The US economy reached a rather important economic data point recently, with hardly a peep on its significance from the politico-economic punditry: Consumer prices fell in March. The following chart of the Consumer Price Index over the last five years, courtesy of the St. Louis Federal Reserve Bank’s database, FRED, shows the fall:
See that slight tick downward, at the end of the line? That was the CPI for March. It fell, meaning consumer prices fell, if only slightly.
The Fed’s preferred gauge of prices, the Personal Consumption Expenditures Index, kept on rising, if only slightly, perhaps explaining the lack of punditry pontifications. I am not sufficiently well-versed, nor care to be, on the subtle differences between the PCE and CPI. I know that the PCE is compiled and published by the Department of Commerce’s Bureau of Economic Analysis, and that the CPI is published by the Department of Labor, which is apt, as I’ll show later, but that’s about it. The PCE is rising, but slowly, and its graph has the same general shape as the CPI over the last five years, except its tail end points continuously up, whereas the CPI now points down.
From the graph above, it is clear that the Fed has mainly succeeded of late in inflating consumer prices, which is the same as devaluing the currency, which is precisely its strategy. But the curve (the rate of price increases) has flattened considerably since mid-2011, even dipping down (indicating price declines) at least two other times.
But why is this important? Because the Fed depends on inflation to make unemployment go away. Simply put, an increase in the overall level of consumer prices means a relative decrease in the wages paid to consumers (a decline in the real wage rate), which causes increased demand for labor (ceteris paribus, lower real prices paid for labor mean expansion in demand for labor), thus increased employment. Wages are stickier than consumer prices (economists say the elasticity of demand is lower for labor than it is for consumer goods), so an increase in consumer prices does not generally cause a commensurate increase in prices paid for labor. For so long as the difference in stickiness (elasticity) remains, increased consumer prices yield increased employment. Though the Fed never explicitly states that its goal of devaluing the currency (i.e., of causing inflation everywhere except for labor) is to make labor relatively cheaper on a real basis, thereby expanding its demand, such is exactly the case.
It is pure Keynesianism. Unlike the Fed, Lord Keynes explicitly explained that decreasing relative wage costs was the point to his admonition for cheap money during hard economic times, from The General Theory of Employment, Interest and Money:
Since a special reduction of money wages is always advantageous to an individual entrepreneur or industry, a general reduction (though its actual effects are different) may produce an optimistic tone in the minds of entrepreneurs, which may break through a vicious circle of unduly pessimistic estimates of the marginal efficiency of capital and set things moving again on a more normal basis of expectation. On the other hand, if the workers make the same mistake as their employers about the effects of a general reduction, labor troubles may offset this favorable factor; apart from which, since there is, as a rule, no means of securing a simultaneous and equal reduction of money-wages in all industries, it is in the interest of all workers to resist a reduction in their own particular case. In fact, a movement by employers to revise money-wage bargains downward will be much more strongly resisted than a gradual and automatic lowering of real wages as a result of rising prices. (Emphasis supplied.)
This is excerpted from a section in which Keynes is attempting to explain why proactive reductions in real wages vis-a-vis expansions in the quantity of money (i.e., inflation, everywhere except for wages) is preferable to the laissez-faire prescription of allowing labor prices to decline with a contraction in aggregate demand. Keynes wanted nominal labor prices to be more or less rigid so that expanding the money supply (through interest rate reductions, just as the Fed does nowadays) would cause an overall decrease in real wages, thereby spurring employment demand. The only difference with Keynes’ prescription and the strategy being employed by the Fed today is that wage rates are only fixed on the low side–the minimum wage operates as a floor beneath which they may not nominally fall. But employment carries a great many other fixed costs that must also be considered by employers (the infrastructure of rights and benefits commensurate to employment that have become codified in federal law), so there is a general inflexibility in labor costs capable of allowing the strategy to work, just as Keynes described.
But what happens to the strategy if money supply expansions don’t cause inflation sufficient to make real wages decline? This is to Keynesian economics something like the singularity at the moment of the Big Bang is to physics, where the equations of General Relativity break down into a meaningless mush. When money as cheap (ZIRP) and plentiful (a tripling of the monetary base since 2008) as now doesn’t spur inflation sufficient to cause a decline in real wages, monetary policy reaches its singularity, breaking down into a mush of meaninglessness. A sustained decline in CPI in today’s monetary environment would be fatal to monetary policy, signaling its total and utter failure to bring about the decline in real wage rates necessary to expanding the demand for labor.
Failure in monetary policy to force wages down would not necessarily, however, mean economic Armageddon. The classical laissez-faire economists to whom The General Theory is directed at impugning would simply have their day in the sun. Real wages would decline commensurate with decreased labor demand until a point of equilibrium were reached, and the excess supply of labor were sopped up, at which point they would begin again to rise. In the meantime, the Fed’s serial bubble blowing, a byproduct of its strategy for bringing down real wages through excess money creation, would finally come to a halt.
I believe we are closer to the point of monetary singularity than most realize. Of late, practically each increase in the money supply yields a decline in the velocity of money, as the following charts show. Money velocity is at its lowest all-time point. What happens when it declines below one–when a portion of each additional dollar the Fed creates sits idly by, doing nothing? The monetary singularity obtains.
Lord Keynes did not have much to say about what would happen if currency manipulations internationally served to thwart the program of reducing real domestic wages via money supply increases. What if other nations pursue similar currency devaluation strategies, and do so more forcefully? It could instead cause domestic prices to fall and real domestic wages to increase. It might not even take active currency manipulation for the strategy to be thwarted. During the recent financial crisis the value of the dollar internationally spiked upward, with money the world over racing to what was considered the safe harbor of dollars assets. The dollar spike upward relative to the currencies of its trading partners yielded the most significant US price declines since at least the Great Depression.
The focus of monetary policy on domestic economic troubles might soon shift to international issues, as Japan, a nation that long ago reached the point of monetary singularity, has embarked on a beggar thy neighbor strategy of currency devaluation. The employment situation the Fed tries to resolve through domestic inflation gets unwound by Japanese currency manipulations and European economic fecklessness. The March decline in CPI might very well be the result of Japan’s recently announced initiative to increase domestic prices through flooding the world with Yen.
Either way, through the ineffectiveness of monetary policy to lower real wages once something of monetary singularity is reached, or through the inability to lower real wages because of domestic price decreases brought about by foreign currency markets, the result is the same. Overall employment rates remain in the doldrums and aggregate demand fails much to grow, if at all.
Considering how ineffectual the whole program seems, perhaps the classical laissez-faire economists had it right all along. Perhaps it is better to just let things alone, and allow the rough and tumble of the marketplace work things out. Perhaps it is time we all became classicists, instead of Keynesians.