Paul Krugman draws our attention to this very interesting 98-pp. paper by Bill Martin and Robert Rowthorn (pdf here, also see this Martin Wolf column). They argue that the current problems of the UK are almost solely demand-based, that the UK’s supposed productivity problem is much overstated and shows up in measurement largely due to labor hoarding, and that observed inflation is due mostly to import price shocks. There is more, so dare I suggest you read the whole thing?
I have a few points, which I will put under the fold…
1. The authors write: “There is an effective demand failure, high unemployment and, within companies, under‐utilisation of the employed workforce – a form of “labour hoarding”.” This implies radical deflation for competitive industries (MC = 0), which does not seem to be the case. Alternatively, it could imply no productivity decline for the more competitive industries, which also does not seem to be the case.
2. Real wages in the UK have been falling, post-recession. In the pure Keynesian view, how much further must they fall through monetary stimulus to restore full employment ? Isn’t this ultimately also a pessimistic view about UK productivity?
3. The authors acknowledge that worker productivity has fallen, but they blame this on cheaper labor, and view it as a symptom rather than as a cause. I doubt if you can fill most of the box that way, as efficiency wage effects are unlikely to be so large. In any case their mechanisms here are not very clear. Furthermore wouldn’t the story imply that further stimulus, by lowering real wages, would lower productivity even more?
4. The whole argument rests upon worker willingness to accept lower real wages (and lower nominal wage acceleration) in response to external shocks (see pp.32-33 on how nominal fits into the story and how the authors clearly assume considerable wage flexibility). Keynesians are otherwise suspicious of this kind of premise, and the real wage decline doesn’t seem to have just come from unseen price inflation. So why suddenly accept a wage flexibility assumption from these guys? And if that premise is accepted, why believe in such a big role for demand shocks? The basic story doesn’t fit together, and it doesn’t fit with Krugman’s own views.
5. Citing “import price shocks” as an explanation for recent UK inflation isn’t actually different from citing “supply side bottlenecks.”
6. This is more speculative: the UK boom of the oughties possibly can be understood as a joint boom of supply and demand, rooted in multiple equilibria. Investors have since reevaluated which equilibrium the UK “belongs” to. The “British story” just doesn’t seem so exciting any more, Jubilee or no Jubilee, and the credit rationing from the banks reflects this. A response to a very large shock can in fact reveal lots of information about future prospects. The authors don’t give much shrift to forward-looking theories and mechanisms. (By the way, maybe you don’t like multiple equilibria stories, but as I read the paper the authors also seem to be relying on one for the labor market wage-productivity link, though again I wish they would spell out their story more formally.)
7. Labor hoarding in the U.S. seems to have gone down a great deal, so it is odd to invoke it as the decisive factor to explain the UK data. It’s declining in popularity as an explanation more generally, and I don’t see what the authors do to resurrect it.
8. There were plenty of new hires after the recession ended; why didn’t firms just reallocate their surplus “overhead” labor that was being hoarded? The discussion circa p.37 doesn’t convince me, as it doesn’t face this question head on.
9. The effects of the credit bust are both demand-side and supply-side, and also suggest maybe that isn’t the key distinction here for the UK.
Let’s try a few general points:
10. There are admittedly some puzzling features of the recent UK economy, most of all how much real wages have fallen. But they are puzzles for all major theories, not just the supply side theories. Since this is a real wage decline, I tend to think supply side stories are going to have a big role here.
11. It is very likely that AD is a problem, but we just don’t know how large the UK output gap is. Given that, it is fine to call for credible nominal reflation, just don’t get your hopes up too much or oversell it.
12. This paper makes one more agnostic by stressing the unreliability of the data (such as business capacity surveys, which don’t suggest a lot of excess capacity). It doesn’t have a coherent demand-side story which fits the cited data, much less a demand-side story consistent with Krugman’s arguments and models.