Steve Waldman was a software developer who became fascinated by finance and started writing about it. He is now a doctoral student in finance at the University of Kentucky. He blogs at Interfluidity.


Richard Williamson offers a report from the UK. Combining bits via Tyler Cowen and Williamson’s own excellent blog:

I think there has been a lot missing from the discussion of the UK in the blogosphere. We are a bit of a puzzle on a purely AD-based explanation of the recession.

We didn’t have deflation (on annual basis at least), and even stripping out the effect of the VAT rise in 2011 should still show persistent inflation over 3% since 2010. United Kingdom Inflation expectations seem to be significantly higher here (if falling away a little recently)

I’m not really sure what is going on… If we were to just look at inflation (at expectations thereof), the country that ought to be having an AD-driven double-dip recession would appear to be the US…

I am becoming steadily less convinced that [an aggregate demand deficiency] is the whole story, at least for the UK. Back in November, Karl Smith made the clearest statement I have ever read of the New Keynesian explanation of a recession:

I can’t hammer this home enough. A recession is not when something bad happens. A recession is not when people are poor.

A recession is when markets fail to clear. We have workers without factories and factories without workers. We have cars without drivers and drivers without cars. We have homes without families and families without their own home.

Prices clear markets. If there is a recession, something is wrong with prices.

Right now, unemployment remains at over 8% in the UK while real wages are lower than they were 7 years ago and are continuing to fall. Yes, you read that correctly. Which immediately leads one to ask: on this explanation of a recession as expounded by Karl, how much further do real wages have to fall to eliminate disequilibrium unemployment?

There are two broad stories having to do with “sticky prices”. One, the mainstream New Keynesian story, emphasizes rigidity in the price of goods and services, most especially “sticky wages”. The other, emphasized by post-Keynesians and sometimes by monetarists, has to do with the sticky price of satisfying debts.

In the standard New Keynesian story, a depression is caused by the relative prices of goods and services falling out of whack. This is the basis for much of the mainstream policy consensus. The source of macroeconomic problems is sluggish adjustment of some goods and service prices, and stabilizing the price level should diminish the need for such adjustments. Macro policy can’t prevent relative prices in the real economy from needing to change sometimes. But it can prevent difficult-to-adjust prices from requiring frequent updates due to fluctuations in the overall price level. Because some important prices – the price of labor especially – are thought to be “sticky downward” (meaning they can “ratchet” upwards but can’t adjust down), targeting a positive inflation rate is recommended. The gradual, predictable movement of prices allows slow updates, preventing misalignments due to sluggish adjustment. The upward-slope permits “sticky downward” prices to fall in real terms relative to other goods and services by simply not rising with other prices. A recession, in the New Keynesian telling, occurs when this stabilization policy is not sufficient. If changes in supply and demand are so great that “sticky downward” prices must fall faster than the targeted rise in the price level, markets won’t clear. If the “sticky downward” price is workers’ wages, then it is employment markets that won’t clear, and we will experience mass joblessness. If this occurs, a cure would be to increase the targeted rate of inflation until real wages fall relative to other goods and services. When real wages fall enough, employment markets will clear again and the recession will end.

In the post-Keynesian story, a depression is driven by an decrease in agents’ willingness or ability to carry debt. Agents “pay for” decreased indebtedness by devoting their income to the purchase of safe assets (including especially their own outstanding debt) rather than spending on real goods and services. Unfortunately, money spent on financial asset purchases does not create income (they are asset swaps), and may not be cycled back into income for producers of real goods and services. So, in aggregate the attempt to reduce indebtedness can lead to a reduction of income that sabotages the attempt to pay down debt. This is the famous “paradox of thrift”. We simultaneously experience unemployment (reduced spending and income to real goods and service providers plus sticky wages means that people get canned) and financial distress (reduced income and fixed debt makes prior debt ever more burdensome). In this story, reducing real wages is not a solution. Real wage reductions might mitigate unemployment temporarily, but they also engender financial distress. Financial distress then causes agents to redouble their efforts to satisfy debts, reducing aggregate income and requiring further reductions in real wages ad infinitum. The only way out of a post-Keynesian depression is to increase real wages relative to the real burden of debt. In the post-Keynesian story, inflation is helpful only if real incomes hold steady, or, at very least, fall more slowly than the real value of prior debt.

One data point is not dispositive. But Williamson’s account of the UK experience is not consistent with the New Keynesian story, while it is perfectly consistent with the post-Keynesian account. There has been inflation in the UK. The real price of labor has not been sticky. The real burden of debt has fallen, sure, but real wages and incomes have fallen even farther, leaving people less able than ever to satisfy debts they’ve contracted and so purchase financial security.

There is a lesson here. If we mean to pursue reflationary policy, the goal should not be to reduce real wages, but to reduce the real value of debt relative to incomes. One way to do this, which the post-Keynesians’ closest frenemies suggest, is to stabilize the nominal income path at its prior trend while tolerating whatever inflation that engenders. This implies a large increase in nominal income from current levels. Going forward, if we hold nominal income to a gently rising path, the burden of aggregate debt relative to income will never unexpectedly rise. (Unfortunately, predictable distress may not prevent debtors in aggregate from taking on more debt than they can service, due to the competitive dynamic of a boom. I think NGDP targeting would be a big improvement, but not sufficient: We must always be mindful of leverage and debt.)

Pace the very brilliant Chris Dillow, the UK has not stabilized the path of NGDP:

Even if, as Dillow suggests, policymakers could not have held NGDP on path in 2009 due to forecast error, after the collapse they certainly could have restored total income to its prior trend with some combination of monetary and fiscal policy. They have not, and so the burden of debt relative to incomes in the UK has increased.

The UK has just entered a “double-dip” recession, and remains, in my view, in a depression, despite occasional thaws and recoveries. That this has happened, despite the plummeting real wages that Williamson reports, tells a tale. It is not “sticky wages” that should concern us, but the sticky burden of precontracted nominal debt.

Afterward: David Andolfatto wonders whether debt dynamics could play so large a role more than three years after a collapse in nominal income. Yes it can, I argue in his comments.

Karl Smith responds to Williamson here.

Update History:
28-Apr-2012, 6:00 a.m. EDT: Had mistakenly used a FRED graph that I thought was NGDP, but was really RGDP. I’ve replaced it with a proper NGDP graph. Removed the word “remotely”, as the proper graph shows a less dramatic picture: “the UK has not remotely stabilized the path of NGDP.

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Category: Inflation, Think Tank

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11 Responses to “Great Britain as a case study: which sticky price?”

  1. gman says:

    I hope Barry is getting a nice check for turning his blog over to the anti-Krugman forces.

  2. gman says:

    Twice in 3 days..

  3. cognos says:

    The INFLATION measure is WRONG.

    Therefore, real wages have not actually declined. Upsets your whole apple cart of thinking. The Keynesian philosophy is very strong, very correct. However, it depends and gets process through “measures” subject to vast human errors and biased.

    For example, we still have consistent positive inflation here in the US. Quite strikingly positive over the past decade. YET – house prices are flat (HUGE part of consumption basket) and interest rates are cut in half.

    I’d say a) house prices + b) interest rates = much greater than 60% of the consumption basket!

    Further more, entertainment and technology prices are DOWN 90%.

    Finally… if we use “quality” adjustments… then HOUSING including all the neighborhood improvements, 90% lower crime rate, internal remodeling improvements (granite counters, 3 shower heads), … is down MUCH MORE.

    Further, if we ue quality then the prices of almost everything are down huge, from healthcare to cars.

    Since vast swaths of people (greeks, spanish, 30% of homeowners) cannot pay low-fixed-interest debt… this commonsense view on inflation being mis-measured is lent even more support.

    The problem is a 2% target (when measurement errors are 2% or more… inflation targets need to be 3%).

  4. dead hobo says:

    Guest author said:

    Prices clear markets. If there is a recession, something is wrong with prices.

    Not really. Assume a recession caused by a liquidity crisis so bad only a central bank could stop the economy from contracting. Perhaps AIG failed, followed by Lehman. Then came a bank run caused by people who were afraid the wall street crooks would shut down all the banks because of how all the banks lend to each other. Then, because liquidity dried up, the community banks had no money to lend, causing working capital loans to vanish and small business to contract. Then people lost their jobs and a vicious cycle developed because customers vanished. All caused by greed and criminal activity, incompetent regulation, and general stupidity among the second level players. (Note the constant theme of vanishing liquidity. Prices are a function of liquidity. )

    Prior to central bank intervention, as prices approached ‘free’ would ‘free’ have fixed things better than central bank intervention? With respect to ‘approaching free’, who goes first? Labor, capital, or sellers? Is desperation the deciding factor as in, the weakest among us relent first? This is supply side economics by a different name .. the wealthy are first in line for benefits and the last for pain. The desperate support the wealthy. Crises create desperation, and keeping some people dependent keeps the top class in wealth. Crises are the best friend ever for the uber greedy if prices are used to determine value. (This is how unions got started)

    Stay in school, young man. You might eventually get it. The study of economics overcomplicates the obvious, confusing otherwise smart people.

  5. cognos says:

    Many highly visible thinkers in economics and finance do not seem to know what “inflation” is… its the PRICE effect of buying the same goods and services (same quality, same availability, etc).

    If you are living the same life, but all nominal #s are 10% higher… you’re salary and all prices. Then you aren’t actually 10% richer (despite 10% greater nominal $)… thats just inflation.

    On the other hand, if you drink single origin coffee, brewed by the cup, and it available on every corner 24-hr per day… and that cup of coffee now cost $4 (versus say 1$ coffee from 10 yrs ago). That IS NOT inflation. That is called – being rich!

    Lack of correctly making this distinction is persistent… and we see a number of pundits saying things like “US real wages have not increased since 1969″. This, despite the fact that evidence (old family pictures, for ex) clearly would show the US was a 2nd world country, compared to today… in 1969.

    Somehow to these people… better cars, with 12 airbags, nav systems, video screens driving us to cruiseship vacations… To these people, these are not “real” wages like the ones that bought that old “woodie” station wagon and drove us to the cabin in the woods.


  6. dead hobo says:

    cognos Says:
    May 8th, 2012 at 5:01 pm

    Many highly visible thinkers in economics and finance do not seem to know what “inflation” is …

    Agree, but the price system says they have value none the less. Go figure. Perhaps they are good at selling what their sponsors are offering, rather than passing along education.

  7. gman says:

    Barry Ritholtz Says:
    May 8th, 2012 at 4:59 pm
    I like to be very organic and unselfconscious about I link to here. Its simply what I am reading, looking at, or think is interesting or provocative.

    I refuse to let the hacks and trolls get into my head. When junk like this surfaces, it has a “work the refs” feel to it. So I end up over -compensating. Expect to see lots of thing gman is going to hate over the next few days.

    Barry may have called me an ASS, but I still think he runs the best blog of this genre!

  8. NoKidding says:

    Anyone over 30 should side with Cognoscenti. Everything material is 1000 times superior. Pro atheletes make their predesessors look like dwarves. You can get a general picture of what is happening anywhere in the world with minuscule efforts right now this moment. You can buy almost any immaginable consumer item and have it shipped to your front door, often for free, without getting off your rear end. Six dollar near-instantaneous stock trades. 40 miles per gallon. 100,000 mile low rolling resistance tires. Disney world 1980 vs 2010… No comparison.

  9. NoKidding says:

    That’s cognos not cognoscenti. iPad autocorrect monkey wrench.

    Oh yeah, add auto-corrected misspelling to the list of erstwhile magic.

  10. ilsm says:

    Trillions for insolvent banks, when the euros come from the periphery governments those government are dictated to by the ECB and have to whip their lower classes and government employees for the banksters’ insolvency.

    All those trillions need to chase something aside from gold.

    Sticky prices, falling real wages, commdotiy spikes, BRIC consumption rising, global cooling.

    A depression is not about prices, unless you are into the world being run by the fed and the ECB. Did the US constitution survive, Nixon?

    And beside prices rising with high uneployment, how does labor get around the higher costs.

    If GDP declines for 6 quarters you have a depression, if prices rise with GDP declining you have a more damaging depression for the masses.

    Great NCAA B’ball at Kentucky!

  11. rallip3 says:

    Maybe the problem is that economists are leaving a huge chunk of debt out of the picture: the present value of the cost of retiring. When interest rates fall, the present value of this debt increases. In the time of Keynes, and especially after the carnage in Europe of WW1, this liability was not as pressing as today with our prospect of baby boomers retiring.
    Consider how much it would have cost to fund a comfortable retirement in Japan over the last two decades. I suggest this explains Japanese consumers’ reluctance to spend. The idea that lowering interest rates encourages spending is only true if entrepreneurs and householders more than compensate for savers and retirees spending less.
    “The only way out of a post-Keynesian depression is to increase real wages relative to the real burden of debt”: but what if the future cost of retirement is the stickiest price of all. If the burden of future retirement is under constant threat from both adverse cost inflation and negative real savings returns, then the only way out is for prices of old-age care to be forced to ‘clear’ downwards. Time will tell whether the UK’s National Health Service is better or worse at delivering a satisfactory management of this key outcome than other countries’ health systems.