So, is there still a lot of slack in the United States' labor markets? On the face of it, that seems an absurd question to ask, given the persistence of very high unemployment and an employment-population ratio far below pre-crisis levels.
Yet it is being asked, partly because we don't see strong evidence of falling inflation.
But how good a criterion is that? Sharply rising inflation would be one thing — but we don't see that either. And there's actually pretty good evidence that inflation tends to stall out at low but positive levels in the face of prolonged slumps.
Let me add something more to the mix: the case of Canada in the early 1990s, the subject of a classic analysis at the time by the economist Pierre Fortin, published in 1996 in The Canadian Journal of Economics.
For idiosyncratic reasons, Canada imposed tight monetary and fiscal policy, leading to a very severe slump in employment (as the chart on this page shows).
As you can see, however, employment eventually recovered. And if you look at real gross domestic product, this looks very much like a temporary (if prolonged) cyclical downturn (the data suggests that by 2000 Canada was more or less back on the previous trend).
So did Canada experience continuing disinflation, heading toward deflation, as the slump persisted? Actually, no. Inflation fluctuated, even though the economy was nowhere near capacity until the late 1990s.
And wages never fell. Indeed, they continued to rise — a phenomenon Mr. Fortin attributed to downward nominal stickiness plus dispersion.
I'd argue that Canada in the 1990s is a good model for the United States now: a severely depressed economy, suffering very much from lack of aggregate demand, in which the effects of downward nominal rigidity can all too easily be misinterpreted as signs that there isn't actually a lot of slack.
And the way to test this is to expand demand and see what happens; yes, there are some risks if I'm wrong (which I'm not!), but compare those with the risks of letting the economy stay depressed for no good reason.
It's Always Time for Austerity
Jonathan Portes, the director of the National Institute of Economic and Social Research, made a nice catch recently: When the ratings agencies upgraded Britain's outlook, David Cameron's government hailed this as proof that austerity was working; when they downgraded it due to poor economic performance, the Cameron government declared that this showed the need for even more austerity.
Mr. Portes described this as the "Macbeth argument." "In other words, since Macbeth has already killed Duncan and Banquo, it is better to carry on (and order the deaths of Macduff and his family) than to stop," Mr. Portes wrote on his blog on March 27. "So, although misguided policy has led to unnecessary economic damage, that damage is (returning to economist speak) a sunk cost; and the pain ahead is less than the pain that we would suffer if we changed course, as a consequence of the possible negative financial market reaction."
Meanwhile, the economist Adam Posen very judiciously and carefully made the case for why Britain has done worse than the United States in his speech last month at the National Institute of Economic and Social Research (available at bankofengland.co.uk): it's the austerity, stupid. (Or let me put that in Parliamentary style: does the right honorable gentleman not realize that it's the austerity, stupid?)