its long run trend, substantial deflation was necessary-- a 2 percent annual rate of deflation in the third quarter of 2008. For the fourth quarter of 2008, the needed annual deflation rate was 8.4 percent. During the first quarter of 2009, the needed deflation rate would have been 5.5 percent. The needed deflation rate in the second quarter 2009 was 2.4 percent. And finally, deflation would need to be approximately 1 percent in the third quarter of 2009. The problem was not too much deflation, it was rather too little deflation!

Emphasis in the original. I guess the idea is that there was a downward shock to monetary growth, and lower inflation would have insulated real GDP from that shock. But if you believe that deflation would have kept real GDP on track, then I do not see how you can explain the drop in real GDP on the basis of locked-in debt contracts and wage contracts. If you believe in locked-in debt contracts and wage contracts, then deflation should have made real GDP worse, not better.

I still need help understanding this concept of a nominal shock.

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COMMENTS (9 to date)
Doc Merlin writes:

"In my view, it is not possible to have a sudden nominal shock. "

Oh come on, the Fed exercising monetary policy is a sudden nominal shock. Also, any other trading partner exercising monetary policy would also create a sudden nominal shock.

Philo writes:

"Non-Fed source"? Obviously the economy is affected by all sorts of factors, from many different sources. Sumner's claim is that the Fed is an important enough potential source that it could have countered whatever other factors were tending to push NGDP down. He's not saying the Fed's behavior was the *only factor*.

Tom Grey writes:

The US recession is so much deeper for two reasons you don't mention:
1) American workers are generally overpaid. All global businesses know this and act on it--investing elsewhere when they can to get higher productivity per dollar.
A related issue is that the domestic housing boom hid this excessive wage issue since the boom; which itself hid excessive wages in the 90s.
And gov't workers are even more overpaid.

2) With the over-investment in housing followed by its bust in 2006, there has been a huge decrease in the number of employed illegal aliens. Thru the 80s, more the 90s, and the 00s to 06, illegals added a lot of off the books cash profits to small local business, as well as reliable low cost labor.
Many have returned to Mexico -- leaving a LOT less demand for local services.
I guess that about half of the working illegals have left, or about 5 mil of the prior 10 mil. Since they've been leaving steadily since 2006, there was no month with a huge shock, but each month for 3 years, now, the real profits (taxed plus untaxed) have been going down w/o the illegals, and without the buying of those who serviced the illegals.
Maybe 3-4% of the adult US workers of 2005 were illegals who are now gone. Fewer renters; fewer buyers of everything; less profit for all services.

There is, for the first time since WW II, overcapacity in every sector -- so there is no sector to lead a recovery.

The US should immediately increase the quotas of legal immigrants; preferably requesting a 10k or 20k downpayment on a house purchase for almost immediate visa qualification (with security check).

ssendam writes:

Once upon a time, the banking sector was viewed as an integral part of the money supply - which is why econ undergraduates have to learn about the reserve ratio and the money multiplier. Or this: China Hits Brakes on Economic Stimulus:
Central Bank Raises Required Reserve Levels as Beijing Takes Aim at Inflation, Bubbles.
Yet for some reason, this notion seems to have disappeared from today's monetary thought. By propping up the banking system with its various facilities and backstops, the Fed _was_ preventing monetary contraction.

fundamentalist writes:

I believe that Sumner's definition of the tight monetary policy is that ngdp falls, isn't it? If so, then given the long and variable lags between policy and effect, the feds must have tightened monetary policy 3-4 years before the collapse in ngdp. And of course the fed did begin raising rates in 2004.

Ted Craig writes:

The nominal shock was gas prices. The crisis started in May 2008, not September 2008.

Douglass Holmes writes:

What economic policies have changed with the election of a new president? Indeed, what policies have changed since 2006 when the Democrats took over Congress? The only significant change is that deficits have grown even faster, taxes are going to go up, and the regulatory picture is even more unclear than before.
The economy will rebound when tax, environmental, and healthcare policies are settled enough for businesses to figure out how they can make a profit in new areas. I probably wouldn't like or approve of the direction that the Democrats will take us, but I have faith that we can have a growing economy once these issues are sufficiently settled.

Ryan writes:

I swear I just do not understand this argument. Sumner/Woolsey's viewpoint (if you can combine them together) seems to imply that prior to the crisis we're in an equilibrium state, then *boom* the economy experiences a severe negative NGDP shock. This disrupts the present equilibrium and due to sticky wages (or some other reason) the entire price structure could not readjust fast enough to absorb the shock, resulting in a tremendous increase in unemployment.

I simply am unable to imagine the real world in any state of "equilibrium" at any point in real time. Equilibrium to me is a theoretical tool to facilitate understanding of changes in certain economic variables, ceterus paribus. But the real world, with real human actors is dynamic and ever changing. It is in a state of ceaseless flux. And to try to employ some sort of quasi-equilibrium like framework to understand extremely complex macro events is not only foolish, but almost impossible.

Joe Calhoun writes:

I think you underestimate the shock caused by the sudden case of uncertainty introduced by TARP and the election of a new President. Business activity slowed dramatically when Paulson introduced TARP and it came to a screeching halt when it failed to pass the House on the first try. It didn't get any better after it finally passed because there was still the matter of how it would be implemented and how long that would take. I think that is ultimately why they decided to make the capital injections instead; it might not have been better but it was surely quicker.

Then the election entered the picture and as it became obvious that Obama would be elected there was further uncertainty. It wasn't so much that his policies were feared but rather that it wasn't clear what they would be. A McCain win would have meant more continuity although that might not have been comforting considering the track record of the Bush administration. Remember when it was leaked that Geithner would be the Treasury nominee and the market rallied? It wasn't so much that he was the best man for the job (as has become painfully obvious since) but he was a known quantity and it lifted the uncertainty, at least for a little while.

The rally didn't last though because the debate immediately shifted to the stimulus package which extended the uncertainty since, again, there were unknowns. Would there be a tax credit for hiring? If so, better to wait and see if you get the credit. And that isn't even considering that it was in November that Rahm Emmanuel let it be known that he didn't intend to let the crisis go to waste. What did that mean? Cap and trade? Healthcare? Something else? The uncertainty continued.

I don't know if this qualifies as a nominal shock since I haven't seen it defined, but I think it explains much of why the economy just ground to a halt for a few months. I think it also explains why hiring is so slow now. Companies addressed the uncertainty by laying off a bunch of workers and discovered they really didn't miss them. Now they're being more careful about who and how many they hire.

I'm also skeptical of Sumner's idea that the Fed could have prevented the drop in NGDP. If they had acted sufficiently and timely enough to prevent Paulson from introducing TARP it might have worked but if not, I don't think monetary policy could have prevented the all stop in the economy.

As for the sticky wage theory, I think it is largely correct. The question is how to address it. Do we inflate and reduce real wages as Sumner seems to want? I guess that is one option but it seems like a pessimistic way to look at things. Aren't there ways to raise labor demand other than just reducing the price? Aren't there ways to increase labor demand other than government spending which doesn't seem to be working anyway? I don't know but surely we can be more creative on the fiscal side than we've been so far.

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