MMT 6: Unemployment and inflation

July 9, 2018

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This is the sixth in a series of posts about Modern Monetary Theory, based on the text by Mitchell, Wray and Watts. If you have not seen the earlier posts, I recommend that you start at the beginning.

The Classical dichotomy

Classical economists gave unemployment and inflation distinct explanations. They weren’t relating the two by focusing on questions like how the government can create more jobs without triggering inflation. Economists have called this compartmentalization the “Classical dichotomy.”

In Classical economics, how many workers were employed depended on the supply and demand of labor, reconciled by the price mechanism. The greater the demand for labor, the higher the price (the wage); but the greater the supply of labor, the lower the price. If wages were too high, the supply of workers willing to work would exceed the demand from employers willing to pay that wage; if wages were too low, the demand for workers would exceed the supply of people willing to work. So in any labor market, there was an equilibrium price point where labor supply equaled labor demand, and that’s how much labor would be employed. Any unemployed workers who remained were those who chose not to work at the going rate. The market had spoken, and everything was as it had to be.

How much was produced with the employed labor depended on the productivity of labor, which depended in turn on the technologies in use.

Inflation had its own dynamic. The general price level for goods and services depended on the amount of money in circulation (and how fast it circulated) relative to the actual output of goods and services. Money was just a medium of exchange. If more money was available to spend on a given level of output, then prices must be higher. “The later Classical economists believed that if the supply of money was, for example, doubled, that there would be no impact on the real performance of the economy. All that would happen is that the price level would double.”

The policy implication of the Classical dichotomy was that government, as the issuer of the currency, could control inflation by managing the money supply, but unemployment was a different matter. The level of employment was set by the invisible hand of the market, and government had little to say about it.

Aggregate demand and the unemployment-inflation trade-off

The massive unemployment of the 1930s forced economists to rethink the Classical position. Unemployment had to involve more than a voluntary decision not to work at the prevailing wage. And as for policy, there had to be something we could do about it. All was not as it had to be. The new Keynesian economics saw the problem as a failure of aggregate demand, and government could take action to alleviate it.

Suppose that businesses decide to cut back on investment because they lose confidence that the market can absorb further increases in production. As I covered in MMT 2, investment is one of the independent variables that determine aggregate demand, national output and income. A drop in investment produces an even greater drop in output and income because of multiplier effects. Each $100 billion drop in investment can easily produce a $200 billion drop in GDP and GNI. Firms lay off workers, unemployment soars, and consumers have less money to spend, encouraging still more cutbacks in investment.

In that situation, lower incomes also mean that the government is collecting less in taxes. That softens the blow for households, but it may encourage governments to cut spending to keep their budgets balanced. That government austerity makes matters worse, since government spending has its own multiplier effect on national income and output. Keynesian theory recommends the opposite policy. Government should increase spending in hard times in order to increase aggregate demand and get the country back to work.

Stimulating the economy with government spending makes the most sense when an economy is suffering from underutilized capacity, as it was during the Great Depression. Once the economy has moved closer to full employment, continued stimulus runs the risk of pushing aggregate demand so high that it presses against a limited supply. That would push prices up, creating “demand-pull inflation.” (In the MMT interpretation, supply can respond to demand and keep prices stable until the economy nears full productive capacity. In graphic terms, the supply curve is seen as pretty flat until prices turn sharply up when that point is reached.)

The policy implication here is that unemployment and inflation are inversely related. Too little aggregate demand creates unemployment, but too much aggregate demand creates inflation. This trade-off was quantified by the introduction of the “Phillips curve” in the 1950s. Policymakers hoped to find a happy medium with neither too much inflation nor too much unemployment.

Stagflation and the monetarist response

In the 1970s, the inverse relationship between unemployment and inflation seemed to break down. The economy experienced both high unemployment and inflation at the same time, a condition that came to be called “stagflation.”

University of Chicago economists under the leadership of Milton Friedman proposed an explanation. He argued that if the government, in its efforts to promote full employment, overstimulated demand, the resulting inflation could end up increasing unemployment as well.

First, he claimed that there is a natural rate of unemployment, which is determined by the underlying structure of the labour market and the rate of capital formation and productivity growth. He believed that the economy always tends back to that level of unemployment even if the government attempts to use fiscal and monetary policy expansion to reduce unemployment.

What would bring unemployment back to its “natural level” was the inflation expectations of workers. Once they came to expect that inflation would keep eroding their purchasing power, they would become less willing to work at the prevailing wage level. This is reminiscent of the Classical idea that unemployment is a personal choice.

Friedman was influential in getting economists to give up fighting unemployment and focus their attention solely on fighting inflation through tight monetary policy.  A certain level of unemployment is natural and government shouldn’t try to change it.

[The] post World War II [Keynesian] consensus was steadily eroded away over the next 40 odd years….Mainstream macroeconomics reverted back to the pre-Keynesian notions of voluntary unemployment and effectively abandoned the concept of true full employment.

A conflict theory of inflation

Modern Monetary Theorists are more in tune with Keynes than with Friedman. As they see it, when government makes fighting inflation the centerpiece of its economic policy, it overlooks policy options that really could reduce unemployment. In effect, it also sides against labor in the class struggle and impedes the efforts of labor to achieve high employment and good wages.

MMT proposes a conflict theory of inflation. Keynes recognized that inflation could be triggered by rising costs as well as rising aggregate demand. MMT acknowledges this “cost-push” inflation and incorporates it into its conflict theory. Increased costs could come from the wage demands of workers, or from the cost of other resources used in production.

Inflation is “the product of distributional struggle over real income shares, reflecting the relative bargaining strength of workers and employers.” Workers want a big enough share of income to maintain or increase their purchasing power. Firms want a big enough share of revenue to cover their costs, including labor costs, and to make enough profit to satisfy their owners or shareholders.

If both sides feel they are benefiting from the shares they have, inflation is avoidable:

If the desired real output shares of the workers and firms is [sic] consistent with the available real output desired, then there is no incompatibility and there will be no inflationary pressures. The available real output would be distributed each period in the form of wages and profits, which satisfy the respective claimants.

If, on the other hand, either side wants to increase its income faster than general economic growth justifies, that cuts into the other’s share of the income. If workers demand wage increases not justified by higher productivity, employers will resist those demands, or else try to pass the costs onto their customers through price increases. General price increases can offset wage increases, leaving workers no better off than before. Price increases that are not matched by wage gains reduce the worker’s share of national income. Inflationary spirals of wages and prices can be initiated from either side. Remember that we are thinking in the aggregate. What matters is what firms and workers are fighting for and getting in the economy as a whole, not just in any one company.

Changes in the relative bargaining power of business and labor may trigger these struggles as well as determine the outcomes. In the early twentieth century, workers responded to the concentration of power in large firms by forming unions to bargain with those firms collectively. “When employers are dealing with workers individually, they have more power than when they are dealing with one bargaining unit (trade unit), which represents all workers in their workplace.” Organized labor made wage gains, but not without a struggle.

Another thing that strengthens labor’s bargaining power is an economy operating at high capacity and employing a lot of labor. Workers can then press their demands for higher wages with less fear of being laid off or replaced. During the postwar economic boom, highly unionized workers were able to obtain a larger share of the national income than they had gotten before, or they have gotten since.

Raw material price shocks such as the 1970s jump in oil prices can both slow the economy and intensify workplace conflict. Workers paying higher gas prices push harder for higher wages. Businesses facing higher costs of production raise prices. If the price shock both slows the economy and generates wage-price spirals, the result is stagflation.

When the Federal Reserve raised interest rates to fight inflation in the 1980s, that raised the cost of borrowing for businesses seeking to expand. That kept the economy operating in low gear, and also increased the resistance of employers to wage increases. The slow economy made workers more vulnerable to layoffs and weakened their bargaining power.

Inflation has been more-or-less under control since then, but workers have faced a perfect storm of sluggish economic growth, competition from cheap foreign labor, declining manufacturing industries, plunging union membership, chronically high unemployment, stagnating real wages, and a declining share of the national wealth and income.

MMT hopes to do better, by identifying a policy that can boost economic growth and achieve full employment, but still keep inflation in check.


The Clash of Economic Ideas (part 3)

May 16, 2013

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Here I will bring together several parts of Lawrence White’s book that deal with monetary policy: the debate over the gold standard, the ascendancy of monetarism during the inflationary 1970s, and the recent sovereign debt crisis in several countries.

Tying a nation’s currency to gold places a limit on the money supply. Mercantilists used to worry that if a country allowed too many imports, paying for them would deplete its stock of gold. In 1752 David Hume made a classical case for free trade, describing an automatic balancing process now known as the “price-specie-flow mechanism.” The gold that flows out of a country that has a trade deficit causes deflation in that country and inflation in the surplus country. That tends to correct the trade imbalance by making the deficit country’s goods cheaper and the surplus country’s goods more expensive. Prosperity does not depend on restricting the import of goods or the outflow of gold.

A more realistic criticism of a gold standard is that it limits the government’s options for financing its spending. Government spending is balanced by tax revenue, a change in debt, or a change in the stock of government-issued money held by the private sector (G = T + ΔD + ΔM). If money is backed by gold, the government can’t just print more of it without causing a run on gold. Many critics of government spending welcome that restraint, but advocates of Keynesian deficit spending do not. Printing more money is not, of course, a way of getting something for nothing, since the country may pay for it through inflated prices. But if the government spending so financed creates employment and increased production, a Keynesian can argue that the benefits outweigh the risks.

World War I set off a chain of events that led to the decline of the gold standard:

During the First World War, the governments of Britain, France, Germany, and other combatant nations of Europe each suspended the gold standard so that it could print money to finance war expenditures. With currency irredeemable in gold, no gold outflows constrained the government’s monetary expansion. Considerable
monetary expansion had the inevitable effect of considerably raising the domestic price level.

After the war, England tried to return to the gold standard by restoring the pound to its prewar price in gold, but with so many pounds now in circulation, the result was a run on gold. Other European countries had similar problems.

Large amounts of British and continental European gold flowed into the United States during and after the First World War. The leaders of the new Federal Reserve System, which first opened its doors in 1914, often chose to “sterilize” the inflows, that is, to prevent them from expanding the domestic money stock and bank credit and thereby raising the price level, although such adjustments were part of Hume’s process for stemming the flows and restoring international payments equilibrium.

Supporters of the gold standard say that it could have continued to work if central bankers hadn’t interfered with it, either by printing money not backed by gold or by trying to control prices instead of letting them respond to gold flows. In any case, European countries found it increasingly burdensome to back their currencies with gold. England went off the gold standard for good in 1931. The Bretton Woods conference of 1944 “committed the major European currencies to redeemability not for gold but only for U.S. dollars, with the U.S. dollar as the key international reserve currency that other central banks could redeem for gold….Exchange rates against the dollar were to be pegged, that is, fixed for the time being but adjustable when necessary.”

This system lasted until 1971, when the U.S. itself left the gold standard because it was experiencing its own balance-of-trade deficit and run on gold. Inflation in the United States was reducing the purchasing power of the dollar at home, but fixed exchange rates between the dollar and other currencies made imported goods a relative bargain. The foreign businesses that sold us goods exchanged the dollars for local currency through their central bank, which then had the option of redeeming the dollars for gold. When very little gold was left in the U.S., the Bretton Woods system broke down.

During the “Great Inflation” of the 1970s, the “monetarist” economists led by Milton Friedman gained influence at the expense of the Keynesians. Friedman was one of the economists who had joined the Mont Pelerin society organized by Friedrich von Hayek in 1947, with the purpose of keeping classically liberal free-market economics alive. Now he argued that the principal cause of inflation was a too-rapid increase in the money supply. (Similarly, he argued that the main reason for the severity of the Great Depression was the failure of the Federal Reserve to maintain an adequate money supply.) He recommended a consistent policy of only modest and steady monetary expansion, and he warned against the kind of activist Keynesian policy that tried to stimulate the economy with deficit spending and/or rapid monetary expansion.

I was surprised that a book about the clash of economic ideas wouldn’t have a chapter on economists’ interpretations of the housing bubble and the Great Recession of 2007-09. White does mention that the recession sparked a new interest in Keynesian economics, but he doesn’t elaborate. He does have a chapter on sovereign debt crisis in countries such as Greece, with a strong monetarist emphasis. An increasing burden of debt gives a government a strong incentive to expand the money supply, since “reducing the value of the monetary unit reduces the real burden of any existing debt denominated in that unit.” In fact, some economists argue that the growth of government debt eventually forces it to resort to inflationary finance. As a government borrows more and more, lenders can demand higher interest, until the cost of servicing the entire debt increases faster than the additional amount borrowed. Additional borrowing is then counterproductive, and expanding the money supply is the only way left to finance a increasing deficit. Eventually, that leads to a collapse of confidence in the currency.

Maybe the reason White focuses on sovereign debt crisis instead of other aspects of the recent economic crisis is that he is most comfortable telling a monetarist story that blames economic problems on government. As with the first chapter about the earlier “turn away from laissez-faire,” he seems more reluctant to acknowledge market failures, which seem rather conspicuous during the housing bubble. Also, having just read Michael Pettis’s The Great Rebalancing, I know that economists differ sharply in their interpretations of sovereign debt crisis as well. Pettis attributes it as much to over-saving in creditor countries like Germany and China as to over-borrowing in deficit countries like Greece and the United States. He specifically warns against blaming the debtors alone for the global capital flows that finance both asset bubbles and sovereign debt.

Overall, I found the book a better exposition of classical and monetarist views than of less free-market-oriented alternatives, especially in its discussions of recent economic developments.