Though starting academic papers with blog quotations is usually a bad idea, Johannes starts with a great and very appropriate one,
As some of us keep trying to point out, the United States is in a liquidity trap: [...] This puts us in a world of topsy-turvy, in which many of the usual rules of economics cease to hold. Thrift leads to lower investment; wage cuts reduce employment; even higher productivity can be a bad thing. And the broken windows fallacy ceases to be a fallacy: something that forces firms to replace capital, even if that something seemingly makes them poorer, can stimulate spending and raise employment.” -Paul KrugmanI endorse this quote, because it is an accurate and pithy description of the properties of many careful new-Keynesian analyses in the academic literature.
Johannes explains
Does destroying productive capacity raise output when the zero lower bound (ZLB) binds? [ZLB: When interest rates are zero, the Fed can't lower them any more in response to shocks -JC] While this question may seem absurd, in fact it is a common prediction of many macroeconomic models: In these models, temporary negative supply shocks raise inflation expectations and lower expected real interest rates at the ZLB, which stimulates consumption and output. While some prominent economists have subscribed to this view and its policy implications (e.g., Eggertsson and Woodford [2003], Eggertsson and Krugman [2011], Eggertsson [2012]), there is wide disagreement over such a radical and unintuitive proposition.Indeed there is.
These are just the beginning of the strange predictions new-Keynesian models (or modelers) make.
"Fiscal stimulus" is the prediction that even completely wasted government spending is good for the economy. Paul Krugman recommended, with refreshing clarity, that the US government fake an alien invasion so we could spend trillions of dollars building useless defenses. (I'm not exactly sure why he does not call for real defense spending. After all, if building aircraft carriers saved the economy in 1941, and defenses against imaginary aliens would save the economy in 2013, it's not clear why real aircraft carriers have the opposite effect. But I'm still working on the nuances of new-Keynesianism, so I'll let him explain the difference. I'm not a big fan of huge defense spending anyway.)
Furthermore, all the new-Keynesian models are "Ricardian." They predict the same stimulus whether spending is financed by borrowing or by lump-sum taxes today. Good, we don't need to argue about "Ricardian equivalence," but to believe their predictions for spending borrowed money, you have to believe that taxing you and me a trillion dollars and spending it on a trillion dollars of alien defenses will raise overall output by 2, 3, or 4 (you can get really big multipliers in these models) trillion dollars.
Actually, stimulus financed by temporary payroll taxes can be even better than from borrowing money. These are a negative supply shock, which causes inflation and lowers the real interest rate. Sand in the gears is good. Stimulus financed by temporary consumption taxes is worse, because that encourages saving. Promises of higher future consumption taxes, anathema in the standard view of the world, are good, as they get people to consume today.
Super-weirdly, many new-Keyensian paradox predictions get worse as the central friction, price stickiness, gets better.
Johannes again on the new-Keynesian paradoxes:
First, according to the “Paradox of Thrift,” a rise in the desire to save is self-defeating at the ZLB, because it reduces output so much that aggregate savings fall (Keynes [1936], Krugman [1998], Eggertsson and Woodford [2003], and Christiano [2004]). Second, according to the “Paradox of Flexibility,” output volatility may rise at the ZLB when prices and wages are more flexible (e.g., Werning [2011], Eggertsson and Krugman [2011]).
My empirical results concern primarily the “Paradox of Toil” (Eggertsson [2010]), whereby a temporary increase in desired labor supply at the ZLB reduces the equilibrium employment level in standard models. .... Following this logic, payroll tax cuts are contractionary at the ZLB because they lower expected inflation (Eggertsson [2011]), and allowing collusion among firms is expansionary because it raises expected inflation (Eggertsson [2012]).A pause in praise of economic models: They tie ideas together. You can't pick and choose. If you like stimulus with borrowed money, but suspect that tax-financed stimulus might not work so well, you can't just waive your hands and refer to new-Keynesian models to defend you. These models predict the two policies have the same effect. If you like your stimulus, but think that maybe hurricanes wiping out a bunch of the capital stock isn't great, sorry, you can't refer to new-Keynesian models to defend you. If you don't buy one of Krugman's assertions, you don't buy any of them. (At a minimum, you have to build a new variant of model -- you can't refer to existing new-Keynesian models to defend you.) To taste fish, you have to swallow the whole whale, hook, line, and sinker.
So, back to Johannes. He notes that the models predict quite different behavior away from the bound than at the bound, so conventional estimates don't really tell us that much about whether these predictions are true. But we have enough experience with economies at the lower bound now, that we can begin to test some of these astonishing predictions.
(Minor suggestion for PhD students. The key requirement for these predictions is that the Fed does not change the nominal interest rate in response to shocks. There have actually been other periods of time when central banks have fixed nominal interest rates, for example between 1945 and 1952 in the US. More generally, the general new-Keynesian view is that interest rates did not respond enough to shocks before 1980. So in fact, versions of the paradoxes should be visible in data away from the zero bound.)
Johannes looks at the earthquake in Japan, and oil price shocks. Surprise, surprise, earthquakes are bad for output. More subtly, the new-Keynesian prediction flows through inflation: "Supply shocks" should raise expected inflation, which lowers real interest rates, and lower real interest rates should raise consumption and output. (As I explained last week, new-Keynesian models anchor expected consumption in the far off future. Then real interest rates determine the growth rate of consumption, and higher growth means a lower level today. In the models consumption=output. See Johannes' equation 2 page 7.) Johannes finds that the supply shocks led to higher expected inflation, and hence a lower real rate. But the lower real rate just didn't have the predicted effect on output. In fact, he finds that oil shocks have worse negative effects on employment at the zero bound than in normal times!
Like all provocative empirical work, I'm sure this one will be picked over. The Booth Macroeconomics workshop did its usual good job of exploring nooks and crannies. But let us also pause in praise of serious empirical work. Rather than blurt "this is ridicuous!" let us go see if indeed earthquakes, hurricanes, labor market restrictions, oligopolization and other normally adverse "supply" shocks actually help the economy. The sun might just come up in the West at the zero bound.
Where to go from here? If I had this great introduction, and results that rather decisively reject a central night-is-day new-Keynesian proposition, clearly linked to all the others, I would obviously have been tempted to write it up as "this model is wrong," and dig deep into which key assumptions of the model drive its basic mistakes. Johannes takes another tack, and adds credit constraints to the model. Whether this is a successful repair or a clever epicycle I will leave for another time -- and frankly I haven't studied it closely enough to opine yet. How many of the paradoxes it overturns is another good question. It seems to overturn quite a few. But the paradoxes are also the sexy policy implications. It may save new-Keynesian models from their prediction that hurricanes are good, by destroying the new-Keynesian multiplier.
