SR vs. LR Unemployment and Economic Growth

Moneybox:

Short business cycle downturns like the ones the United States had in the 1950s and 1960s shouldn't have any real long-term consequences even if they're severe. But prolonged spells of mass unemployment provoke things like the current trend of European employers reducing investment in skills training since if there's going to be a surplus of potential workers and a deficit of potential customers, high-investment firms are going to lose out unless they hit incredible home runs.

The same logic should apply to "hard" capital investments as well. When I was in Paris last fall, I was interested to see that Parisian McDonaldses have computer kiosks where customers can place orders without taking up the time of a human cashier. Rival fast food chains like KFC and Quick didn't yet seem to be using this technology and McDonalds was only employing it to a limited extent. If France was facing a high-demand tight labor market scenario for the future presumably McDonalds would double-down on this bet and rivals would either match their productivity-enhancing capital investments or else be displaced by McDonaldses high productivity model. But instead France has had, and looks scheduled to continue to have, a long period of depressed demand and elevated unemployment. Firms have little reason to spend money insuring themselves against workers quitting in search of higher wages and little reason to believe that increased output will actually be purchased.

NGDP targeting is better than inflation targeting.

Most central banks currently have inflation targets (which perversely seem to keep ratcheting downward).  NGDP targeting is better than inflation targeting. Why? Moneybox:

Immunity to the "zero lower bound" problem is one reason, but the more important reason is that an NGDP targeting central bank would respond better to supply shocks than would an inflation targeting central bank. Consider, for example, the possibility that a terrorist attack in Kuwait disrupts world oil supplies. This is going to contract aggregate demand in the United States because as oil gets suddenly more expensive, the dollar value of our imports from non-disrupted countries will soar but those countries aren't going to immediately start importing more foreign goods in response. But the more expensive oil is also going to push the price level way up. Inflation targeting tempts the central bank to respond to this surge in inflation with tighter money even as the economy is being rocked by a fall in demand. An NGDP targeting central bank, by contrast, is able to say "steady as she goes." For the duration of the negative supply shock the country will experience an unusually large amount of inlation and an unusually small amount of real growth, which will suck, but the suckiness won't be compounded by tight money regime. Conversely, an NGDP targeting central bank will simply take a positive supply shock as welcome news. Real growth rises and inflation falls leading to a nice pleasant span of unusually rapid real wage growth. Everyone applauds. An inflation targeting central bank, by contrast, is going to greet the good news with a weird kind of panic as if improved technology or a natural resource boom is some kind of deflationary crisis.

Oil Prices and Recessions

Kevin Drum:

Jim Hamilton, an economist at UC San Diego who has done extensive work on the economics of oil spikes, has just published a summary of the current state of oil macroeconomics called "Oil Prices, Exhaustible Resources, and Economic Growth." His conclusion: "The historical record surely dictates that we take seriously the possibility that the world could soon reach a point from which a continuous decline in the annual flow rate of production could not be avoided."
Translation: peak oil might not be far away, and we should take it pretty seriously. And Hamilton's research suggests strongly that when peak oil does arrive, it's not going to be pretty:

Coping with a final peak in world oil production could look pretty similar to what we observed as the economy adapted to the production plateau encountered over 2005-2009. That experience appeared to have much in common with previous historical episodes that resulted from temporary geopolitical conflict, being associated with significant declines in employment and output. If the future decades look like the last 5 years, we are in for a rough time.
Most economists view the economic growth of the last century and a half as being fueled by ongoing technological progress. Without question, that progress has been most impressive. But there may also have been an important component of luck in terms of finding and exploiting a resource that was extremely valuable and useful but ultimately finite and exhaustible. It is not clear how easy it will be to adapt to the end of that era of good fortune.

"Pretty similar" to 2005-09 means a big spike in oil prices that causes a big recession. The chart on the right shows what he means. The green line shows expected economic growth. The dashed line shows the Great Recession. And the red line? That's his estimate of the effect of the huge spike in oil prices in 2007-08. If Hamilton is right, then the oil spike is responsible for about two-thirds of the Great Recession all by itself. The housing and credit bubbles are only responsible for a fairly small piece of it.
But even if Hamilton is wrong about the precise trajectory of the 2008 meltdown, the evidence is now clear that oil spikes have a very significant effect on the economy. And as the production of oil starts to plateau, oil prices are going to spike a lot. In fact, they're likely to spike every time the global economy starts to grow.

New Monetarism vs. Friedman vs. Hayek vs. Keynes

Here is some intellectual history by a conservative economist who greatly admires Hayek and even thinks that Hayek's macroeconomic theories have some merit even if they are weaker than many others.  I predict/hope that this is a sign of where a new macroeconomic consensus may be heading.  Conservative economists are promoting NGDP targeting and liberals have no problem with it even though many would also like more government spending during a liquidity-trap recession.  The thing that surprised me the most during the 2008 recession is how little conservative economists promoted tax cuts as a fiscal stimulus like they did in the 2001 and 1990 recessions.   David Glasner:

First, it was the Keynes v. Hayek rap video, and then came the even more vulgar and tasteless Keynes v. Hayek sequel video reducing the two hyperintellectuals to prize fighters.

See the rest at Medianism.org

IS-LM

Brad Delong has an excellent summary of Keynesian Macro:

The Changing Multiplier Since 1925...

The largest shifts in economists’s views of what the value of the multiplier is over the last eighty or so years have been the result not of changing views about the structure of demand, but rather of changing views about the conduct of monetary policy.
The IS-LM framework remains the best way to summarize the issues. (See David Romer (2012), Short Run Fluctuations.) With the long-term risky real interest rates on the vertical axis and the level of real GDP on the horizontal axis, the IS curve summarizes the flow-of-funds through financial markets equilibrium condition--or, if you prefer, the representative agent's Euler equation (for they are the same thing, or rather the second is a very special representative-agent version of the general theory that is the first). But that by itself does not pin down the economy's path. Another condition is needed, a monetary policy condition.
Decompose the long-term real risky interest rate that you need for the flow-of-funds equilibrium condition into four pieces: a risk premium; a term premium; an inflation component; and the short term safe nominal interest rate that comes out of the money market, and equilibrates money supply to money demand.
In the years since Hicks laid out this framework in 1937, the economy has transitted through five different monetary policy regimes.
In not historical but rather logical logical sequence:
First in logical order is monetary dominance: the monetary authority has a view of what level of real spending right now is consistent with its long-run inflation target, and it pushes the money stock wherever it needs to in order to hit that target. Real GDP will be set by the monetary authority as a function of inflation and perhaps other variables according to its monetary policy rule.
On the IS-LM diagram under this monetary policy régime, the counterpart curve to the IS curve is not an LM curve but rather an MP curve, a monetary policy curve. And this monetary policy curve is vertical. Under such a monetary policy regime, the multiplier μ is zero. Whatever effect expansionary fiscal policy has on the IS curve will show up 100% as a change in interest rates and 0% as a change in output levels. This was the monetary policy regime that the Clinton administration believed it was operating under when it proposed a substantial deficit-reduction package in the late winter of 1993, even though the unemployment rate was less than a year past its recession peak.
Figure 3A.1: Monetary Dominance: μ=0

Second in logical order is the Friedman rule: the monetary authority has a smoothly growing target for the money stock, and it takes steps to hit that target. If the Friedman rule is credible, expectations of inflation will not vary: shifts in the inflation premium will not tilt what is now an LM curve up or down on the IS-LM diagram as real GDP increases or decreases. However, under the Friedman rule the LM curve is not vertical: it has a positive slope. Higher nominal interest rates raise the velocity of money. A more prosperous economy makes bankruptcy less likely and reduces the risk premium. In this monetary policy regime, the government purchases multiplier exists: μ is not zero. However, μ is likely to be small because of the likelihood of substantial interest-rate, and perhaps price-level crowding out. How much crowding-out there would be was the subject of debate between Tobin and Friedman, with Tobin stating that it was an empirical issue, and Friedman claiming the multiplier was too small to matter unless the interest elasticity of money demand was near infinity.
Figure 3A.2: Friedman Rule: μ Small
 Third in logical sequence comes the gold standard: the monetary base is fixed but the money supply is elastic because banks respond to higher demand for loans and deposits by taking more risks. A Friedman rule central-bank is not passive: it is strongly leaning against the wind, cutting the monetary base in the boom and increasing the monetary base in the slump. A gold standard central bank is almost an oxymoron: if it is actively managing the monetary base, it is not really a gold standard anymore. Under a true gold standard the LM curve is no longer quite an LM curve—although it is also not right to call it an MP curve either. Whatever it is, the fact of an elastic money supply makes it even flatter than the Friedman-rule LM curve.
Figure 3A.3: Gold Standard: μ Moderate

Fourth in logical sequence is a central bank that targets the real rate of interest: call this the “constant monetary conditions” multiplier. This is the multiplier that would be estimated by cross-state fiscal-policy regressions in the United States, or cross-country fiscal-policy regressions in a monetary union, were there neither demand spillovers nor cross-jurisdiction factor mobility to bias the estimated coefficient one way or another.
Figure 3A.4: Real Interest Rate Targeting: μ Larger Still
 Note that a monetary authority that targets the real rate of interest is likely to be pursuing a policy in which nominal interest rates are rather strongly procyclical. Inflation will surely rise with higher levels of real GDP. Risk spreads are likely to fall as well. Both of these must be compensated for by rising nominal interest rates if the monetary authority is truly going to pursue a policy that keeps the real interest rate constant. The multiplier μ under such a monetary policy rule is likely to be rather large: there is neither investment-based nor export-based interest-rate crowding out, since the purpose of the policy is to ensure that the interest rate does not move.
Fifth and last in logical sequence is when the monetary authority finds itself in a liquidity trap, at the zero-nominal interest rate lower bound. In this case the MP monetary policy curve slopes not upward but downward. As output increases and as expectations of inflation rise, the short-term safe real interest rate declines. An economy with higher output is one with fewer bankruptcies and lower risk premia: spreads fall as well, and the short-term real risky interest rate declines even more along this MP curve.
Figure 3A.5: Zero Lower Bound: μ Large 
Under all the other monetary policy régimes the monetary authority could, if it thought wise, shift the MP or LM curve to provide further monetary expansion. Under monetary dominance it would simply change its near-future real GDP target. Under the Friedman rule it would boost the money stock growth rate. Under a gold standard it could sell some of its own gold holdings or change the gold parity. Under a constant real interest rate régime it could change the target real interest rate.
But at the zero nominal lower bound the monetary authority’s available tools are much weaker, and active monetary policy seems likely to be of limited effectiveness. The monetary authority can promise higher inflation in the future—but how is it to make that promise effective and credible, especially in a political and technocratic environment averse to even moderate inflation? Quantitative easing to boost the money stock can always be reversed if the assets purchased by the monetary authority as it issues more cash are traded in thick markets. And if the monetary authority issues cash and wishes to demonstrate that the transaction will not be unwound by using the cash to purchase assets that cannot easily be sold off —bridges, highway interchanges, and the human capital of twelve-year-olds, for example—that looks a lot more like fiscal than monetary policy, albeit a fiscal policy conducted by the monetary authority.
The monetary authority can attempt to reduce risk and duration premia directly by taking default and duration risk onto its own balance sheet, but portfolio balance considerations suggest that the power of such non-standard monetary policy tools is likely to be small.
The flip side of the likely limited power of change in the monetary authority’s policy rule at the zero nominal lower bound is that the fiscal policy multiplier μ appears likely to be at its largest. The fact that the monetary policy régime produces an MP curve that slopes “the wrong way” means that equilibrium levels are fragile in the sense that small shocks can cause the economy to jump a long way—in either direction.

Macroeconomics and Political Ideology

The left -- right (progressive -- conservative) political spectrum still shows some divisions among  macroeconomic theorists. 

On the Right, the macroeconomists involved in government policy and business forecasting are almost all Keynesians, but they tend favor tax-cuts over government spending and their spending priorities are different from those of the Left:
Keynesian: Conservative Keynesians have dominated economic policy for almost every Republican president and Republican candidate (post primary).  They have tended to focus on cutting taxes as an economic stimulus rather than on raising spending.  For example, both McCain's chief economic adviser, (Doug Holtz-Eakin) and Romney's (Glenn Hubbard) are Keynesians.  Everyone I recognize on the list of past presidential economic advisors are Keynesians too going back to at least the Ford administration.  Conservative Keynesians tend to favor government spending for different priorities than progressives.  For example, they are a bit more likely to promote military spending as a stimulus, but military Keynesianism is also fairly popular on the Left.  The American Conservative Magazine wrote that, "An astonishing number of the Republicans’ most cherished economic thinkers can be called Keynesians." 

What is a conservative Keynesian? While there may not be a formal definition—mainstream Keynesianism has many nuanced variations—it is fair to say that a conservative Keynesian 1.) looks at the world in terms of macroeconomic aggregates, that is, total output, total employment, and most especially aggregate demand; 2.) sees government fiscal policy as a way to improve those aggregates; and 3.) embraces or at least tolerates deficit spending and inflation in the short run. That much is pretty close to standard Keynesianism. What makes one a Keynesian of the Right is a preference for tax cuts over government spending, although the intention is the same: to put money into the hands of consumers as a way to increase aggregate demand during recessions.

Monetarism:  This school was based on Milton Friedman's ideas in the 1970s.  It substantially ceased to exist as a separate school by the 1990s because Friedman won and his ideas merged with Keynesianism.  The main effect has been to put greater priority upon monetary policy than fiscal policy both for fighting recessions and especially for reducing inflation.  Ironically, Friedman drew upon some of Keynes' monetary ideas that Keynes' intellectual followers had been ignoring.  Some libertarians on the right like to portray Keynesian economics as 'central planning' in which fiscal policy is 'socialism'.  They see monetarism as a free-market alternative.  Milton Friedman had this leaning although I don't think he ever said it so bluntly.  But monetarism is also a form of central planning in which the government planners at the central bank adjust the most fundamental price in the economy, the price of money, to fine tune the economy.  They fine-tune interest rates and inflation in order to stabilize unemployment and economic growth.  Fiscal policy seems to be more politically contentious, but monetary policy is also a kind of central planning. 
Real Business Cycle (RBC):  Also known as the "new classical school", freshwater economics, liquidationists, etc.  RBC scholars tend to be libertarians who believe that recessions are natural and inevitable and that government policy changes can only make them worse. 
Austrian Business Cycle:  This theory is "now rarely discussed by mainstream economists, but was more actively debated" before the end of the Great Depression.  Even Hayek gave up on working on it by the end of the Depression.  At the PhD level, the last university in the world that still focused on the Austrian theories was Auburn University, but it was disbanded in 1999 and they never had anyone who taught macroeconomics! The Austrians rejected the RBC mathematical methods, but they agreed with the conclusions of the RBC theorists.  They think that recessions are naturally the best of all possible worlds and nothing can or should be done to try to lessen them. 
Austerians: A term of derision for Austrian and RBC economists who think that the government should fight the recession through the opposite of Keynesian (and monetarist) policies.  Austerity is reducing deficits and the money supply.  Austerians think that the recession is being prolonged because people have lost confidence in the government (worries about government inability to pay back debt) and in our money (worries about inflation). Only a small percentage of economists are Austerians, but this ideology has wide populist appeal outside of the economics profession.  Some of the leaders of elite institutions like the European Central Bank, the Bank of International Settlement, and the OECD are Austerians. 

Left:
Keynesian:   The main schools are the new-Keynsians and the old-Keynesians (or neoclassical Keynesians), but both are more favorably predisposed to government spending than conservative Keynesians who are more likely to favor tax cuts as an economic stimulus.  There are a lot of sub-categories of Keynesians on the left, but their policies are all broadly similar:

Neo-Keynesian, Old-Keynesian, or Neoclassical Keynesian:  This was mainstream macroeconomics from 1936-1980.  It is based on Hicks' IS-LM model and the Phillips curve. 
New-Keynesian: Use the same mathematical modelling techniques as RBC, but add 'frictions' like sticky prices to get very similar results as the old Keynesians. They just use different methods to come to very similar conclusions. 
Post-Keynesians: They claim to be very close to the Keynes' original ideas which they say were warped by the neoclassical Keynesians.  
Monetarist:  Friedman won the intellectual debates over the role of monetary policy and almost all economists on the left embrace monetarist solutions as the primary tool for macroeconomic management and they also support fiscal (Keynesian) measures as well.  In Keynes himself supported monetary stimulus.

Agnostic-Apathetic School:  There are a few economists on the left who simply have little opinion about macroeconomic debates because they did not study recessions in graduate school.   They either focused on  microeconomics or they believed that recessions are not important in comparison with  studying economic growth, international trade, or finance.  I would put Jeffrey Sachs in this camp.  He is a brilliant development economist who keeps saying stupid things about the recession because he clearly has not put much thought into it.  His priorities simply lie elsewhere.  Unfortunately,  Obama has economic advisers who are in this camp.  They went along with calls for austerity because they thought it was politically popular and they did not prioritize fighting unemployment.  The big divide on the left is between Keynesian-monetarist economists and the apathetic economists. 

Today the three main macroeconomic schools of thought to know are:

1. Keyensians
2. Monetarists
3. Real Business Cycle (New Classical)

The monetarists and Keynesians have very similar ideas and make similar predictions about the world.  The big ideological divide in macroeconomics is between them and the RBC economists who make radically different predictions and think that the government cannot do anything to reduce recessions.  The monetarist-Keynesian ideological divide is mostly one of priority.  Economists who call themselves Keynesians put more priority on fiscal stimulus and think that works better.  Economists who call themselves monetarists put more priority on monetary stimulus and think that works better.  A few Keynesians think that monetary policy does not work at all in some situations and a few Monetarists think that fiscal policy does not work at all in some situations but most mainstream Keynesians endorse monetarism and vice versa.

Although RBC is important in some prominent graduate schools, almost all the undergraduate Macro textbooks ignore it in favor of the Keynesian-monetarist synthesis.  Personally, I am both a monetarist and Keynesian.  I think they are two great tastes that go great together.  Massive unemployment and idle capital is a waste and a tragedy and we should use all available tools to reduce the tragic waste of unemployed labor and capital.

NGDP

Real Time Economics:

This helps explain why nominal gross domestic product — that is, total GDP without inflation stripped out – has wound up at the center of a debate over how, and whether, the Federal Reserve can do more to stimulate the U.S. economy and lower the nation’s current 9.1% unemployment rate.
The problem boils down to the Fed’s current dual – or in fact, triple – mandate from Congress. Here is the entire wording of the Fed’s mandate, which falls under Section 2A of the Federal Reserve Act.

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

It is this last part which is at the heart of today’s policy debate. In theory, and in the long run, it should be consistent for the Fed to conduct monetary policy in a way that promotes a healthy economy marked by maximum employment, stable prices, and moderate long-term interest rates. But that is little help at a time like now, when the Fed is roughly meeting the latter two objectives but falling well short on the first; that is, on reaching anything close to “maximum” or full employment, typically defined as something like an unemployment rate of 5% (though many think today, for various reasons including demographic ones, this rate is now closer to 7%). ...
The beauty of the NGDP target, as proponents see it, is that it doesn’t differentiate between inflation and real GDP. So it doesn’t matter whether the gap is closed by three parts inflation and one part real GDP or one part inflation and three parts real GDP. The point is that the gap gets closed, because the Fed is able to be as aggressive as it needs to be, and the economy avoids a prolonged slump and chronically high unemployment a la the Great Depression. And by targeting NGDP, or a stated goal for the total size of the economy, instead of a 3% or 5% inflation rate, the Fed is better able to avoid the backlash that might otherwise undermine its ability to achieve said objective.
But would this really work? Now that NGDP is getting serious attention, this question becomes all the more important. Below, a (very abbreviated) round-up of the debate. Best to get up to speed as much as possible now, as it is only likely to gain momentum from here.
Further reading on NGDP targeting:
–Scott Sumner’s work.
–The Goldman note.
–Karl Smith, “NGDP Targeting in Real Life”
–Interfluidity: “The Moral Case for NGDP Targeting” (with links to many others, including Paul Krugman and Brad DeLong, on this issue)
–Bill Woolsey, emphasizing the monetarist position that underlies an NGDP target.
–Heard on the Street: Inflated Expectations for Economic Fix (and Sumner’s response here.)
–Free Exchange: Understanding NGDP Targeting

The moral case for NGDP targeting

The last few weeks have seen high-profile endorsements of having the Federal Reserve target a nominal GDP path. (See Paul Krugman, Brad DeLong, Jan Hatzius and colleagues at Goldman Sachs.) This is a huge victory for the “market monetarists”, a group that includes Scott Sumner, Nick Rowe, David Beckworth, Josh Hendrickson, Bill Woolsey, Marcus Nunes, Niklas Blanchard, David Glasner, Kantoos, and Lars Christensen....
Here I want to join the market monetarists’ happy dance, and point out several moral benefits of NGDP targeting.

• The most plain moral benefit of NGDP targeting is that it is activist. Relative to the status quo, it demands a serious effort to combat the miseries of depression. This is a big improvement over our current strategy, which is to shrug off and rationalize mass deprivation and idleness.
• A second moral benefit is that under (successful) NGDP targeting, any depressions that occur will be inflationary depressions. Ideally, we’ll find that once we stabilize the path of NGDP, the business cycle is conquered and there will be no more depressions ever again. But that probably won’t happen. If depressions occur even while the NGDP path is stabilized, then they will reflect some failure of supply or technology. Our aggregate investment choices will have proved misguided, or we will have encountered insuperable obstacles to carrying wealth forward in time. It is creditors, not debtors, whom we must hold accountable for patterns of aggregate investment. There always have been and always will be foolish or predatory borrowers willing to accept loans that they will not repay. We rely upon discriminating creditors to ensure that funds and resources will be placed in hands that will use them well. Creditors allocate capital by selecting the worthy from innumerable unworthy petitioners. An economic downturn reflects a failure of selection by creditors as a group. It is essential, if we want the high-quality real investment in good times, that creditors bear losses when they allocate funds poorly. When creditors in aggregate have misjudged, we must have some means of imposing losses without the logistical hell of endless bankruptcies. Our least disruptive means of doing so is via inflation....
  In fact, NGDP targeting, despite the stench of sugar-high money games that Austrians perceive in it, might actually increase our ability to impose losses on foolish creditors via default and bankruptcy. This would pay a huge moral dividend, in terms of our ability to avoid the unfairness of arbitrary bail-outs. Both Nick Rowe and Scott Sumner have suggested to me that if we had sufficiently aggressive monetary stabilization, we could avoid acquiescing to “emergency” rescues that flamboyantly reward bad actors, because allowing bad actors to collapse would no longer threaten the rest of us. Rajiv Sethi has made a similar point:
  

  The main justification for these extraordinary measures in support of the financial sector was that perfectly solvent firms in the non-financial sector would have been crippled by the freezing of the commercial paper market. But as Dean Baker has consistently argued, had the Fed’s intervention in the commercial paper market been more timely and vigorous, it might been unnecessary to provide unconditional transfers to insolvent financial intermediaries....

   In constrast to an inflation-targeting central bank, an NGDP-targeting central bank need not distort the division of income between capital and labor. Under current practice, the Fed tends to encourage asset price inflation but worries frenetically over any growth in unit labor costs, or, equivalently, labor’s share of income. Labor share of income has been collapsing since about 1970.