More Musings on the Sources of Involuntary-Unemployment Business Cycles

Over at Grasping Reality: Robert Waldmann**: Comment on “More Musings on “Monetary Economics”: “Also:

it is not the case that curing the excess demand for safe and liquid assets always requires painful ‘liquidation’ and austerity…

is true but doesn’t go very far.

In particular, painful liquidation doesn’t require austerity–overinvestment is costly to those who overinvested whether or not there is countercyclical stimulus: WorldCom and Global Crossing went bankrupt, even though Greenspan made sure the 2001 recession was tiny.

I think the the weight of evidence strongly suggests that structural adjustment and sectoral rebalancing is accelerated not slowed by demand stimulus. I actually think this is proven beyond reasonable doubt. Non-monetary models with either effect can be written.

I note as always, that there can be fluctuations of production, exchange and welfare in models without money including say the original Diamond search model. In general imperfect competition is plenty (and needed anyway for price stickiness).

Also incomplete markets are enough.

It may be that historically those who understood that something could and should be done about depressions focused on money and money demand, but it is not and was not logically necessary to recognise the existence of money to get the point.

Robert is referring to my (5):

(5) Because of sticky prices and sticky nominal contracts, declines in the price level–declines in the prices of currently-produced goods and services relative to money–cannot quickly rebalance the economy at full employment. Sticky prices do not fall fast enough to do so. And non-sticky prices that do fall produce chains of bankruptcies that further boost demand for money–for safe and liquid assets.

And the extremely thoughtful Roger Farmer agrees with Robert:

Read this excellent piece on Schumpeter by @delong http://t.co/7UVRu0tUmR I agree with all of this except for Brad's point 5.

— Roger E. A. Farmer (@farmerrf) July 2, 2015

I would plead for mercy from Robert and Roger, not because they are wrong (they are right), but rather for two other reasons:

1. (5) is at bottom an idea I had when I was 23, an idea that I thought then was both really smart and original (and that I think now is really smart and semi-original). Think in the terms of Modigliani’s (1944) reduction of Keynesian economics to (i) sticky wages and (ii) the observation that sticky wages kept the market from adjusting quickly turn a high-unemployment into a full-employment real money stock. My idea was that if prices were flexible the process of adjusting to get the full employment real money stock with itself disrupt the economy by getting you the wrong real interest rate and the wrong degree of leverage. I am attached to this idea. I have tried, with a very limited degree of success, to communicate it in “Is Increased Price Flexibility Stabilizing” and “Should We Fear Deflation?. I beg for some slack so that I can continue to do so. (Note: this is why I now say “semi-original”)

2. I would hazard a guess that, empirically, most unemployment-generating business cycles over the past two centuries at least have been primarily driven by the two monetary channels–sticky nominal wages and sticky nominal debts–rather than by market power and coordination failures. (Besides, over here in reserve I have Nick Rowe, who will passionately argue that the notion of “coordination failure” is incoherent in a barter market economy with its n(n-1)/2 open markets, and makes sense only in an economy that is, at least tacitly, a monetary market economy).

John Maynard Keynes (1936): The General Theory of Employment, Interest and Money: Chapter 19: Changes in Money-Wages: “The Classical Theory has been accustomed to rest…

…on an assumed fluidity of money-wages; and, when there is rigidity, to lay on this rigidity the blame of maladjustment…. Let us… apply our own method of analysis to answering the problem…. We must base any hopes of favourable results to employment from a reduction in money-wages mainly on an improvement in investment due either to an increased marginal efficiency of capital under (4) or a decreased rate of interest under (5)….

A sudden large reduction of money-wages to a level so low that no one believes in its indefinite continuance would be the event most favourable to a strengthening of effective demand. But this could only be accomplished by administrative decree and is scarcely practical politics under a system of free wage-bargaining. On the other hand, it would be much better that wages should be rigidly fixed and deemed incapable of material changes, than that depressions should be accompanied by a gradual downward tendency of money-wages…. The effect of an expectation that wages are going to sag by, say, 2 per cent. in the coming year will be roughly equivalent to the effect of a rise of 2 per cent. in the amount of interest…. With the actual practices and institutions of the contemporary world it is more expedient to aim at a rigid money-wage policy than at a flexible policy responding by easy stages to changes in the amount of unemployment….

It is, therefore, on the effect of a falling wage- and price-level on the demand for money that those who believe in the self-adjusting quality of the economic system must rest the weight of their argument…. We can… theoretically at least, produce precisely the same effects on the rate of interest by reducing wages, whilst leaving the quantity of money unchanged, that we can produce by increasing the quantity of money whilst leaving the level of wages unchanged…. Just as a moderate increase in the quantity of money may exert an inadequate influence over the long-term rate of interest, whilst an immoderate increase may offset its other advantages by its disturbing effect on confidence; so a moderate reduction in money-wages may prove inadequate, whilst an immoderate reduction might shatter confidence even if it were practicable. There is, therefore, no ground for the belief that a flexible wage policy is capable of maintaining a state of continuous full employment;–any more than for the belief than an open-market monetary policy is capable, unaided, of achieving this result….

While a flexible wage policy and a flexible money policy… [are] alternative means of changing the quantity of money in terms of wage-units, in other respects there is, of course, a world of difference between them….

(i) Except in a socialised community where wage-policy is settled by decree, there is no means of securing uniform wage reductions for every class of labour. The result can only be brought about by a series of gradual, irregular changes, justifiable on no criterion of social justice or economic expediency, and probably completed only after wasteful and disastrous struggles, where those in the weakest bargaining position will suffer relatively to the rest. A change in the quantity of money, on the other hand, is already within the power of most governments by open-market policy or analogous measures…. A method which it is comparatively easy to apply should be deemed preferable to a method which is probably so difficult as to be impracticable….

(ii) Having regard to the large groups of incomes which are comparatively inflexible in terms of money, it can only be an unjust person who would prefer a flexible wage policy to a flexible money policy….

(iii) The method of increasing the quantity of money in terms of wage-units by decreasing the wage-unit increases proportionately the burden of debt; whereas the method of producing the same result by increasing the quantity of money whilst leaving the wage unit unchanged has the opposite effect. Having regard to the excessive burden of many types of debt, it can only be an inexperienced person who would prefer the former.

(iv) If a sagging rate of interest has to be brought about by a sagging wage-level, there is, for the reasons given above, a double drag on the [nominal] marginal efficiency of capital and a double reason for putting off investment and thus postponing recovery…

It follows, therefore, that if labour were to respond to conditions of gradually diminishing employment by offering its services at a gradually diminishing money-wage, this would not, as a rule, have the effect of reducing real wages and might even have the effect of increasing them, through its adverse influence on the volume of output. The chief result of this policy would be to cause a great instability of prices, so violent perhaps as to make business calculations futile in an economic society functioning after the manner of that in which we live. To suppose that a flexible wage policy is a right and proper adjunct of a system which on the whole is one of laissez-faire, is the opposite of the truth. It is only in a highly authoritarian society, where sudden, substantial, all-round changes could be decreed that a flexible wage-policy could function with success. One can imagine it in operation in Italy, Germany or Russia, but not in France, the United States or Great Britain.