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Tricky

There are two reasons why modern macro irks me. First is that we simply don’t understand it, yet we act as if we do. Second is that for modern macro policy to “work” it has to rely on tricking people. And pardon me, but if we have to rely on tricking people for something to work, count me out.

Where does the trick come from? Right now you are surely aware that we’ve had a long, slow recovery – with unemployment at the time of writing still above 8%. Historically, macroeconomists noticed that employment picks up when inflation picks up and vice versa (the famous Phillips curve). Hence the calls for higher inflation today as a way to help us out of the employment slump. The problem with this idea is that it only works when firms and workers do not think inflation is happening. Each needs to be tricked into expansionary activity.

If firms do not notice that more money is floating in the economy but that the same number of goods and services are still out there, they may falsely think that the willingness of folks to pay more for their goods implies an increase in real demand for their goods. They will expand. Similarly for workers if they do not realize that the reason firms can pay them more is that they are able to charge more for their products, then they will be lured to accept jobs that they otherwise would not take (after all, if you are paid higher wages only to have to pay more for everything you consume, you are no better off).*

Without spending too much time illustrating, the point is that when prices unexpectedly rise, firms will expand and workers will accept jobs, but this is an illusion. The firms and workers are no better off under the high price world than the low price world, since the real amount of goods and services available in the economy is unchanged. The unwinding of these unnecessary expansions can actually leave both firms and workers worse off – unless we shoot the economy up with some more unanticipated inflation.

The point is, workers and firms are tricked – and ultimately these tricks leave them worse off. Now, where are the behavioralists out there? I thought the behavioral economics revolution was an effort to make people better off on their own terms. Wouldn’t the behavioralists be aghast at this idea? Or would they say that the tricking actually serves as a macro-nudge, at least in the short-term? Of course, that is odd, since the nudgers argue rather persuasively that people have discount rates that are way too high – so wouldn’t the behavioralists push for warnings that such inflationary policies are short-sighted and against our long-term interests? I regularly come across defenses of behavioralism indicating that the purpose of paternalism is not really to expand the power of government. Fine. Sure. But if that were really the case, then where are all of the paternalistic nudgers on this issue? Here is another example of what I mean. Here is another.

 

* That is not strictly true, as our micro students can show you.

3 Responses to “Tricky”

  1. Greg W says:

    I'd imagine the trick has a basis in narrow framing, even though mainstream macro doesn't think of it this way. Inflation, corporate sales figures, hiring numbers, salaries, and visible prices of goods in various markets all update at different discrete rates. In my mind, it's plausible that, even at a powerful firm with a small army of statisticians working under a few smart economists, you could see suboptimal decisions.
    Correct me if I'm wrong, but in aggregate stock market data isn't it apparent that investors base decisions on nominal and not real returns? Why bother stating anything in nominal terms at all? This would be the same effect, shown in hiring — and if firms are susceptible to the effect then individual job-seekers are hopelessly lost.

  2. Cedric says:

    Wintercow, I love this blog, so please help me understand why this post isn't complete nonsense.  You tell one story about how tricky inflation could leave people worse off — and I buy your argument — but one downside doesn't mean it's a bad policy.  You have to evaluate the entire societal benefits.  Inflation can assist with the deleveraging process that is necessary for an economy to recover from a recession. When NGDP plummets, like in late 2008, the world had the same resources available to it, but due to the massive NGDP shock, everyone was left with cheaper prices and lower wages, but the same nominal debts.  Milton Friedman says this was one of the big reasons with the Great Depression lasted so long — it took way too long to deleverage in a world of fixed nominal debts but lower nominal wages.  
     "If firms do not notice that more money is floating in the economy but that the same number of goods and services are still out there, they may falsely think that the willingness of folks to pay more for their goods implies an increase in real demand for their goods."
    That's one story, but let me challenge you with an alternate story.  Suppose that everyone is very aware that inflation is here. They are going to spend their money now so that it doesn't lose its value.  So where you say that hapless producers are fooled into thinking that real demand for their goods has risen, I say that they expect short run increased demand.  Either way, inflation helps boost short run nominal AD.  You don't need to trick people — and in fact, it might be better if people knew about inflation.  
    "The firms and workers are no better off under the high price world than the low price world, since the real amount of goods and services available in the economy is unchanged."
    This doesn't seem right at all.  You just admitted that in the inflationary world, more people get hired in the short run (and presumably they don't just sit around — they actually provide things), and you also seem to accept that inflation can boost short run nominal AD.  So it seems like inflation can absolutely boost the amount of real goods and services available in the economy.  
    Another way that inflation can boost employment is by solving the short run downwardly sticky nominal wages.  In a recession, a group of workers in a business would probably be better off as a whole if they all took a pay cut instead of a bunch of people being laid off — but layoffs is exactly what we see in a recession, and when we interview managers they say that pay cuts have such a huge psychological effect that its better just to lay people off.  In a world of inflation, managers can leave nominal wages the same or give small increases (thus avoiding the psychological downsides) but still give lower real wages.
    Another way inflation boosts employment is by boosting exports.  A weaker currency vis-a-vis a foreign trading partner's currency makes our goods cheaper, and thus more attractive on the international market.  A strong currency — and the related ability to import a lot more than you export — has to be earned.
    "The unwinding of these unnecessary expansions can actually leave both firms and workers worse off – unless we shoot the economy up with some more unanticipated inflation."
    True.  OR, the economy starts to recover because employment has risen, nominal AD has risen, and nominal debt decreases all thanks to inflation.  I don't think anyone wants inflation forever (though I would't put it past some Keynesians).  But what do you think about, say, Scott Sumner's NGDP level targeting suggestion?  You have a mix of RGDP growth and inflation or deflation that keeps NGDP on a level path, avoiding the big nominal shocks that cause depressions.  There's some pretty fantastic evidence that the countries that kept NGDP from plummeting in 2008-2010 are a lot better off than everyone else, even if it meant radically debasing their currency, like Iceland.  
    Even Hayek admitted later in life that he might have underestimated the damage that deflation could do in a world of stable nominal debt and short run downwardly sticky wages.
    I don't think we disagree that the big problems in the world economy have a lot to do with governments wasting resources through unwise fiscal policies or state-created monopolies, rigid labor markets due to unions and worker protection laws, etc.  I just think NGDPLT could be a great monetary policy to go along with a lot of other structural reforms that we need.  
     

    • Michael says:

      How does increasing the money supply shorten the deleveraging process? To me, it seems like it would make the process longer since it artificially props up things that need to go bankrupt. This is what I think is happening today, as well as the zombie companies of Japan.

      Also, if everyone knows inflation is coming and wanting to get rid of their dollars, why would someone not raise their prices knowing that the dollars aren’t as valuable?

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