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Update to Wage Growth Does Not Necessitate Inflation

Marcus Nunes left a link to a Cleveland Fed Paper which has some interesting remarks about wage inflation and price inflation:

…since labor costs are a large fraction of a firm’s total costs of production, rising wages and compensation should put pressure on firms to pass these higher costs on as higher prices. We have several reasons to doubt the accuracy of this view. First, if a wage increase is brought about by increased labor productivity, it will not create inflationary pressure.3 Second, a wage increase will not create inflationary pressure if it leads to a squeeze in profits because a firm cannot pass along cost increases. No firm inherits the right to simply “mark-up” the prices of its output as a constant proportion above its costs; competitive market pressures strongly influence the pricing decisions of firms. Finally, causation could work in the opposite direction: An increase in aggregate demand may permit firms to raise the price of their products, and the resulting increase in profits would lead workers to demand higher wages in future negotiations.

And just in case you missed their meaning…

It turns out that the vast majority of the published evidence suggests that there is little reason to believe that wage inflation causes price inflation. In fact, it is more often found that price inflation causes wage inflation. Our recent research, which updates and expands on the current literature, also provides little support for the view that wage gains cause inflation. Moreover, wage inflation does a very poor job of predicting price inflation throughout the 1990s, while money growth and productivity growth sometimes do a better job. The policy conclusion to be drawn is that wage inflation, whether measured using labor compensation, wages, or unit-labor-costs growth, is not a reliable predictor of inflationary pressures.

So if the hawks could all stop clamouring that a tighter labour market means the start of a wage-price spiral of death, that would be great, and dare I say it, rational.

If your central bank crushes income growth…….

It is a self evident fact, given that wages are sticky, that if the sum of total income falls, unemployment must rise. What is less evident, but nonetheless true, is that Nominal GDP is tautologically equivalent to the sum of nominal incomes. What almost no one believes, but is true, is that the central bank has complete control of where it wishes to send nominal variables. Since it controls the price of money, it can always devalue money sufficiently to make it sensible to employ people again. Hurrah!

Some people believe that lowering the price of money is synonymous with inflation, but this is not the case. I lot of people envision inflation along the following lines: there is a stock of real goods, and a stock of money, and if the money supply increases faster than the stock of real goods, then we have inflation. This is an insufficient conception of inflation, in particular, this would mean that high fiscal multipliers would render money printing deflationary! Why? Because a high multiplier means that one dollar printed and spent generates more than one dollar in extra output.

To successfully conceptualise inflation, we must concentrate on money spent. If multipliers are high, then each dollar printed generates multiple extra dollars of demand, and multiple extra dollars in output. In an ideal world this would hold inflation at zero until output approached potential output, at which point extra stimulus will generate purely inflation and no extra real output. In the real world, we get some split between extra output and higher prices. At the moment in a depressed economy like Europe that split favours real output, as we approach full employment/supply side constraints, the split moves towards more inflation and less output.

The critical point is then twofold: in the current environment, monetary stimulus will not lead to inflation in the Eurozone. The second point is that we are in a severely disinflationary environment. Any time NGDP moves below trend, that is the definition of disinflation. Definitions of inflation based around the final prices of goods are a hostage to fortune, since it allows supply side shocks to prices to morph into demand side shocks. The costs of weak demand are immense, as years worth of output goes unused. The costs of supply side shocks which are correctly managed, is a slight one off rise in the price level.

Here is the unemployment graph for selected european countries, so we can all meditate on the ongoing human tradgedy, which is the cost of poor ECB policy:

Credit to SocGen via Alphaville for this one

And lets not forget that the forecast for improvement two years from now is simply the obligatory european forecasting tool of assuming that two years from now things will get better for no clearly specified reason except the general disbelief that they cannot get any worse. In 2010 the EU was predicting spain’s unemployment would peak in 2011 at 20%. That didn’t exactly go according to plan…


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:

By the time Lehman Brothers went under, income growth was already well below trend, with predictable results for default rates.

where as in the UK, Nominal income growth has been below trend since 2001,

That is a pretty big gap in incomes by 2010.

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.

The Slow Motion Train Wreck that is ECB Governance: Cyprus Edition

It is really, truly, colossally staggering quite how wrong the troika seems to be about this crises, its causes, and its solutions.

I banged on in my previous post about the importance of NGDP. NGDP is, essentially, demand. A large rise in NGDP will be split between RGDP and inflation depending on how responsive supply is to increases in demand. This split is not stable. It bears much resemblance to the arguments about money multipliers – if the multiplier is high it means a rise in NGDP will come in mostly RGDP, and little inflation. If they are zero you will get only inflation.

The same point is true in reverse. If you have a large fall in NGDP then it will be split between a fall in RGDP and deflation. One of the major problems in this crises has been that the the CPI the developed countries has not reflected this deflation. This is because wages are sticky, and so prices do not fall easily or quickly. Instead we get large unemployment and stagnant wages, possibly for years, until productivity increases make it possible to rehire workers at their original wage (since you seldom fire you’re entire workforce you can seldom rehire fired workers at lower wages than your current workers).

There is one place where this deflation does show up very clearly, and that is in governments and municipal budgets. Falling NGDP means falling tax revenues, and this puts pressure on wages. The result is that deficits have skyrocketed, resulting in a wave of municipal bankruptcies and even sovereign defaults. These are about the failure to meet nominal claims. If I am a government and agree a five year pay deal, I did that on the expectation of a certain level of inflation, if there is less inflation I am paying my employees more in real terms. In the US inflation is cumulatively about 7% below target since the crises. That means you would expect, all things being equal, a 7% budget deficit. Automatic stabilisers adjusting to large unemployment make things worse in practice.

A second place this shows up is in mortgage defaults. I have a nominal claim to pay $X a month for my mortgage. This is independent of the real value of that money. So among those who were lucky enough to keep their jobs, falling real wages causes an undermining of their ability to pay nominal contracts. This, if it goes on long enough, eventually undermines the stability of financial institutions. While certainly there was some risk taking in banks, by and large their ability to pay was based on the belief that central banks would keep NGDP growth more or less on track. It is no surprise at all that US banks, where the Fed has supported the recovery more or less appropriately, are back in a strong position. EU banks continue to wither, and Japanese banks have spent 20 years as zombies.

The key point is that NGDP falls inevitably cause financial crises if they are sustained. In the eurozone, where tight money continues to choke of NGDP growth, we are slowly working our way up from the bottom in causing financial, and then sovereign defaults. Here is a list of Eu countries by NGDP growth rates:

Notice anything about the bottom countries? Thanks to David Glasner for compiling this chart

The lower NGDP growth is below trend, the quicker the crisis comes. So Greece first, then Ireland, next Spain, then Cyprus. Portugal is doubtless coming. I don’t know anything about slovenia. France is missing its deficit reduction strategies. This is not a symptom, this is the cause. NGDP is completely within the control of the ECB. It is simply allowing eurozone NGDP to stagnate, to the misery of all concerned.

We are witnessing an abject failure of ECB governance, aided and abetted by the complete and dismal failure of the EU policy elite to grasp the problem at all. George Osbourne was quoted today saying that Cyprus’s problems were caused by too much debt, when in fact they were one of the best looking countries by debt statistics pre crisis.

So, if, beyond my bad tempered rant, I have a point, its this: Cyprus, this wasn’t your fault, and there’s nothing you can do, so leave the euro before the abject policy failures of the ECB and the EU condemn you to decades of pointless misery. Also, Portugal: You’re next.

Sticky Wages

This is a very quick observation to reblog a graph from a Krugman Column. Namely:

Further evidence of deflation.

This odd looking spike is further evidence that the US would be in deflation were it not for nominal wage rigidities. See my previous post for a more indepth comment.

The depressing state of the Eurozone

The ECB continues to destroy the Eurozone. Jens Weidmann continues to make a fool of himself pretty much every time that he opens his mouth. Austerity continues not only to fail but to destroy the economies of the Eurozone at the same time. Jens Weidmann warns France about the dangers of not sticking to austerity. The Fed has made history. Its growth and employment forecasts have now been more optimistic than the fact for forty consecutive quarters. A truly staggering observation.

They say that a picture says a thousand words. Well here is my picture.

The price of Failure

Unemployment in the Eurozone

Eurozone employment is now approaching 11%. The lessons of the depression tell us that unemployment will continue to increase every month that NGDP growth stays below trend. Marco Nunes offers us some graphical insight:

Credit to Nunes

The first graph shows the heart of the political problem in the Eurozone. If the Eurozone economy is to re-balance  Wages in Germany must rise, because German workers are more productive. Germany currently has 1.4 million workers earning less than 5 euros an hour. The real secret of German success is a vast underclass that works for a pittance combined with inflation so low that it prevents any meaningful re-balancing of wages. Rowntree will be weeping in his grave.

Germany workers must accept wage increases if the Eurozone economy is to re-balance  You would think persuading workers to accept pay increases would not be so hard, but as we all know, increasing wages is inflation. And there is nothing more certain than that the German political elite cannot accept inflation. Thus German workers accept less than their fair share, which crushes the periphery economies as they cannot compete on price given their relatively overpriced labour and lower capital investment. The Eurozone cannot recover without NGDP growth. Whatever NGDP growth you generate in the Eurozone will not be evenly spread until productivity has balanced out, so Germany `suffers’ from above trend NGDP growth even while the Eurozone falls apart due to insufficient demand.

Eventually, the price of labour will reach an equilibrium. Either through the relatively painless route of higher NGDP growth and some inflation in Germany, or through mass  unemployment and wage cuts, coupled with sovereign defaults, or through mass immigration from the worse performing regions into the better performing ones. Germany is ruling out the first one, happily imposing the second upon the Eurozone periphery. Even France has become a target of the Bundesbank due to its higher than agreed deficits. I fear that the near limitless capacity of Eurozone electorates to accept the pain imposed by the witless ECB is reaching its end.  The ECB has to act.

My pessimism about the ECB and its policies knows no limit. So I have put my money where my mouth is and have cashed out a substantial portion of my long positions in the equity markets last week.