Recently, Ryan Avent at Free Exchange wrote a thought-provoking and ambitious post which he aptly titled “A theory of troubles”. The “troubles” flow from the “puzzles”, of which there has been no shortage of supply lately:
There are puzzles of wage stagnation and falling labour-force participation. There are savings glut puzzles and secular stagnation puzzles. The common thread linking the puzzles is that they almost always mean trouble of one sort or another.
Many stories have been presented to explain some of these phenomena (and others, as well, like rising inequality and the striking emergence of jobless recoveries). But not much effort has been made to tie these stories together into a broader narrative of what is happening to (primarily) rich economies and what might usefully be done about it. The nearest thing to an attempt is the secular stagnation narrative that, while not originating with him, has been popularised in recent months by Larry Summers. In this post I hope to tighten up and extend the arguments in Mr Summers’s story in pursuit of a broader theory of troubles.
I´ll be far less ambitious and will try only to understand the “emergence of jobless recoveries”. Maybe this will also help understand some of the other “puzzles”.
My argument will lean heavily on the (potential) efficacy of monetary policy and this is a point that RA, likely because he focuses on inflation, “misses out”:
Distributional issues are key in this narrative. If we assume that purchasing power is allocated via market wages, then the task facing central banks immediately becomes impossible. If they try to maintain low and stable inflation, then competition for low-skill work will place downward pressure on the wages of low-skill workers, but wages will be too rigid to provide employment for all willing workers.
… But in general, the benefits of growth will flow to high-income workers and owners of capital. Since they have low propensities to spend, central banks will find it difficult to generate adequate demand, except by nurturing unsustainable borrowing by workers with stagnant incomes. Central banks cannot have adequate demand and low inflation.
On the other hand, if central banks are willing and able to raise inflation rates, then real wages will be more flexible, and firms will be more willing to use labour to do tasks that could reasonably, or even easily, be automated. In this scenario the central bank succeeds in generating adequate demand; because low real wages encourage less substitution of capital for labour, a higher share of income flows to labour, to workers with a high propensity to spend. But adequate demand is incompatible with a low rate of inflation. It may also be unsustainable, since many central banks will interpret the high inflation necessary to boost employment as evidence the economy is running at capacity.
What RA is saying, and this has been my longstanding view, is that persisting or even formally introducing an inflation target as the objective of monetary policy once inflation has been conquered (as is mostly the case, especially in advanced economies) can be “dangerous for the economy´s health”.
For example, if the central bank manages, as it mostly did during the period called “Great Moderation”, to maintain NGDP (or nominal spending) growing at a stable rate along a level growth path, the problem of rigid wages won´t manifest itself with any force. Why? Because the ratio of wages to NGDP will also be stabilized.
The upshot: don´t think in terms of higher or lower inflation (as a means to reduce wage rigidity), but focus on maintaining NGDP “hugging” a stable path.
What if a nominal shock disturbs the balance? Try to get NGDP back to the trend level as fast as possible. That´s one reason monetary policy (understood as keeping NGDP close to the trend level) shouldn´t react to real (say, productivity, or oil) shocks. If it does react (fearful of inflation, perhaps), given sticky wages, the wage NGDP ratio will rise and so will unemployment (while employment falls).
I hope the panel below helps to shed some light. The “leading” role in our script goes to employment. The other parts are all ones of “supporting roles”. Looking at the left side of the panel, we see that NGDP growth plays an important supporting role. The large drop in NGDP in the present cycle “translates” into a deep fall in employment, just as the slow NGDP recovery maps into the slow gains in employment.
But some other “force” (or supporting actor) must be “doing” something because, despite NGDP growth for the whole period being the same in the 1990 and 2001 cycles, the 2001 recovery was much more jobless that the 1990 recovery.
The top chart on the right hand side shows that productivity growth was much higher in the 2001 cycle than in the 1990 cycle.
Ryan Avent´s narrative touches on that point:
Productivity-rich recessions, and jobless recoveries, are a product of sticky wages.
Mark Bils, Yongsung Chang, and Sun-Bin Kim find that sticky wages push firms to wring more output from existing employees when confronted by a decline in demand. Productivity therefore rises during recessions—rising most in industries where wage rigidity is most binding—reducing the incentive to take on new workers despite relative wage flexibility among the unemployed.
And again the “inflation solution”:
Taken together, these observations imply that in the presence of moderate inflation, real wages will be more flexible and productivity will flip back to falling, rather than rising, amid weak demand. That brings us back to the motivating example of the Britain versus America comparison, where that implication seems to have verified.
Note, however, that the NGDP gap (relative to its “Great Moderation” trend) was almost non-existent in the 1990 cycle and widened in the 2001 cycle (the stand alone chart takes away the 2007 gap because it distorts the picture).
In the 2001 cycle, therefore, the wage NGDP ratio rose, so “firms wring more output from existing employees when confronted by a decline in demand.” Only when nominal spending rises more strongly does employment pick up.
The present cycle is somewhat “special”. The NGDP gap widened off the charts, so, due to wage stickiness, the wage NGDP ratio must have increased considerably. As the chart shows, it did! Nevertheless, productivity behaved no differently from the 1990 cycle. Demand and output fell by an inordinate amount (so there is no incentive to “wring out more output from remaining employees”) and so has employment, which is crawling back at the rate allowed by the rise in nominal spending, that has been far short from what´s needed to narrow the gap. Only now, 24 quarters after the start of the cycle, the wage NGDP ratio inched below what it was in late 2007!
Takeaways: Focusing on inflation is the wrong “strategy”. Allowing more than moderate falls in NGDP leads to jobless recoveries. If large drops in NGDP occur (as in 2008-09) and monetary policy is “timid”, “job loss” recoveries ensue. Importantly, an NGDP level target will go a long distance in “neutralizing” nominal wage rigidities.
And everything becomes a “puzzle” because the existing models do not account for them! Policymakers say they have done all they could, but unfortunately we are in a “secular stagnation”, which has become the “new normal”!