Economic Nonsense: 11. Inflation is a price worth paying to boost employment

It used to be thought there was a trade-off between inflation and employment.  The economist William Phillips published a 1958 paper in which he found an inverse relationship between money wage changes and unemployment over nearly a century.  The relationship was called the Phillips Curve, and was used by legislators to stimulate the economy by inflation to boost employment rates.

Unfortunately the Phillips Curve went vertical in the 1970s as countries were beset by high inflation and high unemployment occurring simultaneously.  People were building expectation of inflation into their calculations and their economic decisions.  Inflation rewards debtors at the expense of creditors and makes people less ready to lend.  Investment in productive activity diminishes.

No less seriously, the assumption of future inflation makes forward planning difficult.  People do not know what money will be worth by the time their goods reach the market.  What inflation does do is cause misallocation of resources.  People see the new money created by government and make false assumptions about what they should invest in.  When they find that the demand was unreal, goods go unsold and there is an economic downturn with increased unemployment.  This brings about the ‘stagflation,’ in which high inflation and high unemployment happen together.

Inflation can reduce unemployment in the very short term, but only at the expense of more unemployment following afterwards.  This is why some governments have boosted inflation in an election year to take advantage of the apparent stimulus, then face the recessionary consequences after the election is safely out of the way.  The strategy is now called boom and bust because an inflationary boom is followed by a real-world bust.

A miracle cure for central bank impotence

Are central banks ever unable to create inflation? The question may seem absurd – why would we ever want them to create more inflation?

The typical answer is that deflation can be a lot worse than inflation. But this ignores the fact that prices can fall simply because we can produce things more cheaply. Falling oil prices mean cheaper production, which should mean cheaper consumer products. That’s ‘good’ deflation.

But ‘bad’ deflation, caused by tight money, can be very harmful, and indeed is what Milton Friedman blamed the Great Depression on. A variant of this view, which looks at market expectations, blames expectations of deflation for the crisis in 2008. Those of us who think that nominal GDP is what matters – since contracts and wages are set in nominal terms – recognise that deflation can knock NGDP off-course and cause widespread bankruptcies and unemployment that would not have taken place in a more stable macroeconomic environment. (Free banking, say.)

So if inflation is sometimes desirable, when it prevents deflation (or collapses in NGDP), the power of the central bank to create it really does matter. That’s where Paul Krugman and the Telegraph’s Ambrose Evans-Pritchard have clashed. In response to Krugman’s claim that central banks are impotent when their interest rates are zero, Evans-Pritchard writes:

Central banks can always create inflation if they try hard enough. As Milton Friedman said, they can print bundles of notes and drop from them helicopters. The modern variant might be a $100,000 electronic transfer into the bank account of every citizen. That would most assuredly create inflation.

I don’t see how Prof Krugman can refute this, though I suspect that he will deftly change the goal posts by stating that this is not monetary policy. To anticipate this counter-attack, let me state in advance that the English language does not belong to him. It is monetary policy. It is certainly not interest rate policy.

The piece is worth reading in full. I’m less convinced that ‘helicopter drops’ are actually needed now – if central banks said that they’d do as much conventional QE as it took to raise the inflation rate or NGDP level to x%, that may well be enough. But Evans-Pritchard’s basic point that central banks are never ‘out of ammo’ is what counts.

The ECB is fiddling while Europe burns

If not quite burning yet, the eurozone is kindling. For once, most people agree why: money is very tight.

The central bank’s interest rate is low, yes, but this is not a good measure of the stance of monetary policy. What matters is the interest rate relative to the ‘natural’ interest rate – ie, what it would be in a free market. It’s difficult to know what this natural rate is (as Hayek would tell us) but we can look at things like nominal GDP and inflation to help us guess. Both are way, way below levels that the market is used to. Deflation is back on the menu.

As Scott points out, whatever you think about the American or British economies since 2008, the Eurozone looks like a case study in central bank failure:

The eurozone was already in recession in July 2008, and eurozone interest rates were relative high, and then the ECB raised them further.  How is tight money not the cause of the subsequent NGDP collapse?  Is there any mainstream AS/AD or IS/LM model that would exonerate the ECB?  I get that people are skeptical of my argument when the US was at the zero bound.  But the ECB wasn’t even close to the zero bound in 2008.  I get that people don’t like NGDP growth as an indicator of monetary policy, and want “concrete steppes.”  Well the ECB raised rates in 2008.  The ECB is standing over the body with a revolver in its hand.  The body has a bullet wound.  The revolver is still smoking.  And still most economists don’t believe it.  ”My goodness, a central bank would never cause a recession, that only happened in the bad old days, the 1930s.”

. . . And then three years later they do it again.  Rates were already above the zero bound in early 2011, and then the ECB raised them again.  Twice.  The ECB is now a serial killer.  They had marched down the hall to another office, and shot another worker.  Again they are again caught with a gun in their hand.  Still smoking.

Meanwhile the economics profession is like Inspector Clouseau, looking for ways a sovereign debt crisis could have cause the second dip, even though the US did much more austerity after 2011 than the eurozone.  Real GDP in the eurozone is now lower than in 2007, and we are to believe this is due to a housing bubble in the US, and turmoil in the Ukraine?  If the situation in Europe were not so tragic this would be comical.

There is a point here. Economic news, by its nature, tends to emphasise interesting, tangible, ‘real’ events over things like central bank policy changes (let alone the absence of changes).

Of course that can be deeply misleading. The stance of money affects the whole economy (at least the whole economy that does business in nominal terms, which is pretty much everything except for gilt markets), and the Eurozone is experiencing exactly the sort of problems that the likes of Milton Friedman predicted that tight money would create.

Overall, the Euro looks like the most harmful institution in the world, except perhaps for ISIS or the North Korean govt. It may be unsaveable in the sense that it will never really be an optimal currency area, but looser policy (which free banking would provide) would probably alleviate many of the Eurozone’s biggest problems. Instead, what Europe has is the NHS of money – big, clunking and unresponsive to demand.

And the ECB seems wilfully misguided about what it needs to do. The only argument against this is that surely—surely—Draghi and co know what they’re doing. Well, what if they don’t?

Inflation drivel

Labour’s economic team—led by Ed Balls—is either confused and economically ignorant, or deliberately misleading and opportunistic. After Tuesday’s inflation release, they hit out at the government for the continued above-target rate (2.7% over the year to September, the same as over the year to August), as part of their new “cost of living” strategy. Spokesperson Catherine McKinnell said:

This is yet more evidence of the cost-of-living crisis facing families across Britain after three years of this Government’s failing policies. Prices have now risen faster than wages in 39 out of 40 months under David Cameron and now we learn that we have the highest rate of inflation of any EU country.

At the same time, shadow chancellor Ed Balls has repeatedly attacked the Tories’ fiscal austerity policies, blaming them for the extremely lacklustre recovery from the recession and even suggesting they may have been self-defeating. But at the same time he has also blamed above-target inflation for squeezing living standards.

But which is it? If the Tories were wrong to cut spending, it’s because the recession was driven by nominal factors, and cutting spending will further cut aggregate demand, only worsening the pricing mismatch that is leaving resources unemployed and output below potential. But we also know from our basic AD/AS model, the same one that we use to generate the result that falling aggregate demand is bad for output and employment, that higher AD means higher inflation. So if Ed Balls really wants more government spending, any of the models he’s relying on would also tell him he’d have to have higher inflation as well. You can’t criticise austerity and inflation.

But it goes deeper than this. What Ed Balls is missing is that actually the UK’s overall economic policy wasn’t particularly austere at all. Certainly at points it could have standed to be a bit easier, especially in the crucial 2008-2009 crash. But basically Ed Balls completely ignores monetary policy, which, in the final analysis, determines demand. The monetary policy committee, which sets rates and quantitative easing (QE) can choose whatever it wants demand in the economy to be. They use a faulty indicator, the consumer prices index. But they interact with the economy by constricting or expanding demand based on their policy goals (inflation close to 2%, stable output and employment).

Imagine the government decided to cut spending by £100bn (an illustrative number). If this was going to bring inflation down to 0%, from 2%, then the Bank of England would be changing its monetary policy if it allowed inflation to fall there. The Bank, knowing this, will manipulate interest rates and asset buying policy (QE) to make sure their goals are met. This is true even though the Bank’s current framework leaves so much to be desired. In 2010 and 2011 the Bank allowed inflation to go all the way up to 5.2%, meaning that they more than counteracted the effect of austerity on overall aggregate demand.

What this means is that Ed Balls, were he to slow down the pace of fiscal contraction and nevertheless bring inflation down to 2% now, would worsen the nominal recession, and yet redistribute yet more resources to state control. He may not know this—despite his economic education—or he may be staking out a deliberately misleading and opportunistic set of policies, playing on the public’s ignorance of economics.

Why we’re hoping the wisdom of crowds can beat Mark Carney

Today we’ve launched two betting markets to try to use the ‘wisdom of crowds’ to beat government economic forecasters. Here’s the press release we sent out:

The Bank of England’s economic forecasts have been wrong again and again. To counter this, the free market Adam Smith Institute is today (Wednesday 28th August) launching two betting markets where members of the public can bet on UK inflation and unemployment rates, taking the government’s experts on at their own game. The markets are designed to aggregate individual predictions about the economy’s prospects to use the ‘wisdom of crowds’ to beat the predictions of government experts.

The launch coincides with Mark Carney’s first major speech as governor of the Bank of England and follows his announcement earlier this month that the Bank will consider both inflation and unemployment when deciding monetary policy.

The markets (which will be run by bookmaker Paddy Power and can be accessed here) offer these odds:

UK Inflation on 1st June 2015
7/1 – 2% or Less
3/1 – 2.01 – 3.00%
9/4 – 3.01 – 4.00%
5/2 – 4.01 – 5.00%
7/2 – 5% or Greater

UK Unemployment rate on 1st June 2015       
9/2 – 5% or Less
3/1 – 5.01 – 6.00%
15/8 – 6.01 – 7.00 %
5/2 – 7.00- 8.00%
5/1 – 8% or Greater

Bookmaker odds tend to be far more reliable than expert opinions about sports, politics and the Eurovision Song Contest, because betters have a strong financial incentive to bet in a dispassionate way and betting markets collect the judgments of thousands of different people, eliminating individual biases.

Even if no single member of the public can beat the experts, collecting the local knowledge of thousands of people in betting markets allows for a much broader set of data points, weighted according to the strength of people’s beliefs. The Office for Budget Responsibility already collects around two-dozen expert predictions, but this is nothing like the kind of volume needed for the ‘wisdom of crowds’ effect to take place.

These markets follow the CIA’s attempts to use betting markets to anticipate geopolitical crises, which were short-lived because of public objections. In future, the Adam Smith Institute will use these markets to compare betters’ judgments about the direction of the economy to those of government forecasters.

Sam Bowman, Research Director of the Adam Smith Institute, said: “No individual can know enough about the economy to make a really reliable prediction about it. By combining the local knowledge of thousands of people, betting markets can outpredict any panel of experts. If these markets catch on, the government should consider outsourcing all of its forecasts to prediction markets instead of expert forecasters.”

Rory Scott from Paddy Power said “Mr Carney – forget your fancy financial models; let’s see where the great British public put their pound instead. Failing that, perhaps the solution to topping up the Bank of England coffers is to take advantage of Paddy Power’s 7/1 for inflation to be 2% lower come June 1st 2015.”