Krugman’s blog, 6/10/15

There were two posts yesterday.  The first was “The Decade Behind:”

While cleaning out my Princeton office, I became all too aware of the ephemeral nature of policy writing. A depressingly large share of the books on my shelves consisted of 30 years’ worth of books about the crucial decade ahead. Oh well. But as I added all those books to the giveaway pile, I found myself doing a bit of self-referential and maybe self-indulgent thinking, not about the decade ahead, but about the decade behind.

You see, it’s almost 10 years since I started writing about the financial crisis and the Great Recession. True, at first I didn’t know that that was what I was writing about; it began with the diagnosis of a housing bubble, whose bursting I knew would be bad but had no idea would be this bad. Still, there has been a pretty consistent arc, and I find myself thinking about what I got right and what I got wrong.

The starting point, as I said, was the housing bubble. I certainly wasn’t the first to warn on that front; Dean Baker, in particular, was both much earlier and much more forceful. Still, what I think of as my first crisis article did, I think, add value by pointing out the huge difference in price behavior between building-contrained states and others. If you looked at national averages, it was just possible to argue that prices made sense, but once you broke out the right subset of states and cities, the craziness stared you in the face. And the bifurcation was overwhelmingly confirmed in the years that followed:

Goldman Sachs

That was the beginning. Since then, what have I been right about and what have I been wrong about?

Things I got right

1. The housing bubble: It’s very much worth remembering just how much bubble denial there was, and how much it was politically driven; I got a lot of “you only say there’s a bubble because you hate Bush.”

2. Inflation, or the lack thereof: I’ve written about this many times, but after the bubble burst I was an unwavering advocate of the view that the Fed’s expansionary policies posed no inflationary risk. This was again a deeply contentious issue, with the right fully convinced that inflation was coming and some on the center and left at least wobbly on the issue.

3. Interest rates: No crowding out under these conditions. I said it strongly from the start — and on this subject there was a lot of wavering among Democrats, all too many of whom bought into stories about deficit dangers even in a depressed economy.

4. Austerity hurts: A lot of people who should have known better bought into the confidence fairy, or at least accepted the notion that multipliers were fairly small; I said big multipliers under current conditions, little or no offset from confidence, and the research has caught up with and vindicated that position.

5. Inadequate stimulus: I warned, early and often, that the ARRA was hugely inadequate, and that its inadequacy would have lasting consequences — that by falling short, it would discredit the whole notion of stimulus as far as politics was concerned. Alas, I was right.

6. Internal devaluation is nasty, brutish, and long: I argued from the start that adjusting relative prices within the euro area would be extremely hard, that nobody has the kind of wage and price flexibility that would make “internal devaluation” easy — and that countries able to carry out currency devaluations, like Iceland, would have a much easier time.

7. Obamacare is workable: A quite different subject, but back in my book Conscience of a Liberal I argued (not originally) that an ACA-type system of mandates, regulation, and subsidies, while not anything you would build from scratch, would work (I wanted a public option, but that’s another story). Lots of disagreement, both from right-wingers predicting a death spiral and people on the left declaring that it was single-payer or nothing.

Things I got wrong

1. The scale of the disaster: I saw a housing bubble, knew the aftermath would be bad, but had no idea how bad. I was blissfully ignorant of the rise of shadow banking, wasn’t thinking about household debt, and wasn’t paying attention to imbalances within the euro are.

2. Deflation: I thought that Japanese-style deflation was an imminent risk in all depressed economies. Instead, low but positive inflation has been remarkably persistent. I now think that I underestimated the important of downward nominal rigidity, which combined with dispersal of shocks — some workers and firms face strong demand even in a weak economy — tends to keep prices rising even in a depressed world.

3. Euro crackup: For the most part, I think my analysis of the euro area’s economy and its problems was pretty good (but see below). But I vastly overestimated the risk of breakup, because I got the political economy wrong — I did not realize just how willing euro elites would be to impose vast suffering in the name of staying in. Relatedly, I didn’t realize how easy it would be to spin a modest upturn after years of horror as success.

4. Liquidity effects on sovereign debt: Finally, I’m sorry to say that I completely missed the important of liquidity and cash shortages in driving bond prices in the euro area. It wasn’t until Paul DeGrauwe weighed in that I realized just how much difference it would make if the ECB did its job as lender of last resort; if the euro survives, DeGrauwe — and this guy named Draghi, who put his ideas into practice — should get a lot of the credit.

I’ve probably missed some things, although I do think it’s interesting how many of my critics feel the need to attack my record by inventing predictions and claims that I never made. Still, I think that’s the main stuff, and although I have definitely been fallible, I think I did OK — mainly because I never let fashionable worries divert me from basic macroeconomics, and always tried to apply the lessons of history.

Yesterday’s second post was “Notes on Walmart and Wages (Wonkish):”

Walmart reports that its recent wage hike is paying off via reduced turnover, which produces cost savings that offset the direct expense of the higher wages. In other words, efficiency wage theory is vindicated. What are the political/policy implications? What follows is a slightly wonkish note, largely to myself.

Efficiency wage theory is the idea that for any of a number of reasons, employers get more out of their workers when they pay more. It could be effort, it could be morale, it could be turnover. The causes of the efficiency gain could lie in psychology, or simply in the fact that workers are less willing to risk better-paying jobs with bad behavior. The details can matter a lot in some contexts, but in this note I just want to assume that worker productivity is increasing in the wage rate. And I want to focus on the decisions of an individual employer, not the full market equilibrium.

In the absence of an efficiency-wage effect – and also of monopsony power in the labor market, which I’ll come back to another time – an employer can be thought of as choosing employment L to maximize profits, which are equal to the value of sales (net of purchased inputs) generated by the work force minus wages paid:

(1) P = V(L) – wL

where the wage rate w is given by the market, and is outside the employer’s control.

With efficiency wages, we can think of each worker’s productivity E as being an increasing function of the wage paid, so that this problem instead becomes one of maximizing

(2) P = V(L*E(w)) – wL

where the employer gets to choose both L and w.

Let’s assume that the employer actually gets this choice right. That is, I am not going to suggest that Walmart has been making a mistake with its always-low-wages policy, that it would have been more profitable all along if it had been following a Costco-like strategy. Even so, efficiency-wage effects can make a lot of difference.

To see why, suppose that the employer finds itself under some kind of pressure to raise wages – the threat of union organizing, a boycott from consumer groups, politicians looking at it funny. How will it respond to this pressure?

Well, in the absence of efficiency wages the employer has a strong incentive to resist this pressure, because raising wages has a clear negative effect on profits:

dP/dw = -L*

where L* is the initial level of employment. Induced effects on L don’t show up here because of the envelope theorem – L was already chosen to maximize P, so small changes have no further effect.

But if there is a significant efficiency-wage effect, a small rise in wages has a negligible effect on profits:

dP/dw = 0

Why? Envelope theorem again: because w was already chosen to maximize profits, a small change has no further effect. When you’re at the top of a hill, a single step in any direction doesn’t change your elevation much.

And what this suggests in turn is that a relatively small amount of pressure can nonetheless have relatively big effects on wages: the employer may well be willing to raise wages by, say, 20 percent to avoid a consumer boycott or 40 percent to avoid a strike because it knows that it can make up most of the direct cost of the wage hike via reduced turnover and increased productivity.

Or to put it differently, efficiency wages suggest right away that the invisible hand’s grip on labor is a lot looser than people imagine, that wages are relatively easy to shift with social and political pressure. And this is one important reason attempts to reduce inequality can and should involve working on the distribution of market income as well as ex-post redistribution through taxes and transfers.

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