Is the best NGDP targeter a union?

So, a good row in comments at Nick Rowe’s blog, about nominal GDP targeting. I think I should probably develop the argument a little more. This particular “leftie” has doubts about NGDP targeting because, basically, I think it relies on assumptions about political economy that don’t hold.

Chris Dillow argues that the Bank of England is currently operating something very much like an NGDP target, in that it seems to have decided that inflation being over target isn’t a problem as GDP is in the toilet. I would add that the UK Treasury has a declared policy of austerity plus “monetary activism” – i.e. a ZIRP, quantitative easing, and at least benign neglect of the sterling exchange rate. (Although it devalued sharply early in the recession, it’s now picked up somewhat, so you can’t really say that they have a policy of competitive devaluation. But they certainly aren’t trying to push it up, and I suspect they’d welcome it if the rate went lower still.)

Now, this policy is certainly managing to add quite a bit of inflation to the flat or falling real GDP. Even the relatively low-reading CPI is over 5%. This is probably helping with the debts from the Great Bubble, but is it working for the real economy? The problem here is that prices are rising at an impressive clip but wages aren’t. The simple truths of household budgeting can only mean that consumption, the biggest chunk of aggregate demand, will be declining and that’s precisely what the statistics show. On the following chart, the red line shows the change in private consumption, the green line shows the change in wages, and the blue line shows the change in the consumer price index. Consumption obviously tracks wages, but it seems to be strongly influenced by the spread between wage and price inflation.

UK households get squeezed by shadow-NGDP targeting

As a result, absent a massive export (what, with depression in the EU?) or investment boom (and a pony), the economy is going nowhere fast. If this situation persists, whatever is gained by inflating off the debts will be lost on GDP growth. The exact reckoning depends on how much the impact on wealth-effect of reduced debt helps demand vs. how much the squeeze on household budgets hurts it. But the key point is that the effects of the policy are working against each other, reducing its effectiveness

At this point, Nick Rowe accused me of being fallacious, being like Ron Paul (the guy whose newsletter advised readers to arm themselves in order to shoot at their black neighbours because “the animals are coming”, and worse, a big fan of let’em starve gold standard macroeconomics – stay classy, Nick), and being like Michal Kalecki. I guess that last one is an improvement.

His point is that, in theory, changes in the unit of account (like inflation) shouldn’t change anything in the real economy. Knock a zero off the currency, or tack one on, and relative prices – like pints of beer per hour of labour – should remain the same.

Well, that’s sensible enough in as far as it goes. However, it may not go very far. It’s trivially obvious that inflation (or deflation) does have different effects on different actors in the economy. People with lots of liquid savings lose out, people with debts benefit. People whose money is invested in bonds (if they aren’t indexlinked) lose out; people whose money is invested in shares tend to benefit. Entrepreneurs do well, rentiers don’t. In general, inflation (or deflation) changes the terms-of-trade between the present and the future. Inflation causes people to bring forward purchases, deflation to put them off.

To understand this, let’s work through the process. So there is inflation, and both prices and wages rise. But for some reason, prices inflate more than wages. Aggregate demand will, all other things being equal, be reduced. What happens if prices keep going up faster than wages? Eventually, they will price themselves out of the market and there will be a recession, which will eventually drag prices back in line. Mr. Keynes, however, will remind us that the long run can be very long indeed. If nominal prices were frictionless, of course, this wouldn’t be a problem, and I wouldn’t write this and you wouldn’t read this, and Nick Rowe would be out of a job as a macro-economist. We have to deal with the empirical realities.

Of course, I’ve left out an important actor here. What about workers? Sticking with the standard economic apparatus, you’d probably say that if prices inflate faster than wages, “wage bargainers” will integrate higher inflation expectations into their negotiating position and bid wages up. This is all very well if they can negotiate a raise. But we’re starting off in a recession, in the zero lower bound environment, with millions unemployed! Worse, we’re coming off 30 years of macro-economic policy designed to defeat the wage-price spiral – i.e. to damn well stop them bargaining wages upwards and to set expectations of wage inflation as low as possible.

This is where the political economy comes in. The idea of getting out of depression via NGDP targeting requires robust wage bargaining. In the absence of it, in a political context that has invested huge efforts in the destruction of expectations of wage growth, it is useless if not actively harmful.

There’s also another trap here. If prices have to overshoot and fall back in order for monetary neutrality to work, this requires deflation. Deflation is not generally considered – even by the most ferocious monetarist – to be a great recovery plan. And it is the exact opposite of an inflationary exit from a balance sheet recession.


Here’s a helpful chart of consumer price inflation and wage inflation in Canada from 1970 to the present day! As you can see, there is absolutely no spread between them. Or…is there?

Prices can rise faster than wages

21 thoughts on “Is the best NGDP targeter a union?

  1. Hi Alex:

    So this is where you hang out, at one of my favourite blogs?

    I’m still not sure whether or not you are guilty of that very particular fallacy called “the inflation fallacy”. So let me explain it to you, and explain why it is a fallacy.

    First off the “inflation fallacy” and the neutrality of money aren’t the same thing. (“Neutrality of money” is basically what you are talking about about, when you talk about changing the unit of account.)

    Every year I ask my first year students: “Why is inflation bad?”. And most of them give me that really puzzled or even pained look, as if to say “How come the prof can’t see what’s obvious?”. Others will wonder if it’s a trick question.

    What they are thinking is: “If prices rise 10%, that means we can only afford to buy 10% less stuff, so obviously we are worse off and inflation is bad. Duh!”

    That’s the inflation fallacy.

    What it ignores is that for every good bought the same good is sold. A rise in the price of apples makes the buyer of apples poorer but the seller of apples richer. We get our incomes ultimately from producing and selling goods.

    The exactly equivalent fallacy, seen from the other side, would say: “If prices rise by 10%, that means our incomes from selling what we produce go up by 10%, so we can afford to buy 10% more stuff. Duh!”

    The inflation fallacy is a fallacy because it ignores National Income Accounting. Income = Expenditure. Not (just) because it violates the Neutrality of Money (which is only partially valid anyway).

    Now, if you already know all that, and that isn’t what you were saying, then I apologise. But an awful lot of people (not just Ron Paul) don’t. Even very smart people, otherwise well-educated, often don’t get it at all.

    There may be (indeed there are) good reasons why inflation is a bad thing. But the inflation fallacy is not a good reason.

    Any serious discussion about whether or not inflation is a bad thing has to start by first clearing the inflation fallacy out of the way, and then going on to ask: “what caused the inflation?”. Because inflation itself is a symptom, not a cause. Some things that cause inflation also cause real incomes to fall. And those things are bad because they cause real income to fall, with inflation just a side-effect.

  2. >>We get our incomes ultimately from producing and selling goods.

    Yes, but most of us (one might hazard to say 99% of us) don’t live on profits, but on wages. Let us consider a simple model. Inflation in Canada is running at – say – 6%. When the union representing Canadian economics professors meets the vice-chancellors of Canadian universities to negotiate this year’s pay settlement, no doubt their initial negotiating position is 6%. But this doesn’t guarantee they get it. In one scenario they do. In another, the political realities are different, and they have to settle for 3%. In yet a third, zero. In which scenario is Nick Rowe more or less indifferent to inflation?

    Why would firms choose to pass increased nominal revenue on to their employees, rather than sticking to what looks a lot like an improved profit margin, if not because the employees demanded it? “Because otherwise they might be hired by the competition” just kicks the can down the road – that implies some other firm put up wages. Why did *they* do it?

    Yes, inflation is defined as a general rise in all prices. But we have to get there from here! Macrophenomena have microfoundations. My point is that the pass-through from goods prices to the price of labour is dependent on wage bargaining, and therefore on a political economy that treats it as acceptable. Otherwise, the long-run neutrality of money is enforced in a manner which is pathological with regard to the stated aims of the policy.

    Further, it’s very simple to demonstrate that inflation is not uniform with respect to different goods. How do we measure it? We construct a price index representing the weighted average of a basket of goods. Right. If all goods inflated at the same rate, we wouldn’t need to do this. You could measure inflation by looking at the prices of pencils, potatoes, prostitutes, or plutonium. Strangely enough, we don’t assume that inflation is uniform across all goods when we set out to measure it. Economists offer policy advice based on the assumption of uniform inflation, econometricians make observations based on the assumption of non-uniform inflation. It’s as if there was some distinction between empirical and faith-based economics!

  3. But if prices go up and wages don’t, profits have to rise. This may be bad in terms of income distribution, but why does it decrease demand? If you say because the savings rate is different, then, well, you want to lower debt, don’t you?

  4. We want to lower debt; that’s not actually the same thing as lowering net debt. People underwater on their mortgages don’t get much benefit from enterprises holding more cash on their balance sheets/rich individuals loading up on stocks.

  5. And, of course, TOO, over the last 18 months UK corporate earnings have been surprisingly robust and UK corporates have accumulated a great deal of cash. That does sound a lot like businesses managing to widen their profit margins in an environment of loose monetary policy and wage repression.

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  7. This is a good point that the profits from price inflation might end up being saved particularly if they are distributed towards the high end of the income scale (I’m not sure why you say an “investment boom” would be helpful right now – isn’t too much attempted investment i.e. saving, the problem right now?), or towards corporations.

    However, I think you and Nick Rowe are missing something here, which is that (aside from VAT rises) inflation is mainly coming from abroad. Nick Rowe’s argument above assumes a closed economy. Enriching Russian gas producers hardly helps the UK economy.

    But I don’t agree with your or Chris Dillow’s point that the Bank of England is effectively targeting NGDP. The BoE is worried about future domestic disinflation/deflation rather than temporary foreign inflation. And as I said below that post of Nick Rowe’s, according to Krugman, inflation is pretty similar in the US to over here. The Fed’s not targeting NGDP, and neither it would seem is the Bank of England:

    But never mind – the government has today announced that the way out of this mess is to attempt to reflate the housing bubble. What could go wrong with that (yet again!) creditor friendly policy?

    “The idea of getting out of depression via NGDP targeting requires robust wage bargaining”

    Does it? Why can’t we just print loadsa money and hand it out to every citizen? Of course, better workers rights would be good regardless.

    Oh, btw – the graph is confusing. Wage inflation and CPI inflation are on different axes with the zero at different points, so it’ not easy to tell what “the spread between wage and price inflation” is.

  8. Alex: “Let us consider a simple model. Inflation in Canada is running at – say – 6%. When the union representing Canadian economics professors meets the vice-chancellors of Canadian universities to negotiate this year’s pay settlement, no doubt their initial negotiating position is 6%. But this doesn’t guarantee they get it. In one scenario they do. In another, the political realities are different, and they have to settle for 3%. In yet a third, zero. In which scenario is Nick Rowe more or less indifferent to inflation?”

    This is a fairly classic example of the thinking behind the inflation fallacy. From the perspectives of the students and Ontario government that ultimately pay my wages, it is *my* wage increase that is inflation.

    Inflation is always *someone else’s* price increase, never my own.

    Look, I could spend the hour it would take me to properly fisk your original post and reply. But while the Eurozone is falling apart, mostly because of an irrational fear of inflation due to fallacious arguments like this, it’s just too depressing.

  9. But nevertheless Nick Rowe, inflation is hurting not helping the British economy. For fallacies to actually be fallacious, they should be empirically grounded.

    I was going to say that I’m not sure economics is a mature enough science for its evangelists to wave around “fallacies” as rhetorical end games, but then I realised that mature sciences don’t seem to have fallacies at all.

  10. Look, I could spend the hour it would take me to properly fisk your original post and reply.

    Why not? It might help get down the silly arrogance that your original post (and subsequent responses) stink of.

  11. Alex: “Nick…can you really not imagine that your annual wage settlement might not actually == the annual change in CPI?”

    Alex – can *you* really not imagine that I can’t imagine that??

    Do you seriously think that I think that real wages never ever change?

    Of course real wages change!

    Hey, I know! Since real wages = W/P, lets have the Bank of England really tighten monetary policy, and create massive deflation, so that that price level P falls by a really big amount. Mathematically, that will make real wages W/P really really high! Wow! that will make us all really really rich! My God! I wonder why economists never thought of doing that? What a brilliant idea! (sarc. Just in case.)

    Don’t you think there might be something wrong with that argument? Because it’s exactly the same as your argument, only in reverse.

  12. Err.. Nick… surely the point is that if the political economy has instituted upward wage rigidity (and increased downward wage flexibility a little) then the situation regarding W/P is no longer symmetrical?

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  14. Labour, 2008. QE1 announced. Mervyn King says there won’t be inflation because of the ‘output gap’ – all those factories running two shifts when they could be running three. BoE Pension Fund moves all its assets into inflation-proofed bonds.

    Sterling devalues by 25% (and the printed money goes into share and commodity prices). This raises inflation dramatically, because most of what we consume, especially commodities, is imported – those factories were non-existent divisions on the BoE map board. Wages are static, because mass immigration means it’s a buyers market for labour*.

    With prices rising and wages static, the only way to keep household consumption up is to send the wife out to work or spend on credit. But the wife’s been at work since 1989 – it was the only way you could afford the mortgage – and who’s going to increase their personal debts in this economic climate ?

    So consumption falls. Working people are getting poorer at around 5% a year. There’s a small increase in manufacturing for export, but the balance of payments is still massively negative. Retailers suffer, the economy flat-lines.

    OMG. The economy is not recovering ! Inexplicable !

    Conservative, 2011. QE2 announced. King, abandoning reality completely, says it’s because his magic crystal ball says inflation is going to fall dramatically. Sterling devalues again. This raises inflation again, because most of what we consume, especially commodities, is imported.

    Wages are still static, because mass immigration is still at record levels despite the crisis.

    So consumption falls again, as it must.

    OMG. The economy is not recovering !

    Inexplicable ! Time for QE3 !

    Rinse and repeat until UK real wages are at Chinese levels and pensioners are self-immolating in Parliament Square. Where’s Fernand Bonnier de La Chapelle when we need him?

    * Marx – “The main purpose of the bourgeois in relation to the worker is, of course, to have the commodity labour as cheaply as possible, which is only possible when the supply of this commodity is as large as possible in relation to the demand for it”

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