The Federal Reserve has recently received much criticism from economic conservatives who claim it has ignored inflation, thereby risking a rerun of the 1970’s inflation show. In response, renowned Princeton economist Paul Krugman has come to the Fed’s defense arguing today’s inflation is fundamentally different from that of the 1970s.
Krugman is right, but his arguments do more than defend the Fed. They also unintentionally demolish the foundations on which central banks have based monetary policy the past twenty-five years. In effect, re-thinking the inflation of the 1970s also compels re-thinking economic policy.
The essence of Krugman’s argument is that we are not watching a rerun of the ‘70’s show because this time round there is no mechanism for creating a price – wage spiral. That is because unions are now dead so that workers are unable to ask for wage increases that match prices. As an example, Krugman contrasts the United Mine Workers contract of 1981 which bargained a three year eleven percent annual average wage increase with current conditions. Where now are the unions demanding 11-percent-a-year increases? Indeed, where are the unions, period?
Today’s reality is indeed characterized by absence of a price – wage spiral mechanism, and it is the reason why the Fed’s easy monetary policy is unlikely to cause general inflation. However, that raises a critical additional point.
Recognizing that the inflation of the 1970’s was the result of a price – wage spiral triggered by conflict with unions over income distribution, compels rejection of the theory of the natural rate of unemployment. This theory has dominated economists’ thinking about inflation for over a generation and has twisted public thinking.
The late Milton Friedman was the originator of the theory of the natural rate of unemployment, yet according to Friedman unions have absolutely nothing to do with inflation. Instead, inflation is everywhere and always an exclusively monetary phenomenon. For Friedman, the only role of unions is to increase unemployment, which fundamentally contradicts the union wage – price spiral story of inflation
That means if the union price – wage spiral story of inflation is correct (which it is), Friedman’s natural rate theory is wrong and policymakers should abandon it. Instead, the focus of policy can formally return to probing the boundaries of full employment.
Moreover, since inflation involves conflict over income distribution, there remains an unsolved policy challenge of how to fairly distribute income at full employment without triggering inflation.
Seen in this light, it becomes clear that Friedman’s natural rate theory has been used to justify running policy in a business friendly way. Thus, in the 1980’s high interest rates were used to tamp down inflation, thereby causing unemployment and weakening unions by weakening manufacturing. In effect, fighting a price – wage spiral with high interest rates is a form of class based policy that breaks the spiral by undercutting the bargaining power of workers.
A final implication concerns the economics profession and its teaching of economics. In the 1980s Friedman’s natural rate of unemployment theory became the mainstay of economics textbooks. However, if the union wage – price spiral story of inflation is correct, it is time to re-write those textbooks. Today’s students deserve a theory that explains both the inflation of the 1970s and why the Fed is right in downplaying current inflation fears.
Natural rate theory asserts the economy self-organizes with full employment, and that inflation is the result of monetary policy trying to push the economy beyond the natural unemployment rate. The theory is fundamentally ideological and it flooded into the academy as part of the conservative capture of economics in the 1970s. It has always struggled to fit the facts, and now may finally be the time to discard it.
Copyright Thomas I. Palley
The nature of today´s inflation is indeed different. Steve Roach wrote last week on FT about Asia´s new export: stagflation. Wouldn´t Asia be the place to look for a wage-price spiral this time around? Aren´t wages growing fast in China? Isn´t China “ground zero” of the fast money supply growth of an “extended dollar zone”?
Since the ‘mechanism’ whereby labor adjusts wages to prices is ‘broken’, we have the seeds of revolution.
Or worse, social collapse…such as we are witnessing today.
Civil order is only maintained when the public believes their interests are being protected.
Once the public perceives that it’s interests have been abandoned, civil order breaks down…
Allowing the IB’s to dump billions of dollars worth of toxic paper onto the taxpayer’s back is viewed as a betrayal of trust.
The subsequent ‘destruction’ of the dollars purchasing power is confirmation of that betrayal.
When the people who do society’s ‘heavy lifting’ have to choose between food and filling their gas tank so they can report to work…the ‘end’ of civil order is close at hand.
Actually, at the New School 1980s we had a slightly different explanation for the “spiral.” The “action” in the prices change process was felt to have originate on the profit side rather than with wages, as the result of increasingly imperfect competition. Wages, as we now know, have been more or less frozen since the 1970s, so were neither important then nor are they important now. The preponderance of action (after the first oil price shock) was by increasing market segment imperfections then, whose preponderence holds, and who are now able to maintain market corners now, after the second shock. The mechanisms of the two episodes seem quite similar in spirit.
Bernenke knows full well that the Friedman theory of inflation is bogus, but he is trying very hard to not disturb the class-based Friedman doctrine while he walks this tightrope of raging inflation and falling employment/stagnant wages. His stance is calibrated to split the difference between a sagging economy and inflation that he knows is much worse than the rigged inflation metrics indicate in the hope that some miracle will bail him out. If there is not a significant upswing in US economy he will try to “hold”, but will likely have to “cut” again. These last two posts are just excellent, Mr Palley. Thanks.
Well done, Tom. Looking at the US from across the Atlantic, I hope that these new textbooks will (a) be written and (b) be translated and sold in Europe.
Milton Friedman is still very much alive here and the ECB has annnounced a preemptive strike for July against “secondary round effects” of the oil and food price shocks, i.e. against inflationary expectations. This is meant to give a strong signal to the unions in Europe: let the price shock feed through the economy without increasing the wages of your members, we won’t accept a wage-price spiral. There is, however, not the faintest indicator of European wage hikes spuring inflation. Inflation is now steadily beyond and above the 2 per cent target, but as is the case of the US this is coming from energy and food. Yes, this inflation is different from that of the 1970’s. Increasing interest rates in this sort of situation will not lower import prices but kill European growth . The ECB still has not learnt the lesson that you are so eloquently describing in your article.
Workers and their unions in Europe have always fought for a more integrated social Europe. The Brussels consensus of neo-liberal European politics has turned against workers and unions. Sadly enough, the sole institution that stands for true European economic integration is acting against Europe’s potential. High time that a turning tide in the US reaches European coasts!
I think the poltical dimension of the current inflation situation is evolving and potentially “up for grabs.”
There is growing unrest in many workplaces for either a 4-day week or more telecommuting options. Given that top managers are making so many times more than their workers, they will not likley give in because their consumption patterns are impervious to $4.50 per gallon gasoline. With little or no union presence in the US workplace and a rising unemployment rate, I’m not sure how willing workers will be to press their demands, but discontent is on the rise. I’m not sure how any Republican or Democratic policy will placate this anger, but I imagine the outcome of the inflation and housing crisis will likely be diminished economic standards and a continued political morass.
Real productivity growth in the US has recently risen with broad money growth (M2 measure) now at 6.3% (vs 7.1% a year ago). With absence of widespread pattern bargaining by labor unions (except in the entertainment industry) the ingredients for a stagflation scenario are not blended the right way like they were in the 1970s. The Fed has chosen a growth risk mandate by assuring that a debt deflation spiral resulting from “de-leveraging” bank balance sheets will be avoided. The risk of asset deflation (as caused by mass accumulation of debt by the US consumer) is very high if one simply look at the average % change in nation wide delinquincy rates and foreclosure rates. Investment and commercial banks (including credit unions and community banks) are constrained in capital and have tightened credit in the economy. If the Fed would reverse its policy to tightening it would risk further tightening of credit in the economy which will lead to a debt deflation spiral, not a wage-price spiral. It is in my opinion that at this point the risk for possible deflation outweighs the risk of inflation let alone stagflation.