Scott Sumner  

What does Greece tell us about the AS/AD model?

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I am going to criticize a recent Tyler Cowen post on Greece. But before doing so, let me explain where I think we agree.

1. Fiscal policy doesn't explain very much of the business cycle.

2. Greece's problems go far beyond deficient aggregate demand; indeed it has rather severe structural rigidities, and well as excessive government debt.

Is there anything we disagree about? Tyler seems to think so:

I said it before, I'll say it again: the 2008-2012 period was a very special one, with a very high risk premium (sorry, Scott!) and with massive contractions in bank intermediation in some of the key affected countries. We draw broader conclusions from it at our peril.
[Perhaps it's presumptuous to assume that "Scott" refers to me, as it's a very common name. So I googled "Scott economist" and my name came second. However the first name specialized in IO and ag. econ, so I'll assume Tyler was referring to me.] In the past, I've argued against people who put too much weight on aggregate demand, and too little on aggregate supply. I do believe that NGDP shocks are the primary driver of the business cycle in developed countries, but I've also been careful to confine my analysis to single currency zones, such as the US, the UK, the Eurozone and Hong Kong.

Does NGDP matter for Greece? I'd say yes and no. Here's an analogy that might help. Suppose that we measured the NGDP for Detroit and Houston, and discovered that Houston's NGDP was rising fast while Detroit's was flat. Would we say that "AD shocks" explain the divergent paths of those two cities? Clearly not---Detroit has serious structural problems. Both cities are part of the US, and both face the same monetary policy at the national level.

So while I view the national NGDP as being almost completely under the control of the Fed (with an appropriate policy regime), at the local level, variations in NGDP tend to reflect supply-side factors.

Now of course Greece is a country, not a city. But it's one that lacks its own currency. Thus for purposes of analysis, the difference between Greece and Germany is equivalent to the difference between Detroit and Houston.

So why did I say "yes and no" above? Because when talking about business cycles, NGDP always matters in the short run (even if not in the long run) even if ultimately reflects supply side factors. Thus if the Federal government had dropped billions of dollars onto Detroit from a helicopter, I don't doubt that the Detroit economy would have had a temporary boost (although it's long run problems would remain unsolved.)

So why does Tyler think we disagree? He starts off the post citing a predicted 1.8% RGDP growth rate for Greece, and then says:

Of course that's not great, especially with all the catch-up they could be doing (but please don't assume that all or even most of the output gap represents potential catch-up). Still, the Greek economy is not shrinking, even though Keynesian fiscal theories predict it should be:

"We accept that there will need to be a 3.5 per cent primary surplus until the end of the [bailout] programme [in 2018] but after that it should come down to something like 1.5 per cent to allow for more capital expenditure to lift the Greek economy."

When combined with his "sorry, Scott!" remark, I see two possible mistakes:

1. Perhaps Tyler assumes I'm a Keynesian that believes fiscal shocks have a big impact on the business cycle. No, that's Paul Krugman, not me.

2. More likely, Tyler might have meant that I favor AD theories of the cycle, and the recent Greek recovery goes against AD-oriented models. That's wrong for two reasons. First, NGDP in Greece is expected to rise this year. Output is beginning to recover, and Greece just went from deflation to inflation. If anything, I'm surprised that the RGDP growth rate is not even higher----Greece is having more inflation and less RGDP growth than I would have expected for any given NGDP growth. And second, I believe that NGDP shocks only matter in the short run. Thus even if NGDP did not recover, the labor market would eventually adjust---as we've seen in Japan. (Of course Greece's labor market is more rigid, and takes longer to adjust.)

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Tyler also seems to suggest that I overrate the importance of NGDP shocks and underrate the importance of financial distress. I don't think so. In this case, I believe that part of the financial distress (not all) is due to falling NGDP. I also agree that financial distress can have a negative effect on growth, even with stable NGDP growth. And finally, I believe that financial distress plays a greater (negative) role in regional areas such as Greece and Puerto Rico, and that NGDP shocks are relatively more important for large diversified economies, such as the US, Japan and the Eurozone.

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COMMENTS (9 to date)
Charlie writes:

I think Tyler has been staking out a more extreme position than "financial distress" matters. He seems to be arguing that changing risk premiums caused the Great Recession. The closest parallel that I can think of is that the stock market crash of 1929 caused the Great Depression. Whereas, I think you would say the stock market crash and high risk premiums were effects and not causes.

Apparently, he wrote a whole book about it:

IGYT writes:

You're not giving enough weight to the sentence in which Tyler apologized. He was implying that a (real) shock to risk tolerance is more of the story of the Great Recession than failure to keep NGDP on track.

Tyler Cowen writes:

I agree AD matters for Greece, but not so much fiscal. I didn't mean to deny the role of the negative money shock, just didn't bother to repeat it.

That said, I was in fact referring to the ag econ Scott.

Todd Kreider writes:
"Thus even if NGDP did not recover, the labor market would eventually adjust---as we've seen in Japan. (Of course Greece's labor market is more rigid, and takes longer to adjust.)"

That's an understatement... For perspective on labor rigidity, Japan's unemployment rate was 4% before the great recession, rose to 5.5% and was back to 4% just under five years later in 2013. It is now at 2.8%, the lowest since 1994.

Greece had an unemployment rate of 8% before the recession which steadily rose to 28% by 2013 but is still at 23% today, almost four years after its peak.

Tyler Cowen writes:

By the way, without banking union, Detroit is the wrong analogy. It is precisely the banking/solvency risk within Greece that determines how much of ECB-created ngdp ends up as Greek this sense the two theories are fully complementary.

Scott Sumner writes:

Charlie, One of the few things in macro that we know for sure is that the 1929 stock crash did not cause the Depression. Stock market crashes have no impact on GDP. Check out the equally large 1987 crash.

IGYT, I agree, but that doesn't really affect anything I said. I see risk tolerance as part of the financial crisis.

Tyler, Yes, I agree that the Detroit analogy is not perfect. But I was using it to make a point that you yourself have made on a few occasions, changes in NGDP don't always reflect monetary policy.

In Detroit it might have reflected population outflow, whereas in Greece it might have reflected banking problems, as you suggest.

I think we actually agree on this point.

Scott Sumner writes:

Todd, That's right, although of course the fall in NGDP in Greece was much bigger, especially relative to trend.

Charlie writes:

"Charlie, One of the few things in macro that we know for sure is that the 1929 stock crash did not cause the Depression."

I just don't think Tyler would agree with that statement. I think I'm passing a Turing test here, but perhaps not. I know for example Roger Farmer has this view.

I think it's like blaming fires on fire trucks, but what do I know. A lot of very smart people hold macro views I think are crazy.

arqiduka writes:


Is your position that nominal shocks matter more in large, diversified, open economies and these just happen to have their own currency, or that simply having an independent currency makes NGDP shocks have a greater relative importance. If the later is the case, one would think that the opposite would rather be the case, and that not having local control of one's currency would make deviations far more likely (the whole "low inflation in Germany and damn the rest of those guys" gig).

When Greece got into the Euro, did (potential) NGDP shocks start mattering less overnight? The Greek economy wasn’t any smaller or less diversified on January 2 than in December 30. Further, if the country leaves the monetary union tomorrow, will nominal shocks become more important or simply become manageable locally (which is a very different position).

I’m using Greece as an example because the crisis hit almost overnight and it is very hard to make the case that it was real and not (mostly) nominal, unlike with Detroit.

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