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.

Cameron's 'full employment' pledge isn't very convincing

Earlier today in Ipswich, Prime Minister David Cameron pledged to turn Britain into a nation of “full employment”, aiming to overtake Germany for the top percentage of people in work. From the BBC:

The PM is aiming for Britain to have the highest percentage of people in work of any developed nation.

Labour said the Conservatives' promises would sound like "empty words" to the unemployed or those on low pay.

Mr Cameron's goal of "full employment" would involve the UK, currently 72%, overtaking Germany's 74% in terms of the percentage of people in work, said BBC assistant political editor Norman Smith.

There is no timescale, but it is an "aspiration which he wants to achieve", he added.

It’s a nice ‘aspiration’ sure, but Labour’s not the only group to think these are ‘empty words’ coming from the PM.

Why?

His pledge to bring full employment to Britons includes measures to increase the number of start-up loans provided by the government, as well as plans to invest in infrastructure, which he hopes will attract business and support new apprenticeships. But no word about changes to the minimum wage. Not a word about the personal allowance or National Insurance tax.

Research that my colleague Ben recently highlighted shows what a negative effect the minimum wage can have on unemployment – it's estimated that “minimum wage increases reduced the national employment-to-population ratio by 0.7 percentage point(s)” in the United States during the late 2000’s.

What’s more, a job is significantly less valuable to the newly employed if she is still unable to provide for herself and her family. At the same time the PM scraps the minimum wage, he should raise the tax-free personal allowance to the Living Wage, taking the poor out of tax completely. National Insurance tax should also be scrapped for low-earners, as it works as just another form of income tax.

A backtrack on minimum wage increases combined with pegging the personal allowance and NI to a Living Wage would be a serious indication of Cameron’s commitment to ‘full employment.’ But while he continues to spout plans for increased government spending and building, I remain unconvinced.

Unemployment, home-ownership and accommodation vouchers outside London

In a much earlier post, Tim Worstall pointed to the findings of Blanchflower & Oswald (2013), which is particularly important when considering that increasing home-ownership is something that the government has been encouraging. They showed “that rises in home ownership lead to three problems: (i) lower levels of labour mobility, (ii) greater commuting times, and (iii) fewer new businesses.” Alarmingly, they found that “rises in the home-ownership rate in a U.S State are a precursor to eventual sharp rises in unemployment in that state… a doubling of the rate of home-ownership in a U.S. State is followed in the long-run by more than a doubling of the later unemployment rate”. They also postulated that since “the time lags are long”, this could explain why “these important patterns are so little-known.” This means that the “negative externalities” felt from housing policy in this time-period may be felt further down the line and that future generations may be in for a nasty unemployment shock. In the UK, we have lots of council housing but still, we supposedly don’t have enough low-cost housing. Milton Friedman famously suggested that, if we want to continue funding education in a way whilst ensuring that it is of a higher quality than what is currently provided by state schools, we should introduce education vouchers. Analogously, if we insist that society should house those who cannot house themselves, why don’t we introduce accommodation vouchers or housing vouchers which people can spend either on an extremely cheap mortgage (though, admittedly, the claim is that we’re short of low-cost housing) or on going towards rent for another place.

If current tenants of council housing are given the choice between vouchers and their current unit, we may see enough people move out for the council housing itself to be sold to real-estate developers which would, therefore, enable development of more accommodation over and above pre-existing units. This would help plug some of the government’s budget deficit, possibly increase the amount of low-cost housing and ensure dispersion rather than concentration of relative poverty (this last possibility would enable effective local, communal altruism).

Of course, such a policy may not be feasible in London where rents are already very high (due to the government’s ridiculous land-use policies) since accommodation vouchers may only serve to increase them further. However, in the rest of the country, rents are far more reasonable and haven’t grown as quickly as they have in London.

Ultimately, the provision of accommodation vouchers in regions outside of London and the sale of council houses could raise some much-needed revenue and lead to reduced house cost and increased labour mobility at the cost of higher rents.

Challenging Shapiro on involuntary unemployment

A particularly famous efficiency-wages model was the one devised by Shapiro & Stiglitz (1984) - a ‘shirking’ model. The main assumption is that there is imperfect, asymmetric information and that workers have a choice to work or ‘shirk’ (exert little or no effort) and that there is a probability that employers catch them and that they don’t catch them. From this simple assumption, Shapiro & Stiglitz conclude that the wage-rate paid in the market will be an efficiency-wage that is higher than the market-clearing wage. The model predicts that there will necessarily be involuntary unemployment in equilibrium which supposedly acts as a ‘worker discipline device’ since it discourages workers from shirking because their being fired would mean that there is a possibility that they may not find another job. For those who are interested in a graphical representation, the graph below depicts the Aggregate Labour Demand (ALD) curve, the Aggregate Labour Supply curve (ALS – which also presumes a competitive labour supply), the Non-Shirking Condition (NSC) and the Efficiency Wage (EW) at equilibrium. Several of the underlying assumptions can be challenged, however. For example, since the state of technology enters the Aggregate Labour Demand relation and the state of technology is not static but it actually improves over time, when we take a dynamic view of the Shapiro-Stiglitz model, we find that the positive technology shocks consistently shift the ALD curve outward.

Furthermore, Shapiro & Stiglitz make a simplifying assumption that the worker believes the likelihood of finding another job (if fired) is equivalent to the proportion of unemployed people – this simplification means that, at the limit of full employment, the Non-Shirking Condition (NSC) cannot intersect with the Aggregate Labour Supply (ALS) – this means that full employment is a theoretical impossibility. In reality, however, people have individualised estimates with respect to how likely they are to get another job if they are fired (based, for example, on their estimation of their own ability, how well their skills match to vacancies and other variables) – this more realistic assumption makes full employment possible.

Remember, how the Aggregate Labour Demand curve experienced constant positive technology shocks over time? Well, this subsequently means that there would be full employment since the NSC and the ALD would intersect at or beyond the ALS curve as time progressed. However, the outcome of full employment here presumes static population growth. In reality, the population changes over time (generally, the ALS might shift right over time to signify an increase in the population over time) and, because of this, the conclusion of the model becomes ambiguous.

Simplified models yield nice conclusions whilst more complex models yield ambiguous results. With Shapiro & Stiglitz’s initially realistic assumption, one may have thought that involuntary unemployment was going to be an inevitable labour market outcome even in a competitive labour market. However, when relaxing the accompanying unrealistic assumptions, it’s not so straightforward.

Maybe Keynes was right after all?

It has to be said that we're not great fans of macroeconomics around here. Not enough good data from enough different places to definitively answer most questions: and that's before we get onto Hayek's point about simply not being able to calculate the economy without using the economy itself to do so. However, this makes us think that Keynes might well have been right on one point: It took far too long but Britain’s traumatic national pay cut is coming to an end. Even on the somewhat crude median earnings measure, pay is finally going up again, even after accounting for the effects of price rises. Wages are rising a little faster and inflation has collapsed, a golden combination for employees across the country.

Ever since the Industrial Revolution and the spread of capitalism, gradually rising wages have been the norm, apart from in wartime and during brief periods of extreme economic dislocation. The fact that this process went into partial reverse over the past few years despite the recovery came as a shock and helped to explain why so many people began to fall out of love with capitalism. It is therefore excellent news that normality is finally re-establishing itself.

One view of unemployment is simply that it happens when labour is more expensive than people are willing to pay for it. That's obvious in that one sense of course. The question becomes then well, how quickly will the repricing happen if we do ever get to that stage? There are those who insist that it happens immediately and thus unemployment and recessions cannot happen. Not an entirely convincing view. There are also those who insist that it can take forever and this justifies all sorts of interventions. And then we've got the evidence of the past few years.

It could be argued that labour in the UK did become too expensive. We had just had the largest and longest peacetime expansion of the economy after all. So, a repricing was necessary. And this is where Keynes could be said to be correct. It takes time because nominal wages are sticky downwards. People really, really, don't like lower numbers on their paycheques. They'll grumble about their real wages falling if it's disguised with a little bit of inflation but they'll riot if the equivalent fall were at a steady price level.

We don't say that the past few years prove it: only that what evidence we have is consistent with this explanation. And, given the paucity of our evidence base, that's probably the best we can do.

This isn't a rerun of 1930s poverty

Just a small reminder that whatever you see being shouted over in The Guardian and other points left this really is not a rerun of the levels of poverty seen in the 1930s. It's possible that it's a rerun of the inequality of those days (although we would vehemently disagree with that), it's possible, what with Syriza and the Front National, that certain aspects of politics are like they were in the 30s. But it really isn't true that we're anywhere near anything like 1930s levels of poverty. Here's what Dr. Barnardo's calls living in poverty these days:

Families living in poverty can have as little as £12 per day per person to buy everything they need such as food, heating, toys, clothes, electricity and transport.

In 1930s Britain the Public Assistance Committees would provide 22 shillings a week for a family of five, two adults and three children (the PACs being the safety net after eligibility for the dole was exhausted) . That is £1.50 a day per person. Yes, that's after inflation, that is £1.50 per person per day in today's money and at today's prices.

Around here we do not wish either living standard upon anyone: not that £1.50 a day which is some twice the amount that the absolutely poor, the hundreds of millions of them around the globe, still live on. Nor that £12 a day of the poor in our own society. That's why we work to improve economic policy so that the poor do get rich. Through the only economic system that has managed it on a large scale for any length of time, free market capitalism.

But the important point we want to make here is that those two numbers are obviously very different indeed. Whatever else is happening in the UK of today it just is not true that we are getting anywhere near either the living standards or the poverty of 1930s Britain. To claim so is to be entirely ignorant of the facts.

To Polly the populace are just the milch cows of the State

Polly Toynbee is bemoaning the manner in which UK wages aren't rising:

On Wednesday Steve Machin, research director at the LSE’s centre for economic performance, laid out to a meeting of economists the collected evidence on the nature of falling pay – and warned that this is beginning to look not like a slow recovery in wages, but a permanent, structural feature of the UK economy. He showed how the group-think of economic forecasters has consistently and wildly over-estimated an expected increase in wages: the OBR forecast for March this year was a wage rise of 4.3%. What happened has been a continuing real fall.

“There has been a startling and unprecedented lack of wage growth as unemployment falls,” Machin says. The “herd mentality” of forecasters is always to expect things to improve, but there is no sign they are right. This begins to look like the new permanent, as flatlining real median pay began back in 2003, long before the crash. Nor, finds Machin, is immigration a cause of falling pay: areas with high or low immigration saw pay fall equally.

Polly does at least pay lip service to the idea of being a Keynesian but I'm sure she would be surprised to find that Keynes would have been fully supportive of all of this happening. If people are unemployed then those people have to be priced back into work: and it was exactly Keynes who pointed out that people get very touchy indeed about falls in nominal wages but will put up with falls in real wages if they're lightly disguised by a bit of inflation. Further, the Phillips Curve comes out of very much the same sort of thinking. That there's a trade off between the unemployment rate and the inflation rate. We reach NAIRU (the non-accelerating inflation rate of unemployment) and if unemployment dips below that then inflation will rise. If it's above it then inflation will fall. And if we're seeing ever-falling unemployment and no sign of wages rises then we can conclude that NAIRU has fallen: which is absolutely great, for it means fewer people have to be consigned the the scrap heap of unemployment in order to keep inflation at bay in the future. We've had a favourable change in the basic structure of the economy.

However, the real shocker to us here is this:

Low pay is not just unjust, it’s crippling the country’s finances.

That's dangerously close to insisting that the populace are just the milch cows there to pay for the State, the sheep to be shorn of their incomes to pay for public employees. Actually, given that it's Polly saying it that's not dangerously close, that's what she means.