Paul Krugman tries to lure Scott Sumner out of retirement

Krugman writes:

But when you cut the price of everything — which is more or less what happens when wages fall across the board — there’s nothing else to substitute away from.

Yes, economics textbooks typically show a downward-sloping “aggregate demand curve”. But the reasons for that curve’s downward slope aren’t the same as for your ordinary demand curve. It’s a process that works like this: lower prices -> lower demand for money -> lower interest rates -> higher spending. And that process doesn’t operate when, as is currently the case, short-term interest rates (which are the ones that matter for money demand) are zero.

Here is more.

Yet a deflationary downward spiral is not the necessary or even the likely outcome.  Even if a liquidity trap prevents the Fed from credibly inflating to recovery, it is much harder to argue that the Fed is helpless to prevent a downward deflationary spiral.  The Fed can do that very credibly indeed.  The Fed is already doing that.  It’s credible and there is no undesired outcome, such as five or six percent inflation, which needs to be seen through ex post.

Another way to put this point is that the AD curve does not sufficiently embody the Fed’s reaction function (Larry Summers is fond of making a related observation), much less individual expectations based on that reaction function.  The model is incomplete and in this case the incompleteness really matters.

A few smaller points deserve mention:

1.Wages usually fall sequentially, not across the board and all at once, especially not in a large, decentralized, non-trade union-ruled economy such as the United States.  That creates a greater chance that an employment boost kicks in, in some sectors, before prices fall (prices are sticky too!) and thus the economy may enter a Clower-Leijonhufvud-Hutt upward spiral of employment and output.

2. Krugman’s third sentence (“It’s a process that works like this: lower prices -> lower demand for money -> lower interest rates -> higher spending.”) need not be the dominant causal mechanism when so many variables are changing.  Scott in particular might think that interest rates are not so important.

3. A different reason to be skeptical of wage cuts, as a mechanism for macroeconomic recovery, is simply that wage cuts are often small relative to threshold required rates of return for investors, especially when “wait and see” remains an option for those holding the cash.


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