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Bernanke thinks he can use inflation to lower unemployment
Gerard Jackson
By all accounts Bernanke is a thoroughly decent man and a smart one to boot. But I fear what most of his circle would call smart others would biting call "book smart", a disparaging term for someone who has mastered the requisite texts but not the art of thinking. This melancholy conclusion was delivered by the revelation that he still clings to the discredited Phillips curve.
In 1958 the New Zealand-born economist Alban William Phillips published The Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom 1861–1957, a study that purported to demonstrate a negative correlation between inflation and unemployment. The higher the inflation rate the lower the unemployment rate. (By now the reader should see where Bernanke is coming from). It naturally followed that anti-inflationary monetary and fiscal policies are at the root of unemployment. Therefore changes in government spending bring about changes in the level of unemployment.
This line of thinking is thoroughly fallacious, as two examples from American economic history will show. US government spending in the fiscal year 1944 was $95 billion (current US dollars), but in the fiscal year 1947 it had fallen to $39 billion. Thus this three year period witnessed federal spending plunge by $56 billion — a massive 59 per cent drop in government spending that averaged nearly 20 per cent a year. According to the Keynesians simple-minded economics this massive fiscal contraction should have sent America spiralling into a depression with 8 million unemployed by the spring of 1946. Instead it began the longest period of prosperity in US history.
A similar phenomenon occurred between 1954 and 1955, even though federal spending was cut by more than $3 billion. More figures will bring the situation into sharper relief: from 1953 to 1955 federal spending fell from $61 billion $45.2 billion, a 9.5 per cent drop while unemployment averaged 4.4 per cent a year.
Bernanke is considered by the media as an expert on the Great Depression. Of course, this should make Bernanke's alleged expertise on this subject immediately questionable, which, in my humble (and my fan club knows just how humble I am) it is. He completely swallowed the furphy that demand deficiency and hence lack of spending is what kept unemployment at an abominable level during the 1930s. Now economic theory clearly states that if any factor — including labour — is paid, for any reason, in excess of the value of its product a surplus must emerge. In the case of labour this surplus is called unemployment.
This means that if a large excess is maintained a stubbornly high level of unemployment will become the norm. So is this what happened in the 1930s? The grey area in the chart below represents the gap between productivity and wages. As we can see, the gap is a significant one. Therefore this period of high unemployment is one marked by real wages greatly exceeding productivity, just as the theory of marginal productivity predicts.
Source: This chart is designed so that a constant percentage increase would appear as a straight line. The values of product and wages are both expressed in dollars of constant buying power. The data for product are for the private sector, and are from the series by John W. Kendrick in his paper, National Productivity and Its Long-Term Projection (National Bureau of Economic Research, May 1951), brought up to date by the National Industrial Conference Board. For the data on wage rates, see Chapter 1, p. 11.
The Austrians have explained how inflation works its job-creating 'magic' by reducing the costs of hiring labour. Inflation raises the price of the labourer's product relative to the cost of hiring thus making it more profitable to hire more labour. So, according to Keynes (John Maynard Keynes, The General Theory of Employment Interest and Money, Macmillan-St. Martin’s Press, p. 9), if labour will not countenance a real change in wage rates then inflation must be used to bring about the same effect by lowering real wages while maintaining money wages. The whole inflation-employment trade-off 'thesis is just a cheap confidence trick, a fact that some Keynesians freely admit. Robert Kuttner, a well-known American Keynesian, wrote:
Workers resist cuts in the nominal dollars they are paid, though they do tolerate real wage cuts caused by inflation" (Business Week, 15 July 1996).
He, at least, has no illusions about the policy.
Members of the Austrian School have long since pointed out that though the inflation-employment policy works for a time, it must eventually lead to higher unemployment and inflation creating the phenomenon of stagflation. The reason for this is that money is not neutral. Orthodox economics teaches that money is neutral in the sense that changes in the money supply only affect changes in the price level, while individual prices are set in the market place by supply and demand.
What really happens is that monetary expansion takes place by 'injecting' money into the economy at various points. This misdirects labour and creates malinvestments, distorting the structure of relative prices and wages in the process. This is bound to happen because the process changes the distribution of the money stream among the stages of production. However, the malinvestments and jobs that have become dependent on these money changes need continually rising prices to survive as the community's real spending and savings preferences reassert themselves.
One of the interesting things about this process is that even in the absence of inflationary expectations and union intransigence unemployment will still emerge. But in a free market where malinvestments are liquidated instead of subsidised and all prices allowed to adjust to society's savings-consumption ratio such unemployment will be only transitory.
How is it with all of these available statistics Bernanke still believes in the Phillips curve? He knows full well to avoid the fundamental statistical mistake that every introduction to statistics warns against, and that is confusing correlation with causality. Correlation only shows the degree of association, if any, between variables. Statisticians stress that association does not prove causation. For example, though a correlation may exists between two variables both variables may be determined by a third variable. The Phillips curve defers is a graphic example of what Professor Hayek labelled scientism:
. . . a mechanical and uncritical application of habits of thought to fields different from those in which they have been formed". According to Phillips-curve adherents there is a trade-off between inflation and unemployment, more inflation means more employment. 'Austrian' economists pointed out that the 'theory' is false even though it is supported by statistical data. (Friedrich von Hayek, The Counter Revolution of Science, LibertyPress 1979, p. 24)
Bernanke believes because that is what was in the text book and it is what his lecturers taught him. He is still the earnest and eager-to-please student he was at school and then university. He could no more imagine thinking outside the framework of his studies then he could imagine himself littering the street. Obama is indeed fortunate that he has him to do his bidding. But what price will America end up paying for Bernanke's utter failure to break his Keynesian shackles?
Gerard Jackson is Brookesnews' economics editor
BrookesNews.Com
Monday 2 February 2009
