Dan Kervick at Naked Capitalism discusses Paul Krugman’s advocacy of a monetary policy aimed at higher inflation rates. Krugman didn’t explicitly say this would be achieved through higher levels of aggregate demand, but I can’t imagine anyone thinking that Krugman meant the Fed should aim for higher inflation by reducing aggregate supply output. Kervick seems to make that assumption:
Krugman’s two main arguments for the beneficial results of inflation are questionable. First, he argues that inflation will help reduce private sector debt overhang. But inflation only reduces debt overhang in a significant way for households who are fortunate enough to see their nominal wages rise along with the general rise in prices. In today’s economy, workers are frequently not so fortunate.
Suppose you work 40 hours a week for $1000 of take home pay, and you have a weekly debt bill of $500 and a weekly consumption bill of $500. So you work 20 hours for debt repayment and 20 hours for consumption. Now let’s suppose prices rise by 5%. Then the same basket of consumption goods you purchased before for $500 now costs you $525. Your debt bill, which is fixed in nominal terms, remains $500 per week.
Suppose also that your employer does not give you a raise, but chooses to take advantage of the inflation by keeping your nominal wages right where they were at $1000 per 40 hours. Then the result will be that you will have to decrease your real consumption by 4.7%. You will continue to work 20 hours for debt repayment and 20 hours for consumption, but now your consumption will be lower in real terms.
Here’s a homework assignment for economics students out there. Explain Kervick’s argument using an AS/AD model. You will quickly see that it only makes sense if you assume the inflation was created by reduced AS. If it was caused by increased AD, then real GDP would have increased along with prices (assuming the AS curve is not vertical, and I can’t imagine an MMTer making that assumption.)
This is the classic problem of confusing shifts in AD with a movement along an AD curve. It’s true that higher prices would cause people to buy less if you assumed the AD curve didn’t shift, i.e. that their incomes were constant and the inflation was caused by less AS. But Krugman is obviously calling for the Fed to create higher prices via more AD, not less AS.
Never reason from a price change. If we stop talking about inflation and start talking about NGDP, it will at least be clear that we are talking about boosting AD, not reducing AS. At least I thought so, until I came upon this whopper from Kervick:
Yes, there are some people who still believe America’s workers are overpaid! In a recent post, Scott Sumner approvingly quotes Tyler Cowan, who has argued both against public sector hiring and for lower real wages. Cowan said, “the greater the number of protected service sector jobs in an economy, the more likely those citizens will oppose inflation. Inflation brings the potential to lower real wages, possibly for good.” Sumner then argued that Cowan’s considerations are a strong argument for favoring monetary policy over fiscal stimulus.
My post said nothing about wages, and I certainly didn’t endorse lower wages. (Although you wouldn’t know that by clicking on the link, because it doesn’t link to my post. I wonder why?) I was arguing that we shouldn’t aim for a higher inflation rate, but rather for higher NGDP. I thought MMTers also favored higher NGDP, I guess at least one does not.
I finally got around to reading a Steve Keen post mentioned by Krugman and Nick Rowe:
Sigh. The level of currency restrains lending? So banks stop lending as they approach the limits to currency set by the Fed’s printing of notes?
I can’t improve on the comments of Neil Wilson on Krugman’s argument here:
“Krugman needs to start attending the real world. The latest argument is utter tosh. For there to be a constraint in the real world, you have to have the actual power to stop another entity from doing something.
What Krugman is suggesting is that the Fed has the power to limit the amount of currency in issue. In other words he’s suggest that to control the economy the ATMs will be left to run dry and you will be told ‘no’ when you go and try and draw cash at the bank counter.”
[The first part is Keen, the second part is Wilson. Someday I need to learn how to double indent.]
Three hundred years of monetary economics is based on the notion that as money gets scarcer its value will rise. So if the Fed reduces the monetary base, you do not see ATMs run out of currency, rather the price of money rises. In the long run this means deflation, as the value of money is the inverse of the price level. But prices are sticky in the short run so less money may initially raise the opportunity cost of holding money, especially short term interest rates. (Whether rates actually go up depends on other factors as well, such as NGDP growth expectations.) Perhaps I misunderstood Keen (I seem to have misunderstood every other MMT quotation I tried to analyze) but it almost seems like he’s conflating the very different concepts of ‘scarcity’ and ‘shortage.’
HT: John Bennett