By some mysterious process, concerns about inflation are surfacing all over just as the incoming Biden administration proposes not simply to cut taxes for the rich as Donald Trump did, but to make substantial payments to less well-off families hard hit by the pandemic. But inflation theory is one of the weakest areas in mainstream economics. Our new INET working paper critically analyzes the long and tangled history of the Phillips Curve, inflation targeting, and related issues, to shed light on what we term the “Biden trilemma” that now confronts the administration as it struggles to reverse the long decline in labor’s share of the national income. Boiling 12,000 words down to a few hundred is impossible, so only high points are mentioned here.
Distinct monetarist (demand-oriented) and structuralist (cost-based) approaches to inflation can be distinguished. Monetarist thinking dominates in the USA – it has done so for decades. But inflation is a dynamical macroeconomic process. Structurally, it must be analyzed taking into account the demand side of the economy (gross domestic product or GDP) and the cost side including output and labor payments (gross domestic income or GDI). Subject to errors and omissions, GDP = GDI, a macro-level constraint on the system.
Monetarism is basically microeconomic. A change in some variable, say employment, is supposed to affect another, say the price level. This textbook supply-and-demand orientation elides macroeconomics. It is the reason why monetarist theory so frequently fails in practice. It complicates the inflation trilemma that the incoming Biden administration confronts. To a degree, structural policy can help with resolving the trilemma’s contradictions.
The anatomy of cost is central to the structuralist approach. There are several relevant observations. First, the wage or labor share of GDI has been falling for half a century. Because wages are the main contributor to low incomes and profits to high ones, the effect of the declining labor share on household size distributions of wealth and income is pernicious.
In accounting terms, the cause is the fact that the money wage grows less rapidly than the sum of growth rates of price indexes and labor productivity which cuts costs, due to a large extent to erosion of labor protection laws, changing institutions, and the globalization of supply chains.
But the labor share also varies pro-cyclically, leading the activity level or employment out of a slump. This behavior amounts to a “Marx-Goodwin cycle” formalized last century by Richard Goodwin. Conflicting claims to income are the underlying source of inflationary pressure.
Inflation affects income (labor’s spending power) and wealth. Monetarist theory around 1900 concentrated on the latter (Bryan and the “Cross of Gold”), leading to the standard Laffer curve. It was replaced by the Friedman-Phelps model which has incorrect dynamics (labor payments do not fall during an expansion – they go up).
Samuelson and Solow introduced a version of the Phillips curve that violates macroeconomic accounting. Rational expectations replaced Friedman, but was immediately falsified by output drops after the Volcker shock treatment around 1980. There followed a complicated transition from rational expectations to inflation targeting, anchored by economists’ misunderstanding of the physical meaning of ergodicity and ontological blindness. It did not help that the much-ballyhooed real balance effect is irrelevant because money makes up a small part of wealth. Rather than issuing veiled threats of disaster if its policy advice is not followed, the Fed now announces inflation targets which it cannot meet.
Contemporary structuralist theory suggests that conflicting income claims set the inflation rate. Firms can mark up costs but workers have latent bargaining power over the labor share that they can exercise. Import costs and policy repercussions complicate the picture but a simple vector error correction model and visual analysis suggest that money wages would have to grow one percentage point per year faster than prices plus productivity for several years if the Fed is to meet a three percent inflation target.
The results pose a Biden policy trilemma: (i) the only path toward a more egalitarian size distribution of income is through a rising labor share (money wage growth exceeds price plus productivity growth ), (ii) which would provoke faster inflation with feedback to rising interest rates, and (iii) resulting asset price deflation likely facing political resistance from Wall Street and affluent households.