Scott Sumner  

Keynesian economics and cognitive illusions

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Consider the following two paradoxes:

1. Falling wages are associated with falling RGDP. Falling wages cause higher RGDP.

2. Falling interest rates are associated with falling NGDP growth. Falling interest rates cause higher NGDP growth.

You often hear people say correlation doesn't prove causation, but rarely do correlation and causation go in opposite directions as often as in these two cases. I've talked a lot about interest rates in this blog, is there anything to be learned by comparing interest rates to wages? I believe the answer is yes.

The following is going to be an ad hoc model, which just happens to be true during most of recent US history. The "never reason from a price change" maxim warns us to not assume that it will always hold true.

Let's suppose that most employment fluctuations are caused by the combination of NGDP shocks and sticky nominal wages. For simplicity, assume that when NGDP falls by X%, nominal wages fall by only one half times X% in the short run, that is, only half as much as would be required to keep the labor market in equilibrium. We might observe three countries that see NGDP plunge by 2%, 10% and 20%. In those three countries nominal wages fall by only 1%, 5%, and 10%, that is by one half as much as NGDP fell. That's what we mean by sticky wages.

Now think about what that implies. The country where wages fell by the most (minus 10%) is the country where wages are the furthest above equilibrium. And that's likely to be the country with the highest unemployment rate. What conclusion would the average person draw from these stylized facts? They'd conclude that wage cuts "don't work". Cutting wages just causes NGDP to fall even further, and is thus self defeating. I'd argue that this is one of the most important themes in Keynes's General Theory.

And yet I believe this view is completely wrong. For the country where NGDP fell by 20%, a larger wage cut, say 15% or 18%, would have moved wages closer to equilibrium, and this would have led to lower unemployment. Keynes had causation exactly backwards, on an issue that is central to his critique of classical economics.

I hope that by now you see the connection to interest rates. Falling interest rates are a sign of a weak economy. As with wage cuts, a Fed decision to cut interest rates makes the economy stronger than otherwise. So then why are falling interest rates usually associated with a weak economy? Because a weak economy puts downward pressure on market interest rates, and the vast majority of Fed rates changes are merely reacting to changes in the economy, not causing them.

Here's a good recent example. Since the December rate increase, short-term interest rates in the fed funds futures market have been trending downwards. Instead of the 4 rate increases in 2016 predicted by the Fed last month, markets are now forecasting only one or two at most. So what are we to make of this change in the expected path of rates? It's theoretically possible that this reflects an expected easing of monetary policy. That is, the Fed is now less likely to raise rates, even assuming no change in the macroeconomic environment. An easier money policy, which would be expected to boost growth.

In fact, it's far more likely that these lower interest rate forecasts are a prediction of a weaker than expected economy, and also a prediction that the Fed will react to the weaker than expected economy by raising rates less that previously expected. Do we have any evidence for this claim? Yes, a mountain of evidence. All sorts of other asset markets are becoming much more bearish about the economy. If the Fed's likely decision to move away from an aggressive path of rate increases really were an expansionary policy, then asset prices would be rising as bond yields fell. But asset prices are falling with bond yields.

Interest rates usually fall when there is a NGDP growth slowdown. And yet it's also true that interest rates are usually too high when there is a NGDP downturn. This implies the Fed's target interest rate is sticky; it falls more slow than would be required to maintain stable NGDP growth. Sound familiar? So periods when interest rates are falling are also periods where interest rates are becoming increasingly too high.

I believe that Keynes noticed that the deeper the depression, the lower the level of interest rates. Because he viewed low rates as being an expansionary monetary policy, he wrongly concluded that interest rate cuts were relatively ineffective in a deep depression. Unlike with wages, he did not wrongly reverse causation; he was too good a monetary economist to do that. (We'd have to wait for the Neo-Fisherians for that error.) But he did become excessively pessimistic about the potency of monetary stimulus in a depression, and for much the same reason that he wrongly thought that wage cuts would be ineffective in a depression.

His erroneous views on wage flexibility led him to reject classical solutions for depressions. In fairness, wage flexibility is not the best solution, even if Keynes was wrong about causation. The second error led Keynes to reject the views of progressives like Fisher, Hawtrey, Cassel, and even the Keynes of the Tract on Monetary Reform, who favored using monetary policy to stabilize the price level (or NGDP.) Keynes wasn't hostile to their suggestion, he just didn't think that monetary policy alone could get the job done.

By the 1990s, New Keynesians had moved away from Keynes on these issues. They thought monetary policy was enough for stabilization of aggregate spending. And they thought wage cuts were expansionary. Due to the zero bound, economists have recently drifted back to old Keynesian ideas. My view is that they were that view was wrong in the 1930s, wrong in the 1990s, and they are wrong today.

PS. When would wage changes be associated with output moving in the opposite direction? Perhaps if they were caused by exogenous policy shocks, such as the higher wages after July 1933 implementation of the NIRA, which slowed the recovery, or the lower wages resulting from Germany's labor market reforms of 2004, which helped boost growth and reduce unemployment.


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COMMENTS (18 to date)
Philo writes:

All in all, brilliantly insightful. What a marvel, that I'm allowed to read this stuff for free!

It might make for clarity if you distinguished explicitly between "interest rates" and "the interest rate [rates?] directly controlled by the Fed." Referring to "a Fed decision to cut interest rates" makes it sound as if the Fed directly controls all interest rates. But (I think) your point actually is that in cutting the rate (Discount Rate? Fed Funds Rate?) that it controls, in times of economic slow-down, the Fed tends to be behind the trend of falling interest rates in the economy generally.

Scott Sumner writes:

Philo, Thanks, and very good point, I should refer to a "cut in the Fed's interest rate target."

If you want to see the opposite extreme of my blogging ability, go the TheMoneyIllusion, where I post on politics. And that gets all the comments. :)

Nick Bradley writes:

This is really absurd and I expect more from this blog; normal relationships between variables break down as we sink into a liquidity trap and/or and output gap. It's why so many New Keynesians are monetarists in normal times, old school Keynesians in deep recessions.

Of course market monetarists will say that there is no liquidity trap, and that's fine; but that's not what is being said here

Rajat writes:

How were NK's "wrong in the 1990s"? Do you mean "right"?

ThomasH writes:

Quite persuasive, but since no one proposes wage (and price -- why talk only about stick "wages?") cuts in response to a recession, I don't know who you are trying to persuade. As for markets, could you not say that they are not expecting the Fed to return NGDP to its pre-crisis trend, or even the PL? The Fed is not supposed to have an interest rate target [expletive deleted]. Its supposed to, in addition to looking out for employment, strive for price stability, which if it means anything, ought to mean having an inflation target (= a price level trend target), not an inflation rate ceiling target and surely not an interest rate target. Congress did not instrct the Fed to stabilize interest rates!

Kevin Erdmann writes:

It seems to me that there is another layer of confusion on top of this. Since we are in a regime where the Fed is erring toward being above the natural rate, the correlation looks like a lower rate target leads to higher asset prices. But really it's just that optimal rate targets lead to higher asset prices. It's odd to me that while it appears that an obsession with 1970s inflation is behind the current hawkish tendency, the idea that loose money leads to high corporate valuations requires an apparent ignorance of the 1970s.

kczat writes:

"This implies the Fed's target interest rate is sticky." What a great insight! I look forward to reading a detailed explanation of why this happens, though even a basic familiarity with the usual cognitive biases gives some idea.

AbsoluteZero writes:

First, what Philo said.

Second,

Interest rates usually fall when there is a NGDP growth slowdown. And yet it's also true that interest rates are usually too high when there is a NGDP downturn. This implies the Fed's target interest rate is sticky; it falls more slow than would be required to maintain stable NGDP growth. Sound familiar? So periods when interest rates are falling are also periods where interest rates are becoming increasingly too high.

The above paragraph, really just the last sentence, needs to be repeated, everywhere.
People see two things happening. It's very natural (but incorrect in this case) to think that one is causing the other. It's very hard to see that a lot more of one could mean less of the other.

mbka writes:

And who knows, maybe the root cause of the current stock market turmoil and falling expectations is the real shock of an increasing possibility of a Trump POTUS. The markets are slowly pricing it in. The timing sure would fit with T.'s progression in the charts.

Amagi writes:

"By the 1990s, New Keynesians had moved away from Keynes on these issues. They thought monetary policy was enough for stabilization of aggregate spending. And they thought wage cuts were expansionary."

Well, isn't it the case that in NK models, wage flexibility by itself has no effect on output (determined exogenously by the aggregate demand for goods) or technology and thus on the demand for labor and employment? The way wage cuts affect output in a NK model is indirect, through changes in the interest rate (lowering the interest rate makes the representative agent want to trade more future consumption for present consumption, this is the way monetary policy has an impact on aggregate demand in the model and thus on employment), that the BC sets through a rule that partially, at least, targets inflation (which nominal wage cuts lower).
http://crei.cat/people/gali/jg2013_jeea.pdf

A writes:

What would happen if the congress mandated that, on a yearly basis, a percentage of money base expansion can't be withdrawn without an application to some Fed oversight committee? That might maintain some of the benefits from the k% rule and the Audit The Fed movement, while allowing flexibility.

Jose Romeu Robazzi writes:

Interesting post
Coincidentally I happened to find a discussion from a Brazilian economist on Keynes' answers to some economists (like Viner), exactly about the efficacy of monetary policy. The conclusion is that apparently he was skeptical. It seems he wrote an article in 1937, basically talking about money demand. I thought that could be of interest to market monoetarists, but perhaps Prof. Sumner you are familiar with this article. I could not find it on the internet, only the discussion from the brazilian economist: http://www.ie.ufrj.br/moeda/pdfs/cardim1.pdf

Brian Donohue writes:

Great post. Clever, creative thinking.

Scott Sumner writes:

Rajat, That was a typo, I changed it.

Thomas, You said:

"Quite persuasive, but since no one proposes wage (and price -- why talk only about stick "wages?") cuts in response to a recession, I don't know who you are trying to persuade."

I think you missed the point. I was trying to make it easier to understand how the two issues are related.

Kevin, Good point.

Thanks kzcat and absolutezero.

Mbka, I think the rise of Sanders and Trump is one factor behind the stock sell-off. Not so much because they are expected to win, but rather because their rise makes pro-growth policies like TPP less likely.

Amagi, I wasn't thinking so much in terms of that model, but more in terms of the supply-side effects. I think that by the 1990s most Keynesians would have felt that lower wages, such as the German reforms, would boost jobs for supply-side reasons. I'll try to do a post soon on Krugman's views back then.

A, That seems too rigid to me, there are better ways of reforming the Fed.

Thanks Jose.

Thanks Brian.

Lorenzo from Oz writes:

Great post.

Economics is about models and equilibrium conditions: it is amazingly easy to forget that (or, at least, not follow through on its full implications).

Gerben Nap writes:

This doesn't seem very well thought out. The fact that the interest rate represents the relative supply and demand of money in the market, and that the Fed sets those rates not by decree but by putting more or less federal reserves into the interbank clearing market seems not to come into the picture. A lot of 'associations', rather than actually referring to real economic situations. If he says this seems to have held true over the past years of the US he leaves it up to us to find the data to check that, nor does he seem to have looked at actual circumstances. And to top it off he uses this very vague period/location to make grand claims that Keynes didn't know the direction of causation of wage-shifts and NGDP shifts. Maybe I'm missing something, but at first glance, I'm not impressed...

Postkey writes:

"Cutting wages just causes NGDP to fall even further, and is thus self defeating. I'd argue that this is one of the most important themes in Keynes's General Theory."

Although Keynes did say:

" A reduction in money-wages is quite capable in certain circumstances of affording a stimulus to output, as the classical theory supposes." G.T.

Tom Brown writes:

Scott, an interesting post! Thanks.

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