Wednesday, October 17, 2012

John Taylor, Pariah Amongst Piranhas

Lots of heat directed at John Taylor for a recent blogpost about financial crisis and recoveries. Check it out:
Here's an older, better post on the same thing:
And here's some of the reactions, many of which raise some valid points:

Taylor's argument is that that financial crises needen't cause a prolonged slump in output below its potential. Its true that his methodology in the second post was sloppy. The 1973 oil price shock and the 1981 disinflation were not financial crises. Maybe he is guilty of intellectual malpractice, or of trying to manipulate evidence to make his case stronger. But I find his premise that a prolonged slump in the wake of a financial crisis is unnecessary if policy responds appropriately convincing. Por ejemplo, take these three examples: 1893, 1907, and 2008. These three crises WERE financial crises that did result in economic slumps!                                                                 

We currently have unemployment at about 7.8%, or several points above anyone's best guess of the NAIRU. Consensus opinion is that the labor market is still in disequilbirum, with desired quantity demanded less than desired quantity supplied. What is the mechanism that is supposed to bring the market for work into equilibrium? It's the real wage, or the nominal wage / price level. A coherent story about the slump is that the financial crisis caused credit markets to contract and firms to lower expectations of future earnings. This caused a decline in the demand for labor, but because nominal wages are sticky and the price level did not rise, real wages failed to adjust, so more workers are seeking employment than firms want to use as inputs to production. If real wages were perfectly flexible, they would fall in the wake of the crisis, making workers more attractive to employers and causing the remaining jobless to remain so as a result of their leisure/consumption preferences. We had a demand shock. Prices didn't adjust, so we still have a slump. Monetary and fiscal policy (both changes in taxes and targeted spending) can boost aggregate demand. If they haven't, policy makers should be made to answer why. 
The financial crises and recoveries above demonstrate that it IS possible to have a rapid recovery. Maybe prices and wages were more flexible in the past, so demand shocks were not so disequilibrating. But bold movements on taxes, spending and monetary policy can and should go a long way toward mitigating a slump, whatever its origins. Just because poor past policy in other crises may have lead to slow recoveries doesn't mean current policymakers should get a pass. And those who want to throw up their hands and say "It's just how it is after a crisis" are giving a blank check to those in power. A check drawn on the empty account of the unemployed.

Update: John Cochrane weighs in with what I think is the best commentary yet. Here's my favorite excerpt

"If you conclude "recessions are always long and deep after financial crises" then you're saying policy doesn't really you shouldn't be advocating different policies! If policies matter a lot to the length and severity of recessions, then "recessions are always deep and long after financial crisis" is a meaningless statistic, and a poor fig leaf of an excuse."

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