Before starting this post, let me highly recommend George Selgin’s recent post on NGDP targeting.
Nick Rowe has a post discussing a scenario where a lack of media of exchange disrupts trade, without affecting employment and output:
I would call that a “recession”, even though (by assumption) output, employment, and (aggregate) consumption are unchanged. People are worse off, because of a reduction in the volume of exchange, due to a reduction in the circular flow of money around the Wicksellian triangle.
Nick’s terminology is unconventional; recessions are usually defined more in terms of output and employment. I’d prefer a third definition—a sharp rise in the unemployment rate, regardless of what happens to output. But I don’t get to choose definitions, so rather than fight a losing battle I’ll invent a new word for the concept I’m interested in. Let’s call an employment recession an “empression”.
To see the difference, imagine a primitive economy where all workers are peasant farmers. There is zero unemployment, as all are self-employed. A spell of bad weather would cause a recession (falling output), but not an empression. However, it just so happens that in the US all recessions seem to also be empressions, and all empressions seem to be recessions. In the following graph, the grey bars reflect recession periods. You can see that sharply rising unemployment is a necessary and sufficient condition for a recession. You can’t say that about inflation, stock prices, yield spreads, steel output, or numerous other variables.
Lots of things might cause a higher unemployment rate. These include:
1. Sharply higher minimum wage rates, or a surge in union organizing.
2. A sharp rise in the share of GDP going to capital, meaning less money to pay wages.
3. A sharp rise in hours worked per week, meaning fewer workers are needed to produce the same nominal output.
However, I don’t believe that any of those factors are important causes of the US business cycle, at least since WWII. Rather the problem is sticky nominal hourly wages and unstable NGDP. Before looking at NGDP, lets examine the growth rate of total labor compensation:
Notice that nominal labor compensation growth slows sharply during recessions and empressions—every single time. So the problem does not seem to be a surge in hourly wages, rather the labor market is being starved of funds to pay workers—my musical chairs “model” of unemployment. (Or perhaps “metaphor”, as respectable economists wouldn’t think it rises to the level of being a model.)
So what causes nominal labor compensation growth to slow at various times? Does the corporate sector suddenly grab a bigger share of national income, leaving less money to pay workers? Or does growth in national income itself slow? Not surprisingly (as labor compensation is a big share of national income) it’s the latter. It turns out that falling NGDP growth (combined with sticky hourly wages) is the proximate cause of both recessions and empressions:
Recall that I said that wage spikes don’t seem to be the cause of recessions and empressions. There is, however, one wage spike that made a recession/empression somewhat worse than one would have otherwise expected. Notice that the slowdown in NGDP growth was pretty modest during the 1973-75 recession. And yet that was one of the more severe postwar recessions/empressions. Why? It turns that that 1974 saw an unusual wage shock, something that generally does not occur during US recessions:
Why did wage growth spike during the 1974 recession? I’d guess it was because Nixon phased out his wage controls during 1974, and workers demanded wage increases to compensate for the high inflation of 1973-74. But while that sort of situation may be common in some unstable developing countries, it’s pretty unusual in the USA. And even during 1974, slowing NGDP growth was still part of the story. The 1974 recession was one part NGDP shock and one part wage shock.
So the cause of post-war US recessions is actually quite simple. NGDP growth slows while nominal hourly wages are sticky, and thus employment falls while unemployment rises.
Why don’t workers offer wage flexibility to prevent high unemployment? For the same reason that Wall Street financiers don’t offer indexed bonds to prevent falling NGDP from creating financial crises—it’s a collective action problem. If any one worker agrees to flexible wages, it doesn’t help him preserve his job. He shows up at the factory gate and finds his workplace is closed down. Only if all workers have flexible wages can we avoid a recession/empression during periods of sharply slowing NGDP.
If all workers bargained collectively that might be possible. But a labor union that covered all 150,000,000 workers would create lots of microeconomic inefficiency, which might be even worse than the business cycle. Better to use monetary policy to keep NGDP growing at a steady 4%/year, or something close to that figure.
To summarize, recessions/empressions are quite simple. A combination of sticky nominal wages and unstable NGDP (i.e. unstable monetary policy) causes recessions. At elite universities they have models that don’t even feature nominal wages and NGDP. Rather they focus on price inflation, interest rates, output and other irrelevant variables. Again, sticky wages and unstable NGDP are pretty close to a necessary and sufficient condition for US recessions/empressions—no need to look for microfoundations. No need to make it complicated.
The policy implications are also simple. Adjust monetary policy to keep market expectations of NGDP growing along a 4% trend line. That will mostly solve the problem of empressions in the US, and any remaining movement in RGDP will be an efficient “real business cycle”, not be worth worrying about.
READER COMMENTS
Lorenzo from Oz
Jun 23 2018 at 7:43pm
This post is a keeper.
(I still read your blogging religiously, I just comment less than I used to.)
Scott Sumner
Jun 23 2018 at 9:00pm
Thanks Lorenzo, You’ve followed me longer than most commenters, and your comments are always thoughtful, even points I might not agree with.
BC
Jun 23 2018 at 10:19pm
Does Wall St experience less cyclical unemployment than other industries? A large fraction of compensation on Wall St is “bonus”, air quotes because the expected bonus each year is positive instead of zero. In down years, firms can and do cut nominal compensation below expected compensation by not paying or paying smaller than expected bonuses. What about high-end restaurant employment, where waiters’ compensation is largely tip based? When business slows, compensation drops naturally. Wall St and restaurant customers may still suffer unemployment during recessions, but shouldn’t the reduced demand result in lower Wall St and restaurant compensation rather than reduced employment?
Why do more industries not pay “bonuses” like on Wall St? Workers generally like to receive “bonuses” and don’t seem to view below average bonuses in the same way as nominal wage cuts. Call it the “bonus illusion”. Employers should welcome ways to cut compensation during recessions without appearing to cut wages.
Scott Sumner
Jun 23 2018 at 11:40pm
BC, Again, it’s a collective action problem, If one industry has flexible wages, it does not shield that industry from the effects of falling NGDP. For that, you need all industries to have flexible wages.
Bruno Duarte
Jun 24 2018 at 7:04am
Mr Sumner, plotting work effort along with NGDP shows:
more predictive value of recessions in the 60s and the 90s;
the same predictive value in the 70s and 80s;
lower predictive value before 2008.
Perhaps financialisation would help as it seems to increase when NGDP begins declining – except after 2009.
In those terms, plotting compensation, effort, NGDP and financialusfinan indexed to 1990 shows the Fed was absolutely right to start lifting interest rates.
Is your view on NGDP somewhat linked to financialisation/debt intensity?
There’s a post about it, with illustrating charts.
HARRY CHERNOFF
Jun 24 2018 at 11:00am
Scott:
If the 4% NGDP growth policy has no adverse effects on labor markets, fx markets, credit markets, equity markets, real asset markets, intergenerational fiscal balance, and so on, why would the Fed (read: Congress and the President) want to stop there? Every politician will demand a) 5% and then 6% NGDP growth or higher, and b) indexed labor compensation growth so that the growth itself becomes sticky (like Social Security COLAs or inflation-indexed living wages). Such a system has to have one or more limiting factors. The Minsky Financial Instability Hypothesis has to come into play at some point. What and where are your limiting factors?
TMC
Jun 24 2018 at 1:23pm
Good post. Well thought out, and right in your wheelhouse. I didn’t care for Rowe’s definition of recession, it didn’t make sense to me. How are people worse off if consumption is the same? (For half a second I thought it was a link to Mike Rowe – That would have bee cool.)
Scott Sumner
Jun 24 2018 at 7:13pm
Harry, I don’t see why Congress would ask for more nominal growth. If they wanted it, they’d currently be demanding that the Fed raise its inflation target to 3% or 4%. Do you see Congress doing that? Me neither.
And I don’t see any reason why Congress would demand indexed wages with a 4% NGDP target but not a 2% inflation target.
Financial instability is largely a product of government created moral hazard, plus unstable NGDP. The solution is to abolish FDIC and institute NGDP targeting.
HARRY CHERNOFF
Jun 24 2018 at 8:56pm
Scott:
I’m asking a different question than the one you answered. I’m not asking whether Congress is happy with the Fed targeting inflation at 2% versus 3-4%. I’m asking why Congress would ever be satisfied with stable NGDP growth (independent of the level) under any Fed regime. The issue isn’t the NGDP level or the growth rate, it’s the effect of stability on fiscal policy.
The GOP use stability to support their claim that deficits don’t matter and that no matter what percent of national income goes to taxes, it can be lower. If the GOP can produce high and stable NGDP with their current fiscal policies, it proves that they can get higher and equally stable NGDP out of even more policies just like it. A lot of people think this makes perfect sense.
The Dems use stability to claim that there’s plenty of room for more taxes, more spending, hotter AD, and a greater share of NGDP for labor vs. capital. Also, meeting every unmet Dem social objective (affordable housing, free tuition, free healthcare, etc.) means higher and equally stable NGDP in the long-run. A lot of people think this makes perfect sense.
My claim is that any extended period of NGDP stability is going to bring about one of these fiscal regimes because neither party will accept stability making sense. They’ll treat stability as the ultimate justification for going as far as they can until some destabilizing event prevents them from going any further.
It’s the same logic (or lack of logic) associated with MMT. As long as the system is stable, do politically popular stuff until the system breaks because it’s simple, inexpensive, and pain-free to unbreak the system if anything bad ever happens (which would always be the other party’s fault anyway).
Do we really want that much stability?
HARRY CHERNOFF
Jun 24 2018 at 10:20pm
One more comment, more important than Congress not being satisfied with any particular level of NGDP stability.
Large parts of the global financial world would use Fed-generated NGDP stability as a way to take leveraged risks that would be insane in a cyclical NGDP world. At some point, the global financial system would break, just like in 2007-2009 except worse.
Eliminating the FDIC to deal with moral hazard is fine but it’s one agency and one type of moral hazard. It’s a drop in the leveraged asset and leveraged derivatives bucket, globally speaking.
Michael Sandifer
Jun 25 2018 at 2:57am
Scott,
Good post. That’s how I conceptualize recessions.
If you feel like it, you can check out a short post about my model that translates changes in the S&P 500 into changes in GDP. I model the GDP crash during the US financial crisis, comparing it to FRED data.
I include a graph with implied GDP, year-to-date, at the end.
https://wordpress.com/post/thehonestbrokernet.wordpress.com/390
Michael Sandifer
Jun 25 2018 at 9:29am
Sorry, but the link I offered above is wrong. Here’s the right one:
https://thehonestbrokernet.wordpress.com/2018/06/25/test-of-the-sp-500-based-implied-gdp-model/
Scott Sumner
Jun 25 2018 at 4:03pm
Harry, Crazy stuff still harms the economy, regardless of whether we do NGDP targeting or not. We still have to count on Congress having good sense, there is no way around that problem.
Michael, Sorry, but I can’t tell what that’s showing.
Michael Sandifer
Jun 25 2018 at 4:38pm
Scott,
Sorry if the graphs and brief explanation are unclear. I developed a formula to translate changes in the S&P 500 into perceived changes in US GDP.
The graphs show change in perceived GDP level, starting from a baseline of zero. The chart below them has FRED GDP data with which to compare to the graphs.
Though, not perfect, for the reasons mentioned in the post, I wonder if such a model might be useful for targeting NGDP, at least during shocks.
Nick Rowe
Jun 25 2018 at 7:31pm
Hi Scott: Suppose the car mechanic works all day tinkering with his own car because he can’t find a customer who is willing to pay him money to repair the customer’s car that needs fixing. Or digging his own garden to grow the food he wants, even though he has a comparative advantage in fixing cars.
In ordinary language he’s still “unemployed”, in any meaningful sense, even though (by assumption) he’s working (for himself) full time. And if lots of workers are like that mechanic, I say it’s still a recession.
As micro says, trade (normally) makes people better off. And if a shortage of money disrupts trade, people are worse off. Whether they respond to that disruption in trade by engaging in home production, or leisure, is just two different choices to make the best of a bad situation. It’s still a recession, whichever choice they make.
Marcus Nunes
Jun 26 2018 at 12:18pm
Along the same lines. Explaining why Powell can say Fed has little experience with below 4% unemployment!
http://ngdp-advisers.com/2018/06/26/we-delude-ourselves/
Ralph Musgrave
Jun 27 2018 at 4:04am
Scott is right to say “Only if all workers have flexible wages can we avoid a recession..”. But it’s important to be clear on why that is. In a totally free or “flexible” market, wages and prices would fall in a recession, which would increase the real value of the private sector’s stock of base money (and government debt, which is virtually the same thing as base money, as explained by Martin Wolf, Warren Mosler and others). That rise in private sector liquid paper assets would encourage spending. That’s the so called “Pigou effect”.
The nearest real world thing to the latter free market cure for recessions is to increase the private sector’s stock of money via a combination of monetary and fiscal policy: i.e. have the central bank and government create money and spend it, and/or cut taxes. That boosts the real value of the private sector’s stock of money.
In contrast, interest rate cuts do not increase the latter stock. I expand on that point at the link below, which advocates a permanent zero interest rate (also advocated by Milton Friedman and Warren Mosler).
http://www.openthesis.org/documents/permanent-zero-interest-rate-would-603707.html
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