Here’s another post in my favorite theme, cognitive illusions.

Let’s start with sticky wages, the easier concept. Suppose hourly nominal wage rates for many workers are renegotiated every 12 months. Also suppose the economy is in equilibrium and nominal wages are chugging along at 4% growth. Now assume that a shock comes along, such as falling NGDP. The equilibrium wage immediately falls, but each month only 1/12th of hourly workers renegotiate their contract. Thus the average wage rate will fall much more slowly than the equilibrium wage rate.

Paradox #1: Wages are most likely to be “too high” precisely when they are falling, and vice versa. This will confuse people, who will ask “how can sticky wages be a problem when wages are falling?” Sticky wages are a problem precisely when wages are falling (or rising), and are not a problem (ironically) when wages are not changing at all. That’s why falling wages are correlated with recessions. Not because recessions cause wages to fall, but rather because falling wages are an indication that wages are still too high, creating unemployment.

Now let’s consider sticky fed funds rates. This rate is targeted by the Fed, and adjusted every 6 weeks. Let’s assume that policymakers are slow to respond to changing economic circumstances, and adjust the fed funds rate too slowly. This might reflect data lags, but I think there are other problems as well. In some cases that slowness to respond will result in major policy errors, which we might proxy by unstable NGDP.

Paradox #2: During periods when interest rates are falling, they will often be too high (but not always, as this is based on discretionary Fed errors, not the underlying nature of reality, as with sticky wages.) That is, monetary policy should be more expansionary during those periods when rates are falling (in most cases), and vice versa. I’m tempted to say that “interest rates should be falling even faster” but that’s not quite right, as a more expansionary monetary policy would lead to a higher Wicksellian equilibrium interest rate, hence there would be less need to cut rates. But given the current Wicksellian rate, the target rate is often too high precisely when rates are falling.

And falling interest rates confuse people in exactly the same way as falling wages confuse people. People often see interest rates falling during a recession, and conclude that money is getting easier and that the recession is occurring despite the central bank’s efforts. No, falling interest rates usually mean rates are too high, and getting increasingly too high. Tight money from the central bank is causing the recession, (unless it is a supply-side recession, with stable NGDP growth.)

These two cognitive illusions created Keynesian Economics, and continue to dominate the thinking of many modern macroeconomists. Most economists fully understand all the points made in this post, in theory. However due to powerful cognitive illusions, they have trouble recognizing these factors when looking at real world business cycles.

Market monetarists believe that monetary policy drives NGDP, which drives employment. Because we focus a lot on these two cognitive illusions, we are not discouraged by empirical data that others find to be inconsistent with the view that business cycles are usually caused by monetary shocks.