Eli Dourado on the Short and Long Run

Eli Dourado says he is a fan of Scott Sumner, NGDP level targeting and many of the ideas of market monetarists.  That is good to hear.    Since Market Monetarists don't all agree with one another, I am willing to welcome him to the club.   We could use more Ph.D. students interested in the program.   (OK, it would be nice if they were doing money-macro dissertations.)

Dourado argues that QE3 is unlikely to do much good because the economy has already adjusted to the "long run."   His evidence is that corporate profits are at an all time high and that the mean duration of unemployment has leveled off and remains high.

The high corporate profits are relevant because he supposes that low demand results in lower profits which causes firms to cut production.    While production may be low, this evidence shows that it isn't because low demand has resulted in unusually low profits.

But most other Market Monetarists are arguing is that higher spending on output would cause firms to sell more, and so they would produce more.   We aren't saying that higher spending on output would cause firms to make more profit, and so they would produce more.

What is Dourado arguing?   If spending on output rises back towards (or all the way to) the trend of the Great Moderation, all that would happen is that profits would rise while production would remain on its current low growth path?   For profits to rise with no added growth in output,  firms would need to respond to the added sales solely by raising their prices (more quickly.)   If profits are to rise, their costs can't rise as quickly, which could occur because their debt service costs don't rise.  And, of course, wages might stay on their current growth path too.

That's one scenario.

Consider again the scenario most Market Monetarist suggest instead.   Firms sell more and so they produce more.  To produce more they hire more workers.   Profits don't play a key causal role, though I suppose this scenario  requires that price is above marginal cost for many firms so that if they produced and sold more their profits would be higher.    Well, the current high level of profits are consistent with price being greater than marginal cost for many firms. (Of course, historically high profits only require that prices are greater than usual relative to average costs.   Prices could be equal to marginal costs.)

Dourado also explains that firms have been able to expand production while using fewer workers.  This must be true today since production is above its previous peak while employment is below its previous peak.    However, increased productivity doesn't require reduced employment.    It is perfectly consistent with increased production and constant employment.     In other words, if firms have figured out ways to produce a given level of output with less labor, this just suggests that real demand needs to increase even more.    When employment reaches its growth path from the Great Moderation, production will have surpassed its growth path from the Great Moderation   However, if spending on output only returns to the growth path of the Great Moderation, the added production would require that prices shift down to a lower growth path.

Well, that is another scenario.  By increasing nominal GDP back to the growth path of the Great Moderation and observing whether prices remain below their growth path  from the Great Moderation and real GDP rises above its growth path of the Great Moderation, we will find out how much labor productivity has increased.

Of course, there is also the problem of complementary factors of production.   While more rapid increases in demand could result in the employment of  more workers each producing more output, more of the other factors of production would be needed to produce the added output.   Bottlenecks for these other factors of production could lead to higher costs and higher prices of output.

However, it is hard to imagine that an improvement in labor productivity would cause real output to fall below its existing growth path because of bottlenecks from other factors of production.   It just would not rise as much.   The increase in output would be dampened, at least temporarily.

And, of course, real GDP is about 12 percent below its growth path from the Great Moderation and so speculating about how much it would rise above that path because of added labor productivity versus how much employment would remain below its  growth path of the Great Moderation is very premature.

The typical Market Monetarist perspective is that nominal GDP has shifted to a 14 percent lower growth path.    For real output and employment to remain on its previous growth path, the price level and nominal wages need to also shift to 14 percent lower growth paths.   They haven't.   Instead, they are only about 2 percent lower.

It is possible that raising nominal GDP back to its previous growth path (or even to one 2 percent lower) would have no positive impact on production and employment.   It is possible that if the price level and wages shifted down 12 percent more, the increase in real expenditure would  only result in shortages of output and/or labor.   For this to be true, the productive capacity of the economy must have decreased by about 12 percent.

This is, of course, possible.   Enhanced labor productivity is not something that would tend to have such an effect.

Dourado's version of how shifts in nominal GDP impact real output and employment is based upon an assumption of market clearing.    Prices and wages always adjust so real expenditure is sufficient to purchase everything produced, but when prices and wages shift in unexpected ways, people will work or produce more or less than they would if they understood what was happening to the price level or wages.   These mistaken shifts in supply result in shifts in production, but at each and every point in time, the prices and wages are at levels such that real expenditure is sufficient to purchase all that firms wish to sell or employ all the labor households want to provide.

If there is a surprise decrease in nominal GDP, this will cause the price level and wage level necessary for real expenditure to remain equal to productive capacity to fall.   The falling prices and wages lead to confusion, and firms choose to produce less and households choose to work less.   If the decrease in nominal GDP can be rapidly reversed, then the price level and and wage level rise again and firms will go back to producing the right amount and households will go back to working the right amount.

But it is hard to believe that people are still confused about the lower wages and prices after four years.   They must be producing and working the amount they prefer.   It must be that they prefer producing and working much less.

Most Market Monetarists would say that a decrease in nominal GDP could leave real expenditure unchanged if prices and wages drop in proportion.   If that fails to occur, then real expenditures fall, and firms reduce production and employment to match the lower volume of real sales.   If productive capacity is unchanged, then real output is below productive capacity.      If that is the case, then real output and real income can expand by simply increasing spending on output or lowering prices and wages.  

The puzzle, then, is why haven't firms cut the prices they charge and the wages they pay so that real expenditures recover to the productive capacity of the economy?   They have had four years to make these cuts.    Again, if the problem was a decrease in the productive capacity of  the economy, the lower prices and wages would just lead to shortages of output and/or labor, and do no good.   And so, it would seem that if prices and wages haven't been cut after four years, it must be that the productive capacity of the economy decreased.

If the productive capacity of the economy decreased, then increasing nominal GDP back to the trend of the Great Moderation would solely result in an increase in the growth path of the price level.    Market Monetarists, as advocates of nominal GDP level targeting, believe that if the productive capacity of the economy shifts down to a lower growth path, then the least bad consequences is for nominal income to remain on an unchanged growth path and the price level to shift to a higher growth path.  

Still, even after four years, most of us doubt that there was just a happy coincidence that spending on output fell in near exact proportion to a decrease in productive capacity.   And further, we see substantial evidence that firms would be willing and able to produce more if their sales were to increase.   Few of us ever bought into Dourado's market clearing approach--shifts in supply due to confusion--anyway.   But we see the experience of the last four years as providing evidence that it isn't even a close approximation.  

On the other hand, most of us do believe that firms eventually cut prices and wages in the face of persistent surpluses of output and labor.   Most of us remain puzzled by the slow adjustment.   Personally, I lean to seeing credible inflation targeting as increasing price and wage stickiness as a manifestation of Goodhart's law.   I think credible nominal GDP targeting would worsen wage stickiness for much the same reason, though perhaps lessen price stickiness.   I don't see the sticky wages as much of a problem in that context--rather, it just makes it more important to keep nominal GDP on target.