Monday, October 5, 2015

Unemployment & QE / inflation

Economists have spent some 60 years arguing about the link between inflation & unemployment.  Some of the dominant economic theories hold that the two should be related, but the actual evidence reveals the opposite relationship to the theory.  You may not know if increases in wages / prices come from a real increase in demand or from fake, inflationary pressures, but there's one very big reason you should care.

As an example look at our present economy: we've had persistent unemployment, but wages have not fallen.  This raises an interesting question about the future of the economy.  Before we get started in his characteristic wisdom, Dr. Tom Sowell once said: "There are no solutions, there are only trade-offs."  Any discussion of the Phillips Curve can only end with a discussion of trade-offs.... the type of trade-off decisions that politicians & government bureaucrats decide for you unless you make your opinion heard.

The Phillips Curve has its roots in demand-side economics, specifically Keynesian economics.  However, when the Keynesians compare the theory of the curve to what really happens in the economy a major discrepancy arises I'll get into below.

Some thoughts on the Phillips Curve and why you might find it interesting.  These are extracted from one recent article, by Dr. Arnold Kling, that provides a very good summary in layman's terms.  That blog article can be viewed here.  So, first a few quick extracts from that article:

  • The Act I Phillips Curve says flat-out that (wage) inflation will be high when unemployment is low, and vice-versa. 
  • RK's thought: that's the basics, you can read the article for a quick summary of the other 2 variants of the curve.
  • Although the rate-of-change in wage inflation is also correlated with the unemployment rate, the relationship is not as impressive. 
  • RK's thought: not only "not as impressive," in fact it altogether doesn't hold - the author provides a few examples like this one:
  • In terms of wage inflation, the last five years look like a continuation of the Great Moderation.
  • RK's thought: the last 20 year's data show the Phillips Curve doesn't work.  But the trade-off it reveals is what really matters.
Now the problems with the Phillips Curve.  We expect to find a negative coefficient on the curve, just like in the image above.  However... and you can see the author of the blog post reference this a few times.... sometimes the coefficient isn't negative.  Sometimes its positive.  What Dr. Kling doesn't enunciate in the article I linked above is that the difference generally occurs if we are graphing current inflation (which almost always has a negative coefficient), versus lagged inflation (which tends to have a positive one).  Why?

Simple enough.  Inflation lowers unemployment in the short run, but makes unemployment increase in the future.  Anyone familiar with the business cycle recognizes this anticipated result: malinvestments take place in the boom period when things are rising, they're cleansed in the bust period with contractions.  Why should that concern you?  The government has been using QE to lower unemployment in the short run for several years now.  QE & inflation are two names for the same thing.


The definition of QE & the definition of inflation are the same: The Federal Reserve creating new money out of thin air.  The only difference is that most of the times we think of the definition of inflation we think about creating money of thin air at the printing press, then giving it to American people.  This has the bad effect of grocery prices getting bid up higher than housewives prefer, and is unpopular.

Knowing this why not create inflation through another manipulation instead?  That's QE: sending newly created money into the financial sector instead of the consumer sector.  How are stock prices doing?  Pretty amazing.  And how does that come about in a tepid economy?  Inflation causes price increases because too much money chasing too few goods.  Creating money out of thin air bids prices up artificially high.