The subject of today’s post is threefold. I believe that there is three large macroeconomic problems addressable via stabilization policy today, that being real wage stagnation, an expectations trap, and a productivity gap. Solving #1 is a matter of increasing macroeconomic competition at full employment, #2 is a matter of implementing the many plans laid out during in an effort to solve Japan’s liquidity trap, and number three can be solved by effectively-financed spending (and I will argue “effectively” central bank financing).
The Real Wage Problem
BEHOLD MY WORKS, AND REJOICE!
This graph denotes an unbelievably strong correlation between the employment level of the population and real wage gains. This is what we’re after! The question then becomes, “what causes this?”
Possibility #1: Productivity Translation
One possible cause of this is what I’ll call Productivity Translation. I make the assumption that higher employment is driven by inflation that reduces the burden of real wages on firms. If nominal wage inflation grows at a lesser rate than price inflation, as in wage stickiness, that means real wages are lower for the firm, inducing full employment. However, once full employment is reached, firms seeking labour productivity gains start to employ higher real wages where they once would have merely hired more workers.
Possibility #2: Power of the Money Supply
A second potential cause goes back to the monetarist view of the Phillips Curve. Essentially, the Phillips Curve is endogenous to the money supply- low inflation and high unemployment under tight money, high inflation and low unemployment under loose money1- and the Phillips Curve relationship does not always hold.
If high employment is driven by loose money, and not high inflation, it stands to reason that the competitive environment of full employment will cause wage inflation that is higher than price inflation. If there are fewer workers to attract, wages go up in relation to the standard inflation rate. Essentially, wages outpace inflation!
Here’s Alan Cole:
I believe this second possibility is more likely than the first because we cannot be sure of the transmission mechanism needed for scenario #1, whilst we have seen direct evidence for #2.
Interestingly enough, this view is most compatible with Friedman’s Nobel lecture2 as increased competition is a surefire real factor, albeit driven by a nominal factor. In fact, his Quantity Theory allows for inflationless money supply growth under certain circumstances.
Raising real wages will require large expansions of credit- of the money available to businesses and households- which will stimulate the economy and move us to full employment. It will be harder to find workers, so nominal wages will increase. As inflation expectations remain lower, this will cause increased real wages. So how do we expand the effective money supply?
The Expectations Trap Problem
The question has now become, “how do we increase credit?” In my opinion, the economy is trapped in an expectations trap, not only for inflation, which I believe to be relatively orthogonal, but for the effective supply of money. It is a different beast than Japan3, but we can draw certain lessons from the lost decade. Most of the broad money increases we have seen have translated into bloated bank balance sheets, not more money per se. If we want to inflate the effective money supply, we need to break out of the trap, which will involve both communicating a tolerance for a higher inflation rate and most importantly a commitment to more central bank balance sheet expansions.
Commitment to Be Irresponsible
One method discussed to break out of traps is in Krugman’s seminal 1998 paper on Japan’s liquidity trap4. While the “commitment to be irresponsible” method is talking about raising the future price level, it is important to note that in our case (where we care not for the interest rate, but for the money supply), the future price level is not a driving factor but a resultant of a higher effective money supply. The Fed will be expected to offset any inflation it creates by expanding available money unless it proves it won’t.
The way the Fed should do this is by redoubling on AIT, which creates expectations of looser monetary policy, and redoubling its balance sheet purchases. Specifically, the Fed should issue its own securities5, enabling massive, continued, sustainable QE, and start a direct-to-household check program, which will massively expand the effective money supply by bypassing banks. These certainly sound irresponsible, but if the Fed maintains credibility to such a large monetary expansion, demand growth is sure to follow.
While I won’t be advocating Svensson’s “Foolproof Way” in its exact form (I’m way too much of a Friedmanite to advocate pegging), I believe the paper that contains it adds another part to our path out of the trap. In addition to advocating for loosening the future price level path (the redoubling to AIT which I mentioned in regards to Krugman), Svensson mentions keeping interest rates at zero as part of reaching said path6. In our context, keeping rates as low as can be will vastly expand the money supply in the “real” economy, providing us with the demand boost we need and breaking us out of the trap.
How is the trap broken? Well, monetary offset is rendered impossible and expectations of future expansion are locked in by the credibility of flooring the interest rate. As the main policy mechanism, it holds a lot of weight.
The point here is that the central bank should be as absolutely aggressive as possible in restoring to growth. In my view, we are facing such a huge gap from potential that the central bank has a ton of room. Additionally, laying down such effective monetary policy allows for my next proposal, which is redoubling pseudo-“functional finance” policy.
Paying For Itself
My last point is quite unorthodox. It’s no secret I’m basically a Market Monetarist- but this last proposal is almost “functional finance”, Post-Keynesian, almost MMT. Essentially, while I have doubted fiscal policy in the past, my idea now is to allow for a massive program of spending on supply-side improvements while also expanding the money supply by allowing for the Fed to take the reigns and finance.
Who do you think wrote this?
If you guessed venerable MMT advocate Milton Friedman7, you’d be correct (that’s sarcasm, by the way). Wray, of all people, actually has a good treatment of Friedman’s proposal8. Essentially, the Fed would finance all the government initially, creating and destroying money to do so.
Modified for present day, what this proposal would entail would be the Fed issuing its own securities and using those to fund money creation that would ripple through the economy as well as fund massive revenue-neutral programs. This helps avoid the offset of stimulus, as well as gain the high multipliers and “M*V = P*Y” expansions of money-financed stimulus9.
The real economy is due for a massive spending program. While I love free markets, I wholeheartedly believe massive expansionary programs the focus on supply-side improvements help speed up economic growth and power the productivity of the economy. In my opinion, this is the best way to do one.
I’ll leave you all with this incredibly inane screenshot from Snyder’s cut of Justice League, which you shouldn’t see.
Sumner, Scott. “If it ain’t broke, don’t fix it”. EconLog, 5 Feb. 2021. https://www.econlib.org/if-it-aint-broke/
Friedman, Milton. “Inflation and Unemployment”. Nobel Memorial Lecture, 13 Dec. 1976.
Bernanke, Ben. “Some thoughts on monetary policy in Japan”. 31 May 2003.
Krugman, Paul. “It's Baaack: Japan's Slump and the Return of the Liquidity Trap”. Brookings Papers on Economic Activity, 1998 No. 2. See pp. 161, “If the central bank can credibly promise to be irresponsible-that is, convince the market that it will in fact allow prices to rise sufficiently-it can bootstrap the economy out of the trap.”
Tankus, Nathan. “We should Authorize the Federal Reserve to Issue its Own Securities”. Notes on the Crises, 16 April 2020. https://nathantankus.substack.com/p/we-should-authorize-the-federal-reserve
Svensson, Lars. “Monetary Policy and Japan’s Liquidity Trap”. NBER, Sept. 2005.
Friedman, Milton. “A Monetary and Fiscal Framework for Economic Stability”. American Economic Review 38, June 1948, pp. 245-264.
Wray, L. Randall. “A Monetary and Fiscal Framework for Economic Stability: A Friedmanian Approach to Restoring Growth”.
Galí, Jordi. "The effects of a money-financed fiscal stimulus". NBER Journal of Monetary Economics, 2019.