DISINFLATION AND UNEMPLOYMENT
On the Non-Neutrality of Monetary Policy
Heinz-Peter Spahn
"The object of the higher bank rate is to involve entrepreneurs in losses and
the factors of production in unemployment, for only in this way can the
money rates of efficiency earnings be reduced. It is not reasonable, therefore,
to complain when these results ensue."
John M. Keynes (1930, 245)
1. Introduction
The most serious challenge that the existence of unemployment poses to the
theory of credibility and reputation is this: the most reputable type of a
monetary economy is plagued by a lot of it.1 The most reputable economy is,
of course, the Bundesbank-governed system of a monetary economy. It is the
cornerstone of the notion of neutrality of money that neither expansive nor
restrictive monetary policies should have a real impact on the economy.
Whereas traditional classical and monetarist theory held this to be true in
the long run, new classical writers claim that it all depends on expectations
which in turn are derived from the credibility of policy programs and the
reputation of policy institutions. Accordingly in the last decade much effort
has been invested in institutional reforms of monetary policy. At present
many central banks throughout the world have gained political independence, but disinflation seems to be as costly as before.
This paper therefore aims to collect the arguments which might explain
the rise of unemployment when monetary policy in a credible way turns restrictive in order to fight inflation. The first section describes some controversies between old and new monetarists on the conditions of monetary
neutrality. The second section presents some empirical evidence on the
sacrifice ratio, i.e. the employment costs of disinflation in various countries.
1
This phrase is, of course, a modified quotation from Frank Hahn's (1982, 1) famous
dictum on the non-role of money in general equilibrium.
2
Spahn
Three analytically different approaches which might shed some light on the
rise and persistence of unemployment succeeding a contraction of monetary
demand are sketched out in the following three sections; these approaches −
which should be seen as complementary rather than alternative elements −
deal with microeconomic "rational" rigidities, macroeconomic dynamic instabilities in a setting of flexible prices and supply-side reactions to a decrease of goods and labour demand. Another section asks whether monetary
policy especially in Germany is to blame for impeding economic recovery by
deliberately slowing down the process of interest rate reduction. The last
section concludes with a short summary.
2. Disinflation in a new classical world:
Lucas’s private lessons for David Hume
The neutrality of a change in the standard of value2 is regarded as a matter
of course throughout the history of economic thought. David Hume, the
classical founder of the quantity theory of money, however was convinced
that gradual changes in the quantity of money had a different effect: economic activity measured in nominal magnitudes would flourish or shrink,
and only in the long run the result would be a proportionate change in the
price level. More than two hundred years later, similar ideas could be found
in Friedman's treatment of the relation between money and nominal income.
However, one important difference between neoclassical Monetarism and
the classical quantity theory must not be neglected: whereas Friedman in his
famous helicopter parable suggests that an injection of additional money is
equally distributed between all market agents, Hume depicts a monetary
disturbance essentially as an incipient unequal distribution of money, an
abundance or a lack of liquid funds in some sections or places in the economic system, which causes a disequilibrium and a reallocation of resources
or a general increase or reduction of transactions before, after a series of
adjustments, a new equilibrium is reached which differs from the old one
only by an upscaling or downscaling of nominal variables.
The Friedman approach is susceptible to the rational expectations movement as the description of the helicopter scenario abstracts from any market
structure complications embedded in the macro adjustment process. Hence,
it seems reasonable to assume that market agents anticipate the final outcome so that an instantaneous transition from the old to the new equilibrium will occur. In terms of a formal model the supply function s,
p$ = p$ e + y$ - y$ *
2
(1)
The currency reform of substituting 10 new francs for 1000 old francs provides a
typical example.
Disinflation and unemployment
3
derived from a Phillips-curve relationship where p$ e denotes the expected rate
of inflation and y$ * the full employment growth rate, has to shift downwards
in the very moment when the monetary budget restriction of the economy,
i.e. the demand function d,
y$ = m$ - p$
(2)
derived from a simple quantity equation with constant velocity where m$ represents the money growth rate, is being curtailed (move from A to C in figure
1).
Figure 1: Supply and demand functions of inflation and growth
p
y$ *
s1
A
s0
B
d1
y$
C
d0
Obviously, the necessary shift of the supply function depends on the adjustment of the expected rate of inflation. The rational expectation solution
of the above model reveals that p$ e = m$ e - y$ * . If then a highly reputable central
bank announces a policy shift to m$ = y$ * market agents may judge this to be a
credible policy program. Accordingly m$ e = m$ may hold so that point C is
reached.
This sequence of economic logic probably would not have been accepted
by Hume (and is questioned by the traditional, Friedman-orientated "mark I"
Monetarism); at least during some transition period (of undetermined length)
the economy may have a stop-over in B. New classical Nobel Prize winners
nowadays strongly object to such a "soft" reasoning which − in their view −
cannot be defended if a rational behaviour is ascribed to market agents. For
Lucas, the idea "that changes in money are neutral units changes” is incompatible with the hypothesis that they induce movements in employment and
production. The fact that Hume failed to comprehend this implication of
mere economic logic is attributed to his lack of knowledge with respect to the
4
Spahn
rational expectations revolution. Proudly looking back on the progress of
economic thought Lucas finally adds some excuse for the limits of Hume's
analytical capabilities: "This is too difficult a problem for an economist
equipped with only verbal methods."3
The general issue of progress of economic thought cannot be tackled
here4, but, first, it is interesting to note that Lucas explicitly5 identifies the
quantity theory with the trivial case of a change in the standard of value
thereby disregarding what neoclassical writers like Wicksell and Fisher
elaborated on that subject, namely the transition periods between two
monetary equilibria. Second, in doing so he obscures the economic significance of the process of money creation: the central bank charges a price for
modifying the liquidity status of some agents in the financial sector so that a
change in the policy stance has immediate repercussions on the whole
structure of the yields of capital assets; the working of a monetary impulse
thus show more resemblance to Hume's scenario of a partial abundance or
lack of money in the market system as a starting point than to Friedman's
tale of a monetary rain which in turn amounts to a variety of a units change
of the monetary standard of value.
3. Empirical evidence on the costs of disinflation:
The sacrifice ratio
It is now widely recognised that short term, central-bank governed interest
rates are one of the best predictors of real economic activity.6 Figure 2 suggests that it is the nominal short rate which "causes" the outbreak of a recession maybe because its movement is able to signal the intentions of
monetary policy makers to banks and investors so that the pure price effect
of interest rate changes is reinforced by induced shifts in profit expectation
and re-evaluations of investment projects.7 Notice that from cycle to cycle the
lag between the peak of short term interest rates and the low of inflation
rates has increased up to five years.
A more or less distinct increase of unemployment is part of the stylised
facts of a restrictive monetary policy which aims at lowering inflation. The
3
Lucas 1996, 664.
For a comparison of Keynes' and Lucas' contribution to economic science and an
assessment of the rational expectations hypothesis see e.g. Blinder (1987) and Niehans
(1987).
5
Lucas 1996, 662.
6
Cf. Bernanke/Blinder 1992, Filc 1992, Perry/Schultze 1993, Ragnitz 1994, Taylor
1995, Moersch 1996 and Krupp/Cabos 1996.
7
The rise of real short rates in 1987 had no serious repercussions on investment
and growth as it did not signal the threat of a restrictive monetary policy which could
not be expected given the very low rates of inflation.
4
Disinflation and unemployment
5
"sacrifice ratio" may be measured as the cumulative increase in unemployment during a period of disinflation. If the countries are ranked according to
their performance the leading position of some countries like Portugal,
Finland and Greece and the marked change of some of the positions in the
1980s and 1990s are striking (table and figure 3). The costs of disinflation
have increased in Finland, Switzerland, Sweden and France, they became
smaller in Greece, Ireland and in the UK. A remarkable event has been the
success of the Netherlands: starting from a very bad performance this country achieved a negative sacrifice ratio in the 1990s. But the most surprising
fact − with respect to the new classical approach − is that Germany with her
famous Bundesbank-type of monetary policy reached only a lower rank in
both decades.
The sacrifice ratio has been generally higher in the 1990s. The level of inflation was higher in the 1980s; employment losses decreased in the 1990s,
but rose in relation to disinflation. As Germany typically exhibits lower inflation compared to most of the other countries her high sacrifice ratio may
simply mirror the general problem that the trade-off between unemployment
and inflation increases as the economy approaches the zero-inflation line.
But even the existence of a non-linear Phillips curve does not provide a convincing explanation of rising marginal costs of disinflation because we
should expect the curve to shift downwards in cases of anticipated monetary
restriction.
A flat slope of the Phillips curve in the range of low inflation rates recently
has been explained by a widely spread norm which excludes absolute nominal wage cuts.8 If then monetary policy aims at zero inflation the process of
competition and reallocation of resources responding to market shocks will
produce unemployment because relative prices cannot adjust. However, this
one-sided stickiness of nominal wages may just be the result of the experience of an ever-creeping inflation in the past and may wane after a credible
switch to a zero-inflation regime. Furthermore only few central banks really
aim at zero inflation (New Zealand just modified her target to some small
positive rate). The Bundesbank has a two-percent target which should allow
to cope with moderate structural disturbances.
The puzzle is still unsolved why it has been so costly to reduce inflation,
particularly in Germany where it should have been apparent to all market
agents by looking at the history of monetary policy making that the
Bundesbank would not tolerate the 5-6 % inflation prevalent in the beginning of the 1980s and 1990s, respectively.9 It has been argued that having a
high reputation may pose a problem for restrictive central bank policies be
8
Cf. Akerlof et al. 1996.
The disinflation crisis in 1973-75 is different because the policy change at the
breakdown of the Bretton Woods system went unnoticed to the general public and thus
was followed by even more vigorous nominal wage rises in early 1974.
9
6
Spahn
Figure 2: Interest rates, growth, investment,
unemployment and inflation in Germany.
(a)
call money rate
16
12
bond rate
8
4
0
60:1
real call money rate
65:1
70:1
75:1
80:1
business cycle low
700
real GDP growth
(right scale)
600
85:1
90:1
95:1
month
private real gross investment
(DM bill., left scale)
(b)
10
8
6
500
4
400
2
300
0
200
1960
-2
1965
1970
1975
1980
1985
1990
1995
(c)
12
unemployment
9
6
inflation
3
0
1960
1965
1970
1975
1980
1985
1990
1995
Data source: Bundesbank, German Council of Economic Advisers.
Disinflation and unemployment
7
Table: Employment losses in disinflation period
in the 1980s and 1990s.
Periods are defined by the maximum and minimum of the rate of inflation. The employment
loss is the sum of annual additional percentage points of unemployment compared to the
unemployment rate u at the beginning of the disinflation period. In order to take into account the lag between quantity and price movements in many cases the series p$ i have been
compared to the series ui -1 .
Data source: German Council of Economic Advisers, OECD Economic Outlook.
rank country
period
disinflation
D=
p$ max - p$ min
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
Portugal
Finland
Switzerland
Sweden
Norway
Japan
Italy
France
Denmark
Austria
USA
Canada
Greece
Belgium
Ireland
Germany
UK
Netherlands
Spain
employment loss
L=
∑
sacrifice
ratio
/u − u 4
L D
i
1984-88
1981-86
1981-86
1980-86
1981-85
1980-88
1980-87
1980-86
1981-86
1981-87
1980-86
1981-85
1981-84
1981-86
1981-87
1981-86
1980-87
1980-87
1980-88
18,6
8,6
6,4
9,8
7,5
7,6
15,5
10,6
9,1
6,5
8,4
7,5
4,6
7,9
17,0
6,9
12,0
7,2
11,5
1,4
2,4
2,5
4,1
4,5
4,7
14,7
14,4
13,5
9,9
14,0
14,1
9,2
17,1
41,8
19,5
40,1
37,2
74,7
0,1
0,3
0,4
0,4
0,6
0,6
0,9
1,4
1,5
1,5
1,7
1,9
2,0
2,2
2,5
2,8
3,3
5,2
6,5
average
9,6
17,9
1,9
8
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
Spahn
Netherlands
Greece
Portugal
Ireland
Japan
Norway
UK
Denmark
USA
Canada
Italy
Switzerland
Austria
Germany
Sweden
Belgium
France
Spain
Finland
1991-95
1990-94
1990-96
1989-93
1991-95
1990-94
1991-94
1989-93
1990-96
1991-94
1991-96
1991-96
1992-96
1992-96
1991-96
1990-95
1989-95
1989-96
1990-95
2,3
8,9
10,1
1,7
3,0
3,4
4,9
3,3
3,2
4,1
2,9
4,7
1,8
3,3
8,7
2,0
1,8
3,1
4,7
-1,8
4,8
6,5
1,3
2,3
3,0
8,6
5,9
6,3
8,5
6,4
14,2
5,5
10,5
28,7
6,7
8,0
22,6
42,6
-0,8
0,5
0,6
0,7
0,8
0,9
1,8
1,8
2,0
2,1
2,2
3,0
3,1
3,2
3,3
3,4
4,4
7,3
9,1
average
4,1
10,0
2,4
Figure 3: Evaluation of the preceding table. Ranking of countries according to
average sacrifice ratios.
9
8
Sacrifice ratios in selected countries and disinflation periods
1980s
1990s
7
6
5
4
3
2
1
0
SPA
FIN
FRG
FRA
BEL
UK
AUT
NLD
CAN
SWE
USA
CH
DMK
IRL
ITA
GRC
NOR
JAP
POR
-1
Disinflation and unemployment
9
cause the expectation of long term price stability expands the duration of
nominal contracts thereby flattening out the Phillips curve10; a cut in nonminal money growth thus turns into a real contraction because of wage and
price inertia.11 But the logic of the argument is questionable: the very reason
that induces long contracts when inflation is low ought to shorten them
when everyone expects a restrictive policy change in times of high inflation.
In the following the credibility of anti-inflation policies is taken for
granted. The aim is to look for other causes of emerging and sustained unemployment in a period of disinflation.12 These causes will be grouped under
three headings: microeconomic impediments to wage and price flexibility;
macroeconomic interplay between disinflation, profit expectations and effective demand; and supply-side reactions to lower demand.
4. Towards an explanation of disinflation costs
4.1 Sticky nominal market claims
It has been recognised since many years that the stickiness of nominal
wages and prices serves important microeconomic purposes, namely to enhance fairness and efficiency in the organisation of the process of production
and to stabilise "optimal" market positions of firms.13 In the case of a policy
shift towards lower inflation some additional aspects have to be taken into
account.
The usual assumption in new classical models that the rate of inflation
can be taken as an instrument variable of the central bank conceals an
analytical flaw in the argument that a credible disinflation policy would entail no output losses. If really p$ = m$ , the lower rate of inflation appears as
new macroeconomic "fact" which leaves all market agents with the obligation
of adjustment of individual market claims. However, the empirical evidence
of a one or two years' lag between a change in the growth path of money and
a change in the rate of inflation (and a more careful modelling of the economy) helps market agents to learn that inflation only comes down as an aggregate result of their own individual pricing behaviour. As seen from the
10
An almost vertical slope of the Phillips curve in the range of high rates of inflation
can ease monetary stabilisation because money then may have already begun to lose its
functions and the spread of nominally fixed contracts will have decreased; this makes
possible a more rapid wage adjustment. This phenomenon is well known from the study
of hyperinflations (cf. Dornbusch et al. 1990).
11
"Countries with highly independent central banks seem to face the largest real
costs of inflation reduction" (Walsh 1995, 25; cf. Jordan 1997).
12
Some common knowledge on disinflation is provided by Fischer (1985) or Ball
(1995).
13
For a survey see e.g. Romer (1993).
10
Spahn
point of view of the unions, a lower rate of inflation cannot be assessed as a
"gift" provided by the central bank which in turn − as a matter of fairness −
should be "honoured" by the diminishing of wage claims; on the contrary, it
is just this reduction of wage claims which brings about a change in the
path of prices.
The necessary reduction of wage claims cannot be taken for granted as a
straightforward implication of rational expectations. Rather, it seems reasonable to assume that wage claims only will be reduced by the experience of
market pressure. Furthermore, the incentives and motives governing the
market decisions of individuals and groups might work in an asymmetric
way with respect to changes in the state of demand. Because the general
principle of economic behaviour favours to demand prices as high as possible − claims which then are corrected by market forces, i.e. by the opposite
trader − we should expect that improved economic prospects more easily
lead to rising prices compared to a more sluggish response in cases of economic decline.
As a consequence, an expected rise in the rate of inflation most probably
will bring about a more or less immediate reaction of rising wage claims
whereas in the case of an announced disinflation workers may try to defend
the expected rise of their real wage. Three reasons can cause a delay of
downward wage adjustments:
• As unions and workers in general are concerned about their relative
position in the field of wage income distribution each of them maybe
would accept a proportionate real wage cut by means of a higher price
level, but would hesitate to be the first who voluntarily cuts his or her
wage claims.
• Outside the hypothetical world of a one-good model the policy-induced
demand restriction will have a distinct and unknown impact in different
sectors of the economy. Therefore it seems reasonable to wait whether and
to what extent workers should respond by wage moderation to a sectorspecific loss of demand.
• If already unemployment has emerged in some locations the market
power of labour market "insiders" might prevent a sufficient amount of
wage restraint to develop so that an endogenous stabilisation is precluded.
4.2 Macroeconomic dynamic instability
Modern macroeconomic theory highlights the role of inflationary expectations and its impact on wage formation and endogenous stabilisation via the
real balance effect. The simple solution of equations (1) and (2) yields the result that income growth y$ depends with a negative sign on the expected rate
Disinflation and unemployment
11
of inflation p$ e . This approach however confines the importance of price expectations on its impact on wage formation and neglects possible other
transmission channels. A different perspective unfolds if the effect of disinflation on asset markets, and investment decisions in particular, is analysed.
The demand side of an IS-LM model is captured by
/ 4 1 6'J
J(
i = i − p
JJ
M = P L/ Y , i 4
)
Y = C Y + I re , ir
e
r
1
Y = Y M P , r e , p e
⇒
6
(3)
where all symbols have the standard definitions and r e denotes the expected
rate of return of investment ("marginal efficiency of capital"). Approximating
(3) by using growth rates yields
/
4 1
y = α m − p + β dr e + dp e
6
(4)
The growth of demand thus depends, firstly, on the change of real balances;
but it becomes apparent that the expansive effect of disinflation may be
neutralised by changes of profit and inflation expectations. The crucial aspect is the different sign of inflation and the expected change of inflation.
Thus the macroeconomic consequences of credible anti-inflation policies are
ambiguous as expected disinflation lowers productions costs via wage moderation, but at the same time lowers investment by increasing the real rate of
interest.
One of the typical features of such a market constellation is the weakening
of the links between earned profits and profit expectations. Given unemployment real wages then might fall to meet the labour supply curve and yet
extra profits per unit employment − measured as the difference between
marginal productivity of labour and the real wage − will not induce additional investment which is necessary for increasing the level of employment.
A more fundamental problem is the threat of an instable adjustment process. This can be studied by interpreting (4) as a full employment condition
where y$ = y$ * . In figure 4 equation (4) represents a positively sloped line YY
because the restrictive real balance effect of a higher rate of inflation (given
the rate of money growth) can be compensated by a positive change in the
expected rate of inflation which lowers the real rate of interest.14
Starting from A a restrictive demand shock, e.g. by reducing m$ causes the
full employment line to shift downwards to Y'Y'. Full employment then can
be maintained by an expected increase of the rate of inflation (B) or by a
lower effective rate (C). The first option can be ruled out right away as it
lacks a solid economic rationale. An instantaneous jump to C seems to be
14
The diagram is a simplified version of the one given by Tobin (1993); see also
Tobin (1975).
12
Spahn
implausible because of the reasons given in the preceding sections. Thus we
are left with a gradual process of disinflation accompanied by a change of
the expected rate of inflation. Stability rests on the relative speed of both
movements:
Figure 4: Adjustment processes
with flexible prices and inflation expectations
p$
Y
Y'
A
B
(a)
Y
(b)
C
Y'
dp$ e
(a) If the decrease of dp$ e is very large compared to the reduction of p$ investment-driven demand continues to shrink; therefore a stabilisation by expansive policy measures is required.
(b) If on the other hand actual disinflation is faster than the expected reduction of inflation the process will meet the full employment line. Below Y'Y'
prices and inflation expectations would rise again until a stable equilibrium is reached in C.
The instability problem is intensified if the expected rate of return r e depends
positively on the expected rate of inflation. Such an assumption can be justified if there is some lag between price and wage movements. In times of inflationary expectations the propensity to invest furthermore might be
strengthened in case of an imperfect adjustment of the long term nominal
interest rate when debtors are favoured compared to creditors. If dr e dp$ e > 0
each percentage point of expected inflation encourages investment not only
by lowering the real rate of interest but also by supporting the marginal efficiency of capital. Therefore a larger increase of the actual rate of inflation is
necessary to stabilise demand. The slopes of the goods market equilibrium
lines YY and Y'Y' then are steeper (figure 4). As a consequence, if applied to a
Disinflation and unemployment
13
disinflation scenario, a formerly stable adjustment path, e.g. arrow (b), now
might lead to cumulative instability.
Flexible wages and prices thus do not guarantee the stability of a full employment equilibrium. The Great Depression of the early 1930s has been intensified by means of an excess, not of a lack of flexibility. Wide-spread
nominal wage rigidity after the demise of the gold standard may be interpreted as an outcome of increased union power heading for distribution
goals; by their resistance against nominal wage cuts workers demonstrate to
be − as Keynes argued − "instinctively more reasonable economists than the
classical school"15 because such a behaviour enhances macroeconomic stability. Wage rigidity therefore is far from constituting a market failure but
rather represents an answer to an existing systemic instability in a monetary
economy.16
The factual relevance of the threat of macroeconomic instability because of
nominal wage and price flexibility today is controversial. Even Post
Keynesians assessed it to be of minor importance in the early 1980s as the
large share of nominal fixed expenditure, credit-financed budget deficits,
built-in stabilisers and expansive social policy programs would support consumption, prices and profits thereby excluding the possible outbreak of true
deflation.17 At the same time the institutional design of wage contracts
seemed to implement a solid base line for the national price level. In the mid
1990s because of fiscal consolidation, deregulation and the dwindling of the
unions' market power things look different. After fighting inflation for more
than two decades it seems that central banks now have to keep an eye on
the risk of deflation as well. The next section however provides some theoretical evidence that even a persistent abundance of labour may not lead to a
corresponding wage deflation.
4.3 Supply-side effects and hysteresis
The basic result so far is that a restrictive monetary policy cannot avoid a
real negative demand shock to occur: A lowering of m$ in equation (4) can
only be neutralised by an immediate reduction of p$ ; this variable however
according to (1) depends on inflation expectations and excess demand mar-
15
Keynes 1936, 14.
"Maybe the social institutions, attitudes, and behavior patterns that make for
wage and price stickiness in real life should be seen in part as adaptive mechanisms,
and not merely as obstacles to the achievement of a frictionless economy. If the observed or imagined consequences of perfect wage-price-flexibility are damaging, then
institutions that resist wage-price-flexibility might evolve. (...) Wage stickiness could
then emerge as a form of self-defense" (Hahn/Solow 1995, 134).
17
Cf. Minsky 1982.
16
14
Spahn
ket pressure. If market agents recognise that inflation is not determined by
monetary policy directly, but rather as the aggregate outcome of individual
wage and price setting, it seems unconvincing to argue that inflation expectations will go down in the first place. Therefore market pressure, i.e. excess
supply on the goods and labour markets finally has to carry out the task of
bringing down the rate of inflation.
Excess capacity and labour hoarding characterise only the onset of an
economic crisis. The crucial feature of a recession however is not the excess
but rather the reduction of supply.18 If then the demand for the factors of
production is being reduced some medium and long term deterioration of the
productive endowment of the economy is bound to happen. The postponement or cancellation of investment stops the growth of the capital stock
which implies that the future growth path will be located lower. The consequence is a more narrow constraint for the development of productivity, output and employment.19
The reduction of labour demand can take the form of short-time work or of
layoffs. The first alternative seems to be an obvious solution as the problem
is an abundance of labour input measured in working hours. If instead we
assume that due to some organisational rigidities full-time work is required
layoffs cannot be avoided. But how does the entrepreneur decide who is going to be dismissed? In macroeconomic theory labour in general is taken to
be an homogenous entity. If all workers were alike the entrepreneur might
through a dice. Because this is not observed on a large scale two conclusions
might be drawn:
• Entrepreneurs suppose that their workers have a different qualification
and productivity.
• This profile of the employed workforce is not mirrored by a corresponding wage structure.20 Otherwise the decision as to whom to dismiss again
could be solved by a lottery because the firm could not gain by firing a
"bad" worker.
Employment decisions and wage contracts then might be modelled according
to a simple scheme where workers are ordered following their individual productivity q which − by taking into account given output prices P and the
mark-up on wage costs k − determines the value productivity line X (figure
5). Whereas employment N d Y is given by goods demand and the production
function the contract wage w has to equilibrate nominal wage costs and average nominal productivity (so that the shaded triangles are of equal size);
/4
18
Cf. Greenwald/Stiglitz 1993.
Cf. Bean 1989.
20
Explanations for this wide-spread fact can easily be found in the efficiency-wage
and fairness literature.
19
Disinflation and unemployment
15
note that a conjecture on output and prices is necessary to agree on some
w .21
If output and employment are increased during the contract period prices
have to rise because of rising marginal costs.22 An increase of nominal wages
would be passed on to the goods market by raising P. If labour demand
drops from N1 to N0 the entrepreneur will dismiss those workers with the
lowest productivity.23 Profit per unit of employment then is increased as average productivity is higher. If at the same time output prices decrease X
shifts downwards; then the profit effect is absent but real wages rise. Only in
case of a large decrease of prices wages have to be lowered to maintain normal profits.
Figure 5:
Wages and employment in case of heterogeneous workers
/4
w
Nd Y
w
X=
N0
N1
Pq
1+ k
N
The crucial point is that the explanation of unemployment needs giving up
the assumption of homogeneous labour. This sheds light on the state of
competition on the labour market, in particular in post-crisis times. The unemployed are unable to compete with the active workforce at given wages because their very status of being unemployed reveals their inferior qualification − if each entrepreneur expects that all his colleagues behave like he
21
Obviously the firm might be tempted to capture a higher rent by dismissing some
of the "worst" workers. But then it would run the risk of losing some of its market
share; and most probably workers will urge for a new negotiation aiming to raise w .
22
This has been Keynes' (1936, 41, 295) argument for the necessity of a decreasing
real wage when employment would rise whereas neoclassical economics usually base
rising marginal costs on an over-utilised given capital stock.
23
Legal and other regulations restricting the choice of the persons to be fired are
neglected.
16
Spahn
does himself. The occurrence of unemployment causes a segmentation in the
labour market. The "qualification boundary" between the employed workforce and the unemployed is microeconomic in substance, but is drawn as
an endogenous variable in the macroeconomic process.
The welfare costs of existing shortcomings of qualification and productivity
at the lower end of the ranked workforce are shared by all workers (by earning a lower real wage) in the case of full employment; after a restructuring of
firms which use the enforced cut of their workforce for enhancing efficiency
these costs are born by the unemployed only, namely in form of a reduced
opportunity of finding a job. Of course they might become re-employed in
case of an exogenous rise of demand. But otherwise firms hardly have an incentive to hire unemployed workers as substitutes for employed "insiders"
even if the former claim a lower wage. The achievement of a higher average
productivity for the firm offers better prospects than the alternative strategy
of running a low-quality production at low wages.
The labour market segmentation will be intensified by additional forces:
• As a recession typically is accompanied by a faster rate of structural
change the human capital of unemployed persons being fired in shrinking
branches is further devalued.
• As individual unemployment protracts qualification decays because of
being separated from the steady process of learning on the job. The dilemma becomes nearly perfect as the entrepreneurs in turn use the individual duration of unemployment as a screening device for assessing the
expected productivity of applicants.24
The upshot of all this is that the endogenous loss of marketability of dismissed workers amounts to a transformation from cyclical, demand-determined to structural unemployment. It implies that the effective labour curve
shifts inwards following an unemployment shock which in turn weakens the
response of wages to unemployment and finally blocks the road for the real
balance effect. The more fundamental result is that the equilibrium level of
full employment is lower: the market process exhibits hysteresis as the equilibrium position of the NAIRU depends on the history of employment variations. In Germany, the NAIRU seemed to have increased after each recession (figure 6). The supply-side endowment of an economy cannot be unambiguously defined without taking into account the state and the path of effective demand. It seems quite obvious that in such an economic system
monetary policy cannot be neutral.25
24
Cf. Nickell 1988, Pissarides 1992.
The NAIRU looses its information function for deciding on the stance of macro
policies (cf. Galbraith 1997).
25
Disinflation and unemployment
17
Figure 6: Increase of the German NAIRU
in the recessions 1973-75, 1980-83, 1992-94
2,5
increase of inflation
'71
'89
'79
1,5
unemployment
0,5
-0,5
-1,5
'76
'67
'83
'94
-2,5
0
2
4
6
8
10
12
Data source: as in figure 2.
5. The recovery from recession: The role of monetary policy
The pattern of monetary policy during disinflation periods − at least in
Germany − has changed over the decades (figure 2 a). Comparing the path of
short term interest rates around business cycles' lows at 1967, 1975, 1982
and 1993 it is apparent that the Bundesbank shaped a more cautious trend
of monetary relaxation especially in the last years. The impression that the
"natural" decrease of interest rates in a recession deliberately has been
slowed down is confirmed by the Bundesbank which is proud to have corrected "exaggerated" market expectations of interest rate reductions by
means of controlling the terms at which refinancing transactions with the
private banking systems are carried out.26 Two possible justifications for retarding the interest rate slow down may be given.
• A temporary overshooting of money supply figures compared to the announced growth targets caused a credibility problem in the field of implementation of monetary policy; the Bundesbank maybe felt obliged to signal to the private sector that the path of intermediate monetary targets is
taken serious and has some repercussions on the decisions on changing
short term interest rates. However, in some cases the Bundesbank preferred to play down the significance of actual money growth and argued
26
Deutsche Bundesbank 1994, 67, 72.
18
Spahn
that the gains of overall stabilisation allowed some further monetary
ease.27
• Nevertheless, in assessing the general tendency of policy decisions, an
observer might conclude that the Bundesbank chose a more cautious
policy of monetary expansion because of the assumption that inflationary
expectations are still vivid.
As market estimates and conjectures in the private sector during the business cycle phase of disinflation may be contradictory the central bank has to
pursue the difficult task of supporting the investment-driven process of income creation without rekindling inflationary expectations. In this context
the step-wise course of interest rate reduction has been founded on the argument that financial markets after each step still could and should expect a
further cut which ought to keep alive the tendency of declining long term
interest rates; a step assessed to be the "final" one however would already
work on the capital market like the first move towards monetary restriction.28
On the other hand, because inflationary expectations as such are hard to
measure interest rate policies at times seem to be executed by keeping an
eye on actual inflation. The problem is that by orientating monetary policy by
a "lagging" indicator like the rate of inflation the central bank aggravates
macroeconomic disturbances and causes an unnecessary delay in the process of economic recovery.29 In any case this is the general effect of an artificially slow process of interest rate reductions. If there is some flexibility as to
the urgency of investment projects, the expectation of a further decrease of
interest rates may lead to a temporary postponement of investment. The
central bank and the entrepreneurs thus can be modelled in a non-cooperative negative-sum game30: Both players prefer an economic upswing, but the
central bank fears to revive inflation and the firms are able to wait for more
profitable financing conditions. If both parties wait too long the weakness of
demand may worsen the general prospects of economic development so that
even further interest rates reductions then cannot neutralise deteriorated
profit expectations.
Therefore the final question is whether the Bundesbank did not overrate
the risk of inflation in the last years. On the one hand, given the tendencies
of hysteresis one has to concede that an increase of goods and labour demand may lead to rising wage claims long before statistical full employment
is reached.31 On the other hand, excess capacities, opening trade relations,
27
28
29
30
31
Deutsche Bundesbank 1996, 19.
Sievert 1995, 5.
Krupp/Cabos 1996.
Caplin/Leahy 1996.
Cf. Lindbeck/Snower 1988, Blanchard 1991.
Disinflation and unemployment
19
technical progress and the increasing opportunities for firms to use the
32
world excess labour supply work as dampening factors with respect to
wage and price inflation. Figure 7 reveals that the Bundesbank may act
overly sensitive to the inflation risk if compared to other hard currency
countries.
The conclusion might be drawn that a more rapid process of interest rate
reduction might have been appropriate which most probably would not have
had any negative consequences with respect to the desired monetary stabilisation. Possibly the stance of the Bundesbank's monetary policy in the mid
1990s thus cannot be explained by referring to the inflation-disinflation issue alone but also by taking into account the bank's role in the field of
European currency policies, a topic which is beyond the purpose of this paper.
Figure 7: Monthly and annual rates of interest, nominal and real, respectively,
in selected countries.
10
call money rates
8
real call money rates
7
5
6
3
4
1
2
0
92:1
-1
94:1 1990 96:1
FRG
1992
98:1
NLD
1994
1990
1996
1992
CH
1994
1996
JAP
Data source: Bundesbank, German Council of Economic Advisers, OECD Economic
Outlook.
6. Summary and conclusions
The new classical hypothesis of neutral money is being derived from a model
which captures the role of institutions and economic policy preferences, but
which is inappropriate to grasp the complexity of micro-macro market inter32
Cf. Krugman 1995, Freeman 1995.
20
Spahn
action. The simple logic of costless disinflation is displayed in the shaded
area of figure 8. Only by affecting the expected rate of inflation the central
bank has a direct influence on the process of wage and price formation. In
case of success the policy-induced monetary restriction is being neutralised
so that real money balances remain constant. Accordingly, a lack of credibility on the part of the central bank's policy course appears to be the most important cause of non-neutrality. If however even the high reputation of the
Bundesbank does not help to keep unemployment low in periods of disinflation at least some additional problems have to be taken into account.
From a microeconomic point of view rational wage and price setters will
recognise that a desired lower rate of inflation is not "given" by the decision
of the central bank (as suggested by simple new classical models) but rather
is the aggregate outcome of their own market behaviour. A lowering of wage
and price claims therefore has to be enforced by experienced or expected
market pressure. Given the doubt that the central bank can succeed in
bringing about an immediate reduction of the rate of inflation various microeconomic efficient rigidities, including the struggle for relative income
positions and the lack of knowledge about the impact of expected general decrease of demand in different sectors and branches of the economy, will
cause a delayed and staggered adjustment of individual market claims.
Figure 8: Market mechanisms (bold arrows) thwarting a neutrality of monetary
policy during disinflation.
Restrictive
monetary
policy
Reduced
expected
inflation
Real
money
Wages
Prices
Rational
rigidities
Unemployment
Goods demand
Capital stock
Labour demand
Real wage
Marketable
labour suppy
Disinflation and unemployment
21
As real money balances therefore are decreasing the economy will be set
on a path of recession accompanied by a continuous, but not simultaneous
process of actual and expected disinflation, deteriorating profit expectations
and rising unemployment. At the same time realised profits may nevertheless rise but do not encourage investment as the prospects of further development of demand are vague. The crucial analytical point is that actual and
expected reductions of the rate of inflation have an opposite impact on effective demand. Whereas in the theoretical model this scenario may lead to cumulative instability in practise a probable outcome is a prolongation of recession or an only weak recovery.
If then recovery is delayed supply-side reactions may take effect. The
(growth of the) capital stock is lower and the effective labour supply to some
extent adjusts to the size of the employed workforce. Decay and obsolescence
of non-used factors of production more generally indicate that the amount
and quality of resources in monetary economies in the long run are governed
by demand-side forces. The macroeconomic consequence in any case is that
the real balance effect as an endogenously stabilising mechanism is weakened and that supply-side constraints to a future demand expansion will be
felt earlier.
The attitude of monetary policy (at least) in Germany to control the interest rate slow down in order to prevent the revival of inflation thus seems to
be an ambiguous strategy. Unused capacities and unemployment in the
depth of a recession would reduce the rate of inflation anyway; the downward stickiness of short term interest rates however tends to postpone the
recovery and to restrain the scope of future growth. The general message is
that institutional reforms apt to strengthen credibility and reputation of
monetary institutions will not necessarily lower the costs of future disinflation policies. There is no reason to believe that this will not hold true in the
European Monetary Union.
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