Saturday, 18 February 2017

The NAIRU and Nominal Wage Rigidity

Simon Wren-Lewis has a post discussing the NAIRU.  He acknowledges that it has its problems but struggles to find a good alternative.

The idea with the NAIRU is that, when unemployment falls below that level, we don't simply have a higher rate of inflation, we have an ever increasing rate of inflation.

The theory here is that wage inflation reflects an attempt by workers to secure a particular real wage, based on their expectations of price inflation.  If they are thwarted by price inflation higher than expected they will revise their expectations and increase their demands.

However, whilst wage inflation may sometimes be driven by real wage concerns, it is not clear this should generally the case.  Particularly at lower levels of inflation, changes in aggregate wages may have little to do with real wage considerations.

First of all, it is worth noting that the inflation rate, and the rate of wage inflation, are aggregate figures.  At any time, some firms will be facing supply constraints and will be bidding up wages.  Others will find themselves with excess capacity and will be holding wages constant (or in rare cases, cutting them).  The balance will vary with the level of aggregate demand.  There isn't a single labour market and a single wage.

One of the reasons why the idea of a single wage might be unhelpful is to do with nominal wage rigidity.  On the whole, wages are not subject to constant revision.  An individual worker's wage is fixed when he is first employed and then only changed when there is sufficient reason to do so.  

At low inflation rates, therefore, most wage inflation arises from the turnover in jobs, where some firms are hiring and others are firing.  The lower the level of unemployment, the more that turnover requires hiring firms tempting workers to change jobs, rather than simply drawing on the pool of unemployed.  This requires greater wage differentials.

Actual cuts in nominal wages are unusual.  Having greater wage differentials therefore requires having a higher minimum average level wage inflation when unemployment is lower.  The higher average means the wages that are growing the least are not actually falling.

Real wages play no role in this.  It is all to do with relative wages.  So there's no question of foiled expectations or any reason to think that this inflation should accelerate.

All this means that, at low rates of inflation, we may well have some kind of trade-off between unemployment and inflation, rather than the accelerating inflation dictated by the NAIRU.  However, if higher rates of inflation become the norm, this kind of relationship may break down.  If the average rate of wage inflation is high, then cuts in relative wages can be easily achieved simply by holding some nominal wages fixed for longer.  The pay-off between inflation and unemployment depends on the reluctance to cut nominal wages being relevant.

Furthermore, if it becomes normal to frequently adjust wages to compensate for price inflation, then some measure of indexed wages starts to replace the fixed nominal anchor as the benchmark for relative wage competition.

So, accelerating inflation may still be a trap to fall into.  However, as conceived here, this does not simply arise from venturing past the NAIRU.  It comes from allowing inflation to persist at too high a level and for too long.  It is true that this could come from trying to achieve excessively low unemployment.  But wages are not the only factor in determining price inflation.  Things like exchange rates and world commodity prices also play a role.  On the whole, it should be no surprise that it is difficult for advocates of the NAIRU to pin down what the level of the NAIRU actually is.

Friday, 3 February 2017

Global Saving and Current Account Imbalances

I've read various stuff recently on the role of savings behaviour in the causes and effects of current account imbalances, some of which I'd say is rather confused.

It has to be said that this is quite a tricky topic, because it has a number of moving parts, various complicating factors and the common problem of lack of clarity over what is being assumed unchanged when we invoke the ceteris paribus assumption.

Here's one way I think about this question.

We start from the sectoral balances identity that says that private sector net acquisition of financial assets (NAFA) is equal to the public sector borrowing requirement (PSBR) plus the current account surplus (CAS).  The PSBR we will assume is a negative function of GDP (Y) and the current account surplus we will assume is a negative function of GDP, a positive function of the GDP of the rest of the world (Y*) and a negative function of the real exchange rate (e)[1].  Thus we have for each national economy:

NAFA = PSBR ( Y ) + CAS ( Y, Y*, e )

So, the first question is what happens if the private sector in country A decides to increase its net saving, i.e. if NAFA rises?  Well, the answer is that it depends.  And what it depends on is a portfolio decision[2].  The portfolio decision here is whether the private sector wants to accumulate domestic public sector assets or foreign assets.

In the first instance, assume that the private sector wants to accumulate domestic government bonds, so that PSBR increases to match the rise in NAFA and the CAS stays unchanged.  In order for the PSBR to rise (within our limited framework here), GDP has to fall.  And for the CAS to stay constant with falling GDP (and constant GDP in other countries), the real exchange rate has to rise.

In the alternative case, the private sector wants to accumulate foreign assets, so the CAS must rise to match the increase in NAFA whilst the PSBR remains unchanged.  As the PSBR is unchanged, GDP is unaffected and the real exchange rate falls to facilitate the rise in the current account balance.  

At this point, we need to turn to the implications of this for other national economies.  To do this, let's assume there are only two countries, so for the other country - country B - the current account surplus is simply the negative of country A's, and the real exchange rate is the inverse of country A's.  Country B has the same sectoral balances equation and we will further assume that country B's NAFA does not change.  Y* for country B is Y for country A and visa versa.

In the first instance, where country A's private sector accumulates only domestic public sector debt, country B's CAS is unchanged, because country A's CAS is unchanged.  Therefore country B's PSBR is also unchanged and so its GDP is unaffected.  Country B experiences a fall in its own exchange rate, but any impact on exports and imports is offset by the change in Country A's GDP.

In the second scenario, country A's GDP stays the same but country B sees a rise in its own exchange rate and a fall (i.e. becoming more negative) in its own current account surplus.  As its own NAFA is assumed unchanged, the fall in the CAS implies a rise in the PSBR which implies that country B's GDP must fall.  This fall in GDP feeds back into the function for the CAS, but given our assumptions about country A, this only impacts on the exchange rate not the actual level of the CAS.

So, the overall effects are as follows.

1. If country A's private sector wants to save more, the impact depends on whether it wants to accumulate domestic or foreign assets. 

2. If it wants to accumulate domestic assets, this will hit domestic GDP and not foreign GDP. 

3. If it wants to accumulate foreign assets, this will hit foreign GDP and not domestic GDP.

4. Only in the latter case does a current account imbalances arise.

Obviously, I've had to make many simplifications here.  Two of particular importance are worth noting.

First, I have assumed that the portfolio decisions do not depend on the exchange rate.  In practice, capital movements are sufficiently fluid in response to exchange rate deviations that they can dominate the real exchange rate in the short term.

Secondly, I have ignored any kind of inflation mechanism in the relationship between the real exchange rate and the level of GDP.  If, in fact, certain levels of real exchange rate create unmanageable inflation pressures, then domestic policy is likely to respond by influencing the NAFA or the PSBR and this will have knock-on effects for the analysis.

Notwithstanding these points, I think the general conclusions still apply.  This would mean, for example, that the ability of the US to run a persistent current account deficit is not so much about absolute savings behaviour in the rest of the world as the attraction of the dollar as a vehicle for saving.

[1] The real exchange rate here is expressed as the number of foreign currency units that can be purchased for one unit of the domestic currency.
[2] In my opinion, the role of portfolio decisions is one of the most important themes of post-Keynesian economics.  It underlies liquidity preference and it goes to the heart of why the role of banks matters to macro-economic outcomes.

Wednesday, 25 January 2017

Understanding Household Spending with Stocks and Flows

Household expenditure is the largest component of GDP, so understanding why and how it varies is crucial to understanding recessions.

Mainstream economics tends to look to the real interest rate and a household rate of time preference as the central explanation for such variations.  Stock flow models tend to place greater emphasis on the levels of financial stocks. 

The idea here is that household expenditure is driven by a desire to influence various ratios between financial stocks and the level of income.  Stock-flow models often describe certain target ratios, sometimes called stock-flow norms.   Household expenditure is equal to income[1] less the net acquisition of net financial assets.  If we can explain the acquisition and disposal of financial assets and liabilities in terms of a desire to move towards stock-flow norms, then we can explain why household expenditure might vary.

Looking at the UK, it is useful to divide household net financial assets into the following:

1. Pensions and life insurance
2. Other financial assets
3. Debt (i.e. liabilities of households)

The graph below shows the level of each of these relative to household disposal income.

I'll say something about each of these in turn, dealing first with pensions, then debt, then other financial assets.


It seems likely that there should be some kind of target ratio between pension assets and income.  On the whole, people want to achieve a balance between what they can spend during their working years and what they can spend in retirement.  This means they have to save a certain amount whilst working to be run down in later life. This process is naturally going to generate a stable stock-flow ratio.

In fact, we don't need to even postulate that people have a given stock-flow ratio in mind.  Much of the time, the amount of pension contributions will be in a fixed relationship to wage levels, and amounts paid as pensions will be related to the stock level of pension funds.  Institutional arrangements including the tax system influence this.  This process will give rise to a stock-flow norm, even if no-one has such a ratio in mind.

If we look at the graph, however, we can see a clear upward trend in the ratio of pension assets to income.  There are various reasons for this.  The most important is rising life expectancy.  This has reduced the amount of pension income that a given stock of pension assets will buy.  Achieving a similar balance between working and retirement consumption therefore means building a greater stock of pension assets during the working lifetime.

The decline in the yields on government securities has a similar effect.  Pension annuities are priced off fixed income yields, so as these have come down, pension funds need to become larger.

The actual size of pension funds is also impacted by the returns on those funds including stock market gains.  So we should expect to see the actual ratio rising when the stock market is doing well.


The ratio of debt to income shows less fluctuations than the two asset classes, because it is not subject to the sort of variations in value due to market movements.

With debt levels, it also seems likely that that stock-flow ratios are important.  In particular, credit constraints will tend to limit the amount that can be borrowed relative to income.  The growth in debt levels between around 1999 and 2008 reflect a general relaxation of credit criteria. 

Maximum acceptable debt levels are often assessed by comparing the interest expense to income.  The upper bound to the debt to income ratio is therefore likely to be a function of interest rates to some extent.  At the current low level of rates, interest expense is at its lowest level of this period (see chart below), which partly explains why the debt ratio remains high despite tightening credit conditions.

Credit constraints may impose a cap on this stock-flow ratio, but that is not the same as saying this is a target ratio.  It could be that households prefer a debt ratio below that dictated by credit conditions.  However, it seems likely that credit conditions provide the binding constraint in most cases for new borrowers, and this element is a key driver of the stock-flow ratio.

Other Assets

Whilst there are good reasons for thinking that stock-flow considerations play an important role in determining accumulation of pensions and debt, it is less clear in the case of other assets.  Typical stock-flow consistent models tend to assume that there is a target ratio for holdings of other assets, but I'm not sure this is necessarily the case. 

With pensions and debt, we should be able to predict what sort of target ratios we expect to see from a knowledge of things like life patterns, the tax structures, regulatory issues and so on.  No such considerations determine the holding of other assets, so it's quite possible that any target ratio could develop over time, including in response to changes in the actual.

However, looking at the first graph, the ratio of other assets has actually changed the least over time.  Apart from an apparent slight upward trend, two factors appear to drive the variations.

1. As with pensions assets, the level of other financial assets is subject to variations in asset valuations such as stock market movements.

2. The periods of strong growth in debt levels seems to be associated with an increase in holdings of other financial assets.  There are reasons why we might expect this to be the case.  The largest part of debt is for house purchase, and an increase in debt reflects a greater volume of house purchase and/or higher house prices.  This means that those households receiving property sales proceeds and not repaying debt (otherwise overall debt levels are not increasing) are receiving greater windfalls.  This type of cash receipt, does not get spend all at once, if it gets spend at all, and it therefore adds to the accumulation  of deposits, which makes up the largest part of this catergory of assets.

Once these elements are taken into account, it does appear that there is some reversion-to-norm taking place in this stock-flow ratio.  When the actual ratio is increased or decreased by one of these factors, accumulation reacts to bring it back to a more "normal" level.  It is remains an open question, however, how stable this "normal" level is over time.

An analysis of household stock-flow ratios provides a useful insight on what drives changes in household spending.  This is particularly so when we apply a certain level of disaggregation, rather than looking at net finacial assets as a single whole.  Often, we can relate the trends to things that we know are going on.  This approach is likely to be more useful than trying to relate spending to variations in the real interest rate.
[1] Household disposable income is usually calculated after certain pension contributions and pension income.  To align more closely with the theoretical issues, we need here to think about household income before these items.