My view is that it is incredibly easy to run off the rails in macroeconomics unless you start by firmly grounding yourself in John Stuart Mill's (1829) insight: A general glut is an excess demand for financial assets at full-employment levels of activity, which by Walras's Law is the same thing as an excess supply of currently-produced goods and services (at full-employment levels of activity). With economy-wide planned spending below expected income (at full employment), the fact that everybody's income is somebody else's spending means that the circular flow of economic activity spirals down until people forget that they want to build up financial asset holdings and once again have spending equal to income in aggregate.
There the economy sits, in a depressed state--until something happens that makes people want to spend more than their incomes at the economy's current depressed state, and the spiral becomes virtuous rather than vicious.
The Fisher-Friedman monetarist version of this story says that there is an excess demand for the particular financial asset of liquid cash money and that demand for money is proportional to the nominal wage. Hence you can fix the downturn and get the economy out of its depression in one of two ways: you can have the central bank expand the money stock, or you can have the market and the Pinkertons push down the nominal wage. Either works. (You could also create an excess of spending over income by the one actor that does not really care much about its cash balances--the government--but monetarists tend not to go there.)
Richard Williamson sees a world in which the nominal money stock in the U.K. has skyrocketed relative to the nominal wage, and concludes that it cannot be aggregate demand. I think that is wrong. I think that it cannot be the Fisher-Friedman monetarist version of the John Stuart Mill aggregate demand stories.
There are other versions of the John Stuart Mill aggregate demand story. Most important, there is the Bagehot-Minsky-Kindleberger story: the economy has too much in the way of risky (and too little in the way of safe) assets. Thus people are trying to dump risky for safe assets, people are eager to cut spending back below incomes in order to build up their safe assets, people who hold risky assets are anxious to build up their safe asset stocks in order to have loss reserves in case these assets vanish, and people who owe risky assets are anxious to build up their safe asset stocks in order to have loss reserves in case they actually have to pay their debts off. There is an excess demand at full employment for financial assets which by Walras's Law is an excess supply at fully employment of currently-produced goods-and-services--a general glut.
But this general glut cannot be fixed by open-market operations: those simply swap one zero-yield safe nominal government liability for another, and have no effect on the economy.
This general glut can only be fixed by things that reduce the stock of risky assets and debt and raise the stock of safe assets and debt relative to the nominal wage. Thus deflation of nominal wages is not only not the cure for this malady, it is the disease itself. This was (one of) Fisher's insights in 1933...
interfluidity » Great Britain as a case study: which sticky price?: Richard Williamson:
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… relative prices of goods and services falling out of whack… sluggish adjustment of some goods and service prices, and stabilizing the price level should diminish the need for such adjustments…. 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….
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… the attempt to reduce indebtedness can lead to a reduction of income that sabotages the attempt to pay down debt….
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….
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….
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.