Responses to Two Critics
By Arnold Kling
I have been making the following claims about macro.
1. Major surges in unemployment are due to Recalculations. A sudden, large shift in demand across industries can occur in such a way that employment falls sharply in the receding sector(s). Meanwhile, it takes a long time for potentially expanding sectors (a) to realize that they are going to be the winners and (b) to accumulate the human and physical capital to expand. It is as if a central planner has decided to shut down some firms that no longer are producing valuable output but has not yet figured out where to redeploy the resources or how to do the necessary retraining and relocation.
I should emphasize that for economy-wide adjustment one of the most subtle and difficult shifts in demand is a shift in the form in which people wish to save for the future. If we go from wanting to accumulate capital in the form of houses to wanting to accumulate capital in other forms, that is a very difficult Recalculation for the economy to carry out.
2. Inflation rates are very sticky. A major change in the trend inflation rate requires a regime change, which changes people’s expectations. That process of changing expectations takes years.
Under (1) and (2), money does not matter. In the short run, the economy is going its own way, regardless of monetary policy. Higher M leads to lower V, and vice-versa. In the long run, a significant change in the rate of money creation causes a similar change in the rate of inflation. However, the lag is long and the effect on the rate of Recalculation is small and of indeterminate sign (I can think of reasons why it could be helpful or harmful).
Point (1) can be traced to Clower and Leijonhufvud. Point (2) is not far from Fischer Black, who also saw general price behavior as determined by convention and who saw financial markets taking steps to offset changes in the central bank balance sheet. In the sense that I see monetary growth having its effects with long lags, rather than with short lags or leads, I am harkening back to Milton Friedman and rejecting what Paul Krugman calls the “dark age” macro of the past thirty years.
Nick Rowe attacks point (1).
Mackerel can’t stop the inexorable logic of Say’s Law. If you have an excess demand for mackerel, and so does everyone else, you are stuck. Unless you are prepared to go out on a fishing boat, the only way to get more mackerel is to buy it, and you can’t, because you are on the long side of the mackerel market.
Money can stop the inexorable logic of Say’s Law. If you have an excess demand for money, and so does everyone else, you can’t get more money by selling more goods. But you can get more money by buying less goods. Of course, in aggregate these attempts will fail, but that doesn’t stop individuals buying less goods, just like confessions in Prisoner’s Dilemma.
Thanks to Mark Thoma for the pointer.
Rowe, like many economists, has a very hard time imagining anything other than a frictionless economy with instant movement to general equilibrium. In that (mythical) economy, a shift in demand between industries cannot possible lead to unemployment. In order to explain unemployment, these economists posit a shift in demand toward a non-produced good, and they leap on money as an example.
I am explicitly attacking this tradition, which I associate with Keynes, of making a big deal of money as a store of value. In this view, as long as the supply and demand for money are in balance, there can be no unemployment. In my view, the supply and demand for money could be in balance, but if the supply and demand for different forms of capital (houses vs. small businesses) is out of whack, there can be unemployment.
What is known in the macro literature as the “real business cycle” model also assumes frictionless markets. That is why I want to differentiate Recalculation from standard RBC. However, Recalculation is not a monetary story, and in that sense it is a “real” story.
The most expansionary monetary shock in U.S. history, by far, was the 1933 dollar devaluation and the decision to leave the gold standard. During the first four months of this policy, the WPI rose by 14 percent and industrial production soared 57 percent, regaining half the ground lost in the previous 3 ½ years…Other easily-identified monetary shocks, such as the 17 percent decline in the U.S. monetary base between late 1920 and late 1921 had an immediate and severe impact on both prices and output.
Beware of proof by selective example. Some thoughts:
1. The monetary regime in 1920-21 was different than today’s regime. It could be that relative to the gold standard, prices had risen way too much in 1919, and everybody knew it. That would have made it easy to bring prices back into line.
2. As to the 1933 episode, what was the long-term impact on general wages and prices? In the short run, the wholesale price index (WPI) can be dominated by commodity prices, which are volatile. Today, in order to gauge the trend of inflation, economists use broader price indexes, and they remove changes in food and energy prices in order to focus on “core inflation.” I wonder how “core inflation” behaved during the episode in question.
3. I can do “proof by example” going in the other direction. Consider how long it took for inflationary expectations to rise from the early 1960’s to the late 1970’s. Consider how long it took for inflationary expectations to fall from 1980 to 2000, even though the “regime change” under Paul Volcker was sharp and highly publicized.