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A couple years ago I did some posts strongly criticizing the Krugman/Eggertsson argument that the AD curve might slope upward when the economy is stuck in a liquidity trap. If this “paradox of toil” were correct, then moves to increase AS (say by payroll tax cuts or an increased desire to work) would reduce output. Higher minimum wages might increase output. Here’s Tyler Cowen on February 3, 2012:

Another big loser is those liquidity trap theories which tell us that positive real shocks are bad for the economy because the AD curve has a perverse slope, etc., and that negative shocks might help spur recovery. That theory is looking very weak, again. I consider it the weakest economic theory that has any currency in the serious economics blogosphere.

I’m not sure it has much currency today, as three respected bloggers attacked this view within a 24 hour period. Here’s Karl Smith:

Sometimes I think I am detecting a sense that folks are concerned that Labor Force participation will affect the unemployment rate. Eh. Its complicated but there is no lump of growth nor a lump of job creation even in a recession. To put it terms now common place, the number of people who want to work affects the natural rate of interest. If lots of people are trying to work they will drive up demand for capital and durable goods in the attempt and this will drive up the natural rate. In the face of a constant Fed Funds rate this will mean a faster growing economy.

And here’s Ryan Avent, responding to Jared Bernstein’s call for a higher minimum wage:

That last, substantial rise in the minimum wage looks strangely familiar. In fact, it mirrors quite closely the sharp rise in unemployment that occurred over a similar time frame. Now, I wouldn’t begin to suggest that the rise in the minimum wage caused all of that unemployment. And, generally speaking, I’m prepared to accept that in most cases, small increases in the minimum wage are less harmful than straightforward micro would have us believe (although it also seems to me that as a means to fight poverty, minimum wage rises are a far worse idea than other alternatives, like wage subsidies or, hey, tight labour markets). Still, this is terrible timing for a proposal like this. The unemployment rate for workers without a high-school diploma is currently 13.1%. For workers between 16 and 24 it’s 16.0%, and for those between 16 and 19 it’s 23.2%. These are not high marginal productivity workers. I’m trying desperately to think of a dynamic in which raising the cost of employing these people increases their employment, but I just don’t see it.

And here’s Matt Yglesias:

It’s been suggested that recent events have refuted the Eggertsson analysis, but I think that if you look more closely you’ll see that all this work on Retro Keynesianism was predicated on the economy being in an actual state of deflation that the central bank is unable or unwilling to reverse. What actually happened in the United States, however, is that we had a brief deflationary episode followed by an extended period of sub-trend NGDP growth. That’s produced some of the ills you might associate with inflation, but it means that the conditions under which Retro Keynesian ideas were allegedly supposed to apply don’t currently exist and haven’t existed for some time. Under the circumstances, the theoretical questions are perhaps interesting to model-builders and academics but we (thankfully) aren’t living in the kind of universe that would put them to the test.

Yup. If there truly are an infinite number of universes then it’s possible there’s one where “Retro Keynesian” is true, but we aren’t in that one. I’d add that the standard Keynesian model of the fiscal multiplier is also based on the notion “that the central bank is unable or unwilling to reverse” demand shortfalls caused by a lack of fiscal stimulus, although I’d guess Smith, Avent, and Yglesias wouldn’t go quite that far.

Peter Laan sent me the following, from a VoxEU post by Jonathan Portes:

Finally, and returning to what I originally learned at the Treasury, there still remains the view that if we think demand is too low, then the right response is always through monetary rather than fiscal policy. Again, there is a vigorous debate among blogging economists on this topic (see Economist 2012 for an introduction to the debate). And here my perspective has indeed changed; I no longer subscribe to the Treasury View of the last two decades, described above, that fiscal policy never has any role to play in demand management, even though I don’t think it should be the tool of first resort. (See the excellent discussion in Simon Wren-Lewis 2012a, especially the penultimate paragraph). But just as this approach was motivated by pragmatism more than theory – monetary policy was better suited to this task – my change of mind is similarly motivated. If monetary policy alone was indeed enough in practice, we wouldn’t be where we are now, with unemployment in the UK a million higher than the official estimate of the natural rate, and no prospect of it coming down in the immediate future. As I have argued previously (Portes 2012), any demand management policy that delivers that outcome is not one that policymakers should regard as remotely adequate. So my views have indeed changed; not, I would argue, ideologically, but in recognition of the fact that life, and macroeconomics, is considerably more complicated than we thought. Again, this view is shared by Blanchard, who argues: “We’ve entered a brave new world in the wake of the crisis; a very different world in terms of policy making and we just have to accept it. … Macroeconomic policy [specifically fiscal and monetary policy] has many targets and many instruments.” This pragmatic and questioning – but evidence-based – approach to macroeconomic policy is one I share. If he were here, I imagine Keynes would too.

When I read things like that I really want to pull my hair out. He says his views on monetary policy changed, but gives no logical reason why. Did the BOE fail to hit its nominal targets? Didn’t Gordon Brown pursue one of the most aggressive fiscal stimulus programs in the world? And hasn’t Britain had one of the most disappointing recoveries of any non-eurozone economy? And the takeaway from this is that fiscal stimulus works and monetary stimulus doesn’t work? This kind of argument drives me nuts.

Portes also claims that the argument against Keynesian fiscal stimulus is based on Ricardian equivalence, and doesn’t even mention the more important argument that in standard new Keynesian models the fiscal multiplier is close to zero when the central bank targets inflation. Given the inflation rate in Britain over the last few years, I don’t think even the most fanatical Keynesian would claim that the BOE has been unable to keep inflation as high as they’d like. But that’s the assumption you need (in the new Keynesian model) to make fiscal stimulus work. Here’s David Romer:

As Robert Solow stresses in his remarks in this session, we should not be trying to find “the” multiplier: the effects of fiscal policy are highly regime dependent. One critical issue is the monetary regime. Consider estimating the effects of fiscal policy over the period from, say, 1985 to 2005. Central banks were actively trying to offset other forces affecting the economy, and they had the tools to do so. Thus if they were successful, one would expect the estimated effects of fiscal policy to be close to zero.

David Romer doesn’t think this applies to the current situation in the US. But does anyone seriously think the BOE has been unable to keep inflation as high as they’d like? Imagine the laughter in the UK if a pundit made that claim on TV.

Marcus Nunes has a nice new post on fiscal stimulus, NGDP, and RGDP. The graphs are quite illuminating. Compare Britain to the other countries (in terms of government spending and the RGDP/NGDP split) and tell me why I shouldn’t believe Britain has serious supply-side problems.

PS. Nunes’s graphs show the public sector in Sweden is now much smaller than in France. Quite a turnaround from a few decades back. Come to think about it a few decades back France was doing better than Sweden, and now the reverse is true. Now I’m sure the G/GDP ratio will shrink as soon as France “recovers.” But given that the unemployment rate in France has been stuck at 10% for 30 years, the recovery may take a little while.

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