Uneasy Money

I had not planned to post anything today, but after coming across an article (“What the Fed Really Wants Is to Reduce Real Wages”) by Alex Pollock of AEI on Real Clear Markets this morning, I decided that I could not pass up this opportunity to expose a) a basic, but common and well-entrenched, error in macroeconomic reasoning, and b) the disturbingly hypocritical and deceptive argument in the service of which the faulty reasoning was deployed.

I start by quoting from Pollock’s article.

To achieve economic growth over time, prices have to change in order to adjust resource allocation to changing circumstances. This includes the price of work, or wages. Everybody does or should know this, and the Federal Reserve definitely knows it.

The classic argument for why central banks should create inflation as needed is that this causes real wages to fall, thus allowing the necessary downward adjustment, even while nominal wages don’t fall. Specifically, the argument goes like this: For employment and growth, wages sometimes have to adjust downward; people and politicians don’t like to have nominal wages fall– they are “sticky.” People are subject to Money Illusion and they don’t think in inflation-adjusted terms. Therefore create inflation to make real wages fall.

In an instructive meeting of the Federal Reserve Open Market Committee in July, 1996, the transcript of which has been released, the Fed took up the issue of “long-term inflation goals.” Promoting the cause of what ultimately became the Fed’s goal of 2% inflation forever, then-Fed Governor Janet Yellen made exactly the classic argument. “To my mind,” she said, “the most important argument for some low inflation rate is…that a little inflation lowers unemployment by facilitating adjustments in relative pay”-in other words, by lowering real wages. This reflects “a world where individuals deeply dislike nominal pay cuts,” she continued. “I think we are dealing here with a very deep-rooted property of the human psyche”-that is, Money Illusion.

In sum, since “workers resist and firms are unwilling to impose nominal pay cuts,” the Fed has to be able to reduce real wages instead by inflation.

But somehow the Fed never mentions that this is what it does. It apparently considers it a secret too deep for voters and members of Congress to understand. Perhaps it would be bad PR?

This summary of why some low rate of inflation may promote labor-0market flexibility is not far from the truth, but it does require some disambiguation. The first distinction to make is that while Janet Yellen was talking about adjustments in relative pay, presumably adjustments in wages both across different occupations and also across different geographic areas — a necessity even if the overall level of real wages is stable — Pollock simply talks about reducing real wages in general.

But there is a second, more subtle distinction to make here as well, and that distinction makes a big difference in how we understand what the Fed is trying to do. Suppose a reduction in real wages in general, or in the relative wages of some workers is necessary for labor-market equilibrium. To suggest that only reason to use inflation to reduce the need for nominal wage cuts is a belief in “Money Illusion” is deeply misleading. The concept of “Money Illusion” is only meaningful when applied to equilibrium states of the economy. Thus the absence of “Money Illusion” means that the equilibrium of the economy (under the assumption that the economy has a unique equilibrium — itself, a very questionable assumption, but let’s not get diverted from this discussion to an even messier and more complicated one) is the same regardless of how nominal prices are scaled up or down. It is entirely possible to accept that proposition (which seems to follow from fairly basic rationality assumptions) without also accepting that it is irrelevant whether real-wage reductions in response to changing circumstances are brought about by inflation or by nominal-wage cuts.

Since any discussion of changes in relative wages presumes that a transition from one equilibrium state to another equilibrium state is occurring, the absence of Money Illusion, being a property of equilibrium,  can’t tell us anything about whether the transition from one equilibrium state to another is more easily accomplished by way of nominal-wage cuts or by way of inflation. If, as a wide range of historical evidence suggests, real-wage reductions are more easily effected by way of inflation than by way of nominal-wage cuts, it is plausible to assume that minimizing nominal-wage cuts will ease the transition from the previous equilibrium to the new one.

Why is that? Here’s one way to think about it. The resistance to nominal-wage cuts implies that more workers will be unemployed initially if nominal wages are cut than if there is an inflationary strategy. It’s true that the unemployment is transitory (in some sense), but the transitory unemployment will be with reduced demand for other products, so the effect of unemployment of some workers is felt by other sectors adn other workers. This implication is not simply the multiplier effect of Keynesian economics, it is also a direct implication of the widely misunderstood Say’s Law, which says that supply creates its own demand. So if workers are more likely to become unemployed in the transition to an equilibrium with reduced real wages if the real-wage reduction is accomplished via a cut in nominal wages than if accomplished by inflation, then inflation reduces the reduction in demand associated with resistance to nominal-wage cuts. The point is simply that we have to consider not just the final destination, but also the route by which we get there. Sometimes the route to a destination may be so difficult and so dangerous, that we are better off not taking it and looking for an alternate route. Nominal wage cuts are very often a bad route by which to get to a new equilibrium.

That takes care of the error in macroeconomic reasoning, but let’s follow Pollock a bit further to get to the hypocrisy and deception.

This classic argument for inflation is of course a very old one. As Ludwig von Mises discussed clearly in 1949, the first reason for “the engineering of inflation” is: “To preserve the height of nominal wage rates…while real wage rates should rather sink.” But, he added pointedly, “neither the governments nor the literary champions of their policy were frank enough to admit openly that one of the main purposes of devaluation was a reduction in the height of real wage rates.” The current Fed is not frank enough to admit this fact either. Indeed, said von Mises, “they were anxious not to mention” this. So is the current Fed.

Nonetheless, the Fed feels it can pontificate on “inequality” and how real middle class incomes are not rising. Sure enough, with nominal wages going up 2% a year, if the Fed achieves its wish for 2% inflation, then indeed real wages will be flat. But Federal Reserve discussions of why they are flat at the very least can be described as disingenuous.

Actually, it is Pollock who is being disingenuous here. The Fed does not have a policy on real wages. Real wages are determined for the most part in free and competitive labor markets. In free and competitive labor markets, the equilibrium real wage is determined independently of the rate of inflation. Remember, there’s no Money Illusion. Minimizing nominal-wage cuts is not a policy aimed at altering equilibrium real wages, which are whatever market forces dictate, but of minimizing the costs associated with the adjustments in real wages in response to changing economic conditions.

I know that it’s always fun to quote Ludwig von Mises on inflation, but if you are going to quote Mises about how inflation is just a scheme designed to reduce real wages, you ought to at least be frank enough to acknowledge that what Mises was advocating was cutting nominal wages instead.

And it is worth recalling that even Mises recognized that nominal wages could not be reduced without limit to achieve equilibrium. In fact, Mises agreed with Keynes that it was a mistake for England in 1925 to restore sterling convertibility into gold at the prewar parity, because doing so required further painful deflation and nominal wage cuts. In other words, even Mises could understand that the path toward equilibrium mattered. Did that mean that Mises was guilty of believing in Money Illusion? Obviously not. And if the rate of deflation can matter to employment in the transition from one equilibrium to another, as Mises obviously conceded, why is it inconceivable that the rate of inflation might also matter?

So Pollock is trying to have his cake and eat it. He condemns the Fed for using inflation as a tool by which to reduce real wages. Actually, that is not what the Fed is doing, but, let us suppose that that’s what the Fed is doing, what alternative does Pollock have in mind? He won’t say. In other words, he’s the pot.