Qs and As

August 28th, 2011 at 1:11 am

Q: Should the Fed target nominal GDP instead of inflation?

A: No, I think they should just get over the 2% upper bound target on inflation.

I do like the flexibility inherent in this idea, but I don’t see nominal growth as a better target per se.  The problem we face with contemporary monetary policy is not due to targeting.  In fact, the dual goals of stable inflation and full employment are the right ones. They’re “real” variables, which strike me as better targets than nominal growth.  EG, suppose, coming out of a recession, we had strong nominal growth and low inflation, as used to be pretty common in V-shaped recession/recoveries.  I wouldn’t want the Fed to tighten but an NGDP target could lead them to do so.

The problem is that the Fed is too hawkish re the 2% core inflation target.  Sometimes, like now, the economy would benefit from faster inflation, as Ken Rogoff has stressed (I’m not quite where Ken is—he’s right that higher price growth would help to hasten deleveraging, but it also leads to even faster real wage decline than we’re already stuck with).

The way the Fed plays it, the 2% price target isn’t even really the target.  If it was, they’d be OK with 3 and 4 percent sometimes in order to achieve 2 on average.  But they treat it more like an upper bound, so the average target ends up being something lower than 2%.

Q: Re your post on corporate profits and compensation shares of GDP, I’d like to see the full time series.

A: Here tis, from the 1940s through now, though without the cool illustration.  Profits are highly cyclical but note that the trend of both shares broadly follows the timing of the inequality story, which picks up in the latter 1970s.  Also, note that the current profit share is almost the highest on record.

Source: BEA

Q: Re my post on taxing capital gains at the same rate as regular income: Why are you looking at the statutory rate rather than the effective rate? The latter is the relevant decision variable for economic actors, so surely that’s what you should be looking at?

A: First, some would disagree, based on the theory, that the effective rate is what matters here.  The microeconomics would argue that it’s the change in the marginal, not the effective, rate effects investment behavior (your effective rate is your tax liability as a share of your income; the marginal rate is what you pay on the last dollar of capital gains in this case).

I don’t think it matters too much here because the effective and marginal rates are probably close—the structure has not been particularly graduated over time—usually just one or two rates–and there are many fewer loopholes that effect the rate paid here relative to say, corporate income.

Finally, I know of no historical series on effective rates for k-gains taxes, but even if one existed, the relevant series for this analysis, given my first point above, is the marginal rate series.

Q: I’ve heard time and time again the argument that minimum wage increases unemployment is actually detrimental to low-wage workers. You recommended increasing it again. If you know the argument to which I’m speaking, would you mind explaining in a post why this is or isn’t the case and how raising the minimum wage would help?

A:  The theory is that if you make something more expensive by fiat, as opposed to by market forces, people will buy less of it.  So if you raise the min wage, employers will lay off workers who are now more expensive.

In fact, the theory argues that any increase in the minimum wage, even a few cents, should result in massive layoffs.  Nothing of the sort has ever occurred.   So the theory is demonstrably wrong which means you have to look at what has actually occurred when we’ve raised the wage floor.

There’s been extensive research on this question.  Most of the research has found “small” layoff effects (I’ll explain small in a moment); but some high quality work has found no effect at all, and some research has even found positive employment impacts.

By “small” I mean that even if you accept that some workers could be laid off or end up with fewer hours, the vast majority—way over 90%–get a pay hike.

How could this be?  What about “raise the price, people buy less?”  A few explanations:

–our legislated min wage increases tend to  be small, not affecting that many workers and usually just replacing the value eroded by inflation;

–firms have other ways of absorbing the wage increase, including higher productivity or raised prices;

–in some cases, firms that can set wages in a particular market (like the old coal mine towns, with one major employer) and they will set them too low to maximize their profits; a min wage increase will raise employment by drawing more workers into the labor force and increase firm efficiency and profits;

–markets in general, and the labor market in particular, are just more complex than you’d get from a simple supply and demand framework…dynamics, for example, could be important here…raise the minimum wage, more people have higher earnings…they spend them and create more economic activity, demand, and jobs.


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11 comments in reply to "Qs and As"

  1. John says:

    On nominal GDP targeting: it might make it easier now to tell everyday people the fed needs to boost your income to explain expansionary monetary policy. But when were not in recession it’s hard to tell people that the fed thinks your income is going up too quickly so they’re going to slow it down. The fed simply needs to be a leader in fighting inflation phobia and counter the misinformation from the hard money crowd. Help people get over the obsession with 2%. It’s just a number.

  2. urban legend says:

    Better wages means higher morale, more productivity, less turnover, lower hiring and re-training costs. Higher incomes means a virtually dollar-for-dollar increase in discretionary income among those directly affected (since basic needs do not suddenly increase), which means a huge increase in discretionary spending and a good infusion of consumer confidence. Having a higher floor also improves the confidence of those who imagine they might have to rely on a minimum wage someday: not quite as far of a fall. Increases cascade upwards to maintain wage relationships, with the same effects as above, and everyone benefits. As long as all competitors are subject to the same effect, few will be unable to add the relative pennies needed to cover the increase.

    This is supported by good empirical studies as well as a solid theoretical framework. The classic idea based on a couple of theoretical curves is for simpletons, period. A country can never go wrong with steps that will allow its lowest-income members to improve their incomes. Setting minimum standards of decency — allowing employers holding all the power only so much leeway to exploit the lack of power of its lowest-paid workers — is certainly one of those steps.

  3. tom says:

    Another question it is one thing to name an inflation target, another to do anything about it. How can the Fed actually increase inflation directly? Normally, they just stimulate demand by cutting interest rates, and let the demand impact inflation. But with nowhere to go on interest rates, I don’t see what the Fed can do to increase inflation.

  4. Brad says:

    I have a question that maybe Mr. Bernstein can answer in a future Q&A column or maybe a fellow OTE reader can answer. In the debate about the impact on revenue of changes in the tax rate, the measure I see most often is tax revenue as % of GDP. But the counter-argument would be that lowering the tax rate will help grow GDP so even though revenue is a lower percentage of GDP, revenue would still be higher than it would have been had taxes not been lowered. So what is the best way to measure the revenue impact of changes in the tax code?

  5. Jim Edwards says:

    I was spending a few hours looking at historic inflation rates and concurrent historic events, cause I just do things like that. No surprise that every war was accompanied by a sharp increase in inflation and shortly after a sharp decrease in inflation. This makes sense as greater numbers are pulled into the workforce who would not normally be employed such as mothers and the elderly.

    I got to thinking about the baby boomers effect on the economy and politics. I noticed that inflation began to rise steeply in the mid to late 60s which is just when the baby boomers would begin entering the labor force. War historically adds workers to the labor pool who would not have worked, but Vietnam took workers out of the labor pool who would have worked. As soldiers they still got paid, but did unproductive work. When they returned and took new jobs, inflation nearly doubled. As more returned to the workforce, unemployment, stagflation.

    Following the war analogy, we can expect that as the boomers leave the workplace we should expect sharp deflation at levels reflecting the inflation caused by their entry.

    Has anybody studied this idea and do you know where I might look to find out more?


  6. Th says:

    Re: inflation rates; what is the optimal inflation rate for economic growth? How about a nice chart showing inflation rates and real GDP growth so we can see if the target should be higher or lower than 2%.

  7. Steve Roth says:

    Thought you might find this interesting. A while back I extracted the best data I could find on the wage share of income 1919-1931, from the (scanned images of) the Statistical Abstract of the United States:



  8. Steve Roth says:

    Other thoughts:

    “Effective marginal rates” would be a very useful metric. I’ve seen this for some series (corporate taxes) but never for cap gains taxes.

    “How could this be? What about “raise the price, people buy less?””

    One more explanation: this assumes, is based on, substitution. It’s meaningless without that concept. The buyer buys something else with higher utility per dollar.

    While automation is one option for some industries, many industries — especially minimum-wage industries — have no substitute for labor. If they want to supply existing demand, they have to hire accordingly.

    Yes, the alternative is not spending — saving, aka lending the money to someone else.

    And of course that person/business will spend it (on consumption or investment), right? Savings = Investment! There’s no such thing as aggregate hoarding of money, so it circulates within the financial system without ever touching the real economy. The stock of financial assets never expands while real investment is starved! /sarcasm

  9. Robert says:

    My question about inflation targeting is what is the empirical track record of central banks in successfully engineering disinflation with minimizing real output losses? Supposedly disinflationary monetary policy coupled with tight fiscal policy can reduce and stabilize inflation, but at what negative impact on unemployment? Is it really possible to achieve stable prices and “full” employment? Unless there is a proven formula for inflation targeting, IMHO the Fed should not damage the economy with any more untested monetary policy “experiments”.

  10. Peter K. says:

    Robert’s comment:

    “IMHO the Fed should not damage the economy with any more untested monetary policy “experiments”.”

    In my opinion, the economy is being damaged at this very moment moment while the Fed fails to act and experiment. Unfortunately our culture has become coarsened and lowering unemployment isn’t a priority or focus for debate. People suffer from a “blame the victim” mentality and Social Darwinian outlook. Hey I got mine! However, lowering unemployment is really enlightened self-interest and in everyone’s interest for multiple reasons. (for one, look at the recent London riots.)

    Mr. Bernstein writes: “(I’m not quite where Ken is—he’s right that higher price growth would help to hasten deleveraging, but it also leads to even faster real wage decline than we’re already stuck with).”

    Does Rogoff or Jared believe it leads to faster wage decline? (Would quicker deleveraging outweigh this?)

  11. Anon says:

    On the inflation issue, you’re missing an important point. You write:

    “The problem is that the Fed is too hawkish re the 2% core inflation target. Sometimes, like now, the economy would benefit from faster inflation, as Ken Rogoff has stressed (I’m not quite where Ken is—he’s right that higher price growth would help to hasten deleveraging, but it also leads to even faster real wage decline than we’re already stuck with).”

    While true to an extent, an increase in nominal wages that facilitates a decline in debt service obligations generates a beneficial increase in purchasing power EVEN IF the increase in nominal wages is slower than the underlying rate of inflation. By way of example, the median individuals applying to the HAMP program last year were committing 80% (not a typo) of their pretax income to debt service.

    The debt service number needs to come down and write-offs that just throw the debt into the hands of debt collection companies, prompting 25% wage garnishments which is a type of effective wage deflation, won’t get you there. It has be through inflation (or a massive helicopter drop of newly-printed money onto real people). There’s no other way out – or rather the alternative is a generation of stagnation, deflation, and increasing human misery.

    Rogoff’s right on this one.