Manufacturing inflation in a wage deflationary environment
Earlier in the month, I wrote how the currency is the real release valve for a credit based economy using a nonconvertible freely floating currency. It’s not about interest rates. If currency revulsion takes hold from negative real rates and people want to flee a country’s assets, this will be reflected in the currency. This is why the lower and lower yields in the US go against the canard about bond market vigilantes forcing rates higher.
In that post on Currency Revulsion, I wrote:
For monetarily sovereign nations, with their negative real yields aka financial repression, it is the currency where revulsion shows itself, not yields. But if deflation takes hold the currency appreciates as real yields climb. That has trapped Japan in a deflationary episode. If you want to avoid that trap, you will be forced to manufacture CPI inflation; and that means you need currency depreciation before deflation takes hold. QE has not done the trick.
Here’s the problem:
Between June 2009, when the recession officially ended, and June 2011, inflation-adjusted median household income fell 6.7 percent, to $49,909, according to a study by two former Census Bureau officials. During the recession — from December 2007 to June 2009 — household income fell 3.2 percent.
How does manufacturing CPI inflation benefit an economy in which incomes are falling? When inflation rises and incomes are stagnant or falling, the economy rolls over. That’s what the British have seen, for example.
I think that’s why people are focusing on nominal GDP and why Bruce Bartlett says the Fed should just start buying stuff.
The way I read it, the focus on nominal GDP is more about increasing the real GDP part of the equation than the inflation part of the equation. What’s the transmission mechanism for how this is supposed to work? No new net financial assets are created by monetary policy.
The Federal reserve is principally concerned with asset prices, as it has been since the days of Alan Greenspan. If you recall, during the days under Sir Alan’s helm, the Federal Reserve would increase interest rates in baby steps when the economy showed signs of overheating. But the Fed would flood the market with liquidity and lower rates drastically when a recession hit. Lax on the way up and loose on the way down. This was known as the Greenspan Put because it gave investors a sense that there was a floor on stock prices.
Today, the Fed is still trying to reflate the asset-based economic model with PZ money (permanent zero – where extended period language is perpetual). But low Treasury rates affect not only stocks but mortgage rates as well – and this is important in the context of a still dysfunctional housing market. So the Fed certainly wants stocks and bond values to go up, boosting household wealth and hopefully aggregate demand with it. Notice that this also works at odds with deleveraging and with increasing the savings rate.
To me, this is fiscal policy by another name. But the fiscal agent adds net financial assets to the private sector by deficit spending. That’s the essence of fiscal. The monetary agent can’t add net financial assets to the system; it simply creates base money and swaps this for existing assets. That necessarily means that when the interest rate channel is ineffective as rates are zero percent, the monetary agent can only increase asset prices as the transmission mechanism for reflating nominal GDP. This is most certainly at odds with deleveraging and increasing the savings rate.
So if you believe the US had little to no malinvestment and that GDP was not inflated, you’ll want asset prices to be artificially boosted until the economy ‘grows into’ those prices. Larry Summers has said, "that the central objective of national economic policy until sustained recovery is firmly established must be increasing… borrowing and lending." The jobs crisis is all about demand, then.
If you believe, as I do, that the problem is excessive private sector debt and leverage due in large part to resource misallocation, you probably think growing into asset prices via increasing borrowing and lending is misguided. Debt/income and debt/GDP levels are simply too high. The government can act as a counterweight to the demand drag. But the recovery will always remain fragile until you get substantially all of the credit writedowns on unrecoverable loans. The reason financial crises are followed by slow recoveries has everything to do with this. Moreover, you want to focus on income and not GDP because the household sector is indebted and it pays for debt out of income; higher GDP doesn’t make any difference for debt service unless it is felt in income.
Try manufacturing inflation all you want, manufacture nominal GDP all you want; until incomes rise enough to support the debt (numerator) or you get enough credit writedowns so that incomes support the debt (denominator), it’s not going to work.