…and portrays me as an unrealistic ideologue. (In fairness, I implied Mankiw was crazy in my original Mises.org critique to which he was responding, so he handled it with class.) Mankiw first quotes me, saying that future inflation is not necessary to clear the market, because another solution would be for current prices to fall. (Thus, even if it’s true that the “equilibrium real interest rate” is very negative, butting up against the nominal zero rate barrier, then you still get market clearing because the large drop in present prices gives you room for a steep price inflation back up to “normal” levels in the future.) To this Mankiw replies:
I think this analysis is correct, under the maintained assumption that prices (including wages) are completely and instantaneously flexible. But if prices are sticky, then the immediate deflation and concurrent increase in expected inflation won’t occur painlessly. Instead, it would take a while for the price level to fall, and as we wait, the economy would suffer through a period of depressed economic activity.
According to conventional new Keynesian analysis, sticky prices are the ultimate market imperfection that makes aggregate demand matter. If you deny that prices are sticky and assume they can instantaneously jump downward to new equilibrium levels, many macroeconomic problems become much easier to solve. Indeed, you don’t need to solve them at all, as the market would do it.
I wish we lived in the world that Mr Murphy describes, but my reading of the evidence is that we don’t.
[Bold in original]
OK hang on a second. I didn’t say prices would “instantaneously” drop down to new equilibrium levels (where “equilibrium” isn’t even really a good term because Mankiw means something different from what Hayek or Garrison would in this context). Rather, I said that the market isn’t so impotent because of the zero-nominal-interest-rate barrier as Mankiw and others seem to think. The market is trying to adjust to the shocking realizations that have set in after the housing collapse–and this includes the huge increase in the demand to hold cash–but Bernanke won’t let it. So as usual, we have Mankiw et al. blaming the market for something that their own prior interventions are causing.
You don’t need to take my word for it. I will quote someone whom Mankiw presumably respects to make my case:
In this post the economist gives a “Deflation Alert.” So presumably deflation is possible. Oh darnit, on second thought that’s not really such a decisive point in my favor, because people who worry about deflation might mean long-term deflation. In contrast, I was arguing that prices could fall fairly rapidly in order for the market to clear, without the need for Mankiw’s own suggestion of promised massive future inflation.
Ah, but that’s why this blog post from last November is relevant. The author reports with worry that, “The CPI drops 1 percent. Even the core CPI is falling.” Now this is quite interesting. From September to October 2008, general consumer prices fell one percent–and that’s the actual fall, mind you, not an annualized figure (which would have been in excess of 12 percent deflation per year). What’s even more extraordinary is that this price drop of 1 percent occurred while the stock of money held by the public (M1) rose by more than 2 percent (and again, that’s the monthly figure).
Hang in there folks, we’re almost there: Now if prices fell by (more than) 1 percent in one month, at the same time that the quantity of money rose by (more than) 2 percent, we’re looking at a 3 percent monthly drop had Bernanke merely held the money stock constant. If the CNBC pundits are right, and what the economy “needs” right now is a negative 5 percent real rate of interest, and if nominal interest rates are zero, then that means it would take the market economy all of 50 days to achieve the necessary price deflation to clear. (Again, this calculation assumes that Mankiw’s diagnosis of the problem, and his prescription of negative real interest rates, is correct.) The economy has officially been in recession since December 2007, meaning that the interventionist approach has not fixed things in at least 16 months. Note that 50 days << 16 months.
To sum up, in case my cutesy-ness has lost some readers: Mankiw admits that my proposal of allowing prices to fall would work, if only prices in a market economy could quickly fall. But alas, in the real world, market prices don’t fall quickly enough, and so that’s why Mankiw thinks Bernanke needs to promise to dump massive amounts of inflation on us in the future.
Yet I am claiming that the only reason prices haven’t been falling very rapidly is that Bernanke has been pumping in money like there’s no tomorrow. We all know he’s increased the monetary base at an absurd pace, but even the M1 money stock rose 17% during 2008. So if the overall CPI was roughly flat for the year, while the money stock rose by 17%, imagine what would have happened had Bernanke merely pumped in enough base just to maintain M1, let alone had Bernanke truly done nothing and let things play out.
I will leave you with this final quote from Mankiw. Again, does the following sound like a guy who thinks that the market can’t give us price deflation in a timely enough fashion?
The credibility of the promise is paramount. To get long-term real interest rates down, the Fed needs to convince markets that it will vigorously combat deflation, and that if deflation happens in the short run, the Fed will reverse it by subsequently producing extra inflation. A credible promise of subsequent price reversal after any deflation ensures that long-term expected inflation stays close to the inflation rate implied by the Fed’s target price path.
So there you have it, folks. The Fed needs to credibly promise to inflate in the short run, in order to prevent prices from falling. And then the Fed needs to credibly promise to inflate in the long run, because in the imperfect market economy, prices don’t fall in the short run.
UPDATE: I realized I had left one gaping hole in my response. Mankiw might say, “Sure, gasoline and stock prices can fall very rapidly, but the one really sticky price is the wage rate. So you might get housing markets and commodity markets clearing, but you’d still have incredibly high unemployment if we followed your crazy advice and let the CPI drop, say, 17% in 2008.”
It’s true that wages are stickier than many other prices, but that’s largely due to other interventions in the market (unions etc.). But fine, let’s take all those as given. It still doesn’t follow that the market is as fragile as Mankiw believes. It’s not that people in particular jobs would have to take a 20% pay cut, but rather that laid off workers would need to settle for much lower pay in order to get hired someplace else. So if a former quant at a hedge fund that blew up used to make $200,000 a year, and now is driving a cab for $50,000 (I don’t know what cabbies make), that’s a 75% wage cut right there. Were it not for Paulson and Bernanke’s bailouts, there would be plenty of huge cuts like that to be thrown into the national averages.