By Arnold Kling
Scott Sumner brings up some difficulties for anyone who would argue that monetary policy is not a sufficient tool for fighting the recession. He is not arguing from his yet-to-be-articulated new paradigm. He is stating traditional macro.
Traditional macro says that an increase in the money supply causes higher nominal GDP. It says that in a recession, higher nominal GDP leads to greater real GDP. Higher real GDP leads to greater employment.
The case for fiscal stimulus rests in part on the view that there is a disconnect between the money supply and nominal GDP. Keynes had two stories for this. One is the liquidity trap, in which at low interest rates the economy is willing to absorb gobs of money as a store of value. The other is interest inelasticity of investment demand, in which risk-takers are so moved by their animal spirits (or lack thereof) that they ignore changes in interest rates in making investment decisions.
I am willing to argue for a liquidity-trappish point of view, which is that money and government debt are pretty close substitutes. Therefore, when the Fed swaps the two, not very much happens in the broader financial markets. This is my interpretation of Fischer Black’s perspective. One big problem with that perspective, at least as far as I can tell, is that it is not able to give as straightforward an explanation for the inflation of the 70’s and the disinflation of the 80’s as is the monetarist view.
Sumner’s main point is that low interest rates do not necessarily produce a liquidity trap. Instead, the Fed can generate expectations of inflation. (On this point, he may need help from his new paradigm.)
As Sumner points out, I have been arguing most for a different form of disconnect. That is, I see a disconnect between nominal GDP and real GDP. We can raise nominal GDP without raising real GDP, because in a Recalculation the economy acts as if it had suffered a supply shock. Under this view, either monetary or fiscal stimulus will produce more inflation and less employment than one might hope.
David Leonhardt is puzzled by the fact that real wages are still edging up, even though we have double-digit unemployment. One story is that real wages are up because nominal wages are sticky and we have had an unusually large drop in prices. That would be consistent with Scott’s point of view. Another story is that real wages are up because unemployed workers from the housing and mortgage sectors are not exerting much downward pressure on wages in health care and education. That would be consistent with my point of view.
In recent months, perhaps the most interesting disconnect has been between real GDP and employment. With measured real GDP increasing and employment falling, measured productivity is soaring. If these data are reliable, it suggests that profits are recovering. That in turn should provide the basis for a rebound in employment.
Keep in mind the Garrett Jones view that workers are hired not to produce widgets but instead to build organizational capital. In recent months, firms have sharply cut back on their investments in organizational capital, in order to remain profitable and survive. With profits up, the cutbacks should be fewer, and we should start to see some expansion. The question becomes, again, whether the unemployed workers from declining sectors are capable of supplying organizational capital to the expanding sectors.
If conventional macro is correct, then as long as nominal GDP expands, real GDP will expand. The disconnect between real GDP and employment will be erased by rapid increases in employment.
If the Recalculation story is correct, then rapid increases in employment and real GDP are not possible. If policy makers succeed in expanding nominal GDP, much of that increase will go to inflation, and relatively little will go toward real GDP.