The Depression didn’t just see a fall in employment, it saw a fall in the output of those still employed, reversing much of the productivity gains of the 1920s. (This surprised Keynes, among others, who still believed in the declining marginal product of labor, which predicted the opposite.) Recovery in the late 1930s, conversely, didn’t just mean higher employment, it involved a sharp acceleration in labor productivity. There’s a widespread idea that output per worker necessarily reflects supply-side factors — technology, skills, etc. But if demand had such direct effects on labor productivity in the Great Depression, why not in the Lesser Depression too? But for some reason, people who scoff at the idea of the “Great Forgetting” of the 1930s have no trouble believing that the drastic slowdown in productivity growth of recent years has nothing to do with the economic crisis it immediately followed.
EDIT: I should add: While the decline in production during the Depression was, of course, primarily a matter of reduced employment, the decline in productivity was not trivial. If output per employee had continued to rise in the first half of the 1930s at the same rate as in 1920s, the total fall in output would have been on the order of 25 percent rather than 33 percent.
Note also that the only other comparable (in fact larger) fall in GDP per worker came in the immediate postwar demobilization period 1945-1947. I’ve never understood the current convention that says we should ignore the depression and wartime experience when thinking about macroeconomic relationships. Previous generations thought just the opposite — that we can learn the most about how the system operates from these kinds of extreme events, that “the prime test of Keynesian theory must be the Great Depression.” Isn’t it logical, if you want to understand how shifts in aggregate demand affect economic outcomes, that you would look first at the biggest such shifts, where the effects should be clearest? The impact of these two big demand shifts on output per worker, seem like good reason to expect such effects in general.
And it’s not hard to explain why. In real economies, there are great disparities in the value of the labor performed by similar people, and immense excess capacity in the form of low-productivity jobs accepted for lack of anything better. Increased demand mobilizes that capacity. When the munitions factories are running full tilt, no one works shining shoes.
This shows the initial deviation of real per-capita GDP from its long run trend, and the average growth rate over the following ten years, for 1925 through 2005. The long run trend is based on the 1925-2005 average growth rate of real per-capita GDP of 2.3%. The points in the upper left are the ten-year periods beginning in 1931 through 1941.
UPDATE: A number of people have objected to this exercise on the grounds that the Depression and World War II period is not relevant for our current situation. I don’t agree with this. But even without them, the picture is not so different. While the postwar period up til now has never seen a persistent deviation from trend as we are experiencing now, or as rapid growth as the Friedman paper projects, the relationship between the two is clearly present. And a decade of growth far above the postwar norm turns out to be just what you would predict on the basis of that relationship. Here’s the same graph as above, but this time using only 1947-2005.
As you can see, the relationship is a fairly strong one. The Friedman growth number does lie a bit above the regression line. But it’s still true that the current exceptionally low level of GDP relative to trend would, on historical evidence, lead us to expect that growth over the next ten years will be around 3.8 percent — well above anything previously seen in the postwar period and close to double the long-term average.
Note that the seven points well below the line in the middle are 1999-2005, whose 10-year growth windows include the Great Recession. Without them, Friedman’s number would be much closer to the line. What do we make of that? Should the exceptionally poor performance of this period make us more pessimistic about medium-term growth prospects (it’s sign of supply-side exhaustion) or more optimistic (it’s a sign of a demand gap that can be filled)? This is not an easy question to answer. But just counting up previous growth rates won’t help answer it.
My old professor Jerry Friedman wrote a piece several weeks ago, arguing that a combination of increased public spending and income redistribution (higher minimum wages and other employment regulation favorable to labor) proposed by the Sanders campaign could substantially boost growth and employment during his presidency. As readers of this blog know, this piece has gotten a lot of attention in the past couple of days. Most notably, it inspired a letter from four former CEA chairs strongly rejecting the claim that Sanders proposals could “have huge beneficial impacts on growth rates, income and employment that exceed even the most grandiose predictions by Republicans about the impact of their tax cut proposals.” A number of prominentliberaleconomists have endorsed the CEA letter or expressed similar doubts.
I want to try to clarify the stakes in this debate. There are three questions, each logically prior to the other.
1. Is it reasonable to think that better macroeconomic policy could deliver substantially higher output and employment?
2. Are the kinds of things proposed by Sanders capable in principle of getting us there?
3. Are the specific numbers in Sanders’ proposals the right ones for such a really-full employment plan?
The second question doesn’t matter until we’ve answered yes to the first one. And the third doesn’t matter until we’ve answered yes to the first two.
The first question is not only logically prior, it also seems to be what the public debate is actually about . The CEA letter, and almost all the other criticism of the Friedman paper I have seen, focuses on whether the outcomes described are plausible at all, not the specific ways they are derived from the Sanders proposals. Almost all the pushback I have seen has been to the effect that 5 percent real GDP growth and 275,000 new jobs per month are not possible results of any conceivable macro policies.
As I’m sure Jerry Friedman would agree, there are plenty of ways his estimates could be improved. But it’s pointless, even disingenuous, to debate the specific numbers before agreeing on the larger questions. I want to focus on the first question here, both because it is the premise of the others and because it is where the debate is currently located.
So: Is it plausible that there could be 5 percent-plus real GDP growth and 300,000 new jobs per month over the eight years of a Sanders presidency? I think it is — or at least, I don’t think there is a good economic argument that it’s not.
I want to make five related points here. First, conventional wisdom in economics is that an exceptionally deep recession should be followed by a period of exceptionally strong growth. Second, the growth in output and employment implied by the paper are more or less what is required to return to the pre-recession trend. Third, discussions of macroeconomic policy in other contexts imply the possibility of growth qualitatively similar to what Jerry describes. Fourth, it is not necessarily the case that the employment Jerry projects would exceed full employment in any meaningful sense. Fifth, if you don’t believe a growth performance at this level is possible, that implies a sharp slowdown in potential output, for which you need a credible story. The last point is probably the most important.
1. It’s not controversial to say that a historically deep recession ought to be followed by a period of historically strong growth. Every macroeconomics textbook teaches that changes in GDP can be split into two components: short-run variation driven by aggregate demand and by monetary and financial factors, and a long-run trend driven by population growth and technological change. While all sorts of things that constrain or inhibit spending can cause temporary dips in production, over time it should converge back to the fundamentals-determined trend. Unless they involve the destruction of real resources — and they don’t — recessions should not have lasting effects. A direct corollary of this textbook view is that the deeper the recession, the stronger should be growth in the following period — otherwise, there’s no way to get back to trend. The people who are saying that Jerry’s growth numbers are impossible on their face are implicitly saying that that we should expect all output losses in recessions to be permanent. This is not orthodox economic theory, at all. Orthodoxy says that the exceptionally deep recession should be followed by a period of exceptionally strong growth — and if it hasn’t been, that suggests some ongoing demand problem which policy can reasonably be expected to solve.
2. Friedman’s growth estimates are just what you need to get output and employment back to trend. This point is well made by Matthew Klein. As Klein puts it, this “supposedly ‘extreme’ and ‘unsupportable’ forecast implies American output will return to its previous trend just as Sanders would be finishing up his second term, in the third quarter of 2024.”
from Matthew Klein, FT Alphaville
As Klein and others point out, the level of GDP projected by Jerry for the end of Sanders’ second term is right in line with what the CBO and other establishment forecasters were saying just a few years ago. I just now was looking at the CBO’s forecasts as of January 2013; they were projecting 4-4.5 percent real GDP growth over 2016-2017. This is, of course, exceptionally high by historical standards — Paul Krugman says that Jeb Bush was “rightly mocked” by progressives for suggesting he could deliver growth at that level. But the CBO was making the same prediction and it’s no mystery why — a period of growth well above historical levels is the logical condition of a return of output to trend. By the way, I should emphasize that Friedman’s growth estimates were not derived this way. It’s just a lucky coincidence — if it holds up — that the measures proposed by the Sanders campaign happen to be the right magnitude to close the output gap over eight years.
Similarly, Friedman’s employment numbers (around 277,000 new jobs per month) are indeed way above what we have seen recently. But if you want to get the employment-population ratio back to its 2006 levels by 2024, you need even more than that — about 300,000 new jobs per month, by my calculations. Many respectable economists — including at least one of the CEA signers — have written that the employment ratio is a better indicator of labor-market conditions than the unemployment rate, and expressed concern about its decline. A few years ago, Brad DeLong had no doubt that more expansionary policy could raise the employment population ratio back to 60.8 percent, if not to the pre-recession level of 63 percent: “we could still put 5.5 million more people to work with appropriate demand-management policies.” To do that by 2024 would imply monthly job growth around 220,000 — less than what Friedman claims for the Sanders proposals, but about double whatwe are seeing now more than double what the CBO is currently projecting for 2017-2024. It’s just arithmetic: you can’t raise the employment-population ratio without a sustained period of job growth substantially higher than what we are seeing now. So it makes no sense to talk about that as a goal if you think that faster job growth is not a feasible outcome for policy.
It is true, of course, that the aging of the population implies a long-term fall in the employment ratio, all else equal. But let’s put this in perspective. DeLong, for example, suggests that 0.13 points per year is probably an overestimate of the decline due to demographics. David Rosnick, applying the 2006 employment ratios of various age groups to the population projected for 2026, finds a larger decline due to demographics, on the order of 0.25 points per year. But even that leaves most of the fall in employment unexplained by demographics. By any standard, there is a lot of room to do better. But we have to agree that this is something that, in principle, demand side policy can do.
from David Rosnick
3. In other contexts, it’s taken for granted that more expansionary policy could deliver substantially higher growth. Anyone who says that the zero lower bound is a constraint on monetary policy, or who suggests that the “natural rate of interest” is negative, is saying that output could be substantially higher given more expansionary monetary policy. Presumably, this is true for other forms of expansionary policy as well. (In terms of the model beloved by undergraduate textbooks and New York Times columnists: If the preferred point in ISLM space is to the right of the current one, we should be able to get there by shifting the IS curve just as well as by shifting the LM curve.) Obviously, the transition to that higher level of GDP would involve a period of much higher growth. It would be interesting to ask how fast output would have grown if we’d been able to remove the ZLB constraint in, say, 2010; I suspect the numbers might not look that different from Friedman’s.
Similarly, most participants in this debate agree that the ARRA stimulus of 2009 was effective, with multipliers above 2.0 for at least some categories of spending. Many also think that it should have been bigger. If increased government spending could boost output in 2008, then why couldn’t it today? And if the right answer to “how big?” then was “enough to close the output gap,” why isn’t that the right answer today? Yes, it would be a big number. (Again, it’s a lucky coincidence — if correct — that it happens to be close to what Sanders is proposing.) But so what? If “a trillion has a lot of zeroes” wasn’t a good argument against an adequate stimulus in 2009, then it isn’t one today.
Or again: If we think that austerity explains a big part of poor growth in European countries, we have to at least consider the the same might be true here. It would be very good luck, to say the least, if years of feuding between the administration and Republican congresses had somehow delivered exactly the right fiscal balance. In general, this discussion has been muddied by the fact that the pragmatic choice to delegate demand management to central banks, has been turned into an axiom in economic theory. From where I’m sitting, the statement “it would be helpful if the central bank set a lower interest rate” is equivalent, for most macroeconomic purposes, with the statement “it would be helpful if the level of public spending were higher.”
4. Friedman’s projections are unreasonable only if you think the US is already at full employment. The unstated but central premise of the critics is that we are at or near full employment, so there is no space for further demand policy. Friedman’s paper says that by the end of a second Sanders term, unemployment would be at 3.8%. Krugman replies: “It’s possible that we can get unemployment down under 4 percent, but that’s way below any estimates I’ve seen of the level of unemployment consistent with moderate inflation.” Now here we have an interesting question. Whether we are at full employment today depends, first, on how much you think the fall in the employment-population ratio reflects weak demand as opposed to structural or demographic factors — or in other words, to what extent faster job growth would draw nonworkers into the labor market, as opposed to pushing down the unemployment rate. But it also depends on what you think full employment means.
If you believe that any demand-induced acceleration of nominal wage growth will be passed to higher prices, or if you think that price stability should be the sole concern of macro policy, then there will be a hard floor on unemployment, which may not be much lower than where we are today. But if you think some appreciable fraction of faster nominal wage growth would go to an increase in the wage share (or faster productivity growth) rather than to inflation, and if you think some acceleration in inflation is acceptable (or even desirable), then “full employment” becomes a broad region rather than a sharp line. (I wrote a bit about these issues here.) In this case there will even be an argument — made by plenty of mainstream people, including some of the ones criticizing Friedman now — that a period of “overfull” employment would be desirable to bring the wage share back up from its current historically low levels. To believe that a 3.8% unemployment rate is ruled out by price stability considerations is to claim that faster wage growth cannot raise the wage share, which I don’t think is well supported either theoretically or empirically. (Or that raising the wage share is not desirable.) Also worth recalling: In the debates around the NAIRU in the 1990s, the general conclusion was that the idea of a hard floor to unemployment below which inflation will rise uncontrollably, is not in fact a useful guide for policy.
5. The argument against Friedman’s piece comes down to the claim that the economy is already close to potential. If this is the case then, yes, claims that increased public spending can achieve large gains in output are delusional. I think this is a useful debate to have, but I’m not sure how the CEA chairs would make the case. First, again, many of those criticizing Friedman’s numbers have supported the idea of more expansionary policy in other contexts. Second and more fundamentally, the persistent fall in the employment population ratio and the deviation of output from pre-recession trend seem very hard to explain in “supply” terms. Yes, there are demographic changes, but again, even if you hold the age distribution of the population constant, the employment ratio is still 3 points lower than at the start of the recession. That’s a deficit of 10 million jobs. Closing that gap requires an extended period of above average growth, qualitatively similar to what Friedman describes. If you believe that’s impossible, you have to explain why.
Logically, there are a couple possible answers. Either you argue that the earlier estimates of potential GDP were exaggerated, and we were at overfull employment prior to the recession. If you take this route, you have to be ready to make the case that the country needed substantially slower growth and higher unemployment in the 2000s, despite the noticeable lack of wage growth or rising inflation. Or, you can claim that something happened in 2008-2009 that permanently reduced potential output. So then, what is the negative technological shock that hit the economy in 2008-2009? Is Casey Mulligan right that American businesses have been crippled by the red tape of Obamacare? I don’t think either of those are good options for liberals. Another possibility is to talk about hysteresis and so on — the persistent effects on the laborforce and productivity growth from periods of weak demand. Here you will be on firmer ground — there is plenty of evidence that deep recession inflict lasting harm on workers and businesses. But this kind of reasoning makes Friedman’s numbers more plausible, not less. Because if weak demand can drag potential output down, strong demand can presumably pull it up.
The bottom line is this. Ten years ago, the CBO expected GDP to be $20.5 trillion (correcting for inflation) as of the end of 2015. Today, it is $18.1, trillion, or about 12 percent lower. Similarly, the employment-population ratio fell by 5 points during the recession (from 63.4 to 58.4 percent) and has risen by only one point during the past six years of recovery. Either these facts — unprecedented in the postwar period — reflect a shortfall of effective demand, or they don’t. If they do reflect a lack of demand, then there is no reason the expanded pubic spending and downward redistribution that Sanders proposes cannot close the gap, with a period of high growth while output and employment return to trend. (The fact that such high growth hasn’t been seen in the postwar period is neither here nor there, since there also has been no comparable deviation from trend.) Alternatively, you may think that the shortfall relative to previous growth rates reflects a decline in potential output. But then you need to offer some explanation of why the growth of the economy’s productive capacity slowed so abruptly, and you need to apply this belief consistently. I think it’s more reasonable to believe that the gaps in output and employment reflect a demand shortfall. In which case, the Sanders plan could in principle have the kind of results Friedman describes.
UPDATE: There was a significant error in section 2, which I’ve corrected.
Supporters of a higher minimum wage invoke efficiency wage arguments without explaining why that should be expected to dampen disemployment effects rather than amplify them. While opponents of higher minimum wages describe faster productivity growth as a cost, without, as far as I can tell, being against it in any other context. This is a case where abstraction — some equations, even one of those awful supply and demand graphs — might actually be helpful.
Well, for some reason, I sat down and did the math. And the results are interesting.
I need to stress at the outset: This is a “model,” in the sense that it is a set of mathematical equations that are intended to give a simplified description of a phenomenon in the real world. But it is not a model in the sense that you may be used to in economics. I am not making any behavioral assumptions here of any kind. I am simply trying to formalize the logical relationships that everyone in this conversation is discussing. For example, someone says “higher wages will increase labor productivity,” and someone else says, “no they won’t.” Then we can write
y = a w,
where y is the change in percentage output per worker, w is the percentage change in the wage, and a is a parameter. Writing it this way, and reframing the questions themes likely value of a, is not taking a position in the argument or adding anything to the statements that were made. It is just rephrasing them in a way that, first, allows for more precise statement of the disagreement (maybe both people actually agree that a is probably around 0.1, but one of them considers that a meaningful effect and the other thinks it is trivial) and, second, makes it possible to systematically explore how these claims are logically related to others. As soon as you have more than one or two quantitative relationships to fit together, it is easier to work with algebra than with words.
So let’s do it.
As in that other post, we will use lower case variables here as rates of change. e is the percentage change in employment, w is the percentage change in the wage, y is the percentage change in output per worker, q is the percentage change in the quantity of output, and p is the percentage change in the price of output. q and p apply to whatever firm, industry or region wages are increasing for. w, e and y are for whatever group of workers we are interested in — it doesn’t matter for this purpose whether we think of a minimum wage increase as a big percentage increase for a small group of workers (those directly affected) or a small percentage increase for a bigger group. a1 through a4 are parameters. I am writing as if the relationships are all linear, to keep things simpler. But I’m pretty sure everything would turn out the same with a more general functional form.
First, we know that employment depends on the quantity of goods produced and the amount of labor used for each one. So we can write [1]
(1) e = q – y
This is an accounting identity.
(2) q = – a1 p + a2 (e + w – p)
a1 here is the price elasticity of demand faced by the unit where wages have increased. a2 reflects the demand created by the wage increase; it is equivalent to the fraction of wages from the unit (firm, industry, region, etc.) in which wages are changing, that is spent on the output of that unit. We know a1 > 0, and a2 >= 0. For an individual business, or a relatively narrow group of businesses or workers (such as in the case of a minimum wage increase), a2 will be very low — McDonald’s employees are probably McDonald’s customers, yes, but the percent of their total income they spend there can’t be above single digits. Conversely, as we talk about a broader and broader wage increase, a1 will approach zero as there is less and less margin for substitution away from higher-cost producers. Probably there aren’t many cases where we need both parameters.
(3) p = a3 (w – y)
a3 is the fraction of changes in unit labor costs that are passed on to prices. We know that 0 <= a3 <= 1, with a3 = 1 describing a constant markup.
(4) y = a4 w
a4 is the fraction of (exogenous) wage increases that are absorbed in higher labor productivity. Assuming rational (profit-maximizing) behavior by businesses, 0 < a4 < 1 for wage increases imposed from outside. (For voluntary wage increases like the one depicted in the Doonesbury cartoon, presumably the employer thinks a4 > 1.) It doesn’t matter whether we imagine the substantive reality described by Equation 4 as an efficiency wage/motivation/turnover story, or a mechanization/robots story. [2] The question we are interested in is, what are the implications of a high value for a4 for the disemployment effects of an increase in wages?
First we combine these equations and express e as a function of w:
(5) e = w [ a3 (-a1 – a2) (1 – a4) + a2 – a4] / (1- a2)
This isn’t very transparent. For a simpler case, assume that the markup is fixed and demand effects are not important. So a3 = 1 (fixed markup) and a2 = 0 (no demand effects.). Then we have:
(6) e = w (-a1 + a1 a4 – a4)
It’s clearer here that the wages-productivity link enters twice. Which makes sense if you think about it. Higher productivity may translate into lower prices, which in turn may translate into higher sales. That’s the middle term, which also depends on the price elasticity of output. But on the other hand, higher productivity means lower employment per good produced. That’s the second term, –a4 by itself.
Which dominates? The answer is straightforward: For it to be the case that when higher wages lead to higher productivity, that ameliorates any employment loss from higher wages, it must be the case that the price elasticity of demand for goods is greater than one. But in this case, as you can see from equation (6), the employment elasticity with respect to the wage must be at least negative one — a one percent increase in wages must lead to at least a one percent fall in employment. Because in the best case, if wage increases are entirely offset by productivity improvements, then a4 = 1. In which case, we have e = w(-a1 + a1 – 1) = -w. (Recall that all variables here are in percent changes.)
So the conclusion is: if we assume a fixed markup and ignore the demand created by higher wages, it is impossible that efficiency-wage or other productivity stories can explain an absence of disemployment from minimum wage increases. If there are large disemployment effects, efficiency-wage type stories can explain why they are not even larger. But they cannot explain why we don’t see disemployment at all, if that is the case. This might seem like a strong conclusion but it really is unavoidable — and it’s actually quite logical when you think about it. Productivity gains only ameliorate the disemployment effects by moderating the reduction in sales that would otherwise result from higher prices. But they also reduce the number of workers required at any given level sales. The first effect can only dominate when the loss of sales is large, i.e. where there is already a substantial disemployment effect.
Now what if we reintroduce variable profit margins and demand from workers?
Take the derivative of (5) with respect to w (which just gives you the rest of the right hand side) and then with respect to a4, and that tells you how the (dis)employment effect of wage increase varies with the extent to which that increase results in higher productivity. This is:
(7) d(de/dw)/d a4 = [a3(a1 + a2) – 1] / (1 – a2)
For productivity gains to ameliorate rather than exacerbate the disemployment effect, this must be greater than one. Since a2 will always be less than one —affected workers can’t spend more than all of their incremental wages at affected employers — we can ignore the denominator. So we need:
(8) a3(a1 + a2) > 1
Notice that this includes the simple case we considered before, with fixed margins and no important demand from affected workers. Then a3 =1 and a2 = 0 so condition(8) is just that demand for relevant output have price elasticity of at least unity.
In the more general case, we can see that, if demand from the affected workers is important, high productivity is more likely to ameliorate disemployment effects. We have to think carefully, in this case, about how large a2 might plausibly be. Even if we are imaging an across-the-board wage increase in a closed economy, not all of the incremental wages will be spent concurrently produced goods. And in any real-world case, there will also be increased imports, and reduced investment and consumption out of profits. If we are considering one business or a limited sector, a2 will certainly be close to zero. For an economy as a whole,it might be bigger — but it also might be negative. (This is the whole debate about wage-led versus profit-led demand.) Meanwhile, recall that a3 is the share of higher costs that is passed on to prices. (So 1 – a3 gives the fall in profit margins.) Notice that if a3 is small, condition 8 will not be satisfied. In other words, if higher wages come out of profits, then any resulting productivity increases will mean more disemployment, not less.
Again, this initially comes out of the algebra, but if you think about it it makes sense. If costs can’t be passed on to prices, then higher productivity just goes straight to the bottom line. And if costs are not passed on to prices, then lower costs can’t lead to higher sales. All they mean is fewer workers needed for the same output. You might think — I did think, until I worked through this — that “higher wages will mean higher productivity” and “higher wages just come out of profits” reinforce each other as two reasons not to worry about higher wages costing jobs. But actually they are contradictory. Higher productivity only mitigates job losses if higher wages do not come out of profits.
Again, I want to emphasize that this is not a model in the usual economics sense of starting some standard description of individual behavior and then tweaking the assumptions so as to produce the desired results. [3] Rather, I am simply stating the claims everyone in the debate agrees on, and then asking what their logical implications are. In particular, no one disputes that higher productivity both offsets the effect of higher wages on costs, and reduces the number of workers required to produce a given output. But that doesn’t mean they consistently take both effects into account when they consider the effects of a wage increase.
Tl; dr:
Higher productivity alone cannot explain why disemployment effects so small. By itself, higher productivity will only ameliorates job loss if a one percent wage increase causes a fall in employment of more than one percent; otherwise, productivity gains will make the job loss worse. If demand from the affected workers is important, then productivity gains can help even if the elasticity is smaller than negative one, but probably not too much smaller. And to the extent cost increases come out of profits rather than being passed through to prices, productivity gains will definitely make job loss worse. These seem like strong conclusions, but they follow logically from premises that are disputed by no one — that higher productivity means that the same output an be produced by few workers, that higher costs may be passed on wholly or impart to higher prices, and that higher prices may result in lower sales.
One specific lesson I take from this is that the observed lack of disemployment from minimum wages must be the result of higher prices and/or lower profit margins, not efficiency wage type effects. In fact, the lack of observed job loss suggests rather strongly that productivity does not rise with higher wages. An interesting question is why people are so attracted to stories where it does.
UPDATE: I should add — I’m not labor economist, I have only a superficial knowledge of this literature; I’m sure someone else has done exactly this exercise and reached the same conclusions. I don’t claim I’m adding anything anything new. I just did this because I was puzzled about myself, and wanted to know under what conditions higher productivity would moderate job losses from higher wages, and under what conditions it would make them worse. And now I do.
[1] Again, using the fact that percentage changes are approximately equal to log differences.
[2] I wanted to explicitly justify this statement but the post is too long already.
[3] In my experience, it’s basically impossible to talk about this kind of thing with a professional economist without them immediately wanting to reframe it as problems optimization under constraints, even if that’s irrelevant to the question at hand. In this case, for instance, if we want to know what the effects of the wage increase are on sales, ,it’s sufficient to know how much the higher wage is passed on to prices, and how strongly sales fall with higher prices. Both these parameters might well be the result of maximization of profits (or some other objective) but you don’t need to know anything about that to answer to question. With respect to employment, what matters is whether the whole cost increase is passed on topics, or some it, or none; the effect will be the exactly same whether or not that fraction is the result of an optimization process.
A couple interesting pieces in yesterday’s Financial Times, related to last year’s debates about the role of the ECB in the European crisis.
First, this article on proposals to scrap higher-denomination bills (to combat money laundering) notes in passing that “the Central Bank of Luxembourg is a particularly prolific producer of high-denomination notes … Luxembourg issued notes equivalent to 194 percent of its GDP in 2013, compare with 16 percent in Germany, 9 percent in Italy and 4 percent in France.” This is a nice reminder that the printing of banknotes is not centralized in Europe, but — like almost all the day-to-day activity of central banking — remains the responsibility of the various central banks, with little oversight from the center. This little story is also a reminder of how — as I’ve pointed out before — the eurosystem is not like the gold standard. The exceptionally large cash issues in Luxembourg are an issue for law enforcement or financial regulators, but they are not a macroeconomic issue. No one suggests that large cash issues could ever cause the Bank of Luxembourg to exhaust its reserves, in the way that equivalent “internal drains” occasionally threatened the Bank of England in the 19th century. I wish in retrospect than I’d written something during the Greek crisis mentioning that physical euros are in fact already printed in Greece. Not that I think this operational detail is very important in itself, but it crystallizes the continued role, (and potential autonomy) of the national central banks in a way that more abstract arguments don’t.
Second, on the op-ed page there is Wolfgang Munchau suggesting that one of the main reasons for the revival of the German economy in the early years of Nazi rule was the accomodative policy followed by Hjalmar Schacht at the Reichbank, which included not only conventional expansionary policy — enabled by effective exit from the gold standard — but “unilateral restructuring of private debt owed by German companies to foreigners.” (Schacht’s memoir My First 76 Years is fascinating reading.) The recovery of output and employment in Germany ahead of the rest of Western Europe, Munchau writes, was “one reason for Hitler’s initial popularity,” and, more to the point, is evidence for “what an unorthodox central banker can do if he or she has the political support to break with the prevailing orthodoxy.” The relevance for today is obvious:
The current policy orthodoxy in Brussels and Frankfurt, which is shared across northern Europe, has some parallels to the deflationary mindset that prevailed in the 1930s. Today’s politicians and central bankers are fixated with fiscal targets and debt reduction. As in the early 1930s, policy orthodoxy has pathological qualities. Whenever they run out of things to say, today’s central bankers refer to “structural reforms”, although they never say what precisely such reforms would achieve.
In principle, the eurozone’s economic problems are not hard to solve: the European Central Bank could hand each citizen a cheque for €10,000. The inflation problem would be solved within days. Or the ECB could issue its own IOUs — which is what Schacht did. Or else the EU could issue debt and the ECB would buy it up. There are lots of ways to print money. They are all magnificent — and illegal.
There are no Nazi parties in the eurozone today, except in Greece. But France and Italy have populist parties on the right that are clearly outside the current policy consensus. Imagine a scenario in which Beppe Grillo, leader of Italy’s Five Star Movement, were to win the Italian election in 2018.
The term of Ignazio Visco, governor or the Bank of Italy, expires in November that year. Mr Grillo would be in a position to appoint his own central banker. Perhaps he would choose someone as resourceful and ruthless as Schacht and able to plot Italy’s way out of the euro, via a parallel currency regime for a transitional period, defaulting on foreign debt in the process. The devaluation and the increase in public sector investment which would be possible under a new regime could bring instant economic growth.
This is interesting, for a couple of reasons. First, the assumption, which Munchau doesn’t feel he needs to defend or even state explicitly, that any elected European government can appoint its own central bank leadership, without the approval of the ECB. (My understanding is that this is indeed the case, though the relevant national laws all include sweeping but presumably unenforceable language that once appointed the central bank leadership is not to take any outside direction.) Also worth noting, the suggestion of a temporary parallel currency, consistent with my idea that exit from the euro would not have to be an all-or-nothing leap, but involves passing through an extended gray area.
The second interesting thing is Munchau’s evident ambivalence. On the one hand, he sees the parallels between today’s the orthodoxy of the euro today and of the gold standard before World War II. [1] He recognizes the problems with postulating objective constraints on central banks in a depressed economy. He realizes that the current austerity regime shows no signs of delivering material benefits to the great majority of Europeans. And against this … what? “I have no doubt that any populist government in Europe would end in disaster,” he writes, but the basis of this certainty is not explained.
For myself, I have no doubt that the European crisis is not over. At some point, maybe soon, another European government is going to come up hard against the limits of acceptable policy in the Brussels-Frankfurt orthodoxy. I still think the national central banks will be the commanding heights in the ensuing battle.
[1] To be clear: I don’t think there is a close parallel in the way the two systems actually operate, but in their ideology, yes.
This, presumably, is a pro-minimum wage cartoon. This, clearly, is an anti-minimum wage column. But putting our economist’s hat on for a second — aren’t they making the same argument?
This has bugged me about the minimum wage debates for a while. Supporters say, mandating higher wages will lead to more motivated employees, less turnover and training costs, less need for supervision. Opponents say, mandating higher wages will lead to mechanization of jobs currently done by low-wage labor, substitution of capital for labor. But at an abstract level, it seems to me these are just two ways of describing the same thing. Aren’t they both just saying, faster growth of labor productivity? How can the same predicted outcome be an argument both for and against higher wages?
The anti- side seems to be implicitly assuming a fixed quantity of output, so that less labor per unit means less labor overall. The pro- side seems to be implicitly assuming some combination of a flat demand curve and a flattish supply curve, so that a fall in costs leads to a large rise in output. But you’ll still get some fall in employment, in the absence of monopsony or demand effects.
Anyway my interest here is not in what is the right answer. [1] My interest is that supporters of a higher minimum wage invoke efficiency wage arguments without explaining why that should be expected to dampen disemployment effects rather than amplify them. While opponents of higher minimum wages describe faster productivity growth as a cost, without, as far as I can tell, being against it in any other context. This is a case where abstraction — some equations, even one of those awful supply and demand graphs — might actually be helpful.
[1] Just to be clear, I support a higher minimum wage, $15, whatever. A few years ago, I even testified to that effect before the Maryland state legislature.
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.
I have a new piece up at Jacobin on December’s rate hike. In my experience, the editing at Jacobin is excellent. But for better or worse, they don’t go for footnotes. So I’m reposting this here with the original notes. And also for comments, which Jacobin (perhaps wisely) doesn’t allow.
I conveyed some of the same views on “What’d You Miss?” on Bloomberg TV a couple weeks ago. (I come on around 13:30.)
To the surprise of no one, the Federal Reserve recently raised the federal funds rate — the interest rate under its direct control — from 0–0.25 percent to 0.25–0.5 percent, ending seven years of a federal funds rate of zero.
But while widely anticipated, the decision still clashes with the Fed’s supposed mandate to maintain full employment and price stability. Inflation remains well shy of the Fed’s 2 percent benchmark (its interpretation of its legal mandate to promote “price stability”) — 1.4 percent in 2015, according to the Fed’s preferred personal consumption expenditure measure, and a mere 0.4 percent using the consumer price index — and shows no sign of rising.
US GDP remains roughly 10 percent below the pre-2008 trend, so it’s hard to argue that the economy is approaching any kind of supply constraints. Set aside the fundamental incoherence of the notion of “price stability” (let alone of a single metric to measure it) — according to the Fed’s professed rulebook, the case for a rate increase is no stronger today than a year or two ago. Even the business press, for the most part, fails to see the logic for raising rates now.
Yet from another perspective, the decision to raise the federal funds rate makes perfect sense. The consensus view considers the main job of central banks to be maintaining price stability by adjusting the short-term interest rate. (Lower interest rates are supposed to raise private spending when inflation falls short of the central bank’s target, and higher interest rates are supposed to restrain spending when inflation rises above the target.) But this has never been the whole story.
More importantly, the central bank helps paper over the gap between ideals and reality — the distance between the ideological vision of the economy as a system of market exchanges of real goods, and the concrete reality of production in pursuit of money profits.
Central banks are thus, in contemporary societies, one of the main sites at which capitalism’s “Polanyi problem” is managed: a society that truly subjected itself to the logic of market exchange would tear itself to pieces. But the conscious planning that confines market outcomes within tolerable bounds has to be hidden from view because if the role of planning was acknowledged, it would undermine the idea of markets as natural and spontaneous and demonstrate the possibility of conscious planning toward other ends.
The Fed is a central planner that dare not speak its name. [1]
One particular problem for central bank planners is managing the pace of growth for the system as a whole. Fast growth doesn’t just lead to rising prices — left to their own devices, individual capitalists are liable to bid up the price of labor and drain the reserve army of the unemployed during boom times. [2] Making concessions to workers when demand is strong is rational for individual business owners, but undermines their position as a class.
Solving this coordination problem is one of modern central bankers’ central duties. They pay close attention to what is somewhat misleadingly called the labor market, and use low unemployment as a signal to raise interest rates.
So in this respect it isn’t surprising to see the Fed raising rates, given that unemployment rates have now fallen below 5 percent for the first time since the financial crisis.
Indeed, inflation targeting has always been coupled with a strong commitment to restraining the claims of workers. Paul Volcker is now widely admired as the hero who slew the inflation dragon, but as Fed chair in the 1980s, he considered rolling back the power of organized labor — in terms of both working conditions and wages — to be his number one problem. [3] Volcker described Reagan’s breaking of the air-traffic controllers union as “the single most important action of the administration in helping the anti-inflation fight.”
As one of Volcker’s colleagues argued, the fundamental goal of high rates was that
labor begins to get the point that if they get too much in wages they won’t have a business to work for. I think that really is beginning to happen now and that’s why I’m more optimistic. . . . When Pan Am workers are willing to take 10 percent wage cuts because the airlines are in trouble, I think those are signs that we’re at the point where something can really start to happen.
Volcker’s successors at the Fed approached the inflation problem similarly. Alan Greenspan saw the fight against rising prices as, at its essence, a project of promoting weakness and insecurity among workers; he famously claimed that “traumatized workers” were the reason strong growth with low inflation was possible in the 1990s, unlike in previous decades.
Testifying before Congress in 1997, Greenspan attributed the “extraordinary’” and “exceptional” performance of the nineties economy to “a heightened sense of job insecurity” among workers “and, as a consequence, subdued wages.”
As Greenspan’s colleague at the Fed in the 1990s, Janet Yellen took the same view. In a 1996 Federal Open Market Committee meeting, she said her biggest worry was that “firms eventually will be forced to bid up wages to retain workers.” But, she continued, she was not too concerned at the moment because
while the labor market is tight, job insecurity also seems alive and well. Real wage aspirations appear modest, and the bargaining power of workers is surprisingly low . . . senior workers and particularly those who have earned wage premia in the past, whether it is due to the power of their unions or the generous compensation policies of their employers, seem to be struggling to defend their jobs . . . auto workers are focused on securing their own benefits during their lifetimes but appear reconciled to accepting two-tier wage structures . . .
And when a few high-profile union victories, like the Teamsters’ successful 1997 strike at UPS, seemed to indicate organized labor might be reviving, Greenspan made no effort to hide his displeasure:
I suspect we will find that the [UPS] strike has done a good deal of damage in the past couple of weeks. The settlement may go a long way toward undermining the wage flexibility that we started to get in labor markets with the air traffic controllers’ strike back in the early 1980s. Even before this strike, it appeared that the secular decline in real wages was over.
The Fed’s commitment to keeping unemployment high enough to limit wage gains is hardly a secret — it’s right there in the transcripts of FOMC meetings, and familiar to anyone who has read left critics of the Fed like William Greider and Doug Henwood. The bluntness with which Fed officials take sides in the class war is still striking, though.
Of course, Fed officials deny they’re taking sides. They justify policies that keep workers too weak, disorganized, and traumatized to demand higher wages by focusing on the purported dangers of low unemployment. Lower unemployment, they say, leads to higher money wages, and higher money wages are passed on as higher prices, ultimately leaving workers’ real pay unchanged while eroding their savings.
So while it might look like naked class warfare to deliberately raise unemployment to keep wage demands “subdued”, the Fed assures us that it’s really in the best interests of everyone, including workers.
Keeping Wages in Check
The low-unemployment-equals-high-prices story has always been problematic. But for years its naysayers were silenced by the supposed empirical fact of the Phillips curve, which links low unemployment to higher inflation.
The shaky empirical basis of the Phillips curve was the source of major macroeconomic debates in the 1970s, when monetarists claimed that any departure from unemployment’s “natural” rate would lead inflation to rise, or fall, without limit. This “vertical Phillips curve” was used to deny the possibility of any tradeoff between unemployment and inflation — a tradeoff that, in the postwar era, was supposed to be managed by a technocratic state balancing the interests of wage earners against the interest of money owners.
In the monetarist view, there were no conflicting interests to balance, since there was just one possible rate of unemployment compatible with a stable price system (the “Non Accelerating Inflation Rate of Unemployment”). This is still the view one finds in most textbooks today.
In retrospect, the 1970s debates are usually taken as a decisive blow against the “bastard Keynesian” orthodoxy of the 1960s and 1970s. They were also an important factor in the victory of monetarism and rational expectations in the economics profession, and in the defeat of fiscal policy in the policy realm.
But today there’s a different breakdown in the relationship between unemployment and inflation that threatens to dislodge orthodoxy once again. Rather than a vertical curve, we now seem to face a “horizontal” Phillips curve in which changes in unemployment have no consequences for inflation one way or another.
Despite breathless claims about the end of work, there hasn’t been any change in the link between output and employment; and low unemployment is still associated with faster wage growth. But the link between wage growth and inflation has all but disappeared.
Annual wage growth for nonsupervisory workers (X) and CPI inflation (Y), 1965–1995.
Annual wage growth for nonsupervisory workers (X) and CPI inflation (Y), 1995–2015.
This gap in the output-unemployment-wages-inflation causal chain creates a significant problem for central bank ideology.
When Volcker eagerly waited for news on the latest Teamsters negotiations, it was ostensibly because of the future implications for inflation. Now, if there is no longer any visible link between wage growth and inflation, then central bankers might stop worrying so much about labor market outcomes. Put differently, if the Fed’s goal was truly price stability, then the degree to which workers are traumatized would no longer matter so much.
But that’s not the only possibility. Central bankers might want to maintain their focus on unemployment and wages as immediate targets of policy for other reasons. In that case they’d need to change their story.
The current tightening suggests that this is exactly what’s happening. Targeting “wage inflation” seems to be becoming a policy goal in itself, regardless of whether it spurs price increases.
A recent piece by Justin Wolfers in the New York Times is a nice example of where conventional wisdom is heading: “It is only when nominal wage growth exceeds the sum of inflation (about 2 percent) and productivity growth (about 1.5 percent) that the Fed needs to be concerned. . .”
This sounds like technical jargon, but if taken seriously it suggests a fundamental shift in the objectives of monetary policy.
By definition, the change in the wage share of output is equal to the rise in money wages minus the sum of the inflation rate and the increase in labor productivity. To say “nominal wage growth is greater than the sum of inflation and productivity growth” is just a roundabout way of saying “the wage share is rising.” So in plain English, Wolfers is saying that the Fed should raise rates if and only if the share of GDP going to workers threatens to increase.
Think for a moment about this logic. In the textbook story, wage growth is a problem insofar as it’s associated with rising inflation. But in the new version, wage growth is more likely to be a problem when inflation stays low.
Wolfers is the farthest thing from a conservative ideologue. His declaration that the Fed needs to guard against a rise in the wage share is simply an expression of conventional elite wisdom that comes straight from the Fed. A recent post by several economists at the New York Fed uses an identical definition of “overheating” as wage growth in excess of productivity growth plus inflation.
Focusing on wage growth itself, rather than the unemployment-inflation nexus, represents a subtle but far-reaching shift in the aim of policy. According to official rhetoric, an inflation-targeting central bank should only be interested in the part of wage changes that co-varies with inflation. Otherwise changes in the wage share presumably reflect social or technological factors rather than demand conditions that are not the responsibility of the central bank.
To be fair, linking demand conditions to changes in the distribution between profits and wages, rather than to inflation, is a more realistic than the old orthodoxy that greater bargaining power for workers cannot increase their share of the product. [4]
But it sits awkwardly with the central bank story that higher unemployment is necessary to keep down prices. And it undermines the broader commitment in orthodox economics to a sharp distinction — both theoretically and policy-wise — between a monetary, demand-determined short run and a technology and “real”-resources-determined long run, with distributional questions firmly located in the latter.
There’s a funny disconnect in these conversations. A rising wage share supposedly indicates an overheating economy — a macroeconomic problem that requires a central bank response. But a falling wage share is the result of deep structural forces — unrelated to aggregate demand and certainly not something with which the central bank should be concerned. An increasing wage share is viewed by elites as a sign that policy is too loose, but no one ever blames a declining wage share on policy that is too tight. Instead we’re told it’s the result of technological change, Chinese competition, etc.
Logically, central bankers shouldn’t be able to have it both ways. In practice they can and do.
The European Central Bank (ECB) — not surprisingly, given its more overtly political role — has gone further down this road than the Fed. Their standard for macroeconomic balance appears to be shifting from the NAIRU (Non-Accelerating Inflation Rate of Unemployment) to the NAWRU (Non-Accelerating Wage Rate of Unemployment).
If the goal all along has been lower wage growth, then this is not surprising: 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.
Indeed finding fresh arguments for keeping wages in check may be the real content of much of the “competitiveness” discourse. Replacing price stability with elevating competitiveness as the paramount policy goal creates a convenient justification for pushing down wages even when inflation is already extremely low.
It’s interesting in this context to look back at the ransom note the ECB sent to the Spanish government during the 2011 sovereign debt crisis. (Similar letters were sent to the governments of other crisis-hit countries.) One of the top demands the ECB made as a condition of stabilizing the market for government debt was the abolition of cost-of-living (COLA) clauses in employment contracts — even if adopted voluntarily by private employers.
Needless to say this is far beyond the mandate of a central bank as normally understood. [5] But the most interesting thing is the rationale for ending COLA clauses. The ECB declared that cost-of-living clauses are “a structural obstacle to the adjustment of labour costs” and “contribute to hampering competitiveness.”
This is worth unpacking. For a central bank concerned with price stability, the obvious problem with indexing wages to prices (as COLA clauses do) is that it can lead to inflationary spirals, a situation in which wages and prices rise together and real wages remain the same.
But this kind of textbook concern is not the ECB’s focus; instead, the emphasis on labor costs shows an abiding interest in tamping down real wages. In the old central bank story, wage indexing was supposedly bad because it didn’t affect (i.e., raise) real wages and only led to higher inflation. In the new dispensation, wage indexing is bad precisely because it does affect real wages. The ECB’s language only makes sense if the goal is to allow inflation to erode real wages.
The Republic of the Central Banker
Does the official story matter? Perhaps not.
The period before the 2008 crisis was characterized by a series of fulsome tributes to the wisdom of central banking maestros, whose smug and uncritical tone must be causing some embarrassment in hindsight.
Liberals in particular seemed happy to declare themselves citizens of the republic of the central bankers. Cristina Romer — soon to head President Obama’s Council of Economic Advisers — described the defeat of postwar Keynesian macroeconomics as a “glorious counterrevolution” and explained that
better policy, particularly on the part of the Federal Reserve, is directly responsible for the low inflation and the virtual disappearance of the business cycle . . . The story of stabilization policy of the last quarter century is one of amazing success. We have seen the triumph of sensible ideas and have reaped the rewards in terms of macroeconomic performance. The costly wrong turn in ideas and macropolicy of the 1960s and 1970s has been righted and the future of stabilization looks bright.
The date on which the “disappearance of the business cycle” was announced? September 2007, two months before the start of the deepest recession in fifty years.
Romer’s predecessor on Clinton’s Council of Economic Advisers (and later Fed vice-chair) Alan Blinder was so impressed by the philosopher-kings at the central bank that he proposed extending the same model to a range of decisions currently made by elected legislatures.
We have drawn the line in the wrong place, leaving too many policy decisions in the realm of politics and too few in the realm of technocracy. . . . [T]he argument for the Fed’s independence applies just as forcefully to many other areas of government policy. Many policy decisions require complex technical judgments and have consequences that stretch into the distant future. . . . Yet in such cases, elected politicians make the key decisions. Why should monetary policy be different? . . . The justification for central bank independence is valid. Perhaps the model should be extended . . . The tax system would surely be simpler, fairer, and more efficient if . . . left to an independent technical body like the Federal Reserve rather than to congressional committees.
The misguided consensus a decade ago about central banks’ ability to preserve growth may be just as wrong about central banks’ ability to derail it today. (Or at least, to do so with the conventional tools of monetary policy, as opposed to the more aggressive iatrogenic techniques of the ECB.)
The business press may obsess over every movement of the Fed’s steering wheel, but we should allow ourselves some doubts that the steering wheel is even connected to the wheels.
The last time the Fed tightened was ten years ago; between June 2004 and July 2006, the federal funds rate rose from 1 percent to 5 percent. Yet longer-term interest rates — which matter much more for economic activity — did not rise at all. The Baa corporate bond rate and thirty-year mortgage, for instance, were both lower in late 2006 than they had been before the Fed started tightening.
And among heterodox macroeconomists, there is a strong argumentthat conventional monetary policy no longer plays an important role in the financial markets where longer-term interest rates are set. Which means it has at best limited sway over the level of private spending. And the largest impacts of the rate increase may not be in the US at all, but in the “emerging markets” that may be faced with a reversal of capital flows back toward the United States.
Yet whatever the concrete effects of the Fed’s decision to tighten, it still offers some useful insight into the minds of our rulers.
We sometimes assume that the capitalist class wants growth at any cost, and that the capitalist state acts to promote it. But while individual capitalists are driven by competition to accumulate endlessly, that pressure doesn’t apply to the class as a whole.
A regime of sustained zero growth, by conventional measures, might be difficult to manage. But in the absence of acute threats to social stability or external competition (as from the USSR during the postwar “Golden Age”), slow growth may well be preferable to fast growth, which after all empowers workers and destabilizes existing hierarchies. In China, 10 percent annual growth may be essential to the social contract, but slow growth does not — yet — seem to threaten the legitimacy of the state in Europe, North America, or Japan.
As Sam Gindin and Leo Panitch persuasively argue, even periodic crises are useful in maintaining the rule of money. They serve as reminders that the confidence of capital owners cannot be taken for granted. As Kalecki famously noted, the threat of a crisis when “business confidence” is shaken is a “powerful controlling device” for capitalists vis-à-vis the state. Too much success controlling crises is dangerous — it makes this threat less threatening.
So perhaps the most important thing about the Fed’s recent rate hike is that it’s a reminder that price stability and inflation management are always a pretext, or at best just one reason among others, for the managers of the capitalist state to control rapid growth and the potential gains for workers that follow. As the shifting justifications for restraining wage growth suggest, the republic of the central banker has always been run in the interests of money owners.
Some critics of the rate hike see it as a ploy to raise the profits of banks. In my opinion, this theory isn’t convincing. A better conspiracy theory is that it’s part of the larger project of keeping us all insecure and dependent on the goodwill of the owning class.
[1] The role of central banks in disguising the moment of conscious planning under capitalism and preserving the ideological fiction of spontaneous order is clearly visible in the way monetary policy is discussed by economists. From the concrete to the abstract. First, the “independent” status of central banks is supposed to place them outside the collective deliberation of democratic politics. Second, there is a constant attraction to the idea of a monetary policy “rule” that could be adopted once and for all, removing any element of deliberate choice even from the central bankers themselves. (Milton Friedman is only the best-known exponent of this idea, which is a central theme of discussion of central banks from the 18th century down to the present.) Third, in modern models, the “reaction function” of the central bank is typically taken as one of the basic equations of the model — the central bank’s reaction to a deviation of inflation from its chosen path has the same status as, say, the reaction of households to a change in prices. As Peter Dorman points out, there’s something very odd about putting policy inside the model this way. But it has the clear ideological advantage of treating the central bank as if it were simply part of the natural order of optimization by individual agents.
[2] The best analysis of the crisis of the 1970s in these terms remains Capitalism Since 1945, by Armstrong, Glyn and Harrison.
[3] The linked post by Peter Frase does an excellent job puncturing the bipartisan mythmaking around the Volcker and bringing out the centrality of his anti-labor politics. But it contains one important error. Frase describes the late-1970s crisis to which Volcker was responding as “capital refusing to invest, and labor refusing to take no for an answer.” The latter might be true but the former certainly is not: The late 1970s saw the greatest boom in business investment in modern US history; 1981 had the highest investment-GDP ratio since the records begin in 1929. High demand and negative real interest rates — which made machines and buildings more attractive than wealth in financial form — outweighed low profits, and investment boomed. (An oil boom in the southwest and generous tax subsidies also helped.) The problem Volcker was solving was not,as Frase imagines, that the process of accumulation was threatened by the refusal of unhappy money owners to participate. It was, in some ways, an even more threatening one — that real accumulation was proceeding fine despite the unhappiness of money owners. In the often-brilliant Buying Time, Wolfgang Streeck makes a similar mistake.
[4] More precisely, it’s a return to what Anwar Shaikh calls the classical Phillips curve found in the Marxist literature, for instance in the form of Goodwin cycles. (The Shaikh article is very helpful in systematically thinking through alternative relationships between nominal wages, the wage share and inflation.)
[5] It’s worth noting that in these cases the ECB got what it wanted, or enough of it, and did aggressively intervene to stabilize government debt markets and the banking systems in almost all the crisis countries. As a result, the governments of Spain, Italy and Portugal now borrow more cheaply than ever in history. As I periodicallypoint out, the direct cause of the crisis in Greece was the refusal of the ECB to extend it the same treatment. A common liberal criticism of the euro system is that it is too rigid, that it automatically applies a single policy to all its members even when their current needs might be different. But the reality is the opposite. The system, in the form of the ECB, has enormous discretion, and the crisis in Greece was the result of the ECB’s choice to apply a different set of policies there than elsewhere.
Crooked Timber is having a book event on Piketty’s Capital in the 21st Century. My contribution is here. A few supplemental bits:
First, I need to point out a problem in my post. I write: “It’s striking, for instance, that the book does not contain a table or figure comparing r and g historically.” But of course, as David Rosnick points out in email, this is not true. There are three figures in chapter 10 that purport to give historical values for r and g. The inadequacy of these figures to bear the weight put on the r > g apparatus is, I think, evident. Why are there no cross-country comparisons? Why the odd periodizations? Why so much emphasis on the data-free values invented for the distant past and future? Perhaps most damningly, what about the fact that r > g is no more true in the increasingly unequal second half of the 20th century than in the increasingly equal first half? But none of that changes the fact that my sentence, as I wrote it, is wrong.
Some people may be interested in other things I’ve written relating to Piketty on this blog over the past couple years:
With respect to the Crooked Timber piece, I should say — should have acknowledged in the post itself — that it all comes out of conversations I’ve been having with Suresh Naidu over the past year or so. Suresh himself has written various things about Piketty; he’s working on a piece now on these same themes of capital, Piketty and the money view that should move the conversation significantly forward.
I should also have pointed out the Real World Economic Review’s superb special issue on Piketty. Jamie Galbraith’s, Merijn Knibbe’s, and Yanis Varoufakis’ contributions made many of the same points I tried to make in the Crooked Timber post. Knibbe’s piece in particular is a tour de force, everyone interested in these debates should read it.
Finally, I should say: I’ve been reading Crooked Timber since it began, in 2003. For a long while I was a regular commenter there, most of that time pseudonymously as Lemuel Pitkin. Now twelve years is a long time in internet time. Not so long in real life but still long enough for me to go back to graduate school, get my PhD and various teaching jobs, and to start this blog. Crooked Timber was probably my main inspiration to try to write in this format. So I can’t deny it, I’m thrilled to finally have a post up there.
The top of the front page in today’s Financial Times shows Steve Forbes’ scowling face with the caption, “We want our money!” Really, that should be there every day — it could be their new logo.
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Further down the page, the big story is the election of the opposition candidate Mauricio Macri as president of Argentina. I’ll wait to see what Marc Weisbrot has to say before guessing what this means substantively for the direction of the Argentine state. What I want to call attention to now is the consistent theme of the coverage.
The front page headline in the FT is “Markets cheer Argentina’s new order”; the opening words of the article are “Investors hailed the election of Mauricio Macri….” After mentioning his call for the leaders of Argentina’s central bank to step down — the apparent unobjectionableness of which is evidence on the real content of central bank “independence” — the first substantive claims of the article are that “markets reacted positively” and that “Macri has promised to eliminate strict exchange controls” — evidently the most important policy issue from the perspective of the FT reporter.
Over the fold, we learn again that “Investors yesterday cheered the election of Mauricio Macri”; that “dollar bonds issued by Argentina … extended their winning streak”; and that “markets have hoped for an end to ‘Kirchnerismo’.” The only people quoted in the article other than Macri himself are three European investment bankers. One says that “Macri understands what the country needs to do to regain the confidence of international investors and get the country back on its feet” — presumably in that order. Another instructs the new government that “Argentina must normalise relations with the capital markets and start attracting the all- important foreign investors”.
The accompanying think piece explains that among the “most pressing issues” for Macri are that “the country is shut out of international markets by its long court case with holdout creditors” and that “the economy suffers from a web of distortions, including energy subsidies that can shrink a household’s monthly energy bill to the price of a cup of coffee.” (The horror!) It emphasizes again that Macri’s only firm policy commitment at this point is to remove capital controls, and suggests that “Argentina will need to have recourse to multilateral financial support.” The conclusion: “The biggest area where Macri needs to effect change is the investment climate. Investors have cheered his rise … but Mr Macri’s job is to convert Argentina into a destination for real money investment rather than hedge fund speculation … a decisive change for a country that … is unique in having lost its ‘rich nation status’.”
So that’s the job of the president of Argentina, making the country a destination for real money. Good to have that clear!
Now, you might say, if you don’t want to read every story through the frame of “Is it good for the bondholders,” then why are you reading the FT? Fair enough — but the FT is a good newspaper. (The Forbes story is fascinating.) Anyway, it’s worth being reminded every so often that in the higher consciousness of the bourgeoisie, nations and all other social arrangements exist only in order to generate payments to owners of financial assets. [1]
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The question I’m interested in, though, is the converse one — are the bondholders good for Argentina? The claim that foreign investors are “all-important” is obviously an expression of the extraordinary narcissism of finance. But is there a rational core to it? Are foreign investors at least somewhat important?
This is a question that critical economists need to investigate more systematically. Even among heterodox writers, there’s a disproportionate focus on the development of the financial superstructure and the ways in which it can break down. [2] The importance of this superstructure for the concrete activities of social production and reproduction is too often taken for granted. Or else we make the case against free cross-border financial commitments too quickly, without assessing what might be the arguments for them.
So, concretely, what is the benefit to Argentina of regaining “access to the markets,” to enjoying the goodwill of foreign investors, to being a destination for real money? To answer this properly would involve citing lots of literature and looking at data. I’m not going to do that. The rest of this post is just me thinking through this issue, without directly referring to the literature. One result of this is that the post is too long.
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Let’s start by distinguishing foreign direct investment (FDI) from portfolio investment.
The case for FDI is essentially that there are productive processes that can be carried out successfully only if owned and managed by foreigners. Now, obviously there are real advantages to the ways in which production is organized in rich countries, which poorer countries can benefit from adopting. But the idea that the only way this technical knowledge can reach poorer countries is via foreign ownership rests, I think, on racism, that simple. The claim that domestically-owned firms cannot adopt foreign technology is contradicted by, basically, the entire history of industrialization.
A more plausible advantage of foreign ownership is that foreign companies have more favorable access to markets and supply networks. It would be at least defensible to claim that Polish manufacturing has benefited from integration into the German auto industry — not because German management has any inherent superiority, but because German car companies are more likely to source from their own subsidiaries than from independent Polish firms. I don’t see this kind of argument being made for Argentina. When we hear about “regaining the confidence of international investors,” that pretty clearly means owners of financial wealth considering whether to include Argentine assets in their portfolios, not multinational corproations considering expanding their operations there. In other words, we are interested in portfolio investment.
So what are the benefits that are supposed to come from attracting portfolio inflows? I wonder if the people quoted in the FT piece, or the author of it, ever even ask this question. This may be a case where the debate over what “capital” means is not just academic. If financial wealth is conflated with concrete means of production, then it’s natural to think that the goodwill of the owners of the first is all-important, since obviously no productive activity can take place without the second. But purchasers of Argentine stocks and bonds are not, in fact, providing the country with new machines or software or engineers or land. (For this reason, I prefer to avoid the terms “capital flows” and “capital mobility”.) What then are the bond buyers providing?
Macroeconomically, it seems to me that there are really only two arguments to be made for portfolio inflows. First, they allow a current account deficit to be financed. Second, they might allow the interest rate to be lower. Beyond macro considerations, we might also want to keep international investors happy because of their political influence, or because they control access to the international (or even domestic) payments system. And of course, if a country is already committed to free financial flows then this commitment will only be sustainable if net financial inflows are kept above a certain level. But that just begs the question of why you would make such a commitment in the first place.
Let’s consider these arguments in turn.
‘The first benefit, that portfolio inflows allow a country to have a deficit on current account, is certainly real. I think this is the only generally credible macroeconomic story for the benefits of capital account liberalization.
In a world with no international financial flows, countries would have to a balanced current account (or in practice balanced trade, since most income flows are the result of past financial flows) in every period. But there might be good reasons for some countries. to have transitory or persistent trade imbalances If a country’s trade balance moves toward deficit for whatever reason, the ability to reduce foreign assets and increase foreign liabilities allows the movement back toward balance to be deferred. If faster growth would lead to higher import demand (which cannot be limited otherwise) or requires specific imported intermediate or capital goods (that cannot be financed otherwise) then the foreign exchange provided by portfolio inflows can allow faster growth than would otherwise be possible.
There are good reasons to be skeptical about the practical value of portfolio inflows as finance of current account deficits. But there’s nothing wrong with the argument in principle. If that is the argument you are making, though, you have to be clear about the implications.
First, if this is your argument, then saying that Argentina has suffered because of its lack of access to foreign capital markets, is equivalent to saying that Argentina suffered because of its inability to run a trade deficit. I don’t think this is what people are saying — and it would not be plausible if they were, since Argentina has had a large trade surplus over the whole Kirchner period. No help from foreign investors would have been needed to reduce that surplus.
Second, if the benefit of portfolio flows is to finance current account imbalances, then only the net flows matter. There is no purpose to the large offsetting gross flows — you could just as well have the central bank alone borrow from abroad, and then sell the resulting foreign exchange at the market price (or distribute it in some other way). That would deliver all the macroeconomic benefits of international financial flows and avoid one of the major costs — the central bank’s inability to act as lender of last resort or resolve financial crises when financial institutions have liabilities that cannot be settled with central bank’ money.
Again, the only unambiguous macroeconomic reason to support capital-account liberalization, or to make attracting portfolio inflows a priority, is if you want to see larger current account deficits. In an undergraduate textbook, this is the whole story — to say that international lending permits countries to substitute present for future expenditure, or to raise investment above domestic saving, are just different ways of saying it permits current account deficits. If you think larger current account imbalances are unnecessary or dangerous, then, it’s not clear what the macroeconomic function of portfolio investment is supposed to be. The only thing that portfolio investment directly provides is foreign exchange.
The second possible macroeconomic benefit is that foreign portfolio investment allows the interest rate to be lower than it otherwise could be. This is certainly possible as a matter of logic. Let’s imagine a firm with an investment project that will generate income in the future. The firm needs to issue liabilities in order to exercise claims on the labor and other inputs it needs to carry out the project. Wealth owners must be willing to hold the liabilities of entrepreneur on terms that make the project viable; if they demand a yield that is too high, the project won’t go forward. But there may be some foreign intermediary that is both willing to hold entrepreneur’s liabilities on more favorable terms, and issues liabilities that wealth owners are more willing to hold. In this case, the creation of financial claims across borders is a necessary condition for the project to go forward. Note that this case covers all the macroeconomic benefits of diversification, risk-bearing, etc. — the ability to hold an internationally diversified portfolio may be very valuable to wealth owners, but that matters to the rest of us only insofar as that value allows real activity to be financed on more favorable terms.
That story makes sense where there is no domestic financial system, or a very underdeveloped one; it’s a good reason why financial self-sufficiency is not a realistic goal for small subnational units. But it’s not clear to me how it applies to a country with its own banking system and its own central bank. Is it plausibly the case that in the absence of financial flows, the Argentine central bank would be unable to achieve an interest rate as low as would be macroeconomically desirable? Is it plausibly the case that there are productive enterprises in Argentina that are unable to secure domestic-currency loans from the local banking system even given expansionary policy by the central bank, but would be able to do so from foreign lenders? [3]
If this is your argument, you should at least be able to identify the kinds of firms (or I suppose households) that you think should be borrowing more, are unable to secure loans from the domestic banking system, but would be able to borrow internationally. (Or that would be able to borrow more from domestic banks, if the banks themselves could borrow internationally.)
It’s hard for me to see how a reasonably developed banking system with a central bank could be constrained in its ability to provide domestic-currency liquidity by a lack of portfolio inflows. And I doubt that’s what the gentlemen from Credit Suisse etc. are saying. On the contrary, the usual claim is that portfolio flows reduce the feasible range of domestic interest rates. Of course the people saying this never explain why it is desirable — the ability to conduct financial transactions across borders is just presented as a fact of life, to which policy must adapt. [4]
In any case, my goal here isn’t to dispute the arguments for the importance of portfolio inflows, but to clarify what they are, and their logical implications. Do you think that the benefits of portfolio flows are that they finance current account deficits and allow easier credit than the domestic bank system could provide? Then you can’t, for instance, turn around and blame the euro crisis on current account deficits and too-easy credit. Or at least, you can’t do that and still hold up “free movement of capital” as one of the central virtues of the system.
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There are two other non-macroeconomic arguments you sometimes hear for the importance of foreign investors, focused less on what they offer than with what they can threaten. First, the political importance of international creditors in the US and other states may allow them to use the power of those states against government they are unhappy with.
Historically, this is the decisive argument in factor of keeping foreign investors happy. Through most of the period from the 1870s through the 1950s, the possible consequences of a poor “investment climate” included gunboats in your harbor, the surrender of tariff collection and other basic state functions to creditor governments, military coups, even the end of your national existence. [5] (Let’s not forget that the pretext for the war in which the United States claimed half of Mexico’s territory was the mistreatment of American businessmen there.)
That sort of direct state violence in support of foreign creditors has been less common in recent decades, though of course we shouldn’t exclude the possibility of its revival. But there are less overt versions. The extraordinary steps taken by the Judge Griesa on behalf of Argentina’s holdout creditors go far beyond anything the investors could have done on their own. If the point of the FT pieces is that Argentina needs to settle with its creditors because otherwise it will face endless, escalating harassment from the US legal system, then they may have a point. I’d just like them to come out and say it.
A related argument is that failure to get on good terms with finance as a cartel of asset owners, will mean loss of access to finance as a routine service. The version of this you hear most often is that defaulting on or otherwise annoying foreign investors will result in loss of access to trade finance. So that even if the country has a current account in overall balance, its imports and/or exports will be restricted by a sudden need to conduct trade on a pure cash basis. I’ve seen this claim made much more than I’ve seen any evidence for it — which doesn’t mean it’s wrong, of course. But who are the providers of trade finance? Are they so resolutely class-conscious that they would refuse otherwise profitable transactions out of solidarity with their investor brethren? It doesn’t seem terribly likely — if foreign investors are willing to continue buying sovereign bonds post-default, as they unequivocally are, it’s hard to see them refusing this basic financial service to private businesses. Or coming back to Argentina, is there any evidence that the demand for Argentine exports was reduced by the default, or that Argentina was unable to convert its foreign exchange earnings into imports because foreign exporters couldn’t finance the usual 60- or 90- or whatever-day delay before receiving payment?
Another version of this argument — which Nathan Cedric Tankus in particular made in the case of Greece — is that a country that breaks with its creditors will lose access to the routine payment system — credit cards and so on — since it is all administered by foreign banks. In the case of a eurosystem country this may have some plausibility, at least as an acute problem of the transition — over a longer term, I can’t see any reason why this is a service that can’t be provided domestically. But leave aside how plausible they are, let’s be clear what these claims mean. They are arguments that foreign investors matter not because of anything of value they themselves provide, but because of their ability to provoke a sort of secondary strike or embargo by other segments of finance if they don’t get what they want. These are political arguments, not economic ones. In the longer view, they also support Keynes’ argument that finance should be “homespun” wherever possible. If trade finance really is so critical, and so readily withdrawn, wouldn’t it be wise to develop those facilities yourself?
The final argument is that, if you have committed yourself to permitting the free creation of cross-border payment commitments, you will be unable to honor those commitments without a sufficient willingness of foreign units to take net long positions in your country’s assets. [6]
This one is correct. If, let’s say, banks in Argentina have accumulated large foreign currency liabilities (on their own, or more likely, as counterparties to other units accumulating net foreign asset positions) then their ability to meet their survival constraint will at some point depend on the willingness of foreign units to continue holding their liabilities. And unlike in the case of a bank with only domestic-currency liabilities, the central bank cannot act as lender of resort. In other words, the central bank can always maintain the integrity of the payment system as long as its own liabilities serve as the ultimate means of settlement; but it loses this ability insofar as the balance sheets of the domestic financial system includes commitments to pay foreign moneys. [7]
This, probably, is the real practical content of stories about how important it is to maintain the goodwill of footloose capital. If you don’t honor your promises to foreign investors, you won’t be able to honor your promises to foreign investors. The weird circularity is part of the fact of the matter.
[1] Needless to say, not every political development is covered this way. The fact that the bondholder’s view of the world so dominates coverage of Argentine politics is evidently related to the specific way that Argentina is integrated into the global circuits of capital.
[2] I really wish people would stop talking about “the crisis” as some kind of watershed or vindication for radical ideas.
[3] I emphasize domestic currency. Of course domestic banks cannot provide foreign -currency loans. But again, this is only a macroeconomic issue if the country is running a trade deficit. Otherwise, the foreign exchange needed for imports will, in the aggregate, be provided by exports. The same goes for arguments that portfolio flows allow the central bank to target a lower interest rate, as opposed to achieving one.
[4] It would be worth going back and seeing what positive arguments the original framers of the policy trilemma made in favor of “capital mobility.” Or is it just treated as unavoidable?
[5] In the 19th century, “default might even be welcomed as a way of enhancing political influence.”
[6] It would be more conventional to express this thought in the language of capital mobility or international financial flows, but I think the metaphor of “capital” as a fluid “flowing” from one country to another is particularly misleading here.
[7] The capacity of the central bank to maintain payments integrity by substituting its own liabilities for impaired institutions’ is preserved even in the case of foreign-currency liabilities insofar as the central bank’s liabilities are accepted by foreign units. So the development of unlimited swap lines between major central banks represents, at least potentially, an important relaxation of the external constraint and a closer approximation of at least the rich-country portion of the global economy to an ideal closed economy. I’m glad to see that the question of swap lines is being taken up by MMT.
