Wednesday, July 17, 2013

A Paradox of Flexibility or Central Bank Incompetence?

Paul Krugman and Mark Thoma are again making the case against increased wage flexibility in a depressed economy. They contend that rather than helping labor markets clear, increased wage flexibility in a slump will create wage cuts that only serve to lower incomes. In turn, spending will weaken and further stoke the existing deflationary pressures. Policy makers, therefore, should avoid the siren call of reforms that enhance wage flexibility.

This so-called "paradox of flexibility" dates back to John Maynard Keynes, was endorsed by James Tobin, and continues to be advocated by prominent New Keynesians like Gautti Eggertson. Despite this long pedigree, there is a big problem with this view: it assumes that central banks are incompetent. The only reason wage cuts should lead to deflation and a sustained decline in aggregate nominal income is because monetary policy allows it to happen. This very point was demonstrated by none other than Gautti Eggertson and his coauthors in a 2012 paper:
[C]onsider demand shocks. For an increase in price flexibility to be destabilizing we find that the key condition is that the central bank does not raise/cut the nominal interest aggressively enough in response to movements in inflation. Intuitively, what is going on is that a higher price flexibility can trigger unstable inflation expectations if monetary policy does not act aggressively to counteract this by raising/cutting interest rates.
So there is no "paradox" here, but just good old fashion policy failure. Even at the ZLB this is true, since there are policy options--both monetary and fiscal--that can hold back deflation. Even the Fed's flawed approach over the past four years has done that. Fed polices have kept both deflation at bay and nominal income growing, even in the face of a shrinking structural budget deficit. So why fret about increasing wage flexibility? Reforms that improve the working of relative prices by enhancing wage flexibility should be no problem given the Fed's track record. Yes, the Fed could be doing more, but that is far different than saying it would allow the collapse of the price level and aggregate nominal incomes needed for this "paradox of flexibility" to arise. 

Given a competent central bank, increased wage flexibility is fully consistent with growth in aggregate employment and income. Moreover, it probably would hasten a quicker recovery than monetary policy alone could generate. This slump has been so long that many cyclically unemployed individuals may have become structurally unemployed. Labor market reforms that increase wage flexibility would help them. We can have our cake and eat it too when it comes to wage flexibility.

18 comments:

  1. David, until the masses understand that it was bad monetary policy that brought on the Great Recession, not all the other "excuses", monetary policy will be seen as "ineffective". Only things like government spending, taxes and avoidance of more wage flexibility will "save us".
    The idea that MP IS setting the interest rate has been a terrible consequence of NK teaching.

    ReplyDelete
  2. I'm not an economist but this fits my mathematical intuition of the issue. It's nice to be validated by a professional.

    As I commented on the Thoma post: Could the minimum wage be hiding important price signals and deflationary trends and actually preventing the fed from stimulating enough?

    ReplyDelete
  3. "So why fret about increasing wage flexibility?" Because you believe the the drop in aggregate income from lower wages will not be fully offset by the Fed (due to unwillingness or inability) and, therefore, it will have a net negative effect.

    ReplyDelete
    Replies
    1. Foosion, then we agree there is no paradox but policy failure. But even then, the Fed has shown it won't allow deflation over the crisis. So why do you think the Fed would allow deflation to emerge if wages became more flexible?

      Delete
  4. You seem to have focused on trying to disprove that wage flexibility "stoke(s)the existing deflationary pressures" rather than "spending will weaken" which will slow growth.

    Open up the field of view a little and more "slow growth" problems with wage flexibility become evident. First, wage cuts or stagnation have been shown to result in increasing concentration of wealth which lowers growth in the long term (I think this revelation goes back to Adam Smith.) Second, the record shows that most "central banks are incompetent" so this assumption should be made. Third, central banks don't control fiscal policy so how does having a "competent" CB prevent deflation when fiscal action is needed?

    ReplyDelete
    Replies
    1. Anonymous, like I told Foosion the Fed has shown it won't allow deflation. It may not give us the inflation we want either, but it certainly abhors deflation. So yes, the Fed has been incompetent in generating a full recovery, but it has been competent in preventing deflation. Given that, I see now reason why wage flexibility will be a problem.


      Delete
    2. Given that, I see now reason why wage flexibility will be a problem.

      [Glad that you have finally come to your senses.]

      Delete
    3. Anonymous, funny play on my typo. It should be "I see no reason why..."

      Delete
  5. Whose wages are we exactly talking about, hmmn, lets see, How about professors in overpriced colleges.
    Keynesian analysis: Future debt-ridden students will spend future income in other areas of the economy, who will spend their income with greater velocity than above said professors. After all how fast can these professors spend all their hard earned money, anyway. Krugman looks like he could shed a few pounds. A pay cut would do him good...

    ReplyDelete
  6. I have a mortgage that has gone underwater. I have car loans and my kids are starting college.

    Please advise how - when the hideousness of these sticky wages are finally vanquished from the nightmares of our precious wealthy titans of industry - my shrunken wages don't bankrupt me or demand that I (and my college age kids about to become saddled with future debt for which bankruptcy cannot legally erase) massively reduce spending on things like, I don't know, food?

    I'm just curious.... because, here in the real world where virtually no debt forgiveness is feasible, there must be some magical macroeconomics wand that reduces principal where I can't change the principal nor interest rates. And my dreadful understanding of economics indicates that if I and all my neighbors stop spending money, the economy contracts, too.

    So what have I missed in this? Where is it that my impoverishment helps the economy as a whole?

    Please help - I need to become wise.

    ReplyDelete
    Replies
    1. I agree! Even if we accept the argument that the CB won't allow deflation, and even if we ignore the fact that the ZLB does limit the amount of traction orthodox Monetary policy is going to have, and even if we further ignore the political and distributional impacts of diverting money from workers (who are likely to spend) to businesses (who have nowhere to invest), we are still stuck with the problem of effectively making the debt problem worse! Unless by 'preventing deflation', you mean preventing a fall in wages, but then what exactly is the point of this wage flexibility? To someone who is not an economist, this argument looks a lot like someone coming up with any argument possible to arrive at a preordained conclusion - that the 99% need to have less so the 1% can have more!

      Delete
    2. Hey, timm0

      It seems to me that Prof. Beckworth thinks that:

      1- Your nominal wages will rise in line with inflation so, at worst, nothing happens in the real world...
      2- ... except that your debt load get eaten away by inflation, which would be a good thing for you.

      TBH, I don't get it and I would be happy for a deeper explanation. How is (1) not cancelling the 'advantage' of wage flexibility? And, if (1) doesn't occur and real wages do get slashed, as per timm0's point (and my own: see http://theredbanker.blogspot.com/2013/06/on-scott-sumner-monetary-policy.html ), how is this not going to lead to the Paradox of Flexibility?

      Basically, I am still unclear as to what Fed-induced inflation does for the real world, except reducing debt-loads by stealth.

      Delete
  7. Where, in fact, will this deflation take place in the US, anyway. The majority of private sector workers are at their lower bound(point where if their wage is lowered it doesn't pay to show up anymore) in fact, I believe, lower wages in some sectors would be a boon, lower taxes(public sector wages or why does it cost $28 in tolls to go from Brooklyn to Jersey), aforementioned tuition costs(see what salaries are at at NYU), medical(I defy anyone to figure this one out), inflated housing costs(all you microeconomists,Hello). Point is money is in too few hands and real problem is velocity, probably more so than liquidity and I won't believe differently until I find myself knee deep in milk....

    ReplyDelete
    Replies
    1. Debt deflation would destroy credit and thus jobs, income and money. The only thing worth being in would be cash at that point.

      Money is in to few hands, but lower tolls and education costs aren't going to change that. Money inflation is down and that velocity isn't going to change with lower public sector wages which aren't that high now.

      Your problem is not understanding that the corporate balance sheet side is doing well and finally expanding for the first time since the 70's. They don't want the velocity of money(aka money inflation) to rise much.

      Delete
  8. This is a confusing post-I think the good professor needs to do a retake...

    ReplyDelete
    Replies
    1. The post seems straightforward to me. Reform labor markets and have monetary polcy do its job. This really isn't that hard, do both structural reform and stabilization policy.

      Delete
  9. Good post---and yet, the main point, that the Fed has been reckless in its policy, does not come through.

    The Fed had recklessly pursued a low-inflation goal, even when the economy stalled, sank, and barely recovered.

    The Fed recently, and again recklessly, bantered about "tapering down" when the market and economy obviously need "tapering up."

    Sadly, the economics profession has bought into the idea that a "prudent" Fed policy is timid, or "conservative" in term stimulating growth, while being active in terms of limiting inflation.

    In fact, the aforementioned is reckless, cavalier Fed policy, for anyone who works for a living or trying to make a profit in the non-financial sector.



    ReplyDelete
  10. Avail Home Loans in Sydney at Iloans direct. Get in touch with them and find the best home loan deals online.

    ReplyDelete