Welcome to the Dark Side

For once someone left a comment to a posting I wrote, claiming Dean Baker responded to my musings with “I think he agrees that the NAIRU estimates were grossly off.” Upon reading that, I wanted to whack my head against the nearest solid object at first. When will the economics field recognize the fundamental truths about inflation acceleration? To my mind otherwise-neutral concepts like the NAIRU and the wage-price spiral are used more often than not as a cudgel to discredit Keynesian and Hicksian economics, raising the “evil” specter of spiraling price increases when in reality inflation is almost entirely caused by restrictions in aggregate supply.

Still, I decided to go back to the original post and discovered an attached comment that likely was written by Mr. Baker:

One is the demand side — the bubble was central for creating demand. We needed the demand to come from somewhere, the bubble was a really bad way to get the demand, but it did get the demand.

Then there is a supply side question. The NAIRU is a supply issue.

I couldn’t agree more, though Mr. Baker seems oblivious to the fact that he has also just demonstrated that it isn’t low unemployment that accelerates inflation:

Thanks to the eccentricities of Alan Greenspan, the Fed did not raise interest rates. Instead it allowed the unemployment to continue to fall. It fell below 5.0 percent in 1997, it crossed 4.5 in 1998, and reached 4.0 percent as a year-round average. And inflation remained tame. The result was that millions of people had jobs who would not have otherwise. Tens of millions of workers at the middle and bottom of the wage distribution saw substantial real wage gains for the first time in a quarter century.

So, was the NAIRU during the 1990s 4.0%, 3.5%, 3% or even lower? Yes, but only technically. The unemployment rate simply didn’t matter. Supply alone dictates when inflation will tick upwards. So long as Mr. Greenspan ordered flank speed, producers were goaded into expanding economic capacity at a break-neck pace. When aggregate supply expands rapidly enough to accommodate rising aggregate demand, inflation won’t accelerate–full stop (or more appropriately full speed ahead).

But the implication of the statement “the NAIRU is a supply issue” is much more dangerous than Mr. Baker seems to recognize. How do unemployment rates and/or wages enter into the equation if the forces of AD can be contained simply with expanded capacity (a rise in SRAS)? More importantly, if inflation is supply-related, when should central banks tighten the monetary supply?


Never, most likely. Raising interest rates seems more akin to this:

When the General tried to swallow the concoction [of molasses, vinegar, and butter], he went into an episode of convulsive suffocation. He then decided that bloodletting would be a better course and ordered Mr Rawlins to perform venesection on his arm to remove half a pint of blood. General Washington was a strong believer in bloodletting, having used it successfully to cure various maladies affecting his Negro slaves. When Mr Rawlins showed agitation while performing the procedure, he provided gentle encouragement.

“Don’t be afraid. The orifice is not large enough. More, more.”

Colonel Lear noted 2 that Mrs Washington was against bloodletting and begged that not too much blood be removed.

Yes, I’m comparing institutionalized Federal Reserve reactions to eighteenth century bloodletting. Human beings are creatures of habit, clinging to remedies that never worked in the first place. Even at the time, this was recognized as a decidedly poor treatment choice:

The total quantity of blood removed from President Washington has been estimated by various historians and medical authorities to be 5-7 pints. Six weeks after the death of President Washington, Dr James Brickell,10 wrote an article expressing vehement disagreement with the therapeutic modalities administered. This article was not made public until 1903. Estimating the quantity of blood removed to be 82 ounces, he bemoaned the lack of clinical wisdom and appropriateness.

“… I think it my duty to point out what appears to me a most fatal error in their plan … old people can not bear bleeding as well as the young … we see … that they drew from a man in the 69th year of his age the enormous quantity of 82 ounces, or above two quarts and a half of blood in about 13 hours.

“Very few of the most robust young men in the world could survive such a loss of blood; but the body of an aged person must be so exhausted, and all his power so weakened by it as to make his death speedy and inevitable.”10

Washington was killed by misguided, yet widely believed remedies 215 years ago. If the American rate of inflation ticks up in 2015, the Federal Reserve in the city named after the first American president will be under enormous pressure from outside forces to tighten the money supply which will result in higher interest rates; an action that all else being equal will slow the expansion of SRAS and thus worsen inflationary pressures.

Raising interest rates wouldn’t be inflationary for one simple reason—American businesses are conditioned to reverse their hiring practices and engage in widespread furloughs and layoffs of American workers in response to central bank-induced rises in interest rates. Instead of incipient inflation, we endure a recession. Wouldn’t a better course for the Federal Reserve to set when faced with incipient inflation involve coaxing more production out of American producers, even though such policies would be decried (wrongly) as highly irresponsible?

I’m channeling what others have already written, of course. Mr. Baker and his colleagues have warned at length that choking off incipient economic recoveries is foolish; Paul Krugman going as far as challenging the orthodoxy to “dare to be silly.” However, it doesn’t seem these economists realize how radical their assertions truly are.

Wage/Unemployment Fallacy

Last summer Nick Hanauer identified a failed prediction in basic economics:

If you took Econ 101, then you literally were taught that if wages go up, employment must go down. The law of supply and demand and all that. That’s why you’ve got John Boehner and other Republicans in Congress insisting that if you price employment higher, you get less of it. Really?

Because here’s an odd thing. During the past three decades, compensation for CEOs grew 127 times faster than it did for workers. Since 1950, the CEO-to-worker pay ratio has increased 1,000 percent, and that is not a typo. CEOs used to earn 30 times the median wage; now they rake in 500 times. Yet no company I know of has eliminated its senior managers, or outsourced them to China or automated their jobs. Instead, we now have more CEOs and senior executives than ever before. So, too, for financial services workers and technology workers. These folks earn multiples of the median wage, yet we somehow have more and more of them.

The thing about us businesspeople is that we love our customers rich and our employees poor. So for as long as there has been capitalism, capitalists have said the same thing about any effort to raise wages. We’ve had 75 years of complaints from big business—when the minimum wage was instituted, when women had to be paid equitable amounts, when child labor laws were created. Every time the capitalists said exactly the same thing in the same way: We’re all going to go bankrupt. I’ll have to close. I’ll have to lay everyone off. It hasn’t happened. In fact, the data show that when workers are better treated, business gets better. The naysayers are just wrong.

Most of you probably think that the $15 minimum wage in Seattle is an insane departure from rational policy that puts our economy at great risk. But in Seattle, our current minimum wage of $9.32 is already nearly 30 percent higher than the federal minimum wage. And has it ruined our economy yet? Well, trickle-downers, look at the data here: The two cities in the nation with the highest rate of job growth by small businesses are San Francisco and Seattle. Guess which cities have the highest minimum wage? San Francisco and Seattle. The fastest-growing big city in America? Seattle. Fifteen dollars isn’t a risky untried policy for us. It’s doubling down on the strategy that’s already allowing our city to kick your city’s ass.

The Econ 101 argument Hanauer contradicts blames (in the textbooks and other writings of freshwater economists) even the minutest wage increases for setting off inflationary storms. But the argument is dead wrong—capacity constriction, not excess demand leads to spiraling price increases. Even using terms like excess demand is at its heart a supply problem; demand is not in excess unless there is insufficient economic capacity to meet demand. Under the circumstances, why would it be more logical to crush down the demand side with wage restrictions (or stating there is a “pent-up demand for wage cuts”) rather than encourage supply expansion?

Just as in this light the normalized reaction to rising wages leads me to bloodletting comparisons, the common wisdom surrounding unemployment and inflation seems, well, unwise. If unemployment drops to such a low level SRAS can no longer expand, that’s still an issue with supply—throwing workers onto the unemployment rolls would be counterproductive after passing what increasingly appears to be the mythical NAIRU.

To take this full circle, I would have to demolish the freshwater arguments about the stagflation of the 1970s; needless to say the factors supply-siders overlooked played a massive role in twentieth-century stagflation (the stagflations of the early 1920s, late 1940s, and entire 1970s). But that will have to wait for another time—I intend to first explore how the Medicare Part D legislation in 2003 created HDHP/HSA and the era of personal responsibility in health care insurance has still doubled premiums over the following ten years. This is a side to health economics/policy that I never see explored anywhere—but it might explain spiraling health costs over the last 15 years.

Congratulations, Mr. Baker. You’ve disproven the existence of the NAIRU, the wage-price spiral, and perhaps all the underpinnings of rational expectations. All inflation, not just the NAIRU, is a supply issue. Welcome to the dark side.


3 thoughts on “Welcome to the Dark Side

  1. Pingback: Aggregate Demand Dominance: HCE | In The Corner, Mumbling and Drooling

  2. Pingback: NAIRU Nocks me Nonsensical | In The Corner, Mumbling and Drooling

  3. Pingback: The Significance of Shortages | In The Corner, Mumbling and Drooling

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