Unemployment, Recessions and Monetary Policy

Okay, first look at this graph:

This is another FRED graph, courtesy of the St Louis Fed. The blue line represents the unemployment rate while the red line represents year-on-year GDP growth. As you can see there are some interesting relationships.

It doesn't take an (economic) Einstein to tell you that unemployment rises whenever GDP drops - it is one of the most obvious relationships in economic history and one that is borne out quite clearly in the graph above. Moreover, as I pointed out in a previous posting, unemployment in recessions rises quite suddenly and then tapers off slowly as the economy recovers.

Let me put it another way: Downturns lead to very sudden spikes in unemployment; recoveries lead to a slow and steady decrease in unemployment.

This is an important piece of economic data, because it teaches us that, while a definite relationship between GDP and employment exists, the relationship does not have an equal result. During the recession and recovery period, GDP drops then recovers again, and may even exceed GDP levels prior to the recession - yet this occurs while unemployment levels remain higher than what they were prior to the recession.

This graph, again from the St Louis Fed, shows what I am talking about:

Because of the way the graph is designed, the unemployment data appears different to the first graph but is exactly the same. What is different is that the GDP figures are now measured in chained 2000 dollars (which takes inflation into account) rather than the year-on-year GDP growth of the first graph.

Look at the 1979 and early 1980s "double dip" recession. What do we see here? The first thing to note is that US GDP at the beginning of the 1979 recession was lower than at the end of the early 1980s recession. In other words, the US economy had a net expansion - albeit a small one - that spanned these two recessions. Yet unemployment, which was 6% at the beginning of the 1979 recession, reached 10.8% when the second recession was over.

So. We have a situation in which there was net economic growth alongside a considerable increase in unemployment. Why?

The issue is not the fact that there was net GDP growth - the issue is that GDP growth during this period (1979-1982) underwent a series of contractions (whereby GDP actually declined). It is these contractions which have the effect of causing large spikes in unemployment.

I would argue, therefore, that the best conditions for creating steady employment over a long period is not to increase GDP growth, but to prevent economic contractions. The longer the period between contractions, the more stable the labour market is and the less unemployed people there will be.

Of course, this is not to say that GDP growth isn't important - it is. Moreover, preventing an economic contraction logically assumes that GDP should grow.

What I am suggesting, though, is that GDP should never be allowed to grow too fast. Growth must be sacrificed in the short term in order to allow growth over the long term. Moreover, short term growth must be sacrificed in order to prevent a contraction later.

For those whose study of economics takes into account the importance of social justice, economic growth must not become an end it itself. In other words, increasing output, while important, should not be the sole outcome. Any form of economic growth must result in higher standards of living for the people who live in the economy - including those whose contributions are not as great as others.

From a macroeconomic perspective, therefore, progressive economists should embrace any system or policy that will prevent contractions while allowing room for slower-paced economic growth.

Here's one: Absolute Price Stability.

Yes you were probably waiting for my solution, probably even waiting for that one.

Absolute Price Stability (APS) is an alternative form of monetary policy to the inflation targeting practised by most central banks. Rather than trying to keep inflation under 3% (which is the policy of the Reserve Bank of Australia), APS involves the central bank keeping prices completely stable over the course of the business cycle. In practice, this would mean having neither inflation nor deflation. Of course, prices go up and down all the time - but whenever inflation rises it means that prices are going up more and down less. Deflation, of course, has an opposite effect. Moreover APS is not some pseudo price fixing law - prices can go up and down as much as the market dictates. However, for APS to run effectively, the market's ability to affect prices must have a neutral - rather than inflationary or deflationary - effect.

But in order to maintain Absolute Price Stability, central banks must essentially set their inflation targets to zero ("zeroflation") and work hard at maintaining that goal. In practice, this means that interest rates will have to increase while inflation drops to zero. While small amounts of inflation or deflation may be tolerated in the short term, the overall long term goal is to have prices remain where they are. Rather than measuring inflation via the traditional CPI, inflation could be measured as the number 100 in an index. If Absolute Price Stability is achieved on, say, 1 August 2010, then the index would read 100. As inflation or deflation is experienced, that number will go up or down slightly (eg 99.85, 100.25). The long term goal for central banks, however, would be to keep the index at 100, with monetary policy (the raising or lowering of interest rates) being used to achieve this.

So what has Absolute Price Stability got to do with preventing contractions?

Well, since APS requires that interest rates remain relatively high in order to keep inflation low, the natural effect upon the economy would be to dampen economic growth. Rather than investing in shares or in property, or spending money to buy consumer goods, people are more likely to save money. Why? Because they will be in an environment with higher than usual interest rates - the high interest rates reward those who put their money into savings accounts. Keeping money stored in savings accounts and term deposits gives households and businesses a "buffer" against any unforeseen events. Moreover, it means that companies who employ people are more likely to have a cash buffer protecting their business and thus the job security of its employees. Together, this means that both households and businesses have their own form of safety net in case of problems.

To be sure, such practice will hardly speed up the economy in the short term - and that's exactly the point. Any economy who practices Absolute Price Stability will discover that the first few years will be hard. Moreover, the most obvious short term effect of APS will be a dampening of economic activity - even a recession - as higher interest rates begin to bite. It also means that any recovery will be rather slow. From that point on, however, Absolute Price Stability - which is essentially a contractionary policy to start with - will ensure that the economy grows at a slow and steady rate while unemployment drops at a steady rate as well. This process is pretty much covered by Keynesian economics.

It may seem strange that I am advocating a policy that will cause an economic downturn and result in higher levels of unemployment. It may seem even stranger that my reason for advocating this policy is to protect employment. But the reason is that APS is a dynamic policy that results in a downturn first and a sustained recovery later; it results in higher unemployment first and then long term low unemployment later. It is the sacrifice of the now to ensure that the future is better prepared for.

APS will, all things being equal, prevent the economy from contracting - and thus keep the economy running well enough to provide long term job opportunities. Will APS erase contractions enitrely? Will it remove "peaks and troughs" in economic growth? All things being equal, APS will, I believe, be able to achieve this. However, any form of supply shortages (such as oil) will cause the economy to contract, in spite of the practice of Absolute Price Stability. Thus all things are not really equal, although I would still argue that maintaining zeroflation is essential even if the economy is contracting due to any supply shocks.

I need to point out that zeroflation is not deflation - it is simply keeping prices stable, neither rising nor falling. Nor will APS necessarily result in a static or declining money supply - zeroflation is essentially supplying exactly enough money as the economy demands, no more (inflation) and no less (deflation). Zeroflation is quite achievable in an economy in which the money supply is growing.

The only country that has managed to experience zeroflation is Japan, and that only after their mid 90s "long recession", which included a period of destructive deflation. Since Japan's recovery, GDP growth has been quite modest compared to other nations, but their unemployment rate has remained low (and at around 4% is lower than the US) and the standard of living remains high (as shown by GDP per capita - US$33,800 in 2007 - and a high placing in the United Nations Human Development Index). Yet despite the fact that Japan's society is benefiting from its zeroflation economy, many in the US continue to believe that Japan's economy is a "basket case" and is unable to grow at its full potential. (The fact that Japan's economy has long recovered from its 1990s recession seems to have eluded many American commentators).

This combination of zeroflation and low growth has allowed Japan to have a more sustainable economy that has provided long term jobs for its people. While the Japanese are hardly choosing zeroflation (it has essentially been forced upon them by circumstances and does not exist by design) and while the economy still has some major imbalances (namely massive public debt), current economic conditions are reasonably good. Of course, this is not to say that exogenous factors won't affect them - they export to the US so they will obviously feel some pain from the US recession - but their current zeroflation environment will help them cope with any changes they will experience.

At this present time, monetary policy is being questioned. Here in Australia the Labor government has vowed to cut spending in order to control rising inflation, a move back to pre-1996 behaviour whereby Australian governments would aim to use fiscal policy as the way of attacking inflation, rather than the Howard years of paying off debt and leaving it to the Reserve Bank to control prices. In America, the Federal Reserve under the chairmanship of Ben Bernanke seems to have jettisoned any concern about inflation altogether and seems to be trying to create as much money out of thin air as possible in order to prevent a recession. Meanwhile the European Central Bank continues its strict anti-inflationary policies inherited from its immediate predecessor, the Bundesbank, all the time while European unemployment levels remain stubbornly high in comparison to other industrialised nations.

With inflation rising worldwide and economic stagnation a certainty, many will wonder at what influence central banks will have in the future to influence the economy. I don't think it is time to ditch the lessons we learned from the 1970s just yet - strong, independent central banks with an exclusive focus on price stability are more important that this generation realises. If Absolute Price Stability is to be introduced, these central banks need to be trusted more, not less, than what they are now.

© 2008 Neil McKenzie Cameron, http://one-salient-oversight.blogspot.com/

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