Ryan Avent has a good blog post, and an associated column, and a post from two days ago, related to an issue I have been discussing, namely if the negative AD shock is so primary and so terrible why have we seen so much price stability and even some mild inflation? He covers so much ground it is hard to excerpt, so do read the whole thing, here is one summary bit:
The question is: if unemployment and disinflation typically go together, and if central banks effectively prevented disinflation, then why is there still so much unemployment?
I like what Ryan says but would stress some points which he does not relate. Here you will find Krugman and Martin Wolf on the same topic, again many good points but I don’t think they are addressing the crux of the problem.
The key problem is not how to reconcile observed rates of unemployment and inflation (although that is an interesting issue), rather the key problem is how to reconcile observed rates of inflation with repeated claims made about the relative importance of negative AD shocks as the initial sin. That’s the elephant in the room.
Again, wage stickiness might explain why “pressures for five percent deflation” might be translated into no more than “actual two percent deflation.” It will not explain why deflationary pressures are translated into say “1.6% price inflation.”
My take would be this. Let’s start with a simple AS-AD model and assume the AS and AD curves both shift back to the left. It’s then easy to get a fall in output and employment without much if any deflationary pressures.
There is no need for “did they forget how to make ice cubes?” jokes or “was the Great Depression caused by soup kitchens?” kind of unperceptive remarks. Two simple candidates for the AS shocks are increases in the risk premium and credit contraction; I would add TGS-related ideas as well.
For a bit more detail, consider a credit collapse, as we’ve been seeing for instance in Spain. Due to a evaluation of expectations about the future of Spain and the security of euros in Spanish banks, credit dries up and some small and medium-sized businesses go under or cannot expand. Sometimes the credit collapse is driven by deposit flight, other times by the need to recapitalize banks, other times by the greater riskiness of the real economy. A credit collapse is both a negative AD shock and a negative AS shock together.
After all this, you can toss in inflation targeting, if need be, to help explain why so many countries are in the 0-2 percent inflation range. But in any case the net deflationary pressures are not so strong in the first place.
Krugman, by the way, recently considered the view that both demand-side and supply-side forces might be at work, but his response is hardly an argument at all:
Oh, and one more thing: no, you can’t say “Well, there may be truth to both views”. Either the economy is supply-constrained or it’s demand-constrained. Of course even the most ardent demand-siders will admit that there are supply constraints in there somewhere, that if we had an economic boom we would, after some period of time, enter a regime where printing money is inflationary and government borrowing drive up interest rates. But not here, not now.
There is not much here, other than “Either the economy is supply-constrained or it’s demand-constrained.” But that’s oddly non-marginalist. The supply and demand sides interact like Marshallian scissors. It’s not that one or the other has to be some kind of immoveable wall, or vertical curve, beyond which the other cannot budge. A few seconds looking at shifts of AD and AS curves, as mentioned above, can establish this.
In sum, there is no big puzzle once we recognize that significant AD and AS shocks have been at work.