Governments will always let inflation accelerate – apparently

Today the UK Guardian editorial – The Guardian view on Rishi Sunak: time to create jobs, not anxiety – endorsed the introduction of a Job Guarantee to alleviate the terrible unemployment situation that Britain will create in the coming 12 months. Existing programs from the British government are “too small and too reliant on private companies to help much”. Even after the pandemic is solved (hopefully via vaccine) “the unemployment crisis will remain”. That is a positive step from the Guardian. And, it runs counter to the way many progressives are viewing the solution box, with UBI still figuring among their main options. The problem is that the UBI cannot deliver on its promises to everyone. But this blog post is not about UBI. As the Job Guarantee gains more profile in the public debate, several mainstream economists are now taking aim at it. The latest attempt, which I choose not to link to because it is not worth reading in full, invokes one of the arguments that mainstream economists developed in the late 1970s and early 1980s to justify their attacks on discretionary fiscal policy and elevate rules-based monetary policy to become the primary, counter-stabilisation tool. It was, of course part of the neoliberal putsch that has seen sub-optimal outcomes ever since for most of us and superlative outcomes for the top ends of the income distribution. The reason I note this argument is because it is general in nature and should be understood. In other words, I do not have to talk about the paper that introduces this attack on the Job Guarantee, because it just mimics the standard criticisms of government policy making that have been around for ages. So any time some new government policy approach is proposed, these characters just whip out this tired old defense. But it is useful for my readers to be on the lookout for it.

In 1977, Edward C. Prescott and his former PhD student Finn Kydland published a paper entitled Rules Rather than Discretion: The Inconsistency of Optimal Plans in the Journal of Political Economy (85(3), pp. 473-492).

They published a few more papers on this topic in the ensuring years.

Their conjecture was termed ‘time inconsistency’ and they were awarded the (so-called but it is not) a Nobel Prize for the papers.

You can be sure that if some economists are awarded this prize that they are not threatening any of the mainstream fictions. In this case, their work was a fundamental building block to the anti-government policy paradigm that began with Monetarism, then morphed into Real Business Cycle theory, New Classical Economics and most recently New Keynesian economics.

What is ‘time inconsistency’?

Kydland and Prescott argued that (pp.473-474):

We find that a discretionary policy for which policymakers select the best action, given the current situation, will not typically result in the social objective function being maximized. Rather, by relying on some policy rules, economic performance can be improved. In effect this is an argument for rules rather than discretion …

How do they justify this conclusion?:

Current decisions of economic agents depend in part upon their expectations of future policy actions … In situations in which the structure is well understood, agents will surely surmise the way policy will be selected in the future. Changes in the social objective function reflected in, say, a change of administration do have an immediate effect upon agents’ expectations of future policies and affect their current decisions.

Okay, and their example?:

The issues are obvious in many well-known problems of public policy. For example, suppose the socially desirable outcome is not to have houses built in a particular flood plain but, given that they are there, to take certain costly flood-control measures. If the government’s policy were not to build the dams and levees needed for flood protection and agents knew this was the case, even if houses were built there, rational agents would not live in the flood plains. But the rational agent knows that, if he and others build houses there, the government will take the necessary flood-control measures. Consequently, in the absence of a law prohibiting the construction of houses in the flood plain, houses are built there, and the army corps of engineers subsequently builds the dams and levees.

So the government is seen as a sucker – they are forced by smart private sector decision makers into policy development that runs against socially desirable outcomes.

Conclusion: the government shouldn’t have discretion.

Okay, but see the logic flaw.

In most nations, government is not only responsible for building flood protection infrastructures (dams and levees) but also in charge of planning regulations.

If they were reluctant to provide the infrastructure up front and believed that residential development was harmful to social well-being then they can easily prevent it through the planning process.

Yes, that means rules are required, but that doesn’t justify banning discretionary policy shifts.

Kydland and Prescott also claimed that their analysis had implications for “aggregate demand management” aimed at addressing an inflation or unemployment problem.

So they were building on Friedman’s Natural Rate Hypothesis that said that if governments tried to reduce unemployment using fiscal policy initiatives all they would achieve was accelerating inflation because decisions-makers (consumers, households, workers, price setters) would expect higher inflation and build that into their pricing decisions (wage claims, mark-ups, etc) which would just drive the inflation rate up without reducing unemployment.

The only way that the government could stabilise inflation would be to allow unemployment to rise to the ‘natural rate’, which was invariant to aggregate demand management and had to be addressed via microeconomic reforms – cutting unemployment benefits, cutting minimum wages, deregulating occupational health and safety standards.

In other words, the whole neoliberal agenda.

During the 1980s, their estimates of the natural rate rose to ridiculous levels. At one stage, in Australia, in the late 1980s, mainstream economists were trying to argue that the rate of unemployment below which inflation would accelerate was in excess of 8 per cent.

I discussed that issue in this recent working paper – The Job Guarantee and the Phillips Curve (November 2020) as well as countless other papers and blog posts.

In my 2008 book with Joan Muysken – Full Employment abandoned – we provided an analytical approach to debunking the natural rate theories.

Kydland and Prescott claim that (p. 477):

The standard policy prescription is to select that policy which is best, given the current situation … such policy results in excessive rates of inflation without any reduction in unemployment. The policy of maintaining price stability is preferable.

They assume that “private agents or their agents have as much information about the economic structure as does the policymaker”. This is the standard claim of those who consider rational expectations to rule.

I considered that proposition in this blog post (among others) – The myth of rational expectations (July 21, 2009).

RATEX theory claims that individuals (you and me) essentially know the true economic model that is driving economic outcomes and make accurate predictions of these outcomes with white noise (random) errors only. The expected value of the errors is zero so on average the prediction is accurate.

Everyone is assumed to act in this way and have this capacity. So we all understand the QTM and understand that whenever the central bank expands the monetary base or the treasury increases the deficit there will be inflation.

So “pre-announced” policy expansions or contractions will have no effect on the real economy.

For example, if the government announces it will be expanding the deficit and adding new high powered money, we will also assume immediately that it will be inflationary and will not alter our real demands or supply (so real outcomes remain fixed).

Our response will be to simply increase the value of all nominal contracts and thus generate the inflation we predict via our expectations.

If there proposition was true, then there would be no need to undertake a PhD in economics because everybody already understands economics (the “economic structure”).

It is clearly not sensible to believe that households and firms know very much about what drives economic outcomes.

While my blog readership is probably more informed than most, can any of you predict with white noise errors only what is going to happen in the next 12 months.

Do you seriously believe that people use the myriad of financial and economic data to determine every spending decision they take.

Does anyone believe that households are always rational and perfectly informed about all current and future events?

When I was a graduate student, I recall reading a critique of RATEX from James Tobin where he said that if everybody is rational and has the same information as the government and uses the same “model” of the economy that the policy makers use then what use is the economics profession.

If we can get our forecasts from the person who delivers the post or around our kitchen tables what can we learn by studying economics (RATEX says nothing – so sack all the mainstream economists in universities).

Other than me, of course!

Why would we pay economic forecasting agencies (RATEX says they are useless because we already know what they are going to produce – so send all of them broke).

Their point about inflation and unemployment was that if the government committed via its central bank to a low inflation rate and sustained policy rates that delivered that outcome then all of use would come to believe that they were committed and act as if there was to be sustained low inflation.

However, if the government then changed that approach and decided the unemployment rate associated with that low inflation commitment was too high, and, as a consequence, increased spending, Kydland and Prescott claim that we would all know this would be inflationary and we would no longer beleive the government was committed to low inflation.

As a result, we would start hiking wage demands (to protect real wages) and firms would hike prices (to protect real margins) and the situation is “worsened by the discretionary policy”.

So there is nothing left for governments to do but hand over policy responsibility to central banks who have one aim – to lower inflation.

Enter the period of elevated unemployment rates, diminished real wages growth, rising inequality and poverty rates and all the rest of it.

And, the historical record shows that central bank policy is ineffective in altering the inflation rate. For how long have central banks been expanding their balance sheets (through QE bond purchases) to, in their own words, get inflation back up to their price stability targets.

With the massive deficits in Japan over three decades (nearly) where is the accelerating inflation.

The problem with all this time inconsistency stuff is that it is a closed system.

I can write out an economic model with starting assumptions that will prove anything.

For example, I could write a model that proved that government spending leads to my football team winning each week and jazz being played on TV every night. It would be true, within the boundaries set by the model.

But the model would be so preposterous that no-one would credit it.

Same deal here.

GIGO.

I have given other examples of the GIGO disease in economics in these posts:

1. GIGO … (October 7, 2009).

2. OECD – GIGO Part 2 (July 27, 2010).

3. A continuum of infinitely lived agents normalized to one – GIGO Part 3 (February 6, 2012).

Time Inconsistency and the Job Guarantee

Apparently the Job Guarantee will fail to deliver stable inflation due to ‘time inconsistency’.

The argument is simplistic and goes like this.

The authors recognise that the Job Guarantee is a buffer stock mechanism, which means it is an automatic stabiliser.

That means the outlays on the Job Guarantee program are counter-cyclical – rising when the non-government sector economic cycle is falling and vice versa.

So there is no activation needed to build the Job Guarantee pool – as non-government spending falls and job losses occur in that sector, the Job Guarantee pool will increase.

The government doesn’t have to do anything – it just happens as a result of other unconditional job offer.

But that is one aspect of the Job Guarantee, which most people have become familiar with – especially since the GFC and, now the pandemic.

And that is the context in which the UK Guardian Editorial was written yesterday.

The Job Guarantee is a superior mechanism for dealing with declines in non-government sector spending, which would other manifest as harmful unemployment.

But recall that I wrote this blog post – The provenance of the Job Guarantee concept in MMT (April 20, 2020) – partly, because when we set out to develop these ideas, our concern was with the high inflation that was present (for me in the late 1970s).

Which means that the activation of the Job Guarantee mechanism requires government to engage in discretionary policy action.

This is the point that the authors relate the time inconsistency argument to.

So, we start with inflationary pressures in the non-government sector rather than recession.

Mainstream policy says the central bank has to hike interest rates to suppress spending and the outcome is rising unemployment.

Rising unemployment disciplines wage demands by workers and margin push by firms and by transferring workers from the employed sector to the unemployment pool, the government (via the central bank) suppresses the inflationary episode.

This is the standard Friedman-Phelps-style disinflation exercise.

According to their theory, eventually unemployment settles at the natural rate so all is well. I recall Milton Friedman being asked how long a disinflation exercise might have to be engaged in to get the economy back to the ‘natural rate’ and he replied maybe 15 years!

Amazing especially when all the estimates of the natural rate just follow the actual rate up and down anyway.

Under a Job Guarantee, the inflation fight is different but still involves discretionary policy interventions.

Here the government has to tighten fiscal and/or monetary policy and transfer workers into the fixed price Job Guarantee pool. The rising buffer employment ratio (BER) disciplines the inflationary process eventually.

How high does it have to go? That depends but the logic would suggest that the rise in the Job Guarantee pool would be smaller than the rise in the unemployment pool. See the working paper I referred to above.

The government would have other discretionary options, which do not require less spending and/or higher taxes. They could alter administrative pricing rules for example (indexation arrangements in health care, child care, energy pricing etc).

They could change the regulative framework.

But the critics focus on one thing only.

They argue that governments will never increase taxes to curb inflationary pressures.

So, apparently, no government would use the buffer stock to discipline inflation because no one would want to see workers in the Job Guarantee pool. As a consequence, governments will never step in to curb the inflationary pressures.

Which means, according to the assumptions (GIGO) used to mount the argument, that the Job Guarantee fails to provide an inflation anchor.

Two responses.

First, focusing on increasing taxes exclusively (as an expression of fiscal policy intervention) is very narrow.

In Modern Monetary Theory (MMT), we talk about a role of taxes is to create real resource space in which the government can spend without competing for goods and services at market prices and causing inflationary pressures.

However, we never say that when faced with an inflationary environment, the only tool that government would use was taxation hikes.

That is not to say that they would not.

Clearly, history shows that government adjust taxes up and down.

Take the Japanese case, where the sales tax was increased several times (unwisely) since 1997. So to eliminate the possibility of tax rises is counter-factual.

Second, governments have a wider array of policies that can slow the economy down and they regularly use them, in many situations unwisely.

If there was no public acceptance of tighter policies, how can we explain the years of fiscal austerity? Clearly, that exercise has created years of elevated unemployment and other problems.

The point is that while the justification for austerity was spurious, governments did it and continued to be reelected.

Third, if you really believed that government could not use discretionary policy interventions to curb inflation, then even the mainstream approach is invalidated.

Central banks make discretionary interest rate adjustments. We have been indoctrinated to accept them even if they create unemployment (as a tool to fight inflation).

Why would the public tolerate mass unemployment under the mainstream orthodoxy and eschew Job Guarantee employment within an MMT orthodoxy?

The reality is that the public are not very well informed and governments use all sorts of framing exercises to condition our responses.

Conclusion

Apparently, anyone who advocated discretionary fiscal policy interventions is naive to political economy.

So we just should have balanced fiscal outcome rules which provide these smart economic ‘agents’ (us) with certainty and all will be well.

If you believe any of that, send me an E-mail and I have things to ‘sell’ (anyone want to buy the Sydney Harbour Bridge?! Cheap!)

That is enough for today!

(c) Copyright 2020 William Mitchell. All Rights Reserved.