By Dan Kervick
Paul Krugman argues in a recent New York Times column that right-wing critics of Ben Bernanke and his colleagues are trying to bully the Fed into a misguided obsession with inflation, and that “the truth is that we’d be better off if the Fed paid less attention to inflation and more attention to unemployment. Indeed, a bit more inflation would be a good thing, not a bad thing.”
Krugman is absolutely right to lament conservative pundits’ and politicians’ obsessions with inflation when tens of millions of Americans are languishing in unemployment, with all of the personal, social and economic misery and waste that unemployment entails. But his argument, which assumes that the Fed can boost employment by engineering higher inflation, is problematic. He defends the inflationist approach this way:
“For one thing, large parts of the private sector continue to be crippled by the overhang of debt accumulated during the bubble years; this debt burden is arguably the main thing holding private spending back and perpetuating the slump. Modest inflation would, however, reduce that overhang — by eroding the real value of that debt — and help promote the private-sector recovery we need. Meanwhile, other parts of the private sector (like much of corporate America) are sitting on large hoards of cash; the prospect of moderate inflation would make letting the cash just sit there less attractive, acting as a spur to investment — again, helping to promote overall recovery.”
I believe this is the wrong approach. The Fed’s ability to boost employment is very limited, well-intentioned citations of the Fed’s full employment “mandate” notwithstanding. Rather than looking to central bankers and the banking system to accomplish a task for which they are not really cut out, we should turn our attention back toward fiscal policy as the primary tool for bringing the country up to full employment and keeping it there. And rather than seeking engineered inflation as the mechanism for boosting spending and employment, we should implement the MMT job guarantee proposal to achieve full employment and price stability at the same time.
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.
This worry about employers’ behavior is a real one. We don’t live in the old days of strong unions and the wage-price spiral that existed when economists like Krugman were cutting their teeth. We live in a permanent buyers’ market for labor characterized by persistently high unemployment and minimal worker bargaining power. As prices rise, many people’s nominal wages stay fixed or lag well behind the price level increase. Real wages go down and ordinary folks feel the sting of higher prices without the benefits on debt relief.
Doubts can also be raised about Krugman’s claim that people respond to inflation by increasing their propensity to spend their income. The idea is that in an inflationary environment, one is losing money just by holding money, so to the degree people expect higher inflation their incentive to spend rather than save increases. But while this behavioral response sounds plausible in theory, it might not be how people actually behave in practice. Instead, people worried about having to pay higher prices in the future and attempting to maintain a stable level of real expenditures over time might cut back on expenditures now to save for the expected higher prices.
A recent paper by Rüdiger Bachmann, Tim O. Berg and Eric R. Sims, based on data from the Michigan Survey of Consumers, makes this argument. The authors find that:
“… the impact of inﬂation expectations on the reported readiness to spend on durable goods is small in absolute value when compared to other variables, such as household income or expected business conditions. Moreover, it appears that higher expected price changes have an adverse impact on the reported readiness to spend. A one percent increase in expected inﬂation reduces the probability that households have a positive attitude towards spending by 0.15 percentage points. At the zero lower bound this small adverse effect remains, and is, if anything, exacerbated.”
In addition to these concerns about the efficacy of Fed-induced inflation as a tool for boosting employment, we should bring in a further consideration about the monetary policy approach to full employment. There is growing appreciation among economists who study the banking system that the Fed’s powers to engineer significantly higher employment are quite limited. The Fed’s influence on our economy is exerted primarily by its governance of the bank lending channel. But the Fed’s role here is primarily to maintain the smooth functioning of the interbank payments system by passively accommodating any increased demand for bank reserves that result from higher bank lending. Banks are not significantly reserve constrained. The lending comes first; and Fed accommodation comes later. The Fed can’t do much to make banks lend when the demand for credit among qualified borrowers just isn’t there. Scott Fullwiler’s recent New Economic Perspectives post on the Fed’s role in the banking system brilliantly outlines this line of analysis.
However, if one is really determined to boost demand, production and employment by pumping money into the economy, the clear preference should be for the fiscal pumps. Congress could pass a law directing the Fed to credit $500 billion to Treasury’s account, and then pass a series of spending bills directing how that money is to be spent. No new taxes; no additional borrowing. Just credit the money and spend it out into the real world. Demand and production are stimulated directly, rather than relying on the Fed-based, supply side approach of indirection and wishful thinking.
The direct fiscal approach might be inflationary, although the inflationary pressure from new money chasing goods and services in the market should be offset by the expanded volume of goods and services made available to meet the increased demand. But if there is inflation, at least ordinary people would be receiving the higher nominal income they need to cope with it.
Central bank induced inflation is sometimes supported by economists as a strategy for reducing the real wages of workers, in the hope that we then get higher employment by lowering the real cost of hiring people. 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.
But working people have already suffered enough. It is absurd to support lower real wages for working people as a tool for getting to lower unemployment. The real incomes of workers have been falling for years, while the ratio of CEO to worker pay in America is now in the hundreds, and massive amounts of the nation’s productive wealth are skimmed off the top of our economy by a bloated and wasteful financial sector in the American plutonomy. If there is another approach to full employment – one that does not place the burden of assisting unemployed workers on the backs of employed workers who are struggling themselves – we should take it.
The MMT approach to full employment is a federal job guarantee program that will stand ready to offer a job to anyone both willing and able to take it. Descriptions of the job guarantee program and the economic theories supporting it can be found in the writings of many MMT authors. One classic source is Warren Mosler’s article “Full Employment and Price Stability.” And two useful recent discussions of the MMT approach to employment and price stability, by Pavlina Tcherneva and William Mitchell, can be found here and here.
The job guarantee and other fiscal policy initiatives can only be carried out by politicians, not by central bankers. The exaggerated attention that pundits continue to devote to the Fed and monetary policy helps run interference for failing politicians, who are only too eager to continue to shirk their duties; to pass the buck to the convenient scapegoats at the Fed; and to promote the myths of monetary policy fixes for major economic challenges that require political courage and political solutions. The obsession with the Fed, and the public delusions of vast untapped central bank powers that these obsessions propagate, are a massive social distraction. There is no central bank shortcut to the goal of full employment. We need more politics and more action by Congress and the President, not more financial technocracy. It’s good to hold the feet of the powerful to the fire. But right now the wrong feet are being roasted.