The Cause of the Crisis
Pretty much ever since the crisis of 2008, there are those who have been arguing that the sharp fall in NGDP/demand was the cause of the financial crisis, rather than the other way around. Further evidence has now come to light in both the US and the UK, courtesy of David Beckworth and Britmouse, suggesting that the causes of the crisis go back as far as 2005 at least, and largely vindicating the view that the fall in nominal incomes destroyed banks balance sheets. I strongly urge you to read the Beckworth post.
In particular, in the US, expectations of nominal income growth started falling in 2005:
where as in the UK, Nominal income growth has been below trend since 2001,
Interpreting why this happened is obviously tough, but I lay the blame on inflation targeting. If you wish to target the price level of outputs, in the face of real cost pressure on your inputs, you must restrict nominal wage growth. Since someones income is someone else’s expenditure, this means that you are restricting NGDP growth.
Ever since monetarism was put forward as a theory by Freidmann (and others), they have emphasised that there are two nominal variables which are important, income growth, and inflation. The first because income ultimately determines demand, and the second because nominal wage stickiness makes it hard for employers to adjust wages competitively. The first effort at monetarism, was the targeting of the monetary growth rate, the rational was that both incomes and inflation were strongly correlated to monetary growth. In the US and the UK this turned out to be a transient correlation, and money growth targeting failed (-although it largely succeeded in Germany and Switzerland for nearly thirty years, under a slightly different model, you can get a quick overview from this Mishkin paper).
The next logical step was inflation targeting. Why look to target some intermediate variable when you can target them directly. This works just great as long as the two remain strongly correlated. We targeted inflation and got stable income growth for free. :). Of course, this means that had we targeted nominal income/NGDP, we would have got stable inflation `for free’.
The graphs above demonstrate that this correlation started to break down. This is probably a result of falling world inequality. We outsourced a lot of our labour intensive manufacturing to countries where labour was cheaper. Now income in those countries are rising, and we in the developed world must therefore pay more for the basic raw materials that we use as inputs. Thus, by targeting two percent inflation under rising real costs, we crushed income growth. Over the long term this makes it harder for households to meet their debt repayments. Perhaps the small fall in income growth rate in the UK was stable enough not to contribute materially, but the much sharper fall in the US was probably the cause of the financial crisis.
The good news is that central banks can do a lot about this type of nominal problems. By expanding income growth we can put the unemployed back to work. On the other hand, rising wages in the developing world are not going away, so real cost pressures will remain, and higher inflation (in the UK) might be needed in order to keep incomes/demand on a stable trajectory. To my mind, a slightly higher price level is a small cost compared to millions sitting unemployed, so we should do that.
This picture also makes sense in of the UK’s productivity puzzle. If raw material costs increase 4%, productivity increases 2% and wage growth is 0%, we get get roughly two percent inflation. However, its not clear that this type of cost inflation is really captured by the productivity statistics. If productivity is measured by output, then it is negative in the above example, since I am producing the same amount of stuff at a higher cost, despite productivity increases.
A mixed bag for the Uk then: We must increase nominal wage growth to increase spending, and suffer slightly higher inflation as a result, since the central bank cannot overcome the real cost pressures that are a result of the rising living standards of much of the rest of the world.