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.
Chapter 13 – Buffer Stocks and Price Stability
[Continuing from Part 1]
13.2 Measuring the costs of unemployment buffer stocks
Under inflation targetting monetary policy regimes, central bankers use the persistent pool of unemployed (and other forms of labour underutilisation, for example, underemployment) as a buffer stock to achieve a desirable price level outcome. If their inflation outlook rises above their target rate they will induce higher rates of unemployment by increasing in interest rates until they are satified their inflation target is being met.
While some extreme elements of the profession, who still consider rational expectations to be a reasonable assumption, will deny any real output effects, most economists acknowledge that any disinflation engendered by this approach will be accompanied by a period of reduced output and increased unemployment (and related social costs) because a period of (temporary) slack is required to break inflationary expectations.
The real question then is how large are the output losses following discretionary disinflation? There is overwhelming evidence to suggest that the cumulative costs of this strategy in real terms have been substantial.
Economists measure these real costs in terms of sacrifice ratios, which is the accumulated loss of output during a defined disinflation episode as a percentage of initial output expressed as ratio of the accumulated reduction in the inflation rate.
For example, if the sacrifice ratio was two it would mean that a one-point reduction in the trend inflation rate is associated with a GDP loss equivalent to 2 per cent of initial output.
Figure 13.1 is a simple graphical depiction of the sacrifice ratio concept and captures the way most empirical studies have pursued the estimation of sacrifice ratios.
The cumulative output loss as a consequence of the actual output falling below potential output is depicted by the shaded area. In Figure 13.1, we have deliberately constructed output to resume at its potential level at the exact end of the disinflation period (defined as the period between the peak inflation and the trough inflation). This is the normal assumption adopted in empirical studies.
The depiction in Figure 13.1 assumes that the disinflation episode has a relatively finite, short-term impact on real GDP growth and before long the actual growth path converges on the potential path (which was unchanged by the policy change).
However, in the real world, it is clear that a prolonged period of reduced real GDP growth lasts beyond the formal disinflation period and that the potential real GDP growth path also declines as the collateral damage of low confidence among firms curtails investment (which slows down the growth in productive capacity).
As a consequence, the estimates of sacrifice ratios, based on the conception shown in Figure 13.1, will be biased downwards because they ignore the impacts of output persistence and hysteresis.
The concept of persistence means that actual output remains below its potential after the disinflation period has finished. The longer this output gap exists, the longer is the persistence.
Relatedly, hysteresis (in this context) refers to the permanent losses of potential output that arise as a consequence of the disinflation policy.
The important point is that to accurately estimate the sacrifice ratio researchers must not only consider the short-term losses but also the longer-term losses arising from persistence and hysteresis.
Figure 13.2 stylises the impacts of persistence and hysteresis arising from a disinflationary policy stance. It is clear that the real output losses are much greater than would be estimated using the restricted concept shown in Figure 13.1.
From the inflation peak, real output falls immediately as before. But after a time, the reduced levels of economic activity erodes confidence among consumers and firms. Consumers fearing even higher unemployment restrict consumption spending and firms respond to the lack of sales order by cutting investment plans.
Two impacts occur as a result: (a) the potential real output path falls (from Trough + x quarters on Figure 13.2), reducing the growth capacity of the economy; and (b) actual real output deviates from its potential path for much longer that otherwise would have been the case.
As a result, the estimated costs of the disinflation are much larger. Eventually actual and potential may converge but at that point there is less output and national income and almost certainly, persistently higher unemployment.
Economies reach a difficult point where the mass unemployment, initially caused by the failure of aggregate demand induced by the contractionary policy stance of the government, also becomes capacity constrained as a result of the falling potential output level.
The fiscal austerity policies pursued by governments during the global financial crisis also have had this impact. It is much harder to then restore robust growth because it takes longer periods to also ensure there is potential capacity to support it without triggering inflation.
Mitchell and Muysken (2008) drew on an extensive literature analysis and their own empirical work to conclude the following:
- Formal econometric analysis does not support the case that inflation targeting delivers superior economic outcomes in terms of reducing the costs of disinflation.. Both targeters and non-targeters enjoyed variable outcomes and there is no credible evidence that inflation targeting improves performance as measured by the behaviour of inflation, output, or interest rates.
- There is no credible evidence that central bank independence and the alleged credibility bonus that this brings bring faster adjustment of inflationary expectations to the policy announcements. There is no evidence that targeting affects inflation behaviour differently.
- Sacrifice ratios estimates confirm that disinflations are not costless; the average ratio for all countries over the 1970s and 1980s was around 1.3 to 1.4. Significantly, the average estimated GDP sacrifice ratios have increased over time, from 0.6 in the 1970s to 1.9 in the 1980s and to 3.4 in the 1990’s. That is, on average reducing trend inflation by one percentage point results in a 3.4 per cent cumulative loss in real GDP in the 1990s.
- Australia, Canada, and the UK, who announced formal policies of inflation targeting in the 1990s, do not have substantially lower sacrifice ratios compared to G7 countries who did not announce such policies. Australia does record a lower average ratio during the targeting period than in the 1980s, averaged across the three methods it is 1.2 per cent, however this figure is not lower than the average for all previous periods. Canada records a higher sacrifice ratio in the 1990s of 3.6 per cent. The ratio for the UK during inflation targeting is significantly higher at 2.5 per cent (relative to quite low sacrifice ratios in previous periods). Italy, Germany, Japan and the US, average 0.6, 2.3, 2.9 and 5.8, respectively.
[Reference: Mitchell, W.F. and Muysken, J. (2008) Full Employment abandoned, Edward Elgar]
The evidence is clear that inflation targeting countries have failed to achieve superior outcomes in terms of output growth, inflation variability and output variability; moreover there is no evidence that inflation targeting has reduced persistence.
Other factors have been more important than targeting per se in reducing inflation. Most governments adopted fiscal austerity in the 1990s in the mistaken belief that budget surpluses were the exemplar of prudent economic management and provided the supportive environment for monetary policy.
The fiscal cutbacks had adverse consequences for unemployment and generally created conditions of labour market slackness even though in many countries the official unemployment fell. However labour underutilisation defined more broadly to include, among other things, underemployment, rose in the same countries.
Further, the comprehensive shift to active labour market programs, welfare-to-work reform, dismantling of unions and privatisation of public enterprises also helped to keep wage pressures down.
It is clear from statements made by various central bankers that a belief in the long-run trade off between inflation and employment embodied in the NAIRU has led them to pursue an inflation-first strategy at the expense of unemployment.
Disinflations are not costless irrespective of whether targeting is used or not. An average sacrifice ratio of 3.5 in the 1990s means that any attempt to bring down inflation nowadays with 1 per cent-point will result in a cumulative loss in GDP of 3.5 per cent on average. In terms of unemployment the latter can be interpreted roughly speaking as a cumulative increase by 7 per cent.
The increase in the sacrifice ratio over time illustrates that reduced inflation variability allows more certainty in nominal contracting with less need for frequent wage and price adjustments. The latter in turn means less need for indexation and short-term contracts and leads towards a flatter short-run Phillips curve. Thus a consequence of inflation targeting is that the costs of disinflation become higher.
The late Franco Modigliani (2000: 3), who was one of the economics who coined the term NAIRU reflected on the legacy he had created:
Unemployment is primarily due to lack of aggregate demand. This is mainly the outcome of erroneous macroeconomic policies … [the decisions of Central Banks] … inspired by an obsessive fear of inflation, … coupled with a benign neglect for unemployment … have resulted in systematically over tight monetary policy decisions, apparently based on an objectionable use of the so-called NAIRU approach. The contractive effects of these policies have been reinforced by common, very tight fiscal policies.
[REFERENCE: Modigliani, F. (2000) ‘Europe’s Economic Problems’, Carpe Oeconomiam Papers in Economics, 3rd Monetary and Finance Lecture, Freiburg, April 6]
One of the major problems of inflation targetting as a policy paradigm is that it has been accompanied by a view that fiscal policy has to be passive and not compromise the inflation target. As a result economies have tolerated persistently high rates of labour underutilisation despite having achieved low inflation.
As noted earlier in the Chapter, persistent unemployment results not only in massive losses of real output and national income, but other real costs are also endured by the nation, including the depreciation of human capital, family breakdowns, increasing crime, and increasing medical costs.
These additional costs, in particular the depreciation of human capital, also mean that the effectiveness of the unemployment pool as a price anchor deteriorates over time, with ever larger numbers of fresh unemployed or underemployed required to function as a price anchor that stabilises wages.
Given the scale of these costs, it is unlikely that using a persistent pool of unemployed (or casualised underemployed) is the most cost effective way to achieve price stability?
13.3 Employment buffer stocks and price stability
An understanding of the macroeconomic principles developed in the course thus far would suggest that a better alternative to the unemployment buffer stock to price stability would be to utilise an employed buffer stock approach.
This might also be conceived as an alternative way of managing the unemployment program that the government deems necessary to attain price stability.
Thus 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.
Between 1945 and the mid-1970s, western governments realised that, with deficit spending supplementing private demand, they could ensure that all workers who wanted to work could find jobs. Although private employment growth was relatively strong during this period, governments were important employers in their own right, and also maintained a buffer of jobs for the least skilled workers; for example, in the major utilities, the railways, local public services and major infrastructure functions of government.
By absorbing workers who lost jobs when private investment declined, governments acted as an economic safety valve.
British economist Paul Ormerod (GET FULL REFERENCE DETAILS – quote from the Death of Economics) noted that the economies that avoided high unemployment in the 1970s maintained a:
… sector of the economy which effectively functions as an employer of last resort, which absorbs the shocks which occur from time to time, and more generally makes employment available to the less skilled, the less qualified.
He concluded that societies with a high degree of social cohesion (such as Austria, Japan and Norway) were willing to broaden their concept of costs and benefits of resource usage to ensure that everyone had access to paid employment opportunities.
The employment buffer stock approach – which is referred to in the literature as the Job Guarantee – refers to a policy framework where the government operates a buffer stock of jobs to absorb workers who are unable to find employment in the private sector.
Thus the government provides an unconditional, open-ended job offer at a given wage to anyone who desires to work.
THE REST OF THIS MATERIAL WILL BE FAMILIAR – BUT I WILL COMPLETE IT NEXT WEEK FOR THE SAKE OF OUR DRAFT WHICH IS GETTING CLOSER TO COMPLETION NOW.
Case Study: Britain and the 1976 IMF Loan
[NOTE: We are putting this Case Study into the book as it marks an important historical point in the full employment debate and the rise of monetarism]
COMING NEXT WE WILL READ WHY THE BRITISH PM CALLAGHAN WAVED GOODBYE TO SOUND ECONOMIC MANAGEMENT AND OPENED THE DOORS TO THE MONETARISTS AND THE REST OF THE INFESTATION THAT FOLLOWED – HERE HE IS WAVING GOODBYE]
NEXT WEEK I WILL ADVANCE THE BRITISH-IMF CASE STUDY. I HAVE A MASSIVE COLLECTION OF DOCUMENTS AND OLD SCANS THAT I HAVE COLLECTED OVER THE YEARS ABOUT THIS INCIDENT INCLUDING THE EXCELLENT BRITISH TREASURY FREEDOM OF INFORMATION REQUEST DOCUMENT SET.
WE WILL TALK ABOUT THIS NEXT WEEK.
The Saturday Quiz will be back again tomorrow. It will be of an appropriate order of difficulty (-:
That is enough for today!
(c) Copyright 2013 Bill Mitchell. All Rights Reserved.