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The real problem today is not so much nominal

Scott Sumner told us in September 2009 that “the real problem was nominal,” that is, the recession and its high unemployment were primarily due to an unsatisfied excess demand for money (combined with real effects on debt burdens of nominal income being below its previous path). In AS-AD terms, the AD curve (representing combinations of M times V equal to a given level of nominal income Py) had shifted inward, and the economy was sliding down the SR aggregate supply curve. The price level had not yet adjusted enough to clear the market of unsold goods corresponding to deficient money balances. This was a reasonable – almost inescapable – diagnosis in 2009, when the price level and real income were both falling.

Market Monetarists who have been celebrating the Fed’s recent announcement of open-ended monetary expansion (“QE3′) seem to believe that Sumner’s 2009 diagnosis still applies. But what is the evidence for believing that there is still, three years later, an unsatisfied excess demand for money? Today (September 2012 over September 2011) real income is growing at around 2% per year, and the price index (GDP deflator) is rising at around 2%. If the evidence for thinking that there is still an unsatisfied excess demand for money is simply that we’re having a weak recovery, then as Eli Dourado has pointed out, this is assuming what needs to be proved. Dourado writes (I take his “in the short run” to mean “in a situation of unsatisfied excess demand for money”):

So what is the evidence that we are still in the short run? I think a lot of people assume that because unemployment remains above 8 percent, we must be in the short run. But this is just assuming the conclusion. There are structural hypotheses for higher unemployment, but even if unemployment is cyclical, it doesn’t mean that monetary adjustment has failed to occur—real sector recalculation may just take longer than monetary recalculation.

… If we view the recession as a purely nominal shock, then monetary stimulus only does any good during the period in which the economy is adjusting to the shock. At some point during a recession, people’s expectations about nominal flows get updated, and prices, wages, and contracts adjust. After this point, monetary stimulus doesn’t help.

While saluting Sumner 2009, like Dourado I favor an alternative view of 2012: the weak recovery today has more to do with difficulties of real adjustment. The nominal-problems-only diagnosis ignores real malinvestments during the housing boom that have permanently lowered our potential real GDP path. It also ignores the possibility that the “natural” rate of unemployment has been hiked by the extension of unemployment benefits. And it ignores the depressing effect of increased regime uncertainty.
To prefer 5% to the current 4% nominal GDP growth going forward, and a fortiori to ask for a burst of money creation to get us back to the previous 5% bubble path, is to ask for chronically higher monetary expansion and inflation that will do more harm than good.

  • Martin


    what about the balance sheets of private firms? If the firms contracted based upon 5% trend growth, then their balance sheets will still be substantially damaged by the sudden deviation from this trend. This will impair their ability to borrow and invest in projects with a positive NPV and growth as a result will be lower than it could be. No need to invoke malinvestments for the trouble the economy is still in.

    Also whilst the market may clear, this does not mean that the structure of production has adjusted to the new price level: not all prices fall at the same rate. This inefficient utilization of what remains of the previous structure can also be a reason for the low growth. Again, no need to invoke malinvestments for that.

    What I do wonder about is how much of this can be solved by raising NGDP and to what extent this failure of monetary policy has caused permanent damage in loss of wealth.

  • Rob R.

    I have a couple of questions:

    1. It seems that while Larry White would not support monetary easing now he would have supported it in 2008/9 when NGDP was falling. The current situation of high unemployment and low RGDP (compared to trend) is diagnosed as being due to structural issues arising from the housing boom. Given this , what difference would monetary stimulus in 2008/9 have made ? Would it simply have meant RGDP would not have fallen so much back then but we would have arrived at the current situation anyway, or did inappropriate monetary policy from the past have real effects on today’s situation ?

    2. Some proponents of monetary stimulus claim that it is not only required in situations where sticky prices mean that markets are not clearing. They claim that a commitment to higher future NGDP levels will increase expectations of future demand and lead to the AD curve shifting outwards entirely due to more optimistic expectations about future economic conditions. Is there any merit in such thinking ?

  • miguelefe

    IMHO, the real problem is not how much printed paper is needed to cheat people, trying to induce behaviours tending to patch the colossal frauds and bubbles, but instead face the real problem : USA is living above its capabilities.
    The arrival of CHINA as capital demanding power necessarily will lower USA people living standards unless productivity growth outbalances cheapness of China’s workforce.

    Japan has stopped its growth as a consequence of China’s appearence.

    A friend of mine once asked me if I knew which was the best thing USA developed in the 20th century.

    I answered:”DOS and WINDOWS”. He said , no, pal, MAO!!!!! LOL

    Best regards