It’s Wednesday and I just finished a ‘Conversation’ with the Economics Society of Australia, where I talked about Modern Monetary Theory (MMT) and its application to current policy issues. Some of the questions were excellent and challenging to answer, which is the best way. You can view an edited version of the discussion below and…
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
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.
[NEXT WEEK – WE CONTINUE]
I do plan to finish this discussion off next week.
The Saturday Quiz will be back again tomorrow.
That is enough for today!
(c) Copyright 2013 Bill Mitchell. All Rights Reserved.