What does Greece tell us about the AS/AD model?
By Scott Sumner
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.)
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.