It’s good to know that Krugman has retained some of his 1990s views:
We — that is, the United States — have a floating exchange rate. Spain, however, being part of the euro zone, does not. Its wages are too high compared with those of other eurozone members, now that the housing boom and massive capital inflows are over. If Spain still had a peseta, I’d say devalue it; since it doesn’t, wages have to give.
I imagine Krugman’s left wing fans might have choked on their lattes when reading this paragraph. Wages need to be lowered to reduce unemployment? That doesn’t sound like Krugman. But at least he assured them that his conclusions do not apply to the USA. Or do they? Here is my argument in a nutshell:
We — that is, the United States — have an independent central bank. The Fed insists that ”price stability” is its goal. Because of the sharp fall in NGDP, and sticky nominal wages, we need to cut real wages to restore full employment. If Congress had control over monetary policy, I’d say raise the inflation target for a few years (as would Krugman); since it doesn’t employment costs have to give. Cut the minimum wage and the employer share of the payroll tax.
Here’s the problem with Krugman’s analysis. We both accept Eggertsson’s model, which says “depression economics” only applies to situations where the Fed is not inflation or price level target. Krugman say that describes the current situation in the US. I say it doesn’t. Both Krugman and I were highly critical of Bernanke’s response to DeLong’s 3% inflation target proposal. Krugman seems to think the response was a rejection of inflation targeting. I saw it as Bernanke saying something to the effect; “We already have a price stability target. It is so important to us that we aren’t willing to even move up to 3% in order to deal with severe unemployment, even though in theory the proposal would work.” Read the answer yourself and see who you think is right:
The public’s understanding of the Federal Reserve’s commitment to price stability helps to anchor inflation expectations and enhances the effectiveness of monetary policy, thereby contributing to stability in both prices and economic activity. Indeed, the longer-run inflation expectations of households and businesses have remained very stable over recent years. The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations. In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward. The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserve’s policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored.
And Krugman has one more problem do deal with. Earlier in the year you may recall there was a big debate over multipliers. I argued that if the Fed had an optimal policy, or indeed if the Fed was targeting any sort of inflation/NGDP variable, then the multiplier was zero. This is because for fiscal policy to “work” it must boost AD. But higher AD will raise inflation and NGDP. If the Fed is targeting those variables then it would offset the expected impact of fiscal policy by tightening monetary policy. Krugman never addressed my specific post, but definitely did address that general worry. He said something to the effect that it was absurd to think Bernanke would sabotage fiscal stimulus with tighter money policy. (If someone can find the link I’ll add it.) This was when Bernanke still seemed kind of progressive. I never denied that Krugman’s interpretation was plausible, although I also argued that the Fed probably would not let the recession get much worse than it did without taking extraordinary measures, and I think most fiscal proponents overlooked that counterfactual in their multiplier estimates.
Why do I bring up this old multiplier argument? Because it is highly relevant to the wage debate. In the spring Krugman was arguing that fiscal policy would work because the Fed would let it raise inflation expectations. Now Krugman is saying wage cuts won’t work, because the Fed will respond by letting inflation expectations fall. Either of those monetary policy responses are possible, but how likely is it that they are both correct? In Krugman’s posts the Fed seems like a very schizophrenic institution. When faced with a fiscal stimulus package, the Fed puts on its progressive hat and adjusts its implicit inflation target in a way that accommodates the extra government spending. But were Congress to pass a minimum wage or payroll tax cut, the Fed suddenly becomes a Mellon-like liquidationist, cruelly lowering its implicit inflation target to prevent the wage cuts from creating any jobs. My goodness, can both of these views be correct? I scratched my head looking for something in common. Something that could reconcile these two views of the Fed. The only commonality that I could find is that in both cases the Fed adjusted its policy in such a way as to validate Krugman’s opinion about the desirability of alternative policies.
In a follow-up post Krugman criticizes Tyler Cowen and Bryan Caplan in his usual civil fashion:
I feel like I’m arguing with a dining room table.
I know the feeling; I get it every time Krugman fails to respond to my posts.
Krugman complained that Cowen and Caplan failed to respond to his assumption that a nominal wage cut might simply depress prices, leaving real wages unchanged. That may be true, but Caplan clearly used another set of assumptions, which seem equally plausible to me. To use my terminology, Caplan basically assumed that nominal wage cuts would not impact nominal GDP:
1. Cutting wages increases the quantity of labor demanded. If labor demand is elastic, total labor income rises as a result of wage cuts.
2. Even if labor demand is inelastic, moreover, wage cuts reduce labor income by raising employers’ income. So unless employers are unusually likely to put cash under their mattresses, wage cuts still boost aggregate demand.
I have frequently argued that inflation is the wrong variable for almost all its applications in macro. Instead, we should use NGDP growth. The Fisher equation should be nominal rates minus expected NGDP growth. Here’s an example. Krugman is worried that the wage cuts might give you 2% deflation, and that puts you deeper into a liquidity trap. But suppose that instead it is expected NGDP growth that matters. Assume Japan has 1% RGDP growth and China has 10% RGDP growth. If both countries have 2% deflation, then Japan has negative 1% NGDP growth and China has 8% NGDP growth. Who’s more likely to be in a liquidity trap? My intuition here is of course based on the notion that the Wicksellian equilibrium real rate is strongly correlated with the RGDP growth rate. So I think Caplan’s right. It’s not obvious why wage cuts lower NGDP. And it’s not obvious how you go deeper into a liquidity trap without expected NGDP growth falling, even if inflation falls.
I have to admit that I absolutely hate working through the sort of mathematical model that Krugman can handle with ease. So I may be wrong in this analysis. But even if I am, everything I wrote in part one of this post remains valid. I think all these “depression economics” analyses are silly. They assume a Fed policy reaction function that is simply far too ad hoc. I’m not saying the Fed doesn’t mess up at times. And I’m not even going to argue that there aren’t short periods (like late 2008) where they let expectations become unanchored in response to shocks. But I do deny that we can make sober, long term fiscal decisions based on the sort of bizarrely dysfunctional Fed assumed by Krugman. A Fed that seems to have an inflation target, and then arbitrarily raises that target in response to deficits produced by government spending, but cuts it in response to deficits produced by payroll tax cuts.
When all is said and done, there is no reason to banish microeconomists from the fiscal policy debate. It is reasonable to hold NGDP constant in these analyses, and that makes all the micro assumptions valid. But should they ever stick their nose into monetary policy . . .