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Monday, August 15, 2011

What a nominal world!

No one who is not living in Zimbabwe, North Korea or Ukraine thinks in real terms. So long as inflation is moderate, we think in nominal terms. We say “Hey, honey, I got a raise today!”, not “Hey honey, on real terms, I'm barely treading water!”  This is called the “money illusion”, except that, as long as inflationary expectations are in check, it is not an illusion; it is an economic law.


I will now advance the Mahoney Theorem which is appropriated from Scott Sumner, who hasn't yet trademarked it:
When an economy with sticky wages (aka, the West) is mired in a low-growth, low-inflation situation (i.e., low nominal growth), real growth and employment are functions of nominal growth. Nominal growth is therefore a precondition for real growth and employment growth. And the monetary authority is therefore responsible for employment growth.


Why is this? Well, obviously the money illusion, which works so long as inflation is moderate. But, just as importantly, moderate inflation allows nominal wages to rise while real wages fall, in order to regain competitiveness. In the modern economy (other than Hong Kong, where wages are uniquely flexible) nominal wages never fall and normally rise (see: minimum wage laws). The only way that labor can be made competitive in an adverse trading environment is real wage decreases. (And currency depreciation, another topic.) When nominal business revenues rise, nominal payrolls rise. When nominal revenues stagnate, nominal payrolls (at best) stagnate.


Right now, the whole world (besides witch-doctor economies such as Zimbabwe, North Korea and Ukraine) is in the grip of that seventies religion: price stability. We are fighting the last war. Yes, double-digit inflation is bad, a given, no argument, why are we still talking about it! But do we really want price stability,  0% inflation? No. We want moderate inflation in order to provide the correct incentive structure for investment and employment. My desired formula is 3% inflation and 3% real growth, for nominal growth at a healthy 6% (which, BTW, would allow us a 6% deficit and stable debt ratios).


There may be an island-living, survivalist tribe of neo-Keynesians who would still argue that “money doesn’t matter”. In other words, that contractions and expansions of the money supply are irrelevant in the determination of real growth. To which some monetarist once replied, “Well, if that’s true, then why couldn’t all the world’s trade could be conducted using a single penny?” QED. Money matters.

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