I think that the main problem to solve the current economic recession is about how we manage inflation. I know it seems strange because we have and have had moderate inflation for over two decades, but this appearance should not deceive us. To understand why we must understand how we got here. In 1958, W. Phillips published an article which noted the relationship between unemployment and wage increases. A few years before I. Fisher had observed the same relationship and later studies linked unemployment to inflation and called "the Phillips curve" to the plot of this relationship.
According to these observations, inflation tends to be high when unemployment is low and moderate when unemployment is high. It seems a reasonable relationship. When unemployment is high wages tend to grow moderately because there is plenty of labor supply, thereby keeping costs and prices down. But when unemployment is low, employers tend to increase wages because of a shortage of labor, putting upward pressure on costs and prices.
Many Keynesian economists believed in the early 1960s that they had the perfect tool to end with unemployment and economic recessions. When unemployment increased, they only needed to implement monetary policy measures (low interest rates) and demand stimulus measures (increased spending) to increase inflation and reduce unemployment. Today many economists are calling for a return to these policies.
Many Keynesian economists believed in the early 1960s that they had the perfect tool to end with unemployment and economic recessions. When unemployment increased, they only needed to implement monetary policy measures (low interest rates) and demand stimulus measures (increased spending) to increase inflation and reduce unemployment. Today many economists are calling for a return to these policies.
But from the late 1960s, the Phillips curve began to fail and inflation increases were not followed by a decrease in unemployment but by an increase. This failure implied the decline of the Keynesian economics, as higher demand stimulus was not solving the economic recession but causing an increase in inflation and unemployment. The experience from the 1970s with strong and recurring economic crises and numerous increases in inflation caused an aversion to inflation.
M. Friedman and E.Phelps, among others, criticized the causality between inflation and unemployment and considered that policies to stimulate demand had only positive effects on unemployment in the short term. Rising inflation can be positive for unemployment when it causes a sudden decrease in real wages, but as workers want to keep real wages, they demand a greater increase in salaries, so real wages return to previous levels and the positive effect on unemployment disappears. Only a new unexpected increase in prices, can keep the positive effect on unemployment but this process can not be maintained unless we accept hyperinflation.
The interpretation of the facts of the 1970s is a crucial point because the whole economic system created since the 1980s grounds on it. The creation of an independent Central Bank, low inflation aims, privatization and market competition, debt-financed deficits..., the belief that the stimulus policies are neutral or even negative if they encourage inflation... even austerity has its grounds on it.
If we analyze in more detail the behavior of the relationship between inflation and unemployment during the last years we observe:
The interpretation of the facts of the 1970s is a crucial point because the whole economic system created since the 1980s grounds on it. The creation of an independent Central Bank, low inflation aims, privatization and market competition, debt-financed deficits..., the belief that the stimulus policies are neutral or even negative if they encourage inflation... even austerity has its grounds on it.
If we analyze in more detail the behavior of the relationship between inflation and unemployment during the last years we observe:
1. There seems to be a common pattern. An increase in inflation is followed by an increase in unemployment (which is higher than the inflation decrease), thereby breaking the Phillips curve because it implies that the decrease should be equivalent.
2. It seems data supports those who argue that we must avoid at all costs an increase in inflation, because whenever inflation rises (even slightly 2-3%) there is an increase in unemployment.
3. According to the Friedman and Phelps' interpretation, rising inflation can be positive when it causes a sudden decrease in real wages, but it should be neutral in the long term. It should show the ineffectiveness of stimulating the economy when it is at full employment but it should not have a negative effect. In contrast, data shows that whenever inflation increases (regardless of the level of unemployment and inflation) there is an increase in unemployment.
Therefore we need to understand the process that causes recessions when there is an increase in inflation. Considering that it is the increase in inflation that causes the problem (and not a high inflation level) and that economic recessions in the USA have followed a pattern: Increase in inflation / interest rates, housing recession, fall in the production of durable goods and economic recession, I think the most likely interpretation of the events is as follows.
The increase in inflation and interest rates cause the housing recession and the fall in consumption of durable goods due to the tilt effect. The increase in loan payments forces households with variable rate mortgages to reduce consumption while it deteriorates the banks performance (increase in delinquencies and foreclosures) and their assets' quality (lower prices and volume in the housing market). Banks react to such losses by reducing lending, so the aggregate investment also decreases. The process is followed by a negative circle with falling unemployment, consumption and investment. If this interpretation is correct then two significant consequences follow.
1) We need a system that protects the economy from increases in inflation and not only tries to avoid it (like the present one). Price stability without indexed financial products leaves us vulnerable when inflation rises and when we can not avoid sudden increases, like an oil price increase. An inflation-indexed economy (having contracts, deposits, leases, loans, mortgages... indexed to inflation) would help us to achieve this aim.
2) Economic stimulus measures should be possible in an indexed economy without fearing that inflation causes economic downturns because all economic agents are protected against inflation fluctuations and they are indifferent to the inflation level. In contrast, in a non-indexed inflation economy, the fear blocks the implementation of these policies.
I believe that until Keynesian economists give a satisfactory answer to the problem of why increases in inflation cause economic recessions (and indexing contracts to inflation can be a good solution to that problem), economic stimulus policies will have a weakness that will be difficult, if not impossible, to overcome.
3. According to the Friedman and Phelps' interpretation, rising inflation can be positive when it causes a sudden decrease in real wages, but it should be neutral in the long term. It should show the ineffectiveness of stimulating the economy when it is at full employment but it should not have a negative effect. In contrast, data shows that whenever inflation increases (regardless of the level of unemployment and inflation) there is an increase in unemployment.
Therefore we need to understand the process that causes recessions when there is an increase in inflation. Considering that it is the increase in inflation that causes the problem (and not a high inflation level) and that economic recessions in the USA have followed a pattern: Increase in inflation / interest rates, housing recession, fall in the production of durable goods and economic recession, I think the most likely interpretation of the events is as follows.
The increase in inflation and interest rates cause the housing recession and the fall in consumption of durable goods due to the tilt effect. The increase in loan payments forces households with variable rate mortgages to reduce consumption while it deteriorates the banks performance (increase in delinquencies and foreclosures) and their assets' quality (lower prices and volume in the housing market). Banks react to such losses by reducing lending, so the aggregate investment also decreases. The process is followed by a negative circle with falling unemployment, consumption and investment. If this interpretation is correct then two significant consequences follow.
1) We need a system that protects the economy from increases in inflation and not only tries to avoid it (like the present one). Price stability without indexed financial products leaves us vulnerable when inflation rises and when we can not avoid sudden increases, like an oil price increase. An inflation-indexed economy (having contracts, deposits, leases, loans, mortgages... indexed to inflation) would help us to achieve this aim.
2) Economic stimulus measures should be possible in an indexed economy without fearing that inflation causes economic downturns because all economic agents are protected against inflation fluctuations and they are indifferent to the inflation level. In contrast, in a non-indexed inflation economy, the fear blocks the implementation of these policies.
I believe that until Keynesian economists give a satisfactory answer to the problem of why increases in inflation cause economic recessions (and indexing contracts to inflation can be a good solution to that problem), economic stimulus policies will have a weakness that will be difficult, if not impossible, to overcome.