Edmund Phelps on the 80's High Unemployment Problem in Europe

In 2006, Edmund S. Phelps from Columbia was awarded the Nobel Prize "for his analysis of intertemporal tradeoffs in macroeconomic policy".  Phelps works have brought micro economics analysis in incentives of employers and employees to explain macro economic phenomena, unemployment and a natural rate of unemployment.

While studying his works, I was amused by his study on the 1980's Europe. During the first half of the decade, European countries experienced increasing unemployment rate.

His interest in the 80's Europe rests on a fact that there was no evidence of unexpected disinflation or deflation while unemployment rate was rising in the Europe. Rise in unemployment rate in Europe started when the most of the world experienced recession in the early 1980's. However, the unemployment rate in the Europe prevailed at the higher rate while unemployment in the US continuously decreased following a hike during the recession.

Then Phelps tried to solve this puzzle of high unemployment rate together with not so much deflation in Europe. First, he gave an argument on why this surge in the unemployment rate couldn't be explained by some fiscal tightening in Europe if it had one. He disproves fiscal austerity explanation for the unemployment rise by two parts. First, he just looks at the budget deficits of the leading countries in the area. He found that, in fact, there wasn't an evidence of fiscal tightening on the budget balance sheet. The following table shows that the following countries were having an easier fiscal policy than they had in 1980, when the unemployment wasn't high, during the first half of the 80s.  Moreover, he temporarily borrows a Keynesian hat and tries to see what Keynesian theory would say if there was indeed a fiscal tightening, and the the unemployed surge was caused by it. If there was a fiscal tightening during this period, decrease in the government spending or increase in tax would lower nominal interest rate according to IS-LM model "assuming that the supply of money is not permitted to change course in response." However, the empirical evidence doesn't support this Keynesian argument for high unemployment rate because the nominal interest rates in leading European countries except Denmark were higher during the period than they were in 1977.

Phelps further states:

"The evidence is all the more crucial when we reflect that, whatever the
cause, the resulting contraction of employment per se would tend to
slow the growth of nominal wages, thus to reduce the inflation premium
in nominal interest rates that borrowers are willing to pay, and hence,
other things equal, to lower interest rates. The rise of the average
European nominal interest rate is thus doubly hard to square with the
Keynesian fiscal hypothesis."

He finally gives some hope for Keynesian theory by offering a counterfactual argument that if there hadn't been fiscal tightening, the nominal interest rate, output and velocity of money would have been even higher. Therefore, according to Keynesian explanation, there was indeed fiscal tightening, that in fact lowered the nominal interest rate even though the nominal interest rate increased in absolute value. Therefore, Keynesian theory has no problem of telling the story of high unemployment in Europe. However, Phelps argues that in order for this Keynesian explanation to work, there has to be another contractionary shock other than fiscal tightening that raises the nominal interest rate while it contracts employment. If, according to him, there is not such another shock, a lone fiscal tightening would only lower the nominal interest rate in absolute term, but the nominal interest rate increased. To me, the interesting part of his argument is whether there could be a such contractionary shock that raises the nominal interest rate while contracts employment.

To explain this high unemployment period, Phelps proposed broader explanation for it which says that there was a change in the natural rate of unemployment. I will write about his explanation for rise in the natural rate of unemployment in a later post. To prepare my readers for that, I will end this post by quoting the conclusion of his paper (Phelps 1986, 509):

Our vision of the persistence of unemployment in Europe posits a
considerable degree of real wage stickiness, whether loosely imple-
mented through private understandings or enforced by public provisions
for indexation. If, to take the extreme case, the real wage of an employee
is a constant and if, as a consequence, the real cost savings (also
expressed in consumer goods) to the firm of laying off an employee,
which is the true cost of using the employee in production in view of any
benefits paid to the laid off, is likewise a constant, in the sense of having
been earlier predetermined for the course of his employment, a decline
in the real marginal-revenue productivity of labor as a result of devel-
opments such as a rise of markups, a real depreciation of the currency,
a fall of the real price of capital goods output, or a contraction of the
capital stock will cause some employees to be laid off. Further, unless
the real marginal productivity schedule is restored, laid-off workers will
remain laid off for the balance of their years as employees. In this extreme
case of real wage stickiness, it is only the entrance of new workers,
insofar as they can make deals for employment at reduced real wages in
view of the reduced marginal-revenue productivity of labor, that will
erode the average value of the real wage; but this statistical adjustment
will do nothing to put laid-off workers back to work. To the extent that
customer markets inhibit the rise of new firms to absorb the young while
contracts protect existing laid-off employees from being passed over for
recall in favor of hires of cheaper workers from the outside, new entrants
will end up bearing a share of the economy's unemployment-indeed an
increasing share as new entrants accumulate and the laid-off take the
places of retiring workers.

In the expectational sense, the equilibrium unemployment rate is thus
increased, and the natural rate with it. Yet their "long-run" values need
not have increased. (Also, it is not implied that the equilibrium rate
increased as much as the actual rate.)

The Fed and a Bubble: Flashback to 1927-1930

In recent discussions around effects and consequences of the Fed's monetary policy, a bubble in stock market has attracted attention. Even though the Fed's conventional and unconventional easy monetary policy, along with fiscal policies, has been keeping the U.S. economy from slipping into another Great Depression, unintended consequences of the Fed's recent policy, specially QE3, could be a big problem on its own as the policy sustains the recovery. The full effect of QE on the economy and the financial system isn't still fully known. Victoria McGrane quotes San Francisco Fed President John Williams from his recent paper on the zero lower bound:

Added to this uncertainty, the programs also raise “nagging concerns that large-scale asset purchases carry with them particular risks to the economy or the health of the financial system that we still don’t understand well,” he said.

Warning of a stock bubble has already been voiced by some of the Fed's policy makers. They argue that today's historically low federal funds rate has been fueling the stock prices. Therefore, they argue the Fed should pull back its bond-buying program to stop the potential stock bubble. However, the Fed shouldn't, in my opinion, tighten its monetary policy  so quick to just stop any potential bubble.

Here, Economist's 1998 article, "America's Bubble Economy", says:

In the late 1920s the Fed was also reluctant to raise interest rates in response to surging share prices, leaving rampant bank lending to push prices higher still. When the Fed did belatedly act, the bubble burst with a vengeance. The longer that asset prices continue to be pumped up by easy money, the more inflated the bubble will become and the more painful the economic after-effects when it bursts.

Now, let's try to see what was the Fed's action in the years prior to the Great Depression. In 1927, the Fed decreased its federal funds rate in the face of a mild recession in the U.S. and Britain's balance of payments crisis. Following this policy, the stock market prices gained 39% and the price-dividend ratio rose by 27% in 1928 (FYI: IN 2013, the Dow and S&P500 stock prices gained 26.5% and 29.6% respectively.) Worrying about a potential stock market bubble, the Fed raised the discount rate from 3.5% to 5% in the first half of 1928. The contractionary policy seemed to be working as the price-dividend ratio continuously fell until July 1929, when it started to increase again. Acting against this increase in the stock price, the Fed further increased the discount rate to 6% in August 1929. We know what happened next: the stock market crashed in late October of 1929. Here, we can see the Dow Jones Industrial Average price and price-dividend ratio in late 1920s.

As we briefly discussed the actions that the Fed took to cool down the stock market in the late 1920's, we should study further what this Fed's actions led to.

Today, the Fed faces the same problem even though Fed Chairman Ben Bernanke doesn't see an evidence of a bubble. Therefore, today's one of the biggest problems is whether the Fed can manage its bond-buying program in a way such that it's action doesn't burst or sustain any dangerous bubble.

The Income Inequality and the Economic Downturns

When we look at the similarities between the Great Depression and the Great Recession, one stark phenomenon that only these two economic downturns saw was the high income inequality in the U.S. that preceded these economic disasters. If we look at the graph showing the historical percent share of income of the top 10%t, this share was at the record high levels right before the Great Depression, in 1928, and the Great Recession, in 2007. In fact, during those times, the income share of the top 10% was almost 50%. As we look from the graph, this high level of income inequality was not seen during the time between the two great crises. This high level of inequality was seen first time at the onset of the Great Depression, and the next one coincided with the beginning of the Great Recession.

Could the increasing income inequality have been a root cause of the greatest economic panics the U.S. economy has faced in the 20th and 21st century? Let me try to see the potential link between the high level of inequality and the economic downturn. When people at top of the income ladder get bigger share of the total income, the folks at the bottom of the ladder would get less share of the total income. However, when, the top, let’s say, 10% get more income, their propensity to consume would decrease. In other words, the money that would have otherwise been spent for the consumption by the bottom 90% wouldn't be spent for the consumption by the top 10%. This leads to a decrease in total consumption in the economy which could have caused the downturns.

The most interesting data we can see is that since the official end of the Great Recession, the income share of the top 10% has only gone up until 2012, in which the latest data is available. Not only did the income share of top 10% go back to the pre-crisis level, but also it is now greater than 50%. In 2012, the top 10%t collected more than a half of the total income for the first time during the time of data. In other words, the income inequality in the U.S. is going to the same direction as it went to before the crisis. In that sense, I doubt the recovery that U.S economy is going through is healthy one. Not only has the income inequality in the U.S. been increasing, but also that in other countries has increased since the 2007-2009 recession. ( Harold James, Project Syndicate) This increase in income inequality in the U.S. has been facilitated by the Fed's non-conventional monetary policy, which has been potentially creating an asset price boom. The Great Recession challenged everyone in the U.S. in some ways, but the top 1% has already recovered what it has lost during the recession. Meanwhile, the increase in the income of the bottom 99% has been very low if there was any.  (Moran Zhang, IB Times)