BEE Partner, South Africa Economy Watch

This rate has to be the target for which policy makers aim. If they try to reduce unemployment below this rate, they may temporarily succeed, but inflation will ultimately take off. If they raise unemployment above this rate, inflation will decline, but it will not stay lower, or even continue to fall, unless inflationary expectations are lowered. For this to happen, unemployment must stay high, but unnaturally high unemployment, coupled with lower than normal inflation, will lead employers to believe that real wages are exceptionally low. So they will begin to hire labor, and unemployment will move back to its natural level. Inflationary expectations are therefore unlikely to be lowered.

There are two immediate and quite decisive theoretical objections to this theorization. First, conventional theory cannot show that the ‘general equilibrium’ is either unique or stable. There may be any number of possible equilibria, and any or even all of them may be unstable. The system could switch from one equilibrium to another, or it could set off on an unstable path of movement. So the natural rate might not be unique, but could be changing, or even unstable. Secondly, the argument depends on the ‘Classical Dichotomy.’ The general equilibrium is supposed to be independent of what the monetary authority is doing, and, more generally, of what is happening in financial markets.

As a practical or empirical matter, the ‘natural rate‘ presents serious difficulties. The NAIRU is that rate of unemployment at which inflation holds steady; that is, at higher levels of unemployment inflation will fall, at lower levels it will supposedly rise. But surely it matters whether the natural rate is associated with a low or a high steady rate of inflation? Whichever it is, such apparently steady inflation rates have been associated with a large number of very different levels of unemployment in the last few decades. Even if a plausible definition can be given of the natural rate, it clearly has been moving in irregular and unpredictable ways.

In any case, Robert Eisner has shown that the econometric studies estimating the natural rate are seriously flawed. A very simple procedure demo_n_ strates this. Take all the levels of unemployment above the ‘natural‘ rate; these are, in fact, associated with reduced inflation, and higher levels of unemployment are associated with lower rates of inflation. But then consider levels of unemployment below the natural rate. These are not associated with higher rates of inflation. Sometimes lower unemployment goes with lower inflation, sometimes it does not. The relationships are all over the place. In general the conclusion has to be that raising unemployment is likely to lower inflation, but lowering it need not, and very likely will not, increase inflation.

It has been shown that the alleged linkage between inflation and unemployment is actually quite weak. What is true is that inflation can be slowed down or stopped by creating enough unemployment. It is not at all clear that inflation is necessarily set off by high demand, and moreover, it is obvious that many other things can trigger inflation, for example, exchange rate changes, primary price increases (oil shocks), etc. But stopping inflation by creating unemployment is extremely expensive in terms of forgone output, especially forgone growth. So the question arises whether inflation could be controlled in some other way.

After all, with the development of the postwar modern economy, we have seen a change in the size of government relative to the rest of the economy, and the government has taken on many new functions. Moreover, the way the government interacts with the economy has changed, in particular the way the government budget relates to the monetary system. The government budget tends to be counter-cyclical, and government borrowing is an important component of interest rate policy.

Reinvesting Automatic Stabilizers for the Modern System

In the modern economy, government spending is largely defined by various needs of the economy, so it tends to be independent of the cycle. The exception to this is welfare spending, which tends to rise in a slump and fall in a boom. Tax collections, on the other hand, will increase in a boom, and decline in the slump. So the government’s budget in the modern economy will tend to run into deficit in the slump, and is likely to exhibit surpluses in a boom. This, of course, tends to have a stabilizing effect on aggregate demand. The question is, can this be extended to providing a stabilizing effect on wages and prices?

Consider a stabilization program that will help to maintain the value of money — a program that sets a pool of labor to work for a fixed money wage, where that wage is stabilized by operating the pool as a buffer stock. The government sets up a set of public works programs — an employer of last resort

(ELR) system — that will hire anyone wanting a job for what effectively becomes the minimum wage (Harvey, 1989). Many of these jobs will involve training and education or re-education; others will provide goods and services that have public value in the form of externalities, but are not profitable on a private basis. Whenever the private sector expands, it can hire from the ELR, attracting workers by offering a wage marked up above the ELR wage; whenever it contracts, its laid-off workers can take jobs in the ELR.

On this proposal, ELR spending will substitute, largely or in part, for welfare and unemployment compensation. Tax collections will fall in a slump, though not so sharply, since ELR wages are less than private sector wages. Hence the Government’s budget will continue to be counter-cyclical. But now it will also act to stabilize the lower end of the wage scale. It provides an anchor. Of course, this will not tie prices down perfectly. Like all anchors, it could be dragged by strong enough forces. For example, varying sectoral demands could lead relative wage scales to change, or the markup over some kinds of wage costs could vary. But even so, the stabilization of the lower end of the wage scale would provide a dampening effect. In short, the modern monetary system permits, though it does not cause, inflation; but today’s counter-cyclical government budgets can be extended and adapted so as to counteract inflationary pressures.

Possibly related posts: (automatically generated)
The Link Between Inflation and Unemployment continue…

• The Link Between Inflation and Unemployment
• Link Exchange
• THE JOB GUARANTEE AND INFLATION Part 1
• The Monetary System and the Government continue…
• THE JOB GUARANTEE AND INFLATION Part 3
• The Monetary System and the Government
• Modern Money — Asset and Liability
• THE JOB GUARANTEE AND INFLATION Part 2
• THE JOB GUARANTEE AND THE BUDGET DEFICIT continue...
• THE JOB GUARANTEE AND THE BUDGET DEFICIT