Don't apply AD to long run growth/distribution issues
In the 1990s there was (or seemed to be) a consensus that you do not want to apply aggregate demand arguments to questions of long run growth and income distribution. Demand shocks have no long run real effects. In simple terms, you can juice an economy in the short run by printing money, but it won’t affect long term growth, or the long run distribution of income.
As with any model this isn’t quite right. One can imagine AD policies that are so inept that they even damage the long run growth of an economy, perhaps by slowing technological change, or by leading to poor institutional outcomes (think Nazi Germany). Nonetheless, the natural rate model is a reasonable approximation for most plausible public policies outside extreme monetary contraction.
Thus in the 1990s it was widely believed that a higher minimum wage would raise the natural rate of unemployment. More recent studies suggest that modest increases (say a dollar or two) might not have a significant effect on employment. My hunch is that these studies underestimate the long run impact, but I concede it’s an open question.
Tim Worstall has a good post criticizing a recent study of the new $15 minimum wage in Los Angeles (which is not fully implemented until 2019.) He criticized the following claim, made in page 25 of the report:
Net spending increases because lower-wage workers spend higher proportions of their income, generating a greater multiplier than for households who would absorb the higher prices,
I actually have two problems with this sort of argument. First, it confuses consumption and aggregate demand. Aggregate demand is actually C + I + G + NX. And since S equals I, there is no obvious reason why more saving would reduce AD.
Some Keynesians will respond that a higher propensity to save will depress interest rates, which will depress velocity, and if M is held constant this will depress NGDP. They don’t actually put it that way, but that’s essentially what they are claiming, if translated into plain English.
The problem here is obvious—the Fed doesn’t target M, it targets AD. So if Los Angeles residents did save more, the Fed will offset any contractionary effects with easier money. That’s why real GDP growth sped up in 2013. And there’s no reason to assume that AD in 2019 will be any lower than the Fed wishes it to be.
Again, all this was well known in the 1990s but seems to have recently been forgotten by a large segment of the economics profession. Interestingly, a similar mass amnesia occurred after the Great Depression, which also featured a long period of zero interest rates. If Paul Romer wants to spend his time exposing folly, a good place to start is looking at how the neoliberalism of the 1990s regressed to the vulgar Keynesianism of the 2010s.
But let’s say I’m completely wrong, and that the minimum wage increase does boost AD. Is this a good argument for raising the minimum wage? No, because demand shocks have only temporary effects and the minimum wage is best viewed as a long run policy. There is no indication that the LA city council plans to repeal the law in the near future.
This is just one example of something I see all the time, AD arguments misapplied to long run structural economic problems. For instance there was a lot of debate about whether QE helps or hurts the poor. In fact, the impact of a particular monetary policy gesture is irrelevant, as any monetary regime is essentially neutral in the long run. Suppose monetary policy regime X will help the poor when policy is more expansionary than average, and vice versa. Since (by definition) policy is more expansionary than average about as often as it is less expansionary than average, the distributional effects will net out to roughly nothing. Even worse, people usually don’t get even the short run effects right. For instance, in the short run QE probably helps the rich and poor more than the middle class, but so what?
Macro is simple: Use monetary policy to stabilize the path of NGDP, and use radical deregulation, privatization and tax reform to improve the supply side of the economy. Have a progressive consumption tax regime and pollution taxes, and also low wage subsidies to improve distribution. That’s not far from the 1990s consensus, and it was correct. It’s a pity that people on both the left and the right seem to have forgotten why the Clinton years were so good.
PS. The paper’s authors were Michael Reich, Ken Jacobs, Annette Bernhardt and Ian Perry, three of whom are at Berkeley. Don’t consider this post a personal criticism; when doing reports for governmental units one may be forced to look at a lot of factors, not all of which are important.