Site Meter

Friday, January 12, 2007

I'm actually writing about Economics !

Paul Krugman says that Brad DeLong is being too hard on Franklin Roosevelt

The key passage (for my purposes) is here

What really puzzles me, though, is the assertion that wage and price rigidity created by the New Deal aborted the natural recovery process. Through what channel could price flexibility have helped? The US spent most of the 30s pretty much up against the zero bound, with interest rates well below 1 percent. A fall in the price level would have had the same effect as an increase in the monetary base - that is, no effect at all - except for the slight wealth effect of rising real balances. And even this slight effect could easily have been outweighed by debt deflation.

I am impressed by Krugman's brilliance (as always) but not convinced by his argument (is this the first time for me ?). I don't know exactly what to do.

My problem is this. Krugman discusses the price level and notes it didn't matter given the liquidity trap with nominal interest rates as low as they can go. However, this was due to deflation. The price level may not have mattered in the usual way, but the deflation rate mattered a lot.

I can present a story in which the key issue was to get the deflation rate up to 0 and price flexibility was needed to do this. That is a more rapid deflation would be a briefer deflation.

The story follows
banks fail and the money supply falls partly because their reserves become cash in circulation and the money multiplier thus falls and partly because fearing more failures consumers take cash out of banks (more vault cash to cash in circulation) and banks feel they need higher reserves. Finally some of the cash in circulation is really cash stored under matresses so it is not working as money at all.

The reduction of the money supply causes an increase in the relative price of money (a deflation) so 1% nominal is huge real and investment collapses. Only when the deflation ends can firms afford to invest again.

The deflation ends when the real value of money is so high that there is enough so that money actually circulating fits
M*V = P*Y with a normal V. For this to happen, it is necessary that people have built up the desired amount of cash under matresses.

The story is there is a new lower equiilibrium price level and deflation continues until it is reached.

Now, if Krugman bothers to respond to my argument, he will say "what about the Phillips curve. The price level affects nominal interest rates (unless there is a liquidity trap) and they affect aggregate demand, but the change in the inflation rate depends on the unemployment rate via the Phillips curve. The only way to end deflation was to get the unemployment rate down using fiscal policy and/or/including the WPA and public works projects.

To which I say hmmm the old Phillips curve applies in normal times and not when the key issue is how much money people have stuffed under their matresses. There is no empirical evidence, because we have no information on the shape of the Phillips curve at unemployment over 15% do we ?

So finally bottom line. Maybe with more price flexibility there would have been a quicker briefer deflation. Real interest rates would have been even huger during this deflation but investment can be less than zero. I we assume that the bankruptcy of most industrial corporations due to debt deflation would have been no big deal, we can conclude that the NIRA may have prolonged the depression by a few months (by slowing and extending deflation until it was a dead letter).

Anonymous has left a new comment on your post "1/12/2007 03:05:00 PM":

nice dream ...
in destroying the banking system
u forgot that
gold will make
a come back

Wow an actual comment on economics

Anonymous has left a new comment on your post "1/12/2007 03:05:00 PM":

Wasn't this essentially Pigou's argument? In light of both Kalecki's response, and the "stylized fact" (as I recall from grad school many years ago) that the price level fell by about a third and the mfg wage level by about a quarter from 1929-1933, the degree to which the price level would have had to fall, and the degree of wage and price flexibility would have had to be staggering!

Double wow and actual non crazy comment on economics. I think it is also Keynes argument in the paragraph immediately preceding the one implicitly cited by Krugman.

No comments: