The Key to Managing Inflation: Higher Wages

Fix, Blair Working Paper The Key to Managing Inflation: Higher Wages Provided in Cooperation with: The Bichler & Nitzan Archives Suggested Citation: Fix, Blair (2023) : The Key to Managing Inflation: Higher Wages, Economics from the Top Down, Toronto, https://economicsfromthetopdown.com/2023/03/02/the-key-to-managing-inflation-higher-wages/ , https://bnarchives.yorku.ca/772/ This Version is available at: https://hdl.handle.net/10419/269258 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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Higher Wages Blair Fix March 02, 2023 To manage inflation, governments have a simple tool at their disposal: raise wages as fast as possible. —Milton Fryman For the last few months, I’ve been diving into the economics of inflation. In this post, I’m excited to review some forgotten history. Our journey starts with a basic question: what is the key policy tool for managing the rate of inflation? According to mainstream economics, the key tool is the rate of interest. Hike this rate, economists argue, and you will cool an overheated economy, solving the problem of inflation. As you probably know, I don’t think much of this idea. (Criticism here and here.) And so I’ve been looking for alternative theories of inflation management. After months spent in the library stacks, I’m happy to report that I’ve discovered some lost theory. During the mid-20th century, it seems that while most economists were jumping on the interest-rate bandwagon, a few researchers went in the opposite direction. They proposed that inflation could be treated with a dose of wage hikes. Needless to say, this alternative theory remains virtually unknown. And on its face, it seems absurd. But as I’ll show, the wage-hike approach is strongly supported by evidence. Using standard economic tools, I find that rapid wage growth tends to be followed by a drop in inflation. Blair Fix Economics from the Top Down The message? Policy makers should reverse course. Instead of greeting inflation with a dose of interest-rate hikes, governments should reach for the wage-rate lever. Hike wages as fast as possible, and you will surely reduce inflation. The Swisher effect Our dive into inflation management starts with some well-known history. The standard approach to regulating inflation was set in motion by the economist Irving Fisher. One of the early neoclassical economists, Fisher was fascinated by the natural laws which govern returns to capital. In 1907, he discovered a key mechanism. Interest rates, Fisher showed, fluctuate with the rate of inflation. The reason for this connection, he argued, is that markets gravitate towards a constant ‘natural rate of interest’. In other words, when markets work efficiently, they preserve the earning potential of creditors. Today, we call this natural law the ‘Fisher effect’. It is a basic fact which all economics students memorize. What economics students are not told is that the same natural law exists for wages. It’s with this omission that our host history begins. In 1909, a Danish economist named Donald Swisher discovered a corollary to the Fisher effect. Although unaware of Fisher’s work, Swisher had a similar passion for the natural laws determining income. But unlike Fisher, Swisher studied the wage rate. Looking at data from medieval Croatia, Swisher showed that the rate of wage growth tends to rise and fall with inflation. Swisher then argued that he had discovered a natural law. When markets function effectively, they preserve the earning potential of labor power. As a consequence, competitive markets gravitate towards a natural wage rate. In honor of Donald Swisher, I propose that we call this natural law the ‘Swisher effect’. Although virtually unknown to modern economists, the Swisher effect is a remarkable regularity. Figure 1shows the pattern in the United States. Across more than two centuries, the wage growth of unskilled workers remained tightly coupled to the rate of inflation. In short, the Swisher effect is as reliable as the laws of thermodynamics. 2 Blair Fix Economics from the Top Down Figure 1: The Swisher effect in the United States Looking at two centuries of US history, this figure illustrates the tight coupling between inflation and the growth of wages — a pattern first documented by Donald Swisher. The blue line shows the inflation rate, measured using the consumer price index. The red line shows the growth rate for the average wage of unskilled workers. Sources and methods Considering this stunning evidence for the Swisher effect, the arc of history is perplexing. When Irving Fisher discovered the laws of capitalist income, he went on to fame and fortune. And yet when Donald Swisher discovered equivalent laws for labor income, his ideas were largely ignored. (Swisher was denied tenured and died in obscurity.) And so we’re left to wonder ... why did economists accept the idea of a ‘natural rate of interest’, while they ignored the concept of a ‘natural wage rate’? 1 Although rarely discussed, it may be that economic science is not driven entirely by evidence. 1 Search engine results testify to this theoretical asymmetry. Today, a Google Scholar search for ‘natural rate of interest’ returns 10,800 results. A search for ‘natural wage rate’ returns a 274 results. 3 Blair Fix Economics from the Top Down The first Dr. Milton Continuing our history, the plot thickens in the mid-20th century. It was then that Milton Friedman made waves by proclaiming that most of society’s problems could be solved by the strict regulation of the money supply. The trick was to administer the correct dose of interest-rate medicine. Building on the work of Irving Fisher, Friedman argued that the interplay between the ‘nominal’ and ‘real’ rate of interest drove inflation expectations. Although his theoretical path was slightly torturous,Friedman concluded that central banks could regulate inflation by manipulating the rate of interest. Now, the immediate problem for Friedman and his disciples was that evidence for monetarist theory was difficult to unearth. You see, the obvious pattern was that interest rates and inflation moved together — a sure sign of up-regulation. But the Friedmanite task was to transform the data until the correct effect revealed itself. Undismayed by the obvious evidence, economists soon found a method that produced good results. The true effects of rate hikes revealed themselves only in the future. In other words, if you let inflation data lag interest-rate data by the appropriate amount, you observed the actual effect of monetary policy: interest rates down-regulate future inflation. The second Dr. Milton Now to the ‘other’ Dr. Milton. While Milton Friedman was busy creating monetarist theory, an economists named Milton Fryman was deriving an incendiary alternative. One of the few students of Donald Swisher, Fryman was interested in the natural laws that govern wages. He wanted to know how these laws might be used to regulate inflation. Superficially, Fryman’s research was similar to Friedman’s, in the sense that he focused on the supply of money. However, Fryman took a more rigorous approach by basing his theory on the laws of thermodynamics. He called his model the ‘shoebox theory of monetary management’. It worked as follows. 4 Blair Fix Economics from the Top Down After years of field research, Fryman concluded that workers behaved differently than capitalists. In short, workers had a greater ‘marginal propensity to stash’. Capitalists, Fryman observed, put their money in ‘investments’. Crucially, these investments were then recorded on abstract accounting ledgers which were safe from the entropic decay. But workers tended to put their savings in physical containers — proverbial ‘shoeboxes’. There the forces of entropy wreaked havoc. Each year, a significant portion of workers’ savings were misplaced, lost or destroyed. This entropic destruction, Fryman proposed, was the key to monetary management. If you wanted to reduce the money supply, you should hike wages. Let’s lay out the reasoning. As you gave workers more cash, they would store more money in shoeboxes. There, entropy would do its work, resulting in a net destruction of money. The market would then equilibrate to the new monetary regime, causing inflation to fall. Of course, Fryman was careful to point out that the entropic delay would be ‘long and variable’. However, he was confident that the shoebox effect was real. Fast-forward to the present. For reasons that are sadly ironic, Fryman’s theory remains virtually unknown. That’s because Fryman died while formalizing his theory. And in a testament to the effect he described, his manuscript box was lost and his path-breaking work was never published. Fortunately, Fryman’s manuscripts were rediscovered in 2022. And so we’re now in a position to test his theory of inflation regulation. Searching for Fryman’s shoebox effect According to Fryman, a rise in wages should be followed by a reduction in inflation. Now, like his more conventional colleagues, Fryman had no idea what the wage-inflation lag would be. As such, Fryman recommended a proactive approach to testing his theory; simply lag the inflation data until the desired effect appears. Following Fryman’s recommendation, I’ve adopted this robust method and applied it to the United States. I’ve determined that when we lag the inflation one year after the wage-growth data, the shoebox effect reveals itself. 5 Blair Fix Economics from the Top Down Figure 2: Evidence for Milton Fryman’s shoebox effect This figure searches for the ‘shoebox effect’ — the idea that faster wage growth downregulates future inflation. Looking at two centuries of data from the United States, I find that when wage growth increases (horizontal axis), it strongly predicts a reduction in nextyear’s inflation (vertical axis). Note: blue points show annual data. The red line illustrates the smoothed trend, estimated with a local polynomial regression. Sources and methods Figure 2shows the pattern. Here, I plot the annual change in wage growth (horizontal axis) against next-year’s change in inflation (vertical axis). The resulting trend is strongly negative. When wage growth increases, inflation falls in the following year. And when wage growth declines, higher inflation soon follows. So it seems that Fryman was correct: the key to regulating inflation is the judicious dosage of wage hikes. 6 Blair Fix Economics from the Top Down A puzzle We’re now at the end of our forgotten history. Let’s summarize the story. While most economists focused on interest rates as a tool for regulating inflation, a small group of researchers studied an alternative hypothesis. To down-regulate inflation, they argued that governments should raise wages. Having rediscovered this lost theory and subjected it to a rigorous test, I find that it is strongly supported by evidence. And yet I remain puzzled. You see, when I show Figure 2to my economist colleagues, they laugh in my face. ‘Wage hikes couldn’t possibly lower inflation,’ they say. Confused by this reaction., I decided to run a little experiment. Leaving the data unchanged, I took my chart and altered the labels, substituting ‘interest rates’ for the ‘wage rate’. When I showed the revised chart to my economist friends, they leapt with excitement. The same data (which they had previously ridiculed) was now ‘stunning confirmation’ that interest rates down-regulate inflation. Is it just me, or is this dichotomy odd? I’m beginning to suspect that economists might not weigh all types of evidence with equal rigor. A satire unravelled I hope you enjoyed this little satire. As you can guess, there is no Donald Swisher, nor is there a Milton Fryman. And there is certainly no ‘shoebox theory of monetary management’. These ideas were designed to be obvious bullshit. The point was to prime you into confusion; I took ideas that are absurd and then used the tools of economics to find supporting ‘evidence’. Perhaps you recognize the trick. It’s the same sleight-of-hand used by mainstream economists when they argue that interest rates down-regulate inflation. The joke is that we can use the same trick to find ‘evidence’ for an idea that many economists would find appalling — the notion that wage hikes reduce inflation. 7 Blair Fix Economics from the Top Down Figure 3: Tit for tat — the coupling of wage growth and inflation in the United States Looking at two centuries of US history, this figure illustrates the tight coupling between inflation and the growth of wages. The blue line shows the inflation rate, measured using the consumer price index. The red line shows the growth rate for the average wage of unskilled workers. Sources and methods The reason the trick works is because it is based on a subtle (but severe) methodical flaw. Yes, faster wage growth correlates with lower inflation next year. But the key is that this correlation is not evidence for down-regulation. It’s actually a statistical artifact — a consequence of cyclical data. Let’s break it down. Tit-for-tat cycles To understand how the statistical trick works, let’s return to the original evidence — the tight coupling between inflation and wage growth. Figure 3shows the data, this time without the satirical title. The coupling of wage growth and inflation is caused by a tit-for-tat dynamic. The ‘tit’ is a jump in the rate of inflation. On that front, don’t let language confuse you. Many people equate ‘inflation’ with a decrease in the potency of money. Forget this thinking, as it is misguided. In reality, ‘inflation’ is about prices. To calculate inflation, we take a group of commodities and measure their average change in price. Notice 8 Blair Fix Economics from the Top Down – Consumer price index from 1774 to 1912: Historical Statistics of the United States, series Cc1. – Consumer price index from 1913 to 2021: Bureau of Labor Statistics, series CUUR0000SA0. Further reading Fix, B. (2023). Fake history and the people who populate it: A collection of economic satire. A Very Serious Journal,1(1). https://sciencedesk.econ omicsfromthetopdown.com/satire 15