Saturday, December 3, 2011

Do wages cause inflation, or does money?

Oil, the Fed, and Stagflation ...  or: 'twas Arthur Burns that done it!

There are two basic observations that Milton Friedman made on inflation, and which still today consitute the economic mainstream. First is that inflation is a monetary phenomenon- if you have too much money, prices will rise even while the real economy stays the same size as before. He also authored the NAIRU concept- (non-accelerating inflation rate of unemployment)- i.e. the lowest unemployment rate consistent with stable prices.

To a naive observer, these are contradictory ideas. If high employment can cause inflation, then it isn't a montary phenomenon after all. But if monetary causes are paramount, then the NAIRU is merely a symptom rather than a cause, and all the supply-side, trickle-down anti-worker economics of the last few decades have been a cruel as well as wasted effort.

Perhaps there is more going on, and that is what this post is about. Going by what we have learned in MMT economics, the main money-creating mechanism is not the government, (i.e. via net deficit spending, however important that is from time to time), but banks, which create money every time they make a loan, and extinguish it when the loan is paid off (or written off). The bank mechanism is what central banks control via their adjustment of short term (and long-term) interest rates. Only they don't always do such a great job, and this channel of money creation is prone to much more volatility than the government's channel, which in turn necessitates the anticyclical fiscal / monetary policies of Keynesian economics.

How could persistent inflation and high wage demands affect the bank mechanism of money creation? Another tenet of MMT economics is that most lending is demand-driven, in that banks generally lend to any worthy borrower who comes in the door. Every loan is an asset to the bank, and its only total / legal constraint is capital, which can also be raised if its past bets have been sound, perhaps in the interests of growth and the dream of becoming "too big to fail".

One theory would be that inflation is consistently under-appreciated when it is gathering steam. Thus real interest rates tend to not catch up to inflation as fast as they should, creating an incentive for borrowers to ask for loans. In effect, real interest rates in an environment of rising inflation tend to be lower than they should be.

Thus when competitive pressures press on a company, it may be more willing to make up the difference with a loan, and justify that loan with recent growth, even if that growth was only nominal rather than real. The whole environment may become skewed towards monetary growth, in effect.

On the whole, this mechanism seems relevant, but not very strong, given a central bank that is paying attention to real interest rates. It also does not provide a direct channel for wage demands to fuel inflation, since companies are faced with competing demands for money all the time. Being in a hot labor market might cause firms to alter the share of revenue going to wages, but can't automatically give them the power to raise prices.

If the entire labor market were hot, all companies might be faced with the same increasing labor costs, allowing them to raise prices in unison without a competitive penalty. And then perhaps the workers are realizing commensurate wage gains across the board, allowing them to pay the increased prices. It all makes sense, except ... where is all the extra money supposed to come from? That part is very hard to see, unless the banking system funds the general expansion by excess lending, which the central bank is supposed to explicitly monitor and prevent. Price inflation has to come from general monetary expansion.

Other effects may come into play at the margins. Perhaps a hot labor market may cause workers to spend more of their money and save less, increasing monetary velocity, and thus inflation. Perhaps a general "boom" atmosphere causes lending standards to decline, causing monetary inflation. Low unemployment might thus correlate with inflation without being particularly causal. Nor would a particular level of unemployment be strongly associated with a particular level of inflation, which is the lack of relationship that is empirically observed.

Incidentally, a resource shock like higher oil prices is also unlikely to cause inflation directly, since any money spent on oil is withdrawn from other uses (though perhaps from savings, which would be temporarily inflationary). Again, unless monetary expansion occurs, an oil shock can't cause inflation, and indeed if vast amounts of dollars are exported to overseas oil producers, such a shock should cause net deflation instead.

In this scenario, it is possible that an oil shock leads to economic recession, and thus to monetary loosening, which does indeed cause inflation when coupled with declining real economic capacity due to the resource constraint. But loosening during such a recession might be a misuse of monetary policy, as done in the 70's (a paper on the era has details). Incidentally, inflation can arise from dramatic declines in economic capacity, as in Zimbabwe, where the real economy collapsed, without the monetary system contracting in unison- another form of monetary error, though in fairness, this is a very difficult adjustment to make.

The point I am getting at is that inflation does not seem to be caused by high or low employment, but rather by errors of the monetary and/or fiscal policy in trying to control a somewhat chaotic and time-lagged system. Labor demands are only that- demands. If their counterparts lack the money to meet those demands, inflation can't happen.

The Phillips curve, which eventually gave rise to the NAIRU concept, (here is a brief review), showed a general correlation between employment and inflation- an empirical finding that remains true. But as we all know, correlation doesn't necessarily mean causation, and I think that is the case here.

Friedman's ultimate argument was that monetary expansion can't be effective as a continual policy to reduce unemployment, which also remains valid, I think. (Not that this was central to Keyensian policy.) Monetary effects on employment are temporary, though at times like the present such temporary measures can have very long-lasting consequences, to counteract effects of monetary and real contraction. I have to admit that my many statements over the last couple of years about the Fed's general role ensuring full employment in normal times are probably not accurate or wise. In normal times, it should regulate inflation, (and regulate banks properly!), and leave employment policy to other branches. It would also be nice if it gave positive and useful advice on fiscal matters, though its track record there is abysmal- the less said the better!

Yet on the other hand, the deeper point I am getting at is that the war on labor carried out in so many ways over the last few decades, by increased low-wage immigration, by NAFTA, by "supply-side" economics, by union-bashing, and by ending the overall progressivity of the tax system ... was never about inflation, though it was often couched in those terms. Efficiency and productivity were other rationales, though these also applied curiously only to the lower classes.

It was about something quite different. It was about about squeezing more from lower-paid workers while finding ways to pay executives more. It was about redistributing income from the lower classes upward to the rich, who became lost in a self-aggrandizing narrative which Milton Friedman did so much to popularize. It was about reversing the pro-labor policies of the New Deal and the anti-poverty policies of the Great Society, frequently under the cover of fighting inflation. It was a royal restoration of Darwinian, winner-take all economics over Keynesian economics.

It is surely a human weakness to look up to the rich and powerful, assuming that their good fortune arises from good works, divine favor, or at least the favor of natural selection. But mostly, quite unnatural selection is at work, whether through government corruption, financial chicanery, or simple inheritance. The adulation of the rich is part of the social and media complex that has made the Occupy movement so necessary, yet also so tenuous.

What has the Darwinian restoration gotten us? It has eroded the middle class, sapped overall economic growth, promoted gambling by the investor class in place of productive investment, mired the poor in debt peonage, and corrupted our social and political systems into the bargain. Not a pretty sight, in my estimation.

And while right-ists continue to look for inflation under every bed, it is dead. It is high time to put this fight against inflation on the back burner and attend to the suffering that the last decades have wrought. One step would be to create a jobs-for-everyone policy, offering modest-paying public service work to everyone who wants work. The analysis above indicates that despite in essence outlawing unemployment, such a policy would have little effect on inflation. Yet it would have a huge positive effect on our culture and future prospects, in concert with suitably large investments in infrastructure and education.

"The most terrifying thing to emerge from the Bank of England’s reports is that the Bank embarked on its experiment without any macro-economic model specifying how money was to be transmitted to income. In other words, QE was launched on a wing and prayer."
  • Economic quote of the week, from Dean Baker, via Bill Mitchell:
"The European Central Bank (ECB) has been working hard to convince the world that it is not competent to act as a central bank." (Salon provides some background.)
... and Bill continues ...
"Further, I know it is twee for so-called progressives to keep telling us that the solution to the crisis for governments to “make the rich pay” but the reality is that might sound nice and be a useful policy on equity grounds but it is not the solution to the crisis.
The crisis is being extended because there is not enough aggregate demand to drive growth and income. Taking some purchasing power off the rich will probably worsen that situation although it would not be as damaging as taking cash off the lower income groups.
These distributional matters (whether the rich pay or not) should be separated from the main game – which isn’t to say I don’t support higher tax rates for the rich and lower tax rates for the poor."

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