How can we spot a boom?

Suppose I had perfect knowledge about the economy. So I knew exactly what the right monetary policy would be to keep the economy growing along some sustainable path. And I knew exactly what that sustainable path would look like.

I would then be able to tell the difference between:

1. Monetary policy is too loose, and the economy is in an unsustainable boom. Maybe the boom can be prolonged for a bit, by making monetary policy even looser. But eventually the boom must end, and ouput and employment will fall. Maybe they will even fall temporarily below the sustainable path, because adjustment is difficult. Either way, the end of a boom will look like a recession.

2. Monetary policy is not too loose, and the economy is growing along the sustainable path. Then monetary policy suddenly becomes too tight, and output and employment drop below the sustainable path. The economy is in recession.

But I don't have perfect knowledge about the economy, and I don't know exactly what the right monetary policy would be to keep the economy growing along some sustainable path, and I don't know exactly what that sustainable path would look like.

I think that both 1 and 2 are theoretically possible. (But maybe some people think that only 1 is theoretically possible, and other people think that only 2 is theoretically possible?)

I think that it is impossible to have a monetary policy with only 1 and never 2, and also impossible to have a monetary policy with only 2 and never 1. That's because I believe in some sort of long run neutrality of money: so it is theoretically impossible to have monetary policy sometimes too loose and never too tight; and also theoretically impossible to have monetary policy sometimes too tight and never too loose. (It would be like saying monetary policy could sometimes be looser than average but never tighter than average; or that monetary policy could sometimes be tighter than average but never looser than average.)

If I thought that the true model of the economy were linear, so that there was symmettry between loose money/booms and tight money/recessions, then I would say that the total amount of boom was exactly equal to the total amount of recession. In other words, if we bulldozed the tops off the hills, and used the material to fill in the valleys, then the elevation would be exactly the same as the sustainable path with no booms or recessions. (The sustainable path might still be better, because you normally need a non-linear utility function to generate linear demand and supply curves. People like smoothness.)

If the economy were linear, and if the sustainable path were also linear, it would be much easier to spot a boom. "Is economic activity higher than average? We must be in a boom."

But I don't think the true model of the economy is linear. Even if money is long run neutral, so that we see as much loose money as tight money, loose money causes small booms while tight money causes bigger recessions. If you believe in some sort of aggregate demand theory of business cycles, then this sort of non-linearity is inevitable, because loose money will cause the economy to hit some supply constraints. And if booms are smaller than recessions, economic activity can be higher than average even if the economy is not in a boom.

Milton Friedman's plucking model suggests to me that the economy is very non-linear. Empirically, the bigger the fall, the bigger the subsequent rise. But it is not true that the bigger the rise, the bigger the subsequent fall. Or, to use Scott Sumner's metaphor, what look like mountains are really just places in the high plateau where there is no valley. How much you climb down one valley determines how much you climb up the other side, but how much you climb up one side does not determine how much you climb down the next valley. There are recessions (valleys), but no booms (mountains).

I used to think that if inflation was rising (or above target), we were probably in a boom, and if inflation were falling (or below target) we were probably in a recession. Now I'm not so sure about that, because the last recession sure looked like a recession, but inflation wasn't giving its usual signature.

Comments

[Donte]

The acceleration or deceleration of inflation is probably more important. Inflation plunged during the last recession........you need to look globally.

[Nick Rowe]

Donte: Dunno. The UK didn't show a clear signal of falling inflation either.

[Ralph Musgrave]

Booms are easy to spot: they result in excess inflation. More difficult to spot are asset price bubbles, and they’d be ameliorated if we banned fractional reserve banking: letting commercial banks lend money into existence like there’s no tomorrow in a boom.

If the only money was central bank supplied money, and demand was adjusted by adjusting that supply, and central banks stopped trying to control interest rates, then an incipient bubble would cause interest rates to rise which would choke off the bubble to some extent.

[Ben J]

Ralph,

Did you even read this part?

"I used to think that if inflation was rising (or above target), we were probably in a boom, and if inflation were falling (or below target) we were probably in a recession. Now I'm not so sure about that, because the last recession sure looked like a recession, but inflation wasn't giving its usual signature."

[Nick Rowe]

Some background: I should probably have emphasised this bit in the post more: "I think that both 1 and 2 are theoretically possible. (But maybe some people think that only 1 is theoretically possible, and other people think that only 2 is theoretically possible?)".

I get the impression, when arguing with *some* Austrians, that they seem to talk about 1 to the exclusion of 2. "The seeds of the recessions are sown in the preceding boom". While some of the more extreme Keynesians seem to talk about 2 to the exclusion of 1. "If employment falls, it must be that monetary/(fiscal) policy got too tight." But, weirdly, Milton Friedman's plucking model seems more in tune with 2. And I'm trying to make sense of Friedman by assuming it's because of major non-linearity in the response of output to monetary policy (tight money can reduce output a lot but loose money can only increase output a little).

[genauer]

I wondered,
Whether I should comment and stink up the place.
But I think you should be aware that many folks in the 95% outside the US, UK, Can are pretty much amused with these academic sand box models of 70 years ago.

I invite you to take a look at the tracking the Euro Area is doing now:
http://epp.eurostat.ec.europa.eu/portal/page/portal/excessive_imbalance_procedure/imbalance_scoreboard

It tracks 11 parameters:
Number unit
Current account balance % of GDP
Net international investment position % of GDP
Real effective exchange rate - 36 trading partners(1) 3 years % change
Share of world exports 5 years % change
Nominal unit labour cost index 3 years % change
House price index - deflated 1 year % change
Private credit flow % of GDP
Private debt % of GDP
General government gross debt (EDP) % of GDP
Unemployment rate 3 years avg
Total financial sector liabilities 1 year % change

The GDP shows up only as a divisor and inflation only indirectly.

This focus on monetary policy just makes us smile, just like at kids at a science fair.

The focus of the US Fed on raw credit costs did obviously not prevent the epic bubble.

The Warren Brussee “The Second Great Depression 2007 – 2020” forecast was based on private debt, in Japan and the US.

We see focusing on symptoms like GDP and inflation as like the Soviet GOSPLAN people focusing on steel output.

Ralph, where was the inflation pre 1990 in Japan, and pre 2007 in the US?

[Ralph Musgrave]

Ben J,

The point I was making, to elaborate, was that Nick’s post didn’t distinguish correctly between a general boom and an asset price bubble.

I quite agree that prior to the crunch there was no general boom: hence the absence of inflation. But in as far as there was excess demand, it was stoking an asset price bubble. And I think full reserve would ameliorate such bubbles (as do, I believe, Messers Kumhoff and Benes who wrote a paper in favour of full reserve for the IMF – not that full reserve is official IMF policy).

An incidental point here is that it also strikes me that full reserve would NOT ameliorate bubbles to the extent that bank loans and mortgages are securitised – which is a problem for advocates of full reserve. But there are plenty of people out there, e.g. Warren Mosler, who are not pro full reserve, but who nevertheless think that securitisation should be banned. See his point No. 1 here:

http://www.huffingtonpost.com/warren-mosler/proposals-for-the-banking_b_432105.html

[Scott Sumner]

Nick, You said;

"But maybe some people think that only 1 is theoretically possible, and other people think that only 2 is theoretically possible?"

Yup, and the first group is called "Austrians" while the second group is called "Old-style Keynesians." Keynes himself once claimed the second option was true.

I exaggerate slightly--Keynes argued that in practice economies were always at or below potential, not in theory.

[asp]

Can you spot a recession? What happens if Canadian data is plugged into the model talked about here:

http://noahpinionblog.blogspot.com/2013/05/dsge-financial-frictions-macro-that.html

It would be interesting to see the results from mid 2008 data and then from todays data.

[J.V. Dubois]

I was also bothered by what you expressed in your last sentence, but I think I am getting it at least a little bit. Let us think what are the reasons why Friedman's plucking model seems to be true. The biggest cost of tight money is that markets with sticky prices cannot clear efficiently. There may be many sticky prices (including prices of things that were not produced this year) but for practical reasons we focus on prices of labor. Labor is huge in terms of economic importance, but it is also important for political and institutional stability and for utilitarian reasons as unemployment has huge impact on happiness.

So how do we stand with this?

a) To illustrate the first point look at table 4 of this paper (page 34). The model suggests that there is a huge difference between -1% inflation, and 4% inflation in terms of effective labor market clearing. And there seem to be some problems even with positive but low inflation (close to 1%).

b) Second point is to realize what are the costs of too loose monetary policy. It is elevated inflation that has supply side impacts via inneficient taxation and some other possible channels.

So what to make of this?

1) I do not agree that money is long-run neutral in terms of its real impact on economy. Or to be more precise it is neutral only in some narrow band. If monetary policy is outside of this band (too tight or too easy) it is always bad for an economy. Short period of 50% inflation does not remedy short period of 50% deflation. They are both bad for an economy.

Or to say it in a different way - long run consists of long series of short runs. If we now have short period where labor markets are inefficient due to tight money, then the output is lost forever. I do not see how some kind of "boom" created by sudden loose money can bring back those "manmillenia" of labor lost to a bad monetary policy.

2) Positive inflation is not all there is to assure us that all is well. If there are some lessons learned during this crises it is that inflation fetish is stupid. ECB targets inflation including oil and taxes. ECB (and other CB for that matter) completely lost sight of why stabilizing "inflation" is good. What market inefficiency(ies) monetary policy is supposed to remedy.

So maybe Austrians and RBC economist got it right in a way. There are only supply side recessions. And I think that they acknowledge that some supply side recessions are caused by bad government policies and badly designed institutions (corrupt law system, insane market regulations etc.). So the last one was caused by huge mistake in major government policy aimed at efficient labor market clearing (also known as monetary policy).

[J.V. Dubois]

I was also bothered by what you expressed in your last sentence, but I think I am getting it at least a little bit. Let us think what are the reasons why Friedman's plucking model seems to be true. The biggest cost of tight money is that markets with sticky prices cannot clear efficiently. There may be many sticky prices (including prices of things that were not produced this year) but for practical reasons we focus on prices of labor. Labor is huge in terms of economic importance, but it is also important for political and institutional stability and for utilitarian reasons as unemployment has huge impact on happiness.

So how do we stand with this?

a) To illustrate the first point look at table 4 of this paper (page 34). The model suggests that there is a huge difference between -1% inflation, and 4% inflation in terms of effective labor market clearing. And there seem to be some problems even with positive but low inflation (close to 1%).

b) Second point is to realize what are cost of too loose monetary policy. It is elevated inflation that has supply side impacts via inneficient taxation and some other possible channels.

So what to make of this?

1) I do not agree that money is long-run neutral. Or to be more precise it is neutral only in some narrow band. If monetary policy is outside of this band (too tight or too easy) it is always bad for an economy. A few years 50% inflation do not remedy a few years of 50% deflation. They are both bad for an economy. Or to say it in a different way - long run consists of series of short runs. If we now have short period where output to is lost to inefficient labor market due to tight money, it is lost forever. I do not see how some kind of "boom" created by sudden loose money can bring back those "manmillenia" of labor lost to bad monetary policy.

2) Positive inflation is not all there is to assure us that all is well. If there are some lessons learned during this crisis it is that inflation fetish is stupid. ECB targets inflation including oil and taxes. ECB (and other CB for that matter) completely lost sight of why stabilizing "inflation" is good. What market inefficiency(ies) monetary policy is supposed to remedy.

So maybe Austrians and RBC economists got it right in a way. There are only supply side recessions. The last one was a sudden technology shock in a technology we use for efficient labor market clearing.

[Peter N]

I don't think the simple boom-recession taxonomy is sufficient to explain the observed cycles.

One obvious type of recession is caused by external shocks. An example would be Singapore during the Asian currency crisis of 1997. The source of the contagion was the bursting of a property bubble in Thailand. The mechanics of this are clear enough, even if there are disputes about the right remedy.

Then there's the panic. Usually the failure of a major company causes bank runs and financial companies that make money by duration arbitration have liquidity problems. Often under the gold standard, seasonal gold shortages made regional banks vulnerable to any problems with money center banks. 1907 is a good example. There was true tight money - a shortage of base money - gold.

There's also inflation. This is an effect more than a cause. It is possible to have inflation in a stagnant or declining economy, and it is possible to halt inflation without a significant recession. I think inflation is a bit of a red herring in the discussion of booms and recessions.

There are also irrational exuberance booms like the dotcom stock market boom. They tend to be harmless or even long term beneficial to the "real" economy provided that they weren't financed with borrowed money. The 1987 crash would be another example.

Real estate crises tend to be more serious, because they are financed with borrowed money. The S&L crisis is an example, but it's effect on the larger economy was contained, because it didn't spread to the other banks. Still, it took years to work out and required serious government intervention. The actual cost of the government's intervention was around $160 billion, and the crisis was probably responsible for the 1990 recession. Like the current recession, the S&L crisis was associated with drop in new home sales that took 4 years to recover. The current fall was 2 1/2 times as deep and will probably take at least 2 1/2 times as long (from 2005) just to reach 2000 levels.

While real estate crises are particularly serious because they involve more owners than crises in other assets, debt financed speculation in other assets can cause serious crises. The British railroad mania of 1845 was a relatively simple bubble. People bought railroad stock on 90% margin, with the balance subject to capital calls during the build out. The bubble went like this:

People who got in early and sold early made large profits, but later investors were hit with capital calls while stock prices first stalled and then slowly but inexorably fell (rather like 1929-1932 without as many failed rallies). The total investment was around 30% GDP, which makes it comparable to the great recession in the US. However, many of the current credit entanglements were absent, though the national debt was 140% GDP.

The economic results were:
NGDP RGDP RGDP per capita

1843 498 53,471 1,961.79
1844 543 56,358 2,047.53
1845 575 59,339 2,136.35
1846 614 63,345 2,262.16
1847 638 61,761 2,207.97
1848 614 63,718 2,290.35
1849 625 64,649 2,336.52
1850 572 63,531 2,308.21
1851 601 66,326 2,421.27
1852 607 67,630 2,463.93
1853 678 69,586 2,526.55
1854 718 70,797 2,559.74
1855 739 71,822 2,581.48

Of course there are always complicated crises with multiple causes. Here 1837 is a good model. Everything went wrong at once. Falling agricultural prices, tight money, failing banks issuing bad money, bad government policies... "Out of 850 banks in the United States, 343 closed entirely, 62 failed partially, and the system of State banks received a shock from which it never fully recovered."

Still, it's not clear how much damage was done to the "real" economy outside the south. Murray Rothbard observes:

"In a fascinating analysis and comparison with the deflation of 1929–1933 a century later, Professor Temin shows that the percentage of deflation over the comparable four years (1839–1843 and 1929–1933) was almost the same. Yet the effects on real production of the two deflations were very different. Whereas in 1929–1933, real gross investment fell catastrophically by 91 percent, real consumption by 19 percent, and real GNP by 30 percent; in 1839–1843, investment fell by 23 percent, but real consumption increased by 21 percent and real GNP by 16 percent. he interesting problem is to account for the
enormous fall in production and consumption in the 1930s, as contrasted to the rise in production and consumption in the 1840s. It seems that only the initial months of the contraction worked a hardship on the American public and that most of the earlier deflation was a period of economic growth. Temin properly suggests that the reason can be found in the downward flexibility of prices in the nineteenth century, so that massive monetary contraction would lower prices but not particularly cripple the world of real production or standards of living."

http://mises.org/books/historyofmoney.pdf

He then blames government intervention to support prices, but it is just as likely that repudiation of debt and low levels of individual nominal debt in 1837 were responsible. Debt deflation is only a problem if you have nominal debt, and, of course, the primarily agricultural US economy of 1837 was less dependent on a single medium of exchange.

I think that one important conclusion is that when you create a complex credit based economy filled with perverse incentives and rent seeking opportunities, you should expect complex and intractable economic problems. In particular valuing stocks at the marginal price of their flows and then forcing corresponding financial accommodations is a dangerous idea. Economics still hasn't really solved the problem of value. It just declared victory and wandered off.

Another equally important one is that allowing financial institutions to capture their regulatory systems, while insulating them and their benefiting agents from all moral hazard is a recipe for disaster. Cyprus, Spain, Greece - what more evidence do you need?

[Nick Rowe]

Scott: "Yup, and the first group is called "Austrians" while the second group is called "Old-style Keynesians." Keynes himself once claimed the second option was true."

Yep. But notice something weird about that: Milton Friedman's "plucking model", which has empirical support, seems to be closer to the Old Keynesian position.

asp: I don't know. But if you add enough "shocks" to a model, you can get it to "predict" (i.e. match the patterns in the data) almost anything.

JV: you lost me a little there. In your 1. you are talking about non-super-neutrality. ("Does a higher or lower long run target inflation rate make a real difference?") I would agree. But I was thinking more about neutrality (Does a higher or lower long run target price level make a real difference?".

If the economy were perfectly competitive, and wages or prices were sticky, there could be recessions, but there couldn't be booms. Starting at full-employment long run equilibrium, a fall in AD would cause a recession, but an increase in AD would simply cause excess demand for labour and goods, because workers don't want to sell any more labour, and firms don't want to sell any more goods. Friedman's plucking model would work exactly. But if we take a standard New Keynesian model, with monopolistic competition, we get a rough symmettry, where increases in AD cause output and employment to rise above their natural rates.

So I am suffering bad cognitive dissonance: I like monopolistic competition; but I also recognise that Friedman's plucking model works well empirically. I've got a contradiction in my belief system, and I'm trying to work it out! I should probably do a post where I lay this out more clearly, instead of circling around the problem like I'm doing here.

[J.V. Dubois]

Nick: Ok, I will try to explain it differently. Imagine that we start with some stock of money. Now every day central bank sets the monetary policy at random according to an algorithm that is volatile in short run but has a stable long-run average. No concerns for labor market, taxes or anything whatsoever are given when forming these short-term monetary policy decisions. Do you believe that there will be no long-run impact if this short-run chaotic monetary policy on real economy here? It simply does not follow. If monetary policy is effective in short run (as you agree)

As for your second point you say: "Starting at full-employment long run equilibrium, a fall in AD would cause a recession, but an increase in AD would simply cause excess demand for labour and goods, because workers don't want to sell any more labour, and firms don't want to sell any more goods."

If we start at full-employment and more importantly - if we want to keep it that way - we need to keep AD churning along nicely because of all that stuff with sticky wages and such. Which may surely look as a "boom" to casual observer.

PS: I would also dispute a claim of what "full employment" means. I preffer NAIRU definition here - so while it may be possible to sqeeze a little bit more employment by loose monetary policy supporting ever-accelerating inflation, we need to consider long-term supply side effects of high inflation (or costs of disinflation later). The same goes for MM speak. If 10% NGDPL target would be better at achieving 0,1% lower unemployment in short-term compared to 5% NGDPL target the welfare costs of higher average long-term inflation (or later disinflation) may trump benefits of slightly lower unemployment.

[Nick Rowe]

JV: Aha! Yep, I get you now. Sure, the *variance* of monetary policy will have real effects. (If it didn't, I wouldn't care about monetary policy). When we talk about "neutrality", we are normally talking about the mean.

"If we start at full-employment and more importantly - if we want to keep it that way - we need to keep AD churning along nicely because of all that stuff with sticky wages and such. *****Which may surely look as a "boom" to casual observer.*****"

Yes. Exactly. And how can we tell the difference between what looks like a boom to a casual observer, but which is really just the absence of a recession, and something that really is a boom? The answer isn't obvious. "Rising or above target inflation" is one answer. "The technique Milton Friedman used to test his plucking model" is another answer.

[J.V. Dubois]

One more post about neutrality. If I understand it correctly it means that if all other things equal it does not matter if we have a country that uses US dollars as opposed to the same country that uses Italian liras (maybe beyond some weird behavioral things associated with large numbers or green color of money etc.) And I agree.

But I do not think that this is the way you used "neutrality" in your article. It is a difference if country goes from dollars to liras and back (in terms of ammount of currency) in a wild and messy manner as opposed to country that has a smooth and comfortable monetary ride along to the "long-term". So even if there was just one such an episode of monetary mismanagement 1000 years ago one can still count real damage and we can track it in some virtual "total output lost due to bad monetary policy" damage report at any time in a history. So while the overall impact may be small, it is real and non-zero even in the long run.

[J.V. Dubois]

Nick: "And how can we tell the difference between what looks like a boom to a casual observer, but which is really just the absence of a recession, and something that really is a boom? The answer isn't obvious."

I agree. Basically the best answer is that there exist some long-term welfare-maximizing monetary policy that will surely look more and more like Friedman's plucking model (from the welfare maximizing point of view). For the time being the biggest unemployment and inflation were identified as the things that have the biggest long-term welfare impact. So what may be seen as a "boom" (unemployment is down) may be a long term welfare-damage when we need to live decades in elevated inflation environment or face costs of disinflation.

And we for sure know that it is bad to fear rising inflation too much to have unemployment only slightly lower for short time and it surely is not worth to fear short term increase in inflation if it can bring unemployment down several percentage points and preventing long-term damage in form of output lost, hysteresis effects etc. So yes, MM metric of going for stable nominal income growth seems to be as good metric as we have if we have inflation/unemployment concerns.

PS: If the biggest welfare question will be sticky prices and not clearing markets for used canoes thane we may have to come up with some other metrics to base monetary policy on.

[Peter N]

The plucking model only considers plucks down. There is also the possibility of a pluck up. You can use credit to boost output. When you calculate net worth by value stocks of assets by their current flow sale price, you get an enormous wealth effect, and this wealth can be the basis for obtaining credit. Note that this wealth effect has become much greater with relatively recent changes in accounting rules, and that advances in financial engineering have made it easier to create credit and distribute debt and its associated risk. The problem is that this wealth effect can also run in reverse, in which case the value of the debt remains fixed in nominal terms, whereas the countervailing assets are discounted in bulk. The result is that real net worth per household is still down 40%.

This means that to some extent, this time it really is different. This is from the Federal Reserve Bank of St. Louis 2012 annual report:

"Wealth effects. Economists long have sought to estimate how much a one-time, unexpected change in the value of households' assets might affect their spending, both in the short term and in the long term—what are called "wealth effects." Economists Karl Case, John Quigley and Robert Shiller found, first, that housing-wealth effects are much larger than financial-wealth effects (stocks, bonds, mutual funds). They estimated that, in recent years, an unexpected, one-time increase of 1 percent in housing wealth led to an increase of 0.08 to 0.12 percent in consumer spending each year afterward.3 In contrast, the same increase in financial wealth was followed by a less than 0.03 percent permanent increase in consumer spending.

Second, they found that consumer spending reacts much more strongly to declines than increases in household wealth. In particular, an unexpected decline of 1 percent in house prices results in about a 0.10 percent permanent decline in consumer spending, while a 1 percent increase in house prices results in only about a 0.03 percent increase in consumer spending.4 Applying these estimates to the actual declines in housing wealth experienced between 2005 and 2009—about 35 percent after inflation adjustment—the authors estimate that consumer spending ended up on a path about 3.5 percent lower than otherwise would have been expected, or roughly $350 billion less than it would have been in 2010. "

[Peter N]

"And how can we tell the difference between what looks like a boom to a casual observer, but which is really just the absence of a recession, and something that really is a boom? The answer isn't obvious."

Is this the right question? Shouldn't it be "how do we recognize dangerous booms or busts that require some form of intervention?" Suppose that we could just prevent the events of 1928-1939 and 2004-2015. Wouldn't that be enough of an achievement? You can add, if you like 1836-1846 and 1873-1885, but they occurred under a completely different financial system.

Maybe we shouldn't seek to be perfect and should just try not to be incredibly stupid. It seems that would be quite hard enough.

If you feel that conventional monetary policy isn't the solution to this problem, you're probably right, but there are other tools.

[Nick Rowe]

Peter N: "There is also the possibility of a pluck up."

In theory, there is. But do we actually observe plucks up? (Don't say that too quickly!) Maybe the theory is wrong. Maybe what looks like a pluck up, in hindsight, was really just the absence of a pluck down. If you are in a valley, everything around you will look like a hill. (I'm writing a new post on this, but haven't drawn the pictures yet.)

[W. Peden]

Peter N,

On the 1839-1843 period: RGDP per capita fell during this period. The rise in aggregate GDP was a result of the very high levels of immigration to the US in the 1830s and 1840s; population growth was about 2.82% per year in 1839-1843. Prior to immigration controls, the US had a very high population growth rate- about double what it's been since then.

The GDP deflator average RoC of 1839-1843 was half as fast a fall in prices as 1929-1933. Also, the shift in prices and NGDP in 1839-1843 as compared with the preceding 1790-1838 period was much milder than 1929-1933 as compared with 1881-1929. After a long period of inflation (there was a long secular price rise from about 1897 to the 1920s) people would find shifting to a deflationary world much harder than after a period of secular price stability.

It IS true that it isn't possible to explain all of the Great Depression in terms of a fall in prices. The financial crisis, protectionism, and FDR's often insane literally anti-production supply-side policies all didn't help. However, I think that the pleasantness of the 1839-1843 period can be easily exaggerated.

Source: http://www.measuringworth.com/growth/

Nick Rowe,

Do pluck-ups exclude periods where a non-cyclical productivity shock was occuring? Otherwise, the 1920s in the US seem to be a classic pluck-up, as do the late 1990s.

How about Britain during the Barber Boom (1971-1973) or the Lawson boom (1985-1988)? These were periods of accelerating NGDP and RGDP growth, followed by nasty recessions during which there was a reversion to something closer to the trend UK RGDP growth rate. Maybe one could say that the Lawson boom was a return to trend after the early 1980s recession, but the Barber boom came at the end of the Golden Age. Or are these too short to constitute "plucks"? The Barber boom was only about 9 quarters long, but it was certainly a boom: www.tradingeconomics.com has Q2 RGDP in 1973 growing a 5.3% IN A QUARTER!

[W. Peden]

(I hope that this isn't a double-post, but the previous post doesn't show and my connection has been very unreliable today. Perhaps the links got the previous post caught in the spam filter.)

Peter N,

On the 1839-1843 period: RGDP per capita fell during this period. The rise in aggregate GDP was a result of the very high levels of immigration to the US in the 1830s and 1840s; population growth was about 2.82% per year in 1839-1843. Prior to immigration controls, the US had a very high population growth rate- about double what it's been since then.

The GDP deflator average RoC of 1839-1843 was half as fast a fall in prices as 1929-1933. Also, the shift in prices and NGDP in 1839-1843 as compared with the preceding 1790-1838 period was much milder than 1929-1933 as compared with 1881-1929. After a long period of inflation (there was a long secular price rise from about 1897 to the 1920s) people would find shifting to a deflationary world much harder than after a period of secular price stability.

It IS true that it isn't possible to explain all of the Great Depression in terms of a fall in prices. The financial crisis, protectionism, and FDR's often insane literally anti-production supply-side policies all didn't help. However, I think that the pleasantness of the 1839-1843 period can be easily exaggerated.

Source: http://www.measuringworth.com/growth/

Nick Rowe,

Do pluck-ups exclude periods where a non-cyclical productivity shock was occuring? Otherwise, the 1920s in the US seem to be a classic pluck-up, as do the late 1990s.

How about Britain during the Barber Boom (1971-1973) or the Lawson boom (1985-1988)? These were periods of accelerating NGDP and RGDP growth, followed by nasty recessions during which there was a reversion to something closer to the trend UK RGDP growth rate. Maybe one could say that the Lawson boom was a return to trend after the early 1980s recession, but the Barber boom came at the end of the Golden Age. Or are these too short to constitute "plucks"? The Barber boom was only about 9 quarters long, but it was certainly a boom: www.tradingeconomics.com has Q2 RGDP in 1973 growing a 5.3% IN A QUARTER!

[W. Peden]

Ok, so it's a double post! Strange.

The plucking-model vs. monopolistic competition/sticky wages contradiction is interesting. Are there any ways to get sticky wages that don't contradict the plucking-model? For example, if wages are upwardly non-sticky and downwardly sticky?

For example, minimum wages, labour cartels, subsidised industries, coercive monopolies etc. create downward stickiness, but not upward stickiness. So I can imagine a New Institutionalist model of an economy with downward stickiness but not upward stickiness. On the other hand, an incomes policy creates upward stickiness (especially if it's statutory) but not downward stickiness, and interestingly was in place in the UK during most of the Barber boom.

[W. Peden]

Put another way: New Keynesian microfoundations for price stickiness generally seem to be "market failure" concepts e.g. monopolistic competition, efficiency wages, menu costs, labour hoarding, imperfect/asymmetric information, and so on. However, I think that all of these imply that prices are both upwards and downwardly sticky, so they don't handle the plucking-model well. On the other hand, Olsonian distributional coalitions have incentives to act together in the face of downward price pressure, but not against upward price pressure*. So maybe the Mancur Olson New Institutionalist approach to microfounded price stickiness not only beats New Keynesianism on a non-ad hoc prediction of procyclical productivity, but also in that it predicts greater downward stickiness of prices than upward stickiness and therefore an asymmetric business cycle i.e. the plucking model.

* Consumers as a whole have an incentive to act together in the face of upward price pressure, but they lack the selective incentives for effective collective action. When was the last time a consumer advocacy group lobbied for a price level target or free trade? In practice, for good or ill, consumer advocacy groups operate largely as lobbies for restricting competition e.g. via licensing or regulatory compliance costs.

[Peter N]

W. Peden,

I think the important point is that proper taxonomy is crucial to understanding booms and busts. We don't insist on a single cause for other historical phenomena. Why should we do so in busts like the current one or the great depression of 1929?

In fact, the great depression looks a lot like the current European mess - a combination of bad decisions, bad luck, bad timing and fundamental flaws in the financial systems.

If you read through this detailed timeline, you're struck by how many bad decisions it took to cause the great depression, how many foolish ideas and policies were widely advocated and how similar this all is to the current mess in Europe.

http://www.futurecasts.com/Depression_descent-'29.html

[Peter N]

If you take the idea of a ceiling literally in the plucking model, a plucking up would be one through the ceiling - a somewhat painful image, and, perhaps, an appropriate one. There have to be negative consequences from breaking through a ceiling, or it wouldn't really be a ceiling.

In particular, if the result is a return to the previous trend, you might expect a permanent reduction in percent employment by some factor of the ratio between the two trends.

[J.V. Dubois]

W. Peden: " However, I think that all of these imply that prices are both upwards and downwardly sticky"

I disagree. Besides obvious thing like nominal *downward* wage stickiness also other micro reasons for price stickiness suggest asymmetric outcomes from changes in prices. If we assume monopolistic competition then we just know that prices are too high. So whatever is the reason for (real) prices not willing to go down (as that is what we want to achieve) we can remedy it by decreasing the value of money. If we want to counteract that by disinflation somewhere in the future we will only exacerbate the inefficiency.

I believe there are two reasons why we do not want to use tools like unexpected increase of AD to spur booms:

1) Many good effects in terms of market clearing can be achieved also by expected increase of AD.
2) Spur of AD has costs in terms of elevated inflation that by itself has negative long-term supply side impacts.

But I agree that you get a point. This debate may be entirely different if we are talking about macro environment with relatively high inflation where nominal downward rigidity never comes into play. Then we need to take into accounts things like inflation inertia that makes it more costly to disinflate compared to fabricating inflation. I hope Nick can cower this in the article that he prepares :)

[W. Peden]

Peter N,

I agree that no monocausal explanation will work for the entirety of the Great Depression phenomena, especially at an international level.

As for going through the ceiling: the thought of this being a rather nasty affair was what made me think of the Barber and Lawson booms, which were both caused by very loose monetary policy as a result of (1) overestimating the output gap & an erroneous cost-push analysis of inflation in the case of the Barber boom and (2) a "focus on everything" approach (which naturally tended to mean "focus on what gives the least inflationary signal) & an overreaction to the 1987 stock market crash in the case of the Lawson boom.

In both cases, the disruptions to UK asset prices and inflation expectations were very damaging.

J.V. Dubois,

Nominal downward wage stickiness is ad hoc and subject to the Lucas Critique unless it has some underlying microeconomic cause.

Regarding monopolistic competition and price stickiness: in MC firms are insensitive to price changes in the market, but why would firms be insensitive to the prices of rival firms when they are going down, but suddenly become price competitors when prices are rising? Why would firms be price uncompetitive in a bust, but price competitive in a boom? Firms switching cyclically from differentiation competition to price competition seems more than a mildly unrealistic assumption. So I don't see the asymmetry here, unless there's a special macroeconomic kind of MC (and thus ad hoc/Lucas Critique/etc. etc.).

Similarly, menu costs are symmetric: if a firm's pricing structure has significant costs of changing that make quantity changes more profitable, then this applies as much in response to an increase in sales as a fall in sales.

In comparison, it's obvious (for example) than a legal wage floor will be only downwardly operative, meaning that the disequilibrium costs of minimum wages become apparent only during busts.

Market failure explanations of price stickiness also struggle with the historical data: one way to partly explain the different responses of the US economy to the deflation of the early 1840s and the deflation of the early 1930s is by distributional coalitions getting favours from the government, whereas it would be a heroic thesis that the US was more market-orientated in the 1930s than in the 1840s.

[Peter N]

Downward wage stickiness is definitely real. This is supported both by extensive interviews with management and analysis of actual wage data. I have an entire book devoted to the subject.

If you want an economic approach, consider the various incentives of the parties. The employer depends on the goodwill of the employee in any situation where there is employee autonomy. This goodwill has considerable economic value.

You would expect wage cuts to occur most often in those jobs where employees have the least autonomy and the closest supervision and where they don't act as agents for the company, since in those circumstances goodwill is least important. This is what is actually observed.

[PeterN]

Here's one way to spot a boom: