Twitter economics has again led us astray

Do read through my whole argument, here is just one segment from my latest Bloomberg column:

One theory about the benefits of an overheated labor market stems from the work of Robert E. Lucas in the 1970s, which in turn built upon ideas from Milton Friedman. In Lucas’s model, if the central bank boosts the money supply and the rate of price inflation, some people will work more or expand their businesses because they think there is a real and enduring increase in the demand for their output.

That makes sense theoretically, but subsequent empirical studies showed the effect is typically small. In 1986, Lawrence H. Summers wrote a critique of these and related ideas, and the economics profession rightly decided to move on. Inflation does change people’s work and production plans, but not by very much.

A second argument has remained more robust: the Keynesian idea of money illusion, outlined in Keynes’s General Theory. According to Keynes, a central bank can boost the rate of employment by inflating. If nominal wages are sticky, and the rate of price inflation goes from 0% to 5%, inflation-adjusted wages will suddenly be 5% lower. Businesses will hire more workers.

Even if you are an unreconstructed Keynesian economist, you might notice a problem with this mechanism: It boosts employment but not real wages. In fact, it boosts employment by lowering real wages, which is a pretty typical economic mechanism. So if the idea is to “run labor markets hot to raise worker pay,” this approach isn’t going to help. Instead it will increase the temptation to solve employment problems by looking for ways to cut real wages, not raise them.

“Running the economy hot” is a metaphor — it is better to respond with an actual model/argument, and noting the recovery was slow last time does not suffice!