Steve Williamson, the recession, and New Keynesian economics

This recent post by Steve Williamson explains, far better than I did, why no more conventional stimulus is needed in the US.  It’s an argument that carries over fairly neatly to the UK.  And the sort of analysis that confronts head on calls for the authorities to pump up demand by the likes of Paul Krugman and Simon Wren Lewis.

He argues that monetary policy is not the tool to help solve the recession, because all monetary policy is good for is sorting out the distortions created by temporarily sticky prices.  And those distortions must have come and gone, because on average prices are fixed for somewhere between 4 months and a year.  4 months if you take the median frequency of all price changes in the US; a year if you exclude price changes associated with sales, which tend to be followed by a return to the old price.  Output may be far below its pre-crisis trend, and unemployment far higher than pre-crisis levels, but this cannot be laid at the door of monetary policy.

Though I agree with the basic point, and the perspective taken, Steve’s post I think is not the end of the story.

First, one can make the same point about conventional tax and spend fiscal policy.  Many of these instruments, if loosened, would work like monetary policy, stoking up demand.  The coexistence of stable inflation and very weak output would suggest that stoking up demand would just create more inflation.  That might bring temporary benefits, and we can argue about whether the costs of temporarily higher would be worth it, but such policy would not solve the underlying problem.  So, when Steve says that the solution is ‘fiscal’, one has to rule out demand management, since that is essentially like monetary policy.

The second point I’d make is that Steve rather unfairly associates New Keynesian explanations of the crisis and associated policy prescriptions with the simplest possible sticky price model.   This model has a smoothly growing trend potential output, and no other distortions apart from those imparted by sticky prices.  Steve is knocking over a straw man here.  Many researchers using modern sticky price models incorporate financial frictions that impart time-varying distortions to the economy.  For example, if you take a look at Larry Christiano’s web page, you will find several of them.  These papers basically combine sticky price models with Bernanke and Gertler’s model of the financial accelerator.  Models with sticky prices and the financial accelerator show that the two distortions interact.  Monetary policy has effects on the real economy because of sticky prices.  These are amplified by the financial accelerator.  So Steve is right to say that sticky prices and wages can’t explain the great contraction, or rather all of it, but he’s wrong to imply that one should therefore discard these models.    The sticky prices only model is an inadequate tool to describe the recession and proscribe what to do about it.  But, suitably enriched, it is potentially enlightening.   Of course, not everyone would be happy with building in these extra frictions.  Some probably think of it as building a second story to a house of cards.

Third, and relatedly, in these models it’s not the case, as Steve suggests, that monetary policy should simply focus on stabilising inflation.  It’s almost true in the models, because they imply that inflation is more costly by an order of magnitude than anything else.  (Whether this is true of the real world is open to question.)  But not quite.  In sticky price models with financial frictions, a worsening of the financial friction pushes down on output and up on inflation.  Monetary policy can alleviate the financial distortion, but at the cost of higher inflation.

Fourth, he responds to the possibility that the cost of finance may be inefficiently distorted by recommending that the Government (via its agencies) get out of the housing market.  Interpreting the sticky price model plus financial frictions models broadly, one might argue the opposite.  One reason why output may be inefficiently low (say these models) is that the cost of finance is inefficiently high, made so by the fact that the agency problems are worse than normal.  (Perhaps the value of collateral is unusually low, and lending to borrowers unusually risky, therefore).  In such a situation it might be efficient for the deep-pocketed government to intervene in mortgage financing.  (Might).


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