Why aggregate demand stimulation becomes less effective as a recession continues

Megan McArdle raises some doubts about the idea of a four percent inflation target, as has been suggested by Olivier Blanchard and others.  I would stress the point that the optimal inflation target falls as a recession proceeds.  Whatever you think of four percent inflation in absolute terms (I have favored two percent, though not four), it would have done much more good a year or two ago than it can do today.

There is an asymmetry between layoffs and rehires.  If an economy starts heading into recession, robust aggregate demand may limit the number of layoffs.  But once those workers are laid off, robust aggregate demand won't necessarily lead to their rehiring.  The employer already has figured out how to do without those workers and the production process has "moved on," so to speak.  Few employers are looking to recreate the status quo ex ante.

Even a shock which was originally one hundred percent "nominal" becomes increasingly "real" as time proceeds.  The laid-off workers have to find new and different jobs, which often means cross-sectoral adjustments.  Laid-off workers become frustrated, lazier, less healthy, and so on — hysteresis – which also makes for required real adjustments, since now they are less productive.

As time passes in the recession, nominal wages also adjust to some extent, perhaps in a painful manner, but that too limits the value of inflation or reflation.

Repeat after me: "Even a shock which was originally one hundred percent "nominal" becomes increasingly "real" as time proceeds."  Again, that means the case for significantly higher inflation — whether strong or weak in absolute terms — becomes weaker every day. 

Comments

nice try, but you have some explaining to do.

There are recessions that are followed by immediate robust recoveries, such as 1957-58, 1960, and 1970, and 1981-82. Then there are recessions with gradual, sluggish recoveries, at least in the first 18 months, such as following 1990-91, 2001, and currently.

We need a general theory that can explain both.

I think that when the recession is largely caused by monetary tightening, then a relaxation of tightening can cause the economy to shoot up rapidly. In those cases, laid-off individuals in housing and autos can return to exactly what they were doing before. They just got a long vacation.

But when there are serious reallocations of labor involved (regions, industries, skills), recovery is a messy business. Such happened in the early-1990s with a significant reduction in military spending, in the early 2000s with the end of the tech boom, and currently with the shrinkage of the construction bubble and of the financial sector plus the end of bloated unions in Detroit.

In each case, following Scott Summer, the Fed's job is to maintain steady nominal GDP growth.

Your claim of an asymmetry between layoffs and hirings, and your "explanation" for this alleged asymmetry, look dubious. You write: "Few employers are looking to recreate the status quo ex ante." But this is true not only as the economy emerges from a recession, but at all other times as well. Maintaining the status quo is never a satisfactory objective; managers are always aiming to improve the production process.

"The employer already has figured out how to do without those workers and the production process has "moved on," so to speak." - Depends, I think your argument falls short in a lot of cases. F.e. companies only fire people because there are not enough orders to occupy the amount of people that during the boom was necessary. So shrinking is only due to the drop in orders and you will rehire (albeit not the same individual) after the crisis, which means that there will be intra-sector re-deployement. Another situation would be that the production process as a whole ceases to exist, but this doesn't necessarily mean that the workers won't find a job in a different company or in a new one that would like to occupy the niche.

Then there are secondary effects. F.e. due to the clash for clunkers program the automotive market is very weak and thus not only the car companies suffer but especially the suppliers have a hard time. But then suppliers are a diverse bunch and they certainly will fire people and then rehire them (I'm specifically thinking of logistics). But you are right that in several cases the old production process won't come back in any possible way, but again, this doesn't mean that additional and similar workers might not find an opportunity in the same business. It depends on the direction they take and this could mean that only a small process of adaption (one week schooling etc.) is necessary which even lazy workers could do...

Or more accurately, 3.14159%

Actually, the case for a higher inflation target gets stronger as the recession continues, because, as the recession continues, we get closer to the beginning of the next recession. What matters most is how much stimulus we will be able to provide when that next recession is about to begin.

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