Inations Mysterious Vanishing Act

Anusar Farooqui*

February ,

* Department of Mathematics, McGill University. Email: farooqui@math.mcgill.ca

 Abstract

Ination has disappeared from the core of the world economy since . Ultra-
loose monetary policy in the center countries has failed to unleash ination before
and after the Western nancial crises. We argue that the absence of wage ination
accounts for inations mysterious vanishing act. In turn, the disappearance of wage
ination is due to the unbundling of rms supply chains allowing them to pit na-
tional labor pools against each other thereby undermining the bargaining capacity
of workers systemwide.
 e most important macro development of the past few decades has been the
banishing of ination from the center of the international economy. In the United
States, we know that Volckers draconian policy measures were decisive in bringing
down ination from its peak of slightly over per cent to under per cent
by . But the Fed has been extraordinarily accommodative since at least ,
yet core ination has been under per cent since . What accounts for this
startling fact?
In standard macroeconomic textbooks, the general price level is determined
by the money supply. Broadly speaking, the rate of ination equals the dierence
between the rate of growth of the money supply on the one hand, and the rate of
growth of real output on the other. is basic picture is adjusted when there is an
output gap captured by the concept of the natural rate of unemploymentin the
technical jargon, the non-accelerating ination rate of unemployment (NAIRU)
dened as the level of unemployment consistent with stable ination. e GDP
equivalent of full employment is the absence of an output gap. Excess demand bids
up the price level and increases ination; decient demand likewise results in lower
ination. Note that this renement is contingent on monetary accommodation:
You cant have high ination unless the supply of money grows rapidly.
e standard model fails miserably in making sense of the past twenty years.
Not only does it fail to predict the magnitude of the decline in ination; much more
damningly, it gets the direction of the movement wrong. In light of the extraor-
dinarily accommodative monetary policy, it predicts rapidly accelerating ination.
What, then, accounts for inations vanishing act? And why does the standard
model fail so miserably?
e argument that central bank discipline is responsible in not persuasive on two
grounds. First, ination has been tamed not just in the United States and not just in
the core of the world economy, but globally: world-wide ination has declined from
double digits to around per cent over the past twenty years. erefore, central
banks institutional learning can hardly be said to provide an ecient explanation.
Second, and fatally, center countries monetary policies during the past twenty years
can hardly be described as restrained. Any good explanation must account for the
global nature of the phenomena and the failure of ultra-loose monetary policy to
unleash ination.
Back in , Kenneth Rogo argued that globalization is to blame. Specif-
ically, he argued that the most important and most universal factor supporting
world-wide disination has been the mutually reinforcing mix of deregulation and
globalization, and the consequent signicant reduction in monopoly pricing power.
He is right about globalization but wrong about the mechanism. Inter-rm compe-
tition in product markets for tradable goods and services, whether national, through
deregulation, or international, through increasing trade openness has indeed been
responsible for disination in the periphery, but this is not the case in the core of
the world economy. Rather, I will argue that the explanation for disination in
the core of the world economy has to be sought inside rms. Specically, the un-
bundling of rms supply chains allowed them to pit national labor pools against
each other, sharply reducing their ability to bargain for higher wages, and thereby
short-circuiting the central mechanism that drives persistent ination.
Wage ination is the principal driver of persistent ination. is is in fact the
key premise of the concept of the non-accelerating ination rate of unemployment
(NAIRU). Business cannot raise prices without a signicant growth in consumers
purchasing power. Unless the Federal Reserve sends cash-strapped consumers a
check in the mail, consumers can only increase their spending on goods and services
by becoming ever more indebted. But there are inherent limits to credit-fuelled ex-
pansion in consumer spending: it is not enough to generate signicant inationary
pressures. Persistent ination is well-nigh impossible without a sustained rise in
nominal wages.
e Federal Reserve does not control the money supply. is may come as
a shock since in both macroeconomic theory and common parlance, the Fed can
choose to expand the stock of money at will. But this is a fallacy. It is the banks
who create money out of thin air. When you apply for an auto loan, your bank
makes an accounting entry on its books showing that you owe it , and debits
, to your account enabling you to buy the car. To be quite clear: the bank
loaned you , that did not hitherto exist. It is therefore clear that the amount
of nominal dollars oating around depends on general credit conditions; crucially,
it depends on borrowers ability to borrow and lenders ability to lend. e Fed
merely manipulates the constraints on banks to lend by manipulating the federal
funds market. e federal funds market is only the last resort for banks who satisfy
the bulk of their funding needs through the repo market and the oshore market in
eurodollar bank deposits. In fact, the reality is even more sobering. What we have is
a market-based credit system in which the money supply emerges from a complex
interaction of the monetary authorities, the behaviour of banks and shadow-banks,
and general credit conditions. e Fed can hardly be described as quarterbacking
the operation, much less choosing the money supply.
Credit expansion in the absence of any signicant growth in wages is, and can
only be, absorbed in the asset markets. e reason is straightforward. In light of
their depressed incomes, peoples capacity to borrow is inherently limited. Books
may be fudged for a while and subprime lending expanded but sooner or later this
process will reach its limit. Unless, of course, there is an asset price boom that raises
the value of the collateral on which lending can expand. Both of these dynamics
were in play before the nancial crisis. More generally, extraordinarily accommoda-
tive monetary policy buoys up the price of risky assets by prompting a search for
yield by asset managers. Credit expansion thus gets channeled into rising asset
prices.
e collapse of wage ination in the s can be traced directly to the sec-
ond unbundling of rms supply chains. In particular, the addition of hundreds of
millions of Asian workers to the global labor pool undercut the bargaining power
of workers in the core of the world economy. Relocating processes in the periph-
ery not only reduced the production costs of global rms directly but also increased
their bargaining power against unions back home. e competitive pressure iden-
tied by Rogo worked not so much through reduced monopoly pricing power but
rather by forcing rms to adopt cost-competitive supply chains. In fact, it worked
to increase their monopsony power in national labor markets. Schwerho and Sy
identify a second mechanism: competitive pressures unleashed by the second un-
bundling served to eliminate the least productive rms, thereby reducing average
costs, which in turn promoted disination.
e strongest piece of evidence against Rogo s mechanism is that if intensify-
ing inter-rm competition were in fact is responsible for disination then the prot
rates of global rms would show a marked decline as well. is is quite the oppo-
site of what has obtained. New York Times reported last year that corporate prots
were at their the highest level in years. ere is no sign of cut-throat inter-rm
competition to be found.
It is also clear why the standard textbook model fails so miserably. e central
mechanism through which loose monetary policy is translated into ination, i.e.,
wage ination, does not work as advertised due to the economics of global supply
chains. In the absence of wage gains, the modern market-based credit system
channels the Feds monetary expansion into asset markets.

Notes
Kenneth Rogo, Globalization and Global Disination. ( ).
Gregor Schwerho and Mouhamadou Sy. e Global Dimension of the Global Disination.
( ).