Tag: inflation

Inflation, Interest Rates and the Fed: A Dissent

Last week, my Roosevelt colleague Mike Konczal said on twitter that he endorsed the Fed’s decision to raise the federal funds rate, and the larger goal of using higher interest rates to weaken demand and slow growth. Mike is a very sharp guy, and I generally agree with him on almost everything. But in this case I disagree. 

The disagreement may partly be about the current state of the economy. I personally don’t think the inflation we’re seeing reflects any general “overheating.” I don’t think there’s any meaningful sense in which current employment and wage growth are too fast, and should be slower. But at the end of the day, I don’t think Mike’s and my views are very different on this. The real issue is not the current state of the economy, but how much confidence we have in the Fed to manage it. 

So: Should the Fed be raising rates to control inflation? The fact that inflation is currently high is not, in itself, evidence that conventional monetary policy is the right tool for bringing it down. The question we should be asking, in my opinion, is not, “how many basis points should the Fed raise rates this year?” It is, how conventional monetary policy affects inflation at all, at what cost, and whether it is the right tool for the job. And if not, what should we be doing instead?

What Do Rate Hikes Do?

At Powell’s press conference, Chris Rugaber of the AP asked an excellent question: What is the mechanism by which a higher federal funds rate is supposed to bring down inflation, if not by raising unemployment?1 Powell’s answer was admirably frank: “There is a very, very tight labor market, tight to an unhealthy level. Our tools work as you describe … if you were moving down the number of job openings, you would have less upward pressure on wages, less of a labor shortage.”

Powell is clear about what he is trying to do. If you make it hard for businesses to borrow, some will invest less, leading to less demand for labor, weakening workers’ bargaining power and forcing them to accept lower wages (which presumably get passed on to prices, tho he didn’t spell that step out.) If you endorse today’s rate hikes, and the further tightening it implies, you are endorsing the reasoning behind it: labor markets are too tight, wages are rising too quickly, workers have too many options, and we need to shift bargaining power back toward the bosses.

Rather than asking exactly how fast the Fed should be trying to raise unemployment and slow wage growth, we should be asking whether this is the only way to control inflation; whether it will in fact control inflation; and whether the Fed can even bring about these outcomes in the first place.

Both hiring and pricing decisions are made by private businesses (or, in a small number of cases, in decentralized auction markets.) The Fed can’t tell them what to do. What it can do – what it is doing – is raise the overnight lending rate between banks, and sell off some part of the mortgage-backed securities and long-dated Treasury bonds that it currently holds. 

A higher federal funds rate will eventually get passed on to other interest rates, and also (and perhaps more importantly) to credit conditions in general — loan standards and so on. Some parts of the financial system are more responsive to the federal funds rate than others. Some businesses and activities are more dependent on credit than others.

Higher rates and higher lending standards will, eventually, discourage borrowing. More quickly and reliably, they will raise debt service costs for households, businesses and governments, reducing disposable income. This is probably the most direct effect of rate hikes. It still depends on the degree to which market rates are linked to the policy rate set by the Fed, which in practice they may not be. But if we are looking for predictable results of a rate hike, higher debt service costs are one of the best candidates. Monetary tightening may or may not have a big effect on unemployment, inflation or home prices, but it’s certainly going to raise mortgage payments — indeed, the rise in mortgage rates we’ve seen in recent months presumably is to some degree in anticipation of rate hikes.

Higher debt service costs disposable income for households and retained earnings for business, reducing consumption and investment spending respectively. If they rise far enough, they will also lead to an increase in defaults on debt.

(As an aside, it’s worth noting that a significant and rising part of recent inflation is owners’ equivalent rent, which is a BLS estimate of how much homeowners could hypothetically get if they rented out their homes. It is not a price paid by anyone. Meanwhile, mortgage payments, which are the main actual housing cost for homeowners, are not included in the CPI. It’s a bit ironic that in response to a rise in a component of “housing costs” that is not actually a cost to anyone, the Fed is taking steps to raise what actually is the biggest component of housing costs.)

Finally, a rate hike may cause financial assets to fall in value — not slowly, not predictably, but eventually. This is the intended effect of the asset sales.

Asset prices are very far from a simple matter of supply and demand — there’s no reason to think that a small sale of, say 10-year bonds will have any discernible effect on the corresponding yield (unless the Fed announces a target for the yield, in which case the sale itself would be unnecessary.) But again, eventually, sufficient rate hikes and asset sales will presumably lead asset prices to fall. When they do fall, it will probably by a lot at once rather than a little at a time – when assets are held primarily for capital gains, their price can continue rising or fall sharply, but it cannot remain constant. If you own something because you think it will rise in value, then if it stays at the current price, the current price is too high.

Lower asset values in turn will discourage new borrowing (by weakening bank balance sheets, and raising bond yields) and reduce the net worth of households (and also of nonprofits and pension funds and the like), reducing their spending. High stock prices are often a major factor in periods of rising consumption, like the 1990s; a stock market crash could be expected to have the opposite impact.

What can we say about all these channels? First, they will over time lead to less spending in the economy, lower incomes, and less employment. This is how hikes have an effect on inflation, if they do. There is no causal pathway from rate hikes to lower inflation that doesn’t pass through reduced incomes and spending along the way. And whether or not you accept the textbook view that the path from demand to prices runs via unemployment wage growth, it is still the case that reduced output implies less demand for labor, meaning slower growth in employment and wages.

That is the first big point. There is no immaculate disinflation. 

Second, rate hikes will have a disproportionate effect on certain parts of the economy. The decline in output, incomes and employment will initially come in the most interest-sensitive parts of the economy — construction especially. Rising rates will reduce wealth and income for indebted households. 2. Over time, this will cause further falls in income and employment in the sectors where these households reduce spending, as well as in whatever categories of spending that are most sensitive to changes in wealth. In some cases, like autos, these may be the same areas where supply constraints have been a problem. But there’s no reason to think this will be the case in general.

It’s important to stress that this is not a new problem. One of the things hindering a rational discussion of inflation policy, it seems to me, is the false dichotomy that either we were facing transitory, pandemic-related inflation, or else the textbook model of monetary policy is correct. But as the BIS’s Claudio Borio and coauthors note in a recent article, even before the pandemic, “measured inflation [was] largely the result of idiosyncratic (relative) price changes… not what the theoretical definition of inflation is intended to capture, i.e. a generalised increase in prices.” The effects of monetary policy, meanwhile, “operate through a remarkably narrow set of prices, concentrated mainly in the more cyclically sensitive service sectors.”

These are broadly similar results to a 2019 paper by Stock and Watson, which finds that only a minority of prices show a consistent correlation with measures of cyclical activity.3 It’s true that in recent months, inflation has not been driven by auto prices specifically. But it doesn’t follow that we’re now seeing all prices rising together. In particular, non-housing services (which make up about 30 percent of the CPI basket) are still contributing almost nothing to the excess inflation. Yet, if you believe the BIS results (which seem plausible), it’s these services where the effects of tightening will be felt most.

This shows the contribution to annualized inflation above the 2% target, over rolling three-month periods. My analysis of CPI data.

The third point is that all of this takes time. It is true that some asset prices and market interest rates may move as soon as the Fed funds rate changes — or even in advance of the actual change, as with mortgage rates this year. But the translation from this to real activity is much slower. The Fed’s own FRB/US model says that the peak effect of a rate change comes about two years later; there are significant effects out to the fourth year. What the Fed is doing now is, in an important sense, setting policy for the year 2024 or 2025. How  confident should we be about what demand conditions will look like then? Given how few people predicted current inflation, I would say: not very confident.

This connects to the fourth point, which is that there is no reason to think that the Fed can deliver a smooth, incremental deceleration of demand. (Assuming we agreed that that’s what’s called for.) In part this is because of the lags just mentioned. The effects of tightening are felt years in the future, but the Fed only gets data in real time. The Fed may feel they’ve done enough once they see unemployment start to rise. But by that point, they’ll have baked several more years of rising unemployment into the economy. It’s quite possible that by the time the full effects of the current round of tightening are felt, the US economy will be entering a recession. 

This is reinforced when we think about the channels policy actually works through. Empirical studies of investment spending tend to find that it is actually quite insensitive to interest rates. The effect of hikes, when it comes, is likelier to be through Minskyan channels — at some point, rising debt service costs and falling asset values lead to a cascading chain of defaults.

In and Out of the Corridor

A broader reason we should doubt that the Fed can deliver a glide path to slower growth is that the economy is a complex system, with both positive and negative feedbacks; which feedbacks dominate depends on the scale of the disturbance. In practice, small disturbances are often self-correcting; to have any effect, a shock has to be big enough to overcome this homeostasis.

Axel Leijonhufvud long ago described this as a “corridor of stability”: economic units have buffers in the form of liquid assets and unused borrowing capacity, which allow them to avoid adjusting expenditure in response to small changes in income or costs. This means the Keynesian multiplier is small or zero for small changes in autonomous demand. But once buffers start to get exhausted, responses become much larger, as the income-expenditure positive feedback loop kicks in.

The most obvious sign of this is the saw-tooth pattern in long-run series of employment and output. We don’t see smooth variation in growth rates around a trend. Rather, we see two distinct regimes: extended periods of steady output and employment growth, interrupted by shorter periods of negative growth. Real economies experience well-defined expansions and recessions, not generic “fluctuations”.

This pattern is discussed in a very interesting recent paper by Antonio Fatas, “The Elusive State of Full Employment.” The central observation of the paper is that whether you measure labor market slack by the conventional unemployment rate or in some other way (the detrended prime-age employment-population ratio is his preferred measure), the postwar US does not show any sign of convergence back to a state of full employment. Rather, unemployment falls and employment rises at a more or less constant rate over an expansion, until it abruptly gives way to a recession. There are no extended periods in which (un)employment rates remain stable.

One implication of this is that the economy spends very little time at potential or full employment; indeed, as he says, the historical pattern should raise questions whether a level of full employment is meaningful at all.

the results of this paper also cast doubt on the empirical relevance of the concepts of full employment or the natural rate of unemployment. … If this interpretation is correct, our estimates of the natural rate of unemployment are influenced by the length of expansions. As an example, if the global pandemic had happened in 2017 when unemployment was around 4.5%, it is very likely that we would be thinking of unemployment rates as low as 3.5% as unachievable.

There are many ways of arriving at this same point. For example, he finds that the (un)employment rate at the end of an expansion is strongly predicted by the rate at the beginning, suggesting that what we are seeing is not convergence back to an equilibrium but simply a process of rising employment that continues until something ends it.

Another way of looking at this pattern is that any negative shock large enough to significantly slow growth will send it into reverse — that, in effect, growth has a “stall speed” below which it turns into recession. If this weren’t the case, we would sometimes see plateaus or gentle hills in the employment rate. But all we see are sharp peaks. 

In short: Monetary policy is an anti-inflation tool that works, when it does, by lowering employment and wages; by reducing spending in a few interest-sensitive sectors of the economy, which may have little overlap with those where prices are rising; whose main effects take longer to be felt than we can reasonably predict demand conditions; and that is more likely to provoke a sharp downturn than a gradual deceleration.

Is Macroeconomic Policy the Responsibility of the Fed?

One reason I don’t think we should be endorsing this move is that we shouldn’t be endorsing the premise that the US is facing dangerously overheated labor markets. But the bigger reason is that conventional monetary policy is a bad way of managing the economy, and entails a bad way of thinking about the economy. We should not buy into a framework in which problems of rising prices or slow growth or high unemployment get reduced to “what should the federal funds rate do?”

Here for example is former CEA Chair Jason Furman’s list of ways to reduce inflation:

What’s missing here is any policy action by anyone other than the Fed. It’s this narrowing of the discussion I object to, more than the rate increase as such.

Rents are rising rapidly right now — at an annual rate of about 6 percent as measured by the CPI. And there is reason to think that this number understates the increase in market rents and will go up rather than down over the coming year. This is one factor in the acceleration of inflation compared with 2020, when rents in most of the country were flat or falling. (Rents fell almost 10 percent in NYC during 2020, per Zillow.) The shift from falling to rising rents is an important fact about the current situation. But rents were also rising well above 2 percent annually prior to the pandemic. The reason that rents (and housing prices generally) rise faster than most other prices generally, is that we don’t build enough housing. We don’t build enough housing for poor people because it’s not profitable to do so; we don’t build enough housing for anyone in major cities because land-use rules prevent it. 

Rising rents are not an inflation problem, they are a housing problem. The only way to deal with them is some mix of public money for lower-income housing, land-use reform, and rent regulations to protect tenants in the meantime. Higher interest rates will not help at all — except insofar as, eventually, they make people too poor to afford homes.

Or energy costs. Energy today still mostly means fossil fuels, especially at the margin. Both supply and demand are inelastic, so prices are subject to large swings. It’s a global market, so there’s not much chance of insulating the US even if it is “energy independent” in net terms. The geopolitics of fossil fuels means that production is both vulnerable to interruption from unpredictable political developments, and subject to control by cartels. 

The long run solution is, of course, to transition as quickly as possible away from fossil fuels. In the short run, we can’t do much to reduce the cost of gasoline (or home heating oil and so on), but we can shelter people from the impact, by reducing the costs of alternatives, like transit, or simply by sending them checks. (The California state legislature’s plan seems like a good model.) Free bus service will help both with the short-term effect on household budgets and to reduce energy demand in the long run. Raising interest rates won’t help at all — except insofar as, eventually, they make people too poor to buy gas.

These are hard problems. Land use decisions are made across tens of thousands of local governments, and changes are ferociously opposed by politically potent local homeowners (and some progressives). Dependence on oil is deeply baked into our economy. And of course any substantial increase in federal spending must overcome both entrenched opposition and the convoluted, anti-democratic structures of our government, as we have all been learning (again) this past year. 

These daunting problems disappear when we fold everything into a price index and hand it over to the Fed to manage. Reducing everything to the core CPI and a policy rule are a way of evading all sorts of difficult political and intellectual challenges. We can also then ignore the question how, exactly, inflation will be brought down without costs to the real economy,  and how to decide if these costs are worth it. Over here is inflation; over there are the maestros with their magic anti-inflation device. All they have to do is put the right number into the machine.

It’s an appealing fantasy – it’s easy to see why people are drawn to it. But it is a fantasy.

A modern central bank, sitting at the apex of the financial system, has a great deal of influence over markets for financial assets and credit. This in turn allows it to exert some influence — powerful if often slow and indirect — on production and consumption decisions of businesses and households. Changes in the level and direction of spending will in turn affect the pricing decisions of business. These effects are real. But they are no different than the effects of anything else — public policy or economic developments — that influence spending decisions. And the level of spending is in turn only one factor in the evolution of prices. There is no special link from monetary policy to aggregate demand or inflation. It’s just one factor among others — sometimes important, often not.

Yes, a higher interest rate will, eventually reduce spending, wages and prices. But many other forces are pushing in other directions, and dampening or amplifying the effect of interest rate changes. The idea that there is out there some “r*”, some “neutral rate” that somehow corresponds to the true inter temporal interest rate — that is a fairy tale. 

Nor does the Fed have any special responsibility for inflation. Once we recognize monetary policy for what it is — one among many regulatory and tax actions that influence economic rewards and incomes, perhaps influencing behavior — arguments for central bank independence evaporate. (Then again, they did not make much sense to begin with.) And contrary to widely held belief, the Fed’s governing statutes do not give it legal responsibility for inflation or unemployment. 

That last statement might sound strange, given that we are used to talking about the Fed’s dual mandate. But as Lev Menand points out in an important recent intervention, the legal mandate of the Fed has been widely misunderstood. What the Federal Reserve Act charges the Fed with is

maintain[ing the] long run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

There are two things to notice here. First, the bolded phrase: The Fed’s mandate is not to maintain price stability or full employment as such. It is to prevent developments in the financial system that interfere with them. This is not the same thing. And as Menand argues (in the blog post and at more length elsewhere), limiting the Fed’s macroeconomic role to this narrower mission was the explicit intent of the lawmakers who wrote the Fed’s governing statutes from the 1930s onward. 

Second, price stability, maximum employment and moderate interest rates (an often forgotten part of the Fed’s mandate) are not presented as independent objectives, but as the expected consequences of keeping credit growth on a steady path. As Menand writes:

The Fed’s job, as policymakers then recognized, was not to combat inflation—it was to ensure that banks create enough money and credit to keep the nation’s productive resources fully utilized…

This distinction is important because there are many reasons that, in the short-to-medium term, the economy might not achieve full potential—as manifested by maximum employment, price stability, and moderate long-term interest rates. And often these reasons have nothing to do with monetary expansion, the only variable Congress expected the Fed to control. For example, supply shortages of key goods and services can cause prices to rise for months or even years while producers adapt to satisfy changing market demand. The Fed’s job is not to stop these price rises—even if policymakers might think stopping them is desirable—just as the Fed’s job is not to … lend lots of money to companies so that they can hire more workers. The Fed’s job is to ensure that a lack of money and credit created by the banking system—an inelastic money supply—does not prevent the economy from achieving these goals. That is its sole mandate.

As Menand notes, the idea that the Fed was directly responsible for macroeconomic outcomes was a new development in the 1980s, an aspect of the broader neoliberal turn that had no basis in law. Nor does it have any good basis in economics. If a financial crisis leads to a credit crunch, or credit-fueled speculation develops into an asset bubble, the central bank can and should take steps to stabilize credit growth and asset prices. In doing so, it will contribute to the stability of the real economy. But when inflation or unemployment come from other sources, conventional monetary policy is a clumsy, ineffectual and often destructive way of responding to them. 

There’s a reason that the rightward turn in the 1980s saw the elevation of central banks as the sole custodians of macroeconomic stability. The economies we live in are not in fact self-regulating; they are subject to catastrophic breakdowns of various forms, and even when they function well, are in constant friction with their social surroundings. They require active management. But routine management of the economy — even if limited to the adjustment of the demand “thermostat,” in Samuelson’s old metaphor — both undermine the claim that markets are natural, spontaneous and decentralized, and opens the door to a broader politicization of the economy. The independent central bank in effect quarantines the necessary economic management from the infection of democratic politics. 

The period between the 1980s and the global financial crisis saw both a dramatic elevation of the central bank’s role in macroeconomic policy, and a systematic forgetting of the wide range of tools central banks used historically. There is a basic conflict between the expansive conception of the central bank’s responsibilities and the narrow definition of what it actually does. The textbooks tell us that monetary policy is the sole, or at least primary, tool for managing output, employment and inflation (and in much of the world, the exchange rate); and that it is limited to setting a single overnight interest rate according to a predetermined rule. These two ideas can coexist comfortably only in periods of tranquility when the central bank doesn’t actually have to do anything. 

What has the Fed Delivered in the Past?

Coming back to the present: The reason I think it is wrong to endorse the Fed’s move toward tightening is not that there’s any great social benefit to having an overnight rate on interbank loans of near 0. I don’t especially care whether the federal funds rate is at 0.38 percent or 1.17 percent next September. I don’t think it makes much difference either way. What I care about is endorsing a framework that commits us to managing inflation by forcing down wages, one that closes off discussion of more progressive and humane — and effective! — ways of controlling inflation. Once the discussion of macroeconomic policy is reduced to what path the federal funds rate should follow, our side has already lost, whatever the answer turns out to be.

It is true that there are important differences between the current situation the end of 2015, the last time the Fed started hiking, that make today’s tightening more defensible. Headline unemployment is now at 3.8 percent, compared with 5 percent when the Fed began hiking in 2015. The prime-age employment rate was also about a point lower then than now. But note also that in 2015 the Fed thought the long-run unemployment rate was 4.9 percent. So from their point of view, we were at full employment. (The CBO, which had the long-run rate at 5.3 percent, thought we’d already passed it.) It may be obvious in retrospect (and to some of us in the moment) that in late 2015 there was still plenty of space for continued employment growth. But policymakers did not think so at the time.

More to the point, inflation then was much lower. If inflation control is the Fed’s job, then the case for raising rates is indeed much stronger now than it was in December 2015. And while I am challenging the idea that this should be the Fed’s job, most people believe that it is. I’m not upset or disappointed that Powell is moving to hike rates now, or is justifying it in the way that he is. Anyone who could plausibly be in that position would be doing the same. 

So let’s say a turn toward higher rates was less justified in 2015 than it is today. Did it matter? If you look at employment growth over the 2010s, it’s a perfectly straight line — an annual rate of 1.2 percent, month after month after month. If you just looked at the employment numbers, you’d have no idea that the the Fed was tightening over 2016-2018, and then loosening in the second half of 2019. This doesn’t, strictly speaking, prove that the tightening had no effect. But that’s certainly the view favored by Occam’s razor. The Fed, fortunately, did not tighten enough to tip the economy into recession. So it might as well not have tightened at all. 

The problem in 2015, or 2013, or 2011, the reason we had such a long and costly jobless recovery, was not that someone at the Fed put the wrong parameter into their model. It was not that the Fed made the wrong choices. It was that the Fed did not have the tools for the job.

Honestly, it’s hard for me to see how anyone who’s been in these debates over the past decade could believe that the Fed has the ability to steer demand in any reliable way. The policy rate was at zero for six full years. The Fed was trying their best! Certainly the Fed’s response to the 2008 crisis was much better than the fiscal authorities’. So for that matter was the ECB’s, once Draghi took over from Trichet. 4 The problem was not that the central bankers weren’t trying. The problem was that having the foot all the way down on the monetary gas pedal turned out not to do much.

As far as I can tell, modern US history offers exactly one unambiguous case of successful inflation control via monetary policy: the Volcker shock. And there, it was part of a comprehensive attack on labor. 

It is true that recessions since then have consistently seen a fall in inflation, and have consistently been preceded by monetary tightenings. So you could argue that the Fed has had some inflation-control successes since the 1980s, albeit at the cost of recessions. Let’s be clear about what this entails. To say that the Fed was responsible for the fall in inflation over 2000-2002, is to say that the dot-com boom could have continued indefinitely if the Fed had not raised rates. 

Maybe it could have, maybe not. But whether or not you want to credit (or blame) the Fed for some or all of the three pre-pandemic recessions, what is clear is that there are few if any cases of the Fed delivering slower growth and lower inflation without a recession. 

According to Alan Blinder, since World War II the Fed has achieved a soft landing in exactly two out of 11 tightening cycles, most recently in 1994. In that case, it’s true, higher rates were not followed by a recession. But nor were they followed by any discernible slowdown in growth. Output and employment grew even faster after the Fed started tightening than before. As for inflation, it did come down about two years later, at the end of 1996 – at exactly the same moment as oil prices peaked. And came back up in 1999, at exactly the moment when oil prices started rising again. Did the Fed do that? It looks to me more like 2015 – a tightening that stopped in time to avoid triggering a recession, and instead had no effect. But even if we accept the 1994 case, that’s one success story in the past 50 years. (Blinder’s other soft landing is 1966.)

I think the heart of my disagreement with progressives who are support tightening is whether it’s reasonable to think the Fed can adjust the “angle of approach” to a higher level of employment. I don’t think history gives us much reason to believe that they can. There are people who think that a recession, or at least a much weaker labor market, is the necessary cost of restoring price stability. That’s not a view I share, obviously, but it is intellectually coherent. The view that the Fed can engineer a gentle cooling that will bring down inflation while employment keeps rising, on the other hand, seems like wishful thinking.

That said, of the two realistic outcomes of tightening – no effect, or else a crisis – I think the first is more likely, unless they move quite a bit faster than they are right now. 

So what’s at stake then? If the Fed is doing what anyone in their position would do, and if it’s not likely to have much impact one way or another, why not make some approving noises, bank the respectability points, and move on? 

Four Good Reasons to Be Against Rate Hikes (and One that Isn’t)

I think that it’s a mistake to endorse or support monetary tightening. I’ll end this long post by summarizing my reasons. But first, let me stress that a commitment to keeping the federal funds rate at 0 is not one of those reasons. If the Fed were to set the overnight rate at some moderate positive level and then leave it there, I’d have no objection. In the mid-19th century, the Bank of France kept its discount rate at exactly 4 percent for something like 25 years. Admittedly 4 percent sounds a little high for the US today. But a fixed 2 percent for the next 25 years would probably be fine.

There are four reasons I think endorsing the Fed’s decision to hike is a mistake.

  1. First, most obviously, there is the risk of recession. If rates were at 2 percent today, I would not be calling for them to be cut. But raising them is a different story. Last week’s hike is no big deal in itself, but there will be another, and another, and another. I don’t know where the tipping point is, where hikes inflict enough financial distress to tip the economy into recession. But neither does the Fed. The faster they go, the sooner they’ll hit it. And given the long lags in monetary transmission, they probably won’t know until it’s too late. People are talking a lot lately about wage-price spirals, but that is far from the only positive feedback in a capitalist economy. Once a downturn gets started, with widespread business failures, defaults and disappointed investment plans, it’s much harder to reverse it than it would have been to maintain growth. 

I think many people see trusting the Fed to deal with inflation as the safe, cautious position. But the fact that a view is widely held doesn’t mean it is reasonable. It seems to me that counting on the Fed to pull off something that they’ve seldom if ever succeeded at before is not safe or cautious at all.5 Those of us who’ve been critical of rate hikes in the past should not be too quick to jump on the bandwagon now. There are plenty of voices calling on the Fed to move faster. It’s important that there also be some saying, slow down. 

2. Second, related to this, is a question I think anyone inclined to applaud hikes should be asking themselves: If high inflation means we need slower growth, higher unemployment and lower wages, where does that stop? Inflation may come down on its own over the next year — I still think this is more likely than not. But if it doesn’t come down on its own, the current round of rate hikes certainly isn’t going to do it. Looking again at the Fed’s FRB/US model, we see that a one point increase in the federal funds rate is  predicted to reduce inflation by about one-tenth of a point after one year, and about 0.15 points after two years. The OECD’s benchmark macro model make similar predictions: a sustained one-point increase in the interest rate in a given year leads to an 0.1 point fall in inflation the following year, an 0.3 fall in the third year and and an 0.5 point fall in the fourth year.

Depending which index you prefer, inflation is now between 3 and 6 points above target.6 If you think conventional monetary policy is what’s going to fix that, then either you must have have some reason to think its effects are much bigger than the Fed’s own models predict, or you must be imagining much bigger hikes than what we’re currently seeing. If you’re a progressive signing on to today’s hikes, you need to ask yourself if you will be on board with much bigger hikes if inflation stays high. “I hope it doesn’t come to that” is not an answer.

3. Third, embracing rate hikes validates the narrative that inflation is now a matter of generalized overheating, and that the solution has to be some form of across-the-board reduction in spending, income and wages. It reinforces the idea that pandemic-era macro policy has been a story of errors, rather than, on balance, a resounding success.

The orthodox view is that low unemployment, rising wages, and stronger bargaining power for workers are in themselves serious problems that need to be fixed. Look at how the news earlier this week of record-low unemployment claims got covered: It’s a dangerous sign of “wage inflation” that will “raise red flags at the Fed.”  Or the constant complaints by employers of “labor shortages” (echoed by Powell last week.) Saying that we want more employment and wage growth, just not right now, feels like trying to split the baby. There is not a path to a higher labor share that won’t upset business owners.

The orthodox view is that a big reason inflation was so intractable in the 1970s was that workers were also getting large raises. From this point of view, if wages are keeping pace with inflation, that makes the problem worse, and implies we need even more tightening. Conversely, if wages are falling behind, that’s good. Alternatively, you might think that the Powell was right before when he said the Phillips curve was flat, and that inflation today has little connection with unemployment and wages. In that case faster wage growth, so that living standards don’t fall, is part of the solution not the problem. Would higher wages right now be good, or bad? This is not a question on which you can be agnostic, or split the difference. I think anyone with broadly pro-worker politics needs to think very carefully before they accept the narrative of a wage-price spiral as the one thing to be avoided at all costs.

Similarly, if rate hikes are justified, then so must be other measures to reduce aggregate spending. The good folks over at the Committee for a Responsible Federal Budget just put out a piece arguing that student loan forbearance and expanded state Medicare and Medicaid funding ought to be ended, since they are inflationary. And you have to admit there’s some logic to that. If we agree that the economy is suffering from excessive demand, shouldn’t we support fiscal as well as monetary measures to reduce it? A big thing that rate hikes will do is raise interest payments by debtors, including student loan debtors. If that’s something we think ought to happen, we should think so when it’s brought about in other ways too. Conversely, if you don’t want to sign on to the CFRB program, you probably want to keep some distance from Powell.

4. Fourth and finally, reinforcing the idea that inflation control is the job of the Fed undermines the case for measures that actually would help with inflation. Paradoxical as it may sound, one reason it’s a mistake to endorse rate hikes is precisely because rising prices really are a problem. High costs of housing and childcare are a major burden for working families. They’re also a major obstacle to broader social goals (more people living in dense cities; a more equal division of labor within the family). Rate hikes move us away from the solution to these problems, not towards it. Most urgently and obviously, they are entirely unhelpful in the energy transition. Tell me if you think this is sensible: “Oil prices are rising, so we should discourage people from developing alternative energy sources”. But that is how conventional monetary policy works. 

The Biden administration has been strikingly consistent in articulating an alternative vision of inflation control – what some people call a progressive supply-side vision. In the State of the Union, for example, we heard:

We have a choice. One way to fight inflation is to drive down wages and make Americans poorer. I think I have a better idea … Make more cars and semiconductors in America. More infrastructure and innovation in America. …

First, cut the cost of prescription drugs. We pay more for the same drug produced by the same company in America than any other country in the world. Just look at insulin. … Insulin costs about $10 a vial to make. … But drug companies charge … up to 30 times that amount. …. Let’s cap the cost of insulin at $35 a month so everyone can afford it.7

Second, cut energy costs for families an average of $500 a year by combating climate change. Let’s provide investment tax credits to weatherize your home and your business to be energy efficient …; double America’s clean energy production in solar, wind and so much more; lower the price of electric vehicles,…

Of course weatherizing homes is not, by itself, going to have a big effect on inflation. But that’s the direction we should be looking in. If we’re serious about managing destructive price increases, we can’t leave the job to the Fed. We need to be looking for a mix of policies that directly limit price increases using  administrative tools, that cushion the impact of high prices on family budgets in the short run, and that deal with the supply constraints driving price increases in the long run. 

The interest rate hike approach is an obstacle to all this, both practically and ideologically. A big reason I’m disappointed to see progressives accepting  the idea that inflation equals rate hikes, is that there has been so much creative thinking about macroeconomic policy in recent years. What’s made this possible is increasing recognition that the neoliberal, central bank-centered model has failed. We have to decide now if we really believed that. Forward or backward? You can’t have it both ways.

Today’s Inflation Won’t be Solved by the Fed

(This post originally ran as an opinion piece in Barron’s.)

The U.S. today is experiencing inflation. This is not controversial. But what exactly does it mean?

In the textbook, inflation is a rise in all prices together, caused by an excessive increase in the money supply. But when we measure it, inflation is just a rise in the average price of goods and services. That average might reflect a uniform rise in prices due to excessive money creation. Or, as today, it might instead be the result of big rises in the prices of a few items, for their own reasons.

Over the past year, prices have risen by 7.5%, far above the usual 2% target set by the Federal Reserve. But 70% of that 5.5 points of excess inflation has come from two categories that make up just 15% of the consumption basket: energy (2 points) and new and used cars (1.9 points). Used cars alone make up barely 4% of the consumption basket, but accounted for a third of the excess inflation.

Some commentators have argued that inflation is just a matter of too much money. If that were true, it’s hard to see why so much of it would be flowing to cars. (And before you say cheap financing: Rates on auto loans were lower through most of the 2010s.)

In recent months, vehicle and energy prices have begun to stabilize, while food and housing prices have picked up. These price increases hit family budgets harder. A car purchase can usually be put off, but not rent or groceries. But this is still a story about specific sectors following their own dynamics.

Energy prices are global, and their periodic rise and fall depends mostly on the politics of oil-producing regions (as we are being reminded today). As recently as the summer of 2014, gas prices were higher than they are now, before falling precipitously. No doubt they will fall again, but in the short run there is not much to do about them—though it may be possible to shield people from their impact. In the longer run, decarbonization will leave us less vulnerable to the gyrations of the oil market.

As for vehicles, it’s no mystery why prices soared. Early in the pandemic, automakers expected a long period of depressed demand, and cut back production plans. When the economy bounced back rapidly, automakers found themselves short of key inputs, especially semiconductors. Combine this with a pandemic-induced shift in demand from services to goods, and you have a formula for rapid price increases. The effect was strongest for used cars, whose supply is essentially fixed in the short run.

Housing has made a smaller contribution so far—0.6 of the 5.5 points of excess inflation—but given the way the Bureau of Labor Statistics measures them, housing prices are likely to rise sharply over the coming year. This is a problem. But, it was also a big problem before the pandemic, when rents were rising by nearly 4% annually. Housing affordability is a serious issue in the U.S. But if the question is why inflation is higher today than in 2018 or 2019, housing is not the answer.

Finally, there are food prices, which have contributed about 0.7 points to excess inflation over the past year, and more in recent months. Food prices, like energy prices, are famously volatile; there’s a reason they are both excluded from the Fed’s measure of “core” inflation. They’re also an area where market power may be playing a major role, given the high concentration in food processing. Monopolies may be reluctant to fully exploit their power in normal times; price increases elsewhere in the economy give them a chance to widen their margins.

The great majority of the excess inflation over the past year has come from these four areas. Other sectors—including labor-intensive services where prices have historically risen more quickly—have contributed little or nothing.

The point is not that these price increases don’t matter. Food, housing and energy are necessities of life. People are naturally unhappy when they have to pay more for them. The point is that current price rises are not symptoms of economy-wide overheating.

Some of these prices, like autos, will come back down on their own as supply-chain kinks work themselves out. Others, like housing, will not, and call for a policy response. But that response is not raising interest rates, which would only make the problem worse. The main reason why housing costs are rising is that the U.S. does not build enough of it, especially in the expensive metro areas where employment opportunities are concentrated. Construction is one of the most interest-sensitive sectors of the economy. Rate hikes will cause supply to fall further short of demand.

Some might say that the Fed still controls the overall level of spending in the economy. If people spent less on used cars, wouldn’t they spend more on something else? This ignores the existence of balance sheets. Households hold cash, and finance many purchases—including cars—with debt. Lower used-car prices wouldn’t mean higher prices elsewhere, but higher household savings and less debt.

An inability to build housing where people want to live, dependence on fossil fuels, fragile supply chains and the monopolization of key industries: These are all serious economic problems. But they are not monetary-policy problems. Looking at them through the lens of a textbook story of inflation will not get us any closer to solving them.

 

“Inflation is bad. But mass unemployment would have been worse.”

(Lauren Melodia and I had an op-ed in the Nov. 21 Washington Post, challenging the idea that today’s inflation means that the stimulus measures of the past year and half were too large. I’m posting it here as well.)

As we think about rising prices today, it’s important not to lose sight of where we were not so long ago. In the spring of 2020, much of the economy abruptly shut down. Schools and child-care centers closed. Air travel fell below 100,000 people a day, compared with 2.5 million daily passengers in a normal year. No one was staying in hotels or going to the gym. About 1.4 million small businesses shut their doors in the second quarter of the year.

More than 20 million Americans lost their jobs in the early days of the pandemic, and there was a very real possibility that many would face hunger, eviction and poverty. Many economists predicted a deep downturn comparable to the Great Recession that followed the financial crisis of 2007-08, if not the Great Depression of the 1930s.

Even at the start of this year, as Congress was debating the American Rescue Plan, it was far from clear that we were out of danger. In January, there were 10 million fewer jobs than a year earlier. Covid-related deaths were running at 30,000 per week — the highest rate at any point in the pandemic. No one knew how fast vaccines could be rolled out. There was still a real risk that the economy could tip into depression.

Thanks to stimulus measures, including the $2.2 trillion Cares Act, signed by President Donald Trump in March 2020, and the $1.9 trillion American Rescue Plan, signed by President Biden in March 2021, that didn’t happen. People who lost their jobs in restaurants, airports, hotels and elsewhere continued to pay their rent and put food on the table.

For much of 2020 and 2021, all the uncertainty — and the risks associated with vacationing, dining out and so on — meant households held back on spending, and savings piled up. Now, with the economy reopening and the worst of the pandemic (let’s hope) behind us, people are rushing to make use of those savings. Unfortunately, businesses can’t adjust production as fast as people can spend money, resulting in the inflation we’re seeing now: Prices rose 0.9 percent from September to October 2021 and are up 6.2 percent since October 2020.

It would be nice if there were a way to avoid economic catastrophe during the year-plus of pandemic restrictions while also avoiding rising prices today. But in the real world, there probably wasn’t. The pandemic imposed costs on the economy that had to be paid one way or another.

Think of it this way. When a restaurant shuts down for public health reasons, two things happen: Its services are not available for purchase, and the people who work there lose their incomes. If the government does nothing, aggregate demand and supply will remain in rough balance, but the displaced workers will be unable to pay their bills. Alternatively, the government can step in to maintain the incomes of the displaced workers. In this case, the spending that consumers might have done in restaurants will spill over into the rest of the economy — if not right away, then eventually. In a sense, the rising costs we’re seeing today are a result of economic production that didn’t happen last year.

In economics textbooks, the level of demand that brings the economy to full employment will also cause stable inflation — an assumption labeled “the divine coincidence.” But here on Earth, things don’t always work out so neatly. The level of spending required to replace incomes lost in the pandemic, combined with the disruptions to production and trade, meant there was no way to get an adequate recovery without some increase in inflation, especially given the bumps on the road to controlling the coronavirus. As the spread of the delta variant and some Americans’ resistance to getting a vaccine have held back spending on services, demand has spilled over into goods. And as it turns out, our global supply chains are unable to handle a rapid rise in demand for goods — especially because many manufacturers had expected a deep downturn and planned accordingly.

Today’s inflation has surprised many people, including us. We had been more worried about sustained high unemployment. One of us even gave a talk a year ago called “The Coronavirus Recession Is Just Beginning.” We were wrong about that. But then, so was almost everyone. In the summer of 2020, the Congressional Budget Office was predicting that the unemployment rate in late 2021 would be 8 percent; in fact, it has fallen to 4.6 percent. Many private forecasters were similarly gloomy. Under the circumstances, policymakers were absolutely right to prioritize payments to families.

The economist Larry Summers has been making the case since February that the government’s stimulus programs were larger than required and ran the risk of “inflationary pressures of a kind we have not seen in a generation.” Fiscal conservatives are claiming that Summers has been vindicated because inflation is higher than most supporters of the most recent relief package expected. But the economic data doesn’t match the scenario he described.

Summers predicted that the cumulative stimulus impact would be larger than the country’s output gap — the difference between actual and potential gross domestic product. Today, despite the stimulus, both real and nominal GDP remain significantly below the pre-pandemic trend. So unless you think the economy was operating above potential before the pandemic, there’s no reason to think it is above potential now. To the extent that domestic conditions are contributing to inflation, it’s not because spending has surpassed the economy’s capacity but because there has been a rapid shift in demand from services to goods.

In any case, most of the inflation we’re seeing is due not to domestic conditions but to the worldwide spike in food, energy and shipping costs. Perhaps we could have had inflation of 5 percent instead of 6 percent if the stimulus had been smaller. The cost of that trade-off would have been material hardship for millions of families and the risk of tipping the economy into a downturn. And that, fundamentally, is why today’s inflation is not a sign that the stimulus was too large: It has to be weighed against the risks on the other side.

After 2007, the United States experienced many years of high unemployment and depressed growth, thanks in large part to a stimulus that most now agree was too small. Policymakers belatedly learned that lesson, and as a result, the United States is making a rapid recovery from the most severe economic disruption in modern history. Yes, inflation is a real problem that needs to be addressed. In a recent Roosevelt Institute brief, we suggested that rather than raise interest rates, the best way to control inflation is to address supply constraints in the sectors where prices are climbing. But as bad as inflation is, mass unemployment is much worse. Given the alternatives, policymakers made the right choice.

Inflation for Whom?

A point I’ve been emphasizing about inflation (see here and here) is that it is just an average of price changes; it doesn’t have any independent existence.

One implication of this is that there is not, even in principle, a true inflation rate. Pick any basket of goods and measure their prices over time; that is an inflation rate. The “all urban consumers” basket used by the BLS for the headline CPI inflation rate is a useful benchmark, but it’s just one basket among others. Any individual household or subgroup of households will have its own consumption basket and corresponding inflation rate.

Because a small number of items have gone up in price a lot recently, the average price increase in the CPI basket is greater than increase in wages over the past year. In this sense, real wages have gone down. I am not convinced this is a meaningful statistic. For one thing, car prices are almost certain to come back down over the next year, once the current semiconductor bottleneck is relieved and manufacturers ramp up output. Wage gains, on the other hand, have a lot of inertia. This year’s wage gains are likely to continue; certainly they will not be given back.

But there’s another reason the “falling real wage” claim is misleading. When price increases are concentrated in a few areas, the inflation rate facing people who are buying stuff in those areas will be very different from the rate facing those who are not. Most Americans do buy a car every few years, but relatively few need to buy a car right now.8 And even averaged over time, different groups of people spend more or less on cars relative to other things. The same goes for other categories of spending.

The BLS’s Consumer Expenditure Survey (CEX) tries to measure the distribution of consumption spending by different demographic groups. In principle, you could construct a separate CPI for each group, like CPI-E the BLS reports for elderly households. (For what it’s worth the CPI-E increased by 4.8 percent over the past year, a bit slower than the headline rate.) In practice the challenges in doing this are formidable — for the headline measure weights can be based on retail sales, but the weights for demographic group have to be based on household surveys, which are slower and much less reliable. (I have some discussion of these issues in Section 7 of this paper.) Still, the CEX can give us at least a rough sense of the difference in consumption baskets and inflation rates across different groups.

It’s particularly interesting to look at consumption baskets across income groups. One of the central arguments for running the economy hot is that it tends to compress wages. From this point of view, an increase in prices paid disproportionately by lower income households is more concerning than a similar aggregate increase in prices paid more by the better off.

For this post, I chose to focus on the consumption basket of households with pre-tax income below $30,000 a year — about one quarter of the population.

In the table below, I show 20 items, accounting for almost 95% of the CPI basket. The first column shows its share of the CPI-U basket, taken from the most recent CPI Table 2. The second column shows the difference between the weight of the item in consumption by households earning less than $30,000 and its weight in total consumption.9 So a positive value means something that makes up a larger share of consumption for households with incomes under $30,000 than of consumption for the population as a whole. This comes from the most recent Consumer Expenditure Survey, covering July 2019 through June 2020. The third column shows the price change of that item from July 2020 to July 2021, again from CPI Table 2. The items are ordered from the ones that make up the largest relative share of the consumption basket for low-income households to the ones that make up the smallest relative share. So it gives at least a rough sense of the different inflations experienced by lower versus higher income families.

Expenditure Category Overall share (CPI) Relative share, income <$30k (CEX) Inflation, July 2020-July 2021 (CPI)
Rent of primary residence 7.6 8.3 1.9
Food at home 7.6 2.4 2.6
Electricity 2.5 1.5 4
Medical care services 7.1 1 0.8
Medical care commodities 1.5 0.35 -2.1
Recreation commodities 2.0 0.35 3.2
Water and sewer and trash collection 1.1 0.3 3.7
Education and communication services 6.1 0.2 1.2
Motor fuel 3.8 0.2 41.6
Utility (piped) gas service 0.7 0.2 19
Apparel 2.7 0.2 4.2
Motor vehicle parts and equipment 0.4 0.05 4.3
Fuel oil and other fuels 0.2 0.05 30.9
New vehicles 3.7 -0.15 6.4
Transportation services 5.3 -0.15 6.4
Lodging away from home 1.0 -0.3 21.5
Used cars and trucks 3.5 -0.3 41.7
Alcoholic beverages 1.0 -0.3 2.4
Food away from home 6.2 -0.35 4.6
Recreation services 3.7 -0.6 3.7
Household furnishings and supplies 3.7 -0.7 3
Owners’ equivalent rent 22.4 n/a10 2.4

As you can see, the items that are increasing at less than 2 percent a year — highlighted in blue — are all things disproportionately consumed by lower-income households. Rent, in particular, makes up a much higher share of spending for low-income households. Rent growth slowed sharply during the pandemic and, unlike many other prices, it has not so far accelerated again. Rent growth over the past year is about half the average rate in the three years before the pandemic.

Medical goods and services also make up a larger share of spending for lower-income households; prices there have grown slowly or income cases actually fallen over the past year. Prescription drug prices, for example, fell by 2 percent over the past year. Finally, education services, including childcare, have pulled inflation down over the past year, rising by about 1 percent (college tuition was flat.) Education inflation has been slowing for a long time — a trend I don’t recall seeing discussed much — but it slowed even more during the pandemic. Education and childcare make up a slightly higher fraction of spending for low-income households than for others.

On the other side, almost all the sectors where inflation is notably high — highlighted in red — make up a larger share of spending for higher-income households. Lodging away from home, for example, where prices are up over 20 percent, makes up less than 1 percent of the consumption basket for households with incomes under $30,000, but 2.5 percent of the basket for households with incomes over $200,000. Transportation services, food away from home, and new and used cars, which account for  the majority of non-energy inflation, are also disproportionately consumed by higher income households.

In general, it seems clear that lower-income households are facing less inflation than higher income ones. The biggest price increases are in areas that are disproportionately consumed by higher-income families, while several of the most important consumption categories for lower-income families are seeing prices rise more slowly than before the pandemic. Any discussion of “falling real incomes” that ignores this fact is at best incomplete.

There is, of course, one big exception: energy. Gasoline especially, but also electricity and heating gas, are seeing big price increases and make up a larger share of consumption for lower-income families. And unlike auto purchases, energy consumption can’t be postponed. If you want to tell a story about higher prices eating up wage gains, it seems to me that energy is your best bet.

Except, of course, that these are prices that we want to see rise, if we are serious about climate change. Many of the same people fretting about inflation eroding real wages, are strong supporters of carbon taxes or permits. If you think a goal of policy is to raise the relative price of fossil fuels, why object when it happens via the market?

At the end of the day, perhaps the current debate about inflation and real wages doesn’t belong in the macroeconomics box at all, but in the climate box. The difficult problem here is not how to keep demand strong enough to raise wages without also raising prices. The price spikes we’re seeing right now are mainly about short-term supply constraints. I am confident that prices for autos and many other goods will  come back down or at least stabilize over the next year, even if demand remains strong. The really difficult problem is how we make the transition away from fossil fuels without unacceptably burdening the people who are currently dependent on them.

UPDATE: I am getting some very confused readers, who note that historically rent, education and health care have historically risen in price faster than most goods, while in this post I’m saying they are rising more slowly. The original post, should have, but did not, make clear that the pattern of price changes over the past year or so is quite different from what we are used to. That said, this is not all about the pandemic. As I did note, inflation in education has been slowing for a long time; health care inflation has fallen dramatically during the pandemic but was also slowing before that, arguably thanks to the ACA. But the key point is that I am not saying that poor people face lower inflation in general; I’m saying this is a distinct feature of the inflation we’re experiencing now.

Alternative Visions of Inflation

Like many people, I’ve been thinking a bit about inflation lately. One source of confusion, it seems to me, is that underlying concept has shifted in a rather fundamental way, but the full implications of this shift haven’t been taken on board.

I was talking with my Roosevelt colleague Lauren Melodia about inflation and alternative policies to manage it, which is a topic I hope Roosevelt will be engaging in more in the later part of this year. In the course of our conversation, it occurred to me that there’s a basic source of confusion about inflation. 

Many of our ideas about inflation originated in the context of a fixed quantity money. The original meaning of the term “inflation” was an increase in the stock of money, not a general increase in the price level. Over there you’ve got a quantity of stuff; over here you’ve got a quantity of money. When the stock of money grows rapidly and outpaces the growth of stuff, that’s inflation.

 In recent decades, even mainstream economists have largely abandoned the idea of the money stock as a meaningful economic quantity, and especially the idea that there is a straightforward relationship between money and inflation.

Here is what a typical mainstream macroeconomics textbook — Olivier Blanchard’s, in this case; but most are similar — says about inflation today. (You can just read the lines in italics.) 

There are three stories about inflation here: one based on expected inflation, one based on markup pricing, and one based on unemployment. We can think of these as corresponding to three kinds of inflation in the real world — inertial, supply-drive, and demand-driven. What there is not, is any mention of money. Money comes into the story only in the way that it did for Keynes: as an influence on the interest rate. 

To be fair, the book does eventually bring up the idea of a direct link between the money supply and inflation, but only to explain why it is obsolete and irrelevant for the modern world:

Until the 1980s, the strategy was to choose a target rate of money growth and to allow for deviations from that target rate as a function of activity. The rationale was simple. A low target rate of money growth implied a low average rate of inflation. … 

That strategy did not work well.

First, the relation between money growth and inflation turned out to be far from tight, even in the medium run. … Second, the relation between the money supply and the interest rate in the short run also turned out also to be unreliable. …

Throughout the 1970s and 1980s, frequent and large shifts in money demand created serious problems for central banks. … Starting in the early 1990s, a dramatic rethinking of monetary policy took place based on targeting inflation rather than money growth, and the use of an interest rate rule.

Obviously, I don’t endorse everything in the textbook.11 (The idea of a tight link between unemployment and inflation is not looking much better than the idea of a tight link between inflation and the money supply.) I bring it up here just to establish that the absence of a link between money growth and inflation is not radical or heterodox, but literally the textbook view.

One way of thinking about the first Blanchard passage above is that the three stories about inflation correspond to three stories about price setting. Prices may be set based on expectations of where prices will be, or prices may be set based on market power (the markup), or prices may be set based on costs of production. 

This seems to me to be the beginning of wisdom with respect to inflation: Inflation is just an increase in prices, so for every theory of price setting there’s a corresponding theory of inflation. There is wide variation in how prices get set across periods, countries and markets, so there must be a corresponding variety of inflations. 

Besides the three mentioned by Blanchard, there’s one other story that inflation is perhaps even more widespread. We could call this too much spending chasing too little production. 

The too-much-spending view of inflation corresponds to a ceiling on output, rather than a floor on unemployment, as the inflationary barrier. As the NAIRU has given way to potential output as the operational form of supply constraints on macroeconomic policy, this understanding of inflation has arguably become the dominant one, even if without formalization in textbooks. It overlaps with the unemployment story in making current demand conditions a key driver of inflation, even if the transmission mechanism is different. 

Superfically “too much spending relative to production” sounds a lot like “too money relative to goods.” (As to a lesser extent does “too much wage growth relative to productivity growth.”) But while these formulations sound similar, they have quite different implications. Intuitions formed by the old quantity-of-money view don’t work for the new stories.

The older understanding of inflation, which runs more or less unchanged from David Hume through Irving Fisher to Milton Friedman and contemporary monetarists, goes like this. There’s a stock of goods, which people can exchange for their mutual benefit. For whatever reasons, goods don’t exchange directly for other goods, but only for money. Money in turn is only used for purchasing goods. When someone receives money in exchange for a good, they turn around and spend it on some good themselves — not instantly, but after some delay determined by the practical requirements of exchange. (Imagine you’ve collected your earnings from your market stall today, and can take them to spend at a different market tomorrow.) The total amount of money, meanwhile, is fixed exogenously — the quantity of gold in circulation, or equivalently the amount of fiat tokens created by the government via its central bank.

Under these assumptions, we can write the familiar equation

MV = PY

If Y, the level of output, is determined by resources, technology and other “real” factors, and V is a function of the technical process of exchange — how long must pass between the receipt of money and it spending — then we’re left with a direct relationship between the change in M and the change in P. “Inflation is always and everywhere a monetary phenomenon.”12

I think something like this underlies most folk wisdom about inflation. And as is often the case, the folk wisdom has outlived whatever basis in reality it may once have had.13

Below, I want to sketch out some ways in which the implications of the excessive-spending-relative-to-production vision of inflation are importantly different from those of the excessive-money-relative-to-goods vision. But first, a couple of caveats.

First, the idea of a given or exogenous quantity of money isn’t wrong a priori, as a matter of logic; it’s an approximation that happens not to fit the economy in which we live. Exactly what range of historical settings it does fit is a tricky question, which I would love to see someone try to answer. But I think it’s safe to say that many important historical inflations, both under metallic and fiat regimes, fit comfortably enough in a monetarist framework. 

Second, the fact that the monetarist understanding of inflation is wrong (at least for contemporary advanced economies) doesn’t mean that the modern mainstream view is right. There is no reason to think there is one general theory of inflation, any more than there is one general etiology of a fever. Lots of conditions can produce the same symptom. In general, inflation is a persistent, widespread rise in prices, so for any theory of price-setting there’s a corresponding theory of inflation. And the expectations-based propagation mechanism of inertial inflation — where prices are raised in the expectation that prices will rise — is compatible with many different initial inflationary impulses. 

That said — here are some important cleavages between the two visions.

1. Money vs spending. More money is just more money, but more spending is always more spending on something in particular. This is probably the most fundamental difference. When we think of inflation in terms of money chasing a given quantity of goods, there is no connection between a change in the quantity of money and a change in individual spending decisions. But when we think of it in terms of spending, that’s no longer true — a decision to spend more is a decision to spend more on some specific thing. People try to carry over intuitions from the former case to the latter, but it doesn’t work. In the modern version, you can’t tell a story about inflation rising that doesn’t say who is trying to buy more of what; and you can’t tell a story about controlling inflation without saying whose spending will be reduced. Spending, unlike money, is not a simple scalar.

The same goes for the wages-markup story of the textbook. In the model, there is a single wage and a single production process. But in reality, a fall in unemployment or any other process that “raises the wage” is raising the wages of somebody in particular.

2. Money vs prices. There is one stock of money, but there are many prices, and many price indices. Which means there are many ways to measure inflation. As I mentioned above, inflation was originally conceived of as definitionally an increase in the quantity of money. Closely related to this is the idea of a decrease in the purchasing power of money, a definition which is still sometimes used. But a decrease in the value of money is not the same as an increase in the prices of goods and services, since money is used for things other than purchasing goods and services.  (Merijn Knibbe is very good on this.14) Even more problematically, there are many different goods and services, whose prices don’t move in unison. 

This wasn’t such a big deal for the old concept of inflation, since one could say that all else equal, a one percent increase in the stock of money would imply an additional point of inflation, without worrying too much about which specific prices that showed up in. But in the new concept, there’s no stock of money, only the price changes themselves. So picking the right index is very important. The problem is, there are many possible price indexes, and they don’t all move in unison. It’s no secret that inflation as measured by the CPI averages about half a point higher than that measured by the PCE. But why stop there? Those are just two of the infinitely many possible baskets of goods one could construct price indexes for. Every individual household, every business, every unit of government has their own price index and corresponding inflation rate. If you’ve bought a used car recently, your personal inflation rate is substantially higher than that of people who haven’t. We can average these individual rates together in various ways, but that doesn’t change the fact that there is no true inflation rate out there, only the many different price changes of different commodities.

3. Inflation and relative prices. In the old conception, money is like water in a pool. Regardless of where you pour it in, you get the same rise in the overall level of the pool.

Inflation conceived of in terms of spending doesn’t have that property. First, for the reason above — more spending is always more spending on something. If, let’s say for sake of argument, over-generous stimulus payments are to blame for rising inflation, then the inflation must show up in the particular goods and services that those payments are being used to purchase — which will not be a cross-section of output in general. Second, in the new concept, we are comparing desired spending not to a fixed stock of commodities, but to the productive capacity of the economy. So it matters how elastic output is — how easily production of different goods can be increased in response to stronger demand. Prices of goods in inelastic supply — rental housing, let’s say — will rise more in response to stronger demand, while prices of goods supplied elastically — online services, say — will rise less. It follows that inflation, as a concrete phenomenon, will involve not an across-the-board increase in prices, but a characteristic shift in relative prices.

This is a different point than the familiar one that motivates the use of “core” inflation — that some prices (traditionally, food and energy) are more volatile or noisy, and thus less informative about sustained trends. It’s that  when spending increases, some goods systematically rise in price faster than others.

This recent paper by Stock and Watson, for example, suggests that housing, consumer durables and food have historically seen prices vary strongly with the degree of macroeconomic slack, while prices for gasoline, health care, financial services, clothing and motor vehicles do not, or even move the opposite way. They suggest that the lack of a cyclical component in health care and finance reflect the distinct ways that prices are set (or imputed) in those sectors, while the lack of a cyclical component in gas, clothing and autos reflects the fact that these are heavily traded goods whose prices are set internationally. This interpretation seems plausible enough, but if you believe these numbers they have a broader implication: We should not think of cyclical inflation as an across the board increase in prices, but rather as an increase in the price of a fairly small set of market-priced, inelastically supplied goods relative to others.

4. Inflation and wages. As I discussed earlier in the post, the main story about inflation in today’s textbooks is the Phillips curve relationship where low unemployment leads to accelerating inflation. Here it’s particularly clear that today’s orthodoxy has abandoned the quantity-of-money view without giving up the policy conclusions that followed from it.

In the old monetarist view, there was no particular reason that lower unemployment or faster wage growth should be associated with higher inflation. Wages were just one relative price among others. A scarcity of labor would lead to higher real wages, while an exogenous increase in wages would lead to lower employment. But absent a change in the money supply, neither should have any effect on the overall price level. 

It’s worth noting here that altho Milton Friedman’s “natural rate of unemployment” is often conflated with the modern NAIRU, the causal logic is completely different. In Friedman’s story, high inflation caused low unemployment, not the reverse. In the modern story, causality runs from lower unemployment to faster wage growth to higher inflation. In the modern story, prices are set as a markup over marginal costs. If the markup is constant, and all wages are part of marginal cost, and all marginal costs are wages, then a change in wages will just be passed through one to one to inflation.

We can ignore the stable markup assumption for now — not because it is necessarily reasonable, but because it’s not obvious in which direction it’s wrong. But if we relax the other assumptions, and allow for non-wage costs of production and fixed wage costs, that unambiguously implies that wage changes are passed through less than one for one to prices. If production inputs include anything other than current labor, then low unemployment should lead to a mix of faster inflation and faster real wage growth. And why on earth should we expect anything else? Why shouldn’t the 101 logic of “reduced supply of X leads to a higher relative price of X” be uniquely inapplicable to labor?15

There’s an obvious political-ideological reason why textbooks should teach that low unemployment can’t actually make workers better off. But I think it gets a critical boost in plausibility — a papering-over of the extreme assumptions it rests on — from intuitions held over from the old monetarist view. If inflation really was just about faster money growth, then the claim that it leaves real incomes unchanged could work as a reasonable first approximation. Whereas in the markup-pricing story it really doesn’t. 

5. Inflation and the central bank.  In the quantity-of-money vision, it’s obvious why inflation is the special responsibility of the central bank. In the textbooks, managing the supply of money is often given as the first defining feature of a central bank. Clearly, if inflation is a function of the quantity of money, then primary responsibility for controlling it needs to be in the hands of whoever is in charge of the money supply, whether directly, or indirectly via bank lending. 

But here again, it seems, to me, the policy conclusion is being asked to bear weight even after the logical scaffolding supporting it has been removed. 

Even if we concede for the sake of argument that the central bank has a special relationship with the quantity of money, it’s still just one of many influences on the level of spending. Indeed, when we think about all the spending decisions made across the economy, “at one interest rate will I borrow the funds for it” is going to be a central consideration in only a few of them. Whether our vision of inflation is too much spending relative to the productive capacity of the economy, or wages increasing faster than productivity, many factors are going to play a role beyond interest rates or central bank actions more broadly. 

One might believe that compared with other macro variables, the policy interest rate has a uniquely strong and reliable link to the level of spending and/or wage growth; but almost no one, I think, does believe this. The distinct responsibility of the central bank for inflation gets justified not on economic grounds but political-institutional ones: the central bank can act more quickly than the legislature, it is free of undue political influence, and so on. These claims may or may not be true, but they have nothing in particular to do with inflation. One could justify authority over almost any area of macroeconomic policy on similar grounds.

Conversely, once we fully take on board the idea that the central bank’s control over inflation runs through to the volume of credit creation to the level of spending (and then perhaps via unemployment to wage growth), there is no basis for the distinction between monetary policy proper and other central bank actions. All kinds of regulation and lender-of-last-resort operations equally change the volume and direction of credit creation, and so influenced aggregate spending just as monetary policy in the narrow sense does.

6. The costs of inflation. If inflation is a specifically monetary phenomenon, the costs of inflation presumably involve the use of money. The convenience of quoting relative prices in money becomes a problem when the value of money is changing.

An obvious example is the fixed denominations of currency — monetarists used to talk with about “shoe leather costs” — the costs of needing to go more frequently to the bank (as one then did) to restock on cash. A more consequential example is public incomes or payments fixed in money terms. As recently as the 1990s, one could find FOMC members talking about bracket creep and eroded Social Security payments as possible costs of higher inflation — albeit with some embarrassment, since the schedules of both were already indexed by then. More broadly, in an economy organized around money payments, changes in what a given flow of money can buy will create problems. Here’s one way to think about these problems:

Social coordination requires a mix of certainty and flexibility. It requires economic units to make all kinds of decisions in anticipation of the choices of other units — we are working together; my plans won’t work out if you can change yours too freely. But at the same time, you need to have enough space to adapt to new developments — as with train cars, there needs to be some slack in the coupling between economic unit for things to run smoothly. One dimension of this slack is the treatment of some extended period as if it were a single instant.

This is such a basic, practical requirements of contracting and management that we hardly think about it. For example, budgets — most organizations budget for periods no shorter than a quarter, which means that as far as internal controls and reporting are concerned, anything that happens within that quarter happens at the same time.16Similarly, invoices normally require payment in 30 or 60 days, thus treating shorter durations as instantaneous. Contracts of all kinds are signed for extended periods on fixed money terms. All these arrangements assume that the changes in prices over a few months or a year are small enough that they can be safely ignored.can be modified when inflation is high enough to make the fiction untenable that 30, 60 or 90 days is an instant. Social coordination strongly benefits from the convention that shorter durations can be ignored for most periods, which means people behave in practice as if they expect inflation over such shorter periods to be zero.

Axel Leijonhufvud’s mid-70s piece on inflation is one of the most compelling accounts of this kinds of cost of inflation — the breakdown of social coordination — that I have seen. For him, the stability of money prices is the sine qua non of decentralized coordination through markets. 

In largely nonmonetary economies, important economic rights and obligations will be inseparable from particularized relationships of social status and political allegiance and will be in some measure permanent, inalienable and irrevocable. … In monetary exchange systems, in contrast, the value to the owner of an asset derives from rights, privileges, powers and immunities against society generally rather than from the obligation of some particular person. …

Neoclassical theories rest on a set of abstractions that separate “economic” transactions from the totality of social and political interactions in the system. For a very large set of problems, this separation “works”… But it assumes that the events that we make the subject of … the neoclassical model of the “economic system” do not affect the “social-political system” so as … to invalidate the institutional ceteris paribus clauses of that model. …

 Double-digit inflation may label a class of events for which this assumption is a bad one. … It may be that … before the “near-neutral” adjustments can all be smoothly achieved, society unlearns to use money confidently and reacts by restrictions on “the circles people shall serve, the prices they shall charge, and the goods they can buy.”

One important point here is that inflation has a much greater impact than in conventional theory because of the price-stability assumption incorporated into any contract that is denominated in money terms and not settled instantly — which is to say, pretty much any contract. So whatever expectations of inflation people actually hold, the whole legal-economic system is constructed in a way that makes it behave as if inflation expectations were biased toward zero:

The price stability fiction — a dollar is a dollar is a dollar — is as ingrained in our laws as if it were a constitutional principle. Indeed, it may be that no real constitutional principle permeates the Law as completely as does this manifest fiction.

The market-prices-or-feudalism tone of this seems more than a little overheated from today’s perspective, and when Arjun and I asked him about this piece a few years ago, he seemed a bit embarrassed by it. But I still think there is something to it. Market coordination, market rationality, the organization of productive activity through money payments and commitments, really does require the fiction of a fixed relationship between quantities of money and real things. There is some level of inflation at which this is no longer tenable.

So I have no problem with the conventional view that really high inflations — triple digits and above — can cause far-reaching breakdowns in social coordination. But this is not relevant to the question of inflation of 1 or 2 or 5 or probably even 10 percent. 

In this sense, I think the mainstream paradoxically both understates and overstates the real costs of inflation. They exaggerate the importances of small differences in inflation. But at the same time, because they completely naturalize the organization of life through markets, they are unable to talk about the possibility that it could break down.

But again, this kind of breakdown of market coordination is not relevant for the sorts of inflation seen in the United States or other rich countries in modern times. 

It’s easier to talk about the costs (and benefits) of inflation when we see it as a change in relative prices, and redistribution of income and wealth. If inflation is typically a change in relative prices, then the costs are experienced by those whose incomes rise more slowly than their payments. Keynes emphasized this point in an early article on “Social Consequences of a Change in the Value of Money.”17

A change in the value of money, that is to say in the level of prices, is important to Society only in so far as its incidence is unequal. Such changes have produced in the past, and are producing now, the vastest social consequences, because, as we all know, when the value of money changes, it does not change equally for all persons or for all purposes. … 

Keynes sees the losers from inflation as passive wealth owners, while the winners are active businesses and farmers; workers may gain or lose depending on the degree to which they are organized. For this reason, he sees moderate inflation as being preferable to moderate deflation, though both as evils to be avoided — until well after World War II, the goal of price stability meant what it said.

Let’s return for a minute to the question of wages. As far as I can tell, the experience in modern inflations is that wage changes typically lag behind prices. If you plot nominal wage growth against inflation, you’ll see a clear positive relationship, but with a slope well below 1. This might seem to contradict what I said under point 4. But my point there was that insofar as inflation is driven by increased worker bargaining power, it should be associated with faster real wage growth. In fact, the textbook is wrong not just on logic but on facts. In principle, a wage-driven inflation would see a rise in real wage. But most real inflations are not wage-driven.

In practice, the political costs of inflation are probably mostly due to a relatively small number of highly salient prices. 

7. Inflation and production. The old monetarist view had a fixed quantity of money confronting a fixed quantity of goods, with the price level ending up at whatever equated them. As I mentioned above, the fixed-quantity-of-money part of this has been largely abandoned by modern mainstream as well as heterodox economists. But what about the other side? Why doesn’t more spending call forth more production?

The contemporary mainstream has, it seems to me, a couple ways of answering the question. One is the approach of a textbook like Blanchard’s. There, higher spending does lead to to higher employment and output and lower unemployment. But unless unemployment is at a single unique level — the NAIRU — inflation will rise or fall without limit. It’s exceedingly hard to find anything that looks like a NAIRU in the data, as critics have been pointing out for a long time. Even Blanchard himself rejects it when he’s writing for central bankers rather than undergraduates. 

There’s a deeper conceptual problem as well. In this story, there is a tradeoff between unemployment and inflation. Unemployment below the NAIRU does mean higher real output and income. The cost of this higher output is an inflation rate that rises steadily from year to year. But even if we believed this, we might ask, how much inflation acceleration is too much? Can we rule out that a permanently higher level of output might be worth a slowly accelerating inflation rate?

Think about it: In the old days, the idea that the price level could increase without limit was considered crazy. After World War II, the British government imposed immense costs on the country not just to stabilize inflation, but to bring the price level back to its prewar level. In the modern view, this was crazy — the level of prices is completely irrelevant. The first derivative of prices — the inflation rate — is also inconsequential, as long as it is stable and predictable. But the second derivative — the change in the rate of inflation — is apparently so consequential that it must be kept at exactly zero at all costs. It’s hard to find a good answer, or indeed any answer, for why this should be so.

The more practical mainstream answer is to say, rather than that there is a tradeoff between unemployment and inflation with one unambiguously best choice, but that there is no tradeoff. In this story, there is a unique level of potential output (not a feature of the textbook model) at which the relationship between demand, unemployment and inflation changes. Below potential, more spending calls forth more production and employment; above potential, more spending only calls forth higher inflation. This looks better as a description of real economies, particular given that the recent experience of long periods of elevated unemployment that have not, contrary to the NAIRU prediction, resulted in ever-accelerating deflation. But it begs the question of why should be such a sharp line.

The alternative view would be that investment, technological change, and other determinants of “potential output” also respond to demand. Supply constraints, in this view, are better thought of in terms of the speed with which supply can respond to demand, rather than an absolute ceiling on output.

Well, this post has gotten too long, and has been sitting in the virtual drawer for quite a while as I keep adding to it. So I am going to break off here. But it seems to me that this is where the most interesting conversations around inflation are going right now — the idea that supply constraints are not absolute but respond to demand with varying lags — that inflation should be seen as often a temporary cost of adjustment to a new higher level of capacity. And the corollary, that anti-inflation policy should aim at identifying supply constraints as much as, or more than, restraining demand. 

Varieties of the Phillips Curve

In this post, I first talk about a variety of ways that we can formalize the relationship between wages, inflation and productivity. Then I talk briefly about why these links matter, and finally how, in my view, we should think about the existence of a variety of different possible relationships between these variables.

*

My Jacobin piece on the Fed was, on a certain abstract level, about varieties of the Phillips curve. The Phillips curve is any of a family graphs with either unemployment or “real” GDP on the X axis, and either the level or the change of nominal wages or the level of prices or the level or change of inflation on the Y axis. In any of the the various permutations (some of which naturally are more common than others) this purports to show a regular relationship between aggregate demand and prices.

This apparatus is central to the standard textbook account of monetary policy transmission. In this account, a change in the amount of base money supplied by the central bank leads to a change in market interest rates. (Newer textbooks normally skip this part and assume the central bank sets “the” interest rate by some unspecified means.) The change in interest rates  leads to a change in business and/or housing investment, which results via a multiplier in a change in aggregate output. [1] The change in output then leads to a change in unemployment, as described by Okun’s law. [2] This in turn leads to a change in wages, which is passed on to prices. The Phillips curve describes the last one or two or three steps in this chain.

Here I want to focus on the wage-price link. What are the kinds of stories we can tell about the relationship between nominal wages and inflation?

*

The starting point is this identity:

(1) w = y + p + s

That is, the percentage change in nominal wages (w) is equal to the sum of the percentage changes in real output per worker (y; also called labor productivity), in the price level (p, or inflation) and in the labor share of output (s). [3] This is the essential context for any Phillips curve story. This should be, but isn’t, one of the basic identities in any intermediate macroeconomics textbook.

Now, let’s call the increase in “real” or inflation-adjusted wages r. [4] That gives us a second, more familiar, identity:

(2) r = w – p

The increase in real wages is equal to the increase in nominal wages less the inflation rate.

As always with these kinds of accounting identities, the question is “what adjusts”? What economic processes ensure that individual choices add up in a way consistent with the identity? [5]

Here we have five variables and two equations, so three more equations are needed for it to be determined. This means there are large number of possible closures. I can think of five that come up, explicitly or implicitly, in actual debates.

Closure 1:

First is the orthodox closure familiar from any undergraduate macroeconomics textbook.

(3a) w = pE + f(U); f’ < 0

(4a) y = y*

(5a) p = w – y

Equation 3a says that labor-market contracts between workers and employers result in nominal wage increases that reflect expected inflation (pE) plus an additional increase, or decrease, that reflects the relative bargaining power of the two sides. [6] The curve described by f is the Phillips curve, as originally formulated — a relationship between the unemployment rate and the rate of change of nominal wages. Equation 4a says that labor productivity growth is given exogenously, based on technological change. 5a says that since prices are set as a fixed markup over costs (and since there is only labor and capital in this framework) they increase at the same rate as unit labor costs — the difference between the growth of nominal wages and labor productivity.

It follows from the above that

(6a) w – p = y

and

(7a) s = 0

Equation 6a says that the growth rate of real wages is just equal to the growth of average labor productivity. This implies 7a — that the labor share remains constant. Again, these are not additional assumptions, they are logical implications from closing the model with 3a-5a.

This closure has a couple other implications. There is a unique level of unemployment U* such that w = y + p; only at this level of unemployment will actual inflation equal expected inflation. Assuming inflation expectations are based on inflation rates realized in the past, any departure from this level of unemployment will cause inflation to rise or fall without limit. This is the familiar non-accelerating inflation rate of unemployment, or NAIRU. [7] Also, an improvement in workers’ bargaining position, reflected in an upward shift of f(U), will do nothing to raise real wages, but will simply lead to higher inflation. Even more: If an inflation-targetting central bank is able to control the level of output, stronger bargaining power for workers will leave them worse off, since unemployment will simply rise enough to keep nominal wage growth in line with y*  and the central bank’s inflation target.

Finally, notice that while we have introduced three new equations, we have also introduced a new variable, pE, so the model is still underdetermined. This is intended. The orthodox view is that the same set of “real“ values is consistent with any constant rate of inflation, whatever that rate happens to be. It follows that a departure of the unemployment rate from U* will cause a permanent change in the inflation rate. It is sometimes suggested, not quite logically, that this is an argument in favor of making price stability the overriding goal of policy. [8]

If you pick up an undergraduate textbook by Carlin and Soskice, Krugman and Wells, or Blanchard, this is the basic structure you find. But there are other possibilities.

Closure 2: Bargaining over the wage share

A second possibility is what Anwar Shaikh calls the “classical” closure. Here we imagine the Phillips curve in terms of the change in the wage share, rather than the change in nominal wages.

(3b) s =  f(U); f’ < 0

(4b) y = y*

(5b) p = p*

Equation 3b says that the wage share rises when unemployment is low, and falls when unemployment is high. In this closure, inflation as well as labor productivity growth are fixed exogenously. So again, we imagine that low unemployment improves the bargaining position of workers relative to employers, and leads to more rapid wage growth. But now there is no assumption that prices will follow suit, so higher nominal wages instead translate into higher real wages and a higher wage share. It follows that:

(6b) w = f(U) + p + y

Or as Shaikh puts it, both productivity growth and inflation act as shift parameters for the nominal-wage Phillips curve. When we look at it this way, it’s no longer clear that there was any breakdown in the relationship during the 1970s.

If we like, we can add an additional equation making the change in unemployment a function of the wage share, writing the change in unemployment as u.

(7b) u = g(s); g’ > 0 or g’ < 0

If unemployment is a positive function of the wage share (because a lower profit share leads to lower investment and thus lower demand), then we have the classic Marxist account of the business cycle, formalized by Goodwin. But of course, we might imagine that demand is “wage-led” rather than “profit-led” and make U a negative function of the wage share — a higher wage share leads to higher consumption, higher demand, higher output and lower unemployment. Since lower unemployment will, according to 3b, lead to a still higher wage share, closing the model this way leads to explosive dynamics — or more reasonably, if we assume that g’ < 0 (or impose other constraints), to two equilibria, one with a high wage share and low unemployment, the other with high unemployment and a low wage share. This is what Marglin and Bhaduri call a “stagnationist” regime.

Let’s move on.

Closure 3: Real wage fixed.

I’ll call this the “Classical II” closure, since it seems to me that the assumption of a fixed “subsistence” wage is used by Ricardo and Malthus and, at times at least, by Marx.

(3c) w – p = 0

(4c) y = y*

(5c) p = p*

Equation 3c says that real wages are constant the change in nominal wages is just equal to the change in the price level. [9] Here again the change in prices and in labor productivity are given from outside. It follows that

(6c) s = -y

Since the real wage is fixed, increases in labor productivity reduce the wage share one for one. Similarly, falls in labor productivity will raise the wage share.

This latter, incidentally, is a feature of the simple Ricardian story about the declining rate of profit. As lower quality land if brought into use, the average productivity of labor falls, but the subsistence wage is unchanged. So the share of output going to labor, as well as to landlords’ rent, rises as the profit share goes to zero.

Closure 4:

(3d) w =  f(U); f’ < 0

(4d) y = y*

(5d) p = p*

This is the same as the second one except that now it is the nominal wage, rather than the wage share, that is set by the bargaining process. We could think of this as the naive model: nominal wages, inflation and productivity are all just whatever they are, without any regular relationships between them. (We could even go one step more naive and just set wages exogenously too.) Real wages then are determined as a residual by nominal wage growth and inflation, and the wage share is determined as a residual by real wage growth and productivity growth. Now, it’s clear that this can’t apply when we are talking about very large changes in prices — real wages can only be eroded by inflation so far.  But it’s equally clear that, for sufficiently small short-run changes, the naive closure may be the best we can do. The fact that real wages are not entirely a passive residual, does not mean they are entirely fixed; presumably there is some domain over which nominal wages are relatively fixed and their “real” purchasing power depends on what happens to the price level.

Closure 5:

One more.

(3e) w =  f(U) + a pE; f’ < 0; 0 < a < 1

(4e) y = b (w – p); 0 < b < 1

(5e) p =  c (w – y); 0 < c < 1

This is more generic. It allows for an increase in nominal wages to be distributed in some proportion between higher inflation, an increase in the wage share,  and faster productivity growth. The last possibility is some version of Verdoorn’s law. The idea that scarce labor, or equivalently rising wages, will lead to faster growth in labor productivity is perfectly admissible in an orthodox framework.  But somehow it doesn’t seem to make it into policy discussions.

In other word, lower unemployment (or a stronger bargaining position for workers more generally) will lead to an increase in the nominal wage. This will in turn increase the wage share, to the extent that it does not induce higher inflation and/or faster productivity growth:

(6e) s = (1  – b – c) w

This closure includes the first two as special cases: closure 1 if we set a = 0, b = 0, and c = 1, closure 2 if we set a = 1, b = 0, and c < 1. It’s worth framing the more general case to think clearly about the intermediate possibilities. In Shaikh’s version of the classical view, tighter labor markets are passed through entirely to a higher labor share. In the conventional view, they are passed through entirely to higher inflation. There is no reason in principle why it can’t be some to each, and some to higher productivity as well. But somehow this general case doesn’t seem to get discussed.

Here is a typical example  of the excluded middle in the conventional wisdom: “economic theory suggests that increases in labor costs in excess of productivity gains should put upward pressure on prices; hence, many models assume that prices are determined as a markup over unit labor costs.” Notice the leap from the claim that higher wages put some pressure on prices, to the claim that wage increases are fully passed through to higher prices. Or in terms of this last framework: theory suggests that b should be greater than zero, so let’s assume b is equal to one. One important consequence is to implicitly exclude the possibility of a change in the wage share.

*

So what do we get from this?

First, the identity itself. On one level it is obvious. But too many policy discussions — and even scholarship — talk about various forms of the Phillips curve without taking account of the logical relationship between wages, inflation, productivity and factor shares. This is not unique to this case, of course. It seems to me that scrupulous attention to accounting relationships, and to logical consistency in general, is one of the few unambiguous contributions economists make to the larger conversation with historians and other social scientists. [10]

For example: I had some back and forth with Phil Pilkington in comments and on twitter about the Jacobin piece. He made some valid points. But at one point he wrote: “Wages>inflation + productivity = trouble!” Now, wages > inflation + productivity growth just means, an increasing labor share. It’s two ways of saying the same thing. But I’m pretty sure that Phil did not intend to write that an increase in the labor share always means trouble. And if he did seriously mean that, I doubt one reader in a hundred would understand it from what he wrote.

More consequentially, austerity and liberalization are often justified by the need to prevent “real unit labor costs” from rising. What’s not obvious is that “real unit labor costs” is simply another word for the labor share. Since by definition the change real unit labor costs is just the change in nominal wages less sum of inflation and productivity growth. Felipe and Kumar make exactly this point in their critique of the use of unit labor costs as a measure of competitiveness in Europe: “unit labor costs calculated with aggregate data are no more than the economy’s labor share in total output multiplied by the price level.” As they note, one could just as well compute “unit capital costs,” whose movements would be just the opposite. But no one ever does, instead they pretend that a measure of distribution is a measure of technical efficiency.

Second, the various closures. To me the question of which behavioral relations we combine the identity with — that is, which closure we use — is not about which one is true, or best in any absolute sense. It’s about the various domains in which each applies. Probably there are periods, places, timeframes or policy contexts in which each of the five closures gives the best description of the relevant behavioral links. Economists, in my experience, spend more time working out the internal properties of formal systems than exploring rigorously where those systems apply. But a model is only useful insofar as you know where it applies, and where it doesn’t. Or as Keynes put it in a quote I’m fond of, the purpose of economics is “to provide ourselves with an organised and orderly method of thinking out particular problems” (my emphasis); it is “a way of thinking … in terms of models joined to the art of choosing models which are relevant to the contemporary world.” Or in the words of Trygve Haavelmo, as quoted by Leijonhufvud:

There is no reason why the form of a realistic model (the form of its equations) should be the same under all values of its variables. We must face the fact that the form of the model may have to be regarded as a function of the values of the variables involved. This will usually be the case if the values of some of the variables affect the basic conditions of choice under which the behavior equations in the model are derived.

I might even go a step further. It’s not just that to use a model we need to think carefully about the domain over which it applies. It may even be that the boundaries of its domain are the most interesting thing about it. As economists, we’re used to thinking of models “from the inside” — taking the formal relationships as given and then asking what the world looks like when those relationships hold. But we should also think about them “from the outside,” because the boundaries within which those relationships hold are also part of the reality we want to understand. [11] You might think about it like laying a flat map over some curved surface. Within a given region, the curvature won’t matter, the flat map will work fine. But at some point, the divergence between trajectories in our hypothetical plane and on the actual surface will get too large to ignore. So we will want to have a variety of maps available, each of which minimizes distortions in the particular area we are traveling through — that’s Keynes’ and Haavelmo’s point. But even more than that, the points at which the map becomes unusable, are precisely how we learn about the curvature of the underlying territory.

Some good examples of this way of thinking are found in the work of Lance Taylor, which often situates a variety of model closures in various particular historical contexts. I think this kind of thinking was also very common in an older generation of development economists. A central theme of Arthur Lewis’ work, for example, could be thought of in terms of poor-country labor markets that look  like what I’ve called Closure 3 and rich-country labor markets that look like Closure 5. And of course, what’s most interesting is not the behavior of these two systems in isolation, but the way the boundary between them gets established and maintained.

To put it another way: Dialectics, which is to say science, is a process of moving between the concrete and the abstract — from specific cases to general rules, and from general rules to specific cases. As economists, we are used to grounding concrete in the abstract — to treating things that happen at particular times and places as instances of a universal law. The statement of the law is the goal, the stopping point. But we can equally well ground the abstract in the concrete — treat a general rule as a phenomenon of a particular time and place.

 

 

 

[1] In graduate school you then learn to forget about the existence of businesses and investment, and instead explain the effect of interest rates on current spending by a change in the optimal intertemporal path of consumption by a representative household, as described by an Euler equation. This device keeps academic macroeconomics safely quarantined from contact with discussion of real economies.

[2] In the US, Okun’s law looks something like Delta-U = 0.5(2.5 – g), where Delta-U is the change in the unemployment rate and g is inflation-adjusted growth in GDP. These parameters vary across countries but seem to be quite stable over time. In my opinion this is one of the more interesting empirical regularities in macroeconomics. I’ve blogged about it a bit in the past  and perhaps will write more in the future.

[3] To see why this must be true, write L for total employment, Z for the level of nominal GDP, Y for per-capita GDP, W for the average wage, and P for the price level. The labor share S is by definition equal to total wages divided by GDP:

S = WL / Z

Real output per worker is given by

Y = (Z/P) / L

Now combine the equations and we get W = P Y S. This is in levels, not changes. But recall that small percentage changes can be approximated by log differences. And if we take the log of both sides, writing the log of each variable in lowercase, we get w = y + p + s. For the kinds of changes we observe in these variables, the approximation will be very close.

[4] I won’t keep putting “real” in quotes. But it’s important not to uncritically accept the dominant view that nominal quantities like wages are simply reflections of underlying non-monetary magnitudes. In fact the use of “real” in this way is deeply ideological.

[5] A discovery that seems to get made over and over again, is that since an identity is true by definition, nothing needs to adjust to maintain its equality. But it certainly does not follow, as people sometimes claim, that this means you cannot use accounting identities to reason about macroeconomic outcomes. The point is that we are always using the identities along with some other — implicit or explicit — claims about the choices made by economic units.

[6] Note that it’s not necessary to use a labor supply curve here, or to make any assumption about the relationship between wages and marginal product.

[7] Often confused with Milton Friedman’s natural rate of unemployment. But in fact the concepts are completely different. In Friedman’s version, causality runs the other way, from the inflation rate to the unemployment rate. When realized inflation is different from expected inflation, in Friedman’s story, workers are deceived about the real wage they are being offered and so supply the “wrong” amount of labor.

[8] Why a permanently rising price level is inconsequential but a permanently rising inflation rate is catastrophic, is never explained. Why are real outcomes invariant to the first derivative of the price level, but not to the second derivative? We’re never told — it’s an article of faith that money is neutral and super-neutral but not super-super-neutral. And even if one accepts this, it’s not clear why we should pick a target of 2%, or any specific number. It would seem more natural to think inflation should follow a random walk, with the central bank holding it at its current level, whatever that is.

[9] We could instead use w – p = r*, with an exogenously given rate of increase in real wages. The logic would be the same. But it seems simpler and more true to the classics to use the form in 3c. And there do seem to be domains over which constant real wages are a reasonable assumption.

[10] I was just starting grad school when I read Robert Brenner’s long article on the global economy, and one of the things that jumped out at me was that he discussed the markup and the wage share as if they were two independent variables, when of course they are just two ways of describing the same thing. Using s still as the wage share, and m as the average markup of prices over wages, s = 1 / (1 + m). This is true by definition (unless there are shares other than wages or profits, but none such figure in Brenner’s analysis). The markup may reflect the degree of monopoly power in product markets while the labor share may reflect bargaining power within the firm, but these are two different explanations of the same concrete phenomenon. I like to think that this is a mistake an economist wouldn’t make.

[11] The Shaikh piece mentioned above is very good. I should add, though, the last time I spoke to Anwar, he criticized me for “talking so much about the things that have changed, rather than the things that have not” — that is, for focusing so much on capitalism’s concrete history rather than its abstract logic. This is certainly a difference between Shaikh’s brand of Marxism and whatever it is I do. But I’d like to think that both approaches are called for.

 

EDIT: As several people pointed out, some of the equations were referred to by the wrong numbers. Also, Equation 5a and 5e had inflation-expectation terms in them that didn’t belong. Fixed.

EDIT 2: I referred to an older generation of development economics, but I think this awareness that the territory requires various different maps, is still more common in development than in most other fields. I haven’t read Dani Rodrik’s new book, but based on reviews it sounds like it puts forward a pretty similar view of economics methodology.

Causes and Effects of Wage Growth

Over here, a huge stack of exams, sitting ungraded since… no, I can’t say, it’s too embarrassing.  There, a grant proposal that extensive experimentation has shown will not, in fact, write itself. And I still owe a response to all the responses and criticism to my Disgorge the Cash paper for Roosevelt. So naturally, I thought this morning would be a good time to sit down and ask what we can learn from comparing the path of labor costs in the Employment Cost Index compared with the ECEC.

The BLS explains the difference between the two measures:

The Employment Cost Index, or ECI, measures changes in employers’ cost of compensating workers, controlling for changes in the industrial-occupational composition of jobs. … The ECI is intended to indicate how the average compensation paid by employers would have changed over time if the industrial-occupational composition of employment had not changed… [It] controls for employment shifts across 2-digit industries and major occupations. The Employer Costs for Employee Compensation, or ECEC… is designed to measure the average cost of employee compensation. Accordingly, the ECEC is calculated by multiplying each job quote by its sample weight.

In other words, the ECI measures the change in average hourly compensation, controlling for shifts in the mix of industries and occupations. The ECEC simply measures the overall change in hourly compensation, including the effects of both changes in compensation for particular jobs, and changes in the mix of jobs.

Here are the two series for the full period both are available (1987-2014), both raw and adjusted for inflation (“real”).

What do we learn from this?

First, the two series are closely correlated. This tells us that most of the variation in compensation is driven by changes within occupations and sectors, not by shifts in employment between occupations and sectors. This is clearly true at annual frequencies but it seems to be true over longer periods as well. For instance, let’s compare the behavior of compensation in the five years since the end of the recession to the last period of strong wage growth, 1997-2004. The difference between the two periods in the average annual increase in nominal wages is almost exactly the same according to the two indexes — 2.7 points by the ECI, 2.6 points by the ECEC. In other words, slower wage growth in the recent period is entirely due to slower wages growth within particular kinds of jobs. Shifts in the composition of jobs have played no role at all.

On the face of it, the fact that almost all variation in aggregate compensation is driven by changes within employment categories, seems to favor a labor/political story of slower wage growth as opposed to a China or robots story. The most obvious versions of the latter two stories involve a disproportionate loss of high-wage jobs, whereas stories about weaker bargaining position of labor predict slower compensation growth within job categories. I wouldn’t ask this one piece of evidence to carry a lot of weight in that debate. (I think it’s stronger evidence against a skills-based explanation of slower wage growth.)

While the two series in general move together, the ECEC is more strongly cyclical. In other words, during periods of high unemployment and falling wages in general, there is also a shift in the composition of employment towards lower-paid occupations. And during booms, when unemployment is low and wages are rising in general, there is a shift in the direction of higher-paid job categories. [1] Insofar as wages and labor productivity are correlated, this cyclical shift between higher-wage and lower-wage sectors could help explain why employment is more stable than output. I’ve had the idea for a while that the Okun’s law relationship — the less than one-for-one correlation between employment and output growth — reflects not only hiring/firing costs and overhead labor, but also shifts in the composition of employment in response to demand. In other words, in addition to employment adjustment costs at the level of individual enterprises, the Okun coefficient reflects cyclically varying degrees of “disguised unemployment” in Joan Robinson’s sense. [2] This is an argument I’d like to develop properly someday, since it seems fairly obvious, potentially important and empirically tractable, and I haven’t seen anyone else make it. [3] (I’m sure someone has.)

What’s going on in the most recent year? Evidently, there has been no acceleration of wage growth for a given job, but the mix of jobs created has shifted toward higher-wage categories. This suggests that to the extent wages are rising faster, it’s not a sign of labor-market pressures. (Some guy from Deutsche Bank interprets the same divergence as support for raising rates, which it’s hard not to feel is deliberately dishonest.) As for which particular higher-wage job categories are growing more rapidly — I don’t know. And, what’s going on in 1995? That year has by far the biggest divergence between the two series. It could well be an artifact of some kind, but if not, seems important. A large fall in the ECEC relative to the ECI could be a signature of deindustrialization. I’m not exploring the question further now (those exams…) but it would be interesting to ask analogous question with some series that extends earlier. It’s likely that if we were looking at the 1970s-1980s, we would find a much larger share of variation in wage growth explained by compositional shifts.

Should we adjust for inflation? I give the “real” series here, but I am in general skeptical that there is any sense in which an ex post adjustment of money flows for inflation is more real than, say, The Real World on MTV. I am even more doubtful than usual in this case, because we are normally told to think that changes in nominal wages are the main determinant of inflation. Obviously in that case we have to think of the underlying labor-market process as determining a change in nominal wage. Still, if we do compute a “real” index, things look a little different. Real ECI rises 14 percent over the full 1987-2014 period, while real ECEC rises only 5 percent. So now we can say that about two-thirds of the increase in real wages within particular job categories over the past three decades, was offset by a shift in the composition of employment toward lower-paid job categories. (This is all in the first decade, 1987-1996, however.) This way of looking at things makes sense if we think the underlying wage-setting process, whatever it is, operates in terms of a basket of consumption goods.

This invites another question: How true is it that nominal wages move with inflation?

Conventional economics wisdom suggests we can separate wages into nominal and “real” components. This is on two not quite consistent grounds. First, we might suppose that workers and employers are implicitly negotiating contracts in terms of a fixe quantity of labor time for, on the one hand, a basket of wage goods, and on the other, a basket of produced goods (which will be traded for consumption good for the employer). This contract only incidentally happens to be stated in terms of money. The ultimate terms on which consumption goods for the workers exchange with consumption goods for the employer should not be affected by the units the trade happens to be denominated in. (In this respect the labor contract is just like any other contract.) This is the idea behind Milton Friedman’s “natural rate of unemployment” hypothesis. In Friedman’s story, causality runs strictly from inflation to unemployment. High inflation is not immediately recognized by workers, leading them to overestimate the basket of goods their wages will buy. So they work more hours than they would have chosen if they had correctly understood the situation. From this point of view, there’s no cost to low unemployment in itself; the problem is just that unemployment will only be low if high inflation has tricked workers into supply too much labor. Needless to say, this is not the way anyone in the policy world thinks about the inflation-unemployment nexus today, even if they continue to use Friedman’s natural rate language.

The alternative view is that workers and employers negotiate a money-wage, and then output prices are set as a markup over that wage. In this story, causality runs from unemployment to inflation. While Friedman thought an appropriate money-supply growth rate was the necessary and sufficient condition for stable prices, with any affect on unemployment just  collateral damage from changes in inflation, in this story keeping unemployment at an appropriate level is a requirement for stabilizing prices. This is the policy orthodoxy today.  (So while people often say that NAIRU is just another name for the natural rate of unemployment, in fact they are different concepts.) I think there are serious conceptual difficulties with the orthodox view, but we’ll save those for another time. Suffice it to say that causality is supposed to run from low unemployment, to faster nominal wage growth, to higher inflation. So the question is: Is it really the case that faster nominal wage growth is associated with higher inflation?

Wage Growth and Inflation, 1947-2014

A simple scatterplot suggests a fairly tight relationship, especially at higher levels of wage growth and inflation. But if we split the postwar period at 1985, things look very different. In the first period, there’s a close relationship — regressing inflation on nominal wage growth gives an R-squared of 0.81. (Although even then the coefficient is significantly less than 1.)

Wage Growth and Inflation, 1947-1985

Since 1985, though, the relationship is much looser, with an R-squared of 0.12. And even is that driven almost entirely by period of falling wages and prices in 2009; remove that and the correlation is essentially zero.

Wage Growth and Inflation, 1986-2014

So while it was formerly true that changes in inflation were passed one for one into changes in nominal wages, and/or changes in nominal wage growth led to similar changes in inflation, neither of those things has been true for quite a while now. In recent decades, faster nominal wage growth does not translate into higher inflation.

Obviously, a few scatterplots aren’t dispositive, but they are suggestive. So supposing that there has been a  delinking of wage growth and inflation, what conclusions might we draw? I can think of a couple.

On the one hand, maybe we shouldn’t be so dismissive of  the naive view that inflation reduces the standard of living directly, by raising the costs of consumption goods while incomes are unchanged. There seems to be an emerging conventional wisdom in this vicinity. Here for instance is Gillian Tett in the FT, endorsing the BIS view that there’s nothing wrong with falling prices as long as asset prices stay high. (Priorities.) In the view of both Keynes (in the GT; he modified it later) and Schumpeter, inflation was associated with higher nominal but lower real wages, deflation with lower nominal but higher real wages. I think this may have been true in the 19th century. It’s not impossible it could be true in the future.

On the other hand. If the mission of central banks is price stability, and if there is no reliable association between changes in wage growth and changes in inflation, then it is hard to see the argument for tightening in response to falling unemployment. You really should wait for direct evidence of rising inflation. Yet central banks are as focused on unemployment as ever.

It’s perhaps significant in this regard that the authorities in Europe are shifting away from the NAIRU (Non-Accelerating Inflation Rate of Unemployment) and increasingly talking about the NAWRU (Non-Accelerating Wage Rate of Unemployment). If the goal all along has been lower wage growth, then this is what you should expect: When the link between wages and inflation weakens, the response is not to find other tools for controlling inflation, but other arguments for controlling wages. This may be the real content of the “competitiveness” discourse. Elevating competitiveness over price stability as overarching goal of policy lets you keep pushing down wages even when inflation is already low.

Worth noting here: While the ECB’s “surrender Dorothy” letter to the Spanish government ordered them to get rid of price indexing, their justification was not, as you might expect, that indexation contributes to inflationary spirals. Rather it was that it is “a structural obstacle to the adjustment of labour costs” and “contribute to hampering competitiveness.” [4]  This is interesting. In the old days we would have said, wage indexing is bad because it won’t affect real wages, it just leads to higher inflation. But apparently in the new dispensation, we say that wage indexing is bad precisely because it does affect real wages.

[1]  This might seem to contradict the previous point but it doesn’t, it’s just that the post-2009 recovery period includes both a negative composition shift in 2008-2009, when unemployment was high, and a positive compositional shift in 2014, which cancel each other out.

[2] From A Theory of Employment: “Except under peculiar conditions, a decline in effective demand which reduces the amount of employment offered in the general run of industries will not lead to ‘unemployment’ in the sense of complete idleness, but will rather drive workers into a number of occupations [such as] selling match-boxes in the Strand, cutting brushwood in the jungles, digging potatoes on allotments which are still open to them. A decline in one sort of employment leads to an increase in another sort, and at first sight it may appear that, in such a case, a decline in effective demand does not cause unemployment at all. But the matter must be more closely examined. In all those occupations which the dismissed workers take up, their productivity is less than in the occupations that they have left.”

[3] The only piece I know of that makes the connection between demand and productivity variation across sectors is this excellent article by John Eatwell (which unfortunately doesn’t seem to be available online), but it is focused on long run variation, not cyclical.

[4] The ECB’s English is not the most felicitous, is it? The Spanish version is “contribuyen a dificultar la competitividad y el crecimiento,” which also doesn’t strike me as a phrase that a native speaker would write. Maybe it sounds better in the original German.

The Call Is Coming from Inside the House

Paul Krugman wonders why no one listens to academic economists. Almost all the economists in the IGM Survey agree that the 2009 stimulus bill successfully reduced unemployment and that its benefits outweighed its costs. So why are these questions still controversial?

One answer is that economists don’t listen to themselves. More precisely, liberal economists like Krugman who want the state to take a more active role in managing the economy, continue to teach  an economic theory that has no place for activist policy.

Let me give a concrete example.

One of Krugman’s bugaboos is the persistence of claims that expansionary monetary policy must lead to higher inflation. Even after 5-plus years of ultra-loose policy with no rising inflation in sight, we keep hearing that since so “much money has been created…, there should already be considerable inflation.” (That’s from exhibit A in DeLong’s roundup of inflationphobia.) As an empirical matter, of course, Krugman is right. But where could someone have gotten this idea that an increase in the money supply must always lead to higher inflation? Perhaps from an undergraduate economics class? Very possibly — if that class used Krugman’s textbook.

Here’s what Krugman’s International Economics says about money and inflation:

A permanent increase in the money supply causes a proportional increase in the price level’s long-run value. … we should expect the data to show a clear-cut positive association between money supplies and price levels. If real-world data did not provide strong evidence that money supplies and price levels move together in the long run, the usefulness of the theory of money demand we have developed would be in severe doubt. 

… 

Sharp swings in inflation rates [are] accompanied by swings in growth rates of money supplies… On average, years with higher money growth also tend to be years with higher inflation. In addition, the data points cluster around the 45-degree line, along which money supplies and price levels increase in proportion. … the data confirm the strong long-run link between national money supplies and national price levels predicted by economic theory. 

… 

Although the price levels appear to display short-run stickiness in many countries, a change in the money supply creates immediate demand and cost pressures that eventually lead to future increases in the price level. 

… 

A permanent increase in the level of a country’s money supply ultimately results in a proportional rise in its price level but has no effect on the long-run values of the interest rate or real output. 

This last sentence is simply the claim that money is neutral in the long run, which Krugman continues to affirm on his blog. [1] The “long run” is not precisely defined here, but it is clearly not very long, since we are told that “Even year by year, there is a strong positive relation between average Latin American money supply growth and inflation.”

From the neutrality of money, a natural inference about policy is drawn:

Suppose the Fed wishes to stimulate the economy and therefore carries out an increase in the level of the U.S. money supply. … the U.S. price level is the sole variable changing in the long run along with the nominal exchange rate E$/€. … The only long-run effect of the U.S. money supply increase is to raise all dollar prices.

What is “the money supply”? In the US context, Krugman explicitly identifies it as M1, currency and checkable deposits, which (he says) is determined by the central bank. Since 2008, M1 has more than doubled in the US — an annual rate of increase of 11 percent, compared with an average of 2.5 percent over the preceding decade. Krugman’s textbook states, in  unambiguous terms, that such an acceleration of money growth will lead to a proportionate acceleration of inflation. He can hardly blame the inflation hawks for believing what he himself has taught a generation of economics students.

You might think these claims about money and inflation are unfortunate oversights, or asides from the main argument. They are not. The assumption that prices must eventually change in proportion to the central bank-determined money supply is central to the book’s four chapters on macroeconomic policy in an open economy. The entire discussion in these chapters is in terms of a version of the Dornbusch “overshooting” model. In this model, we assume that

1. Real exchange rates are fixed in the long run by purchasing power parity (PPP).
2. Interest rate differentials between countries are possible only if they are offset by expected changes in the nominal exchange rate.

Expansionary monetary policy means reducing interest rates here relative to the rest of the world. In a world of freely mobile capital, investors will hold our lower-return bonds only if they expect our nominal exchange rate to appreciate in the future. With the long-run real exchange rate pinned down by PPP, the expected future nominal exchange rate depends on expected inflation. So to determine what exchange rate today will make investors willing to holder our lower-interest bonds, we have to know how policy has changed their expectations of the future price level. Unless investors believe that changes in the money supply will translate reliably into changes in the price level, there is no way for monetary policy to operate in this model.

So  these are not throwaway lines. The more thoroughly a student understands the discussion in Krugman’s textbook, the stronger should be their belief that sustained expansionary monetary policy must be inflationary. Because if it is not, Krugman gives you no tools whatsoever to think about policy.

Let me anticipate a couple of objections:

Undergraduate textbooks don’t reflect the current state of economic theory. Sure, this is often true, for better or worse. (IS-LM has existed for decades only in the Hades of undergraduate instruction.) But it’s not much of a defense, is it? If Paul Krugman has been teaching his undergraduates economic theory that produces disastrous results when used as a guide for policy, you would think that would provoke some soul-searching on his part. But as far as I can tell, it hasn’t. But in this case I think the textbook does a good job summarizing the relevant scholarship. The textbook closely follows the model in Dornbusch’s Expectations and Exchange Rate Dynamics, which similarly depends on the assumption that the price level changes proportionately with the money supply. The Dornbusch article is among the most cited in open-economy macroeconomics and international finance, and continues to appear on international finance syllabuses in most top PhD programs.

Everything changes at the zero lower bound. Defending the textbook on the ground that it’s pre-ZLB effectively concedes that what economists were teaching before 2008 has become useless since then. (No wonder people don’t listen.) If orthodox theory as of 2007 has proved to be all wrong in the post-Lehmann world, shouldn’t that at least raise some doubts about whether it was all right pre-Lehmann? But again, that’s irrelevant here, since I am looking at the 9th Edition, published in 2011. And it does talk about the liquidity trap — not, to be sure, in the main chapters on macroeconomic policy, but in a two-page section at the end. The conclusion of that section is that while temporary increases in the money supply will be ineffective at the zero lower bond, a permanent increase will have the same effects as always: “Suppose the central bank can credibly promise to raise the money supply permanently … output will therefore expand, and the currency will depreciate.” (The accompanying diagram shows how the economy returns to full employment.) The only way such a policy might fail is if there is reason to believe that the increase in the money supply will subsequently be reversed. Just to underline the point, the further reading suggested on policy at the zero lower bound is an article by Lars Svennson that calls a permanent expansion in the money supply “the foolproof way” to escape a liquidity trap. There’s no suggestion here that the relationship between monetary policy and inflation is any less reliable at the ZLB; the only difference is that the higher inflation that must inevitably result from monetary expansion is now desirable rather than costly. This might help if Krugman were a market monetarist, and wanted to blame the whole Great Recession and slow recovery on bad policy by the Fed; but (to his credit) he isn’t and doesn’t.

Liberal Keynesian economists made a deal with the devil decades ago, when they conceded the theoretical high ground. Paul Krugman the textbook author says authoritatively that money is neutral in the long run and that a permanent increase in the money supply can only lead to inflation. Why shouldn’t people listen to him, and ignore Paul Krugman the blogger?

[1] That Krugman post also contains the following rather revealing explanation of his approach to textbook writing:

Why do AS-AD? First, you do want a quick introduction to the notion that supply shocks and demand shocks are different … and AS-AD gets you to that notion in a quick and dirty, back of the envelope way. 

Second — and this plays a surprisingly big role in my own pedagogical thinking — we do want, somewhere along the way, to get across the notion of the self-correcting economy, the notion that in the long run, we may all be dead, but that we also have a tendency to return to full employment via price flexibility. Or to put it differently, you do want somehow to make clear the notion (which even fairly Keynesian guys like me share) that money is neutral in the long run. That’s a relatively easy case to make in AS-AD; it raises all kinds of expositional problems if you replace the AD curve with a Taylor rule, which is, as I said, essentially a model of Bernanke’s mind.

This is striking for several reasons. First, Krugman wants students to believe in the “self-correcting economy,” even if this requires teaching them models that do not reflect the way professional economists think. Second, they should think that this self-correction happens through “price flexibility.” In other words, what he wants his students to look at, say, falling wages in Greece, and think that the problem must be that they have not fallen enough. That’s what “a return to full employment via price flexibility” means. Third, and most relevant for this post, this vision of self-correction-by-prices is directly linked to the idea that money is neutral in the long run — in other words, that a sustained increase in the money supply must eventually result in a proportionate increase in prices. What Krugman is saying here, in other words, is that a “surprising big” part of his thinking on pedagogy is how to inculcate the exact errors that drive him crazy in policy settings. But that’s what happens once you accept that your job as an educator is to produce ideological fables.