Inflation and Why this “Feels” Like a Recession

Paul Krugman writes:

But as I said, this time around there’s no wage-price spiral in sight.

The inflation hawks point out that consumers are, for the first time in decades, telling pollsters that they expect a sharp rise in prices over the next year. Fair enough.

But where are the unions demanding 11-percent-a-year wage increases? (Where are the unions, period?) Consumers are worried about inflation, but you have to search far and wide to find workers demanding compensation in the form of higher wages, let alone employers willing to accept those demands. In fact, wage growth actually seems to be slowing, thanks to the weakness of the job market.

And since there isn’t a wage-price spiral, we don’t need higher interest rates to get inflation under control. When the surge in commodity prices levels off — and it will; the laws of supply and demand haven’t been repealed — inflation will subside on its own.

Krugman is right in pointing out that wages are not beginning (or in the midst of) an inflationary spiral. Krugman seems to blame the invisible presence of the unions. Their invisibility could be due to their declining power and/or the fact that inflation today is quite different than the 1970s, but not for reasons that Krugman emphasizes. In my view, it is not the case that invisibility of the labor unions is the cause of a different kind of inflation, but rather that a different kind of inflation is causing the invisibility of the unions.

During the 1970s, the inflation rate was rising at a much higher rate than is currently the case. Energy prices were high, but there were also a great deal of other prices on the rise as well. As Krugman points out:

In May 1981, the United Mine Workers signed a contract with coal mine operators locking in wage increases averaging 11 percent a year over the next three years. The union demanded such a large pay hike because it expected the double-digit inflation of the late 1970s to continue; the mine owners thought they could afford to meet the union’s demands because they expected big future increases in coal prices, which had risen 40 percent over the previous three years.

Where the current situation is different is that the rise in the price level is less diversified. Food and energy prices are leading the charge, while technology and globalization are putting downward pressure on other prices. The result is that despite the fact that prices of consumer staples are rising, the overall inflation rate remains low by historical standards. This may also explain Krugman’s claim that, “it feels like a recession to most people” even if it technically isn’t. When the economy is slowing and the prices of consumer staples are rising, it forces some belt-tightening.

What to do about the current situation, however, is somewhat more difficult. Krugman believes that there is too much risk involved in raising rates and precipitating further crisis in the financial markets. However, one must also bear in mind that the low rate policies in the wake of September 11 and afterward largely set the stage for the current credit crisis. In my view, thanks in large part to financial market innovation, inflation targeting has proven to be quite inept. In addition, targeting a rate of inflation and simultaneously ignoring the forces of globalization and productivity growth leads to an environment of easy money. The economy is (and has been) moving ever toward completely inside money of the variety described by Wicksell, which makes monetary policy and especially inflation targeting more difficult to conduct.

In any event, I am convinced that the Fed Funds rate is below the natural rate and leaving it there for some time will only lead to further asset price bubbles. If there are underlying problems in the financial market, we cannot ignore them by keeping rates low and hoping that they will go away.

3 responses to “Inflation and Why this “Feels” Like a Recession

  1. Government employee unions are still powerful. They are nearly a shadow government. Their wage demands will be unrelenting. Weak governments will give in to them. Already we see Los Angeles turning over one third of their tax receipts to retired union teachers.

  2. Hi! I’ve been reading your blog, and you discuss some of the same issues we do in our new book. We’ve also set up our own blog to discuss the current economic climate – see what you think.

  3. Even the government unions are having a hard time now. The State of California’s budget is so bad that they are planning for no cost-of-living increase this year. Also, the City of Vallejo’s bankruptcy is forcing the fire and police unions to scale back. This could set a trend for other cities to cut back. The reality is that states and cities have to balance their budgets. Just as for-profit companies do, they are finding the most savings through payroll.

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