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My last post discussed Taylor rules and how Paul Krugman gets it wrong in thinking that the European Central Bank (ECB) is raising its rates (tightening) when "only Germany even arguably needs it". Aside from Finland and arguably France, the "core" countries seem to need monetary restraint before the economy overheats next year. This conclusion was based on the NAIRU and standardized unemployment rates being below the normal range or close to full employment, and the gap between potential output and real output is quickly closing as shown in the output gaps. This post will continue its wonkish discussion of the Taylor rule and use some actual numbers for the core Eurozone countries as labeled by Fernanda Nechio of the San Franciso Fed.

The Taylor Rule formula used below is from the paper Taylor Rules by Athanasios Orphanides (.pdf, page 7):

i = 2 + π + 1/2*(π - 2) + 1/2*(q - qe)

where i is the nominal target rate for short-term interest rates, π is the rate of inflation, q is output, and qe is desired level of output. The expression (q - qe) becomes simply the output gap. Both series data are derived from the OECD Economic Outlook using Table 10. Output gaps and Table 18. Consumer prices indices. Core inflation would have been preferable as Krugman points out, but since Taylor used headline inflation anyway and using an average for the year should prevent as much volatility in food and fuels to affect the outputs. Also, the factors used above may not be the best for this situation, or in technical terms, it may be a misspecified model.

click to enlarge charts

It is worth noting that raising rates now seems appropriate according to the graph, with a target around 2 1/2%, which is significantly higher than it is now at close to 1%. The Taylor rules index drops off for all countries since the inflation rates drop across all countries shown for 2012. As we saw last time, this drop is not due to the output gap dropping.

The results are fairly robust for other Taylor factors like the one suggested for the US with 1.5 for inflation gap and .5 for output gap. These results for 2012 are very similar to the one above with around 2.5% average for the 7 core countries (equally weighted). During this year the Taylor rates are suggesting even higher for the core with almost a 5% rate.

‘Structural Rigidity’ or a Flexible Economy?
Before addressing the issues brought forth concerning structural rigidity in the Eurozone and the US, this would be a good time to review the theory of structural rigidity. The theory of a "flexible economy" is most attributed to Tony Killick who works for the Overseas Development Institute (ODI) and wrote the book entitled "The Flexible Economy: The Causes and Consequences of the Adaptability of National Economies". His definition of a flexible economy is:

Broadly expressed, we can define a flexible economy as one in which individuals, organizations and institutions efficiently adjust their goals and resources to changing constraints and opportunities.

Structural rigidity is simply the presence of impediments to a flexible economy, whether this be social, economic or political constraints on people to adjust their goals and resources. So the goal is to have a flexible economy, as much as is possible.

Historically, economic models assumed capital was the biggest constraint on an economy and with no regards to labor inputs. Now that unemployment is the greatest concern for the growth of the economy then it has become natural to think in terms of labor markets being inflexible and structurally rigid. That has been loudly rejected by leftist economists such as Paul Krugman. Overall, they might be right, but macro views may hide the individual sectors or job classifications that could use more workers. This is especially true since the labor markets are marked by more heterogeneity, which is more and more division of labor with increasing specialization in each job category.

It is also important to emphasize that the resources Killick is talking about are not merely labor, but all the inputs to creating goods and services. As noted in previous posts, energy and natural resources could be one of the constraints for the present economy. It is the one area that is expanding employment, even given the slow permit processing by the present administration. One recent example of this structural rigidity is discussed at The EPA and Mining Jobs.

Structural Rigidity: Eurozone, US
The divergence of core and peripheral countries observed in the last post shows the structural rigidity of the Eurozone. Some of this is obviously attributed to language barriers and social customs. But whatever the cause, this makes monetary policy all the more likely to not fit the needs of all constituent countries, but not like Paul Krugman states that it only helps one possibly. This divergence in needs from the central bank and European Council could be a negative signal going forward for investors. With overheating economies with inflation of the core and stagnant, slow growth in the peripheral countries, this spells out weakness in the Eurozone going forward.

Their losses are not necessarily our gains just as the tragedies in Japan have not helped the US or Europe. The US does not have many of the structural rigidity problems that the Eurozone has, but it is far from being at an optimally flexible economy. Anecdotally, housing appears to be one constraint preventing labor from moving either to another city or state, and this is a continuation of the historical trend toward less labor migration. One factor that helps the US out is the large pool of immigrant workers. Immigrant workers, through both documented and undocumented routes, will congregate in locations and jobs that are in most demand. Whether it was in New Orleans construction or IT firms in the Silicon Valley, immigrants went where the jobs were, first and foremost.

Not that other countries don't have byzantine rules for hiring and firing workers, but it is worth considering what would be the cost and benefits from less restrictions in labor markets. Some of the costs of these rules and regulations, along with all other business regulatory costs, are demonstrated by the difficulty in starting small businesses.

Warren Meyer discusses Where Have All The Small Businesses Gone? Warren does a good job showing examples of how raising the fixed costs of businesses leads to less competition which is marked by increasing monopoly market power for the firms that do survive. Monopoly market power is also enhanced by the licensing process. This is one of the most pervasive methods of raising fixed costs while not necessarily raising social benefits.

Source: Paul Krugman: Wrong on Monetary Policy (Part 2)