Wages, Prices, Depressions, Deficits (Wonkish), by Paul Krugman, in NY Times: I mentioned the piece by Capital Economics arguing that policy makers in Britain are greatly understating the output gap, the amount of excess capacity in the economy, which is leading to badly skewed policies. This actually raises a whole set of related issues, with bearing on the US as well. So here’s a longish, wonkish discussion.
So: the starting point here is the official estimate by the Office of Budget Responsibility that Britain right now has an output gap of less than 3 percent. This is a remarkable assertion, when you bear in mind that real GDP remains well below its level pre-crisis, and that we used to think that Britain’s long-run growth rate was around 2.5 percent. As the CE guys say, simple trend projection would indicate a shortfall of 14 percent; how did that become less than 3?
Part of the answer is the assertion that the UK economy was operating well above sustainable levels in 2007, even though there were none of the usual signs of overheating. Beyond that, however, is the claim that the financial crisis somehow reduced potential output by a huge amount. As CE says, there is no plausible story about how that might have happened.
But, say the small-gap people, if Britain is deeply depressed relative to potential, we should be seeing deflation, whereas there’s actually inflation. Is this a decisive argument?
Well, the great bulk of UK inflation these past few years reflects one-off factors: VAT increases, commodity prices, and import prices. Domestically generated inflation is low, and headline inflation is declining too.
But that’s not deflation; shouldn’t we be seeing that right now? Indeed, standard textbook Phillips curves do say that if you’re below the natural rate of output, you should have falling inflation eventually turning into accelerating deflation.
Yet there are very good reasons to believe that these standard Phillips curves break down at low inflation, because nominal wage cuts are always and everywhere very hard to demand or accept.
A side observation: I’ve always wondered about the numbers one often sees for U.S. average wages in the 1930s, which show a sharp decline in the early part of the Depression. Has wage stickiness been exaggerated? My thought was always that this might be a misleading number, because average earnings might have fallen due to greatly reduced overtime and such rather than through big cuts in basic wages. And it turns out that there is a really early NBER study on just that question; sure enough, the fall in basic wage rates was much less than the fall in average earnings. (Advocates of internal devaluation take heed: even in the Great Depression, US wages fell only about 7 percent before rising again):
Oh, by the way: the failure of wages to fall more was a good thing, not a bad thing.
Back to the main argument: as the CE report says, if you have a false view that excess capacity necessarily leads to accelerating deflation, you can all too easily come to believe that a deeply depressed economy represents a “new normal” that must be adjusted to:
If the Phillips Curve is horizontal over wide ranges of the inflation/unemployment/spare capacity relationship, but policymakers believe that a stable inflation rate means that the economy is operating at its potential, this raises the risk that they will persistently allow the economy to operate below its potential. After all, the conventional signal that this is the case – falling inflation – will not be flashing.
In Britain, this translates both into complacency about monetary and fiscal policy in the short run, and into excessive alarm about the long-run fiscal picture. If you like, Cameron/Osborne are imposing harsh cuts to deal with a fiscal crisis that exists only in their minds, while failing to address a current crisis of inadequate demand that falls into their statistical blind spot.
But it’s not just British policy that gets messed up. In America, monetary hawks like James Bullard look at stable inflation and conclude that the Fed is doing fine, failing to appreciate the likely possibility that we have depression-type stability with a massive output gap.
And the preponderance of evidence is that we do indeed have massive output gaps, on both sides of the pond. It’s a huge failure of both intellect and will that we allow these gaps to persist.