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.


Tyler, thanks for reminding me, early in the morning, why I should not waste my time analyzing and applying macro theory.

"No undesired outcome" -- well if you ignore revolutions in MENA, including the Al Qaida affiliated rebel forces in Libya, ignore the doubling of energy costs and unprocessed food costs and their effect on the poor and middle class, ignore the creation of another stock market bubble destined to collapse in a couple years or less, ignore the transfer of vast sums of wealth from the middle class to the well-connected bankster class, and ignore the renaissance of TBTF since 2008 -- there is no undesired outcome to what the Fed is doing.

Ask yourself -- why are the bottom 90% of Americans showing such low levels of consumer confidence? Why do they say the recession never ended? Are they just stupid? Or is this Fed unprecedented money-printing experiment a disaster for everyone who doesn't have their money in the stock and commodity bubbles?

I've decided I can't take seriously tracts that talk about falling wages fails to mention wealth, savings and expectations. There is something to substitute away from because if there are n goods, money is good n+1. If folks expect their money is becoming a better store of value than other things, they'll hoard their money with the belief they can buy cheap at some point in the future. If folks expect their money is going to lose value sitting under their mattress, they go out, buy back into that S&P 500 index fund, and life gets back to normal.

You don't mean to suggest that somehow this kind of policy will encourage corporations who are already sitting on $1 trillion in cash and recording record profits to horde even more cash in the face of deflation instead of investing it or hiring do you??? What in the world would lead you to believe that? I mean, the people that designed this policy would surely be looking after the best interests of working people would face even more crushing debt burdens instead of the wealthy who would see their purchasing and political power go through the roof, right?

Why? Why do you think this is a worthwhile model of reality? Why?

Yes, the market reaction to QE2 shows that Krugman's liquidity trap model is wrong. They are clearly determined to prevent declines in NGDP, which means wage cuts would help. Of course the very fact that people suggest wages cuts points to the fact that money is still too tight, as monetary stimulus is at least an order of magnitude more effective at promoting a timely recovery than wage cuts, which are likely affect only a few sectors. To be effective, it's not enough that wages fall where unemployment is high, they must all fall (relative to NGDP) in booming sectors like health care. Only monetary stimulus can do that.

I meant they must "also fall"

It appears that Scott Sumner, like our Fed masters, never met a bubble he didn't like.

"Too tight". Let's see -- oil has tripled off its 2008 lows, silver quadrupled, S&P doubled, Naz tripled, raw food prices doubled to tripled, cotton quadrupled, and Sumner thinks money is "too tight". Yeah, right.

the commodity price inflation and stock indices can be explained by booming economies in china, india and other growing emerging markets, and low interest rates and high corporate profits, respectively. Scott is right.

The only coherent way of characterizing monetary policy as being either too“easy” or “tight” is relative to the policy stance expected to achieve the central bank’s goals. The Fed should adopt the policy stance most likely to achieve its goals which implicitly are 2% core inflation and low unemployment. Since yoy core inflation is about 1% and unemployment is about 9% I would characterize that as, em, mighty "tight".

And those are relative price changes (as well as asset prices) that you are referring to. The Fed has little control over relative price changes. However it is worth mentioning that oil is still 30% down from its previous peak nearly three years ago, the S&P 500 is off 16% from its previous peak nearly 4 years ago, the Nasdaq composite is off around 45% from its previous peak 11 years ago, and raw food prices are up only 7% since July of 2008, nearly three years ago. Of the examples you mentioned only silver and cotton are up sharply. Silver is an important input in, well, er, almost nothing. The price of cotton is a fraction of the total cost of a pair of jeans. The price of labor somewhat more important, and unit labor costs are down sharply in apparel the last few years. And in fact apparel prices are up by exactly 0% since July 2008. So your implicit definition of "loose" is somewhat wanting.

So, yeah, I would say he's right.

The way for our country to be richer is for the people who live in this country to be poorer. Is that an accurate summation? Wasn't that Carter's point in his falsely named "malaise" speech? Wasn't the whole notion ridiculed and rejected by the Reaganauts? Are we now to believe that Carter was right 30 years ago?

"when you cut the price of everything — which is more or less what happens when wages fall across the board"

What? What about internationally traded commodities? Do they also fall by the same proportion? Do we really think oil prices will move with US wages perfectly? China matters only when its convenient.

Seems Krugman is delirious and sees zero bounds everywhere.


But, I'd like to know if anyone can comment on or describe the intuition of a "Clower-Leijonhufvud-Hutt upward spiral of employment and output."

Those calling for wage cuts are not volunteering to cut their own wages first to get the economy going, and they are generally the ones who call for making it harder to shed debt or have it written down to allow those whose wages they want cut to either shed or pay debt.

When Hoover was president, business, especially small business, was on equal footing with the individual, so public policy was directed in not only restoring the higher wages but also the higher prices.

I find it interesting that many failed to understand the aid to small businesses that even Hoover agreed to, small business in those days being farmers and ranchers, which involved paying for the lost business production, called cattle and crops, so the small businesses - farmers and ranchers - could pay their debt. I've seen many who call that ridiculous which makes it clear many think that the right way to run a small business is borrowing $2 to buy supplies to produce $1 in output, or in the "dust bowl" $0 in output, so that banks takeover the small business - farms - and then go bankrupt causing depositors to lose their money.

The only way it makes sense to call for lower wages is if you first call for debt write downs, then prices cuts based on the write down of debt to fund inventory and work in progress (farm-rancher debt), and then wage cuts supported by lower costs of living.

To call for wage cuts of others without those other measures is basically theft of property and living standards by an aspiring governing elite.

I am simply astonished Krugman could write that. Is there no capital to substitute away from? Is all labor really homogeneous in his mind?

The narrative about sticky-wages may be true, but it is a complicated narrative and hard to picture. Sticky house prices, on the other hand, are easy to picture. I can see them across the street. People are reluctant to take a nominal loss -- which is why house prices keep slowly sliding, month after month, never yet quite reaching a market clearing price. The Fed should create at least enough inflation for the housing market to clear. Until then the economy will continue to suck.

Yeah and IMO all the measures, other trying to create some inflation, that the Gov. has taken to keep home prices from falling have been counter productive.


Yeah and IMO all the measures, other than trying to create some inflation, that the Gov. has taken to keep home prices from falling have been counter productive.

The reason that I think that the measures like the $8000 credit to new home buyers were counter productive is that housing prices were so far above where they should have been to come in line even after a year or 2 of 6% inflation. It seems better to have the home prices drop sharply and start to build from there by drawing more conservative buyers who have been waiting.

Why would the Fed creating inflation cause house prices to go up? And do you really expect them to go up to bubble levels so some guy 20% underwater doesn't have to take a loss.

The best thing that could happen to a lot of people who are underwater is that prices decline a little more, they realize how idiotic it is to make payments on an underwater property, and default. They live through the "horror" of having bad credit for a few years and then everything is fine.

Here's what is a lot more likely to happen if the Fed tries to increase housing prices through inflation. It ends up chasing those few goods that aren't oversupplied: food, energy, tradeables, and wage rates of those who can restrict supply (healthcare, finance, etc.) For the Fed to create enough inflation to make house prices go up 20% you'd see $400/barrel oil.

The only sensible policy is for underwater homeowners to restructure with principal forgiveness, and for the banks that would make insolvent to be taken into government receivership. Have their managements removed, the management, shareholders, and bondholders all take varying haircuts, and spin them back out. Why not actually fix the problem: debt on house > house value, as opposed to spew money all over the place in some desperate hope it will end up bidding up one of the most oversupplied goods in our economy that everyone knows it toxic.

dave, your premise seems to be that houses are oversupplied. They aren't. They were back in 2007, but not much has been built the past 4 years -- housing growth is at the point where we are under-trend. The problem now is not that there are too many houses but that vacancy rates are not decreasing much. There is simply too much of a spread between what sellers are willing to sell for and what potential buyers are willing to pay, and the spread exists because money is so much tighter now than it was 4 years ago. I'm not suggesting we go from too tight to too loose, only that we should look for a Goldilocks middle. Global demand is driving commodity prices higher, but whereas that might send the price of wheat and sugar higher because they can be easily shipped to Asia it doesn't affect the prices of houses in Florida so much.

The problem is human psychology. It has been demonstrated that people are quicker to take a profit than they are to take a loss. If it weren't for that psychological sticking point the housing market would have cleared a long time ago. As it is, better the general price level rises so that people won't have to take as large of a nominal loss and the market clears quickly. It's really 6 of 1 a half dozen the other, but most people aren't willing to swallow the red pill and see things as they are.


Prices on oil and all commodities as well as stock prices are driven by the TBTF banks putting their free Fed dollars into anything with a ticker, not "Global Demand".

My premise is that housing prices should roughly follow metrics related to income and other such measures that have held pretty constant for decades till the bubble. If that's true, then house prices should probably be around 20-30% less then what most people paid during the bubble, varying wildly by market of course. I don't think consider credit in the housing market tight by any measure. If anything there are massive government supports. Any credit worthy borrower can get a quite generous rate on a mortgage loan from Fannie and Freddie. Tight credit isn't holding down prices, they are just getting pretty close to where they should be. If that is true, then people who bought in the bubble are going to be waiting a decade or two if they don't want to sell at a loss.

So if the supply of credit is not holding back house prices the only way to inflate them is to inflate the entire economy to such a degree that housing has to track up with all other prices. That's going to take an awful lot of inflation, considering houses are the last place that new money is likely to go. There are bound to be lots of negative side effects, and I don't expect prices to rise uniformly, but rather for those resources in tightest demand to be bid up the most (basic commodities we need to live). This is especially true given the Feds mechanism for creating new money is basically to shovel it to TBTF banks who then use it for various financial market speculations, as opposed to say just a massive payroll tax holiday so the money went straight to wage earners and was at least a bit more likely to push up wages instead of assets and commodities that have been securitized.

So once again, if the problem is that people don't want to sell houses they have negative equity in, just modify the damn principal down. Why are we messing with the idea of causing massive inflation to drive all prices up in the hopes it drags housing along for the ride when we can just mod these mortgages to current more reasonable market prices.

I thought that part of the point is that if wage cuts were focused on those with little unfulfilled demand and who aren't investing their income in capital it would tend to be beneficial: aggregate demand would be mostly unchanged, the primary result would be higher debt or lower long-term savings, and costs would fall, allowing those people who do have unfulfilled demand due to a shortage of the medium of exchange to fulfill more of their demand. On the other hand, if wage cuts primarily hit people who had unfulfilled demand already due to a lack of the medium of exchange, it would decrease costs without increasing consumption. In that case, lower prices might not keep up with falling wages, due sticky prices, and thus demand would fall, rather than rise, further decreasing the impetuous to hire and leading to further wage reductions.

I would propose that the most stimulative form of wage cuts would be the introduction of universal government-supplied health care. Companies would no longer base hiring on the cost of providing health care even if the costs were paid on the basis of higher corporate taxes, as well as the actual cost savings it would provide.

That may require that public health is more cost effective as well. But that's easy: the USA spends more per capita on health care than any other country in the world, regardless of how you measure it and receives relatively poor results for it.

That's how I present the argument up here in Canada, in any case, whenever someone suggests that we have something to learn from American health care. (I don't reject the possibility that our system could learn something from yours, but I am certainly not ware of what that would consist in.)

And I especially like how your suggestion could decrease the cost of labour for companies without hitting the workers paycheque.

Insurance company overhead is, on average, 17%, whereas Medicare has 5% overhead, so it doesn't necessarily require more cost-effective health care to see cost savings from a single-payer program. Especially if we factor in the current administrative overhead paid by hospitals in order to successfully track and bill the enormous quantity of insurance companies. I find this graph illustrative:

I support single payer for a lot of reasons, but I'm really tired of this untrue meme.

There are a lot of reasons for Medicare's overhead ratio, few of which have to do with "evil" insurance companies gouging. Consider the difference in the two insured groups, and the difference in what goes into overhead in the two numbers.

I worked in health care, so I do have some idea. In general, Medicare patients are less healthy and use more health services than non-Medicare patients, so I'm not sure what demographic characteristics you are referring to.

It isn't that insurance companies are "evil", and that's not what I was claiming: they are inefficient, which can be measured. They make about 3.4% profit, which I don't begrudge them but by definition that is money that doesn't need to be spent on health care. They have additional high overhead costs, produce worse outcomes than public solutions in other countries and gain most of their cost-savings through controlling who they enroll, not addressing health care costs. It takes overhead to know when someone gets sick in such a way that you can kick them out of your plan, but it is definitely profit-maximizing.

It's the absolute numbers not the % overhead that matters. As bad as they may be insurance uses that overhead to attempt to reduce costs. The gov probably needs more overhead %wise to resuce costs.

Where exactly is this zero interest rate money at, and where can I get it?


You can't, because you aren't one of the TBTF banks. All animals are equal, but some are more equal than others. . .

Of course I knew this, but wanted to point out the nonsensical assertion of a zero rate. The entire formula of investment being a function of interest can be misapplied when scholars assume federal funds and discount rates translate to prevailing capital costs in the general populace.

In the standard intro economics course the profs spend the entire course trying to convince the students that if you want more of something you raise its price.

Than they turn around and try to teach that if you want more employment you need to cut the price.

Next, the econ profs wonder why the students do not get it.

"In the standard intro economics course the profs spend the entire course trying to convince the students that if you want more of something you raise its price."

Oh dear. It's the other way around. When people demand (want) more of something, its price rises. But if its price rises for supply reasons, then people will demand less of it.

I wonder why you didn't get it.

"A different reason to be skeptical of wage cuts, as a mechanism for macroeconomic recovery"

Who said anything about recovery? It is about cash in the pocket or banks....

90% of the population reduced income by $100 equals a lot of money if one is saving
this expense and putting it into their pocket.

Do you think "they" care anything about recovery if profits are up and humming along?
Get Real or take the Meds......

I often hear references to them, but I've yet to see a good explanation online. I think Leijonhufvud is still around, so he should be invited on EconTalk.

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