Saturday, June 2, 2012


Various Keynesian and Monetarists stimulus programs have been tried and failed since 2008 and the response of their advocates to their failure is always "the level of stimulus didn't go far enough - lets have more please".

What the advocates of these forms of stimulus have in common is a belief that the recession is somehow caused by nominal factors (not enough money) or confidence factors (future expectations too low) rather than real factors. This seems inconsistent with the facts. There was a large drop in RGDP in 2008 accompanied by a fall in NGDP and levels of employment. Since then NGDP has risen more or less in line with its long-term trends while employment has increased much more slowly. If this was nominal wouldn't we have expected a more significant recovery in employment as NGDP has increased substantially since 2008 ?

To my mind this looks like something real happened in 2008 from which we have not yet recovered - perhaps there was a realization (doesn't really matter what it was for the purposes this post) that year that something fundamental had changed that would render a proportion of investment unprofitable ?

What would we have expected to see happen if this was the case.

- A sudden drop in RGDP and employment as these unprofitable lines of business were terminated accompanied by a fall in NGDP as effective demand is reduced
- A reduced demand for labor that if not resulting in lower real wages would result in higher long-term unemployment
- If effective demand has fallen but wages have not then there will be less profitable investment opportunities. This will increase savings and reduce borrowing and lead to a fall in IR potentially to zero and a "liquidity trap" that will again cause NGDP to fall.

This chain of  events is consistent with what has happened. What then will be the effect of an attempt of the monetary authorities to set expectations that NGDP will increase at a higher rate in the future? It will depend upon how businesses expect this increased money supply to affect relative prices - in particular the wage level relative to the price of final goods. In the best case scenario then this will cause real wages to fall and allow investment to increase. Even here though the effect will be via inflation which will affect different goods differently and disrupt the price mechanism. Based on the experience since 2008 though the increased money supply will cause real wages to rise almost as much as final goods. We will get higher inflation and only a marginal effect on employment. This is stagflation and will quickly wipe out any beneficial effects of the marginal lower real wages.