In praise of wage inflation!!!!

"Wage inflation". The very words strike terror into the hearts of economists and financiers everywhere. We are taught that wage inflation is categorically evil, as if some comprehensive set of data proved this beyond any doubt. But, maybe there is a time and place for wage inflation, and maybe that time is now and that place is here.

A primary goal of the government today should be to stimulate the economy to, in principle, cause hiring to create additional GDP. US companies are sitting on record balances of cash, so they have no problem funding capital expansion and hiring. The low interest rates may help them on current interest payments by some refinancing, but otherwise makes not difference to them. They see no demand for more goods and services beyond what they currently plan to produce, so they sit and wait. They are waiting to be signaled by consumers to increase production by consumers buying more goods and services than these companies are currently planning for. This is the demand signal that moves companies to hire workers and invest in capital expansion.

Consumers, seeing their pay stagnate or shrink, and being up to their ears in debt, are in no position to increase their spending to create the demand needed to signal companies. So, they muddle through hoping not to loose the jobs they have and become one of the tens of millions of unemployed.

The long-term unemployed try to find work, but are unable. Neither are they in much of a position to start businesses of their own. I suppose some try to do odd jobs or deal things at flea market and on line. But they just hope to find some decent job before their unemployment runs out. BTW, unemployment insurance payment is the one fiscal stimulus that is actually in effect to boost demand.

I believe this whole line of argument is the one Keynes made to justify government intervention in the first place. And that fiscal policy is needed during recessions.

Consumers are spending all they can afford to, but that level is below the amount that the businesses in the economy are structured to produce. The lack of growth in the economy is because the consumer isn't buying more. And the consumer isn't buying more because they lack the income to do so. In other words, incomes have not kept up with expectations of producers. So, production is cut back to a level that consumers can currently afford. This means the supply and demand curve is moved to lower demand and thus lower supply at a lower price. This is source of the lack of inflation that we've been seeing.

What is needed is for consumers incomes to grow, which would spur purchasing, which would spur increased production, which would spur hiring and capital expansion. Which would...increase incomes. This is, in fact, wage inflation. Prices would necessarily rise as demand is bid up by rising incomes, and rising supply would only happen if prices were bid up to motivate the increase in production.

The happy side effects of this wage inflation are: lowered unemployment, raised taxes, and likely increases in long term profits for companies as those sales increases accrue over the years. This is a much better situation for all then if those unemployed stay idle, government deficits continue at the current pace, and production at companies remain below the potential output.

Going back to Keynes, this is where the government needs to step in. How to achieve wage inflation? By cutting taxes on wage earners. I.e. those folks who make their incomes through work producing real goods and services. Also known as the middle class and the working class. The groups who have been taking the brunt of the economic crisis. One which they largely didn't create. How to pay for this? By increasing taxes on those who benefit by increased incomes from unproductive activities. I.e. Wall St types and those who's incomes come from rents and capital gains. This isn't a punitive suggestion, merely a recognition that the wealth is flowing to those groups and they are not spending it to produce increased demand for the goods and services that the nation's companies are set up to produce. Such a trade off of taxes would be essentially revenue neutral, but would increase demand in the economy and send it back to full production and employment.

Such a suggestion goes against the entire "cut taxes on job creators and the wealthy" arguments.  But, I think that those arguments were weak to begin with, and have now been largely discredited by the current economic and financial crisis.  Will government have the will to make these changes?  Will the economics profession have the will to acknowledge these new policies are the correct ones to make?  Only time will tell.

Should America remain a sovereign nation??

The modern nation-state is a political entity that was created at the end of the thirty years war by the Peace of Westphalia.  This new concept recognized geographic boundaries of a nation and that nations should largely be free of outside influence.  Also, that the nation was the primary, cohesive entity with common internal interest that negotiated with other nation states that have their own interests.  The idea of empire became passe', particularly as related to a single sovereign person (king, emperor) or one of a religious state that ailed with a particular religious sect.

The essential properties of a nation-state are:
Sovereignty:  being independent from other nations.
Independence of the influence of external agents, either other nations or others.
Have relations with other nations.  The nation is the primary negotiating entity.
Has a population of citizens.  These folks have rights and responsibilities to the nation.
Has a geographic boundary.  The nation controls the land within its boundaries.
Has a national currency.  Controls and regulates the values of the currency used by the nation.
Has a common culture.  Common values, rituals, symbols, mythology, and history.
System of laws aligned with the culture.
A national defense to defend against other nations which could be hostile.

The United States of America, one could argue, became by the mid-twentieth century, the purest realization of the ideal of the nation-state.  It kicked out the british king and became sovereign.  It kicked out the british to get rid of external agents (at least they tried).  It formed relations with other nations, e.g. France.  Americans then thought of themselves as, well, Americans rather than brits.  The borders were the combination of the state boarders.  They eventually created a national currency, but that took some time.  By mid-twentieth century the US had a culture that bound its citizens (most of them at least) together with a common identity.  It had laws which reflected this culture and the founding principles of the rights of man.  And it developed a military in WWII that was able to overwhelm fascism.  So, the USA became truly a nation-state.

But how does a nation cause those properties to come into being and continue into the future?  That is what actions does a nation-state take and what structures does it put in place to actually be a nation-state?  Looking back at the list we see that the essential feature of a nation-state is controlling what transits boarders.  That is, what leaves and enters the geographic boundary of the nation.  Control over boarders is how the nation-state puts into effect the properties to be a nation-state.  In a sense, a nation is defined by its borders and the control thereof.  Well, what transits borders?  People, goods, services, money, communications, ideas.  These elements that transit borders are mostly economic and financial in nature.  So, being a nation entails border concerns with economic and finance issues as well as political issues.  So the opposite must also be true.  That is, nations which don't control their borders are no longer sovereign.

The US used to control these boarder crossing entities quite strictly, as do all sovereign nations.  Entering and leaving the country was controlled by strict visas on how long one could visit.  And for work, relatively few could enter and stay on a temporary basis.  Entry for work was predicate upon intent to immigrate and become a citizen.  And the right to immigrate was relatively difficult to secure.  The currency, i.e. the US dollar, was backed by gold and then by the gold exchange mechanism of Bretton Woods, which ensured its value and stability.  Trade was regulated to prevent deficits and protect key national industries by means of tariffs and quotas.  Even ideas were regulated to some extent as certain books and publications were prohibited from import.

Today the situation for the US is much different.  No longer are borders so controlled.  People flow over the border relatively unimpeded as illegals aliens to work in agriculture and construction.  H1-B visa workers come by the tens of thousands for years to fill technology positions because of a supposed shortage of domestic talent.  Trade is now almost totally unregulated, so massive deficits accrue year after year.  Financial transactions across the border are similarly almost unregulated with foreigners able to buy up property and businesses unimpeded.  National defense has become world policing for someone's interests.  However, who's interests that is remains a bit unclear.

Many of the essential characteristics of a sovereign nation have been given up by the US over the last few decades.  The US really doesn't control its borders anymore.  Which makes me ask: is the US still a sovereign nation?  and should it even continue to try to be one?  Perhaps the globalists are right? or at least are getting their way?

Dealing with China

In 2012 the US had a trade deficit with China of $315.0B.  That is, the US exported $110.6 to China while importing $425.6B of goods and services[1].  This is an extraordinary imbalance and constitutes the largest single contributor to the total trade deficit of $735B that same year.

Why would China want to run such a huge trade surplus with the US? And why would the US allow such a situation to continue so long?  There has been much speculation about these reasons.  Mainly because in politics the announced reasons are often not the real reasons.  So, I will also speculate about these as well.

For the first question, the Chinese have been growing their economy at a furious rate of about 8-10%/year in a bid to become a technologically advanced, developed nation.

In order to do this they need to spur domestic development at a level that is much higher than in the developed countries.  To do so using only domestic resources and investment mechanisms would likely proceed at a slower rate simply due to the inherent difficulties in growing that quickly.  Instead, the Chinese are supplementing growth by exporting the excess production, mainly to the US.  Thus, the US provides the demand to spur growth that would not generally come at home in China so quickly.  The other reason, which may be the more important one, is that China wants to import advanced technology that is only available in the west, and in the US in particular.  Many of the deals China now makes are not to purchase goods and services from the US with its vast holdings of USD, but to buy US companies with technologies that they need.  Or, to enter into production agreements with US firms which requires the US company to share their technology with their Chinese counterpart.

Why the US would allow this?  From a national perspective this ongoing deficit is bad as it adds to the total deficit and reduces employment in manufacturing in the US.  Worse, it transfers important technology from US companies to Chinese ones, or transfers the whole company to China.  Who benefits from this situation?  Well, US companies that move manufacturing to China can reduce their manufacturing costs to generate larger profits, as long as the Chinese Yuan (CNY) remains low relative to the USD.  That's the key for US companies, a low Yuan.  If the Yuan rises in value relative to the USD then the advantages of manufacturing in China drop and will eventually disappear, and so will their out-sized profits.

China, it is well known, intervenes in the currency market to keep the Yuan low against the dollar.  This keeps their exports up and technology flowing in.  It also pleases US companies that import from China, as they can continue to generate large profits.  But this creates the trade imbalance that doesn't allow market forces to bring trade into balance, and continues all the dislocations to the economy that have occurred.  One would think that the advocates of free trade would be furious at this and vociferous in their demands for market exchange rates for the Yuan.  But, hardly a peep.  The US sends some trade delegates, and even the President, to ask for a floating Yuan, but nothing happens.  In response, Washington does nothing.  Why would the Chinese change anything if there are no consequences to their policies?

The traditional solution to this is again the tariff.  Imposing a tariff is the needed consequence to not allowing the Yuan to float.  To be clear, a tariff for this reason has nothing to do with trade imbalances that exist for reasons other than China's intervention in the Yuan currency market.  The sole reason is that the currency market is designed to work only when exchanges of currencies are due to market forces alone.  Intervention breaks this system, so either China needs to play by the rules or we need a new system.  Now, I'm not a fan of floating market currency systems, as they have many problems that have be previously discussed.  But, at a minimum, if we're going to use this system then all participants need to play by the rules.  Or else face consequences.

A significant tariff (in a previous post I suggested ~60% for general trade) should be applied to imports from China.  The Chinese might not like this, as it thwarts their plan for growth and technology acquisition, and US companies which import would certainly not like the immediate hit to their bottom line.  So, imposing a tariff would largely be a political fight.  But with such powerful foes like China and US corporations on one side, who will represent America's interests in this fight?


[1] http://en.wikipedia.org/wiki/List_of_the_largest_trading_partners_of_the_United_States#cite_note-2

Two kinds of growth

Much has been written about how China and other developing nations are growing much faster than the developed nations in general, and the US in particular.  The growth of China's GDP over the last decade has averaged nearly 10%, while that of the US has been below 3%. 

 

This difference, it is implied, is due to the superiority of the Chinese model over the US model, which is now seen as faltering.  I think this kind of comparison is unfounded.  There are really two kinds of growth which I will term: Innovative growth, and Catch-up growth.

Developed nations, like the US, are operating near their potential production.  Although recently the recession has put a major dent in this.  What being near potential production means is that the economy is at full employment using state-of-the-art technology and is producing the maximum possible output.  More importantly the per capita production is maximal.  Any increase in production has to come from either increases in efficiency of current methods or innovations of new methods of production.  And, in any case, the former is usually a form of the latter.  So, for an advanced developed nation like the US to grow it has to innovate.  Innovation is risky, expensive, and time consuming.  Innovation forms a cost to current consumption that promises an increase in future growth, albeit at an uncertain rate.  The rate of growth in a developed country is mainly determined by the rate of investment in innovation.

In a developing country like China, the state of technology is generally far behind that of the developed countries.  That's pretty much the definition of developed and less-developed nations.  So, for that country to develop further it must first acquire existing technologies from the developed countries and implement them domestically.  The developing country must catch up technologically with the developed countries.  Importing technology is much simpler, cheaper, less risky, and less time consuming than creating new innovation themselves.  So, the developing country can grow much faster than the developed country.

The real issue for the US is that investment in innovation and new production has fallen, which limits the rate of growth of the economy.  But, even when those pick up again, a growth rate much above 3% is unlikely due to the need for massive investment in innovation to spur such high growth rates.  A massive level of investment does not seem likely without some government mandate for some great national cause.

The effects of imposing tarrifs on trade

Today tariffs average a mere 1.3% [1], which is quite low by historical levels, where tariffs have more typically been in the 10%-30% range.  What would be the effect of raising the average tariff to 10%?  The US imported $2299B of goods and services in 2012 [2], and exports of $1564B in the same year [3], so we'll use these number for a simple analysis.

What effect would that 10% tariff have on the balance of trade?  This is a complicated question but one for which we can make some simple estimates.  A recent study of the effects of trade barriers [4] finds that "The elasticity of imports to the domestic cost of importing is about 0.50, and that of exports to the domestic cost of exporting is about 0.48. That is, a 10% reduction in the cost associated with importing (exporting) would increase imports (exports) by about 5% (4.8%)."  Per country details vary but we can nonetheless use these values to estimate the effect of changes in tariffs on the level of imports and exports for the US.  An increase in tariffs acts the same way.  That is, for imports an increase in the tariff of 10% will decrease the amount of imports by 5%.  A tariff is just a percentage increase in price of an imported good.

Elasticity is a bit difficult for many people to understand.  But it basically says if I perturb one value a little bit, how much does the other value change?  In the case of imports a small change in price causes half as much change in imports.  A key concept here is that elasticity is only valid for small changes in values.  Even the change of 10% in price is probably a bit unrealistic, but it will nonetheless give us some idea of how imports are changing with price.

Balancing trade requires that the level of imports equals the level of exports.  So, to decrease the level of imports to that of the level of exports in 2012 is a drop from $2299B to $1564B, which is a large reduction of imports of 32%.  Given the elasticity factor of tariffs for imports of 0.50, this means the tariff increase needed on imports to achieve this goal is 32%/0.50 = 64%.  This is a large tariff by historical standards, and in practice this amount may not be needed as the actual adjusting of trade is not so simply defined by the elasticity.

The complexities of trade suggest that an incremental approach to tariff be taken.  Start by increasing the tariff to 10% one year and see the effects.  Perhaps increase the tariff again the next year and see the effects.  Continue increasing the tariff until trade comes to a balance.  Or in the case of the US, a surplus is generated, which is needed to pay down the years of accumulated trade deficits.

A second benefit of the tariff is raising revenue for the government.  A simple application of the tariff assuming no change in imports for a 10% tariff  to all of the new level of imports of $2184B it would produce $218.4B of revenue for the US government, which is $190B more than the government collected would have collected.  Tariffs reduce the tax burden on Americans and helps balance the budget as well as affecting trade.


Still using general references due to the government shutdown
[1] http://en.wikipedia.org/wiki/Tariffs_in_United_States_history
[2] https://www.cia.gov/library/publications/the-world-factbook/rankorder/2087rank.html
[3] https://www.cia.gov/library/publications/the-world-factbook/rankorder/2078rank.html
[4] Hoekman, Bernard & Nicita, Alessandro, 2011. "Trade Policy, Trade Costs, and Developing Country Trade," World Development, Elsevier, vol. 39(12), pages 2069-2079.

Balancing trade by tariff is a Keynsian approach

The previous policy recommendation of balancing trade by the use of tariffs, when the market mechanism are not working in a rapid enough manner to balance trade on its own, is a kind of Keynesian response to the problem.

The problem addressed by Keynesian economics is a recession, where unemployment is high and production is below the potential production levels.  The market forces will, in the long run, bring the production levels up and the unemployment levels down, but not in a timely manner that is acceptable to society.  And as Keynes said "in the long run, we are all dead".  Instead, Keynes argued that the government needs to take an active role in returning the economy to a level of its potential output and employment to normal levels.

Similarly, the imbalance of trade over long periods, and in particular, the running of trade deficits over those long periods, also causes economic dislocations that are adverse to the economic prosperity of society and long term economic growth.  Thus, the government must also take an active approach in dealing with the long term trade deficits by taking actions which will move trade back to a state of balance.  The government needs to approach long term trade imbalances with the same urgency as it does recessions.

The previous post examined the time scale of the long term run of trade deficits and found that the deficits had continued for many decades, and it would be at least 50 years, and probably much longer, before any market mechanism caused anual trade to return to a balanced condition.  This did not include the additional time needed to run surpluses to pay down the accumulated trade debt, which we can only assume would be a similar time scale of decades.  It also looked at the time scale of the beginning of adverse effects of these deficits and found that they start to occur in only one to few years, which is much less than the time scale over which the market actions are operating   Thus, some action needed by the federal government to counter these trade deficits and return trade to a balanced condition within a few years of the beginning of persistent trade deficits.

The Great Depression showed that government intervention is required when the difference between what the economy could do and what it is doing is great.  Similarly, the Great Recession has shown that the government can't ignore trade when dealing with a recession, but needs to address trade imbalances when they become persistent to avoid the harmful dislocations that long term deficits produce.

Trillion dollar coin and bonds have a markedly different effect on the money supply

Much has been made of issuing a "trillion dollar platinum coin" as a part of a solution for the current budget crisis.  While such an action is possible it will produce monetary outcomes which are significantly different than if the government sold an additional $1 trillion in bonds as it usually does to finance its deficit spending.

The difference comes down to what is money?  In the case of the US it is the US dollar.  A bond, while having value and a use in exchanges, is not money.  Thus, adding bonds to the market does not increase the amount of money in circulation.  Adding $1 trillion does add to the money supply.  But the change to the money supply does not end there.  The US banking system is a fractional reserve system in which the vast majority of money is created not by the government, but by the banks.

Under a fractional reserve system the amount of money is largely determined by the so called money multiplier, which is derived from the reserve requirements in effect at the time.  Currently, this is about 10% of deposits, which indicates that the money multiplier is about 10x the amount of the monetary base.  This mean that for every dollar of monetary base, or high-powered money, the total money supply (M1) will increase by 10 dollars through bank lending.  The monetary base is created by the government mostly through the purchasing of bonds by the Fed.

The issuing of bond by the government doesn't change the money supply, but the issuing of a trillion dollar coin not only changes the money supply directly, but induces a multiplier effect because the trillion dollars will add to the monetary base.   Therefore, the trillion dollars deposited in the treasury account will add 10 trillion dollars to the money supply (M1) as the government spends that money.  This won't happen immediately, as the government won't actually spend that trillion dollars at once, but will leak into the financial system as the government uses those funds to pay its bills.

This addition to the money supply is, of course, of crucial interest to the Fed as its job is to regulate the money supply.  It could react to the addition to the monetary base in many ways.  1) it could reduce its own purchases of bonds, 2) it could increase the reserve requirements such the the money multiplier is reduced from the current value, 3) it could use its recently formed mechanism of paying interest on reserves held at the Fed by banks to induce the banks to leave the extra money in their Fed accounts so as to not lend it out.

One important benefit to the government of issuing the trillion dollars is that it won't have to pay interest on it as it would if it had issued a trillion dollars in bonds.  This adds up to a big savings for the American people over time.