sticky wages and downward nominal wage rigidity

Sticky Wages and the Macro Wars by Krugman

Simon Wren-Lewis, following up on Bryan Caplan, makes the case that downward nominal rigidity of wages is simply a fact, attested to by overwhelming evidence. Furthermore, it’s a fact that we understand fairly well in terms of behavioral economics. So he suggests that the unwillingness of many macroeconomists to incorporate this fact in their models — because it doesn’t have “microfoundations” — says something disturbing about the state of the field.  

He’s right, but I have the sense that many of his readers — and just about all of Caplan’s commenters — don’t understand the significance of this observation for the history of macroeconomics over the past 40 years.  

You see, the question of wage (and price) stickiness, and hence of real effects of changes in nominal demand, was what the great rejection of Keynesianism was all about. And I mean all about. Back in the 70s, there was hardly any discussion of the determinants of nominal demand; what Lucas and his followers were arguing was that Keynesianism must be rejected because it was unable to derive wage stickiness from maximizing behavior.

Lucas initially argued that unexpected nominal shocks still mattered, because people couldn’t initially distinguish them from real shocks, but that this offered no room for useful policy. Later, freshwater economics rejected even that proposition; the business cycle was all about real shocks, with demand playing no role at all.

At no point was this rejection of Keynesianism driven by superior empirical performance; it was all about the principle, about refusing to incorporate anything that wasn’t derived from maximization all the way.

So you can’t say, “Well, OK, maybe people aren’t hyperrational, and wages really are sticky” and then go back to hating on Keynesians. Grant that one point — as you should, because the evidence is overwhelming — and you’ve conceded, whether you know it or not, that much of macroeconomics spent three-plus decades following a blind alley.

I see that some of Caplan’s commenters are willing to accept that nominal demand matters, but draw the line at “nonsense” like the liquidity trap. Well, the zero lower bound is also a fact, and once you start admitting that demand matters, you’ll find yourself inexorably arriving at liquidity-trap analysis. But leave that for another day. The key point here is that to concede the obvious about nominal wages is, like it or not, to concede that Lucas, Prescott, and so on were just a great detour away from useful macroeconomics.

and

Wage Flexibility in Doctrine and Policy (Wonkish)

Krugman: "state of the practical art"

Modern Applied Macro by Krugman

Makes me think back to this post from last week. Is monetary policy assumed to be sub-optimal in Romer's model as deflation is expected. (But as Krugman says DNWR is keeping the price level up.)

NGDPLT: the guard dog you want

For David Andolfatto: why I switched from IT to NGDPLT by Nick Rowe

We had three guard dogs, named IT, PLT, and NGDPLT, that were all saying about the same thing from 1992 to 2008. The Bank of Canada listened to the first of those three dogs, and things seemed to go pretty well. So we figured IT was a good guard dog. In 2009 things changed. The Bank of Canada kept on listening to the IT dog, and did what was needed to make sure the IT dog stayed fairly quiet. The PLT dog stayed fairly quiet too. But the NGDP dog started barking loudly, telling us that monetary policy was too tight. And when I looked out the window, I saw exactly those symptoms that I normally associate with a random tightening of monetary policy: people having greater difficulty selling things for money; greater ease buying things for money; and a fall in the quantities of things sold for money. I saw exactly the same sort of recession I would expect to see if monetary policy suddenly at random became too tight. The NGDP dog was right to start barking loudly; the IT and PLT dogs failed to warn us of the recessionary burglar.

So I say: get rid of the IT dog and start listening to the NGDPLT dog instead.

[Update: and raising the inflation target is like giving the IT dog a hearing aid in the hope it will do better; and switching to a temporary NGDPLT but only during a recession is like having the NGDPLT dog temporarily replace the IT dog when you already know there's a burglar in the house.]

In comments he writes: "Fiscal policy: given standard arguments for Barrovian tax-smoothing, plus diminishing marginal benefits to government expenditure, I would be wary of distorting micro-optimal fiscal policy to make it do a job that monetary policy should be able to handle."

I would share objections others have on fiscal policy. Multipliers. Implications for inequality and fairness. During downturns the government can make needed infratstructure repairs on the cheap. Also politics. The Fed has become a lightening rod - even with its lackluster performance - because of Congress and austerity.

devalue or deflate and downward nominal wage rigidity

BRAD DELONG (1996): REVIEW OF JOHN MAYNARD KEYNES, "A TRACT ON MONETARY REFORM": TUESDAY BOOK REVIEW WEBLOGGING by DeLong

DeLong quotes Keynes on the options government have when enacting policies to return to full employment and close the output gap.

Chapter four--"Alternative Aims in Monetary Policy"--sees Keynes shift from analyst to advocate: he comes down, in the context of Western Europe in the 1920s, on the side of devaluation to bring official currency values in line with relative national price levels rather than of deflation to force national price levels into consistency with pre-WWI exchange rate parities. He argues that when you are forced to choose between maintaining a stable exchange rate and maintaining a stable internal price level, choose the second. For avoiding fluctuations in your internal price level avoids a host of evils:

We see, therefore, that rising prices and falling prices each have their characteristic disadvantage.... Inflation is unjust and Deflation is inexpedient.... [I]t is not necessary that we should weigh one evil against the other. It is easier to agree that both are evisl to be shunned. The Individualistic Capitalism of today, precisely because it entrusts saving to the individual investor and production to the individual employer, presumes a stable measuring-rod of value, and cannot be efficient--perhaps cannot survive--without one...

He argues against return to the gold standard, on the grounds that modern central banks can do a better job of maintaining price stability if they are not tied to gold. Keynes's arguments in chapter four look very good: current opinion among economic historians, exemplified by Barry Eichengreen's Golden Fetters: The Gold Standard and the Great Depression, is that attachment to gold did a large part of the work in preventing central banks from stemming the Great Depression of the 1930s.

Over the past 5 years, the economy has been growing but not enough to make up for lost ground and close the output gap. Demand management  (fiscal, monetary and trade policy) has been such that the economy has achieved slow growth and a sort of deflation in hysterisis - an increase in long term unemployment and a degradation of the economy's productive capacity. Downward nominal wage rigidity has prevent outright deflation and a return to full employment by that painful route.

downward nominal wage rigidity

Potential Mistakes (Wonkish) by Krugman

But right now we have high unemployment combined with more or less stable core inflation. Typical models would interpret this as a sharp rise in the natural rate, from maybe 5.5 to 8 percent. But what it almost surely reflects instead is the stickiness of inflation at low levels; the long-run Phillips curve isnot vertical thanks mainly to downward nominal wage rigidity,and that reality is central to what’s happening now. 

I wish that these were narrow technical issues, of no importance for real-world policy. Unfortunately, they’re not. Understating output gaps leads to excessive demands for austerity and excessive complacency at central banks; this perpetuates the depression; and the longer the depression goes on, the more misleading the standard estimates become. 

So it’s good news that at least somebody in Brussels is aware that there might be a problem.

DNWR

The Fed Is More Out of It Than You Thought It Was by Mike Konczal

The Fed's Real Mistake in 2007: Forgetting About Aggregate Demand by Yglesias

Under "normal" conditions, one stabilizing element of the Fed is that people think they know how the Fed will respond to future contingencies. We all know that if core inflation gets up to 3 percent for a couple of quarters in a row, the Fed will respond with tighter money. That means nobody expects that to happen. And the expectation that it won't happen helps prevent it from happening. Everyone's plans are coordinated around a no-high-inflation scenario. And for a long time, that also operated on the downside. But the Fed didn't articulate in advance any clear ideas about the zero bound to reassure people. People knew Ben Bernanke had written some old papers about this. But he wasn't publicly speaking about strategies, and we can see in the transcripts that he wasn't privately trying to build consensus either. It was a failure of contingency planning that exacerbated the problems when the bad contingency arose.

If downward nominal wage rigidity hadn't occurred to extent it did - which surprised Yellen and Krugman - we could have had deflation seeing as how the Fed as slow to react and communicate its intentions.

Shrink this e-dollar by Ryan Avent

Quoting Miles Kimball:

There are only two important things that economists talk about that are worse at zero inflation than at 2% inflation. One that has attracted some interest is that a little inflation makes it easier to cut the real buying power of workers who are performing badly. But by far the biggest reason major central banks set their long-run inflation targets at 2% is so that they have room to push interest rates at least 2% below the level of inflation. With electronic dollars or euros or yen as the units of account, there is no limit to how low short-term interest rates can go regardless of how low inflation is. So inflation at zero would be no barrier at all to effective monetary policy. It might be that we would still choose inflation a bit above zero to help make it easier to cut the real (inflation-adjusted) wage of poor performers at work, but I doubt it.

Emphasis added. And also:  DNWR (downward nominal wage rigidity).

Again:

The Cult of "Price Stability" Is Killing American Workers by Yglesias

Sticky (economics)

What has surprised Krugman and Jane Yellin lately is the extent of downward nominal wage rigidity.

Real rigidity

Krugman:

Why Are Wages Still Rising? (Wonkish)  (7.9.11)

Mysteries Of Deflation (Wonkish) (7.26.10)

Internal Devaluation, Inflation, and the Euro (Wonkish) (7.29.12)

Sticky Wages and the Macro Story  (7.22.12)

Nominally Legal  (7.12.12)

Pointless Pain in Spain (7.11.12)

Revenge of the Optimum Currency Area  (6.24.12)

Still more, searching NYTimes for downward nominal wage rigidity.