Can labour markets be too flexible?

My latest at Pieria:

"Krugman has an interesting article in the New York Times. In it he suggests that when interest rates are at the zero lower bound and therefore (in an economy where physical cash is still important) unable to fall further, there is effectively no floor to aggregate demand. Here are his charts showing the difference between an economy where interest rates can fall and one where they can't.

Classical AS/AD model.

LRAS = long-run aggregate supply
SRAS = short-run aggregate supply
AD = Aggregate demand

The classic short-run/long-run picture.
Krugman explains this chart as follows:
"Suppose aggregate demand falls for some reason, say a global financial crisis. Then what the textbook says happens is illustrated by the red arrows. First the economy contracts, then, over time, it expands again as prices fall. And this leads to the notion that demand-side stories are all bound up with the assumption of price stickiness......... you should think though the mechanism by which flexible prices supposedly restore full employment. In the picture I just drew, the answer is that you slide down the AD curve. But why is the AD curve downward-sloping? Any plausible story runs through interest rates: either you have a fixed nominal money supply, so a rise in the real money supply drives rates down; or you have in mind some kind of stabilizing policy by the central bank."
So either you have an automatically-stabilizing currency system*, or you have an activist central bank.

Classical AS-AD model with interest rates at the zero lower bound.

AS-AD with the ZLB.

Krugman again:
 "Falling prices can’t reduce interest rates, so it’s hard to see why the AD curve should slope down....and in fact, because falling prices worsen the real burden of debt, it’s a good bet that the AD curve slopes the “wrong” way. "
For non-wonks, that means if real interest rates are too high and are unable to fall, falling prices and wages drive the economy into depression. Let me explain what that means in relation to the Eurozone periphery.

In most advanced economies, central banks have been using unconventional monetary tools such as QE to depress real interest rates. The jury is out on how effective these tools are at achieving that, but it is fair to say that countries such as the US and UK have not experienced the disastrous economic collapse that the Eurozone periphery countries are currently going through.

In contrast, the ECB has not eased monetary conditions for the distressed periphery countries. In fact it is currently tightening them as LTROs are repaid. The difference in real interest rates between core and periphery is substantial, and this has a direct bearing on the cost of finance for businesses, individuals and governments alike in periphery countries. Put bluntly, the periphery countries are experiencing a credit crunch - the cost of debt is very high relative to real incomes. The ECB claims that it can do nothing more to ease this situation."

The rest of this article can be read here.

Comments

  1. I have been wondering how the eurozone peripheral crisis will evolve after everyone gets back from their vacations, and I think it could be ugly, although I have no idea how long it would take to play out.

    We all recall that when the peripheral countries joined the euro, their interest rates swiftly converged towards German rates. Now, they were not really as credit-worthy as Germany, so it must be that the market mistakenly attributed to them a Germany-like credit-worthiness, so why?

    I think the answer is that the market simply ignored the "no bail-out" clause and assumed that if the periphery got into trouble, they would get bailed out, much as you might assume that parents might threaten not to bail out profligate teenagers, but if it came to it they would bail the teenagers out just to save their own reputations. In other words the market was assuming that countries like Germany would be unwilling to endure the embarrassment they turn out to be willing to endure.

    But now peripheral rates are converging again? Why? Because Draghi threatened to "do what it takes". Which means? Well, partly it means reinstating the illusion that by some "whatever it takes" magic the periphery can be made more like Germany in their market-perceived credit-worthiness.

    And can they? Well, I think we have seen that Greece was small enough to save, but it hasn't been saved. Ireland was small enough and arguably has been saved. And Spain and Italy are simply too big to save. While France, Eesh.

    I can be wrong, but I think this reality must hit home sooner or later. The market is still coasting on an illusion. It's just that this time they were given the illusion by Draghi instead of coming up with it themselves.

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