Buffer stocks and price stability – Part 1

I am now using Friday’s blog space to provide draft versions of the Modern Monetary Theory textbook that I am writing with my colleague and friend Randy Wray. We expect to complete the text during 2013 (to be ready in draft form for second semester teaching). Comments are always welcome. Remember this is a textbook aimed at undergraduate students and so the writing will be different from my usual blog free-for-all. Note also that the text I post is just the work I am doing by way of the first draft so the material posted will not represent the complete text. Further it will change once the two of us have edited it.

This material was going to be in Chapter 12 on unemployment and inflation but I suspect we will put it into a separate Chapter given its centrality to understanding key aspects of the approach by Modern Monetary Theory (MMT) to price stability.

Chapter 13 – Buffer Stocks and Price Stability

13.1 Introduction

In Chapter 12, we discussed how distributional conflict between the claimants on real income could trigger inflation if the competing nominal claims (wages, profits) exceeded the actual amount of real income produced in each period.

We saw how this conflict could be triggered by increasing real wage aspirations from workers, rising profit rate aspirations from price setters (firms), and exogenous squeezes on available national income arising from, for example, an imported raw material price rise.

The underlying dynamics of the capitalist system is driven by the target rates of profit determined by firms. In this context, workers can create unemployment by seeking real shares of national income that undermine the capacity of firms to achieve the target rate of profit.

But this is not the typical marginal productivity theory argument that relates real wages to marginal productivity. Rather, the unemployment rises from a reduction in effective demand that follows firms withdrawal of investment spending in response to a squeeze on the rate of profit.

An inflationary spiral arising from demand-pull forces or cost-push forces still requires certain aggregate demand conditions to be maintained if that spiral is to continue.

As we saw in Chapter 12, this observation means that the concept of a supply-side inflation blurs with the concept of a demand-pull inflation, although their originating forces might seem quite different.

In this Chapter, we compare two broad ways in which price stability may be achieved. We construct the discussion in terms of a comparison between two types of buffer stocks both of which are created by changes in government policy aimed at reducing aggregate demand pressures that are fuelling the inflationary spiral.

The two broad buffer stocks we will compare and contrast are:

  • Unemployment buffer stocks: Under a NAIRU regime, inflation is controlled using tight monetary and fiscal policy, which leads to a buffer stock of unemployment. This is a very costly and unreliable target for policy makers to pursue as a means for inflation proofing.
  • Employment buffer stocks: The government exploits the fiscal power embodied in a fiat-currency issuing national government to introduce full employment based on an employment buffer stock approach. The Job Guarantee (JG) model is an example of an employment buffer stock policy approach.

The two approaches to inflation control both introduce so-called inflation anchors. In the NAIRU case, the anchor is unemployment, which serves to discipline the labour market and prevent inflation wage demands from being pursued. Under a Job Guarantee, the inflation anchor is provided in the form of a fixed wage employment guarantee.

To realign nominal aggregate demand growth to be compatible with the available real income, and hence break out of the distributional conflict, the government has to reduce demand growth while trying to promote increased productivity and investment in productive capacity (that is, expanding the supply potential of the economy). Expanding the supply potential of the economy is a medium- to long-term aim of the government and cannot be achieved in the immediate period.

That means that adjustments to aggregate demand growth are likely to be the focus of government policy when an inflationary spiral is threatening. Policy thus has to find a way to induce some labour slack into the overheating economy so that incompatible distributional claims abate.

We will see that a superior use of the labour slack necessary to generate price stability is to implement an employment program for the otherwise unemployed as an activity floor in the real sector, which both anchors the general price level to the price of employed labour of this (currently unemployed) buffer and can produce useful output with positive supply side effects.

The two different buffer stock approaches also define particular approaches to fiscal policy conduct. The NAIRU approach to price stabilisation sees the government spending on what we call a quantity rule. This means that the government budgets for a quantity of dollars to be spent at prevailing market prices to prosecute its socio-economic program.

Spending over-runs are usually met with cut-backs in an attempt to meet the budget estimates.

Conversely, the employment buffer stock approach represents a shift from spending on a quantity rule to spending on a price rule. Accordingly, the government offers a fixed wage (that is, a price) to anyone willing and able to work, and thereby lets market forces determine the total quantity of government spending that would be required to satisfy the demand for public sector jobs under the Job Guarantee.

In this Chapter we will explain how spending on a price rule provides the government with a superior inflation control mechanism. We will see that when the private sector is inflating, a tightening of fiscal and/or monetary policy can shifts workers into a fixed-wage Job Guarantee sector to achieve inflation stability without causing costly unemployment.

13.2 Unemployment buffer stocks and price stability

There have been two striking developments in economics over the last thirty years. First, a major theoretical revolution has occurred in macroeconomics (from Keynesianism to Monetarism and beyond) since the mid 1970s. Second, unemployment rates have persisted at the highest levels known in the Post World War II period and in the current crisis have sky-rocketed upwards.

The concept of full employment as a genuine policy goal was abandoned with introduction of the natural rate of unemployment hypothesis (Friedman and Phelps) which has became a central plank of current mainstream thinking.

It asserts that there is only one unemployment rate consistent with stable inflation. In the natural rate hypothesis, there is no discretionary role for aggregate demand management and only microeconomic changes can reduce the natural rate of unemployment. Accordingly, the policy debate became increasingly concentrated on deregulation, privatisation, and reductions in the provisions of the Welfare State with tight monetary and fiscal regimes instituted.

The almost exclusive central bank focus on maintaining price stability on the back of an overwhelming faith in the NAIRU ideology has marked the final stages in the evolution of an abandonment of earlier full employment policies.

The modern policy framework is in contradistinction to the practice of governments in the Post World War II period to 1975 which sought to maintain levels of demand using a range of fiscal and monetary measures that were sufficient to ensure that full employment was achieved. Unemployment rates were usually below 2 per cent throughout this period.

Under inflation targeting (or inflation-first) monetary regimes, central banks shifted their policy emphasis. They now conduct monetary policy to meet an inflation target and, arguably, have abandoned any obligations they have to support a policy environment which achieves and maintains full employment. Unemployment since the mid-1970s has mostly persisted at high levels although in some economies, low quality, casualised work has emerged in the face of persistently deficient demand for labour hours. In this case, underemployment has replaced unemployment.

As we saw in Chapter 12, underemployment acts in a similar way to unemployment as a disciplining force on workers’ wage aspirations and demands. It weakens the capacity of workers to secure nominal wages growth.

Thus, unemployment temporarily balances the conflicting demands of labour and capital by disciplining the aspirations of labour so that they are compatible with the profitability requirements of capital.

Similarly, low product market demand, the analogue of high unemployment as workers’ incomes fall, suppresses the ability of firms to pass on prices to protect real margins.

Thus by inducing labour slack into the economy, inflation targetting supported by passive fiscal policy leaning towards austerity, has created what Karl Marx called a “reserve army of the unemployed” and this reduces the chances of an inflationary spiral emerging from the wage bargaining process.

We have seen significant shifts in the distribution of national income towards profits since the mid-1980s as real wages growth has lagged behind productivity growth. This redistribution of national income has overridden the previous outcomes that emerged when strong trade unions met on more equal terms with employer groups to determine a distribution of national income that would be acceptable to both sides of the bargaining process.

But with trade unions weaker as a result of shifting industry composition towards services, smaller public sectors and anti-union legislation, the danger of wage-price spirals igniting have been significantly reduced.

As a consequence, the use of unemployment as a tool to suppress price pressures has, based on the OECD experience since the 1990s, been successful in that inflation is now no longer driven by its own expectations.

The empirical evidence is clear that most OECD economies have not provided enough jobs since the mid-1970s and the conduct of monetary policy has contributed to the malaise. Central banks around the world have forced the unemployed to engage in an involuntary fight against inflation and the fiscal authorities in many cases have further worsened the situation with complementary austerity.

The creation of unemployment buffer stocks is, however, very costly and becomes more costly as time passes.

It is well documented that sustained unemployment imposes significant economic, personal and social costs that include:

  • loss of current national output and income;
  • social exclusion and the loss of freedom;
  • skill loss;
  • psychological harm;
  • ill health and reduced life expectancy;
  • loss of motivation;
  • the undermining of human relations and family life;
  • racial and gender inequality; and
  • loss of social values and responsibility.

These costs are very large and are irretrievable. In terms of the goals of macroeconomic policy they also present a major conflict. AS we have learned a central idea in economics whether it be microeconomics or macroeconomics is efficiency – getting the best out of what you have available. We have discussed the difficulties that economists have in defining such a concept and the ideological dimensions of it.

But economists can put aside their difference and agree that at the macroeconomic level, the “efficiency frontier” is normally summarised in terms of full employment. The hot debate, which we covered in Chapter 12 concerned how we might define full employment. But it is a fact that full employment is a central focus of macroeconomic theory.

Using our macroeconomic resources to the limit is a key part of all macroeconomic theories. The debate is what that limit actually is.

But mass unemployment involves perhaps millions of workers (depending on which nation were are referring to) not producing any output or national income. This would violate our notion of macroeconomic efficiency under any reasonable definition of that term.

Further, persistently high unemployment not only undermines the current welfare of those affected and slows down the growth rate in the economy below its potential but also reduces the medium- to longer-term capacity of the economy. The erosion of skills and lack of investment in new capacity means that future productivity growth is likely to be lower than if the economy was maintained at higher rates of activity.

The overwhelming quandary that the unemployment buffer stock approach to inflation control faces is whether the economy, once deflated by restrictive aggregate demand management, can be restarted without inflation.

If the underlying causes of the inflation are not addressed a demand expansion will merely reignite the tensions and a wage-price outbreak is likely. As a basis for policy the NAIRU approach is thus severely restrictive and provides no firm basis for full employment and price stability.

It success as an inflation anchor requires a chronic pool of high unemployment.

The disciplining power of unemployment requires that the unemployed constitute a threat to those still in work so that they will moderate their wage demands. However, over time, the threat from this unemployment pool starts to wane as the unemployed endure skill losses and firms introduce new technologies and processes.

In this case, the so-called NAIRU has to be pushed higher and higher by contractionary fiscal and monetary policy for the same degree of threat to be maintained.

On any reasonable grounds, this approach to price stability is very costly and ultimately, unworkable in a modern economy. High and sustained levels of unemployment, ultimately, undermine the social and political stability of a nation, which creates unintended costs that go far beyond those itemised above.



I do plan to finish this discussion off next week.

Saturday Quiz

The Saturday Quiz will be back again tomorrow.

That is enough for today!

(c) Copyright 2013 Bill Mitchell. All Rights Reserved.

This Post Has 14 Comments

  1. Para starting “Two approaches to inflation…”. This para ties NAIRU to a regime where there is no JG. I’m baffled. NAIRU (on a broad or vague definition of the acronym) is simply the idea that there is a relationship between inflation and unemployment – an idea which Bill accepts. The validity or otherwise of that idea has nothing to do with the argument as to whether JG ought to be implemented.

  2. “anchors the general price level to the price of employed labour..”. Exactly how does JG do any “anchoring”? That is, if demand is excessive, then prices and the wages of those in regular jobs will rise willy nilly. The existence of a selection of people on some given JG wage won’t stop those price and/or wage rises.

    In fact just after the above passage, it says “We will see that when the private sector is inflating, a tightening of fiscal and/or monetary policy can shifts workers into a fixed-wage Job Guarantee…”. Quite right. I.e. it’s the “tightening of fiscal and/or monetary policy” that controls inflation, not JG.

  3. “That is, if demand is excessive, then prices and the wages of those in regular jobs will rise willy nilly. ”

    It works in exactly the same way as an unemployment buffer, except that the people so affected don’t become unemployed. The JG catches them.

    JG isn’t “full employment” in the sense bandied around by the basic income crowd. It creates full employment by turning the unemployed queue into an employable queue while increasing the amount and quality of common goods for all to exploit and enjoy.

  4. “Quite right. I.e. it’s the “tightening of fiscal and/or monetary policy” that controls inflation, not JG.”

    And the replacing of currently employed people (and threat of replacement) with the cheaper people on the JG buffer at the appropriate margins – which helps prevent wages from rising quite as fast as things tighten.

    Those people are cheaper because they are demonstrating they are employable on a current JG job rather than sat around somewhere being long term unemployed. That reduces the implicit cost of hiring risk making substitution cheaper.

    One of the functions of the JG is to flatten the wage rise curve as things tighten which gives you that little bit of extra space before you hit the inflation barrier. So you can be slightly looser with the monetary/fiscal response.

    Obviously as all buffers exhaust they become less effective. The JG buffer is effective for longer.

  5. Herewith two points.

    First, unless JG jobs are going to be hopelessly inefficient, they will require concomittant capital equipment, materials, and permanent skilled labour. But those “other factors of production” cannot just be bought from the existing economy, else demand rises, which exacerbates inflation. So demand has to be reduced, which draws people out of regular jobs and into unemployment or into JG work: not exactly the object of the exercise.

    (Alternatively if demand CAN BE RAISED without exacerbating inflation, then demand might as well be raised – creating extra regular jobs.)

    The solution to the above problem is to allocate JG people to EXISTING public sector employers where there is an EXISTING and decent supply of those other factors of production (as distinct from setting up specially created employers along the lines of the WPA).

    Second, Bill says, “Accordingly, the government offers a fixed wage (that is, a price) to anyone willing and able to work, and thereby lets market forces determine the total quantity of government spending that would be required to satisfy the demand for public sector jobs under the Job Guarantee.”

    Re the above mentioned “demand”, if that refers to those unemployed individuals who are attracted VOLUNTARILY to JG work, they must ipso fact find JG work more attractive than unemployment. But that REDUCES the relative attractions for them of regular jobs. And that means aggregate labour supply drops, which is inflationary (a point made about twenty years ago by the Swedish economist, Lars Calmfors).

    If the employability enhancing characteristics of JG outweigh the latter problem, then JG brings net benefits. If not, it won’t.

    The only way of making sure JG does bring the latter net benefits is to make it relatively “workfarish”: that is, not rely too much on the “demand” to which Bill refers, but rely on force, that is keep the JG wage relatively low and threaten to withdraw benefits from those who fail to take up JG jobs.

  6. BILL (or anyone who can help me) –

    I have a friend down here in Florida who I argue with about MMT. I ask him “when has a severe cut in government spending ever produced sustained economic growth?” His answer is invariably “1921 in the US” – he claims, that due to massive tax cuts and lower spending, these actions set the stage for the so-called “roaring 20s”.

    I check the relevant data and note that federal outlays dropped from 6.3 billion in 1920 to 5.0 billion in 1921 and then down each year to as low as 2.9 billion in 1924. Tax revenues soared during the same period, leading to large surpluses, pretty much the entire decade. I try to explain that spending was on a wartime footing (as high as 18.5 billion in 1919) and we brought back large numbers of troops from Europe and first there was a severe recession, but he claims the Mellon tax rate cuts spurred economic growth which led to those surpluses.

    What is the best answer for this data series? Are today’s economic conditions vastly different from the 1920s (aside from the gold standard of those times)? I could perhaps concede that lower taxes were a form of stimulus but it doesn’t seem they were enough to offset the large drop in federal outlays.

    Thank you much and I greatly enjoy your work.

  7. Melia, Perhaps this is the answer.

    National debts balloon during wars. It happened in the UK during the Napoleonic wars, WWI and WWII. Ditto in the US. However, the private sector is forcefully prevented from spending its newly acquired financial assets during the actual war. But that constraint is removed AFTER the war. So as debts mature after the war, the private sector finds itself with a nice inflow of cash, which boosts its spending. In fact it boosts it too much, and government has to confiscate some of that money via increased tax and/or public spending cuts.

    And if someone wants to get hold of cash BEFORE their debt holding matures, they can always use the debt as collateral to borrow from a bank.

    An alternative is for government to refuse to honor its commitment to convert the debt to cash, which is what the UK government did with so called “post war credits”. Those “credits” were eventually honored, but long after they should have been. See:


  8. Both WW1 and WW2 injected economy with large amounts of wealth (public sector indebtedness is the accounting counterpart of the private sector wealth) and with house price bubble it was estimated that households increased their spending by 6 cents for every additional dollar or housing equity. In other words people spend increases in wealth over long periods of time, that would explain roaring twenties after ww1. Economists used to talk about “pump priming”.

  9. “And that means aggregate labour supply drops, which is inflationary (a point made about twenty years ago by the Swedish economist, Lars Calmfors).”

    Even if it is is:

    (i) it stops the chase to the bottom helping income inequality and gets rid of employers that work on the undercutting model below the living wage. Minimum wage studies show that has no effect on employment quantities.

    (ii) Inflation only really affects money lenders. It’s positive for pretty much everybody else. This obsession with low inflation over everything else is entirely a neo-classical construct – pushed forward by the money lenders that funded the propaganda. All everybody else wants is a stable inflation.

    The job of the JG is to *replace* the unemployment buffer with something that does *precisely the same job*, but does it better.

    BTW capital letters mean that you are shouting on the Internet – as well as being harder to read.

  10. I want to defend Ralph Musgrave’s type-style but but not all of his points. An extended passage in capitals does imply shouting and it is also hard to read. Individual key words capitalised means emphasis is added to the words. They are not “shouted”. Capitalising of individual words is sometimes used when the font does not support underlining or the writer does not know how to generate underlined text in the application being used. For example, I don’t know how to produce underlined text here so I would be in the same quandry if I wanted to emphasise a word or phrase.

    It is all very well to talk about some JG jobs being potentially “hopelessly” inefficient. However, you must first contextualise this and recognise and acknowledge that the most hopelessly inefficient phenomenon of all is unemployment. The common inefficienies of unemployment are;

    (a) lost productivity of the unemployed.
    (b) welfare paid to the unemployed for no productive return
    (c) de-skilling and discouragement
    (d) health, social and crime problems attendent on idleness.

    In the case of unemployed with dependents, total welfare payments go close to equalling a wage anyway. If a JG living wage is paid and some (small) taxes levied on that living wage and other concommitant costs in the health and justice systems reduced, the net budget outcome may well be neutral. It may well cost the state and nation no more to employ many persons than to keep them on welfare. The knock-on effects of improved efficiency and improved aggregate demand will rapidly take the initiative into positive territory.

    There is much that needs to be done in our society and economy. One of the most urgent tasks is the complete changeover of our economy from fossil fuels to renewable energy. If this is not undertaken as a thorough-going emergency national transition led by dirigist government action then fossil fuel exhaustion and climate change will wreck our entire economy.

    The human economy is not free-standing. It depends essentially on three aspects of the environment or biosphere;

    (a) A relatively benign climate (the “Holocene Benignity”);
    (b) Stocks and flows of materials and energy from the environment (resources);
    (c) The environment’s waste absorption and re-cycling capacity.

    With respect to (b), stocks are finite and “one-use-only” resources. Once we have exploited certain stocks to their limit then we must revert to resources available as flows. For example, once all fossil fuels are substantially used or banned from further use due to climate change then we must rely mainly on incoming solar energy (a flow) and wind energy (also a flow and also generated by incoming solar energy). Once all ground waters and aquiferes are substantially depleted we must rely on rains and rivers (flows).

    Economists and financial advisers should understand that the position of humanity is now somewhat like that of a person on two incomes. One income derives from a large deposit which generates no interest and from whence capital is being drawn down to maintain an income. Natural capital in the form of fossil fuel deposits, ground water etcetera is being drawn down to fund our high energy, high consumption lifestyle. The other income derives from capital that earns interest in perpetuity. In this case investment in infrastructure to collect energy and material flows can (with maintenance and replacement) draw this income in perpetuity. We must make the transition and move our capital investment from infastructure which draws down the one-use-only deposits of materials and energy sources to the infrastructure which collects energy and materials from “perpetual” flows. These flows are “perpetual” so long as the sun shines ie. several billion years.

  11. “For example, I don’t know how to produce underlined text ”

    If you want to emphasise text then you should do that semantically using the emphasis html tag as described in the instructions below the comment box.

    So <em>I want to make this point</em>

    which gives

    I want to make this point

    Then the formatting of the page or the feed can alter the emphasis mechanism based on the layout of the page. Bill’s a gentle spoken guy, so the emphasis here is naturally understated.

    The established norm on the Internet is that capital letters is shouting. I literally hear it as that when I read the stuff. I and no doubt many others stop reading at that point because like most people I don’t like being shouted at.

    So it’s really down to whether you want to lose readers for what you have to say. All I can ask is “please don’t shout”.

  12. The entire “buffers stock” issue strikes me as irrelevant here. I just wouldn’t mention buffer stocks.

    When making the case for X, normal procedure is to concentrate on ways that X differs from the existing system or is an improvement on the existing system. And given that the existing system (unemployment benefit) has much the same “buffer stocking” characteristics as JG, why mention buffer stocks? Certainly where the JG wage is equal to benefits, the “buffer stocking” effect is much the same.

    Moreover, the main purpose of a buffer stock is to maintain or stabilise the price of something. And the price of unskilled labour nowadays is underpinned to a significant extent by, or primarily by minimum wage laws: which renders the whole buffer stock idea even less relevant.

  13. Very interesting work, I’ll have to study this in much more detail. Those familiar with my ramblings will know I’m trying to build a model of economics that properly includes feedback loops (the Black-Scholes equation neglects the impact of applying the Black-Scholes equation, which is why it became increasingly metastable in relation to use) and latencies (these are notoriously difficult to compute and, again, can vary as you become aware of them). However, I am a systems engineer/mathematician, I understand logic, relations and dynamics. A bottom-up approach if you like, from components on up. It’s valid, but it can construct an infinite number of possibilities, of which only one actually exists.

    It looks to me as though this theory is a much more top-down approach, a comprehensive analysis of what actually is and how it’s put together. The part of the puzzle I’m missing and could never hope to achieve using my own strategy. This is going to be a very interesting read, as it’ll help identify glitches in my own thinking – learning is good. In turn, my own thinking will allow me to ask questions of value as I progress through this work.

    In relation to job guarantee vs natural levels of unemployment, I quantify essentially the same harms as listed but also add in a latency factor. Skills rust when not in use, the longer they are not in use, the greater the rust. The effect is non-linear. Furthermore, industries evolve. In the case of quarrying, they change slowly but they obviously still change. In information technology, it’s a bit more rapid. Going from unemployed to employed, then, has a latency period equal to (recovery of skills + advancement of skills to current baseline) in which a company is paying wages but not obtaining benefits through productivity at the value expected. The productivity attained will probably follow something like the logistics curve, a very useful curve to be using when modeling any form of ramp-up.

    Yes, it’s only a short time when considering the average length of time spent at a job, but if you’re trying to examine a business in a field or geographic region that is coming out of recession (when this latency is going to be abnormally long and the financial buffer available to soak up that latency simply doesn’t exist), then this term must surely become dominant. Since it is an irrecoverable harm to businesses from unemployment, there must presumably be an extra table of such harms to business from unemployment in times of under-capacity, of which this is but one item on it.

    It seems reasonable, then, to suppose a third table must also exist, for the third major branch of society, that of government. If two variables in a three variable system are changing in the same direction, it would be truly bizarre to have the third remain constant. If it goes up, that would imply that the aggregate harm is less than the harm to industry or individuals. I can’t see how that could possibly work. The psychological impact of uncertainty tends to be to perceive more uncertainty than there really is. This implies that the government variable is going in the same direction as the others. It doesn’t just do so, factors are present, the psychological impact is the result of those factors (the factors have to be present first).

    These two additional tables are probably not dominant, overall, and it may be valid to ignore them. I say “may” because of these nasty surprises called “Black Swan Events” – events that shouldn’t happen, aren’t predictable using the thought processes of the time, but do happen and happen often enough that it has become a field of study in its own right.

    This leads me (finally) to my two questions.

    First, if we use this sort of analysis to try and expose hidden variables, do we find those hidden variables are either insignificant or dependent on the variables already exposed? (In either case, they’re of no importance.)

    Second, profit measures are a function of timeframe (strategic short term losses can result in long term gains that exceed any realizable value of non-strategic short term profits over the same long timeframe, for a suitable definition of short an long term), the latency involved in hiring someone being a good example. Since the taxation system is macroeconomic, can we falsify the conjecture that only microeconomic strategies alter the underlying unemployment rate?

    (In other words, can we prove that there exists at least one macroeconomic lever that demonstrably changes the underlying unemployment rate? Better still, where there is at least one value for one such lever that creates the set of periodic cycles shown by Feigenbaum to apply to all systems of this class? If both elements of the claim are falsified – that of no such macroeconomic lever existing, and that only one level of unemployment – ie: a constant – will work with stable inflation, you would successfully show that hidden assumptions exist in Friedman and Phelps’ work that don’t hold up to reducio ad absurdium.)

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