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.

Recession Officially Over, U.S. Incomes Kept Falling, NYTimes

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.

The Fed wants asset price inflation not consumer price inflation

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.

  1. Dave Holden says

    Good analysis.


    “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.”


  2. Deschain says

    Ed – don’t we need to differentiate here between what I call ‘fake’ inflation (prices of goods going up, but not incomes) and a real wage/price spiral? If we get wage inflation, then we lower the real debt burden, even if prices of goods are going up as well. The problem as I see it is that fed policy by itself can drive increased prices of assets/goods but not increased wages. To get increased wages you need increased government spending which acts as a competitve bid for labor and drives wages higher. This can be ‘monetized’ by the fed. In that sense, targeting nominal GDP makes sense, but it only works if you coordinate fiscal & monetary policy.

    1. Edward Harrison says

      Yes, that’s it. If you are going to try asset price reflation, in the absence of wage gains, it won’t be sustainable. That is how we got here. You could have policy oriented toward increasing labor’s share of the gains from nominal GDP so that households have higher incomes. The only way to do that is to “redistribute” or to add net financial assets by government bidding for labor resources. It’s either this i.e. increasing the numerator of debt/income calculations or defaults and writedowns i.e. decreasing the denominator.

  3. David Lazarus says

    US policy is doomed to failure. High asset prices will raise the costs of new businesses starting up and make the recovery very weak. As your analysis shows it is wages that need to increase. Without which, paying down that debt becomes harder. In fact with US wages falling this can only mean that asset prices are on a one way trip, down. Higher or even just stable prices will become even more unaffordable with falling wages. So lets see if banks increase their loan loss reserves.

  4. fresno dan says

    “The jobs crisis is all about demand, then.”

    I got plenty of demand. I just don’t got money!If they had given me a trillion dollars, that money would have stimulated the stripper, booze, and rock and roll industry to no end…and me.
    But they gave it to the TBTF banks. And look what we got.

    Why do we continue with these ineffective policies? Look, you dont even have to give me a full trillion. Try 500 billion and lets see what happens….

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