Monetary Policy and Inequality: Target Inflation, Wages, and Unemployment

I should describe the human race
as a strange species of bipeds
who cannot run fast enough
to collect the money
which they owe themselves
—Don Marquis

So I was in class listening to a discussion regarding the natural rate of unemployment this week and I had some serious issues I needed to think through. I wanted to question the methodology for determining unemployment’s so called “natural rate”, specifically the use of the Non-accelerating Inflation Rate of Unemployment (NAIRU) analysis for the natural rate of unemployment and the actual accuracy of the Phillips curve, which states  pi = pi_e - b(U-U_n) + v , . In this model π and πe are the inflation and expected inflation, respectively; b is a positive constant; U is unemployment, and Un is the natural rate of unemployment, or NAIRU; v is unexpected exogenous shocks to the world supply. (*See the end of the post for a note on the old model)

Without going into all the details, there are two crucial assumptions built into the concept of NAIRU: first, that inflation is self-perpetuating; second, that unemployment is inversely related to inflation , so that as unemployment goes down, inflation goes up, and vice versa.

The basic NAIRU analysis assumes that when inflation increases workers and employers account for expectations of higher inflation and create contracts that matches the expected level of price inflation to maintain constant real wages. That is, they expect high inflation and counter up their wages to maintain a constant level of real wages. Thus, to prevent ever increasing wages through contract bargaining due to higher labor demand, the analysis requires accelerating inflation to maintain a targeted unemployment level (hence the central bank target inflation rate).

The implicit assumption is that workers and employers cannot contract to incorporate accelerating inflation into wage expectations. However, there is no explicit justification for assuming that expectations or contract structures are limited in this way, aside from the fact that these wage arrangements are not commonly observed. Given a scenario with low unemployment, i.e. a higher demand for labor, why wouldn’t they adjust their wage expectations to reflect accelerating inflation? Why must the wage contracts lead to runaway wage increases and thus self-perpetuating inflation?

I want to challenge these fundamental assumptions. Why is inflation necessarily self-perpetuating? Why does low unemployment necessitate runaway inflation? Why couldn’t inflation rise initially and level off after these increases in inflation are incorporated into expectations?

My greater question is how the use of the Phillips curve (and the Taylor rule) negatively impacts monetary policy decisions. What is the consequence of a target rate of inflation? What is the impact of high employment on real rages? Does increasing globalization and world competition limit the ability of American firms to raise prices, and prevent workers from pushing for higher wages? Maybe this makes up more competitive globally, but what of the real-wage’s impact on domestic aggregate demand? How can we sustain growth if we can’t afford to buy domestic goods?

When I asked my professor about these questions, specifically regarding the relationship between inflation and unemployment, his answer was less than satisfactory. He responded that, yes, inflation is artificially created by the federal reserve, but the major increases of inflation are due to money supply shocks, such as those created by oil shocks. I continued imploring: If unemployment and inflation are linked, how is it that real-wages have not increased in more than three decades? How is this possible that inflation has persisted, that goods have continued rising in price, and that GDP has continued to grow and increase, yet no one has seen a rise in earnings? What’s happening here that I don’t understand?

More plainly, how the hell does our economy continue growing if prices are increasing, yet peoples wages, their buying power, has not?? How are we buying increasingly expensive goods if we don’t have any more money to buy them with? What is fueling our GDP growth for Christs sake?

But my professor wavered, he went on and on about money supply shocks and what not. I actually don’t think he could see the connection I was making, and given that class had been over for ten minutes and his next class was filing in to fill the seats, I could only express my appreciation to him for entertaining and clarifying my confusion which, in the latter case, he did not.

Of course, my convicted intuition is that debt is how, that people have been living on less and less, that necessary consumption has increased and surplus or luxury consumption has decreased. If you look at inflation, debt, and savings rate data, this is clear as day. In my mind, increasing debt and over leveraging have been sustaining domestic consumption for the past several decades. This is the only explanation for how an economy can maintain rising inflation and stagnating wages, yet increase its GDP. This is ALSO why I suspect we’re struggling as an economy right now, why our unemployment is so high and our demand is so low: after the recent recession there was a collapse in the debt market, specifically involving the housing market, and people experienced a massive shock to their balance sheets when the value of their net assets, like tied up in their homes, essentially dried up overnight. The hardest hit were those with large debt balances. Many people were forced to cut back consumption to pay off the massive debt they accrued for a house that’s significantly less valued than when they bought it. In order to get their finances in order and repair their impaired balance sheets households had to cut back consumption. This resulted in the drop in consumer demand we’re experiencing today. Though it’s all interrelated, this may be a little beside the point.

My main contention is this: monetary policy is ruining our country. The federal reserve is operating on behalf of corporate interests rather than in terms of the well being of the citizens at large.

What is the consequences of a target inflation rate of 2-3% in order to keep unemployment at 4-5%? The higher the unemployment, the lower demand for labor, and the lower the wage bargaining power. People can’t demand higher wages if there’s a surplus of workers desperately pandering for the same job: High supply means low demand. If we never allow for low unemployment, never experience a high demand for labor, wages will not increase because workers possess no wage bargaining power; that is, there’s no demand for hiring additional workers, especially at the wages they request to live on. The result? Wage stagnation (WSJ). Familiar?

I have much more to say, and perhaps I didn’t even say my intuitions too clearly here.

I’ll end by saying that I think financial liberalization, inflationary targets, and institutional bargaining power are the cause of wage inequality, debt, and unemployment. Basically all our problems.

I know there’s the whole international competition thing, but I don’t like the assumptions built into the NAIRU and the Phillips curve. I believe they are plain wrong.

*I’ll elaborate and expand on why is this significant later, specifically regarding the use of coefficients: The older Phillips curve, as the long run expectation equilibrium, states [ gP = [1/(1 − λ)]·(−f(U − U*) + gUMC) ] In this model: gp is the price inflation rate; f() function is assumed to be monotonically increasing; U is unemployment; U* is the NAIRU;  λ represents the degree to which employees can gain money wage increases to keep up with expected inflation, preventing a fall in expected real wage, and is presumed constant during any time periods; gPex is the expected inflation rate).


Financial Euphoria & Its Speculative Ruin

The recent financial and economic crisis is yet again the result of the same speculative orgy that happened not twenty years prior in the 1987 market crash. When the dust settled, the same inimical features culpably appear as reason for the disaster. As happened so many times in history, there was intense speculation that was fueled by misplaced faith in the lenders and rich. The association with intelligence and money contributed to a speculative boom that lead individuals to risks and over extend their confidence and credit. In addition, financiers at large investment banking companies were hailed for their seemingly innovative, yet unoriginal, practices of leveraging debt through financial instruments taking the forms of derivatives, securities and ARM’s (adjustable rate mortgages).

In the 90’s the US government passed a series of policies allowing home buyers to more easily secure mortgages through government backed debt. As more and more people began buying homes, housing values began to increase all over the countries. In attractive states such as Florida and Nevada, housing prices near tripled their original value. Lending companies began to underwrite mortgages well under standards to meet the demand and soon began pushing sub-prime loans onto home buyers. Many unworthy home buyers maintained poor credit, or bought multiple homes with hopes of flipping the home on speculation that its value will continue appreciating.

The speculative housing mania fostered the creation of massive MDS (mortgage backed securities) and subsequently CDO’s (collateralized debt obligations) which allowed shadow banking systems and credit markets to flourish while operating with little or no oversight. These and other “financial innovations”, nothing more repackaged debt being attractively marketed to meet investor demands, resulted in growing specious debt being incorrectly valued and over leveraged.

To hedge against risk, investors unloaded securities through CDS’s (credit default swaps) to mitigate against potential loss. These CDS’s allowed for more speculation as investors could basis trade on CDS spreads. As more and more loans defaulted, packaged MDS and CDO’s became riddled with unknown risk value and were dubbed toxic. These derivatives soon became worthless as panic stricken investors began selling bonds.

The banks bought these mortgage backed securities with the thought that, being backed by actual homes, they were fairly risk free. They predicted that the home values would sustain and that they could simply turn around and sell the properties at these high prices to compensate for any defaulted debt. In 2006 the crisis was set in motion when the housing bubble began to deflate as economic pressures forced home buyers to walk out on loans, leaving a wake of severely overvalued and ‘toxic’ securities in its path.

Major financial institutions, deemed credible and near prophetic with their steady gains, capitalized on the public’s gullibility for getting rich quick, as well as their short term memory of the financial crash just twenty years prior. These lending and banking institutions were thought to be “too big to fail” and garnered the pollyanna support of investors all over the world. As the housing market evaluations increased so too did the financial and banking markets in exponential disproportion.

In addition, individuals hailed as innovative financial frontiersman possessed the reputations that granted the support of willful and ignorant investors of all over. Such financiers included once NASDAQ chairman Bernard Madoff who masterminded a reminiscent Ponzi scheme that would rob investors of more than $60 billion. Hedge funds and the wealthy elite all over the world became victims of his vacuous enterprise.

As in all major financial disasters to date, the subsequent crash caused a sudden and permanent drop in US wealth as more than a quarter of wealth evaporated from their coffers. A decrease in consumption lead to an increase in unemployment above fourteen percent and the annualized rate of decline in US GDP reached closed to fifteen percent.

As the past has revealed, the aftermath of the crash caused a blind hunt to find and persecute the blameworthy. Everyone from the banks to the investors to the fed chairman and even the president of the US has been subject to scrutiny and called out for not predicting and preventing such an event. While regulation policies and reform measures followed, there was almost predictably no talk to the wide spread delusion and mania persistent throughout society which allowed for such a disaster to take place. Little blame was placed on the mass insanity of those who gullibly entrusted their money to “intelligent investors” of the financial community. Nor was their criticism of the baseless free-enterprise attitudes that the market is a perfect and neutral force absolved from external influences and inherent errors.

Those held responsible, mostly investment bankers and hedge fun managers, found their integrity and confidence completely ruined. As seen in the past, some fled in light of the impending crash, cashing out and leaving with their pockets full before they were apprehended as the cause. Many others, broken and shamed, thought suicide was the more appropriate measure for reconciling their guilt.

In the end euphoric speculation was the crux of the financial disaster as the masses became entranced with the seemingly boundless increases in the market. Vacuous financial innovations that leveraged risky debt were fabricated to promote and continue the growth. Those jumping on the bandwagon only fueled and reinforced the delusion. Caught up in the euphoric mood, many sage and perspicacious people overlooked the risks and the inevitable end that was to come.