February 28, 2007

Fun With Monetary Policy

Jared Bernstein goes before Congress and points out that real median wages have stagnated since 2000, even though productivity has been rising. A wee problem, you might say. Bernstein blames the Federal Reserve, for trying to stabilize unemployment at a "natural" rate that is—in his view—much too high. And so long as there's slack in the labor market, there's no upward pressure on wages at the lower end. Hence the current situation. Anyway, here's the Fed's logic for acting this way:
In brief, and simplifying considerably, the original NAIRU story was based on the idea that the unemployment rate is usually at equilibrium, i.e., just where it should be in terms of supply, demand, and stable prices. Those unemployed at this "natural rate" can’t find work at the wage they think they deserve, but that’s because they have an upwardly skewed view of their worth (or marginal product). However, the monetary or fiscal policy authorities want to lower the unemployment rate, and get these folks a job, so they undertake stimulative actions (lower interest rates, tax cuts, etc.).

Wage offers do rise, and these formerly jobless workers leave the sidelines and join the job market. However, firms offset their now higher labor costs by raising prices. Soon, the new workers recognize that they’ve been tricked: their reservation wage, though finally met, is not going as far as they think it should. They then demand yet higher wages and the wage/price spiral is underway. The only way to stop it is for unemployment to return to the natural rate, but by then, the inflationary damage is done.
So, to avoid an inflationary disaster—which would, horrors, be terrible for wealthy lenders—the Fed tries to keep things at the "natural level" by tinkering with interest rates. But Bernstein points out that the Fed's tale doesn't quite fit modern-day reality. Workers these days have considerably less bargaining power than their ancestors in, say, the 1960s—not least because union density has plummeted—so they can't push for ever higher wages every time prices go up slightly anymore. And that makes the whole "wage/price spiral" nightmare scenario less likely in this day and age.

Now that means, if I'm understanding correctly, that the current models are off a bit, the Fed could step on the gas somewhat harder than it's currently doing and reduce the unemployment rate even further without bringing about Armageddon. Median wages would rise for a change—and workers could finally share in all this marvelous productivity growth—but you wouldn't see some horrible inflationary spiral that destroys the country (or whatever it's supposed to do). Makes sense to me, I suppose.
-- Brad Plumer 2:39 PM || ||