Additive Shocks By Bryan Caplan

A common complaint about Sumner is that he ignores important real

shocks, such as the “Recalculation Problems” that Arnold keeps pushing. I’m still not convinced that recalculation is a big deal, though this graph that Arnold’s promoting is the kind of evidence that might eventually change my mind.

Whether or not I convert to the recalculation story, however, Sumner’s main points still stand. Why? Because real and nominal shocks are basically additive.

To see why, consider two variants on the following thought experiment: Over the last five years we wasted 10% of GDP on mud pies. Now we’ve suddenly realized that no one wants mud pies.

Variant #1: Scott Sumner runs the Fed. He keeps nominal GDP growing at 5% per year. What happens? Unemployment still rises – and measured output falls – because mud pie workers have to look around for a better use of their skills. But output of non-mud-pies gradually rises as the productive 90% of the economy absorbs the cast-offs of the unproductive 10%.

Variant #2: A misguided utilitarian deflationist (he likes Rothbard’s macro, but not his ethics) runs the Fed. He adjusts the money supply to make nominal GDP shrink by 5% per year. What happens? The mud pie industry still collapses. But unless psychological resistance to nominal way cuts changes far quicker than it ever has in the past, workers throughout the economy quickly become grossly overpaid relative to their productivity. This leads to massive falls in employment and output in the industries that would otherwise absorb the displaced mud pie workers.

Leading Question: If you subtract the damage in Variant #1 from the damage in Variant #2, what do you get? You get exactly the damage you would expect if the mud pie debacle never happened BUT our misguided utilitarian deflationist made nominal GDP shrink by 5% per year! Namely: Massive unemployment caused by excessive nominal wages, and a corresponding fall in output.

P.S. If this seems horrifically Keynesian to you, I have to point out that Rothbard, Dr. Deflation himself, quietly grants my two key points in a crucial section of America’s Great Depression:

1. Deflation reduces employment and output when wages are downwardly rigid.

It is, moreover, a common myth among laymen

and economists alike, that falling prices have a depressing effect on

business. This is not necessarily true. What matters for business is not

the general behavior of prices, but the price differentials between

selling prices and costs (the “natural rate of interest”). If wage rates,

for example, fall more rapidly than product prices, this stimulates

business activity and employment. [emphasis mine]

The flip side, obviously, is that if wage rates barely fall at all, and product prices do, the “common myth” is true.

2. Wage rigidity is partly a product of human psychology, not just unions and regulation.